Opinion
NOT TO BE PUBLISHED IN THE OFFICIAL REPORTS
APPEAL from a judgment of the Superior Court of Los Angeles County No. BC341146, Andria K. Richey, Judge. Affirmed.
Nagler & Associates, Lawrence H. Nagler and David F. Berry for Plaintiffs and Appellants.
DLA Piper US, Jeffrey A. Rosenfeld, William P. Donovan, Jr., and Yvette Neukian for Defendant and Respondent.
OPINION
ASHMANN-GERST, J.
The question presented is the scope of an auditor’s liability under Bily v. Arthur Young & Co. (1992) 3 Cal.4th 370 (Bily) to third parties for negligent misrepresentations in an opinion letter. This appeal by appellants Barry Epstein, Shawn Denton, Adam Levine and Jason Shapiro (owners) challenges the judgment of dismissal entered after the trial court sustained a demurrer without leave to amend their first amended complaint (complaint). The owners contend that they pleaded sufficient facts to state a claim under Bily against respondent BDO Seidman, LLC (BDO). In the alternative, they contend that they should be given leave to amend to allege a fraud cause of action based on information they learned after this appeal was filed. The owners’ arguments are unavailing and we therefore affirm.
FACTS
The complaint for negligent misrepresentation
As alleged, the owners were directors and 25 percent owners of Rekaren, Inc. (Rekaren), a company that was in the business of originating and selling subprime residential loans. American Business Financial Services, Inc. (American) was in the business of originating, selling and servicing subprime home equity loans. BDO audited American’s financial statements for the fiscal year ending June 30, 2003, (audited financial statements) and issued an opinion letter (opinion letter) representing that the audited financial statements “‘present fairly, in all material respects, the consolidated financial position of [American] and subsidiaries as of June 30, 2003 and 2002, and the consolidated results of their operations and their cash flow for each of the three years in the period ended June 30, 2003[,] in conformity with accounting principles generally accepted in the United States of America.’” On December 24, 2003, the owners entered into a deal (American-Rekaren deal) to sell all of Rekaren’s assets to American in exchange for $475,000, plus a 15 percent equity interest. The American-Rekaren deal gave the owners executive positions within American or its wholly owned subsidiary, Home American Credit, Inc. American declared Chapter 11 bankruptcy on January 21, 2005, which was converted to Chapter 7 on May 17, 2005. The owners lost millions of dollars.
In entering into the American-Rekaren deal, the owners relied on the audited financial statements and the opinion letter. Because BDO did not use generally accepted accounting principles (GAAP), those documents overvalued American’s servicing rights and interest only strips.
American transferred the securitized loans it originated but retained servicing rights to the loans and an interest in the cash flow generated by those loans. That cash flow is known as “interest-only strips.”
The demurrer
BDO demurred to the complaint and argued that it was defective under Bily because it did not allege: (1) American’s retention of BDO was designed to benefit the owners; (2) BDO generated the opinion letter to benefit Rekaren or the owners; (3) BDO was retained to work on the American-Rekaren deal; (4) Rekaren or its owners had any contacts with BDO; (5) BDO undertook an obligation to supply information to Rekaren and the owners; (6) BDO issued any documentation for the American-Rekaren deal; (7) BDO gave permission to American to republish its opinion for use in connection with the American-Rekaren deal; and (8) American republished the opinion letter specifically for the American-Rekaren deal.
In opposition, the owners argued that the complaint was sufficient because it alleged that BDO knew it was highly likely that American would pursue a deal like the American-Rekaren deal and that American would use the opinion letter to induce reliance by a third party.
The trial court sustained the demurrer without leave to amend and entered a judgment of dismissal.
At the hearing on BDO’s demurrer to the original complaint, the trial court stated that Bily required the owners to allege that BDO knew about the American-Rekaren deal and intended to induce their reliance. In its minute order sustaining BDO’s demurrer to the original complaint, the trial court stated: “[The owners] have not sufficiently alleged that [BDO] actually intended to influence the particular transaction sued upon here, and that it knew investors such as [the owners] would rely on the alleged misrepresentations in consummating such a transaction. It is not clear to the court that [the owners] can correct these deficiencies, because it does not appear they can allege that BDO knew of this transaction or authorized use of their report in connection with this transaction.” Despite this last statement, the trial court allowed leave to amend. The record does not contain a minute order sustaining BDO’s second demurrer, and the reporter’s transcript does not reveal the specifics of why the second demurrer was sustained. The minute order regarding the first demurrer is the best expression of the trial court’s interpretation of Bily.
This appeal followed.
