On May 24, 2019, the United States Court of Appeals for the Fifth Circuit affirmed in a unanimous decision the dismissal of a putative securities class action against a major financial services company and several of its subsidiaries in relation to their alleged involvement in Enron’s “financial manipulation.” Lampkin et al. v. UBS PaineWebber Inc. et al., No. 17-20608 (5th Cir. May 24, 2019). Plaintiffs—(i) individual retail-brokerage customers of defendants, and (ii) former Enron employees who acquired Enron stock options through Enron’s stock option plan—alleged defendants violated Section 11 and Section 12 of the Securities Act of 1933 (the “Securities Act”) by acting as an underwriter and seller of Enron securities and were liable for materially false and misleading statements contained in Enron’s prospectuses and registration statements. Plaintiffs also alleged defendants violated Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder by failing to disclose their alleged knowledge of Enron’s alleged manipulation of its “public financial appearance.”
Plaintiffs alleged that defendants collectively were a “single, integrated business venture” that “maintained a ‘mutually self-serving relationship [with Enron] that took precedence over and conflicted with the interests of [defendants’] retail customers.’” According to plaintiffs, the brokerage subsidiary defendant that operated Enron’s employee stock option plan acted as a “seller” and “underwriter” of Enron securities within the meaning of the Securities Act through its administration of the plan, and as such is liable for “materially false statements contained in the Enron prospectuses and registration statements” related to Enron’s stock. Plaintiffs further alleged that defendants “had knowledge of Enron’s ‘financial chicanery’ because of [their] ‘long standing banking history with Enron,’” which allegedly included “material nonpublic information about Enron’s financial manipulations,” and that such knowledge created a “duty to disclose that information” to plaintiffs. Plaintiffs highlighted several Enron transactions that defendants participated in that allegedly amounted to “devices and schemes designed to inflate the appearance of Enron’s financial status,” and argued that defendants had a duty to disclose the material nonpublic information they obtained through their participation in these actions and failed to do so in violation of the securities laws.
The Fifth Circuit first considered in the context of plaintiffs’ Securities Act claims whether the Enron employee stock option plan constituted a sale of securities, thus bringing the plan within the purview of the Securities Act. Plaintiffs argued that “the district court erred by conflating employee stock ownership plans and employee stock option plans” in determining that the plans did not constitute a “sale” under the securities laws. Citing the Supreme Court’s decision in Int’l Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 558 (1979), the Fifth Circuit noted that “an employee’s ‘participation in a noncontributory, compulsory pension plan’ is not the equivalent of purchasing a security.” The Court further noted that post-Daniel, the SEC issued releases clarifying that “for the registration and antifraud provisions of the 1933 Act to be applicable, there must be an offer or sale of a security,” and that although “plans under which an employer awards shares of its stock to covered employees at no direct cost to the employees” do award securities, “there is no ‘sale’ in the 1933 Act sense to employees, since such persons do not individually bargain to contribute cash or other tangible or definable consideration to such plans.” Noting that “[c]onsistent with the interpretations of the SEC, courts have extended Daniel to compulsory and involuntary employee stock option plans,” the Fifth Circuit stated that the central question is “whether employees made an investment decision that could be influenced by fraud or manipulation.” The Court found that where the employees’ participation is an “incident of employment”—as was alleged by plaintiffs—there is “no bargained-for exchange that requires an affirmative investment decision” and that “under Daniel, the ‘exchange of labor’ is insufficient.” Further, the Court determined that plaintiffs’ claim is based entirely on the grant of the options, rather than an exercise of those options, an action which “required no affirmative investment decisions by plaintiffs.” As such, the Fifth Circuit affirmed the dismissal of the Securities Act claims.
Turning to the brokerage customer plaintiffs’ Exchange Act claim, the Fifth Circuit held that plaintiffs failed to sufficiently allege that defendants had a duty to disclose or that they possessed “material, nonpublic knowledge.” Plaintiffs alleged that the defendant brokerage firm they used (then a separate legal entity, but presently a subsidiary defendant of the financial institution defendant) and another subsidiary defendant “united in a joint venture” in an effort to establish that the various defendant entities shared knowledge and a duty to disclose any materially misleading information of which they were aware. The Court rejected this argument, citing Giancarlo, et al. v. UBS Financial Services Inc., et al., No. 16-20663 (5th Cir. Feb. 26, 2018), a recent unpublished decision by another panel of the Fifth Circuit that heard a related case (previously discussed in a prior post). Although not bound by the decision, the Fifth Circuit adopted the reasoning from Giancarlo, finding it “persuasive,” and held that plaintiffs failed to adequately allege defendants operated as a joint venture (as there was no sharing in loss or profits and no joint control) and failed to advance any persuasive theories to “aggregate the actions and knowledge of the defendant entities for purposes of assessing liability.”
The Court next considered plaintiffs’ argument that defendants’ alleged “special relationship” with its retail clients (plaintiffs) and issuer client (Enron) created a duty to disclose material nonpublic information to plaintiffs. Plaintiffs cited as support the Supreme Court’s decision in Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 128 (1972), which held that defendants’ “special relationship” with plaintiffs gave rise to a duty of disclosure. In distinguishing Affiliated Ute, the Fifth Circuit found that plaintiffs failed to “allege an analogous relationship” in the instant case because plaintiffs were relying on “grouping” entities with “separate legal statuses” in order to cure the lack of evidence against any particular entity. The Court held that because plaintiffs failed to allege the existence of a joint venture, plaintiffs must demonstrate that the subsidiaries independently knew of the alleged material information, something plaintiffs “fundamentally fail[ed] to establish.” According to the Court, the “lack of particularized allegations that any defendant entity possessed material information about Enron’s finances and a duty of disclosure [were] fatal to their claim.”
The Court similarly rejected plaintiffs’ argument that the securities industry’s self-regulatory organization rules imposed a duty to disclose, finding that although the brokerage firm defendant had a duty to disclose based on the regulatory organization’s rules, plaintiffs failed to allege that the brokerage firm defendant possessed any knowledge to disclose. According to the Court, it was the other subsidiary defendants that participated in the transactions that would have the alleged knowledge about the accounting issues. But because plaintiffs could not establish the existence of a joint venture between defendants and there were no allegations that the information was actually shared between them, defendants did not have a duty to disclose.
Finally, the Court considered whether the district court had properly dismissed the third amended complaint with prejudice. As in Giancarlo, plaintiffs argued that the district court abused its discretion and that the reason plaintiffs failed to timely amend their complaint was due to the depositions of Enron’s former CFO and defendants’ expert, which occurred after the deadline to amend and from which plaintiffs sought additional information. The Fifth Circuit rejected this argument, emphasizing that plaintiffs failed to clarify how their amended allegations, if permitted, would have provided support for “their theory that [the brokerage firm and the other subsidiary] participated in a joint venture.” The Fifth Circuit thus determined that the district court did not abuse its discretion in refusing to grant leave to amend and affirmed the district court’s dismissal.