Opinion
NOT TO BE PUBLISHED
APPEAL from a judgment of the Superior Court of Los Angeles County, Los Angeles County Super. Ct. No. BC298370 James C. Chalfant. Reversed with directions.
Geragos & Geragos, George W. Buehler, Gregory R. Ellis, Mark M. Kassabian; and Matthew H. Tambor for Cross-complainant and Appellant.
Mayer, Brown, Rowe & Maw, Donald M. Falk, Steven O. Kramer and Germain D. Labat for Cross-defendant and Respondent.
MALLANO, Acting P. J.
Edward Czuker appeals from a judgment dismissing his complaint against Ernst & Young (E&Y) after the trial court sustained E&Y’s demurrer to claims that E&Y prepared tax returns and financial documents misrepresenting the value of several companies, causing Czuker either to invest in those companies or affiliated companies, or to retain investments he previously had made in the companies that he otherwise would have sold. We conclude that the trial court correctly sustained the demurrer to the cause of action for negligent misrepresentation because the complaint fails to allege facts establishing that E&Y undertook to “inform and guide” Czuker with respect to his transactions, a requirement under Bily v. Arthur Young & Co. (1992) 3 Cal.4th 370 (Bily). But we determine that the court erred in sustaining the demurrer to the cause of action for intentional misrepresentation because the Bily requirement does not apply to such a cause of action, and Czuker adequately pleads a claim for intentional misrepresentation.
I
BACKGROUND
“Because this is an appeal from a sustained demurrer, we rely on the facts alleged in [the] complaint without judging their veracity.” (Murphy v. BDO Seidman (2003) 113 Cal.App.4th 687, 690.) Thus, the pleadings create a world of “virtual reality” (see Charpentier v. Los Angeles Rams Football Co. (1999) 75 Cal.App.4th 301, 306), in which we deem to be true “all material facts properly pled and matters subject to judicial notice, but not deductions, contentions, or conclusions of law or fact” (Cadlo v. Owens-Illinois, Inc. (2004) 125 Cal.App.4th 513, 519).
After E&Y’s demurrers to Czuker’s previous pleadings were sustained with leave to amend, Czuker filed his third amended cross-complaint against E&Y for intentional and negligent misrepresentation. For convenience, we refer to the third amended cross-complaint as the complaint.
A. ALLEGATIONS OF THE COMPLAINT
Ryan Kavanaugh operated a consulting company, Kavanaugh Consulting, Inc. (KCI), which managed Czuker’s investments. From April 2000 to June 2001, Kavanaugh induced Czuker to invest a total of $11.5 million as a limited partner in various limited partnerships which in turn used the funds to invest in three corporations: TeleCruz, Inc. (TeleCruz), TransCast, Inc. (TransCast), and PreNet Corporation (PreNet). Kavanaugh sat as a director on the boards of the corporations. The two causes of action of the complaint, intentional and negligent misrepresentation, were based on the following underlying allegations regarding E&Y’s representations.
1. E&Y’s Tax Returns for TeleCruz Fund I, L.P.
TeleCruz purportedly had developed proprietary, low-cost technology to allow television sets to access the Internet. Kavanaugh solicited Czuker’s investment in TeleCruz through a vehicle known as TeleCruz Fund I, L.P. (TeleCruz Fund). TeleCruz Fund invested in securities of TeleCruz. In June through August 2000, Czuker invested $5 million in TeleCruz Fund. Czuker signed a subscription agreement and partnership agreement, intending to become a limited partner with a 36.978 percent interest in TeleCruz Fund. But TeleCruz Fund was not properly formed as a limited partnership, so it was treated by operation of law as a general partnership, depriving Czuker of the benefits of limited partner status.
The business prospects and value of TeleCruz’s product were misrepresented to Czuker. Kavanaugh and others looted the company. By 2001, the company was worthless and not in operation. In April 2001, Czuker’s investment in TeleCruz still had some value, but by the time he learned of the over-valuation of the investments, they had become worthless or had substantially declined in value.
In February and November 2000, E&Y prepared audited financial statements for TeleCruz for the period of its inception in 1996 through September 30, 2000. E&Y’s “Report of Independent Auditors” accompanying the financial statements both reported that TeleCruz “has incurred substantial operating losses since inception. This condition raises substantial doubt about [its] ability to continue as a going concern.”
In April 2001, E&Y, through a partner or under the direction of an E&Y partner, prepared the year 2000 federal tax return for TeleCruz Fund, including federal and state “K-1” forms containing Czuker’s name and specific information about Czuker’s $5 million investment. The Internal Revenue Code (title 26 of the United States Code) and related federal regulations require partnerships to prepare Schedule K-1 forms that report each partner’s share of partnership income and losses. (Katz v. C.I.R. (10th Cir. 2003) 335 F.3d 1121, 1123.) The documents reflected an unrealized gain in value of his investment in TeleCruz Fund from $5 million to over $8.5 million in under a year, notwithstanding the fund’s investment in TeleCruz, which the November 2000 audit report noted as having suffered substantial operating losses. Czuker received the tax returns and K-1 form for TeleCruz Fund shortly after they were prepared.
E&Y knew or should have known that TeleCruz Fund had not increased in value because E&Y had prepared audited financial statements for TeleCruz reflecting that in 1999, TeleCruz had a net loss of approximately $12 million, so that if TeleCruz’s operations continued, it would exhaust its resources in about 13 months. TeleCruz’s audited financial statement for 2000 revealed that the only reason the company did not go bankrupt was that in 2000 it received new investments of working capital, including Czuker’s $5 million investment in TeleCruz Fund, which money was then “upstreamed to TeleCruz itself.”
