UNION BANK v. ERNST WHINNEY (1991)

Appeal from a judgment of the Los Angeles County Superior Court, the Honorable Richard Adler, Judge Presiding, dismissing the second amended complaint with prejudice.   Affirmed.

I.

INTRODUCTION

This appeal follows the trial court's sustaining of the demurrer of respondent/defendant Ernst & Young (“E & Y”) ¹ to the second amended complaint (“SAC”) of appellant/plaintiff Union Bank (“Bank”).   The SAC contained causes of action for fraud, conspiracy to defraud, negligent misrepresentation and professional negligence.   The SAC, insofar as it concerns E & Y, is based upon the central allegation that E & Y was retained by ZZZZ Best Co. Inc. (“Z Best”) to perform a review of the interim financial statements that Z Best had prepared for the three month period ending July 31, 1986.   The Bank maintains that, in connection with its December 1986 loan to Z Best, it relied on certain oral representations made to it by E & Y and on a preliminary prospectus, prepared by Z Best in connection with a planned stock offering which included a draft, unsigned E & Y review report.

The trial court sustained E & Y's demurrer without leave to amend and dismissed the SAC.

II.

CONTENTIONS

Appellant Bank formulates the following contentions on appeal:

1. The SAC states causes of action against E & Y for fraud and deceit, aiding and abetting a fraud and conspiracy to defraud, negligent misrepresentation, and professional negligence by setting forth with sufficient specificity the elements of each cause of action.

2. The SAC complies with Code of Civil Procedure section 1974 (statute of frauds) by specifying representations made in writing and subscribed by E & Y.

3. The SAC states a cause of action for professional negligence since E & Y had a duty to Bank which it breached by issuing a review opinion representing that “we are not aware of any material modifications which should be made to the consolidated interim financial statements” of Z Best, when in fact E & Y was aware or should have been aware that the financial statements were completely false and materially misleading.

For the reasons hereafter discussed, we find no merit in Bank's second and third contentions.   We find it unnecessary to address Bank's first contention since our holding against the Bank on the second and third contention is dispositive of the appeal.

III.

STATEMENT OF FACTS

Z Best borrowed $7,000,000 from the Bank, a major banking institution, in December 1986.   The loan was not repaid.   Since that time, Z Best's founder, Minkow, and others have been convicted and/or pled guilty to a variety of criminal charges in connection with Z Best's operations.   Minkow has been sentenced to a lengthy prison term.   The Bank now seeks to recover its losses from several defendants who performed services for Z Best.   These include E & Y, an independent accounting firm which was retained in 1986 to provide certain independent accounting services for Z Best.

The Bank asserts that E & Y reviewed Z Best's financial statements for the three months ending July 31, 1986.   The Bank also asserts that E & Y prepared and signed a written review report in connection with those interim financial statements.   The Bank does not contend that E & Y conducted an audit of Z Best.²  Similarly, the Bank does not contend that E & Y issued any opinion with respect to Z Best's financial statements.

The Bank further asserts that it relied on the preliminary prospectus prepared by Z Best and its officers and directors.   The preliminary prospectus contained a draft, unsigned copy of the E & Y review report.   That report made no representation concerning Z Best's credit worthiness, and the report contained language which expressly declined to render any opinion on Z Best's interim financial statements by stating:

“[A review report] is substantially less in scope than an examination in accordance with generally accepted auditing standards, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole.   Accordingly, we do not express such an opinion.”  (Emphasis added.)

The preliminary prospectus also clearly and expressly disclosed the limits of the work that E & Y had performed in the following language:

“With respect to the unaudited interim consolidated financial statements for the three months ended July 31, 1986 included in this Registration Statement, Ernst & Whinney have reported that they have applied limited procedures in accordance with professional standards for a review of such information.   However, their separate report for the interim period ended July 31, 1986 included herein, states that they did not audit and they do not express an opinion on that interim financial information.   Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied.”  (Emphasis added.)

IV.

PROCEDURAL HISTORY

The SAC is Bank's third attempt to state a claim for relief against E & Y.   The Bank filed its original complaint on December 4, 1987.   E & Y maintained that it was vague, uncertain and defective.   E & Y demurred to the complaint.   The Bank voluntarily filed and served a first amended complaint in response thereto.   E & Y demurred again, on substantially the same grounds that are now at issue in this appeal.   The court sustained E & Y's demurrer to Bank's first amended complaint and granted the Bank leave to amend.

E & Y maintained that the SAC at issue in this appeal was deficient as well and E & Y again demurred.   The trial court held that the Bank's claims were barred by section 3 1974 of the Code of Civil Procedure.   In addition, relying, inter alia, on the distinctions between a review and an audit, and the holding of International Mortgage Co. v. John P. Butler Accountancy Corp. (1986) 177 Cal.App.3d 806, 223 Cal.Rptr. 218, the trial court concluded, as a matter of law, that the Bank could not establish liability against E & Y.   The court sustained E & Y's demurrer without leave to amend and dismissed the SAC against E & Y.

V.

