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July - Duke Energy Employee Advocate
Deregulation - December, 2001 - Page Six

“Enron was a major player during the utilities deregulation debate, for which Bush lobbied actively, and
in ‘tort reform,’ making it harder to sue corporations for the damage they do” - San Jose Mercury News

Nebulous Energy Accounting

The Wall Street Journal – by Jonathan Weil – December 30, 2001

(12/4/01) - With their industry's pioneer in bankruptcy court, the legions of energy companies that followed Enron's lead into the go-go world of commodity trading are finding their own profits and accounting practices under scrutiny as well. What ultimately triggered the collapse of investor confidence in Enron were its indecipherable disclosures for related-party transactions, compounded by its admitted financial misstatements and massive off-balance-sheet liabilities. But many critics say disclosure issues of a different sort dog the financial statements of most companies that trade electricity, natural gas and the like -- with the approval of the nation's accounting-rule makers.

At issue is a technique called "mark to market" accounting, under which the Financial Accounting Standards Board has given energy traders wide discretion to include as current earnings those profits they expect to realize in future periods from energy-related contracts and other derivative instruments.

For many energy-trading companies, significant chunks of earnings in recent years have come from recording unrealized, noncash gains through such accounting entries. Often, these profits depend on assumptions and estimates about future market factors, details of which the companies don't provide. And because of the minimal disclosure standards, it is difficult for investors to assess whose assumptions might be too aggressive, or what market changes might invalidate the assumptions -- and force earnings revisions.

"Whenever there's a considerable amount of discretion that companies have in reporting their earnings, one gets concerned that some companies may overstate those earnings in certain situations where they feel pressure to make earnings goals," says ABN Amro analyst Paul Patterson, who follows energy-trading firms.

Mark-to-market accounting is required whenever companies have outstanding energy-related contracts on their balance sheets, either as assets or liabilities, at the end of a quarter. For example, these could be agreements to sell electricity or buy natural gas over time at certain prices. Under the rules, companies estimate the fair values of the contracts. Quarterly changes in value -- representing unrealized, noncash gains and losses -- then are run through the companies' income statements.

One way to gauge the size of some companies' past unrealized gains is to dig through their cash-flow statements, which sometimes specify the noncash portion of trading gains. At Enron, unrealized trading gains accounted for slightly more than half of the company's $1.41 billion of originally reported pretax profit in 2000 and about a third of its originally reported pretax profit of $1.13 billion in 1999.

At Dynegy, unrealized gains accounted for nearly half its $762 million in 2000 pretax profit and about half its $227 million in 1999 pretax profit. Dynegy executives say there isn't anything wrong with the quality of their company's earnings. And they point to financial reports for the first nine months of 2001 showing that none of the company's reported earnings for this year came from unrealized gains.

Other energy traders whose earnings have been boosted in recent years by mark-to-market gains include American Electric Power, Duke Energy, El Paso, Entergy, Mirant, Pinnacle West Capital and Williams Cos.

How much discretion do energy traders have in valuing their contracts? The rule, pretty much, is that there aren't many rules.

For instance, during a conference last week sponsored by the FASB and the American Accounting Association, attendees were shown a hypothetical example under which the fair value of a power contract could range from $40 million to $153 million, depending on which assumptions of future trends were used.

And the mark-to-market rules that do exist for energy contracts were crafted in large part on approaches that Enron and other traders lobbied for. "We developed those rules," Enron's chief accounting officer, Richard Causey, said in an August interview.

Over the past three years, members of the FASB's Emerging Issues Task Force have extensively debated the subject of how to value energy-related contracts. What they have decided is that companies should be left to their own discretion, though the task force recognizes that could create problems. In a June 2000 report, for instance, the group noted that two companies in similar circumstances might apply different methods to estimate the fair value of their energy contracts, resulting in widely different valuations. "Those differences lead to the question of whether some of the methods in practice yield estimated amounts that are not representative of fair value," the report said.

