MGT 506 – Financial Fraud Sham Related Party Transactions DYNEGY

1. MGT 506 – Financial FraudSham Related Party TransactionsDYNEGY YVES BLECHNER DAI NGUYEN JIDE OLATEJU

2. 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

3. 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)

4. …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

5. 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

6. 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.

7. 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.

8. 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.”

9. 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.