Adams v. Kinder-Morgan, Inc. , 340 F.3d 1083 ( 2003 )

F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
AUG 11 2003
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT
JAMES E. ADAMS; STANLEY R.
LAMB; ANTHONY VARTULI, on
behalf of themselves and all others
similarly situated,
Plaintiffs - Appellants,
v.
No. 02-1208
KINDER-MORGAN, INC., formerly
known as KN Energy Inc.; LARRY D.
HALL; CLYDE E. MCKENZIE, II;
RICHARD KINDER,
Defendants - Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF COLORADO
(D.C. No. 00-N-516)
Michael G. Lange, Berman, DeValerio, Pease, Tabacco, Burt & Pucillo, Boston,
Massachusetts (Michael T. Matraia, Berman, DeValerio, Pease, Tabacco, Burt &
Pucillo, Boston, Massachusetts; Gary C. Davenport and Eric Beltzer, McGloin,
Davenport, Severson & Snow, P.A., Denver, Colorado; and Curtis V. Trinko, Law
Offices of Curtis V. Trinko, LLP, New York, New York, with him on the briefs)
for Plaintiffs-Appellants.
Michael A. Noone, The Beatty Law Firm, P.C., Denver, Colorado (Michael L.
Beatty and John E. Matter with him on the brief), for Defendant-Appellee Kinder-
Morgan, Inc.
Susan Bernhardt, Netzorg, McKeever, Koclanes & Bernhardt, LLC, Denver,
Colorado, for Defendants-Appellees Larry D. Hall and Clyde E. McKenzie.
Gayle Boone, Bracewell & Patterson, LLP, Dallas, Texas (J. Clifford Gunter III,
Bracewell & Patterson, LLP, Houston, Texas, on the brief), for Defendant-
Appellee Richard Kinder.
Before EBEL, Circuit Judge, McWILLIAMS, Senior Circuit Judge, and
ARMIJO, District Judge. *
EBEL, Circuit Judge.
The plaintiffs brought this lawsuit as a class action alleging securities fraud
under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“the
Act”), 15 U.S.C. §§ 78j(b), 78t(a), and Rule 10b-5, 17 C.F.R. § 240.10b-5, on
behalf of all people who purchased the common stock of KN Energy, Inc.
(“Kinder-Morgan” or “the Company”) 1 from October 30, 1997 to June 21, 1999
(the “class period”). The plaintiffs appeal the district court’s dismissal of the
case pursuant to Fed. R. Civ. P. 12(b)(6).
*
The Honorable M. Christina Armijo, United States District Judge for the
District of New Mexico, sitting by designation.
1
In October 1998, after the events at issue in this litigation, KN Energy,
Inc. merged with Kinder Morgan Delaware. The resulting company was named
Kinder-Morgan, Inc., which is the successor-in-interest of KN Energy, Inc. and
the corporate defendant in this case. We will refer to the corporate defendant as
Kinder-Morgan even though during most of the period relevant to this case the
corporate entity accused of wrongdoing by the plaintiffs was KN Energy, Inc.
-2-
The basis for the lawsuit is the plaintiffs’ allegations that the defendants
made misleading statements about Kinder-Morgan’s profitability during the class
period. They claim that the defendants reported that a key business of the
Company was profitable when in fact it was losing money, and that Kinder-
Morgan engaged in transactions that violated Generally Accepted Accounting
Principles (“GAAP”) and the Company’s own accounting policy in order to inflate
net income, even as the defendants reported that their financial reporting
complied with GAAP. The defendants took these actions, the plaintiffs allege, to
sell securities at favorable prices to finance an acquisition and to facilitate
completion of a merger.
After the plaintiffs twice amended their complaint, the district court
dismissed the complaint pursuant to Fed. R. Civ. P. 12(b)(6), stating that the
second amended complaint failed to satisfy the pleading requirements for
securities fraud established by the Private Securities Litigation Reform Act
(“PSLRA”), 15 U.S.C. § 78u-4(b)(1) and (2). Section 78u-4(b)(1) requires
plaintiffs to specify the statements by the defendants they allege were misleading,
the reasons why the statements were misleading, and, if the allegations in their
complaint are made upon information and belief, to state with particularity all
facts supporting their belief that the statements were false or misleading. Section
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78u-4(b)(2) requires that plaintiffs’ allegations give rise to a strong inference of
scienter.
We have previously ruled on what is required for plaintiffs to plead scienter
sufficiently under § 78u-4(b)(2) of the PSLRA. See City of Philadelphia v.
Fleming Cos., Inc., 264 F.3d 1245, 1248–49 (10th Cir. 2001). We have not yet,
however, had occasion to rule on what is required to satisfy the pleading
requirement of § 78u-4(b)(1) that facts supporting a complaint made on
information and belief be stated with particularity in the complaint.
The district court had jurisdiction over this case pursuant to Section 27 of
the Act, 15 U.S.C. § 78aa and 28 U.S.C. § 1331, and we have jurisdiction to
review the district court’s dismissal of the action under 28 U.S.C. § 1291. We
hold that the second amended complaint pled facts with sufficient particularity to
satisfy the § 78u-4(b)(1) standards for pleadings made on information and belief.
We conclude, however, that the complaint adequately pleads scienter under § 78u-
4(b)(2) only as to defendants Kinder-Morgan, Hall, and McKenzie. We also find
that the complaint adequately pleads control person liability under § 78t(a) as to
Hall and McKenzie, but not as to Kinder. Accordingly, we REVERSE the district
court’s dismissal of the complaint as to defendants Kinder-Morgan, Hall, and
McKenzie. We AFFIRM the dismissal of the complaint as to Kinder.
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I. BACKGROUND
Because this is an appeal from a motion to dismiss, we accept all well-
pleaded facts, as distinguished from conclusory allegations, as true. Ruiz v.
McDonnell, 299 F.3d 1173, 1181 (10th Cir. 2002), cert. denied, 123 S. Ct. 1908(2003).
At the time of the events underlying the complaint in this case, Kinder-
Morgan was the nation’s sixth largest integrated natural gas company and had
more than $8 billion in assets. Its operations spanned sixteen states and included
the gathering, processing, storage, marketing, and transportation of natural gas
and natural gas liquids. During the class period, Larry D. Hall was president and
chief executive officer of Kinder-Morgan, Clyde E. McKenzie was vice president
and chief financial officer of the Company, and Richard Kinder was a director of
the Company. The plaintiffs are investors who purchased shares of Kinder-
Morgan common stock during the class period, October 30, 1997 to June 21,
1999.
The plaintiffs’ securities fraud claims focus upon transactions and business
operations in, and corporate reports and press releases related to, three areas of
Kinder-Morgan’s business: the Bushton Gas Processing Complex (the “Bushton
Plant”), a contract to supply natural gas to the University of Colorado
Cogeneration Plant (the “CU Cogen contract”), and a transaction with an alleged
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shell company called Blue Moon Holdings. The crux of the fraud allegations is
that Kinder-Morgan overstated its net income, and thereby masked operational
problems, by accelerating the recording of income in violation of Generally
Accepted Accounting Procedures.
A. The Bushton Plant
Kinder-Morgan purchased the Bushton Plant from Enron in March 1997.
The plaintiffs allege that, despite Kinder-Morgan’s statements to the contrary, the
Bushton Plant was unprofitable during the third quarter of 1997 and was a
significant cash drain on the Company. The Bushton Plant was initially
unprofitable because Kinder-Morgan was obligated to make lease payments on the
plant of $23 million per year. Immediately prior to the acquisition of the Bushton
Plant, Rose Robeson, the Assistant Treasurer of Kinder-Morgan at the time, told
defendant Clyde McKenzie and John DiNardo, a Kinder-Morgan vice president,
that their positive financial projections for the plant were incorrect and that,
because of the $23 million lease payment, the Bushton Plant would not be
profitable. During the third quarter of 1997, McKenzie and DiNardo frequently
went to Robeson’s office to complain to her about how the Bushton Plant was
losing money and to ask her how they could get out of the lease.
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Another reason it was alleged that the Bushton Plant was unprofitable was
the “keep whole” contracts to which the Plant was a party. Under such contracts,
the Bushton Plant processed natural gas for third parties to remove natural gas
liquids (“NGLs”), which Bushton sold separately from natural gas. In exchange
for being able to keep the NGLs to sell itself, Bushton was obligated to “keep
whole” the third parties for the reduction in the energy content of their natural gas
stream associated with the removal of NGLs. That is, Bushton had to replace the
NGLs with processed natural gas containing an equivalent amount of energy. As
long as the market value of the processed gas that Bushton had to provide to keep
the third parties whole was less than the value of the NGLs it sold for itself, it
could turn a profit under the contracts. The risk under “keep whole” contracts,
however, was the possibility of a price inversion. A price inversion is a market
condition in which the value of the processed gas Bushton had to contribute under
the contracts exceeded the value of the NGLs it extracted. In this situation, the
contracts would be unprofitable. The complaint alleges that the Bushton Plant
suffered from a price inversion affecting the profitability of its “keep whole”
contracts. In the Spring of 1998, DiNardo held a meeting with employees to
discuss the problems at the Bushton Plant, and at that meeting he reported that
Bushton was generating losses of as much as $700,000 per month.