The task force's chairman, Tim Lucas, says it simply is too difficult to draft a one-size-fits-all solution: "There's no one way to do it. There are various models, and we think it requires professional judgment to assess." Further, he says, requiring companies to disclose all the estimates underlying their earnings would produce disclosures so voluminous that they would be of little value.

That is in line with the industry's longtime position. In a June 2000 letter to Mr. Lucas, for instance, Mr. Causey said "the valuation process should be determined by individual companies," and the task force "should not address the valuation methodology for energy or energy related contracts."

In its financial filings, Dynegy explains that when market-price quotes aren't available for certain long-term contracts, "the lack of long-term pricing liquidity requires the use of mathematical models to value these commitments." As a result, actual cash returns may "vary, either positively or negatively, from the results estimated."

Quoted market prices offering independent guidance on many short-term energy contracts have become more readily available in recent years. Even then, there aren't rules specifying which market quotes companies must use. For instance, should companies mark their contracts based on the "bid" price, which is the price a market maker would offer to pay for a given contract? Or should they use the "ask" price, which is the price at which a trader is willing to sell? Or somewhere in between? Currently, individual companies decide for themselves.

On most contracts for short-term deliveries of natural gas, bid-ask spreads are fairly small, about 1% or so. But even for some short-term electricity contract prices quoted on Enron's now-shuttered online trading portal, spreads of 20% were common. On contracts for short-term delivery of telecommunications bandwidth, Enron often posted "ask" prices that were as much as eight times the posted "bid" prices.

For other long-term derivatives, such as electricity contracts stretching 20 years or longer, market quotes don't exist. In such cases, companies are allowed to base contract valuations on their own undisclosed estimates, covering everything from future commodity prices to credit risks and discount rates.

"It would seem wise for energy companies in this highly skeptical environment to provide the disclosures necessary for financial statement readers to understand the quality of their earnings, and provide the disclosures voluntarily," says Tom Linsmeier, an accounting professor at Michigan State University.

For now, however, energy traders aren't stepping up their disclosures. Dynegy's senior vice president and controller, Michael Mott, for instance, says his company "is committed to full disclosure and to eliminate any cloudiness around these disclosures." But he says Dynegy won't disclose any information about the market assumptions or methodologies underlying the unrealized gains it has recorded over the years. He says that would place Dynegy "at a competitive disadvantage in the marketplace."

Duke Paid Commissioner $20,000 a Month

10News, San Diego – December 29, 2001

Port Commissioner Helped Negotiate Duke's Contract With Port

SAN DIEGO - San Diego Port Commissioner David Malcolm was earning thousands of dollars a month from a power company accused of gouging customers for electricity during the energy crisis, 10News reported Friday.

Under terms of a contract with Duke Energy, Malcolm received $20,000 a month to "act in the best interests" of the power company and "not assist any competitor," according to a confidential letter from the port's attorney to Port Commission members, The San Diego Union-Tribune reported.

Malcolm served as a consultant to Duke from May 2000 to late April 2001, the newspaper reported. The company operates the South Bay Power Plant on property controlled by the San Diego Unified Port District.

Before Malcolm began working for Duke, he assisted in negotiating a long-term lease that allows the company to operate the power plant on the Chula Vista waterfront. The lease was signed in April 1999.

Local attorney Michael Aguirre, who has filed a class-action lawsuit against Duke alleging the firm overcharged customers during the energy crisis, said the relationship between Malcolm and Duke should be investigated by state authorities.

"The amount of money he was paid not only raises questions of fundamental integrity, but raises questions about whether Duke was involved in a scheme to pay off a key member of the Port District while ripping off the people of San Diego County," Aguirre told the Union-Tribune.

Aguirre said an investigation by the state Attorney General should look at whether Malcolm leaked information to Duke about port business.

"There's an inherent conflict between his working for Duke and his working for the port," Aguirre said. Malcolm said yesterday that he regrets entering into the contract with Duke, but denied that he had broken any laws.

