The Commission found 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.
"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," said Harold F. Degenhardt, administrator of the Commission's Fort Worth Office. "In this case, Dynegy portrayed as operating cash flow what was essentially a loan. As a result, Dynegy investors were deceived."
Degenhardt added: "This is the first SEC enforcement action resulting from an energy trading company's use of so-called `round-trip' trades. Dynegy misled investors about the level of its energy trading activity by failing to disclose that the company's publicly released numbers included results inflated by such sham trades."
Stephen M. Cutler, director of the Commission's Division of Enforcement, noted: "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. Just as the Commission is prepared to reward companies that cooperate fully and completely with agency investigations, the Commission will also penalize those who do not. If companies wish to receive the maximum benefit from their cooperation, the cooperation must be complete and meaningful from the outset. Companies would be well advised to familiarize themselves fully with the Commission's Section 21(a) report on cooperation issued on October 23, 2001. "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," Cutler said. "The amount of the penalty here reflects the commitment of the company's present board of directors to cooperate with the Commission, 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." More specifically, the Commission's Order finds 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.
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.
In agreeing to accept Dynegy's offer of settlement, and in determining the proper remedies and penalties, the Commission considered Dynegy's conduct after contact by Commission staff, as well as the company's cooperation otherwise in connection with this matter. The Commission also considered the steps Dynegy has taken to ensure its employees' compliance with Dynegy's new policy prohibiting round-trip trades, and the internal procedures Dynegy has implemented to ensure exclusion of illicit round-trip trade results from Dynegy's public disclosures regarding its business activities.