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The complaint states that to hide the operational problems at the Bushton
Plant, Kinder-Morgan accelerated, in violation of Generally Accepted Accounting
Principles (“GAAP”) and the Company’s own revenue recognition policy, the
recording of income from three contracts associated with the Bushton Plant. 2
Specifically, the plaintiffs point to contracts with three energy companies: Louis
Dreyfus Natural Gas Corp., KMEP (an entity in which defendant Richard Kinder
was chairman and CEO), and Koch Industries, Inc. By recording the income from
these contracts before it had actually been earned and received, the plaintiffs
allege that Kinder-Morgan inflated the Company’s financial results for the 1997
third quarter and fiscal year.
The Dreyfus and KMEP contracts obligated Kinder-Morgan to store natural
gas liquids over five-year periods in exchange for total payments of
approximately $3.5 million. The Koch contract required Kinder-Morgan to
refrain from operating a “butane liquid isomerization unit” at Bushton for a ten-
year period, in exchange for payments totaling $18 million over the life of the
2
The plaintiffs allege that GAAP includes the principle that revenue, and
the income earned from that revenue, must be earned before it is recognized on a
company’s books. For example, when a company has a contract to provide
services for a fixed price, the company should not record the receipt of the price
for its services until they are actually delivered.
Kinder-Morgan appeared to embrace this principle in its own stated polices.
The Company’s 1997 Annual Report of Form 10-K stated: “(D) Revenue
Recognition Policies. In general, the Company recognizes revenues as services
are rendered or goods are delivered.”
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contract. The complaint alleges how Kinder-Morgan allegedly accelerated
recognition of the income due under the contracts:
In order to record inflated earnings, [Kinder-Morgan] reduced the
Louis Dreyfus, KMEP and Koch contracts to their present value as of
the third quarter of fiscal year 1997 and recorded the present value of
the contract as income. The present value of the three contracts is
approximately $14,300,000. Recording transactions in this manner
violated GAAP because [Kinder-Morgan]’s performance obligations
were not complete. The Company was still obligated to provide
storage services and refrain from operating the isomerization unit
well into the future. Under these circumstances, income should have
been recorded ratably over the life of the contract. As a result of
accelerating the revenue recognition, third quarter and fiscal year
1997 net income was overstated by approximately $14,300,000.
Second Am. Compl. at 23, ¶ 87. Without the accelerated income recognition, the
Bushton facility would have recorded a loss of approximately $10 million in the
third quarter of 1997 instead of the $5.1 million of operating income recorded by
the company in the Form 10-Q it filed for that quarter. Despite the fact Bushton
actually was losing money and had profits only because of the allegedly improper
income recognition, Kinder-Morgan stated in reporting its financial results for the
third quarter of 1997 that the Bushton plant “positively impacted [Kinder-
Morgan’s] earnings.”
B. The CU Cogen Contract
The plaintiffs allege that Kinder-Morgan also improperly accelerated the
recognition of income related to its twelve-year contract to provide natural gas to
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the University of Colorado cogeneration facility. Rather than simply book the
present value of the future income from this contract as it did with the three
Bushton contracts, Kinder-Morgan realized the present value of the CU Cogen
profits by entering into an undisclosed contract with Enron. Under the terms of
the deal, Enron paid Kinder-Morgan $6 million, which represented the estimated
profit Kinder-Morgan was to realize during the four years that remained in the
term of the CU Cogen contract. Enron made the one-time payment to Kinder-
Morgan in the first quarter of 1998, and Kinder-Morgan recorded it as income
during that quarter.
The deal with Enron involved the creation of a “dummy” corporation called
Red Rock LLC. Enron owned 100% of the Class A shares of Red Rock, entitling
Enron to all of Red Rock’s dividends. Kinder-Morgan owned all of the Class B
or C shares of Red Rock. The complaint alleges that Kinder-Morgan assigned the
CU Cogen contract to Red Rock to create the appearance that it was not legally
liable to provide the gas to the University of Colorado. In fact, Kinder-Morgan
was still obligated to provide the gas required by the CU Cogen contract for the
contract’s duration. The complaint alleges, however, that when the CU Cogen
plant paid Kinder-Morgan for the gas supplied, Kinder-Morgan forwarded these
payments to Red Rock. Enron then would remove the payments from Red Rock
as a dividend. Thus, the transaction permitted Kinder-Morgan to record
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$6 million of income in the first quarter of 1998 without having completed its
obligations under the CU Cogen contract as required by GAAP.
Arthur Andersen LLP, Kinder-Morgan’s independent auditor, examined the
CU Cogen transaction and questioned whether it complied with GAAP. The issue
was resolved, the complaint alleges, when Kinder-Morgan management pressured
Arthur Andersen to approve the transaction, and the auditor acquiesced. As a
result of the improper booking of profits from the CU Cogen contract, Kinder-
Morgan inflated the net income it reported for the first quarter of 1998 in its
filings with the SEC. The $6 million profit recorded as a result of the Enron deal
represented 27% of the $22.5 million in net income reported by Kinder-Morgan
for the first quarter of 1998. Without the alleged improper income recognition,
Kinder-Morgan would have reported net income of only $16.4 million for the first
quarter of 1998.
C. The Blue Moon Transaction
The plaintiffs alleged that Kinder-Morgan engaged in another transaction
involving a dummy corporation, this one called Blue Moon Holdings. This
transaction occurred sometime in 1998 and involved the improper recognition of
at least $2 million in income. The complaint provides no further details about
this transaction.
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D. Motives for Overstating Kinder-Morgan’s Financial Results
The plaintiffs allege two primary motives for the defendants’ issuance of
misleading statements about Kinder-Morgan’s financial performance. The first
was their desire to have Kinder-Morgan issue securities to finance the Company’s
December 1997 acquisition of MidCon, a natural gas transmission and marketing
subsidiary. Kinder-Morgan engaged in four transactions in 1998 involving the
issuance of approximately $ 4 billion in securities, and the plaintiffs allege that
Kinder-Morgan overstated its financial performance to ensure that these securities
would be sold at prices favorable to it.
The second alleged motive for the misleading statements was the
defendants’ desire to hide operational problems that could have undermined a
planned merger with Sempra Energy that was announced in March 1999. The
plaintiffs alleged that the individual defendants stood to gain personally from a
completed merger with Sempra. Larry Hall allegedly would have received a
$1.87 million severance package and a yearly consulting fee of $800,000 if the
merger closed. Clyde McKenzie allegedly would have received a severance
payment of approximately $500,000. Sempra walked away from the merger,
however, when it allegedly discovered during due diligence Kinder-Morgan’s
improper accounting and the poor performance of the Company’s operations.
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When the Sempra merger collapsed, so did the price of Kinder-Morgan’s
common stock. On the last trading day prior to the announcement that the merger
had been called off, Kinder-Morgan shares traded at $21.25 per share. On the day
of the announcement, Kinder-Morgan stock fell to $12.81 per share.
E. Procedural History of the Litigation
The plaintiffs filed their initial complaint and a first amended complaint in
2000. The first amended complaint was dismissed, with prejudice as to some
claims and without prejudice as to others, in March 2001. 3 The plaintiffs filed
their second amended complaint a month later, in April 2001.
At a hearing in March 2002, the district court entertained a motion by the
defendants to dismiss the second amended complaint pursuant to Fed. R. Civ. P.
12(b)(6). The court granted the motion and dismissed the second amended
3
At the same time that the district court dismissed the first amended
complaint, it dismissed a separate case brought by different plaintiffs who also
alleged securities fraud claims against Kinder-Morgan. On appeal, we affirmed
the district court’s dismissal of that case. McDonald v. Kinder-Morgan, Inc., 287
F.3d 992, 999 (10th Cir. 2002). That case involved allegations that Kinder-
Morgan failed to disclose certain future risks associated with the Bushton Plant
when it reported its results from that operation. Id. at 994. As discussed in more
detail below, because the plaintiffs’ theory in McDonald was one of fraud by
omission to disclose future risks, they conceded during their litigation that the
financial information that Kinder-Morgan reported in the 1997 third quarter 10-Q
was accurate. In contrast, the plaintiffs in the instant case claim that statements
made by Kinder-Morgan in the 1997 third quarter 10-Q and elsewhere are
inaccurate and materially misleading as stated.
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complaint with prejudice, concluding that the plaintiffs had failed, with respect to
the Bushton claims and the Blue Moon Holdings claim, to meet the requirement
of the Private Securities Litigation Reform Act (PSLRA), 15 U.S.C. § 78u-4(b)(1)
and (2), to plead facts supporting their allegations with particularity and to plead
allegations supporting a strong inference of scienter. The court found that the
plaintiffs had pled facts with sufficient particularity about the CU Cogen contract,
but concluded that claim should be dismissed because it did not meet the
PSLRA’s requirements that the allegations in the complaint support a strong
inference of scienter. 15 U.S.C. § 78u-4(b)(2). Having dismissed the underlying
securities fraud claims against both Kinder-Morgan and the individual defendants,
the court also dismissed the claims of derivative liability—the § 20 claims of
control person liability—against the individual defendants. The district court
delivered these rulings from the bench and subsequently entered a written final
judgment summarizing them, which the plaintiffs now appeal.
II. DISCUSSION
“We review de novo the district court’s dismissal under Fed. R. Civ. P.
12(b)(6) for failure to state a claim upon which relief can be granted.” Ruiz, 299
F.3d at 1181.
