In November 1995, respondent accounting firm Logan, Throop & Company (Logan) prepared a financial statement for World

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In November 1995, respondent accounting firm Logan, Throop & Company (Logan) prepared a financial statement for World Interactive Networks, Inc. (WIN), a non-publicly-traded corporation, for the period ending in August 1995. The statement misrepresented the value of various WIN assets, claiming they were worth $145 million when in fact they amounted to only $30 million. Logan also claimed the financial statement complied with generally accepted accounting principles (GAAP) when it did not. In February 1996, Logan repeated essentially the same misrepresentations in its auditors’ report of WIN’s 1995 balance sheet. 

The same month that Logan released its auditors’ report, respondent accounting firm BDO Seidman, LLP (Seidman), issued WIN’s audited financial statement for 1995. In the statement, Seidman misrepresented the value of WIN’s assets, claiming they were worth slightly more than $121 million, when they were truly worth only $6.9 million. In addition, Seidman misrepresented WIN’s shareholder equity as $88 million, when the company was worthless. Several months later, Seidman repeated essentially the same misrepresentations when it released its review of WIN’s quarterly balance sheet for the period ending March 1996. 

Struthers Industries, Inc. (Struthers), was a publicly traded corporation. In 1995, WIN and Struthers agreed to a reverse merger, subject to shareholder approval, in which WIN would sell its assets to Struthers in return for Struthers stock, following which Struthers would become WIN’s subsidiary. While the proposed merger was pending, Seidman prepared a pro forma financial statement of Struthers and WIN as a combined entity, which substantially repeated, from Seidman’s earlier audit of WIN, the same false asset values and misrepresentations about complying with GAAP. In January 1997, Seidman sent the pro forma statement to the Securities and Exchange Commission. The SEC told Struthers the pro forma statement did not comply with GAAP because it did not properly account for the inherent uncertainty of the proposed merger. Seidman did not tell appellants, all of whom either owned or later bought WIN or Struthers stock, about the SEC’s rejection of Seidman’s accounting for the proposed merger. 

In March 1998, WIN and Struthers filed for bankruptcy, and appellants, who allege they relied on Seidman’s and Logan’s financial statements to buy stock in the companies, lost their investments. Consequently, appellants sued both accounting firms, alleging causes of action for negligent and intentional misrepresentation. * * * 

Respondents demurred to the complaint * * * arguing it failed for a number of reasons to state a cause of action and pleaded fraud with insufficient detail. The court adopted respondents’ arguments and sustained [the] demurrers without leave to amend. Its minute order added that ‘‘The complaint remains scrambled … and lacks essential information, i.e., Who said what to whom? When? What was the reliance?’’ The court entered judgment for respondents. This appeal followed. 

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        II. Respondents’ Duty to Appellants 

Respondents assert that their liability for any inaccuracies in the financial statements was only to their clients, WIN and Struthers, not to third parties. Accordingly, respondents contend appellants cannot state a cause of action for negligent or intentional misrepresentation because they owed no duty to appellants. We disagree.

In Bily v. Arthur Young & Co. [citation], our Supreme Court formulated a hierarchy of duty for accountants who prepare inaccurate financial statements. Casting an ever-widening circle of obligation, Bily established that the more egregious the misstatement, the broader the duty:

For ordinary negligence, an auditor owes a duty only to its client. As Bily explained, ‘‘[A]n auditor’s liability for general negligence in the conduct of an audit of its client financial statements is confined to the client, i.e., the person who contracts for or engages the audit services. Other persons may not recover on a pure negligence theory.’’ [Citation.]

For negligent misrepresentation, the duty expands to specifically intended beneficiaries of the report who are substantially likely to receive the misinformation. Bily defined such beneficiaries as ‘‘persons who, although not clients, may reasonably come to receive and rely on an audit report and whose existence constitutes a risk of audit reporting that may fairly be imposed on the auditor. Such persons are specifically intended beneficiaries of the audit report who are known to the auditor and for whose benefit it renders the audit report.’’ [Citation.] Liability arises toward such plaintiffs when the representation was made ‘‘with the intent to induce plaintiff, or a particular class of persons to which plaintiff belongs, to act in reliance upon the representation in a specific transaction, or a specific type of transaction, that defendant intended to influence. Defendant is deemed to have intended to influence [its client’s] transaction with plaintiff whenever defendant knows with substantial certainty that plaintiff, or the particular class of persons to which plaintiff belongs, will rely on the representation in the course of the transaction.’’ [Citations.]

For intentional misrepresentation, the duty expands yet further to include anyone whom the auditor should have reasonably foreseen would rely on the misrepresentations. Bily explained, ‘‘The representation must have been made with the intent to defraud plaintiff, or a particular class of persons to which plaintiff belongs, whom defendant intended or reasonably should have foreseen would rely upon the representation. One who makes a representation with intent to defraud the public or a particular class of persons is deemed to have intended to defraud every individual in that category who is actually misled thereby.’’ [Citation.]

