Epstein v. Washington Energy Co.

Decision Date14 May 1996
Docket NumberNos. 94-35873,s. 94-35873
Parties, Fed. Sec. L. Rep. P 99,222, 96 Cal. Daily Op. Serv. 3383, 96 Daily Journal D.A.R. 5527 Mark G. EPSTEIN; Samuel C. Arsers, on behalf of themselves & all others similarly situated, Plaintiffs-Appellants, v. WASHINGTON ENERGY CO.; James A. Thorpe, Defendants-Appellees.
CourtU.S. Court of Appeals — Ninth Circuit

Steve W. Berman, Hagens & Berman, Seattle, Washington, for plaintiffs-appellants.

Douglas M. Schwab, Heller, Ehrman, White & McAuliffe, San Francisco, California, for defendants-appellees Washington Energy Company and James P. Torgerson.

Evan L. Schwab, Bogle & Gates, Seattle, Washington for defendant-appellee James A. Thorpe.

Appeal from the United States District Court for the Western District of Washington; Carolyn R. Dimmick, District Judge, Presiding. D.C. No. CV-94-00245-CRD.

Before: REINHARDT and TROTT, Circuit Judges, and SCHWARZER, District Judge. *

TROTT, Circuit Judge:


Plaintiffs Mark Epstein and Samuel Arsers, purchasers of Washington Energy Company's common stock, appeal from the district court's order dismissing their securities fraud class action suit. In their Amended Complaint, Plaintiffs allege that Washington Energy Company and two of its senior officers violated §§ 10(b) & 20 of the Securities Exchange Act of 1934 and various state laws by stating the potential benefits of a rate increase for its subsidiary Washington Natural Gas, a regulated public utility, without disclosing: 1) that the Washington State Utilities and Transportation Commission had previously disapproved of Defendants' wrongful allocation of costs and attempts to subsidize unregulated operations, and 2) that the 1992 rate increase request was predicated on the same condemned practices. In the vernacular, Plaintiffs alleged that they were the victims of a "fraud on the market." The district court granted Defendants' motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6) for failure to state a claim. Affirmed.


Plaintiffs brought this class action suit against Washington Energy Company (WEC) and two of its senior officers, defining the class as all persons who purchased WEC common stock during the period of July 27, 1992 to September 28, 1993 (the Class Period). During the Class Period, Defendants represented that WEC's subsidiary Washington Natural Gas (WNG) had filed for a substantial rate increase from the Washington State Utilities and Transportation Commission (WUTC). The securities market allegedly believed that a rate increase in some material amount was likely and priced WEC stock higher as a result. Ultimately, the WUTC rejected the rate increase and ordered Washington Natural Gas to lower its rates, finding that the rate increase proposal inappropriately sought to recover costs associated with WEC's non-utility subsidiaries. WEC's stock fell from a high of $25-3/8 per share during the Class Period to $17 per share at the close of the Class Period.

A. Defendants' Statements Regarding the Rate Increase

Plaintiffs assert their fraud on the market theory based on the following statements:

July 1992 Press Release. Defendants announced Washington Natural Gas's filing for a general rate increase requesting an additional 13%, or approximately $41 million, in revenues annually.

Registration Statement. On September 10, 1992, Defendants filed a Form S-3 Registration Statement with the Securities and Exchange Commission (SEC) representing that Washington Natural Gas had "historically been allowed general rate increases primarily to offset increased operating costs Letter to Shareholders. On December 4, 1992, Defendants sent a letter to WEC shareholders portraying the rate request filing as "designed to enable us to earn a proposed 10.68 percent rate of return at our utility," and that "if approved it would increase our annual revenues by up to $41 million, or 13%." The letter stated that it was the first request in eight years for an increase in basic rates. The letter's discussion of business as a regulated activity acknowledged that "government regulation can be a major factor in Washington Energy's ability to perform," and that "[r]egulation can make or break us." The letter explained the WUTC's role in the rate increase request and stated that "[t]he commission has until October 1993 to act upon our proposal."

                attributable to inflation."   The statement noted that the "WUTC has until June 1993 to act on the filing."

