Nutmeg Securities v. McGladrey & Pullen

• Decision Date: 23 October 2001
• Docket Number: No. B146165.,B146165.
• Citation: 112 Cal.Rptr.2d 657,92 Cal.App.4th 1435
• Court: California Court of Appeals Court of Appeals
• Parties: NUTMEG SECURITIES, LTD., Plaintiff and Appellant, v. McGLADREY & PULLEN, Defendant and Respondent.

112 Cal.Rptr.2d 657

92 Cal.App.4th 1435

NUTMEG SECURITIES, LTD., Plaintiff and Appellant, v. McGLADREY & PULLEN, Defendant and Respondent.

No. B146165.

Court of Appeal, Second District, Division 7.

October 23, 2001.

Rehearing Denied November 20, 2001.

Review Denied January 16, 2002.

Wehner and Perlman, Rodney M. Perlman and Stephen T. Hodge, Los Angeles, for Plaintiff and Appellant.

Keker & Van Nest, Christopher C. Kearney, Steven A. Hirsch, San Francisco, and Stacey L. Wexler, for Defendant and Respondent.

JOHNSON, J.

The underwriter of an initial public offering of a now-defunct corporation brought this action for damages against the corporation's accounting firm, alleging the firm prepared false and misleading financial and audit reports knowing and intending the underwriter would rely on these reports in agreeing to underwrite the offering. The trial court applied a "Bily club"¹ to the action and sustained the accounting firm's demurrer without leave to amend. We reverse.

FACTS AND PROCEEDINGS BELOW

The complaint alleges in relevant part:

Plaintiff Nutmeg Securities, Ltd. (Nutmeg) is in the business of providing financial advice and underwriting for companies "going public" with their stock through an initial public offering (IPO).² Defendant McGladrey & Pullen (McGladrey) is a firm of certified public accountants which performed accounting and auditing services for American Diversified Holdings, Inc. (AmDiv) in connection with AmDiv's IPO.³

In the fall of 1997 McGladrey and Am-Div devised a scheme by which AmDiv could launch its IPO based on false information contained in its financial reports.⁴ At the heart of this scheme was AmDiv's representation it possessed $11 million in assets derived from the sale of a bearer note.⁵ McGladrey participated in this scheme by assisting AmDiv to prepare a financial statement showing $11 million in proceeds from the sale of the bearer note "without ever properly confirming whether such funds actually existed." Later, conducting an "independent audit" of the very financial records it had participated in preparing, McGladrey affirmed the existence of the proceeds from the bearer note.⁶ This affirmation by McGladrey was false and known by it to be false because McGladrey had never verified the existence of the bearer note or its proceeds.⁷

McGladrey also assisted AmDiv in preparing and filing other pre-IPO reports with the Securities and Exchange Commission which contained materially false information concerning AmDiv's financial strength, the state of the company's development and its ability to execute its business plan.⁸

In November 1998 Nutmeg agreed to provide underwriting services to AmDiv in connection with AmDiv's IPO. Nutmeg entered into this agreement with AmDiv based on the false or misleading financial records and other documents prepared and audited by McGladrey.⁹ The false and misleading statements in these documents were material to Nutmeg's decision to undertake the IPO and were made by McGladrey with the knowledge and intent Nutmeg would rely on them in making its decision. Nutmeg did in fact rely on these false and misleading statements in agreeing to assist in AmDiv's IPO.¹⁰

While proceeding with the steps necessary for the IPO, Nutmeg raised questions about AmDiv's accounting practices. In response to Nutmeg's concerns, McGladrey assisted AmDiv in the preparation of a letter assuring Nutmeg "the statements set forth in the registration statement [with the SEC] that are not legal in nature are true and correct ... and that there are no omissions or misrepresentations of any material facts contained therein, nor are there any omissions of fact necessary in order to make the statements made in the registration statement not misleading." These statements were untrue and McGladrey was aware these untrue statements would be communicated to Nutmeg, and intended Nutmeg to rely upon them.¹¹

AmDiv subsequently terminated Nutmeg's services and refused to pay the fees due Nutmeg in the sum of approximately $775,000.¹² This action followed against AmDiv, McGladrey and AmDiv's attorneys.¹³

McGladrey demurred to the complaint on the ground Nutmeg's claim is barred under the decision in Bily because Nutmeg did not and cannot allege it was McGladrey's client, it had any direct contact with McGladrey concerning any of the matters alleged in the complaint, or that it was an intended recipient of McGladrey's audit reports relating to the financial statements of AmDiv.

