The opinion of the court was delivered by: Judge James B. Zagel
MEMORANDUM OPINION AND ORDER
In a civil enforcement action, the United States Securities and Exchange Commission (the "Commission") sued three former officers of the gas utility company Nicor, Inc. for violations of the securities laws incident to a purportedly massive financial accounting fraud. The claims come under the Securities Exchange Act and rules promulgated thereunder. Jurisdiction and venue are uncontroversial.
Two of the three Defendants, Kathleen Halloran and George Behrens, now move for summary judgment. (Defendant Thomas Fisher has settled his case). The motion's primary argument is that the SEC has failed to uncover sufficient evidence of the requisite mental state (scienter for some claims, negligence for others). I find that the Commission has produced sufficient evidence to warrant a trial with regard to the mental state requirements, so the motion on that basis is DENIED.
I do find, however, that the Commission has not produced material misleading statements relevant to its claim for civil penalties. Further, I find that the Commission has failed to produce sufficient evidence regarding the need for the remedies of injunction and an officer/director bar against Defendants. Thus, where the motion relates to those remedies, the motion is GRANTED.
The case therefore proceeds on all counts, but only for the equitable remedy of disgorgement of profits.
Recounted with all reasonable inferences in favor of the Commission, the undisputed facts of the case are as follows.
Throughout the time relative to the allegations, Nicor Inc. was a gas utility holding company headquartered in Naperville, Illinois. Its common stock was registered pursuant to Section 12(b) of the Exchange Act and trades on the New York Stock Exchange. Through its subsidiary, Northern Illinois Gas Co. ("Nicor Gas"), Nicor provides natural gas service to much of northern Illinois. Nicor Gas, as a public utility, is regulated by the Illinois Commerce Commission ("ICC").
Defendant Kathleen Halloran, age 59, received a bachelor's degree in accounting from Lewis University in 1974 and a Master's in Business Administration degree from Northern Illinois University in 1979. She is an unlicensed CPA, who took and passed the CPA exam but never practiced as such. Halloran worked for Nicor from 1974 until she retired in August, 2004. Halloran has not worked since her retirement. From May 1999 through November 2003, Halloran was Executive Vice President Finance and Administration. Halloran was the Chief or Principal Financial Officer in 1999 and was both the Chief or Principal Financial Officer and the Chief or Principal Accounting Officer from 2000 through at least 2002.
Defendant George Behrens, age 56, received a bachelor's degree in accounting in1976, a Master's in Business Administration degree in finance in 1982, and is an unlicensed certified public accountant. Behrens was hired by Northern Illinois Gas Co. in 1996 and served in a variety of capacities until he resigned in June 2006. Behrens directly reported to Halloran from at least November 1, 1999 through at least March 1, 2003. Behrens was Vice President and Controller for Nicor and Nicor Gas from 1998 through 1999, Vice President Administration for Nicor and Nicor Gas from 1999 through 2000, and Vice President Administration and Treasurer for Nicor and Nicor Gas from 2000 through at least March 1, 2003.
Quarterly and Annual Financial Statements For each fiscal year ending in December 1999, December 2000 and December 2001, Nicor publicly filed Form 10-Ks with the SEC that included unqualified opinions on Nicor's financial statements from its independent outside auditors at the Arthur Andersen accounting firm. Nicor also filed the corresponding 10-Q quarterly forms in that time period.
In March 2003, Nicor restated its financial statements for 1999, 2000, and 2001, as well as its quarterly financial statements for the first three quarters of 2000, 2001 and 2002.
Nicor filed a Form 8-K signed by Halloran and filed on August 14, 2002, certifying, pursuant to a Commission Order dated June 27, 2002, that Nicor's 2001 annual and quarterly filings with the Commission contained no untrue statement or omission of material fact. Nicor filed on the same day a Form 10-Q for the second quarter of 2002 which included previously issued financial statements of Nicor for earlier periods, which earlier financials, the SEC alleges, contained material errors and were ratified.