"Nothing was hidden, I fully disclosed and reported," he said.

Chula Vista councilwoman Mary Salas said that Malcolm should resign and an investigation into his dealings with Duke should be conducted.

"Unfortunately, it's a pattern -- something that's been talked about in hushed tones for years," Salas said. "But the leadership in Chula Vista has chosen to close their eyes and look the other way."

Malcolm told the newspaper he plans to serve out his second term on the Port Commission, which expires in January 2003.

Tom Williams, a spokesperson for Duke Energy, claimed that Malcolm's contract with the power company was not a payoff.

"Not in any way, shape or form," he said.

Previous Stories:

Filner Calls For Public Takeover Of Duke Power

Democrats Will Not Sell Out to Enron

Forbes – by Dan Ackman – December 28, 2001

NEW YORK - In the weeks before filing bankruptcy, Enron continued its usual practice of giving massive contributions to political parties--but with a twist. Historically one of the largest contributors to Republican Party coffers, Enron contributed $100,000 to Democrats, according to an Associated Press report.

Enron gave the money to the Democratic Senatorial Campaign Committee, an organization that aids Senate Democratic candidates. But Robert Bennett, a Washington attorney representing Enron, said the contributions were business as usual, and were not intended to influence impending congressional investigations into the company's dramatic collapse.

"Donations of this type reflect certain political realities which are followed by all major corporations,'' Bennett told the Associated Press, referring to Enron's $50,000 checks issued on Nov. 25 and Nov. 26, just a week before Enron filed for bankruptcy protection on Dec. 2. The reality Bennett referred to was the return of Democratic control of the Senate. Many corporations, in fact, contribute to candidates and even more to political parties as such "soft money" contributions are subject to fewer regulations. But not many do it on the scale of Enron. In the 2000 election, the Houston-based company contributed more than $2.4 million in individual, soft money and political action committee (PAC) contributions to federal candidates and parties, according to the Center for Responsive Politics, a Washington-based nonprofit organization that tracks political contributions. The center ranked Enron among the top 50 donor organizations in the 1999-2000 election cycle.

Between 1989 and 1991, Enron's Chairman and Chief Executive Officer Kenneth Lay contributed $793,110 to Republicans and $86,470 to Democrats. Overall, 72% of Enron's contributions went to Republican organizations or candidates, according to a Center for Responsive Politics report. Lay is a close personal friend of President George W. Bush, and was one of the top fundraisers for his presidential and gubernatorial campaigns.

The contributions are a pittance for Enron and its executives: Lay was paid $123 million in total compensation in 2000 alone; and the company's vice chairman and chief financial officer were paid a total of $50 million that year. But the money helped allow Enron extraordinary access and even influence over state and federal political processes. Its business was helped immensely by the movement to deregulate energy markets.

A spokeswoman for the Democratic committee said it doesn't want Enron's money and that it was looking for an appropriate charity to which the cash could be redirected, perhaps to benefit Enron's ex-employees. This week, Democrats on the Senate Commerce Committee demanded that the Federal Trade Commission investigate why company executives were allowed to cash out their stock while other employees were prevented from selling the company's sinking shares in their retirement accounts.

Not surprisingly, the Senate's top recipients of Enron's largesse were Texas senators Kay Bailey Hutchison and Phil Gramm, both Republicans. But Charles Schumer (D-N.Y.), Michael Crapo (R-Idaho), Christopher Bond (D-Mo.), and Gordon Smith (R-Ore.) also received at least $18,000 each since 1989. Schumer and Crapo serve on the Senate Banking Committee. Bennett, who will represent Enron in dealings with Congress, said it would be "very unfair to draw any improper motive based on these contributions. While the money was given in November, a large portion of it had been committed as far back as September.'' September is two months before Enron's troubles became public, but a month after former CEO Jeffrey Skilling resigned from the company for still unexplained "personal reasons."

