J.P. Morgan Staring at Record Fine Over Energy

July 17, 2013
The Wall Street Journal
Dan Fitzpatrick, Rebecca Smith, and Ryan Tracy

Bank Set to Pay Hundreds of Millions of Dollars Over Allegations of Electricity-Market Manipulation

J.P. Morgan Chase & Co. is in discussions with U.S. electricity regulators about paying what would be a record fine to settle allegations that the bank manipulated electricity markets in California and the Midwest, according to people familiar with the talks.

The Federal Energy Regulatory Commission and the New York bank are exchanging drafts of an agreement that would result in J.P. Morgan paying hundreds of millions of dollars, these people said. The fine, they said, likely will be larger than the record $435 million fine levied by FERC on Tuesday against British bank Barclays BARC.LN PLC for its alleged manipulation of the California energy markets from 2006 to 2008. Barclays said on Wednesday that it intends to fight the matter in court.

The settlement discussions had included a possible fine of close to $1 billion, but the figure has gotten smaller as talks have progressed, these people said.

It isn't clear whether J.P. Morgan will admit wrongdoing as part of a settlement, and the discussions still could fall apart, the people close to the talks said. Spokesmen for J.P. Morgan and FERC declined to comment.

The possible deal is a sign of the increasingly aggressive stance taken by FERC, a low-profile federal agency that oversees transmission lines, natural-gas pipelines and power trading markets across the U.S. Using enforcement muscle beefed up in the wake of Enron Corp.'s collapse, the agency is broadly scrutinizing potential manipulation of energy markets and has sought fines from Wall Street firms that include Barclays and Deutsche Bank AG, DBK.XE which settled with FERC.

Many of the biggest U.S. banks and trading firms began buying and selling power in the nation's deregulated energy markets following a California energy crisis in 2001, which was caused in part by manipulative trading behavior linked to Enron.

Following Enron's collapse, FERC received authority from Congress to levy fines of up to $1 million per violation per day, up from $10,000 per violation. It has assessed $291 million in penalties since 2007 in 78 separate enforcement actions.

FERC Chairman Jon Wellinghoff has said the agency's goal is to punish alleged market manipulators so much that they don't try to rig the market again.

J.P. Morgan has disputed FERC's allegations, and the question of whether to settle has divided some executives within the bank.

J.P. Morgan commodities chief Blythe Masters recommended the firm reject an earlier offer from FERC that involved a payout of close to $1 billion and a trading ban for three employees, according to two people familiar with the matter. Her view was these employees and the bank did nothing wrong, these people said. Ms. Masters declined to comment.

There is now a strong movement within J.P. Morgan to get a deal done quickly amid heightened regulatory scrutiny on several fronts, according to someone with knowledge of the deliberations.

The company already expects to be hit with other enforcement actions targeting alleged weaknesses in its consumer operations, and it is working through four other regulatory enforcement actions addressing what regulators have described as risk-management problems related to a trading loss that cost it more than $6 billion, and anti-money-laundering fixes.

The firm has redeployed hundreds of employees to handle the regulatory requests, and its legal costs are escalating. J.P. Morgan added $600 million to its litigation reserves in the second quarter, but it didn't give a reason why it did so.

FERC notified the New York bank in March that it intended to recommend an enforcement action against its power-trading unit, J.P. Morgan Ventures Energy Corp.

The notice alleged the bank misrepresented the prices of electricity contracts with California and the Midwest that resulted in overpayments, and that Ms. Masters and three other traders had made false representations under oath, according to a person familiar with the document.

J.P. Morgan has said it disputes the allegations, defending its behavior aggressively in a formal response to FERC that ran hundreds of pages long, said a person familiar with that document.

FERC officials have said any improper payments to generators are ultimately borne by the households, businesses and government entities that are end users of electricity, although whether that happened in the J.P. Morgan case isn't known. The amount of improper payments to J.P. Morgan alleged by FERC totaled at least $73 million, according to a court filing.

The enforcement push is tied to deregulation of U.S. electricity markets that began in the early 1990s.

By the end of the decade, the most populous states, including California, Texas and New York—which also faced the highest retail electricity prices—had all reorganized their electricity markets. Regional organizations were created to run markets in which wholesale electricity could be bought and sold each day. All except the one in Texas operated under FERC oversight.

J.P. Morgan began buying and selling energy largely because of its 2008 purchase of securities firm Bear Stearns Cos., which had a power group based in Houston.

The unit gave the bank a new revenue source amid regulatory clampdowns on practices that previously fattened bank profit margins, such as trading with its own capital. It also allowed the bank to tap a larger corporate client base.

The accusations against J.P. Morgan caught the attention of regulators in early 2011 when the California Independent System Operator, which oversees the daily trading that sets wholesale electricity prices in the state, saw bidding strategies it believed allowed J.P. Morgan's energy trading unit to extract excessive profits from the market, according to regulatory filings FERC has said describe the allegations against J.P. Morgan. The California ISO referred the matter to FERC for enforcement.

The filings don't mention J.P. Morgan, but they show that market monitors in California and the Midwest focused on the alleged manipulation of "make-whole" payments that electricity providers are supposed to receive in the event that their revenue on a given day doesn't cover the fixed costs for starting up a power plant. At the time, the bank's traders were handling the sale of electricity from power plants in Southern California owned by AES Corp. AES has declined to comment.

The filings describe the strategy this way: Traders would submit a relatively low bid to deliver electricity in the "day-ahead" market, ensuring that system operators would schedule their power plant to turn on the following day.

Then the traders would make an offer the next day to deliver electricity from that same plant at a relatively high price, which prevented them from being chosen to provide electricity that day.

While the traders might lose money because they weren't dispatched to generate power, they would also be eligible for a "make-whole" payment because their power plant unit had been scheduled the day ahead to deliver a substantial amount of electricity. The "make-whole" payment could cover any losses and generate a profit for the firm overall.

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