SCOPE OF APPELLATE REVIEW

The scope of appellate review upon the sustaining of a demurrer without leave to amend is well settled:  “ ‘[A]ll intendments weigh in favor of the regularity of the trial court proceedings and the correctness of the judgment.   Unless clear error or abuse of discretion is demonstrated, the trial court's judgment of dismissal following the sustaining of defendants' demurrer will be affirmed on appeal.’ ”  (Wilhelm v. Pray, Price, Williams & Russell (1986) 186 Cal.App.3d 1324, 1330, 231 Cal.Rptr. 355.)

 Where, as in this case, the facts are not in dispute and the nature of the claim is clear, but where there is no liability under substantive law, the sustaining of a demurrer without leave to amend is proper.   (Johnson v. County of Los Angeles (1983) 143 Cal.App.3d 298, 306, 191 Cal.Rptr. 704.)

VI.

SECTION 1974 BARS THE BANK'S ACTION AGAINST E & Y

 Claims premised on the alleged oral representations by third party E & Y, as to the financial credit of Z Best are barred by application of section 1974 unless some exception takes the claims outside the confines of the statute.  Section 1974 provides in pertinent part:  “No evidence is admissible to charge a person upon a representation as to the credit of a third person, unless such representation, or some memorandum thereof, be in writing, and either subscribed by or in the handwriting of the party to be charged.”

Section 1974 is broad and all-encompassing.   As the court stated in Seneca Communications Inc. v. International Bank of California (1980) 103 Cal.App.3d 541, 552, 163 Cal.Rptr. 176:  “ ‘[a] test, if not the sole test, for determining whether a misrepresentation is within [section 1974], is whether the representation induced the recipient thereof to enter into a transaction which resulted in a debt due to him from a third person.’ ”  (Emphasis added.)

 Contrary to the Bank's assertion, section 1974 is not merely a rule of evidence.  Section 1974 specifically provides that it is a statute of frauds and is to be applied as such.  “This section is a Statute of Frauds provision and is to be applied in a manner that is consistent with ․ Section 1624 of the Civil Code․”  (§ 1974.)

All of the following decisions affirmed trial court rulings which sustained demurrers on grounds of section 1974:  (Seneca Communications, Inc. v. International Bank of California, supra, 103 Cal.App.3d 541, 163 Cal.Rptr. 176;  Bank of America v. Western Constructors (1952) 110 Cal.App.2d 166, 242 P.2d 365;  Baron v. Lange (1949) 92 Cal.App.2d 718, 207 P.2d 611;  Carr v. Tatum (1933) 133 Cal.App. 274, 24 P.2d 195.)

Only two narrow exceptions to the broad bar of section 1974 exist, and these exceptions have no application in this case.   One exception to the bar of section 1974 is pursuant to the doctrine of estoppel where a fiduciary relationship exists.   The other is where the defendant derives a benefit.   (Seneca Communications, Inc. v. International Bank of California, supra, 103 Cal.App.3d at p. 550, 163 Cal.Rptr. 176.)   Neither circumstance is extant in this case.   No fiduciary relationship is alleged to have existed between E & Y and the Bank, and the record is devoid of any suggestion that E & Y gained a benefit to itself by Bank's loan to Z Best.

 Nor may the Bank be permitted to bootstrap its claims by making conclusory “conspiracy” allegations.   In Bank of America v. Western Constructors, supra, 110 Cal.App.2d 166, 242 P.2d 365, the appellate court expressly held that if the alleged conspirators are not liable individually, because of the bar of 1974, neither could they be liable, either individually or collectively, by reason of their alleged conspiracy.  (Id. at p. 169, 242 P.2d 365.)

The Bank's claims fall squarely within the ambit of the statute and are barred.   The Bank alleged only that it was induced to extend credit to Z Best based upon (1) Z Best's preliminary prospectus;  (2) alleged oral representations that Z Best was growing and E & Y expressed it was happy to have Z Best's account;  and (3) the reputation of the professional defendants, including E & Y.

The Bank has failed to allege reliance on any written representation, signed by E & Y, which would take the claim outside the bar of the statute.   Both E & Y's “reputation” and the alleged “oral representations” are clearly covered by the statute and cannot support the Bank's claim.   The preliminary prospectus is likewise within the ambit of the statutory bar since there are no allegations that E & Y prepared it or signed it.   Nor is it alleged that E & Y prepared, signed or certified any of Z Best's financial statements, including those set forth in the prospectus;  nor is it alleged that E & Y rendered any opinion on such financial statements.   In sum, the record before this court indicates that E & Y made no written representations concerning “the credit” of Z Best.

A. E & Y's Review Report Is Not A “Signed Writing”

 The Bank has not pointed to any writing, signed by E & Y, which would permit the Bank to pursue this action against E & Y.   In an attempt to avoid the bar of section 1974, the Bank makes the argument that the E & Y review report of Z Best's quarterly financial statement, for the period ended July 31, 1986, is a “signed writing” within the meaning of the statute.   The argument fails on several independent grounds.

First, the Bank did not allege that it relied on the review report.   Instead, the Bank alleged that it relied on Z Best's preliminary prospectus, an unsigned document, containing Z Best's financial information.   It is not alleged that E & