Transcript Energy Trading in a Watershed Year

Identifying and Managing
Legal Risk Post-Enron
by
Andrea S. Kramer
Partner
McDermott, Will & Emery
<[email protected]>
Futures Industry Association
Expo
November 7, 2002
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Various Ways to Manage Risk
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Hedging activities
Insurance
Diversification and entry and exit strategies
State-of-the-art contracts, policies, and procedures
Tax compliance (federal and state)
Regulatory compliance (federal and state)
Securitizations and hybrid products
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Risk Management
“Risk management tools have emerged to help
market participants protect themselves against
uncertain price movements. Wholesale electric
power markets, while still developing, are
beginning to look like markets for other
commodities.”
– FERC Staff Report, 1998
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Board of Directors
Responsibilities
• Clearly establish overall risk philosophy
• Approve risk management policies and
procedures
• Support management needs for technical
capacities
• Evaluate risk management performance
• Oversee risk management activities
– designate and delegate various responsibilities
– risk management committee
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Types of Risks to Address
• Market Risk — the loss in market value of
a position due to unexpected changes
before position can be liquidated or offset
• Credit Risk — the risk a counterparty is
unable to meet its obligations or make
payments when due
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Types of Risks to Address
(Cont’d)
• Liquidity Risk
– market risk: can’t easily unwind or offset positions
– funding risk: unable to meet payment obligations
when due (such as margin calls)
• Operational Risk — Losses due to inadequate
systems, internal controls, human error, or
management failure
• Legal Risk — Losses due to unenforceability of
a contract, incorrect documentation, or
unexpected tax consequences
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Risks Not Easily Measured
• Operational Risk
• Legal Risk
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Risk Management
Operations
• Trading authorizations, approvals, limits,
and guidelines
• Approval of new products
• Monitoring operations
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Risk Management
Administration
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Master agreements and netting agreements
Scheduling procedures
Settlement procedures
Computer tracking
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Avoid Trading Surprises
• Set out trading authority and responsibilities
• Proper performance reviews and appropriate
compensation packages
• Employee screening and background checks
• Careful and ongoing monitoring to watch for
– trading authority and responsibilities
– trading model failure
– trading deceptions
– Front, Middle, and Back Office discrepancies
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Warning Signals to Prevent Trader
Deception
• Must understand and listen to warning signals to
avoid surprises
• Need to distinguish between warning signals
and “trader talk”
• What may be a warning signal in one situation
can be just “trader talk” in another situation
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Adequate Compliance Programs
• Develop company-wide culture to support internal
controls
• Senior management must support compliance efforts
• There must be adequate staffing and resources to
perform all compliance functions
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Adopt Ethics Codes
• Identify appropriate general conduct
• Provide “aspirational” Codes that express business
aims and intent
• Evaluate behavior and transactions as “right” and
“appropriate”
• Require employees to acknowledge compliance
with the Ethics Code
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Compliance Culture and Behavior
• Senior management supports the Ethics Code
• Communicate and reinforce ethical culture
throughout company
• Train employees
• Establish and enforce ethical values
• Conduct annual and spot compliance audits
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Employee Acknowledgements
• Received, read, and understand employee’s
responsibilities
• Will conduct activities consistent with terms,
philosophy, and spirit of all policies and procedures
• Will comply with all conflict of interest policies
• Will protect confidential and proprietary information
• All conversations will be conducted on recorded
lines, which may be monitored and taped
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Corporate Sentencing Guideline
Requirements
• Standards and procedures “reasonably capable”
of preventing criminal conduct
• Oversight by high-level personnel
• Careful delegation of discretionary authority
• Effective communication to all employees
• Reasonable steps taken to assure compliance
• Enforce disciplinary mechanisms
• Respond if an offense is detected
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New Corporate Reform Regulation
• Proposed Revised NYSE Corporate
Governance Standards
• Sarbanes-Oxley Act of 2002
• SEC Rulemaking
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NYSE Listing Requirements
• Pending rule changes will substantially raise
corporate governance standards
• Mandating “best practices” for all listed
companies
• Requires shareholders to vote on equitycompensation plans
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Sarbanes-Oxley