Bily can thus be briefly summarized as follows: (1) ordinary negligence—no duty to third parties; (2) negligent misrepresentation—duty to third parties who would be known with substantial certainty to rely on the misrepresentation; and (3) intentional misrepresentation—duty to third parties who could be reasonably foreseen to rely on the misrepresentation.

* * * Relying on Bily, respondents contend the complaint fails to state a cause of action because, first, it does not allege respondents knew that appellants planned to invest in WIN or Struthers and, second, it fails to allege respondents intended to influence such investment decisions. We conclude respondents misread the complaint.

1. Appellants Allege the Duty for Negligent Misrepresentation. The complaint alleges WIN and Struthers hired respondents to prepare various financial statements that appellants relied upon in buying WIN or Struthers stock and in approving their merger. The complaint also alleges respondents knew WIN or Struthers would distribute the statements to existing and potential shareholders for such purposes. * * * Such an allegation, and similar allegations targeted at Logan, satisfy Bily’s criteria for negligent misrepresentation: respondents knew with substantial certainty that potential investors such as appellants would rely on the misstatements. [Citation.] The complaint therefore states a cause of action for negligent misrepresentation.
2. Appellants Allege the Duty for Intentional Misrepresentation. The complaint alleges respondents either intentionally or recklessly misstated the value of WIN’s assets and shareholder equity. It further alleges respondents should have foreseen that current and future investors in WIN and Struthers would rely on the misstated values in deciding whether to invest in those companies and to approve their merger. * * * The complaint therefore states a cause of action for intentional misrepresentation.
3. Appellants Who Bought Struthers Stock Allege Causes of Action. Some appellants bought only Struthers stock. Respondents note that Struthers hired Seidman, but not Logan, to prepare its financial statements. According to respondents, Struthers appellants therefore cannot state a cause of action against Logan because Struthers was not Logan’s client and thus owed no duty to Struthers’ shareholders for any misstatements.

Bily imposes on respondents a duty to more than just their clients. Respondents owed a duty to anyone whom they (1) should have reasonably foreseen would rely on their intentional misrepresentations, or (2) knew with substantial certainty would rely on their negligent misrepresentations. [Citation.] The complaint alleges respondents knew the proposed merger of WIN and Struthers would induce investors in Struthers to rely on financial statements about WIN in anticipation of the two companies becoming one. In addition, the complaint alleges respondents knew Struthers investors would rely on WIN’s financial statements in deciding whether to approve the merger itself. The complaint therefore alleges a duty from respondents to Struthers’ shareholders, making respondents liable to those shareholders for their misrepresentations. 

III. Reliance

1. Sufficient Detail. Logan contends the complaint does not describe appellants’ reliance on Logan’s alleged misrepresentations with enough detail. According to Logan, appellants must identify the ‘‘when, where, and how’’ of their reliance. Our review finds most appellants describe their reliance on WIN’s inflated assets with enough specificity, often including the precise date they bought stock in the company and the amount paid, to permit respondents to prepare a defense. * * *
2. Forbearance Is Reliance. A number of appellants, whom we identify in Appendix 2, bought WIN or Struthers stock before Logan and Seidman issued their first reports, and thereafter relied on respondents’ rosy misstatements in deciding not to sell their stock. * * * After briefing ended in this appeal, our Supreme Court held in [citation] that holding stock can be actionable reliance. * * *
3. ‘‘Grapevine’’ Plaintiffs. Some appellants did not read or otherwise directly rely on the Logan or Seidman financial statements. Instead, they relied on what others told them the statements said. Respondents argue such indirect reliance by those appellants, whom they call ‘‘grapevine plaintiffs,’’ does not constitute legal reliance and is thus not actionable.

The law is otherwise. Indirect reliance is actionable if Logan or Seidman had reason to know others would convey their misrepresentations to appellants. Under Bily, respondents are liable for (1) negligent misrepresentation if they knew it was substantially certain that appellants would receive the misstatements and (2) intentional misrepresentation if it was reasonably foreseeable appellants would receive the statements. Thus, nothing in Bily’s formulation of negligent or intentional misrepresentation precludes indirect reliance. * * * 

Respondents’ contention is well-taken, however, as to certain appellants who do not expressly allege relying on any Logan or Seidman misstatement, whether directly or indirectly. Because they do not allege reliance, the trial court properly dismissed them for failing to state a claim for negligent or intentional misrepresentation. * * * 

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The trial court’s judgment is reversed in part and affirmed in part. * * *

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Smith and Roberson Business Law

ISBN: 978-0538473637

15th Edition

Authors: Richard A. Mann, Barry S. Roberts

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