MGT 506 – Financial Fraud Sham Related Party Transactions DYNEGY YVES BLECHNER DAI NGUYEN JIDE OLATEJU

Introduction 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 1) No stock splits since August 2000, thus lower stock price not a result thereof. Sources: www.dynegy.com finance.yahoo.com

Fraud Scheme… 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. related-party transactions)

…Fraud Scheme 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

Fraud Committed 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 Dynegy misled investing community by concealing financing cash flow as cash from operations in the amount of $300 million in order to close gap between net income and operating cash flow. Dynegy said that the funds from Project Alpha were for risk management activities rather than debt financing. Dynegy lied/denied the true purpose of Project Alpha, stating that the SPE was created “to secure a long-term natural gas supply,” when in fact it was meant to enhance the company’s operating cash flow and to achieve an “Alpha-linked tax benefit.” Dyney overstated its performance with energy trades engaging in round-trip transactions. Dynegy engaged in sham related-party transactions by buying and selling energy at pre-arranged buy/sell trades with the same counterparty, which had no economic effect for either party. This resulted in the overstatement of financial performance because the entities were not consolidated. Dynegy ignored its auditors with respect classification of the SPE as a consolidated entity by way of improper hedging of the risk to the equity investment in ABG Supply.

Detection & Investigation 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. The Enron scandal created an environment of suspicion of energy trading companies, leading to inquiries and investigations of the entire industry’s trading practices and finances by prosecutors and regulators, such as the Federal Energy Regulatory Commission, for the industry’s role in the California power crisis of 2000 and 2001. The possibility of fraud committed by Dynegy was first detected by a Wall Street Journal article in April 2002. The Wall Street Journal obtained internal documents that revealed Project Alpha was created for little other purpose than to increase cash flow and decrease taxes. The newspaper also reported the inaccurate accounting of cash flows related to Project Alpha. The WSJ attributed the cash flow analysis of Project Alpha to an unnamed fund manager who was short Dynegy stock. Sources: Associated Press, The Houston Chronicle, CNN Money Online, SEC Documents

Resolution: The Company 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. An SEC director stated that the amount of the penalty reflected the SEC’s dissatisfaction with Dynegy’s lack of full cooperation in the early stages of the Commission’s investigation. In addition, the penalty was balanced by the SEC’s desire to avoid penalizing innocent shareholders with the economic consequences of the penalty. In agreeing to accept Dynegy’s offer of settlement, the SEC also considered the steps the Company had taken to ensure employees’ compliance with the new company policy of prohibiting round-trip trades, as well as internal procedures implemented to ensure exclusion of illicit round-trip trades results from Dynegy’s public disclosures regarding its business activities. Sources: Associated Press, The Houston Chronicle, CNN Money Online, SEC Documents

Resolution: The Perpetrators 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.” As part of their plea bargain, Foster and Sharkey were required to testify in court proceedings. Foster and Sharkey face a maximum penalty of five years in prison without parole and a fine of $250,000 for their role in Project Alpha. Olis faces a maximum sentence of 35 years in prison. Sources: Associated Press, The Houston Chronicle, CNN Money Online, SEC Documents

Prevention 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.