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Duke Settles SEC Charges Regarding Deficient Accounting Controls

The Securities and Exchange Commission said Friday that Duke Energy has agreed to settle charges of violations of the Securities Exchange Act of 1934 involving internal accounting control deficiencies that allowed three Duke Energy traders to misclassify $56.2 million in trading losses between Jan. 1, 2001 and June 30, 2002 in order to receive larger year-end bonuses. The three were indicted in April 2004 by the U.S. Attorney's Office for the Southern District of Texas (see Daily GPI, April 22, 2004).

Duke accepted a cease and desist order from the SEC on Friday but paid no fine in its settlement. In settling with the Commission, Duke neither admitted nor denied the SEC's findings.

The SEC explained that there is different accounting treatment for hedging and speculative trading transactions under Generally Accepted Accounting Principles (GAAP). If a transaction is properly designated a hedging transaction it qualifies for accrual accounting in which a portion of the gain or loss could be deferred until a later period. Conversely, gains or losses from speculative transactions should all be recognized currently in earnings, on a mark-to-market basis.

The SEC said that from 1997 through 2002, Duke's internal accounting controls were insufficient to ensure traders were properly recording their transactions. In fact, traders were manipulating Duke's books to maximize the size of their year-end bonuses and other performance-based compensation.

While Duke based bonuses on trading profitability over the year, it also allowed certain traders to have control over both accrual and mark-to-market accounted trading books, "thereby giving these traders an opportunity improperly to shift losses into their accrual books where at least a portion of the losses would not be recognized until a later period after the trader's annual bonus determinations already had been made."

The SEC said Duke failed to monitor traders to ensure proper accounting and failed to time stamp trading tickets, making it difficult to detect misclassifications. As a result, between Jan. 1, 2001 and June 30, 2002, three Duke employees, including two former vice presidents and an energy trader at Houston-based Duke Energy North America (DENA), were allowed to misclassify nearly $60 million in speculative trading losses. Those losses were improperly accounted for on an accrual basis when they should have gone on the books on a mark-to-market basis. As a result, these traders were awarded hefty bonuses by Duke for 2001.

In April 2004, the U.S. Attorney's Office for the Southern District of Texas issued an 18 count-indictment charging Timothy Kramer, 40, a former DENA vice president; Todd Reid, 41, former vice president; and Brian Lavielle, 33, a former energy trader, with racketeering, conspiracy, wire and mail fraud, money laundering and falsifying the corporate records of the Duke Energy subsidiary.

The indictment accused the men of conspiring to use round-trip energy trades and "other fraudulent devices" to buy and sell natural gas or power. Prosecutors alleged there were more than 400 trades that resulted in $50 million in fraudulent profits. Because of those profits, DENA paid cash and stock bonuses in 2001 to the men, including $5 million to Reid, $4 million to Kramer and $340,000 to Lavielle. All three pleaded innocent to the charges and two are still awaiting trial, a spokesman for the U.S. attorney's office said. Lavielle was convicted on Feb. 10 and is cooperating with the court.

Although the misclassifications didn't have a material impact on Duke's financial statements, Duke did violate the Securities Exchange Act which requires companies to keep accurate books and records in reasonable detail and maintain a system of internal controls to ensure that books and record conform with GAAP.

The SEC said Duke responded promptly with remedial action. "We took action to address these matters back in 2002 and have addressed these issues internally," said Duke spokesman Randy Wheeless.

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