Subsequent events
Three days after this appeal was filed, American’s bankruptcy trustee sued various defendants in the United States District Court of the Eastern District of Pennsylvania (Pennsylvania action). Though BDO was not a named defendant, the complaint in the Pennsylvania action contained allegations pertaining to the services BDO rendered to American.
On January 18, 2007, we granted the owners’ motion requesting judicial notice of the Pennsylvania action.
STANDARD OF REVIEW
When reviewing an order sustaining a demurrer without leave to amend, “[t]he reviewing court gives the complaint a reasonable interpretation, and treats the demurrer as admitting all material facts properly pleaded. [Citations.] The court does not, however, assume the truth of contentions, deductions or conclusions of law. [Citation.] The judgment must be affirmed ‘if any one of the several grounds of demurrer is well taken. [Citations.]’ [Citation.] However, it is error for a trial court to sustain a demurrer when the plaintiff has stated a cause of action under any possible legal theory. [Citation.] And it is an abuse of discretion to sustain a demurrer without leave to amend if the plaintiff shows there is a reasonable possibility any defect identified by the defendant can be cured by amendment. [Citation.]” (Aubry v. Tri-City Hospital Dist. (1992) 2 Cal.4th 962, 966–967 (Aubry).)
DISCUSSION
1. Bily.
In Bily, our Supreme Court adopted the approach of the Restatement Second of Torts, section 552, subdivision (2) “regarding the plaintiff or group of plaintiffs who may sue for negligent misrepresentation.” (Bily, supra, 3 Cal.4th at p. 414.) The court summarized the rule this way: “[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.” (Id. at p. 392.)
The court noted that comment (h) to the Restatement Second of Torts, section 552, subdivision (2) “observes that the liability of a negligent supplier of information is appropriately more narrowly restricted than that of an intentionally fraudulent supplier,” and “a commercial supplier of information has a legitimate concern as to the nature and scope of the client’s transactions that may expand the supplier’s exposure liability.” (Bily, supra, 3 Cal.4th at pp. 392–393.) If an auditor is on notice of a specific potential liability, then it may act to “encounter, limit or avoid the risk.” (Id. at p. 363.) But “an auditor who is simply asked for a generic audit and report to the client has no comparable notice.” (Ibid.) Pursuant to the Restatement rule, “an auditor retained to conduct an annual audit and to furnish an opinion for no particular purpose generally undertakes no duty to third parties” even though the auditor knows that financial statements, coupled with an auditor’s opinion, are customarily used in the client’s transactions and may influence “lenders, investors, shareholders, creditors, purchasers, and the like, in numerous possible kinds of transactions.” (Id. at pp. 393–394.) Bily concluded that “the Restatement rule requires that the supplier of information receive notice of potential third party claims” and the “receipt of such notice justifies imposition of auditor liability for conduct that is merely negligent.” (Id. at p. 409.) The question of intent to benefit is not necessarily 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.” (Id. at p. 414.)
The court suggested that trial courts give the following jury instruction. “‘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.)
2. The complaint does not sufficiently allege that BDO had an intent to benefit the owners or those in their class.
In the owners’ view, BDO can be held liable under Bily if it knew with substantial certainty that the owners, or a class of persons to which they belong, would rely on BDO’s representations in a particular type of transaction. We do not disagree. But the complaint does not establish that BDO was on notice of the American-Rekaren deal, or the likelihood of a similar transaction, at the time that BDO issued the audited financial statements and opinion letter. Consequently, we conclude that the complaint does not state sufficient facts under Bily.
a. The relevant allegations.
According to the owners, the intent to benefit element was sufficiently pleaded in paragraphs 20, 24, 25, 26, 27 and 28 of the complaint.
It was alleged in paragraphs 20 and 28 that BDO authorized the reissuance of the opinion letter with the audited financial statements that were part of a November 7, 2003 debt offering prospectus, a December 1, 2003 exchange offer, and an amended fiscal 2003 annual report filed December 11, 2003. At the time, BDO knew of the proposed American-Rekaren deal.
As alleged in paragraph 24, an amended fiscal 2003 annual report with an unspecified date indicated that American had “discontinued originating home equity loans through retail branch offices and had lost most of its wholesale loan origination employees and broker relationships”; American’s adjusted business strategy was to replace the loan origination employees it lost and create an expanded broker initiative in order to increase loan originations; the adjusted business strategy would involve significantly increasing the use of loan brokers and retaining additional resources in the form of executive employees to manage the broker program. Note 1 to the audited financial statements acknowledged American’s new emphasis on whole loan sales and its “adjusted business strategy.”
In paragraph 25, the owners averred that on June 30, 2003, BDO knew American “would have to acquire businesses and/or employ individuals that had an existing wholesale loan origination business and significant broker relationships in order to carry out its stated adjusted business strategy.”