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A. Scope of the District Court’s Review of the Complaint
1. Review of the Complaint In Its Entirety
The plaintiffs first attack the district court’s decision to dismiss their
complaint by arguing that the court failed to consider the complaint’s allegations
in their entirety. When evaluating a motion to dismiss pursuant to Fed. R. Civ. P.
12(b)(6), the district court must evaluate “the totality of the pleadings” to
determine if the plaintiffs have stated an actionable claim of securities fraud. See
City of Philadelphia v. Fleming Cos., Inc., 264 F.3d 1245, 1261–62 (10th Cir.
2001). The plaintiffs contend that while the district court did consider the
allegations about the acceleration of income under the three Bushton contracts,
the court did not consider Kinder-Morgan’s public statements about Bushton’s
having made a “positive impact” on earnings, which the plaintiffs allege were
false and misleading. The plaintiffs state that their complaint “alleges a black-
and-white contradiction between what Defendants said during the Class Period
about Bushton’s purported ‘positive impact’ on the Company’s earnings and the
value of the assets, and what they really knew or recklessly disregarded regarding
the plant’s money-losing operations and impaired condition.”
We conclude that the district properly considered the complaint in its
entirety for two reasons. First, the district court said that it did. In the hearing at
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which the district court gave its oral ruling dismissing the second amended
complaint, the court said:
The next question is whether the pleading in this case . . . is
sufficient to raise a strong inference of scienter. And once again,
I’ve examined the authorities and the pleadings. I’ve considered the
pleadings in their totality to determine whether the plaintiffs have
pleaded facts supporting a strong inference of scienter.
Hr’g on Mot. to Dismiss at 7 (emphasis added). In light of the district court’s
express statement that it considered the pleadings in their entirety, we have no
reason to conclude otherwise. See Abrams v. Baker Hughes, Inc., 292 F.3d 424,
431 (5th Cir. 2002) (“[I]n its conclusion, the district court also stated that the
facts in the complaint were insufficient when viewed in the aggregate . . . . The
district court’s clear statement that it considered the allegations insufficient in the
aggregate, although without analysis, is difficult for us to contradict.”). Although
the court did not explicitly refer to the plaintiffs’ allegations that Kinder-
Morgan’s statements about Bushton’s “positive impact” on 1997 third quarter
earnings were misleading, the court was not required to make explicit findings of
fact and conclusions of law when making a Rule 12(b)(6) ruling. See Fed. R.
Civ. P. 52(a) (“Findings of fact and conclusions of law are unnecessary on
decisions of motions under Rule 12 . . . .”).
Second, in the written final judgment dismissing the second amended
complaint, the court expressly referred to the press release and SEC filings that
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contained the Bushton statement. The court specifically mentioned “plaintiffs’
allegations concerning defendants’ press releases and 1997 10-Q and 10-K filings
with the Securities and Exchange Commission.” Final J. at 2. This reference to
the sources of the Bushton statement supports the conclusion that the district
court did, in fact, consider the statement when it decided to dismiss the complaint.
For these reasons, we reject the plaintiffs’ contention that the district court failed
to consider its allegations about the Bushton statement.
2. Issue and Claim Preclusion
The defendants argue that issue and claim preclusion bar any of the
plaintiffs’ claims. We turn first to the defendants’ claim of issue preclusion.
a.) Issue Preclusion
According to the doctrine of issue preclusion, when “an issue of ultimate
fact has been once determined by a valid and final judgment, that issue cannot
again be litigated between the same parties in any future lawsuit.” United States
v. Botefuhr, 309 F.3d 1263, 1282 (10th Cir. 2002) (quotation and citation
omitted). The defendants here have the burden of establishing issue preclusion,
In re King, 103 F.3d 17, 19 (5th Cir. 1997), and four elements must be shown:
“(1) the issue previously decided is identical with the one presented in the action
in question, (2) the prior action has been fully adjudicated on the merits, (3) the
party against whom the doctrine is invoked was a party, or in privity with a party,
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to the prior adjudication, and (4) the party against whom the doctrine is raised had
a full and fair opportunity to litigate the issue in the prior action.” Botefuhr, 309
F.3d at 1282 (quoting Dodge v. Cotter Corp., 203 F.3d 1190, 1197 (10th Cir.
2000)).
The defendants argue that issue preclusion bars the plaintiffs from
litigating issues of the materiality or the accuracy of the statements made in
Kinder-Morgan’s 1997 10-K and 10-Q filings. They contend that our decision in
the case of McDonald v. Kinder-Morgan, Inc., 287 F.3d 992 (10th Cir. 2002),
decided these issues. Although the plaintiffs in McDonald were different from
the plaintiffs here, we need not decide if the two sets of plaintiffs are in privity
because we conclude, in any event, that the defendants’ argument fails because
the critical factual issue—whether Kinder-Morgan’s statements about the Bushton
plant in its 1997 10-Q and 10-K filings were accurate—was not adjudicated on
the merits in McDonald.
In Botefuhr, we held that “[i]n the issue preclusion context, the underlying
issue must have been adjudicated on the merits.” Botefuhr, 309 F.3d at 1282. We
explained:
A judgment is not conclusive in a subsequent action as to issues
which might have been but were not litigated and determined in the
prior action.
....
An issue is not actually litigated if the defendant might have
interposed it as an affirmative defense but failed to do so; nor is it
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actually litigated if it is raised by a material allegation of a party’s
pleading but is admitted (explicitly or by virtue of a failure to deny)
in a responsive pleading; nor is it actually litigated if it is raised in
an allegation by one party and is admitted by the other before
evidence on the issue is adduced at trial . . . .
Id. at 1282 (quoting Restatement (Second) of Judgments § 27 cmt. e at 256-57
(1982)).
The factual accuracy of Kinder-Morgan’s statement made about the
Bushton plant in the 1997 third quarter 10-Q and 10-K was not litigated in
McDonald. McDonald was admittedly a securities fraud case against Kinder-
Morgan, but it was filed by different plaintiffs who relied on a different theory of
fraud. The plaintiffs in that case conceded for the purposes of their litigation the
factual accuracy of the statements in the 10-Q and 10-K about the Bushton Plant
and Kinder-Morgan’s earnings and they attempted to predicate liability only upon
the alleged failure of Kinder-Morgan to disclose future risks to future earnings
because of the “keep whole” provisions in some of the Bushton contracts.
McDonald, 287 F.3d at 994, 996–97, 998. The concession by the plaintiffs in
McDonald means that the issue of the factual accuracy of the Bushton statement
and Kinder-Morgan earnings for the historical periods covered in the financial
reports was never litigated and, because these are the issues in this case, issue
preclusion should not apply. Botefuhr, 309 F.3d at 1282.
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b.) Claim Preclusion
The defendants also argue that claim preclusion bars the plaintiffs from
making allegations about the Bushton statement. They argue that the district
court order of February 23, 2002, dismissing the first amended complaint
precluded the plaintiffs from making additional claims about the factual accuracy
of Kinder-Morgan’s financial reports and press releases. But the district court did
not enter a final order at that time. At the hearing at which the court ruled on the
second amended complaint, the defendants challenged that complaint by, inter
alia, arguing that it contained allegations that were outside the scope of the
repleading permitted by the February 2001 order—e.g., that it was false and
misleading to say in the 1997 third quarter financial reports that Bushton
positively impacted earnings. But the district court rejected this objection,
finding that it was “inclined . . . to permit the amendment.” Hr’g on Mot. to
Dismiss at 4–5. The district court therefore modified its earlier order by
considering on the merits the claims contained in the second amended complaint.
It is the defendants burden to establish claim preclusion, Nwosun v.
General Mills Restaurants, Inc., 124 F.3d 1255, 1257 (10th Cir. 1997), and given
the uncertainty surrounding the district court’s action, we cannot conclude that
the defendants have met this burden.
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B. Pleading Requirements of the PSLRA
Section 10(b) the Act, 15 U.S.C. § 78j(b), and the SEC’s Rule 10b-5
promulgated thereunder, 17 C.F.R. § 240.10b-5, prohibit fraudulent acts done in
connection with securities transactions. Section 10(b) makes it unlawful “[t]o use
or employ, in connection with the purchase or sale of any security . . . any
manipulative or deceptive device or contrivance in contravention of such rules
and regulations as the [SEC] may prescribe as necessary or appropriate in the
public interest or for the protection of investors.” 15 U.S.C. § 78j(b). Rule 10b-5
identifies certain actions that are prohibited by the statute. In particular, Rule
10b-5 makes it unlawful “[t]o make any untrue statement of a material fact or to
omit to state a material fact necessary in order to make the statements made, in
the light of the circumstances under which they were made, not misleading . . . .”
17 C.F.R. § 240.10b-5.
To state a claim under Rule 10b-5 for securities fraud, we have held that a
plaintiff’s complaint must contain allegations addressing the following five
elements: (1) the defendant made an untrue or misleading statement of material
fact, or failed to state a material fact necessary to make statements not
misleading; (2) the statement complained of was made in connection with the
purchase or sale of securities; (3) the defendant acted with scienter, that is, with
intent to defraud or recklessness; (4) the plaintiff relied on the misleading
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statements; and (5) the plaintiff suffered damages as a result of his reliance. See
Grossman v. Novell, Inc., 120 F.3d 1112, 1118 (10th Cir. 1997). Prior to passage
of the PSLRA, Fed. R. Civ. P. 9(b) set the standard for the level of particularity
required when pleading the elements of a securities fraud claim. City of
Philadelphia v. Fleming Cos., Inc., 264 F.3d 1245, 1258 (10th Cir. 2001). Rule
9(b) dictates that “in averments of fraud . . ., the circumstances constituting fraud
. . . shall be stated with particularity. Malice, intent, knowledge and other
condition of mind may be averred generally.”
