In a case resulting from the collapse of Enron, originally filed in 2002, the 5th U.S. Circuit Court of Appeals has affirmed a lower court’s dismissal of charges against UBS Financial Services, formerly UBS PaineWebber, for failure to disclose material information about Enron’s financial manipulations.
The case involved two classes of plaintiffs: individual retail-brokerage customers of PaineWebber who purchased Enron securities and Enron employees who acquired employee stock options. PaineWebber was tasked with facilitating the exercise of options and providing recordkeeping services related to that process. It was later acquired by UBS.
The plaintiffs claimed UBS violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by failing to disclose the conflicts under which it operated its brokerage business. They also claimed the information and knowledge it possessed during the class period concerning the manipulation of Enron’s public financial appearance. They contended that defendants’ acts, practices and course of business combined to operate a fraud upon the plaintiffs, deceiving them “into believing the price at which they purchased or held their Enron securities was determined by the natural interplay of supply and demand,” according to the court’s opinion.
Specifically relating to the employee stock options, the plaintiffs claimed violations under Sections 11 and 12 of the Securities Act of 1933. They alleged that PaineWebber violated the Securities Act by serving as a “seller” and “underwriter” of Enron securities within the meaning of that statute, making PaineWebber liable for “materially false statements contained in the Enron prospectuses and registration statements” for the company’s stock. They also allege that UBS had knowledge of Enron’s “financial chicanery” because of its “long-standing banking history with Enron.” The Appellate Court noted that, under Section 11, an underwriter can be liable to a person who acquires a security where the registration statement “contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein.” Under Section 12, any person who “offers or sells a security” in a company whose prospectus or oral communication “includes an untrue statement of a material fact or omits to state a material fact necessary in order to make such statements, in the light of the circumstances under which they were made, not misleading,” is liable to the person “purchasing such security from him.”
However, the parties disputed whether the Enron employee stock option plans amounted to a sale of securities within the meaning of the statute. The plaintiffs contended that the district court erred by conflating employee stock ownership plans (ESOPs) and employee stock option plans. While an employee benefit plan requires a court to determine whether the beneficiary interest is a security, the plaintiffs asserted that the stock options here are securities under the statutory definition. This meant the test established by the U.S. Supreme Court in Int’l Brotherhood of Teamsters v. Daniel to determine whether such an interest would be a security was inapplicable. Relying on the same distinction, the plaintiffs maintained that the Securities and Exchange Commission (SEC)’s “no-sale doctrine” for employee benefit plans does not apply to employee stock option plans. The plaintiffs contended there was a “sale” because the grant of the Enron options was “for value”—the provision of services through employment.
The 5th Circuit explained that, in Daniel, the Supreme Court determined that an employee’s “participation in a noncontributory, compulsory pension plan” is not the equivalent of purchasing a security. To determine whether a transaction “constitutes an investment contract, ‘[t]he test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.’” The court noted that, for the employees participating in the pension plan, the “purported investment is a relatively insignificant part” of the employee’s total compensation, and the decision to accept and retain employment likely had only an attenuated relationship to the investment. For that reason, participation in the noncontributory, compulsory pension plan was unlike other cases where the court recognized “the presence of a ‘security’ under the Securities Acts”—in those cases, the investor gave up a specific consideration in return for a “separable financial interest with the characteristics of a security.”
According to the court opinion, shortly after Daniel, the SEC issued a release to “resolve the uncertainty” surrounding the case’s application to “many types of employee benefit plans not covered by the decision.” In that release, the SEC clarified that, “for the registration and antifraud provisions of the 1933 Act to be applicable, there must be an offer or sale of a security.” The agency went on to explain that, even though “plans under which an employer awards shares of its stock to covered employees at no direct cost to [them]” do award securities, “there is no ‘sale’ in the 1933 Act sense to employees, [as] such persons do not individually bargain to contribute cash or other tangible or definable consideration to such plans.”
The 5th Circuit found that, where employees’ participation is an “incident of employment,” there is no bargained-for exchange that requires an affirmative investment decision. Under Daniel, the “exchange of labor” is insufficient.
The Appellate Court concluded the district court correctly recognized that the grant of options to employees was not a sale. The employees did not bargain for the options, and they were not granted for cash consideration. “Plaintiffs attempt to distinguish option grants by pointing out that the employees would be forced to make an affirmative investment decision after the grants were made—at that point, employees would decide whether to exercise the option or allow it to expire unexercised. However, plaintiffs expressly disclaim reliance on the exercise of the options. Indeed they repeatedly emphasize that ‘[t]he Options- Plaintiffs’ claims in no way depend upon the exercise of a stock option to purchase the underlying stock.’ Their claim is based entirely on the grant of the options—an action [that] required no affirmative investment decision by the plaintiffs,” the opinion says.