April 1993 Press Release. Defendants issued a press release and filed a Form 8-K with the SEC noting that the WUTC staff had recommended a rejection of the proposed rate increase. The press release stated that "WNG strongly disagrees with the majority of the staff's proposals and will contest them to the maximum extent possible."

June 1993 Announcement. Defendants announced that Washington Natural Gas had lowered its rate increase request to 4.6%, and that the revised request was expected to raise $14.8 million annually.

B. Market's Perception of the Rate Increase Request

The following observations by analysts exemplify the market's perception of the proposed rate increase:

July 1992 Ragen MacKenzie Report. A research report from Ragen MacKenzie observed that "based on future rate relief and more normal weather, we believe the common stock dividend may again be increased in late calendar 1993." This report concluded by upgrading its investment opinion on WEC.

March 1993 Ragen MacKenzie Report. An analyst noted that "we believe earnings could rebound to the $1.75 per share range or higher, depending on the level of rate increase granted and the level of weather-related heating sales next winter."

April 1993 Ragen MacKenzie Report. Following the WUTC staff's recommended rejection of the proposed rate increase, Ragen MacKenzie issued a report stating:

The staff proposed to disallow (among other things) $30 million of water heaters on lease that have historically been allowed in rate base.

The staff of the WUTC has in recent years carried an extremely adversarial position in many utility rate cases. We consider this to be the "opening volley" of the rate case, whereby the staff postures for its position. The WUTC has been known to differ quite often with staff recommendations.

Nevertheless, this negative proposal highlights the "tougher" regulatory climate arising in most states as many utilities benefit from lower interest rates but face slower economies.

Ultimately, we believe Washington Energy will receive a rate increase in October (enough to retain the current $1.40 dividend), but will not receive the majority of its $34.4 million (13%) request in additional revenues.

April 1993 Merrill Lynch Report. A Merrill Lynch research report also attempted to explain the difference in the commission staff's filing versus WEC's:

That staff has requested that $80 million be removed from WNG's rate base which would result in $14 million in lower tariff revenues. The $80 million pertains to working capital differences and leased merchandise. At the commission's request (some time ago) WNG purchased water heaters for customers to lease and allowed WNG to include this investment in the rate base and provide a tariff accordingly. It is not known at this time if the commission has changed its position on this issue.


While WNG has been allocating costs according to functions, activities, businesses, etc., it is not clear why the staff has recommended ...

a different approach, or which method will ultimately be approved by the Washington Commission.

We believe several of these issues deal with philosophical differences.... Although the outcome remains uncertain, we believe that even if some costs are ultimately excluded, WNG earnings outlook remains positive. It is important for investors to realize that certain businesses could ultimately be excluded from WNG's rate base.

Several other market reports emphasized that WEC's future profits and dividends depended on the proposed rate increase.

C. WUTC Decision

On September 28, 1993, WEC announced that the WUTC had ordered Washington Natural Gas to lower its rates by 5 percent. The WUTC found that Washington Natural Gas had used utility income to subsidize its non-utility subsidiaries. The WUTC excluded numerous improper items from the rate base, including $5.5 million in costs from marketing trips and sport events and $1.1 million in advertising expenses. A supplemental order from the WUTC concerning the 1992 proposal stated that "the company's initial proposal was predicated upon a number of positions that the Commission had strongly and repeatedly rejected.... It is regrettable that so many of these items had to be relitigated in this proceeding."

D. Alleged Omissions of Material Fact

Plaintiffs base their securities fraud claims on the theory that Defendants failed to disclose that the WUTC had denied similar requests by WEC on previous occasions because WEC had improperly allocated costs in the areas of advertising expenses, salaries, and merchandising. A 1988 WUTC Final Report stated:

It strikes the staff that WNG is subject to the same market driven diversification strategy that has caused difficult allocation problems in the telecommunications industry.... Without structural separations it puts a heavy emphasis on proper allocations.... The staff was surprised by WNG's apparent lack of concern about improper accounting for marketing expenditures.

This 1988 WUTC decision was a matter of public record pursuant to section 80.01.090 of the Washington Code.

Additionally, Plaintiffs contend that Defendants recklessly disregarded the following trends: a major decline in long term interest rates, which caused a decline in the rates of return allowed for public utilities; growing regulatory skepticism toward regulated utilities' charges for marketing expenses; and increasing regulatory...

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