Prior to issuing the restatements, on July 18 and July 19, 2002, Nicor issued press releases disclosing that allegations of errors or improprieties related to its accounting under its performance based rate program ("PBR") had occurred. Through these two publicly issued press releases, Nicor advised that it was possible that "the company will have to restate some of its prior financial results or take a charge against further earnings, although the extent of or need for any such restatement or charge is not currently known." Nicor also announced that it had formed a Special Committee of the Board of Directors to conduct an inquiry and that the Special Committee, in turn, had retained former U.S. Attorney Scott Lassar to perform an independent investigation. "Last-In, First Out" Inventory Valuation
Nicor valued its natural gas inventory using the last-in, first-out ("LIFO") cost method. LIFO is an inventory costing method that assumes for accounting purposes that the last goods purchased or manufactured are the first ones sold, irrespective of the actual physical flow of goods. In periods of rising prices, LIFO usually produces a lower inventory valuation on an entity's balance sheet -- or "book value" -- than results from using a first-in, first-out ("FIFO") method, which assumes that the first goods purchased or manufactured are the first ones sold.
LIFO requires that inventory quantity increases in a given year be priced at current replacement cost, which usually approximates current market prices. When there is a quantity increase from the prior year end, a new LIFO layer is created. The new LIFO layer, priced at current replacement cost, is then added onto the layers created in past years to arrive at the total year-end inventory valuation.
Conversely, should year-end quantities decrease from the prior year -- i.e., the company experiences a "LIFO decrement" -- the reduction is accounted for by eliminating or reducing some or all of the most recent inventory layer or layers to determine the year-end inventory valuation. Depending on the size of the inventory reductions and the carrying values of the remaining layers, LIFO decrements frequently result in a significant mismatching of current revenues versus the amount reported as cost of goods sold, with the latter reflecting quantities carried at the lower costs prevailing in prior years rather than current replacement costs.
Under the LIFO method, as of December 31, 1998, Nicor's inventory consisted of gas "layers" priced at historical prices from 1954 to 1996. (Id. ¶ 19; SEC Ex. 65.) The most recent layers from 1996 and 1984, internally known at Nicor as the "high-cost" layers, were carried at costs of $3.23 and $2.88 per MMbtu (a measure of gas volume) respectively. These two layers represented about 78% of the total LIFO dollar valuation at December 31, 1998 although they were only about 26% of the gas volume in inventory at that date. (Id.) The remaining 74% of the gas volume at December 31, 1998 consisted of so-called "low-cost" LIFO layers dating from 1973 back to 1954 and were carried at costs per unit of gas ranging from $.45 to $.19.
The combination of Nicor's LIFO accounting policy and a substantial increase in gas market prices in the years following gas industry deregulation meant that, by the late 1990s, the market value (or replacement cost) of Nicor's inventory of gas in storage far exceeded the book value at which Nicor carried the inventory. As of December 31, 1999, Nicor was carrying on its books inventory that had "cost" only $31 million but that had a current market value of $203 million, a difference of approximately $172 million.
The $172 million difference represented the unrealized "value" that Nicor was seeking to capture when it developed its PBR proposal, discussed below. This $172 million dollar value is at the heart of the allegations in the Commission's theory of the alleged fraud.
Nicor Forms an "Inventory Value Team"
Under its traditional regulatory rate plan, PGA, Nicor was required to pass its cost of gas directly to customers without a markup -- i.e., if lower cost layers of gas were used to supply customers, then customers would pay less for the gas. This pass-through was accomplished by means of the purchased gas adjustment ("PGA"). In addition to the cost of gas, other recoverable costs are defined under the Illinois Administrative Code and include costs to store natural gas, costs to transport natural gas through natural gas transmission pipelines, and other out-of-pocket costs related to the purchase and transportation of natural gas. Utilities cannot recover costs through the PGA other than those specifically defined as recoverable gas costs.
In 1998, Nicor was facing a situation in which and industry phenomenon known as "unbundling," along with other developments, was expected to cause Nicor to liquidate some or all of its low-cost LIFO inventory. Under the company's traditional rate mechanism then in place, 100% of the previously unrealized value of any such liquidated LIFO inventory would have gone to Nicor's ratepayers.
In early 1998, Nicor assembled an Inventory Value Team ("IVT") in order to capture the value of the LIFO layers for the company. Defendant Behrens had some role in the formation of the IVT, though the extent of that role is disputed. (Defendant Hallaron was not a member of the IVT). According to the testimony of Jeffrey Metz, Nicor's controller and a direct subordinate of Defendant Behrens, Behrens "told" Metz to form the IVT. Metz stated that the purpose of the IVT "was to look at different ways of monetizing the LIFO inventory value." According to documents prepared by the IVT, the team was formed to explore Nicor's "best strategy to capture the value of the LIFO layers" and to "evaluate stockholder capture of excess market value."
