McDonald v. Kinder-Morgan, Inc., 01-1139.

• Citation: 287 F.3d 992
• Decision Date: 23 April 2002
• Docket Number: No. 01-1139.,01-1139.
• Parties: Patrick R. McDONALD and James P. Rode, Plaintiffs-Appellants, v. KINDER-MORGAN, INC., formerly known as KN Energy, Inc., Defendant-Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

287 F.3d 992

Patrick R. McDONALD and James P. Rode, Plaintiffs-Appellants, v. KINDER-MORGAN, INC., formerly known as KN Energy, Inc., Defendant-Appellee.

No. 01-1139.

United States Court of Appeals, Tenth Circuit.

April 23, 2002.

William F. Demarest, Jr., Shook, Hardy & Bacon, L.L.P., Washington, D.C.; Gary C. Davenport, McGloin, Davenport, Severson and Snow, P.C., Denver, CO, for Plaintiffs-Appellants.

Michael L. Beatty, Susan E. Chetlin, Michael Noone, The Beatty Law Firm, P.C., Denver, CO, for Defendant-Appellee.

Before LUCERO and MURPHY, Circuit Judges, and ALLEY, Senior District Judge.^*

MURPHY, Circuit Judge.

After examining the briefs and appellate record, this panel determined unanimously that oral argument would not materially assist the determination of this appeal. See Fed. R.App. P. 34(a)(2); 10th Cir. R. 34.1(G). Accordingly, on December 28, 2001, we granted Appellants' Motion to Submit Appeal on the Briefs and ordered the case submitted without oral argument.

Patrick McDonald and James Rode brought suit against Kinder Morgan, Inc. ("KM") and several KM officers asserting claims under the Securities Exchange Act of 1934 (the "Act") and its implementing regulations. They asserted that statements in KM's¹ third quarter 10-Q describing increased revenue and operating income flowing from KM's acquisition of a natural gas processing plant imposed a duty on the defendants to further disclose potential financial risks associated with "keep whole" contracts to which that plant was subject. The district court granted KM's Fed.R.Civ.P. 12(b)(6) motion to dismiss, holding that the statements in the 10-Q relied on by McDonald and Rode were accurate reports of historical fact and that the disclosure of such facts did not create a duty to disclose the "keep whole" contracts.² McDonald and Rode appeal. This court exercises jurisdiction pursuant to 28 U.S.C. § 1291 and affirms.

The following recitation of facts is drawn from the well-pleaded allegations set out in McDonald's and Rode's first amended complaint. See Maez v. Mountain States Tel. & Tel., Inc., 54 F.3d 1488, 1496 (10th Cir.1995). KM is an integrated energy company with operations that include gathering, processing, marketing, storage, and transportation of natural gas and natural gas liquids. On December 19, 1997, KM merged with Interenergy Corp. ("IEC"), a natural gas gathering, processing, and marketing company. McDonald and Rode owned approximately 35% of the issued and outstanding shares of IEC at the time of the merger. As consideration for the merger, holders of IEC stock received shares of KM stock. Each share of IEC stock was converted into a fixed number of KM shares pursuant to an exchange ratio based on the average of the daily closing price of KM stock during a specified twenty-day period prior to the merger. It is the conversion formula that is at the heart of this lawsuit. McDonald and Rode assert that the price of KM shares was artificially inflated, resulting in their receipt of fewer shares of KM stock under the conversion formula, by omissions from KM's 1997 Third Quarter 10-Q. In particular, McDonald and Rode assert that KM failed to disclose the existence of risky "keep whole" contracts to which it was subject as a result of its then-recent acquisition of a large natural gas processing plant (the "Bushton Plant").

KM purchased the Bushton Plant nine months prior to the KM/IEC merger. The Bushton Plant processes natural gas to remove liquid and liquefiable hydrocarbons ("NGLs"), which are sold separately from natural gas.³ Approximately 33% of the natural gas processed at Bushton is owned by third parties and subject to "keep whole" contracts. KM processes natural gas for these third parties in exchange for being allowed to retain the NGLs in the natural gas. KM must, however, agree to "keep whole" these third parties for the reduction in the energy content of the natural gas stream associated with the removal of the NGLs. "Keep whole" contracts affect the cost of operation of a processing plant by requiring the processor (KM in the case of the Bushton Plant) to replace the British thermal units ("Btus") of the NGLs removed from the gas stream with an equivalent number of Btus of processed gas. As long as the value of the Btus of the NGLs is greater than the value of the replacement Btus of gas supplied by the processor under "keep whole" contracts, the plant's processing activities may be profitable. The risk in "keep whole" contracts is the possibility of a price inversion, a market situation where the value of the replacement Btus of natural gas supplied under the "keep whole" contract will exceed the value of the Btus of the NGLs removed from the gas stream. Such a price inversion occurred in 1998, shortly after the KM/IEC merger, causing KM to suffer millions of dollars of losses at the Bushton Plant and causing its stock price to fall precipitously.

