Ernst & Young v. Pacific Mutual Life Ins. Co., 00-0232

• Decision Date: 21 June 2001
• Docket Number: No. 00-0232,00-0232
• Parties: (Tex. 2001) Ernst & Young, L.L.P., Petitioner v Pacific Mutual Life Insurance Company, Respondent
• Court: Texas Supreme Court

Page 573

51 S.W.3d 573 (Tex. 2001)

Ernst & Young, L.L.P., Petitioner v Pacific Mutual Life Insurance Company, Respondent

No. 00-0232

SUPREME COURT OF TEXAS

Argued on January 3, 2001

June 21, 2001.

On Petition for Review from the Court of Appeals for the Fifth District of Texas

Justice O'Neill delivered the opinion of the Court.

In this case, we must decide the scope of an accounting firm's liability for making fraudulent misrepresentations in an audit report. Specifically, we consider whether the intent-to-induce-reliance element of a fraud claim requires a direct relationship between the alleged fraudfeasor and a specific known person -- commonly referred to in this context as "privity." The court of appeals followed the Restatement (Second) of Torts section 531, which does not require privity and recognizes liability when an alleged fraudfeasor "has reason to expect" a person's or class of persons' reliance on the misrepresentations. 10 S.W.3d 798, 804-05. Concluding that the plaintiff-investor raised a fact issue on this element, the court of appeals reversed the trial court's summary judgment for the accounting firm. Id. at 810. Although we need not decide whether to adopt Restatement section 531, we conclude that section 531's reason-to-expect standard is consistent with our fraud jurisprudence. But we agree with the accounting firm that the court of appeals misapplied that standard in this case. We hold that the accounting firm established as a matter of law that it had no reason to expect the investor's reliance on the audit report in the transaction at issue, and because the investor's remaining claims were premised on the fraud claim the trial court properly granted summary judgment in the accounting firm's favor. Accordingly, we reverse the court of appeals' judgment and render judgment that the investor take nothing.

I. Background

At the center of this litigation is a series of notes that InterFirst Corporation issued in 1982 and Pacific Mutual Life Insurance Company purchased in 1987 after InterFirst merged with RepublicBank Corporation. Pacific claims that in purchasing the InterFirst notes it relied on an Ernst & Young¹ audit report that confirmed RepublicBank's financial strength. When RepublicBank filed for bankruptcy shortly after the merger and the InterFirst notes became virtually worthless, Pacific sued Ernst & Young for fraudulent misrepresentation. Before addressing Ernst & Young's potential fraud liability, we review the underlying transaction and the context in which the alleged misrepresentations were made.

In 1982, InterFirst issued a series of notes scheduled to mature in 1989. By 1986, InterFirst was in financial difficulty and it began to negotiate a merger with RepublicBank, which appeared at the time to be a stronger, more profitable bank. Ernst & Young audited RepublicBank's financial statements for the year ending December 31, 1986, and gave an unqualified opinion that those statements fairly presented the bank's financial position. RepublicBank incorporated Ernst & Young's audit report and the audited financial statement in the 1986 annual report it made to its shareholders and the Form 10-K it filed with the Securities and Exchange Commission.

The banks merged in June 1987.² RepublicBank offered several securities as part of the merger, including notes and two classes of stock in the merged entity. Together with InterFirst, RepublicBank issued a Joint Proxy and Prospectus soliciting their respective shareholders' proxies to approve the merger. The Joint Proxy and Prospectus also discussed the common stock and one series of preferred stock to be issued in connection with the merger. To promote another series of preferred stock and capital notes, RepublicBank issued two other prospectuses. These two prospectuses incorporated by reference the Joint Proxy and Prospectus. All three prospectuses incorporated RepublicBank's 1986 Form 10-K, which contained the audited financial statements and Ernst & Young's audit opinion. These documents were also incorporated by reference in a section of the prospectuses entitled "Experts," which stated that the RepublicBank financials were incorporated "in reliance upon [the audit] report and upon the authority of [Ernst & Young] as experts in auditing and accounting." Finally, RepublicBank included the three prospectuses in the Form S-3 registration statements filed with the SEC to register the securities described in the prospectuses. Ernst & Young consented to including its audit opinion and the financial information that had been the subject of its report in the prospectuses and to having its name mentioned in the "Experts" section.