Later in 1998, the IVT prepared a report recommending that Nicor file and implement a Gas Rate Performance Plan (or PBR) in order to capture the value of Nicor's LIFO inventory for the company. According to the Inventory Value Team Report, "[d]ue to [industry developments] it is likely that we will liquidate some of our LIFO inventory and reduce or eliminate the low priced LIFO layers, thus 'releasing' some of this value." The report acknowledged that under Nicor's traditional rate program, and absent a PBR program, the full economic value associated with the liquidation of Nicor's low cost LIFO layers would pass through the PGA for the benefit of ratepayers: "Under our current rate structure, book value of gas inventory reductions would be included in the PGA."
Under the "Recommendation" section, the Inventory Value Team Report noted that the economic value associated with the low-cost LIFO inventory was likely to begin accruing to ratepayers via inventory liquidation spurred by the trend toward unbundling. In relevant part, the report stated, "[t]here is a critical need to act quickly with the inventory value issue since the pace of unbundling may cause us to start withdrawing the low priced gas in two or three years."
The IVT explored various "Ways to Capture the LIFO Inventory Value," including the elimination of the PGA, conversion to a fixed-price PGA, and the PBR. After exploring the pros and cons of each approach, the IVT, as reflected in the report, concluded that implementing a performance based rate plan was "the recommended method for the Company to capture the value from the LIFO layers."
Nicor's Change from the "PGA" Rate Plan to a "PBR" Rate Plan
Performance-based ratemaking is an alternative to traditional utility ratemaking. The goal of performance-based ratemaking, as generally understood in the utility industry, is to provide ratepayers with benefits that would not be achieved under traditional regulation, typically by allowing utilities the ability to profit from outperforming certain benchmarks established by regulators. In the case of the PBR proposed, and ultimately adopted by Nicor, to the extent that actual gas costs were lower than the benchmark, then the savings were shared between Nicor and its ratepayer customers. To the extent that actual costs were higher than the benchmark, then the losses likewise were shared between Nicor and the ratepayers and the utility.
On November 20, 1998, the IVT presented its report and findings to Defendants Halloran and Behrens, as well as other senior Nicor executives. The report was distributed to everyone, who was invited to the meeting including Defendants. During the meeting, the IVT discussed the reasons why it had concluded that the PBR plan was the recommended method to capture the value of the LIFO layers. Among the important benefits of a PBR plan that were discussed was the fact that the benefit Nicor was expecting to reap from the LIFO inventory liquidations was "not explicit."
On August 4, 2000, Nicor controller Jeffrey Metz wrote a memorandum, which was shared with Defendants, noting that on an interim basis, Nicor "will need to be careful to not highlight the LIFO benefit. In the actual year-end PBR computation, the LIFO benefit will be very difficult to recognize. It may be more transparent on an interim basis."
On February 16, 1999, the Financial Policy Committee, of which Halloran and Behrens were members, met. The IVT presented its findings. The Financial Policy Committee then authorized their subordinates to prepare and file with the ICC an application for approval of a PBR plan. After the meeting Behrens told the company's controller Metz to go ahead and proceed with the PBR plan.
In March 1999, Nicor petitioned the ICC to approve its PBR. Nicor cited three objectives in proposing the GCPP: (1) to provide an economic incentive for Nicor to improve its performance in providing the best gas costs for customers; (2) to establish a reasonable balance between risk and reward for Nicor; and (3) to lower regulatory costs by eliminating retrospective prudence reviews. Nicor also explained that the Company's proposal "responds to changing gas supply markets brought about by the restructuring of the natural gas industry" and the resultant "opportunities to aggressively pursue cost minimization through innovative, nontraditional means." The rationales for the PBR presented by Nicor in its petition and its supporting testimony, and the reasons cited by the ICC in approving a modified version of Nicor's proposed PBR reflect the reasons, as widely understood in the utility industry at the time, that utilities and regulators pursued performance-based ratemaking.
Nicor was represented by the law firm of Mayer, Brown & Platt in presenting the proposed PBR to the ICC. Mayer Brown attorney Stephen Mattson reviewed the testimony submitted by Nicor witnesses, advised Nicor's witnesses, drafted briefs submitted to the ICC, and argued orally before the ICC on Nicor's behalf. Neither Halloran nor ...