On November 12, 1997, before the KM/IEC merger became effective and before the start of the twenty-day measurement period for determining how many shares of KM stock would be exchanged for IEC stock, KM issued its quarterly report for the third fiscal quarter of 1997 (the "10-Q"). In that report, KM stated that its earnings were positively affected in the third quarter by operations at the Bushton Plant. The 10-Q did not reference the "keep whole" contracts to which the Bushton Plant was subject or note the financial risks associated with such contracts if a price inversion was to occur.

In its 1998 10-K Annual Report, issued in 1999, KM disclosed the existence of Bushton's "keep whole" contracts and the significant commodity risks associated with these contracts. In fact, KM disclosed that corporate operating expenses had increased by $77.2 million more than operating revenues, primarily due to the negative effect of the "keep whole" contracts. These disclosures by KM, however, came only after independent financial analysts disclosed the problems with KM's "keep whole" contracts to the investing public and the stock acquired by McDonald and Rode through the merger had fallen drastically.

After the disclosure of the revenue problems associated with the Bushton "keep whole" contracts, and the concomitant drop in the share price of KM, McDonald and Rode filed a complaint alleging that the failure to disclose the existence of the "keep whole" contracts in the 10-Q violated the Act and its implementing regulations. The complaint quoted and emphasized, at paragraph 30, the following language from the 10-Q:

The significant increases in the 1997 operating revenues, costs, and expenses largely reflect the contributions of the Bushton-related assets acquired on April 1, 1997, and power marketing activities. The Bushton acquisition provided incremental 1997 third quarter and nine months operating revenues of $35.4 million and $71.5 million and operating income of $5.1 million and $10.6 million, respectively. However, certain power marketing transactions were structured in a way that was not in compliance with the Company's risk management policies, and losses of $4.0 million were incurred. Power marketing activities have been suspended until the Company either owns, or has a power marketing partner that owns, electric generating assets.

With regard to this language in the 10-Q, McDonald and Rode alleged as follows:

These statements are incomplete and, therefore, materially misleading because, while addressing certain risks, i.e., those related to the Company's power marketing activities, they do not disclose the existence of the significant risks associated with the Bushton-related "keep whole" contracts while reporting the incremental operating revenue and operating income attributable to the operation of the Bushton Plant.

In response to McDonald's and Rode's first amended complaint, KM filed a motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6) asserting that the statements in the 10-Q set out in the complaint were not actionable. At a hearing on the motion to dismiss, the district court began by noting that it was inclined to grant the motion to dismiss without allowing leave to amend. In response, McDonald and Rode asserted repeatedly that their complaint rose or fell on the 10-Q. They also quoted during the hearing additional statements from the 10-Q which they argued supported their claim that KM's assertions regarding increased revenues and profits flowing from the Bushton acquisition created a duty to disclose the "keep whole" contracts.⁴ At the conclusion of McDonald's and Rode's arguments at the hearing, the district court granted KM's motion to dismiss, concluding that the statements identified in the 10-Q were not actionable as a matter of law. In ruling from the bench, the district court stated as follows:

With respect to the 10-Q, I do not see — I still disagree, notwithstanding the [additional] quotations from the 10-Q, that this is anything other than an accurate statement of historical results, even when the ... Bushton language... is included.

And the accurate disclosure of purely historical results does not give rise to a duty to disclose the keep-whole contracts in order to make the disclosure of past financial data not misleading.

As acknowledged [by McDonald and Rode], the stated revenues in the 10-Q are conceded to be true. The argument is that the disclosure of the Bushton revenue obligated [KM] to disclose the existence of the risks involved with the keep-whole contract[s].

In part I rely on the District of Massachusetts decision in [In re Boston Technology Securities Litigation, 8 F.Supp.2d 43 (D.Mass.1998)]. In that case the 10-Q disclosed that North American revenues were slightly below the previous year's corresponding quarter. The plaintiffs there argued that the reference to North American revenues obligated the defendants to disclose the existence of an alleged impending decline and the factors behind it.

The Massachusetts court...