Adams v. Kinder-Morgan, Inc.

• Citation: 340 F.3d 1083
• Decision Date: 11 August 2003
• Docket Number: No. 02-1208.,02-1208.
• Parties: James E. ADAMS; Stanley R. Lamb; Anthony Vartuli, on behalf of themselves and all others similarly situated, Plaintiffs-Appellants, v. KINDER-MORGAN, INC., formerly known as KN Energy Inc.; Larry D. Hall; Clyde E. McKenzie, II; Richard Kinder, Defendants-Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (10th Circuit)

340 F.3d 1083

James E. ADAMS; Stanley R. Lamb; Anthony Vartuli, on behalf of themselves and all others similarly situated, Plaintiffs-Appellants, v. KINDER-MORGAN, INC., formerly known as KN Energy Inc.; Larry D. Hall; Clyde E. McKenzie, II; Richard Kinder, Defendants-Appellees.

No. 02-1208.

United States Court of Appeals, Tenth Circuit.

August 11, 2003.

As Amended on Denial of Rehearing August 29, 2003.

COPYRIGHT MATERIAL OMITTED

COPYRIGHT MATERIAL OMITTED

Michael G. Lange, Berman, DeValerio, Pease, Tabacco, Burt & Pucillo, Boston, MA (Michael T. Matraia, Berman, DeValerio, Pease, Tabacco, Burt & Pucillo, Boston MA, Gary C. Davenport and Eric Beltzer, McGloin, Davenport, Severson & Snow, P.A., Denver, CO;, and Curtis V. Trinko, Law Offices of Curtis V. Trinko, LLP, New York, NY, with him on the briefs) for Plaintiffs-Appellants.

Michael A. Noone, The Beatty Law Firm, P.C., Denver, CO (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, CO, 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 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 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.

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, ___ U.S. ___, 123 S.Ct. 1908, 155 L.Ed.2d 826 (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 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.

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.

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...