The owners began negotiating with American in November 2003.
Paragraph 27 alleged: “At the times that [BDO] performed its audit for [American] . . . and issued . . . [the] opinion letter, [BDO] knew it was substantially certain that anyone considering selling a loan origination business to [American] for anything less than 100% cash up front, or having significant broker relationships and considering going to work for [American] on a partially deferred compensation basis or with compensation partially or wholly in [American] stock or stock options, would do so only in reliance [on American’s] audited financials, including the valuation of the interest-only strips and servicing rights,” and the statement in the opinion letter that the audited financial statements complied with GAAP.
Paragraph 28 averred that the owners are informed and believe that American advised BDO of the American-Rekaren deal while it was in negotiation. American paid BDO $1,102,770 in fiscal year 2004. The owners believe that some of those fees were for evaluating the potential impact of the American-Rekaren deal on American’s financials and reporting requirements. As a result, the owners alleged on information and belief that as of November 7, 2003, BDO knew to a substantial certainty that when it reauthorized the issuance of the opinion letter, it would be used by American to influence the owners.
b. Notice.
The allegations in the complaint do not establish that on June 30, 2003, BDO was on notice that American would, or might, enter into a deal for a business buyout in which the sellers would receive cash plus equity and executive positions. As alleged, all BDO knew on June 30, 2003, was that American would have to acquire businesses or employ individuals who had an existing wholesale loan origination business. But there is no allegation that BDO knew what type of transaction would occur or how that transaction would be structured. Unless American indicated that it was planning a specific transaction or type of transaction at least involving the transfer of American stock, BDO did not have notice of its exposure to liability.
To further their cause, the owners contend that we should follow the lead of Murphy v. BDO Seidman (2003) 113 Cal.App.4th 687 in assessing the merits of the complaint. But Murphy is inapposite. In that case, it was alleged that a company hired BDO to prepare reports in order to induce investors to purchase securities and to induce a specific merger and approval of that merger. It was further alleged that BDO knew how its reports would be used. (Id. at pp. 695–696.) The allegations in Murphy sufficiently demonstrated that BDO was on notice of the specific transactions its reports would influence. Unlike in Murphy, the owners’ allegations do not establish notice of a particular type of transaction.
Nutmeg Securities, Ltd v. McGladrey & Pullen (2001) 92 Cal.App.4th 1435, also cited by the owners, is similarly unavailing. The plaintiff alleged that the auditor “knew and intended [plaintiff] would rely on [the] audit and other statements [by the auditor] regarding AmDiv’s financial condition in agreeing to act as underwriter for AmDiv’s IPO. [Plaintiff] did in fact rely on the audit and other statements by [the auditor] in taking on the AmDiv IPO.” (Id. at p. 1444.) Once again, the auditor had notice of the specific transaction. That the court found the pleading sufficient in Nutmeg is not pertinent to our analysis.
The owners suggest that liability can be based on the allegation that when BDO authorized the reissuance of its opinion letter it knew to a substantial certainty that it would be used to induce the American-Rekaren deal. This allegation does not change our analysis. According to Bily, “The ‘intent to benefit’ language of the Restatement Second of Torts . . . 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.) As alleged, the reissuance of the opinion letter was related to Securities and Exchange Commission (SEC) filings and an amended annual report. There is no allegation that the reissuance was authorized in order to benefit the owners, and that BDO was told the opinion letter would be used in a specific type of transaction involving cash, equity and executive positions. And the foreseeability of American’s use of the opinion letter in connection with the American-Rekaren deal is not enough, by itself, to subject BDO to liability.
On this last point, we note that Bily does no more than impose a duty of care on an auditor with respect to the creation of information. But the owners did not cite any law establishing that an auditor has an additional duty of care when it authorizes the reissuance of prior work.
In the reply, the owners cite Reisman v. KMPG Peat Marwick LLP (2003) 787 N.E.2d 1060, 1077, a Massachusetts case, for the proposition that audit opinions reaffirmed at a later day can support a negligent misrepresentation claim. Arguments raised for the first time in a reply brief are waived. (Wurzl v. Holloway (1996) 46 Cal.App.4th 1740, 1754, fn. 1.)
Because notice was not adequately alleged, the owners’ cause of action for negligent misrepresentation was legally deficient.
3. The trial court did not abuse its discretion in denying leave to amend.
The owners contend that the facts alleged in the Pennsylvania action supply them with the facts necessary to state a claim for fraud. As a result, they contend that they should be given leave to amend even though they were unable to make this specific request to the trial court.
In their reply, and for the first time on appeal, the owners contend that the Pennsylvania action contains facts that also support amendment of their negligent misrepresentation cause of action. Fairness militates against our consideration of arguments an appellant raises only in a reply brief. (Varjabedian v. Madera (1977) 20 Cal.3d 285, 295, fn. 11.)