In 1995, Congress heightened the pleading standard for federal securities
fraud claims with the passage of the PSLRA. See Private Securities Litigation
Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737. The purpose of the
PSLRA was to curb perceived abuses in the prosecution of private securities fraud
lawsuits, “particularly the filing of strike suits.” Fleming Cos., 264 F.3d at 1258(internal quotation marks omitted). To achieve its purpose, the PSLRA did not
add to the list of the five elements that make up the 10b-5 cause of action;
instead, it strengthened what is required adequately to plead two of those
elements. See 15 U.S.C. § 78u-4(b)(1), (2).
First, the PSLRA increased the burden on a plaintiff’s pleading of the first
element of a securities fraud action: the allegation that the defendant made a false
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or misleading statement, or failed to state a material fact necessary to make
statements made not misleading. The PSLRA requires that
[i]n any private action arising under this chapter in which the
plaintiff alleges that the defendant—
(A) made an untrue statement of material fact; or
(B) omitted to state a material fact necessary in order to make
the statements made, in the light of the circumstances in which
they were made, not misleading;
the complaint shall specify each statement alleged to have been
misleading, the reason or reasons why the statement is misleading,
and, if an allegation regarding the statement or omission is made on
information and belief, the complaint shall state with particularity all
facts on which that belief is formed.
15 U.S.C. § 78u-4(b)(1).
Second, the PSLRA heightened the standard for pleading the scienter
element of a securities fraud claim. Under Rule 9(b), “[m]alice, intent,
knowledge, and other conditions of mind may be averred generally.” The PSLRA
supersedes this part of Rule 9(b), imposing a more stringent rule for pleading
scienter:
In any private action arising under this chapter in which the plaintiff
may recover money damages only on proof that the defendant acted
with a particular state of mind, the complaint shall, with respect to
each act or omission alleged to violate this chapter, state with
particularity facts giving rise to a strong inference that the defendant
acted with the required state of mind.
15 U.S.C. § 78u-4(b)(2); Fleming Cos., 264 F.3d at 1255 n.13.
The district court held that the second amended complaint failed to satisfy
the heightened pleading standards imposed by the PSLRA because it did not plead
- 23 -
the circumstances of fraud with particularity and it did not plead facts supporting
a strong inference that the defendants acted with scienter. Specifically, the court
concluded that the allegations relating to the Bushton Plant and Blue Moon
Holdings were not pled with sufficient particularity. While finding that the
allegations relating to the CU Cogen contract were pled with sufficient
particularity, the district court concluded that the facts alleged did not raise a
strong inference that the defendants acted with scienter with regard to any of the
alleged false statements. We disagree with the district court and conclude that the
plaintiffs’ complaint satisfies the pleading requirements of the PSLRA.
1. Pleading the Circumstances of Fraud with Particularity Under the
PSLRA
We begin by applying the requirements of § 78u-4(b)(1) that apply to every
securities fraud claim: that “the complaint shall specify each statement alleged to
have been misleading [and] the reason or reasons why the statement is
misleading.” 15 U.S.C. § 78u-4(b)(1). Then, we consider whether the additional
requirement of § 78u-4(b)(1)—that when allegations are made on information and
belief the complaint “shall state with particularity all facts on which that belief is
formed”—is applicable to this case. Id. Concluding that it is applicable, we
apply that standard to the plaintiffs’ allegations and conclude that it is satisfied.
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a.) The Misleading Statements
The plaintiffs’ complaint clearly sets out the allegedly misleading
statements and the reasons why the statements are claimed to be misleading. The
complaint points to Kinder-Morgan’s Form 10-Q and Form 10-K filings made
between October 1997 and March 1999, in which it allegedly reported misleading
net income figures for the Company and misleading operating income figures for
the Bushton Plant. In addition to several of these SEC filings, the Company’s
press releases announcing its results for the third and fourth quarters of 1997
stated, in varying formulations, the allegedly misleading claim that the
Company’s earnings “were positively impacted by earnings from the Bushton
[Plant] . . . .” The plaintiffs also allege that the SEC filings were misleading
when they stated that Kinder-Morgan’s financial statements were prepared in
accordance with GAAP.
The complaint explains why these statements are alleged to be misleading.
It states that “Bushton did not ‘positively impact earnings’ . . . [because] it was
unprofitable and a substantial cash drain on the Company . . . .” The complaint
states that Bushton was unprofitable because of the sizable lease payment Kinder-
Morgan was obligated to make on the Plant and the fact that “keep whole”
contracts with customers of the Bushton Plant were losing money due to
unfavorable market conditions.
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Furthermore, the complaint explains that those figures included income
that, under GAAP and the Company’s own income recognition policies, should
not have been recorded. In particular, the complaint points to the accelerated
recognition of income from the three Bushton contracts and from the CU Cogen
contract as examples of improperly recorded income. The complaint states that
but for the allegedly improper income recognition, the Bushton facility would
have recorded a loss of approximately $10 million in the third quarter of 1997,
instead of the $5.1 million operating profit recorded by the company in the Form
10-Q filed for that quarter. In addition, the complaint states that without the
allegedly improper income recognition from the CU Cogen contract, Kinder-
Morgan would have reported net income of $16.4 million for the first quarter of
1998, instead of the $22.4 million actually recorded.
Finally, the complaint states that it was misleading for the Company to state
that its financial statements were prepared according to GAAP because, according
to the complaint, they were not. The complaint alleges that a fundamental
principle of GAAP is that revenue and income are not recognizable until the good
or service that is due has actually been provided. In the case of the three Bushton
contracts and the transaction with Enron regarding the CU Cogen contract, the
complaint alleges that Kinder-Morgan booked income for services that it had not
yet delivered.
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Based on the foregoing detailed allegations, we find that the plaintiffs’
complaint clearly sets forth the statements they alleged to be misleading and the
reason or reasons why those statements were misleading. See 15 U.S.C. § 78u-
4(b)(1).
b.) Applicability of the Standard for Pleadings Made on
Information and Belief
We next turn to whether the allegations in the plaintiffs’ complaint were
made on information and belief, thereby triggering the requirement that the
complaint “state with particularity all facts on which that belief is formed.”
15 U.S.C. § 78u-4(b)(1). The plaintiffs argue that this requirement does not apply
to their complaint because their complaint is “based on counsel’s investigation[,
which] is not the same as a complaint pled upon information and belief.” We
disagree.
Courts have split on the question whether allegations in a complaint made
upon “investigation of counsel” should be treated as being made on information
and belief for the purposes of the heightened pleading standard of the PSLRA.
Compare, e.g., ABC Arbitrage Plaintiffs Group v. Tchuruk, 291 F.3d 336, 351
n.70 (5th Cir. 2002) (“We also agree with those courts which have held that
allegations made on ‘investigation of counsel’ are equivalent to those made on
‘information and belief’ for the purposes of the heightened pleading requirements
under 15 U.S.C. § 78u-4(b)(1).”), In re Theragenics Corp. Sec. Litig., 105 F.
- 27 -
Supp. 2d 1342, 1351 (N.D. Ga. 2000) (same), In re Equimed, Inc. Sec. Litig., No.
98-CV-5374 NS, 2000 WL 562909, Fed. Sec. L. Rep. (CCH) ¶ 90,975 at 94,324
(E.D. Pa. May 9, 2000) (“To distinguish between ‘information and belief’ and
‘investigation of counsel’ is meaningless; it would permit evasion of the clear
intent of the statutory mandate.”), and Brady v. Anderson, No. 97-2154(SHx),
1998 U.S. Dist. LEXIS 20774, at *11–12 (C.D. Cal. 1998) (refusing to consider
investigation of counsel as distinct from information and belief), with Queen Uno
Ltd. Partnership v. Coeur D’Alene Mines Corp., 2 F. Supp. 2d 1345, 1353–54 (D.
Colo. 1998) (holding that plaintiffs did not plead on information and belief where
their allegations were based “upon the investigation of their counsel”), and
Warman v. Overland Data, Inc., No. 97CV833 JM (JFS), 1998 WL 110018, at *3
(S.D. Cal. Feb 20, 1998) (stating that because “plaintiffs have pled their
allegations based on the investigation of the attorney and not upon information
and belief, the complaint need not state with particularity all the facts on which
the belief is formed”). This is a question of first impression in our
Circuit—among circuit courts only the Fifth has addressed it thus far—and we
conclude, like the Fifth Circuit, that the better view is espoused by the cases
equating allegations made upon investigation of counsel with those made upon
information and belief.
