• Dynegy is an energy production, distribution and trading company.
• Energy products include natural gas, electricity, natural gas liquids, and coal.
• Distribution network is focused on North America
• Headquarters are in Houston, Texas (cf. Enron).
• NYSE Ticker Symbol: DYN
• Market Capitalization (as of Feb. 1, 2004): $1.69 BN
• Share Price (as of Feb. 1, 2004): $4.47
• Share Price as of April, 2002 (pre-fraud): approx. $30
FINANCIAL FRAUD SCHEME DYNEGY

• Gap between net income and cash flow from operations
• Causes of the gap:
- Recognition of net income in the form of unrealized gains from net forward positions
- Net forward positions generate no current cash flow
- This treatment of unrealized gains as net income was required under
"mark-to-market" accounting principles
• Dynegy wanted to plug the gap:
- Project Alpha: Creation of Special Purpose Entities (SPE’s) in April
2001
• The SPE’s are involved in a complex web of transactions (i.e. relatedparty transactions)
FINANCIAL FRAUD SCHEME DYNEGY

• First phase in fraud (duration: 9 months):
- SPE funded by loans from Citibank, Deutsche Bank, and CSFB
- SPE buys natural gas at market price
- SPE sells natural gas to Dynegy at a discount
- Dynegy sells natural gas at market price
• Second phase in fraud (expected duration: 51 months):
– SPE buys natural gas at market price
– SPE sells natural gas to Dynegy at a premium
– SPE repays creditors with funds from sale to Dynegy
• Result:
- 2001 cash flow from operations increased by $300 MM, or 37%, thus reducing the gap between net income and operating cash flow
- Dynegy obtained a $79 MM tax benefit
FINANCIAL FRAUD SCHEME DYNEGY

• Concealed financing cash flow as cash flow from operations
• Announced that funds from Project Alpha are for “risk management activities” rather than debt financing
• Lied about the true purpose of Project Alpha:
- Stated that the SPE was created to “secure a long-term natural gas supply”
- In reality: Project Alpha served to enhance Dynegy’s cash flow from operations and to obtain a tax benefit
• Overstated performance of energy trading activities by engaging in round-trip transactions:
- Buying and selling energy at pre-arranged buy & sell prices with the same counterparty (sham related-party transactions)
- Should have no economic effect, but the entities were not consolidated -> overstatement of performance
• Ignored auditors with respect to the classification of the SPE as a consolidated entity
FINANCIAL FRAUD SCHEME DYNEGY

• The energy industry was under intense scrutiny due to the Enron scandal.
• Possible fraud relating to Project Alpha was first detected by a Wall
Street Journal article criticizing the transaction in April 2002.
• The newspaper article prompted the SEC to contact Dynegy and to begin an informal inquiry of Project Alpha and the company.
• SEC’s informal inquiry of Dynegy upgraded to a formal investigation in May 2002.
• The SEC filed an enforcement action against Dynegy in September
2002 based on findings of:
– Improper accounting for and misleading disclosures relating to Project
Alpha’s $300MM financing transaction.
– Overstatement of energy trading activity resulting from round-trip trades.
FINANCIAL FRAUD SCHEME DYNEGY

• Dynegy paid a $3MM civil penalty to settle a SEC enforcement action related to Project Alpha in September 2002. As part of the settlement,
Dynegy:
– Agreed to cease and desist from violating anti-fraud provisions of securities laws.
– Neither admitted nor denied the SEC’s findings of: securities fraud resulting from the company’s improper accounting of Project Alpha and misleading statements about the true nature of the SPE and the firm’s round-trip energy trades.
• The company later restated its 2001 financial statements to correctly account for the $300MM as cash from financing rather than operations and erased the $79MM tax benefit achieved by Project Alpha.
FINANCIAL FRAUD SCHEME DYNEGY

• A federal grand jury issued a criminal indictment of the three Dynegy employees involved in Project Alpha in June 2003 on charges of conspiracy, securities fraud, mail fraud and wire fraud.
– Gene Foster, CPA, VP of Taxation: Pleaded guilty in August 2003.
– Helen Sharkey, CPA, Manager-Accounting, Deal Structure: Pleaded guilty in August 2003.
– Jamie Olis, Sr. Director, Tax Planning: Found guilty by a federal jury in
November 2003.
• A civil suit filed by the SEC against the three Dynegy employees sought fines and “disgorgement of the defendants’ ill-gotten gains, which included bonuses and trading profits received during the period of their misconduct.”
FINANCIAL FRAUD SCHEME DYNEGY

• Acknowledge the gap between cash flow from operations and net income and explain its causes (mark-to-market accounting principles in relation to net forward positions)
• Investigate legitimate ways of closing the gap (rather than a quick fix)
• Be open and honest with analysts and investing public
• Employees that are given stock and/or stock options as part of their compensation have particular incentives:
- Create a method to oversee the actions of such employees in executive roles more closely
• Create an independent internal audit department reporting to the board
Audit Committee
• Have the Audit Committee guarantee that management implements auditors’ recommendations.
FINANCIAL FRAUD SCHEME DYNEGY