Before Enron, Bennett represented President Bill Clinton in the sexual harassment lawsuit filed by Paula Jones. That lawsuit, while ultimately dismissed, dragged on long enough to lead to the Monica Lewinsky scandal and Clinton's impeachment. One wonders if Bennett will attempt a tighter schedule in this case.

Washington to Join Enron Class-Action Suit

Seattle Times – by Drew DeSilver – December 28, 2001

OLYMPIA — Washington will join one of several class-action lawsuits against bankrupt Enron, though precisely what role the state will play may not be clear for months.

The State Investment Board, which manages pension funds and other assets, voted last week to join Ohio and Georgia in their planned suit against the energy company.

Enron's financial collapse and subsequent bankruptcy filing have caused its stock to lose nearly all its value. Dozens of shareholder lawsuits seek to recover some of what was lost.

Washington's board, which manages $54 billion in assets, at one time had $12 million in Enron stock and $112 million in the company's bonds in its portfolio. The stock was worth less than $1 million when it was sold, executive director James Parker said, and the bonds are now worth about $20 million.

The Enron stock was part of an index fund that mimicked the Standard & Poor's 500, Parker said, and was sold after the index dropped Enron late last month.

The multiple Enron suits eventually will be consolidated, Parker said, with one chosen as the lead case by whichever court assumes jurisdiction. If the Ohio-Georgia-Washington suit is chosen, the states would become co-lead plaintiffs, giving them more say in how the case is prosecuted or settled.

"You can just sign up as a member of the class and take what happens as it comes, or you can seek to be a little more active," he said, adding that Arizona also was considering joining.

The investment board, working through the Attorney General's Office, also is weighing whether to intervene in Enron's bankruptcy case, Parker said.

Because Enron was a very small part of the board's portfolio, and because most pension participants are in traditional plans with defined benefits, no pensions overseen by the board will be affected by Enron's bankruptcy, Parker said.

Deregulation Means Lost Benefits

The Legal Intelligencer – by Shannon P. Duffy - December 28, 2001

A divided 3rd U.S. Circuit Court of Appeals on Friday overturned an arbitrator's decision in a dispute between the Pennsylvania Power Co. and an electrical workers union after finding that the arbitrator's award did not "draw its essence from the collective bargaining agreement."

But a dissenting judge complained that the majority in Pennsylvania Power Co. v. Local Union 272 was ignoring a recent decision from the U.S. Supreme Court that severely restricted the scope of court review when arbitration awards are appealed.

The dispute began when Local 272 of the International Brotherhood of Electrical Workers, AFL-CIO, filed a grievance on behalf of workers who were denied voluntary retirement benefits. The claimants worked at the Bruce Mansfield plant in Shippingport, Pa.

Under a 1996 collective bargaining agreement, Pennsylvania Power and the union had agreed to "actively support and participate in a joint effort to improve the competitive position of the power plant."

Due to impending deregulation, the cooperative agreement provided for a "period of transformation" during which the company said it would use a voluntary retirement program if it needed to reduce the workforce.

The company had the sole power under the agreement to decide whether workforce reductions were necessary and whether the union had cooperated in attaining "production efficiency."

Pennsylvania Power struck similar agreements with the unions at its other plants in Pennsylvania and Ohio.

In 1998, the company told the Bruce Mansfield plant workers that it was not planning to reduce the workforce but that, even if it did, the workers would not be entitled to the voluntary retirement benefits because the union had failed to cooperate in the efficiency improvement efforts.

But workers at other plants were offered the benefits because the company determined that those unions had cooperated. And supervisory workers at Bruce Mansfield were also deemed entitled to the voluntary retirement package.

An arbitrator found that while the Bruce Mansfield union had failed to cooperate, the company had nonetheless violated the collective bargaining agreement by paying the voluntary retirement benefits to supervisory workers while denying them to union members.

Such disparate treatment, the arbitrator said, amounted to a violation of the anti-discrimination clause of the collective bargaining agreement in which the company promised not to "discriminate, coerce nor intimidate any employee because of membership or non-membership in the union."

