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U.S. Securities and Exchange Commission

Securities and Exchange Commission
Washington, D.C.

Litigation Release No. 17744 / September 25, 2002

Release No. 1632 / September 25, 2002

Securities and Exchange Commission v. Dynegy Inc. Civil Action No. H-02-3623, U.S.D.C./Southern District of Texas (Houston Division)

In the Matter of Dynegy Inc.
Securities Exchange Act of 1934
Release Number 34-46537

SEC Settles Securities Fraud Case with Dynegy Inc. Involving SPEs and Round-Trip Energy Trades

The Securities and Exchange Commission announced today that it filed a settled enforcement action against Dynegy Inc., in connection with alleged accounting improprieties and misleading statements by the Houston-based energy production, distribution and trading company. The Commission's case arises from (i) Dynegy's improper accounting for and misleading disclosures relating to a $300 million financing transaction, known as Project Alpha, involving special-purpose entities (SPEs), and (ii) Dynegy's overstatement of its energy-trading activity resulting from "round-trip" or "wash" trades — simultaneous, pre-arranged buy-sell trades of energy with the same counter-party, at the same price and volume, and over the same term, resulting in neither profit nor loss to either transacting party.

The Commission issued a settled cease-and-desist Order against Dynegy and filed a settled civil suit in the Southern District of Texas, Houston Division, seeking a $3 million penalty. The Commission made findings in the cease-and-desist order (and alleged in the civil complaint) that Dynegy engaged in securities fraud in connection with its disclosures and accounting for Project Alpha, and negligently included materially misleading information about the round-trip energy trades in two press releases it issued in early 2002. In settlement of the Commission's enforcement action, Dynegy, without admitting or denying the Commission's findings, has agreed to the entry of the cease-and-desist order and to pay a $3 million penalty in a related civil suit filed in U.S. district court in Houston.

The Commission's investigation is continuing as to others.

More specifically, with respect to the action against Dynegy, the Commission's Order finds (and civil complaint alleges) as follows:

Project Alpha

By 2000, some energy analysts following Dynegy had noticed a widening gap between Dynegy's net income and operating cash flow. The gap resulted from Dynegy's recognition of net income in the form of unrealized gains from net forward positions, and the fact that the net forward positions generate no current cash flow. This treatment of unrealized gains as net income was required under "mark-to-market" accounting principles. In April of 2001, Dynegy closed on Project Alpha, a complex web of transactions involving SPEs, to boost its 2001 operating cash flow by $300 million, or 37%, and thereby reduce the gap between its net income and operating cash flow, as well as to achieve a $79 million tax benefit.

Dynegy defrauded the investing public by failing to disclose in its 2001 Form 10-K the true financing, as opposed to operating, nature of the $300 million. In reality, the $300 million was a loan masquerading as operating cash flow on Dynegy's 2001 Statement of Cash Flows. This is particularly significant for two reasons: first, analysts view operating cash flow as a key indicator of the financial health of energy trading firms such as Dynegy; and second, historically, the Statement of Cash Flows has been considered immune from cosmetic tampering.

In addition, Dynegy's accounting in its financial statements for the $300 million failed to conform to GAAP in at least two respects. Under Financial Accounting Standard 95, Dynegy should have accounted for the Alpha-related cash flow as financing, rather than operating, cash flow. Moreover, Dynegy failed to comply with the 3% at-risk requirement for SPEs. Consequently, Dynegy overstated net income in 2001 by 12% — the amount of the purported $79 million Alpha-linked tax benefit.

The Commission's Order emphasizes that public companies using off-balance sheet, special purpose entities must ensure not only that their accounting treatment complies with GAAP, but also, that they have accurately portrayed the economic realities of the transactions. In this case, Dynegy portrayed as operating cash flow what was essentially a loan. As a result, Dynegy investors were deceived.

Round-Trip Energy Trades

Dynegy issued materially misleading information to the investing public about the amount of trading on its electronic trading platform, Dynegydirect. On November 15, 2001, Dynegy entered into two massive "round-trip" electricity transactions. In a January 2002 press release, Dynegy included the notional trading value (multiple of volume, price and term) from one of these trades in a discussion of an increase in trading traffic on Dynegydirect. In an April 2002 press release, Dynegy included the results of these trades in its reported energy trading volume and in its first quarter 2002 revenues and cost of sales.

In both releases, Dynegy negligently failed to disclose that the resulting increases in energy trading volume, revenue and notional trading value were materially attributable to the round-trip trades. The contents of the press releases were also used in the offer and sale of securities. Because the round-trip trades lacked economic substance, Dynegy's statements were materially misleading to the investing public. This case is the first enforcement action resulting from an energy trading company's misleading disclosures regarding use of "round-trip" or "wash" trades.

Dynegy's Conduct after Contact by Commission Staff

Dynegy disclosed Alpha's impact on its financial performance in a Form 8-K that the company filed with the Commission on April 25, 2002, only after the Commission staff expressed to Dynegy concerns about Alpha. After those concerns were first raised, but before the filing of the Form 8-K, Dynegy's former Chief Financial Officer falsely stated to the public that Alpha's "primary purpose" was to secure a long-term natural gas supply, and Dynegy continued to assert that its obtaining a long-term gas supply was a principal purpose of Alpha. Dynegy officials did not, prior to Dynegy's filing of the Form 8-K, acknowledge that Alpha's principal purposes were, in fact, to minimize the gap between Dynegy's reported net income and reported operating cash flow and to realize an associated tax benefit.


The $3 million penalty imposed directly against Dynegy in this case reflects the Commission's dissatisfaction with Dynegy's lack of full cooperation in the early stages of the Commission's investigation, as discussed in the Commission's Order.

In assessing a penalty directly against Dynegy, the Commission was mindful of the impact that a penalty on a corporate entity can have on the entity's innocent shareholders. The amount of the penalty here reflects the commitment of the company's present board of directors to cooperate with the Commission and certain remedial actions undertaken by the company, as well as a careful balancing by the Commission between the need to encourage full cooperation and the desire to avoid imposing the economic consequences of a penalty on shareholders. As the Commission's investigation continues, it will consider the responsibility of and take appropriate actions against others with respect to the penalty that the company has agreed to pay.

The cease-and-desist order finds (and civil complaint alleges) that Dynegy, with regard to Project Alpha, violated, committed or caused violations of Sections 17(a)(1), (2) and (3) of the Securities Act, and Sections 10(b), 13(a) and 13(b)(2) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1, thereunder, and with regard to round-trip trading, Sections 17(a)(2) and (3) of the Securities Act and Section 13(b)(2) of the Exchange Act and Rule 13b2-1, thereunder.

SEC Complaint in this matter



Modified: 09/26/2002