“Based on the TeleCruz financial statements which it had prepared, E&Y actually knew or should have known that TeleCruz Fund, which invested in securities of TeleCruz, had not risen in value by 70% because E&Y expressed doubts about TeleCruz’s very survival. If TeleCruz declined in value, an entity (TeleCruz Fund) which invested in securities of TeleCruz would also have declined in value. As such, E&Y had a duty to not misrepresent the supposed rise in value of TeleCruz Fund to Czuker on the Forms K-1.” In other words, “E&Y’s audits of TeleCruz gave it information that it had an obligation to take into account in the preparation of Czuker’s Forms K-1 and the TeleCruz Fund tax return.” Thus, E&Y intentionally or unreasonably failed to investigate the true value of TeleCruz Fund and merely “rubber-stamped” figures provided to it by Kavanaugh and KCI, notwithstanding E&Y’s ability to verify the information provided by Kavanaugh through E&Y’s involvement in the TeleCruz audits.
Because E&Y prepared the TeleCruz Fund tax forms which had Czuker’s name on them and were for his use, E&Y knew or should have known that Czuker would rely on the information contained therein. Czuker relied upon the information provided by E&Y and was deceived into believing the TeleCruz Fund had increased substantially in value. Had Czuker known the true facts — that TeleCruz Fund had never been formed properly as a limited partnership and that the tax returns and forms prepared by E&Y misrepresented the value of his investment — he “immediately would have sold all of the investment thereafter or undertaken other mitigating steps including legal action” against Kavanaugh and others. Czuker alleged that there were no legal or contractual obstacles that would have prevented a sale of his interest in TeleCruz Fund and that he would have been able to sell his interest to an appropriate investor in a legal manner. TeleCruz was featured in an article in Forbes Magazine in July 2001, and his interest in TeleCruz Fund had value and was marketable at that time. As a result of Czuker’s reliance on E&Y’s false valuation of TeleCruz, Czuker was damaged “by the decline in value of the investment between the time he otherwise would have sold it and the present.”
In reliance on the TeleCruz Fund tax returns and K-1 forms prepared by E&Y, Czuker also signed an agreement with KCI titled Binding Term Sheet (KCI contract) on July 1, 2001, which was the basis for a lawsuit by Kavanaugh against Czuker asserting that the KCI contract obligated Czuker to invest $20 million in KCI, Kavanaugh’s management company which managed Czuker’s investments. In the lawsuit by Kavanaugh, Czuker disputed the validity of the KCI contract. Had Czuker known that the values reported in the tax returns and K-1 forms prepared by E&Y were false, he would not have signed the KCI contract and exposed himself to additional obligations.
2. E&Y’s Tax Returns for TransCast Fund I, L.P.
Complementing the technology allegedly developed by TeleCruz to allow television sets to access the Internet, TransCast purportedly had developed a related system allowing television sets to serve as conduits for “‘e-commerce.’” TransCast Fund I, L.P. (TransCast Fund) was the vehicle by which Kavanaugh solicited Czuker’s investment in TransCast. In June through August 2000, Czuker invested $4 million in TransCast through TransCast Fund, acquiring an 88.939 percent interest in TransCast Fund. Czuker signed a subscription agreement and partnership agreement by which he intended to become a limited partner in TransCast Fund, but the required filings with the state were never made and a limited partnership was never formed. By operation of law, TransCast Fund became a general partnership.
During 2001, TeleCruz misappropriated all of the assets of TransCast for little or no consideration. Further, TransCast did not have any real products or prospects, but was “merely a shell used and intended to be used to divert Czuker’s investment.” The finances of TransCast and TeleCruz were “commingled to such an extent that an audit of TeleCruz would or should have revealed facts regarding TransCast.”
In April 2001, E&Y, through a partner of E&Y or under the direction of an E&Y partner, prepared TransCast Fund’s federal tax return and a California tax form K-1 containing Czuker’s name and specific information about Czuker’s investment in TransCast Fund for the period from June to December 2000. Czuker received copies of the documents soon after they were prepared. The documents stated that Czuker’s investment experienced an unrealized gain in value from $4 million to $10,016,825. But the entries on the documents were false in that TransCast Fund did not increase in value but appeared to decline in value. E&Y knew or should have known that TransCast Fund had not increased in value because E&Y’s audits of TeleCruz provided, or should have provided, information showing that the TransCast investment was “problematic” and that there were issues regarding whether TeleCruz and its affiliate, TransCast, could continue as going concerns. Instead of verifying the financial information about TransCast Fund, E&Y merely rubber-stamped numbers presented to it by Kavanaugh and TransCast Fund.
Czuker was unaware that the tax forms and tax returns prepared by E&Y misrepresented the value of his investment and that TransCast Fund had never been properly formed as a limited partnership. In reliance on the TransCast Fund tax return and K-1 form, and on the TeleCruz Fund tax return, Czuker entered into the KCI contract, which is the subject of litigation between Kavanaugh and Czuker. Had Czuker known that the returns prepared by E&Y misrepresented the value of his investment, he would not have signed the KCI contract. Further, had Czuker known that his investment did not have the value ascribed to it in the tax forms prepared by E&Y, Czuker “immediately would have sold all of the investment thereafter or undertaken other mitigating steps,” including legal action against Kavanaugh and others at a time when there were still some recoverable assets in TransCast Fund and TransCast. In April 2001, the TransCast portion of Czuker’s investments still had some value, but by the time Czuker learned of the over-valuation of his investment, the investment had become valueless or had declined substantially in value. E&Y’s misrepresentations deprived Czuker of an opportunity to recover any value for his investment. Thus, Czuker was damaged “by the decline in value of the investment between the time he otherwise would have sold it and the present.”
3. PreNet, PreNet Fund I, L.P., and KC Capital I, L.P.
The business of PreNet was to develop and market prepaid cellular phone services and other prepaid products. In April 2000, Czuker invested $500,000 in PreNet through a “Kavanaugh/KCI entity known as PreNet Fund I, L.P. (‘PreNet Fund’).” In June 2001, Czuker invested $2 million in PreNet, but through another “Kavanaugh/KCI entity known as KC Capital I, L.P. (‘KC Capital’).” In connection with his investment in PreNet, Czuker signed subscription agreements and partnership agreements for PreNet Fund and KC Capital and made contributions to those partnerships in the amounts of $500,000 (PreNet Fund) in April 2000 and $2 million (KC Capital) in June 2001. But PreNet did not have the value, successful products or realistic prospects for development that was represented to Czuker.
