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

FINANCIAL FRAUD SCHEME

DYNEGY

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 (SPEs) in April
2001
The SPEs are involved in a complex web of transactions (i.e. relatedparty transactions)
FINANCIAL FRAUD SCHEME

DYNEGY

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

FINANCIAL FRAUD SCHEME

DYNEGY

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 Dynegys 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

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.
SECs 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
Alphas $300MM financing transaction.
Overstatement of energy trading activity resulting from round-trip trades.
FINANCIAL FRAUD SCHEME

DYNEGY

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 SECs findings of: securities fraud
resulting from the companys improper accounting of Project Alpha and
misleading statements about the true nature of the SPE and the firms
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

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.
FINANCIAL FRAUD SCHEME

DYNEGY

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.
FINANCIAL FRAUD SCHEME

DYNEGY