- 28 -
We are persuaded by the district court’s reasoning in In re Theragenics
Corp.:
The Court has reviewed the cases on point and agrees with those that
hold that allegations based on the investigation of counsel are the
equivalent of allegations based on information and belief. For this
court to rule otherwise would elevate form over substance and allow
plaintiffs to avoid the [PSLRA]’s mandate merely by cloaking with a
license to practice law the information and belief on which a
complaint is based. Rule 11 of the Federal Rules of Civil Procedure
provides that, by presenting a pleading, motion, or other paper to a
court, an attorney is certifying that he has conducted “an inquiry
reasonable under the circumstances.” Fed. R. Civ. P. 11(b). Prior to
the [PSLRA], Rule 11 required that an attorney in every case must
investigate claims before filing a complaint. Congress, rightly or
wrongly, decided that the protection of Rule 11 against frivolous
lawsuits was not enough. The Court must conclude that a bare
recitation that the Complaint is based upon the investigation of
counsel does not satisfy the pleading requirements of the [PSLRA].
105 F. Supp. 2d at 1351.
Because the plaintiffs’ complaint refers to the investigation of their counsel
as the basis for their allegations, we treat their complaint as having been made on
information and belief. Therefore, with respect to their allegations that the
financial results reported in Kinder-Morgan’s SEC filings and press releases were
false, and that the Company’s statement that Bushton’s operations positively
impacted earnings was false, the plaintiffs’ complaint also must “state with
particularity all facts upon which [their] belief is formed.” 15 U.S.C. § 78u-
4(b)(1); see also Flemming Cos., 264 F.3d at 1258.
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c.) The Content of the Standard for Pleadings Made on
Information and Belief
Our Circuit has not yet had occasion to analyze what § 78u-4(b)(1) means
when it says that where an allegation regarding the statement or omission is made
on information and belief, “the complaint shall state with particularity all facts
upon which that belief is formed.” 15 U.S.C. § 78u-4(b)(1). When giving
meaning to a provision of a statute, we begin with the plain language of the
statute itself. United States v. Green, 967 F.2d 459, 461 (10th Cir. 1992). What
is obvious in the text of this part of § 78u-4(b)(1) is that it requires a plaintiff to
identify in the complaint specific facts that support the allegations about the
misleading nature of the defendant’s statements. Generalized or conclusory
allegations of fraud will not be sufficient.
However, we agree with the courts that have concluded that
“notwithstanding the use of the word ‘all,’ paragraph (b)(1) [of § 78u-4] does not
require that plaintiffs plead with particularity every single fact upon which their
beliefs concerning false or misleading statements are based.” Novak v. Kasaks,
216 F.3d 300, 313–14 (2d Cir. 2000); accord ABC Arbitrage Plaintiffs Group, 291
F.3d at 353; In re Cabletron Sys., Inc., 311 F.3d 11, 29–30 (1st Cir. 2002); In re
Theragenics Sec. Litig., 105 F. Supp. 2d at 1355. But see In re Party City Sec.
Litig., 147 F. Supp. 2d 282, 306 (D.N.J. 2001) (“[Novak] inexplicably read the
- 30 -
word ‘all’ out of the statute.”). We reach this conclusion because to read “all”
literally would produce absurd results that Congress could not have intended:
Contrary to the clearly expressed purpose of the PSLRA, it would
allow complaints to survive dismissal where “all” the facts
supporting the plaintiff’s information and belief were pled, but those
facts were patently insufficient to support that belief. Equally
peculiarly, it would require dismissal where the complaint pled facts
fully sufficient to support a convincing inference if any known facts
were omitted.
Novak, 216 F.3d at 314 n.1; see also Long v. Bd. of Governors of the Fed.
Reserve, 117 F.3d 1145, 1157 (10th Cir. 1997) (stating that the plain meaning of
statutory text must control unless it would lead to absurd results). Moreover, it is
unclear how a reviewing court could implement the standard if “all” were to be
read literally. We wonder, for example, how a court could know whether a
plaintiff had included in his complaint literally every relevant fact of which he
has knowledge.
In answering the obvious next question—if literally all facts need not be
pled, what facts must?—the Second Circuit concluded that “plaintiffs need only
plead with particularity sufficient facts to support those beliefs.” Id. at 313–14.
The Novak court explained, “Our reading of the provision focuses on whether the
facts alleged are sufficient to support a reasonable belief as to the misleading
nature of the statement or omission.” Id. at 314 n.1; accord ABC Arbitrage
Plaintiffs Group, 291 F.3d at 353 (“Under the interpretation of section 78u-
- 31 -
4(b)(1) we adopt today, a plaintiff must plead with particularity sufficient facts to
support their allegations of false or misleading statements made on information
and belief.”) (internal quotation marks omitted); In re Cabletron Sys., Inc., 311
F.3d at 29 (“The approach we take, similar to Novak, is to look at all of the facts
alleged to see if they provide an adequate basis for believing that the defendants’
statements were false.”) (internal quotation marks omitted); In re Theragenics
Sec. Litig., 105 F. Supp. 2d at 1355 (adopting the approach used in Novak).
We adopt an approach similar to the Second Circuit’s in Novak of
evaluating the facts alleged in a complaint to determine whether, taken as a
whole, they support a reasonable belief that the defendant’s statements identified
by the plaintiff were false or misleading. Such an approach will involve an
evaluation of (1) the level of detail provided by the facts stated in a complaint;
(2) the number of facts provided; (3) the coherence and plausibility of the facts
when considered together; (4) whether the source of the plaintiff’s knowledge
about a stated fact is disclosed; (5) the reliability of the sources from which the
facts were obtained; and (6) any other indicia of how strongly the facts support
the conclusion that a reasonable person would believe that the defendant’s
statements were misleading. See In re Cabletron Sys., Inc., 311 F.3d at 29–30.
If, measuring the nature of the facts alleged against these indicia, a reasonable
person would believe that the defendant’s statements were false or misleading, the
- 32 -
plaintiff has sufficiently pled with particularity facts supporting his belief in the
misleading nature of the defendant’s statements. We adopt this approach because
it “strikes the balance Congress intended in the PSLRA. The statute was designed
to erect barriers to frivolous strike suits, but not to make meritorious claims
impossible to bring.” Id. at 30. Requiring plaintiffs to state with particularity
facts that support a reasonable belief in the misleading nature of a defendant’s
statements creates a significant hurdle for plaintiffs to overcome before
discovery, but it permits plaintiffs with valid claims to proceed with their
lawsuits.
The defendants argue for a more rigorous particularity standard, contending
that in addition to stating specific facts in support of their allegations, plaintiffs
also must disclose the sources from which the plaintiff obtained knowledge of
those facts. We acknowledge that there are cases containing language indicating
that plaintiffs must state sources from which they learned the facts asserted in a
complaint made upon information and belief. The First Circuit, for example, has
taken the position that when “the plaintiff brings his claim on information and
belief, he must set forth the source of the information and the reasons for the
belief.” Aldridge v. A.T. Cross Corp., 284 F.3d 72, 78 (1st Cir. 2002) (internal
quotation marks omitted); see also In re Silicon Graphics, Inc. Sec. Litig., 970 F.
Supp. 746, 763–64 (N.D. Cal. 1997) (holding that to plead with particularity
- 33 -
plaintiffs “‘must literally, in [their] pleadings, include the names of confidential
informants, employees, competitors, Government employees, members of the
media, and others who have provided information leading to the filing of the
case’”) (quoting 141 Cong. Rec. H2849 (Mar. 8, 1995) (statement of Rep.
Dingell)), aff’d 183 F.3d 970, 983–84 (9th Cir. 1999).
Other courts have taken a more moderate approach, suggesting that
personal sources do not have to be disclosed so long as the key allegations are
supported by documentary evidence. The lead decision in this line of cases is
Novak from the Second Circuit. 216 F.3d at 312–14. Adopting and explaining
the multi-step analysis that Novak established to determine what sources a
plaintiff must disclose, the Fifth Circuit has written:
[W]e see no reason to embroider the multi-step analysis of the
Second Circuit and accept it as stated:
(1) if plaintiffs rely on confidential personal sources and other
facts, their sources need not be named in the complaint so long as
the other facts, i.e., documentary evidence, provide an adequate
basis for believing that the defendants’ statements or omissions
were false or misleading;
(2) if the other facts, i.e., documentary evidence, do not provide
an adequate basis for believing that the defendants’ statements or
omissions were false, the complaint need not name the personal
sources so long as they are identified through general
descriptions in the complaint with sufficient particularity to
support the probability that a person in the position occupied by
the source as described would possess the information pleaded to
support the allegations of false or misleading statements made on
information and belief;
(3) if the other facts, i.e., documentary evidence, do not provide
an adequate basis for believing that the defendants’ statements or
- 34 -
omissions were false and the descriptions of the personal sources
are not sufficiently particular to support the probability that a
person in the position occupied by the source would possess the
information pleaded to support the allegations of false or
misleading statements made on information and belief, the
complaint must name the personal sources.
ABC Arbitrage Plaintiffs Group, 291 F.3d at 353 (footnote omitted); see also
Johnson v. Tellabs, Inc., 262 F. Supp. 2d 937, 946 (N.D. Ill. 2003) (“This Court
agrees with the Second Circuit’s approach in Novak.”); In re ATI Techs., Inc.
Sec. Litig., 216 F. Supp. 2d 418, 432 (E.D. Pa. 2002) (adopting Novak approach);
In re Theragenics Sec. Litig., 105 F. Supp. 2d at 1355 (same). According to the
approach used by these courts, the facts alleged by a plaintiff can come from
either of two sources—people or documents—and the complaint must specifically
refer to one of them. Thus, the court in Novak said, “a complaint can meet the
new pleading requirement imposed by paragraph (b)(1) by providing documentary
evidence and/or a sufficient general description of the personal sources of the
plaintiffs’ beliefs.” 216 F.3d at 314; see also ABC Arbitrage Plaintiffs Group,
291 F.3d at 354 n.83 (“[D]ocumentary evidence may be pleaded as the source or
factual basis for the plaintiff’s belief underlying his allegations.”).
For several reasons, we do not adopt the position that the particularity
requirement of § 78u-4(b)(1) establishes a per se rule that a plaintiff’s complaint
must always identify the source, either personal or documentary, of the facts
alleged. First, the text of § 78u-4(b)(1) does not impose such a requirement.
- 35 -
Section 78u-4(b)(1) requires only that the pleader state with particularity all
“facts” upon which belief is formed, and it is not required that the pleader always
state the source of those facts. Indeed, the Second Circuit in Novak
acknowledged this when it stated: “[T]he applicable provision of the law . . .
requires plaintiffs to plead only facts and makes no mention of the sources of
these facts.” 216 F.3d at 313; see also, In re Digi Int’l, Inc., Sec. Litig., 6 F.
Supp. 2d 1089, 1096–97 (D. Minn. 1998) (“[T]he Court declines to adopt the
view that the language of the Reform Act mandates that each and every
‘information and belief’ allegation must be supported by underlying documentary
evidence.”), aff’d 2001 WL 753869 (8th Cir. 2001). Judicial gloss requiring the
allegation of the sources, either documentary or personal, of all facts alleged is in
our view too restrictive a response to the requirement of pleading facts with
particularity.
Second, requiring plaintiffs to identify the source of the facts they allege is
to require, in effect, that the plaintiffs plead their evidence in their complaint.
See, e.g., Novak, 216 F.3d at 314 (“[A] complaint can meet the new pleading
requirement . . . by providing documentary evidence.”); ABC Arbitrage Plaintiffs
Group, 291 F.3d at 353 (same). The PSLRA did not, however, purport to move
up the trial to the pleadings stage. While the PSLRA certainly heightened
pleading standards for securities fraud lawsuits, we believe that if Congress had
- 36 -
intended in securities fraud lawsuits to abolish the concept of notice pleading that
underlies the Federal Rules of Civil Procedure, Congress would have done so
explicitly. “Clearly, the Reform Act requires some precision in alleging facts,
however, it does not require pleading all of the evidence and proof thereunder
supporting a plaintiff’s claim.” In re Cephalon Sec. Litig., No. Civ. A. 96-CV-
0633, 1997 WL 570918, at *2 (E.D. Pa. Aug. 29, 1997); Paraschos v. YBM
Magnex Int’l, Inc., No. CIV A 98-6444, 2000 WL 325945, at *8 (E.D. Pa. Mar.
29, 2000) (same); In re First Merchants Acceptance Corp. Sec. Litig., No. 97-C-
2715, 1998 WL 781118, at *7 n.3 (N.D. Ill. Nov. 4, 1998) (“The complaint sets
forth detailed allegations of fraud and alleges substantially more than ‘rumor or
hunch.’ The fact that Plaintiffs do not have all of the specific documents to
support their claims at this time is not fatal to their complaint.”) (citations
omitted).
Third, requiring plaintiffs to identify the personal or documentary sources
of the facts they allege in an “information and belief” complaint is not always
necessary to further the object of the heightened pleading standards under the
PSLRA. The purpose of § 78u-4(b)(1) is to afford a defendant fair notice of a
plaintiff’s claims and the factual ground upon which they are based. Novak, 216
F.3d at 314; In re Theragenics, 105 F. Supp. 2d at 1348–49. Defendants in
securities fraud lawsuits do not require, for example, the name of the employee
- 37 -
who provided plaintiffs with facts, or the title of the internal report relied upon by
the plaintiffs, so long as the facts alleged in the plaintiffs’ complaint are detailed
enough to support a reasonable belief that the defendant’s statements identified by
the plaintiffs were false or misleading. The level of factual specificity required to
meet this standard may put defendants on notice of precisely what they are alleged
to have done wrong and permit them to defend against the charge.
Although we disagree with cases like Novak and ABC Arbitrage Plaintiffs
Group to the extent they require plaintiffs to disclose either personal or
documentary sources for the key allegations in an information and belief
complaint, we agree with their general sentiment that by disclosing such sources
plaintiffs can significantly strengthen their pleading. In pleading the misleading
nature of a defendant’s statements, the support provided by source information
will often be helpful in distinguishing whether a particular allegation is mere
rumor and speculation or whether it is based on concrete information from
relevant documents or people who were in a position to know the truth of the
allegations. Thus, depending on the generality of the allegation, it may or may
not be necessary to plead the source of the information in order to satisfy the
particularity requirement of § 78u-4(b)(1) in an information and belief complaint.
For example, facts that are difficult to verify, such as allegations of secret
meetings, the content of private conversations, or alleged motivations, may be
- 38 -
sufficiently ambiguous or indistinct so that disclosure of source information is
required before they lend measurable support to a reasonable belief in the
misleading nature of a defendant’s statements. Little weight would be accorded
to a plaintiff’s allegations that, for instance, simply stated that an unidentified
employee working for the defendant believed that a certain corporate profit
statement was misleading. By contrast, such an allegation would carry more
weight if the complaint identified the name or title of a person working for the
chief financial officer who participated in the preparation of the company’s
financial reports and who claimed to know that a certain financial statement was
misleading.
On the other hand, other allegations may be objectively verifiable by the
defendant without the necessity of the plaintiff divulging how he or she acquired
such information. Examples may include allegations of specific contract terms,
the financial result of a transaction, or specific prevailing market conditions.
Allegations of facts such as these ordinarily will not require the plaintiff to
disclose how he or she learned such information before a court may give weight
to the substantive allegations of fraud.
In sum, in this Circuit we will apply a common-sense, case-by-case
approach in determining whether a plaintiff has alleged securities fraud with the
particularity required by § 78u-4(b)(1) without adding a per se judicial
- 39 -
requirement that the source of facts must always be alleged to support substantive
allegations of fraud in an information and belief complaint. In deciding whether
the factual allegations support a reasonable belief that fraud occurred, courts
should evaluate the facts alleged as a whole, evaluating the level of detail,
number, and coherence and plausibility of the allegations; whether the allegations
are specific enough to be verified or refuted by a defendant without requiring the
complaint to disclose how the plaintiff learned of such facts or experts to prove
such facts at trial; whether the sources of the facts are disclosed and the reliability
of those sources; and any other factors that might affect how strongly the facts
alleged support a reasonable belief that the defendant’s statements were false or
misleading. To meet the standard, plaintiffs are not required to disclose the
documentary or personal sources from which they learned the facts alleged in an
information and belief complaint. We emphasize, however, that the PSLRA did
heighten the standard for pleading securities fraud, and where a plaintiff does not
identify the sources of the facts stated in the complaint, the facts alleged in an
information and belief complaint will usually have to be particularly detailed,
numerous, plausible, or objectively verifiable by the defendant before they will
support a reasonable belief that the defendant’s statements were false or
misleading.
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d.) Applying the Standard for Pleadings Made on Information and
Belief
After reviewing the factual statements made in the complaint, we find that
they support a reasonable belief that Kinder-Morgan’s reported net income,
Bushton’s reported operating income, and statements that the Bushton Plant
contributed positively to earnings were all false or misleading. “Overall, the
accumulated amount of detail the [complaint] provides tends to be self-verifying;
these are not conclusory allegations of fraud, but specific descriptions of the
precise means through which it occurred . . . .” In re Cabletron Sys., Inc., 311
F.3d at 30.
The allegation that Bushton was losing money was supported by two sets of
facts in the complaint. The first set of facts showed that Bushton was, in fact,
unprofitable. Included in this set of facts is the information from Rose Robeson,
the Assistant Treasurer, that her analysis of the Bushton Plant before it was
acquired determined that the Plant would be unprofitable, and that after Kinder-
Morgan acquired Bushton, defendant McKenzie and Kinder-Morgan vice
president John DiNardo frequently complained to Robeson during the third
quarter of 1997 about the losses being incurred by the Bushton Plant. Also
included in this set of facts is the employee meeting that DiNardo held in the
Spring of 1998, in which he addressed the problems at Bushton and told the
employees that the Plant was losing money at a rate of $700,000 per month.
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Finally, there is a report from an industry publication identified and quoted in the
complaint which stated that with its large lease payment, Bushton became “a
perpetual money-loser whose cashflow rarely covers the lease payment, much less
generating a profit.”
The second set of facts supporting the allegation that Bushton was
unprofitable is the detailed explanation in the complaint of why Bushton was
unprofitable. In nine paragraphs of the complaint, the plaintiffs explained how
the large lease payment on the Bushton Plant and unfavorable market conditions
affecting “keep whole” contracts caused Bushton to lose money. With respect to
the keep whole contracts the complaint not only explained how the terms of the
contracts made them unprofitable during market conditions prevailing during the
relevant period, but it explains what the market conditions were and what they
would have to have been for Kinder-Morgan to have broken even on those
contracts.
This level of detail about why Bushton was unprofitable is significant. Far
from resting on conclusory assertions about the state of the Bushton operation, the
plaintiffs have articulated a plausible explanation for their allegations, based on
objectively verifiable market data, sources who were inside the company, and
statements by industry observers made to a trade publication. We conclude that
the plaintiffs have stated sufficient facts to support a reasonable belief that it was
- 42 -
false or misleading for Kinder-Morgan to state that the Bushton Plant positively
impacted the Company’s earnings.