E&Y was engaged to provide accounting services to PreNet Fund and KC Capital. E&Y prepared “tax returns, tax forms, financial statements and other documentation regarding the KCI investments and PreNet which materially misrepresented the value of Czuker’s investment and the value of PreNet.” E&Y prepared the following documents:
a. E&Y’s Financial Statements for KC Capital
In February 2000, E&Y prepared a Report of Independent Auditors for KC Capital’s performance in 1999 (the 1999 audited financial statement), which Czuker received in February 2001. In September 2000, E&Y prepared a Schedule of Investment Performance Statistics with a Report of Independent Accountants for KC Capital for the period from October 1, 1998, through December 31, 1999, which Czuker received sometime around February 2001 and before his $2 million investment in KC Capital in June 2001.
The 1999 audited financial statement for KC Capital indicated that 42.8 percent of KC Capital’s assets were invested in PreNet, the PreNet assets were valued at $4.5 million, and the net increase in assets for KC Capital’s limited partners during 1999 was over 1,000 percent (from $763,437 to $7,961,738). Further, the value of KC Capital’s PreNet assets was represented to have increased from $740,000 to $4.5 million, a 600 percent return.
The two documents “materially misrepresented the previous performance of KC Capital.” E&Y knew or should have known that KC Capital did not increase in value because a minimal investigation would have shown that its major asset, PreNet, did not increase in value. In September 2000, when E&Y prepared KC Capital’s Schedule of Investment Performance Statistics for 1999, “PreNet’s audited financial statements were available.” In June 2000, a report of independent accountants (by PricewaterhouseCoopers, LLP), showed that in 1998 and 1999 PreNet had no revenue from operations and instead had an operating loss of about $2 million, with cash on hand at year’s end of only $3 million. In other words, PreNet “had no revenue and would burn through its resources . . . within a year and a half.” As PreNet had no revenue, “E&Y either ignored the financials of PreNet in valuing the [KC Capital investment in PreNet] at $4.5 million or failed to perform any investigation into the actual value of PreNet in issuing the Schedule of Investment Performance Statistics and the 1999 Audited Financials for PreNet” in 2000.
E&Y knew that the KC Capital financial documents it prepared “would be used to influence purchasers to purchase interests in KC Capital and/or retain their interests in entities investing in PreNet that had been purchased through KCI and Ryan Kavanaugh.” E&Y prepared the documents for a “target audience” which included “KC Capital, its management, partners in that partnership and those interested in investing in that partnership. By its nature as a financial statement, [the 1999 audited financial statement] would be provided to potential investors. By its nature as a retrospective accounting of investment statistics, [the Schedule of Investment Performance Statistics] is primarily designed as a selling document. As a potential investor, Czuker was known to be or should have been known to be part of the target audience of [the documents]. E&Y should reasonably have foreseen that KC Capital and its management would provide [the documents] to potential partners in KC Capital. As such, Czuker is within the class of people whom E&Y intended to reach and whom E&Y intended would rely on [the documents].”
Czuker reasonably relied on the KC Capital documents prepared by E&Y in investing $2 million in PreNet through KC Capital in June 2001. Had Czuker known the true value of KC Capital and PreNet, he would not have invested $2 million in KC Capital in June 2001. And in July 2001, he would not have entered into the KCI contract, potentially obligating him to invest $20 million in KCI. In addition, had Czuker known the true state of KC Capital and PreNet, he “immediately would have sold all of his investment in PreNet Fund as soon as was reasonably possible thereafter or undertaken other mitigating steps.” But by the time Czuker learned of the overvaluation, his investment in KC Capital had become valueless or had declined substantially. Czuker was damaged “by the decline in value of [his] KC Capital investment between the time he otherwise would have sold it and the present.”
b. E&Y’s Tax Returns for PreNet Fund
On or about April 11, 2001, E&Y, through a partner or under the direction of a partner of E&Y, prepared the federal and state tax returns for PreNet Fund, including the schedule K-1 for federal Form 1065, listing Czuker’s share of income, credits and deductions for the 2000 tax year as a partner in PreNet Fund. E&Y placed Czuker’s name and address on the federal and state PreNet Fund K-1 forms and sent them to Kavanaugh, who sent them to Czuker, who received the schedule K-1 forms on April 13, 2001. E&Y knew that Czuker was to be the ultimate recipient of the K-1 form for PreNet Fund. The K-1 form listed Czuker’s April 2000 investment of $500,000 in PreNet Fund, stated that such investment had an unrealized gain in value of $387,061, and valued his total capital account as of December 31, 2000, at $887,061. In addition, E&Y had direct communication with Czuker in March 2001, when E&Y faxed to Czuker for his signature a letter confirming the amount of his investment in PreNet Fund.
As PreNet Fund invested in securities of PreNet, E&Y knew or should have known that PreNet Fund had not increased in value because E&Y knew or should have known that PreNet had not increased in value. E&Y “failed to investigate the true value of PreNet Fund, failed to obtain the required ‘back-up’ and merely ‘rubber-stamped’ figures provided to it by Kavanaugh and KCI.” E&Y “passed along the inflated valuation information without performing any investigation into PreNet Fund’s valuation despite its ability to verify the information . . . .” E&Y “knew or should have known the PreNet investment was problematic and there were issues regarding whether PreNet could continue as a going concern.”
In reliance on E&Y’s April 2001 misrepresentations concerning the value of his investment in PreNet Fund, Czuker, in June 2001, invested an additional $2 million in PreNet through KC Capital. Also in reliance on E&Y’s April 2001 misrepresentations, Czuker signed the KCI contract, potentially obligating him to invest $20 million in KCI. Finally, Czuker claims that he was damaged by his reliance on the false valuation placed by E&Y on PreNet Fund because “by the time Czuker learned of the over-valuation the investment had become valueless or declined substantially in value. [He] has been damaged, at a minimum, by the decline in value of the investment between the time he otherwise would have sold it and the present.”