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Public companies
Officers and directors
Employees
Auditors
Investment bankers
Attorneys
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Sarbanes-Oxley
Summary
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CEO/CFO Certification
More “real-time” disclosure of events
Audit committee
Auditor independence
Accelerated Section 16 reporting
Retirement fund “blackout periods”
Prohibit loans to executive officers and
directors
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Sarbanes-Oxley
Loan Prohibition
• Broad blanket prohibition with limited
exceptions
• Material modifications not allowed to
existing loans
• May cover many compensatory agreements
• SEC guidance unlikely anytime soon
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Corporate Governance
Directors Duties Have Not Changed
• Directors have fiduciary duties to stockholders
• Company must be run for the benefit of the
stockholders
• Duty of Loyalty — must act in best interests of
the company, free from conflict with personal,
financial, or other interests
• Duty of Care — must make decisions on an
informed basis — which requires oversight of
risk management and legal compliance programs
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Corporate Governance
Business Judgment Rule
• Actions taken in good faith and on an informed
basis are usually protected from judicial scrutiny
and second-guessing
• Courts will not substitute their business
judgment for the judgment of the Board acting
without self-interest; but lack of self-dealing
must be carefully documented
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Corporate Governance
Acting on an Informed Basis
• Directors need to probe and understand
information and transactions under consideration
• Board micro-management is not required —
but if in doubt, Board should ask questions
• Directors can rely on internal reports (including
financial) if presented by employees reasonably
believed to be reliable
• Directors can rely on reports by outside advisors
reasonably believed to be qualified
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Corporate Governance
Acting on an Informed Basis - Practical Advice
• Directors must understand the operations, profit
model, and strategy of the company
• Management team must be committed to provide
and update this information
• Directors must study the information provided
and ask penetrating questions —
no “rubberstamping”
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Corporate Governance
Acting on an Informed Basis - Practical Advice
• Corporate governance guidelines — prepares the
Board for critical action by establishing policies
• Review basics (Board composition, setting
agenda items, handling Board materials, and
attendance of non-directors at meetings)
• Typically deals with holding Board meetings
without the CEO or management, selection of a
Director to lead such meetings, evaluation of the
CEO, and succession planning
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Corporate Governance
Acting on an Informed Basis - Practical Advice
• Orientation program for new directors (meeting
the CEO, the CFO, the heads of the key business
units, the general counsel and the auditor)
• Directors manual — a handy reference guide for
each director with key information and company
documents
• Directors should regularly get copies of media
coverage and the analyst reports on the company
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Corporate Governance
Bottom Line
• Corporate reform regulation raises the bar
for Directors in fulfilling their duties,
forcing a return to fundamentals
• Directors who do not comply with increased
standards and heightened stockholders
expectations face increased liability for
breach of duty
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Sarbanes-Oxley
Code of Business Conduct and Ethics
• Listed companies will be required to have and
publicly disclose a Code of Business Conduct and
Ethics, as well as a separate Code of Ethics for
Senior Financial Officers, and must also disclose
any subsequent changes or waivers to such codes
• Code of Conduct and Ethics policies currently in
place may need refinement, with new financial
executives code established once relevant NYSE
and SEC rules are finalized
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Sarbanes-Oxley
Whistleblower Protection
• Companies cannot discriminate against
employees who assist investigations of securities
law violations
• Audit committees must, subject to future SEC
rules, establish procedures:
– for handling complaints regarding accounting or
auditing matters, and
– for employees to submit confidential, anonymous
concerns regarding questionable practices
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Causes of Legal Risk
• Inadequate documentation (unintended
consequences)
• Counterparty lacks authority
• Transaction not permitted by applicable law
• Insolvency laws limit or alter contractual
remedies
• Unintended tax consequences
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Legal Review
• Counterparty capacity
• Counterparty authority
• Periodic review of agreements to update for
legal and market practice developments
• Customer appropriateness
• Tax compliance
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Contract Terms
Planning and Preparation
• Understand terms of contracts
• Are there liquidated damage provisions?
• Are there curtailment provisions for firm
transactions?
• What is emergency power, and under what
conditions is it sold?