The facts alleged in the complaint also support the allegations that the
Company’s reports of net income and Bushton operating income statement during
the relevant period were false or misleading. The facts discussed above about the
condition of the Bushton operation bolster this conclusion. Because it is
reasonable to believe that it was false or misleading for Kinder-Morgan to claim
that Bushton was adding to net income, then it is also reasonable to believe that
the $5.1 million operating income figure for Bushton that Kinder-Morgan
reported in its 1997 third quarter 10-Q filing was also false or misleading.
Furthermore, because it is reasonable to believe that the Bushton Plant did not
contribute the $5.1 million in operating profits stated in the 10-Q filing, then it is
also reasonable to believe that the total profits reported by Kinder-Morgan were
overstated by at least the amount the Company claimed Bushton contributed to the
bottom line.
There are additional facts that support a reasonable belief that Kinder-
Morgan’s net income was overstated during the relevant period. The complaint
identifies three contracts related to the Bushton Plant that, it is alleged, were
reduced to their present value during the third quarter of 1997 and recorded as
income at the Bushton Plant in violation of GAAP and the Company’s own
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income recognition policy. Again, the complaint provides significant detail about
these contracts. It discloses not just the existence of the contracts, but also their
terms and the identities of the parties to them.
The complaint also discloses significant details about another transaction
alleged to have violated GAAP. The transaction between Kinder-Morgan and
Enron involving a dummy entity called Red Rock LLC that, according to the
complaint, permitted Kinder-Morgan to realize the income on its CU Cogen
contract several years before it could have done so under GAAP. The complaint
specifies the precise amount involved, $6 million, and explains how receipt of
this amount from Enron inflated Kinder-Morgan’s 1998 first quarter net income
by 27%. In light of the Company’s statement that it adhered to GAAP in
preparing its financial statements, the details of this transaction support a
reasonable belief that Kinder-Morgan’s net income report for the first quarter of
1998 was false and misleading. 4
Finally, we note that the complaint also alleges that the defendants
possessed motives to engage in fraud, such as the desire of the Company to sell
4
We note that it would not have satisfied our standard if the complaint had
merely alleged generally that the defendants had violated GAAP in support of its
allegations that the Company’s profit reports were false or misleading. The
critical facts alleged by the plaintiffs in this case are the identification of the
specific transactions alleged to have violated GAAP and the amount of detail
provided in explaining those transactions.
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its securities at favorable prices and to close a merger transaction with Sempra
Energy. This is the type of factual allegation that would be bolstered if the
plaintiffs could disclose a reliable source which one might expect to have
knowledge of the defendants’ actual motives. Because there is nothing in the
allegations of the defendants’ motives to indicate they are anything more than
pure speculation, we do not accord much weight to these allegations in our
analysis.
Nevertheless, we conclude that the complaint produced by the plaintiffs,
when considered as a whole, is not based on conclusory assertions. Although
based on information and belief, it alleges sufficient “facts on which that belief is
formed” to satisfy the pleading requirement of § 78u-4(b)(1). It adequately puts
the defendants on notice of the substance of the plaintiffs’ claims, and the range,
sources, and level of detail of the facts alleged demonstrate that this complaint is
not frivolous or conclusory and deserves to proceed to the next stage of litigation.
2. Pleading Scienter Under the PSLRA
Having concluded that the complaint satisfies the pleading requirements of
§ 78u-4(b)(1), we now turn to whether it satisfies the PSLRA’s heightened
standard in § 78u-4(b)(2) for pleading the element of scienter. In a securities
fraud case, the appropriate level of scienter is “a mental state embracing intent to
deceive, manipulate, or defraud,” or recklessness. Fleming Cos., 264 F.3d at
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1259. Section 78u-4(b)(2) states that the complaint shall “state with particularity
facts giving rise to a strong inference that the defendant acted with . . .
[scienter].” We have interpreted this provision to mean that “[w]hen reviewing a
plaintiff’s allegations of scienter under the PSLRA, a court should . . . examine
the plaintiff’s allegations in their entirety . . . and determine whether the
plaintiff’s allegations, taken as a whole, give rise to a strong inference of
scienter.” Fleming Cos., 264 F.3d at 1263.
An inference is a logical conclusion drawn from the facts. See, e.g.,
Webster’s Third New International Dictionary 1158 (1986) (defining “inference”
as “the act of passing from one or more propositions . . . considered as true to
another the truth of which is believed to follow from that of the former”). We
therefore understand a “strong inference” of scienter to be a conclusion logically
based upon particular facts that would convince a reasonable person that the
defendant knew a statement was false or misleading.
We consider first the allegations of scienter as to Clyde McKenzie, who
was Kinder-Morgan’s chief financial officer during the class period. We
conclude that the complaint adequately pleads scienter as to him. As discussed in
detail in Part II.B.1, supra, the complaint pleads a number of facts supporting the
conclusion that the Bushton Plant was unprofitable. Two of those facts are that
Rose Robeson told McKenzie before Kinder-Morgan acquired Bushton that it
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would be unprofitable, and that McKenzie frequently came to Robeson’s office
during the third quarter of 1997 to complain about the fact that Bushton was
losing money. These are particularized facts that establish a strong inference that
McKenzie acted with intent to deceive when he signed the company’s financial
statements declaring that the Bushton Plant positively impacted earnings.
These facts also establish that McKenzie acted with intent to deceive when
he signed financial filings with the SEC during the class period stating Bushton’s
operating income and the Company’s net income. Reinforcing that conclusion are
the allegations about the decision, in contravention of GAAP and the company’s
own accounting policies, to accelerate the recognition of income from the three
Bushton contracts and the CU Cogen contract. An allegation of GAAP violations
or accounting irregularities standing alone does not give rise to a strong inference
of scienter. Fleming Cos., 264 F.3d at 1261. Here, however, the alleged GAAP
violations come on top of other particularized facts indicating that a key operation
of the company was losing money, McKenize knew that fact, and he falsely
reported a profit for it. The alleged GAAP violations in this case strengthen the
inference that McKenzie signed financial statements with intent to deceive,
particularly in light of the detail with which the alleged GAAP violations are
stated, the fact that McKenize was Kinder-Morgan’s chief financial officer, and
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the fact that the Company’s financial reports declared that Kinder-Morgan’s
financial statements were prepared in accordance with GAAP.
We also conclude that the allegations in the complaint, considered as a
whole, give rise to a strong inference that Larry Hall acted with intent to deceive
when he signed Kinder-Morgan’s financial statements during the class period.
We begin by noting that Hall was the president and chief executive officer of
Kinder-Morgan during the class period. We have held that, standing alone, the
fact that a defendant was a senior executive in a company cannot give rise to a
strong inference of scienter. Fleming Cos., 264 F.3d at 1263–64. However, that
Hall was the most senior executive of the Company is a fact relevant in our
weighing of the totality of the allegations.
Several other facts, when considered in conjunction with Hall’s position as
president and chief executive officer, give rise to a strong inference that he acted
with scienter. First, we have already determined that the complaint alleges with
sufficient particularity that Hall’s chief financial officer knew of the false
statements in the Company’s financial reports. Typically, the chief financial
officer is second only to the chief executive officer in the management of a
corporation’s financial affairs. The fact that McKenzie knew of the false
statements is an important link in the inferential chain between Hall’s position as
president and chief executive officer and the conclusion that Hall knew of the
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false statements. Because McKenzie was Hall’s chief financial officer, the fact
that McKenzie was aware that the financial statements were false reduces the
likelihood that Hall was ignorant of that fact.
Strengthening the inference that Hall knew of the statements was the
magnitude of the alleged falsity. In the first quarter of 1998, the complaint
alleges that the accelerated recognition of income from the CU Cogen contract
added $6 million to the Company’s reported net income. This represented more
than one quarter of the $22.4 million in net income reported by the Company that
quarter. It is reasonable to infer that such a substantial contribution to earnings
from the CU Cogen contract would be known by the president and chief executive
officer. Moreover, the likelihood that Hall knew of the circumstances under which
Kinder-Morgan recognized the CU Cogen income on an accelerated basis is
increased by the fact that Arthur Andersen, Kinder-Morgan’s outside auditor at
the time, challenged the transaction. Thus, we conclude that a strong inference
arises that Hall acted with scienter when he signed the financial reports covering
the 1998 fiscal year.
Because the complaint adequately alleges that Hall, the president and chief
executive officer of Kinder-Morgan, and McKenzie, the chief financial officer of
Kinder-Morgan, had the scienter to defraud, those allegations are also sufficient
to allege scienter to defraud on behalf of Kinder-Morgan itself. The scienter of
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the senior controlling officers of a corporation may be attributed to the
corporation itself to establish liability as a primary violator of § 10(b) and Rule
10b-5 when those senior officials were acting within the scope of their apparent
authority. Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87,
100–01 (2d Cir. 2001) (holding that the scienter of an agent of a corporate
defendant is attributable to the corporation as a primary violator of § 10(b) and
Rule 10b-5); Cromer Finance Ltd. v. Berger, Nos. 00 Civ. 2284 (DLC) & 00 Civ.