B. Demurrer
E&Y demurred to the complaint on the grounds that (1) the allegations regarding the July 2001 KCI contract exceed the narrow scope of the leave to amend granted by the trial court, (2) the fraud claims fail because they are not pleaded with the requisite specificity, (3) the negligent misrepresentation claims fail because Czuker is not within the class of plaintiffs entitled to sue under Bily, and (4) with respect to the investments made before April 2001, the pleading fails to plead the reliance required by a “holder’s action” under Small v. Fritz Companies, Inc. (2003) 30 Cal.4th 167 (Small). A “holder’s action” is a cause of action by persons wrongfully induced to hold stock instead of selling it. (Small, supra, 30 Cal.4th at p. 171.) Thus, a person induced by fraud or negligent misrepresentation to refrain from selling stock and who suffers damages as a result has a cause of action for fraud or negligent misrepresentation. (Ibid.) But the cause of action is limited to those stockholders who can “make a bona fide showing of actual reliance upon the misrepresentations.” (Ibid.)
E&Y argued that Czuker failed to allege a “holder’s action” because no facts were alleged showing that he had a legal right to sell his limited partnership shares (which he purchased by way of a private placement of securities and not by a registered public offering), and because no facts were alleged that the partnerships legally could have agreed to a transfer of his shares. E&Y also maintained that the complaint contained insufficient facts establishing Czuker’s reasonable reliance on the documents prepared by E&Y. In a companion motion to strike, E&Y sought to have the court strike the “holding” claims, the allegations regarding the KCI contract, and all of the exhibits except those pertaining to KC Capital and the PricewaterhouseCooper’s audit of PreNet. Czuker filed opposition and E&Y filed a reply memorandum.
After a hearing, the court granted the motion to strike and sustained the demurrer without leave to amend. The court’s original written order stated in pertinent part: “Czuker’s problem in suing E&Y has always been that all of his TeleCruz and TransCast investments, and $500,000 of his PreNet Investment, were made before he received any document prepared by E&Y. [¶] [Czuker was] required to allege a form of holding theory under [Small]. [T]his requires an allegation that Czuker took action, as distinguished from unspoken and unrecorded thoughts, that would indicate he actually relied on E&Y’s misrepresentations in continuing to hold his investments and would have sold them otherwise. Given Czuker’s purchase of limited partnership interests, he also was required to allege that he could have transferred or sold the investments in compliance with securities law. [¶] [The complaint] does not contain any actions showing a contemplated and rescinded sale that would support Czuker’s holding claim. There is no allegation of a planned transfer that was rescinded when Czuker received E&Y documents. Nor are there any ultimate facts alleged, only a conclusion, that Czuker could have made such a sale in compliance with securities law. Thus, the holding theory fails.”
With respect to the allegations of the KCI contract to invest $20 million in KCI, the court’s ruling acknowledged that “Czuker has alleged ‘action’ (entering into the contract) which ‘indicates’ he relied on E&Y’s misrepresentations,” but the trial court struck these allegations as made without leave of court because Czuker “was granted leave to amend to allege one specific transfer that Czuker subsequently revoked to support his holding theory as required by [Small]. He was not granted leave to amend to take another try at reliance.” The court’s ruling further stated that even if the KCI contract allegations were not stricken, the court would nevertheless sustain the demurrer because “it is evident from [Kavanaugh’s] cross-complaint [against Czuker] that Czuker never made the $20 million investment required by the contract. Instead, he contends that [Kavanaugh’s] fraud induced him to sign the KCI contract. . . . The act of signing a contract is insufficient reliance unless the signator has some resulting obligation from the contract. [¶] . . . [¶] But what is true is that Czuker’s entry into the KCI agreement has nothing to do with the holding theory. . . . Czuker’s action of entering into the KCI contract may demonstrate his desire to buy more of the same investment (PreNet and TeleCruz), and may also reflect a reliance on E&Y’s misrepresentations in doing so, but this action does not indicate the converse: that Czuker would have sold his initial investment without the misrepresentations. It is one thing for a misrepresentation to cause a person to buy more of the same stock he owns, it is quite another for a misrepresentation to cause the person to hold the initial stock purchase without selling it. . . . The holding requirements of Small are not satisfied in the [complaint].”
The court also determined that the complaint failed to state claims for fraud and negligent misrepresentation with respect to Czuker’s June 2001 investment of $2 million in PreNet through KC Capital because the complaint did not allege “any facts to show that E&Y intended Czuker to rely on the [1999 audited financial statement and schedule of performance statistics for KC Capital] in connection with the specific transaction or type of transaction in issue [that is, the June 2001 PreNet investment].” The court’s ruling explained, “It is one thing for Czuker to rely (foolishly or not) on stale information, and it may even be foreseeable that he would do so. It is quite another for E&Y to intend that Czuker [rely] in June 2001 on a 1999 financial statement. . . . Certainly, it is conceivable that E&Y intended the financial statement to be used by KC Capital to induce investment at a time when the statement was timely. Why, however, would E&Y expect that a 1999 financial statement, prepared and issued in February 2000 before the bubble burst in the internet stock market, [would] induce a $2 million investment in KC Capital in the Summer 2001? The fact that it may have been foreseeable (even expected) that Czuker would see the documents does not mean that E&Y intended him to rely on those documents in making his investment decisions. The [complaint] contains no facts which would explain how E&Y would have intended this stale information to induce investment. Yet, [Bily] requires the pleading of facts which would objectively show this.”
On its own motion, the court reconsidered the motion to strike with respect to the KCI contract allegations, stated that it was error not to permit Czuker leave to amend to allege facts concerning the KCI contract, and analyzed whether those allegations were sufficient to state a cause of action. The court then determined that the KCI contract allegations still failed to cure the pleading defects, and in a “supplemental order” reaffirmed the granting of the motion to strike. Thus, the motion to strike was granted not because the allegations were outside the scope of the leave granted to amend, but because the complaint was deemed deficient even with the new KCI contract allegations. The court concluded that Czuker had indeed alleged the element of reliance because the act of entering into the KCI contract was an act of reliance. But the court determined that Czuker still had not adequately pleaded a “holder’s action” under Small because “the reliance must be with respect to holding the stock and not for the purchase of new stock.”
Second, the supplemental order addressed the issue, “argued extensively by E&Y, . . . that Czuker [had] not adequately alleged that he would have been able to sell his partnership interests in TeleCruz, TransCast, and PreNet if he wanted to do so. Although the [complaint] states a conclusion that he could have legally done so, it alleges no ultimate facts explaining how Czuker could have sold these interests in compliance with securities law.”
Czuker appealed from the judgment of dismissal. Czuker challenges the trial court’s rulings with respect to his claims for both negligent and intentional misrepresentation.
II
DISCUSSION
“On appeal, we review the trial court’s sustaining of a demurrer without leave to amend de novo, exercising our independent judgment as to whether a cause of action has been stated as a matter of law and applying the abuse of discretion standard in reviewing the trial court’s denial of leave to amend.” (McKell v. Washington Mutual, Inc. (2006) 142 Cal.App.4th 1457, 1469.)
“Each element in a cause of action for fraud or negligent misrepresentation must be factually and specifically alleged. [Citation.] The policy of liberal construction of pleadings is not generally invoked to sustain a misrepresentation pleading defective in any material respect. [Citation.] Thus, the mere assertion of ‘reliance’ is insufficient. The plaintiff must allege the specifics of his or her reliance on the misrepresentation to show a bona fide claim of actual reliance. [Citation.]” (Cadlo v. Owens-Illinois, Inc., supra, 125 Cal.App.4th at p. 519.)
But certain exceptions “mitigate the rigor of the rule requiring specific pleading of fraud. Less specificity is required when ‘it appears from the nature of the allegations that the defendant must necessarily possess full information concerning the facts of the controversy,’ [citation]; ‘[e]ven under the strict rules of common law pleading, one of the canons was that less particularity is required when the facts lie more in the knowledge of the opposite party . . . .’ [Citation.]” (Committee on Children’s Television, Inc. v. General Foods Corp. (1983) 35 Cal.3d 197, 217.)
A. Negligent Misrepresentation
“Negligent misrepresentation is a separate and distinct tort, a species of the tort of deceit. ‘Where the defendant makes false statements, honestly believing that they are true, but without reasonable ground for such belief, he may be liable for negligent misrepresentation, a form of deceit.’ [Citations.] [¶] Under certain circumstances, expressions of professional opinion are treated as representations of fact. When a statement, although in the form of an opinion, is ‘not a casual expression of belief’ but a ‘deliberate affirmation of the matters stated,’ it may be regarded as a positive assertion of fact. [Citation.] Moreover, when a party possesses or holds itself out as possessing superior knowledge or special information or expertise regarding the subject matter and a plaintiff is so situated that it may reasonably rely on such supposed knowledge, information, or expertise, the defendant’s representation may be treated as one of material fact. [Citations.] There is no dispute that . . . statements in audit opinions fall within these principles.” (Bily, supra, 3 Cal.4th at pp. 407–408.)
As explained in Bily, a narrow class of persons who are not clients of an auditor and who may not recover under a general negligence theory, nevertheless may recover on a theory of negligent misrepresentation under limited circumstances. Bily adopted the principles set out in section 552 of the Restatement Second of Torts (section 552). The court paraphrased section 552 as providing that “a supplier of information is liable for negligence to a third party only if he or she intends to supply the information for the benefit of one or more third parties in a specific transaction or type of transaction identified to the supplier.” (Bily, supra, 3 Cal.4th at p. 392.) Section 552 “states a general principle that one who negligently supplies false information ‘for the guidance of others in their business transactions’ is liable for economic loss suffered by the recipients in justifiable reliance on the information. [Citation.] But the liability created by the general principle is expressly limited to loss suffered: ‘(a) [B]y the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.’” (Bily, supra, 3 Cal.4th at p. 392.)
With respect to audit reports, the court in Bily held that “‘The representation must have been 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. If others become aware of the representation and act upon it, there is no liability even though defendant should reasonably have foreseen such a possibility.’” (Bily, supra, 3 Cal.4th at p. 414.) The court in Bily did not suggest that “the question of intent to benefit a third party will inevitably involve a question of fact. If competent evidence does not permit a reasonable inference that the auditor supplied its report with knowledge of the existence of a specific transaction or a well-defined type of transaction which the report was intended to influence, the auditor is not placed on notice of the risks of the audit engagement. In such cases, . . . plaintiff will not, as a matter of law, fall within the class of intended beneficiaries.” (Id. at pp. 414–415.)
1. Financial Statements for KC Capital
We conclude that the cause of action for negligent misrepresentation fails because it does not meet the Bily requirements for negligent misrepresentation with respect to E&Y’s 1999 audited financial statement and the schedule of performance statistics. Czuker alleged that, in reliance on these documents, he undertook the following transactions: He invested $2 million in PreNet through KC Capital in June 2001; he entered into the KCI contract in July 2001; and he was induced to hold (that is, he refrained from selling or transferring) his $500,000 interest in PreNet Fund previously acquired in April 2000. But the complaint does not allege sufficient facts that E&Y undertook to inform and guide Czuker, or a specific class of persons including Czuker, with respect to the foregoing transactions or type of transactions. Indeed, Czuker does not assert that when E&Y prepared the KC Capital financial documents in 2000, E&Y had any reason to know that in 2001, Czuker would enter into the KCI contract and invest an additional $2 million in KC Capital.
E&Y asserts that the trial court struck the allegations pertaining to the KCI contract. But, as noted above, the trial court’s supplemental order indicates that the court considered the allegations on their merits and then granted the motion to strike after determining that no cause of action was stated.
As explained in Bily, section 552 “creates an objective standard that looks to the specific circumstances (e.g., supplier-client engagement and the supplier’s communications with the third party) to ascertain whether a supplier has undertaken to inform and guide a third party with respect to an identified transaction or type of transaction. If such a specific undertaking has been made, liability is imposed on the supplier. If, on the other hand, the supplier ‘merely knows of the ever-present possibility of repetition to anyone, and the possibility of action in reliance upon [the information] on the part of anyone to whom it may be repeated,’ the supplier bears no legal responsibility. [Citation.]” (Bily, supra, 3 Cal.4th at p. 410, italics omitted.)