We disagree.
A sketch of the pertinent rule is contained in Aubry, which stated, “‘Where the complaint is defective, “[i]n the furtherance of justice great liberality should be exercised in permitting a plaintiff to amend his complaint, and it ordinarily constitutes an abuse of discretion to sustain a demurrer without leave to amend if there is a reasonable possibility that the defect can be cured by amendment. [Citations.]”’ [Citations.] This abuse of discretion is reviewable on appeal ‘even in the absence of a request for leave to amend’ [citations], and even if the plaintiff does not claim on appeal that the trial court abused its discretion in sustaining a demurrer without leave to amend. [Citation.]” (Aubry, supra, 2 Cal.4th at pp. 970–971.)
But Aubry does not expressly explain what we must focus on when determining whether to permit leave to amend. Our research indicates that leave to amend should be granted unless the pleading shows on its face that it is incapable of amendment. (California Federal Bank v. Matreyek (1992) 8 Cal.App.4th 125, 130–131.) Stated another way, “it is error for a trial court to sustain a demurrer when the plaintiff has stated a cause of action under any possible legal theory.” (Genesis Environmental Services v. San Joaquin Valley Unified Air Pollution Control Dist. (2003) 113 Cal.App.4th 597, 603.) These cases suggest that we must focus solely on the operative pleading and its latent potential. Indeed, Aubry is in tacit agreement with this proposition. Aubry held that the plaintiff should be granted leave to amend to state an unpleaded third party beneficiary claim that was suggested by a contract referenced in the complaint. (Aubry, supra, 2 Cal.4th at pp. 965, 971.)
However, experience teaches that a plaintiff seeking leave to amend will often advert to additional facts. How far can a plaintiff go beyond what was already pleaded in lobbying for a chance to amend? According to CAMSI IV v. Hunter Technology Corp. (1991) 230 Cal.App.3d 1525, 1542 (CAMSI), “[A]n abuse of discretion could be found [in denying leave to amend], absent an effective request for leave to amend in specified ways, only if a potentially effective amendment were both apparent and consistent with the plaintiff’s theory of the case.”
Following CAMSI, we conclude that the trial court did not abuse its discretion in denying leave to amend. The owners seek leave to allege a fraud cause of action based on facts in the Pennsylvania action. But the amendment proposed by the owners was not apparent at the time of the demurrer.
It is true, as the owners point out, that a reviewing court may sometimes factor postjudgment events into the analysis of an appeal. While it “is an elementary rule of appellate procedure that, when reviewing the correctness of a trial court’s judgment, an appellate court will consider only matters which were part of the record at the time the judgment was entered” (Reserve Insurance Co. v. Pisciotta (1982) 30 Cal.3d 800, 813 (Reserve)), courts nonetheless have the power to consider postjudgment events that render an appellate issue moot. (Ibid.)
To support the proposition that a reviewing court can consider a postjudgment event if it renders an appellate issue moot, Reserve cited Estate of Henry (1960) 181 Cal.App.2d 173. In Estate of Henry, a plaintiff died pending the appeal of a nonsurvivable cause of action. (Id. at p. 176.)
Reserve does not assist the owners. The case at bar does not involve events that made any of the appellate issues moot. Furthermore, the general rule set forth in Reserve leaves the CAMSI rule untouched. That we took judicial notice of the Pennsylvania action is of no moment. When we take judicial notice of matters not before the trial court, we “need not give effect to such evidence.” (Doers v. Golden Gate Bridge, Etc. (1979) 23 Cal.3d 180, 184.) We note generally that “documents not before the trial court cannot be included as part of the record on appeal and thus must be disregarded as beyond the scope of appellate review. [Citations.]” (Pulver v. Avco Financial Services (1986) 182 Cal.App.3d 622, 632.)
DISPOSITION
The judgment of dismissal is affirmed.
BDO shall recover its costs on appeal.
We concur: DOI TODD, Acting P. J., CHAVEZ, J.
We note that Reisman was distinguishable. The auditor in that case reaffirmed misrepresentations in an SEC filing which was issued and circulated in the midst of a deal in which the auditor “played an active and variegated role.” (Reisman, supra, 787 N.E.2d at p. 1077.) Also, the misrepresentations were reaffirmed only after the auditor reviewed its client’s financial condition to determine whether its financial statements were still free of false and misleading information. (Id. at pp. 1064–1065.) Even if Reisman had been cited in the opening brief, we would not follow it. It is not binding on us. Also, it did not engage in an intent to benefit analysis, and is therefore not consistent with the rule established in Bily.