The underwriters who were seeking buyers for the merger-related securities contacted Pacific. At the time, Pacific was considering whether to purchase the 1982 InterFirst notes. It was initially reluctant to do so because of its experience with other InterFirst notes purchased some years earlier, which it had placed on its problem asset list due to InterFirst's poor financial condition. But after reviewing public information relating to the merger, including the merger prospectuses and newspaper articles, Pacific decided that the InterFirst notes were a good investment because they would be backed by the merged bank. Pacific bought $415,725 of the 1982 InterFirst notes one month after the merger, and then bought nearly $8 million more a few months later. Pacific did not buy any securities offered in the three prospectuses.

Shortly after Pacific completed buying the InterFirst notes, the merged entity, First RepublicBank Corporation, disclosed serious financial problems with its real-estate portfolio and filed for bankruptcy. Alleging that it had been misled by fraudulent representations in the three prospectuses, Pacific sued Ernst & Young, among others.³ Pacific alleged that Ernst & Young's audit opinion contained misrepresentations, including statements that the audit complied with generally accepted auditing standards ("GAAS") and that the financial statements "fairly presented" RepublicBank's financial position as of December 31, 1986. Pacific alleged that the financial statements did not accurately reflect RepublicBank's financial condition and actually understated RepublicBank's real-estate liabilities. Pacific further alleged that Ernst & Young violated GAAS standards, including the auditor's standard of independence. Ernst & Young allegedly violated the independence standard by failing to disclose that, at the time Ernst & Young issued its opinion, several of its partners had significant outstanding RepublicBank loans.

Ernst & Young moved for summary judgment based in part upon affidavits asserting that Ernst & Young did not specifically intend for Pacific to rely on representations made in the 1986 audit report when making its decision to buy the InterFirst notes. Pacific responded and filed a cross-motion for partial summary judgment claiming that, as a matter of law, Ernst & Young intended to induce its reliance. Pacific also argued that, because Ernst & Young failed to challenge its claims for conspiracy and "aiding and abetting" the fraud others committed, summary judgment on those claims was improper.

To defeat Ernst & Young's motion, Pacific produced two experts' affidavits and an affidavit from Larry Card, a Pacific vice-president who had overseen the InterFirst note purchases. All three affidavits state that it is a commonly known and accepted practice in the financial industry for investors like Pacific to rely on representations about an entity contained in SEC filings, whether the investor is purchasing the specific security being offered or another investment the entity backs.

The trial court granted Ernst & Young's summary judgment motion and denied Pacific's cross-motion as moot. Pacific appealed, and the court of appeals reversed the summary judgment. 10 S.W.3d 798. It held that there were fact issues on each element of Pacific's common-law fraud claim and that Ernst & Young's motion did not discuss the conspiracy and "aiding and abetting" claims. Id. In concluding that a fact issue existed on Ernst & Young's intent, the court of appeals applied section 531 of the Restatement, which provides:

One who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation, for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced.

Restatement (Second) of Torts § 531 (1977) (emphasis added). The court held that Pacific's three affidavits created a fact issue on whether Ernst & Young had "reason to expect" that an institutional investor like Pacific would rely on its representations about RepublicBank's financial strength in purchasing securities issued by InterFirst before the banks merged. 10 S.W.3d at 807.⁴ We granted Ernst & Young's petition for review to examine the intent element of Pacific's fraud claim.

II. Fraud

As the summary judgment movant, Ernst & Young has the burden to establish, as a matter of law, that there are no material fact issues concerning one or more of the essential elements of Pacific's claims. See Phan Son Van v. Pena, 990 S.W.2d 751, 753 (Tex. 1999). When reviewing a summary judgment, we assume that all evidence favorable to the nonmovant is true. Id. at 753. We indulge every reasonable inference and resolve any doubts in the nonmovant's favor. Id.

To prevail on its fraud claim, Pacific must prove that: (1) Ernst & Young made a material representation that was false; (2) it knew the representation was false or made it recklessly as a positive assertion without any knowledge of its truth; (3) it intended to induce Pacific to act upon the representation; and (4) Pacific actually and justifiably...