Here, Czuker attempts to comply with Bily by alleging that the KC Capital documents, by their nature, were “selling documents” and intended to influence potential investors like him. But these allegations beg the question and are insufficient to state claims for negligent misrepresentation. The Bily requirement — that the representation be made in the context of an undertaking to inform and guide the plaintiff in a specific transaction or type of transaction — would be meaningless if the requirement could be established merely by labeling the representation as one made for the purpose of informing and guiding the plaintiff. Nor is the Bily requirement met by Czuker’s allegation that E&Y had direct communication with him in March 2001, when E&Y sent a letter to him to confirm the amount of his PreNet Fund investment. E&Y’s confirmation of the amount of Czuker’s investment in PreNet Fund does not amount to an undertaking to inform and guide Czuker with respect to the retention or sale of his April 2000 investment in PreNet Fund, his June 2001 investment in KC Capital, or his July 2001 contract with KCI. Accordingly, Czuker fails to state negligent misrepresentation claims arising out of statements in the KC Capital documents prepared by E&Y.
2. Tax Returns for TeleCruz Fund, TransCast Fund, and PreNet Fund
There is no allegation that E&Y was acting in the capacity of an auditor when preparing the tax returns for TeleCruz Fund, TransCast Fund and PreNet Fund. Rather, E&Y is alleged to have been acting only as a tax preparer. Even though Bily deals with the issue of the liability of auditors for negligent misrepresentation to non-clients, language in Bily intimates that its principles may also apply to tax preparers. “Accountants are not unique in their position as suppliers of information and evaluations for the use and benefit of others. Other professionals, including attorneys, architects, engineers, title insurers and abstractors, and others also perform that function. And, like auditors, these professionals may also face suits by third persons claiming reliance on information and opinions generated in a professional capacity.” (Bily, supra, 3 Cal.4th at p. 410.)
Assuming that Bily’s principles apply to the negligent misrepresentation claims based on the tax returns prepared by E&Y, we conclude that the complaint fails to state a cause of action because there are no allegations that E&Y prepared the tax returns with the intent to inform and guide Czuker in his investment decisions. Czuker alleged that in preparing the tax returns for TeleCruz Fund, TransCast Fund, and PreNet Fund, E&Y failed to undertake an investigation of the true value of the funds and merely “rubber-stamped” figures provided by Kavanaugh and others. But the tax preparer “‘generally may rely in good faith without verification upon information furnished by the taxpayer. Thus, the preparer is not required to audit, examine or review books and records, business operations, or documents or other evidence in order to verify independently the taxpayer’s information.’” (Schneider v. U.S. (S.D.Ind. 2003) 257 F.Supp.2d 1154, 1161 (Schneider).) That E&Y allegedly had access to information acquired from its audit of TeleCruz (which revealed that there were doubts about the viability of TeleCruz as a going concern) does not establish that E&Y, in preparing the tax returns for TeleCruz Fund, intended to inform and guide Czuker with respect to his investment in TeleCruz Fund.
With respect to TransCast and the alleged misappropriation of its assets by TeleCruz, the complaint does not allege that E&Y knew of such misappropriation. There are no allegations that E&Y performed audits for TransCast or TransCast Fund. As the tax preparer for TransCast Fund, E&Y was not obligated to conduct an audit of TransCast Fund’s books or records, or an audit of TransCast. Thus, the complaint does not allege facts showing that E&Y, in preparing TransCast Fund’s tax returns, undertook to inform and guide Czuker as to whether he should retain or sell his TransCast Fund investment.
Because Czuker fails to meet the Bily requirement with respect to all of the E&Y documents alleged to contain misrepresentations, we need not discuss the other traditional elements of negligent misrepresentation, including the element of actual reliance. We also need not analyze the negligent misrepresentation claims under Small. As explained in Bily, “[o]ur decision effects no change in those traditional elements [of the misrepresentation torts]; it merely describes the category of plaintiffs who may recover provided all other elements [of negligent misrepresentation] are satisfied.” (Bily, supra, 3 Cal.4th at p. 414.)
B. Intentional Misrepresentation
Unlike negligent misrepresentation, a claim for intentional misrepresentation is not subject to the “intended to inform and guide” rule enunciated in Bily. (Nutmeg Securities, Ltd. v. McGladrey & Pullen (2001) 92 Cal.App.4th 1435, 1441.)
The well-known elements of a cause of action for intentional misrepresentation are: “(1) a misrepresentation, which includes a concealment or nondisclosure; (2) knowledge of the falsity of the misrepresentation, i.e., scienter; (3) intent to induce reliance on the misrepresentation; (4) justifiable reliance; and (5) resulting damages.” (Cadlo v. Owens-Illinois, Inc., supra, 125 Cal.App.4th at p. 519.) Whether a plaintiff’s reliance is justified is ordinarily a question of fact; however, the issue may be decided as a matter of law if reasonable minds can come to only one conclusion based on the facts. (Alliance Mortgage Co. v. Rothwell (1995) 10 Cal.4th 1226, 1239.) And negligence on the part of the plaintiff in failing to discover the falsity of a statement is no defense to a claim for intentional misrepresentation, but if the conduct of the plaintiff in the light of his own intelligence and information was manifestly unreasonable, he will be denied recovery. (Id. at pp. 1239–1240.)
1. Unaudited Tax Returns
We conclude that it was unreasonable for Czuker to retain his existing investments or to make new investments in reliance upon the unaudited tax returns, including the K-1 forms, prepared by E&Y. Czuker could not reasonably expect that E&Y, as a tax preparer, had verified the information provided to it by the partnerships, or that E&Y had conducted an audit of the partnerships. (Schneider, supra, 257 F.Supp.2d at p. 1161.) Thus, it is unreasonable to interpret the unaudited tax returns as expressions of E&Y’s opinion as to the value of Czuker’s investments in the partnerships; the unaudited tax returns are nothing more than reiterations of the values as reflected in the partnerships’ records.