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Why Documentation Is Critical
• Enforceability and the statute of frauds
– does the UCC apply
– Qualified Financial Contracts
• Activation of the material provisions
• Bankruptcy and insolvency protections
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Documentation Considerations
• Representations and warranties
• Force majeure
• Netting provisions
– payments
– delivery obligations
• Setoff provisions
• Events of default
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Counterparty Appropriateness
• Counterparty sophistication
• Counterparty needs
• Transaction complexity
• Maintain contact with counterparty’s
senior management
• Avoid counterparty confrontations
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Typical Contracts
• Swaps
• Caps
• Floors
• Collars
• Options
• Futures contracts
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Documentation
• Master Agreement
– recognized master agreement
– homegrown master agreement
• Netting Agreement
– cross-product master netting agreement
– homegrown netting agreement
• Futures Contracts
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Connecting The Documentation Pieces
•Master Agreement
•Schedule (or letter agreement with general
business terms)
•Confirmations (with specific deal terms)
•Credit Support Documents
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Legal and Risk Issues
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Designate principal contact persons
Confirm counterparty authority
Obtain consent to recording
Analyze credit risk
Provide traders with guidelines
Confirmations
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Guidelines
• Senior management must understand products
and their consequences
• Consider purposes and types of transactions
• Establish counterparty limits reflecting credit
issues and underlying economics
• Develop standard master agreements
• Provide for netting, set-off, and unwind
provisions
• Monitor compliance with policies, procedures,
and controls
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Preparation of Company Documents
• Lawful conduct can become suspect
• Avoid poor word choices and ambiguous
expressions
• Avoid careless or inappropriate language in
company communications
• Avoid “guilt” words (“Please destroy after reading”)
• Avoid exaggerated use of power words
(“This
program will ‘destroy’ our competition”)
• Use care when discussing competition and prices
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Beware: Communications Are
Not Secret or Confidential
• Common sources of damning evidence
• Xerox copies, telephone recorders, e-mail,
phone-mail, PC disks, e-calendars, and pocket
diaries
• All electronic data, including system databases,
system activity logs, word processing files, and
transaction data
• Business expressions and marketing terms can
appear suspect in a courtroom
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Brief Focus
on
Energy Markets
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Regulatory Considerations
• Once a product or practice is identified, is it
permissible?
– corporate authorizations, policies, and procedures?
– compliance with state laws?
• Is the product regulated by the FERC?
• Is the product regulated by the CFTC or SEC?
• Any other regulation? PUC or state insurance
commissions?
• If regulated, are there limitations on trading?
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CFTC Jurisdiction
• Exclusive jurisdiction over futures contracts
• Limited jurisdiction over certain forward
contracts of a cash commodity for deferred
shipment or delivery (fraud or manipulation)
• Limited jurisdiction over certain spot transactions
(fraud or manipulation)
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Price Manipulation
• Overlap between FERC and CFTC
• Potential conflicts over standards used to
determine if there has been manipulation
• FERC will follow CFTC’s definition in
Enron investigation
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The Commodity Exchange Act
Manipulation Violations
• Wrongdoer must have the ability to influence
market prices
• Wrongdoer must specifically intend to create an
artificial price
• The price of the commodity must be artificial
• Wrongdoer must have caused the artificial price
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Competition Law
Do’s and Dont’s
• Trading activities
– dealing with competitors
– bidding
– pricing
• Involvement in associations and group organizations
• Documents
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Trading Activities
Dealing With Competitors
• Price-fixing in forward markets and real time
markets
– bilateral contracts issues
– day of, day ahead, hour ahead issues
– real time imbalance market issues
• 1998 Midwest Price Spike – FERC found a
likelihood of conspiracy to send false signals to
the market
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Do Not Discuss With Competitors
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Present and future pricing decisions
Methods of determining or settling prices
Specific sales or marketing plans
Evaluation of specific market conditions
Specific counterpartys for products
Specific cost of production and selling
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Trading Activities
Pricing Issues
• Avoid implication that information on
competitor prices or plans was obtained
under a collusive arrangement or through an
unsanctioned trade association information
exchange program
• Avoid words that imply that a course of
action is a matter of “industry agreement”
or “industry policy”
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Competition Law Violations
Red Flags
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Substantial price increases
Fluctuations in supply
Concentrated suppliers
Association among suppliers
Organized efforts and frequent
communications among competitors
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Varying Market Power Standards
• “Market power
– FERC “just and reasonable” standard
– traditional antitrust “power to raise prices above
a competitive level”
– CFTC “artificial price” standard
• Market power can occur in niche markets
– ICAP
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Regulatory Environment in Flux
• The standard for judging trading behavior is still
being developed, but it appears to be very broad
• The standard applied and the remedies imposed
are likely to depend upon the magnitude of the
market price at issue
• The cost/price gap is becoming a proxy for what
is considered fair
• There is a high probability that trading behavior
and underlying data will be subject to review
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