The trial court sustained McGladrey's demurrer without leave to amend and subsequently entered judgment for McGladrey. Nutmeg filed a timely appeal.

DISCUSSION

I. STANDARD OF REVIEW

We note at the outset a well-established rule. When a demurrer to a complaint is sustained without leave to amend the complaint is reviewed de novo to determine whether, liberally construed, it states a cause of action under any conceivable theory, or could be amended to do so.¹⁴ As we shall explain below, the trial court erred in sustaining the demurrer to Nutmeg's complaint for three independent reasons. First, Nutmeg's complaint falls outside Bily's "intended reliance" limitation on liability for independent audits,¹⁵ because it alleges McGladrey was more than an independent auditor. In essence, the complaint alleges McGladrey knowingly assisted AmDiv in preparing false or misleading financial reports and then, in an audit of the reports it had prepared, certified those reports as fairly representing the company's financial position. Second, even under the "intended reliance" rule in Bily, we conclude the allegations in the complaint are sufficient to state a cause of action for negligent misrepresentation. Third, the complaint falls outside the "intended reliance" rule because it alleges intentional misrepresentation on the part of McGladrey. Intentional misrepresentation is not subject to the "intended reliance" rule applicable to negligent misrepresentation.¹⁶

II. BILY'S LIMITATION ON LIBILITY FOR NEGLIGENT MISREPRESENTATION ONLY APPLIES TO THOSE CONDUCTING INDEPENDENT AUDITS; IT DOES NOT APPLY TO THOSE WHO PREPARED THE UNDERLYING FINANCIAL REPORTS

The Supreme Court began its opinion in Bily by stating the issue: "We granted review to consider whether and to what extent an accountant's duty care in the preparation of an independent audit of a client's financial statements extends to persons other than the client."¹⁷ The court explained an "audit," for purposes of its opinion "`is a verification of the financial statements of an entity through an examination of the underlying accounting records and supporting evidence.' ..."<sup>18</sup> In an audit, "`an accountant reviews financial statements prepared by a client and issues an opinion stating whether such statements fairly represent the financial status of the audited entity.' ... "¹⁹ An auditor, the court observed, "is a watchdog, not a bloodhound.... As a matter of commercial reality, audits are performed in a client-controlled environment. The client typically prepares its own financial statements; it has direct control over and assumes primary responsibility for their contents.... Because the auditor cannot in the time available become an expert in the client's business and record-keeping systems, the client necessarily furnishes the information base for the audit."²⁰

Given the limited "secondary" role of the auditor in the financial reporting process,²¹ the Supreme Court concluded the auditor's liability to third parties also must be limited. Otherwise, the auditor would be subjected to "multibillion-dollar professional liability that is distinctly out of proportion to ... the fault of the auditor ... and ... the connection between the auditor's conduct and the third party's injury...."²² Accordingly, the court held "an auditor's liability for general negligence in the conduct of an audit of its client financial statements is confined to the client."²³ The court further held an auditor's liability to third parties for negligent misrepresentation is confined to those representations "`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 [the auditor] intended to influence.'"²⁴

The limitations Bily imposed on auditor liability are not applicable to the present case. Here, according to the allegations in the complaint, McGladrey did not simply conduct an independent audit of AmDiv's financial statements. Rather, McGladrey participated in the creation of these financial statements.²⁵

Specifically, the complaint alleges McGladrey "manipulated American Diversified financial information as to include as an asset in financials for American Diversified for the year end August 1998, the purported proceeds of the sale of the bearer note in an amount in excess of $11 million even though neither [McGladrey nor AmDiv's attorneys] had ever properly verified whether the note existed or whether the proceeds had been received by American Diversified." (Emphasis added.) McGladrey, it is alleged, included the $11 million "as an asset of American Diversified only after demanding the information and documents, and being threatened with losing the opportunity to remain as American Diversified's accountants ...." The complaint further alleges McGladrey "assisted [AmDiv] in filing the reports necessary to publicly sell stock in [AmDiv], which reports included materially false information concerning the financial strength of [AmDiv]...."

Taking the allegations of the complaint to be true, as we must,²⁶ Nutmeg alleges McGladrey participated in the preparation of AmDiv's most significant financial records and then conducted a purported "independent audit" of the records it prepared. Under these circumstances McGladrey is not entitled to the protection from liability to third parties which the Supreme Court, in Bily,...