“The finding that no justifiable reliance can be shown on the allegedly false representations contained in the IRS Schedule K-1 is underpinned by Section 6264 of the IRC, which allows the recipient of a Schedule K-1 not to rely on the information contained therein and to challenge the alleged misstatements before the IRS. Thus, any claimed reliance on the Schedule K-1, as a matter of law, cannot be considered justifiable.” (Thompson v. Central Ohio Cellular, Inc. (Ohio App. 1994) 639 N.E.2d 462, 471–472, fn. omitted.) And in cases involving assessments of deficiencies or penalties against taxpayers, the taxpayers’ assertions of reliance on professional advice of accountants and tax preparers have been rejected as unreasonable when the advisers knew nothing about the non tax business aspects of the contemplated investment. (See David v. C.I.R. (2nd Cir. 1995) 43 F.3d 788, 789–790 [in investing in oil and gas partnerships, plaintiff’s reliance on partnership returns and K-1 schedules prepared by accountants was not reasonable].) “Reliance on expert advice is not reasonable where the ‘expert’ relied on knows nothing about the business in which the taxpayer invested.” (Goldman v. C.I.R. (2nd Cir. 1994) 39 F.3d 402, 408.)
Because there are no allegations that E&Y is knowledgeable about the businesses in which Czuker invested (Internet, “‘e-commerce,’” television technology, and cellular phone services), Czuker’s reliance on the unaudited tax returns prepared by E&Y was unreasonable as a matter of law.
2. KC Capital Financial Statements
We conclude that the complaint adequately states claims for intentional misrepresentation based on the audited financial statements which E&Y prepared for KC Capital and upon which Czuker allegedly relied in entering into the KCI contract and in investing $2 million in KC Capital in mid-2001.
E&Y contends that Czuker could not reasonably rely upon those documents because they were prepared in February and September 2000 and they were “stale” by mid-2001. E&Y also argues that Czuker reasonably could not rely upon those documents in mid-2001 because of the technology sector “crash” in late 2000 and early 2001. E&Y maintains that the technology sector crash is subject to mandatory judicial notice and has filed a request for judicial notice that “[i]n late 2000 and early 2001, the technology and telecommunications industries experienced a sharp downturn in economic activity that was accompanied by a precipitous decline in the value of many securities related to those industries. That is, in late 2000 and early 2001, the technology and telecommunications stock bubble burst.” E&Y also requests that we take judicial notice of the 2000 and the 2001 Annual Report of the Board of Governors of the Federal Reserve, which document the economic downturn in the technology sector.
The materiality and relevance of the technology sector “crash” to the value and prospects of PreNet, KC Capital and KCI are unclear. Accordingly, the issue of the reasonableness of Czuker’s reliance on documents predating the crash remains a factual one. Because our analysis of the issue of justifiable reliance would be the same whether or not we take judicial notice of the matters requested by E&Y, we deny E&Y’s request for judicial notice. We also cannot conclude as a matter of law that the KC Capital financial statements prepared in 2000 were “stale” in mid-2001 because this is a factual matter that cannot be resolved on the allegations of the complaint.
E&Y maintains that Czuker’s reliance was not justified as a matter of law because the KC Capital financial documents contained “disclosures and warnings” that the values stated therein were only estimates of the fair market value as determined by the general partner of KC Capital and that there was inherent uncertainty in the valuation of the investments that were in private placements.
E&Y points out that Note 2 to the 1999 audited financial statement provides in part that “[t]he [KC Capital] Partnership also invests in private placements which are carried as estimated fair value as determined by the General Partner. Due to the inherent uncertainty of valuation, the values may differ significantly from the values that would have been used had a ready market for the security existed. Differences could be material.” E&Y also points to Note 1 to the schedule of performance statistics for KC Capital. It states in part that “[n]ot readily marketable securities are carried at estimated fair value as determined by the General Partner. Due to inherent uncertainty of valuation, the values may differ significantly from the values that would have been used had a ready market for the securities existed. Differences could be material.”
But, as maintained by Czuker, whether the “disclaimers,” when viewed in the context of the remaining portions of the documents, preclude reasonable reliance involves factual issues which cannot be resolved as a matter of law on the instant record. Czuker also argues that “the disclaimer nowhere states that E&Y took no steps to verify the information and was merely ‘rubber-stamping’ the information.” As E&Y admitted in the 1999 audited financial statement, “[E&Y’s] responsibility is to express an opinion on these financial statements [of KC Capital] based on our audit,” and “[w]e conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.” Similarly, the schedule of performance statistics stated that “Our responsibility is to express an opinion on this schedule based on our examination. Our examination was conducted in accordance with standards established by the American Institute of Certified Public Accountants . . . .
In light of the foregoing provisions, we conclude that whether Czuker’s reliance on the KC Capital financial statements was reasonable under the circumstances of this case presents factual matters that cannot be resolved on demurrer.
E&Y asserts that Czuker has not adequately pleaded the scienter element (knowledge of the falsity of the representations) because the June 2000 PricewaterhouseCooper report, showing that PreNet had no revenue in 1998 and 1999, “was issued months after E&Y issued its opinion on KC Capital’s financial statements.” But according to the allegations of the complaint, E&Y prepared its Schedule of Investment Performance Statistics in September 2000, after the issuance of the PricewaterhouseCoopers report of June 2000. And the complaint alleged that when E&Y prepared the 1999 audited financial statement in February 2000, PreNet’s unaudited financial records should have been available to E&Y and that E&Y “either ignored the financials of PreNet,” or “failed to perform any investigation into the actual value of PreNet . . . .”
The foregoing allegations are sufficient to plead the scienter element for fraud because an investor suing an auditor for intentional misrepresentation may allege either the auditor’s actual knowledge of the false or baseless character of its opinion, or that the auditor had no belief in the truth of the statement and made it recklessly, without knowing whether it was true or false. (Kouri v. Superior Court (2007) 148 Cal.App.4th 460, 465; see also Engalla v. Permanente Medical Group, Inc. (1997) 15 Cal.4th 951, 974 [false statements made recklessly and without regard to their truth in order to induce action by another are the equivalent of misrepresentations knowingly and intentionally made].)