2498 (DLC), WL 826847, at *7–8 (S.D.N.Y. May 2, 2002) (holding that scienter
of partner of accounting firm could be imputed to the firm itself under traditional
agency principles); In re JDN Realty Corp. Sec. Litig., 182 F. Supp. 2d 1230,
1246 (N.D. Ga. 2002) (holding that scienter of chief executive officer of
defendant corporation was attributable to the corporation); 2 Thomas Lee Hazen,
Treatise on the Law of Securities Regulation § 12.8[4], at 444 (4th ed. 2002)
(“[K]nowledge of a corporate officer or agent acting within the scope of authority
is attributable to the corporation.”); cf. Kerbs v. Fall River Indus., 502 F.2d 731,
741 (10th Cir. 1974) (holding defendant corporation liable for securities fraud
“because . . its president, acting within the scope of his apparent authority as
principal officer and agent of the corporation, engaged in conduct which violated
provisions of § 10 of the Act and Rule 10b-5”), abrogated on other grounds by
Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 191
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(1994) (holding that § 10(b) of the Act does not support claims by private
plaintiffs of aiding and abetting liability).
Finally, we conclude that the complaint fails to provide sufficient
particularized facts that give rise to a strong inference that Larry Kinder, a
Kinder-Morgan board member during the class period, knew that the statements
about Bushton’s profitability were false, or that the Company’s financial
statements were false. For example, the plaintiffs allege that “senior
management” attended meetings at the end of each month to identify improper
transactions that could be booked to boost reported earnings and mask operational
problems. No specific allegation is made that Kinder attended these meetings.
Conclusory allegation about the involvement of “senior management” does not
amount to a particularized claim that Kinder—who was a director not a
manager—knew about the false statements. The plaintiffs’ allegations with
respect to Kinder are nothing more than “generalized imputations of knowledge”
and are not sufficient to establish scienter. Fleming Cos., 264 F.3d at 1264.
We hold that the plaintiffs’ complaint satisfies the pleading standards of the
PSLRA as to all of the defendants except for Kinder. As to Kinder, the complaint
fails to adequately plead scienter and we affirm the dismissal of the cause of
action for primary violations of § 10(b) of the Act and Rule 10b-5 as against him.
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C. Control Person Liability
Section 20(a) of the Securities Exchange Act states:
Every person who, directly or indirectly, controls any person liable
under any provision of this chapter or of any rule or regulation
thereunder shall also be liable jointly and severally with and to the
same extent as such controlled person is liable, unless the controlling
person acted in good faith and did not directly or indirectly induce
the act or acts constituting the violation or cause of action.
15 U.S.C. § 78t(a). Interpreting the provision, we have explained that “[t]o state
a prima facie case of control person liability, the plaintiff must establish (1) a
primary violation of the securities laws and (2) ‘control’ over the primary violator
by the alleged controlling person.” Fleming, 264 F.3d at 1270–71 (citing Maher
v. Durango Metals, Inc., 144 F.3d 1302 (10th Cir. 1998)). The district court
dismissed the plaintiffs’ claims against the individual defendants for controlling
person liability under Section 20(a) of the Act, 15 U.S.C. § 78t, because the
district court had concluded that the plaintiffs had not adequately pled primary
claims that Kinder-Morgan violated § 10(b) of the Exchange Act and Rule 10b-5.
With respect to the first element of the prima facie case, we have already
concluded that the plaintiffs have successfully pled primary violations of the
securities laws by Kinder-Morgan. Therefore, the plaintiffs have satisfied the
first requirement in pleading a claim of control person liability.
The second element of the prima facie case requires that the plaintiffs plead
facts from which it can be reasonably be inferred that the individual defendants
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were control persons. Maher, 144 F.3d at 1306. To make this showing, the
plaintiffs must point to facts which indicate that the defendants had “possession,
direct or indirect, of the power to direct or cause the direction of the management
and policies of a person, whether through the ownership of voting securities, by
contract, or otherwise.” Id. at 1305.
We first conclude that the plaintiffs have failed to allege sufficient facts to
support the conclusion that Kinder was a control person. During the period in
question, he was not an executive of the company, but simply a member of the
board of directors. The assertion that a person was a member of a corporation’s
board of directors, without any allegation that the person individually exerted
control or influence over the day-to-day operations of the company, does not
suffice to support an allegation that the person is a control person within the
meaning of the Exchange Act. See, e.g., Dennis v. General Imaging, Inc., 918
F.2d 496, 509–10 (5th Cir. 1990) (holding that status as a director will not make
someone a controlling person absent “evidence [the alleged controlling person]
was able to influence the firm’s direction”); Burgess v. Premier Corp., 727 F.2d
826, 832 (9th Cir. 1984) (“A director is not automatically liable as a controlling
person. There must be some showing of actual participation in the corporation’s
operation or some influence before the consequences of control may be
imposed.”); Cameron v. Outdoor Resorts of Am., Inc., 608 F.2d 187, 195 (5th Cir.
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1980) (“As a director without effective day-to-day control and without knowledge
[the defendant] was not liable as a control person.”). Accordingly, the district
court was correct to dismiss the claim of control person liability against Kinder.
Second, we conclude that the plaintiffs have pled facts supporting the
allegation that Hall was a control person. He was the Chairman, President, and
CEO of Kinder-Morgan during the relevant period. As President and CEO, Hall
would have possessed the ultimate management authority of the corporation on a
daily basis. There were no managers higher than Hall. He thus clearly possessed
“the power to direct or cause the direction of the management and policies of
[Kinder-Morgan].” Maher, 144 F.3d at 1305; see also In re Ribozyme
Pharmaceuticals, Inc. Sec. Litig., 119 F. Supp. 2d 1156, 1167 (D. Colo. 2000)
(holding that plaintiffs adequately pled that defendant was a control person when
they asserted he was the CEO, President, and a director of the company during the
relevant period). Hall also had direct control over McKenzie, his chief financial
officer and an alleged primary violator of Rule 10b-5. Maher, 144 F.3d at 1305.
Hall argues that even if he is a control person, he should not be subject to
control person liability because the plaintiffs have not pled facts suggesting that
he was a culpable participant in a fraud. It is true, as Hall argues, that some
courts require evidence that a control person was a participant in the fraudulent
activity. See, e.g., In re Cendant Corp. Sec. Litig., 76 F. Supp.2d 539, 548
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(D.N.J. 1999). However, we have “expressly rejected those decisions that may be
read to require a plaintiff to show the defendant actually or culpably participated
in the primary violation.” Maher, 144 F.3d at 1305.
Hall attempts to overcome this clear language by arguing that our
“decisions did not rely on or fully consider the relationship of the increased
pleading requirements in the PSLRA with the requirements to establish
controlling person liability under Section 20(a).” He says that our rulings conflict
with the PSLRA’s requirement that “with respect to each act or omission alleged
to violate this chapter, [plaintiffs] state with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind.” Aple.
Hall’s B. at 33 (quoting 15 U.S.C. § 78u-4(b)(2)). But Hall imagines a conflict
where there is none. The section of the PSLRA that he cites—§ 79u-
4(b)(2)—applies only to a “private action arising under this chapter in which the
plaintiff may recover money damages only on proof that the defendant acted with
a particular state of mind . . . .” 15 U.S.C. § 79u-4(b)(2) (emphasis added).
Section 20 of the Exchange Act contains no requirement that plaintiffs must prove
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a control person’s state of mind. 5 Hall’s argument that we should overrule our
precedent is unpersuasive.
Finally, we turn to defendant McKenzie, who was a vice president and the
chief financial officer of Kinder-Morgan during the relevant period. In support of
their contention that he was a control person, the plaintiffs merely refer to his
position within the company. In other circumstances, this would not likely be
enough satisfactorily to allege control. In the present case, however, the two
identified, actionable claims of securities fraud relate specifically to official
reports of the company’s financial performance. As Kinder-Morgan’s chief
financial officer, it is reasonable to infer that McKenzie had at least indirect
control over the KM’s financial reporting. We conclude that under the
circumstances of this case, the plaintiffs adequately pled facts indicating that
McKenzie had direct or indirect control over the alleged fraudulent activity
because he was the chief financial officer.
5
Section 20 does state that a controlling person is not liable if he acted in
good faith and did not induce the acts on which the liability of the controlled
person is founded. However, courts have held that these are affirmative defenses,
to be pleaded and proved by defendants. See, e.g., Kaplan v. Rose, 49 F.3d 1363,
1382–83 (9th Cir. 1994); Gould v. Am.-Haw. S.S. Co., 535 F.2d 761, 779 (3d Cir.
1976).
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In sum, the district court was correct to dismiss the claim of control person
liability against Kinder, but erred in dismissing that claim against Hall and
McKenzie.
III. CONCLUSION
We conclude that the second amended complaint pled facts with
particularity sufficient to satisfy 15 U.S.C. § 78u-4(b)(1)’s special pleading
standard for securities fraud allegations made on information and belief. We
conclude, however, that the complaint adequately pleads scienter under § 78u-
4(b)(2) only as to defendants Hall, McKenzie, and Kinder-Morgan. We also
conclude that the complaint adequately pleads control person liability under 15
U.S.C. § 78t(a) as to Hall and McKenzie, but not as to Kinder. Therefore, we
REVERSE the dismissal of the complaint as to defendants Hall, McKenzie, and
Kinder-Morgan. We AFFIRM the dismissal of the complaint as to Kinder.
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