The arbitrator's award required the company to provide the benefits to the Bruce Mansfield plant union workers.

Pennsylvania Power filed suit in U.S. District Court in Pittsburgh to challenge the award, but Judge Gary L. Lancaster refused to vacate it.

On appeal, Pennsylvania Power argued that the arbitrator's ruling did not "derive its essence" from the collective bargaining agreement but instead directly conflicted with it.

Senior 3rd Circuit Judge Max Rosenn found that because federal policy encourages arbitration awards, "there is a strong presumption in their favor."

Nonetheless, Rosenn said, courts can intervene when the arbitrator's decision does not draw its essence from the agreement or when the arbitrator is "dispensing his or her own brand of industrial justice."

Rosenn found that Pennsylvania Power was correct when it argued that the arbitrator "exceeded his powers" by issuing an award that effectively altered the agreement.

"He wrote into the contract that the plant production and maintenance employees shall have the same benefits as the supervisory employees. The agreement specifically excludes supervisory employees from its terms," Rosenn wrote in an opinion joined by 3rd Circuit Judge Maryanne Trump Barry.

Rosenn found that the arbitrator's reasoning was flawed because "nothing in the anti-discriminatory provision of the contract ... remotely provides a basis for a determination that the company discriminated against its union employees because it did not offer the same [voluntary retirement] benefits it afforded its supervisors."

Instead, Rosenn said, "Congress understood that the dynamics of industry and commerce required that loyalty owed by supervisory personnel to their employers excludes them from collective bargaining for rank-and-file employees."

Benefits usually differ between the two groups of workers, Rosenn said.

Since supervisors aren't legally considered "employees" as that term is defined in the National Labor Relations Act, Rosenn found that providing more benefits to them "cannot possibly constitute discrimination between employees."

Rosenn concluded that the arbitrator "strayed far beyond the scope of the arbitration" and that his award "has no basis in reality, law or industry practice."

In his closing paragraphs, Rosenn offered a blistering summation:

"What the arbitrator has wrought here not only alters and amends the collective bargaining agreement, but far exceeds the power of the arbitrator. Were it applied generally in the marketplace, it would wreak consternation and havoc throughout American industry. The award amounts to nothing more than the arbitrator's personal brand of justice with which we do not agree."


But in dissent, 3rd Circuit Judge Samuel A. Alito said his colleagues were guilty of the same offense they found in the arbitrator -- exceeding their power.

"Just last term, the Supreme Court reminded us how narrow our proper scope of review is in a case such as this," Alito wrote, citing the high court's decision in Eastern Associated Coal Corp. v. United Mine Workers of America.

Alito said the high court emphasized that when companies and unions give arbitrators the power to interpret their contracts, they have "bargained for the arbitrator's construction of their agreement ... and courts will set aside the arbitrator's interpretation of what their agreement means only in rare instances."

The majority, Alito said, had set aside an arbitrator's decision simply because it "strongly disagreed" with it.

Alito said he, too, found the arbitrator's interpretation less convincing than the one offered by his colleagues.

"But I cannot agree that the arbitrator's decision did not 'draw its essence from the contract' or that the arbitrator was not 'even arguably construing the contract,' " Alito wrote.

Instead, Alito said, the arbitrator's decision was based on his interpretation of the anti-discrimination provision in the contract.

"That the arbitrator probably misconstrued that provision is beside the point. The parties bargained for the arbitrator's construction of the agreement and that is what they got," Alito wrote.

"By intervening to rescue the Pennsylvania Power Co. from one of the consequences of its bargain, the majority has exceeded the proper scope of our court's authority."

Pennsylvania Power was represented by attorneys James A. Prozzi and A. Patricia Diulus-Myers of Jackson Lewis in Pittsburgh.

The union was represented by attorney Joshua M. Bloom of Gatz Cohen in Pittsburgh.

Deregulation - December, 2001 - Page 5