Czuker also has adequately pleaded the element of intent to induce reliance with the following allegations: In preparing the KC Capital financial statements, “E&Y’s target audience included KC Capital, its management, partners in that partnership and those interested in investing in that partnership,” that Czuker was “within the class of people whom E&Y intended to reach and whom E&Y intended would rely on [the KC Capital financial statements],” and that “E&Y knew to a substantial certainty that the [KC Capital financial statements] would be used to influence purchasers to purchase interests in KC Capital and/or retain their interests in entities investing in PreNet . . . .”
E&Y’s intent to induce reliance also can be inferred from the allegations pertaining to the chronology of E&Y’s accounting services for the entities allegedly controlled by Ryan Kavanaugh in relation to Czuker’s investments. E&Y’s preparation of KC Capital’s schedule of performance statistics occurred in September 2000, after Czuker had invested $500,000 in PreNet through PreNet Fund in April 2000. Thus, the complaint alleges that Czuker was already an investor in PreNet and therefore within the class of persons whom E&Y reasonably could expect to rely on its September 2000 schedule of performance statistics.
And E&Y prepared the schedule of performance statistics after Czuker had invested $5 million in TeleCruz through TeleCruz Fund in June through August 2000, and after E&Y had performed its February 2000 audit of TeleCruz, in which E&Y stated that it had doubts about TeleCruz’s ability to continue as a going concern. According to the complaint, Kavanaugh, who was a director of TeleCruz, supplied financial information to E&Y, which E&Y used to prepare its February 2000 audit of TeleCruz. It was also Kavanaugh who hired E&Y to prepare the KC Capital financial statements. The complaint thus alleges sufficient facts permitting the reasonable inferences that, at the time it prepared the KC Capital financial statements in February and September 2000, E&Y knew the following: (1) that Kavanaugh was involved with TeleCruz, and that there were doubts about TeleCruz’s viability as a going concern; (2) that Kavanaugh was also involved with other related entities, including KC Capital and PreNet; (3) and that there was a class of investors in several Kavanaugh-controlled entities, including KC Capital and PreNet. Accordingly, we conclude that the complaint alleges facts supporting the allegation that “Czuker is within the class of people whom E&Y intended to reach and whom E&Y intended would rely on [the KC Capital financial statements].”
3. Holder’s Action as to $500,000 Investment in PreNet
Czuker alleged that, in reliance on the KC Capital financial statements, he retained, and did not sell, his $500,000 interest in PreNet. This claim is thus a “holder’s action.”
California has rejected the federal “fraud on the market” doctrine under which buyers or sellers of stock may establish fraud without proving that they personally relied on a defendant’s misrepresentations on the theory that, regardless of their reliance, the misrepresentations influenced the market price at which they later bought or sold. (Small, supra, 30 Cal.4th at p. 179.) Under California law, a plaintiff suing for fraud must prove actual reliance in order to separate meritorious from nonmeritorious cases. (Id. at pp. 180, 184.) “In a holder’s action a plaintiff must allege specific reliance on the defendant’s representations: for example, that if the plaintiff had read a truthful account of the corporation’s financial status the plaintiff would have sold the stock, how many shares the plaintiff would have sold, and when the sale would have taken place. The plaintiff must allege actions, as distinguished from unspoken and unrecorded thoughts and decisions, that would indicate that the plaintiff actually relied on the misrepresentations.” (Id. at p. 184.)
We reject Czuker’s argument that the principles in Small apply only to publicly traded stock and not to his interests in the privately held limited partnerships. Small was concerned with the separation of meritorious from nonmeritorious suits in the situation where the investor claims that he was fraudulently induced to forbear from selling his interest. If a plaintiff’s interest in a privately held limited partnership or in unregistered securities legally could not be sold or transferred under federal securities laws, then a plaintiff’s reliance on the alleged misrepresentations in refraining from selling the interests would not have caused the plaintiff damage. Thus, the concern in Small for separating the meritorious from the nonmeritorious cases arises here, but with respect to the issues of causation and damages. And, regardless of whether Small applies, all of the elements of fraud must be pleaded with specificity, including the elements of causation and damage. Accordingly, we conclude that Czuker must allege specific facts supporting his conclusion that an applicable exception to the registered federal securities laws would have allowed him to sell his interests. He failed to do so.
For the first time, Czuker, in his appellate briefs, identifies at least two specific exceptions to federal securities laws which he alleges would have allowed him to sell his interests: (1) 15 United States Code section 77d(1), which provides a general exemption from the registration requirements for “transactions by any person other an issuer, underwriter, or dealer,” and (2) 15 United States Code section 77d(2), which provides an exemption for “transactions by an issuer not involving any public offering.” Czuker asserts that he could allege facts within those exemptions. E&Y notes in its respondent’s brief that exemptions from the federal registration requirements involve a fact-intensive inquiry into the facts surrounding the sale. Accordingly, we conclude that, on remand, Czuker is entitled to leave to amend to plead specific facts bringing him within one of the exceptions to the registration requirements of the federal securities laws with respect to the intentional misrepresentation claim involving his $500,000 investment in PreNet Fund I, L.P. (Ochs v. PacifiCare of California (2004) 115 Cal.App.4th 782, 796 [plaintiff may make showing that defective pleading may be cured for the first time on appeal].)
15 United States Code section 77e(a) provides in pertinent part: “Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly — [¶] (1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise . . . .”
DISPOSITION
The judgment is reversed. On remand, the trial court is directed to enter a new order: (1) sustaining the demurrer without leave to amend to the cause of action for negligent misrepresentation, and (2) overruling the demurrer to the cause of action for intentional misrepresentation and affording Czuker a reasonable time to file an amended pleading for intentional misrepresentation as to Czuker’s “holder’s action” involving his April 2000 investment of $500,000 in PreNet Fund I, L.P.
Ernst & Young’s request for judicial notice is denied.
The parties are to bear their own costs on appeal.
We concur:
Judge of the Los Angeles Superior Court assigned by the Chief Justice pursuant to article VI, section 6 of the California Constitution.
15 United States Code section 77d provides in pertinent part: “The provisions of section 77e of this title shall not apply to — [¶] (1) transactions by any person other than an issuer, underwriter, or dealer. [¶] (2) transactions by an issuer not involving any public offering.”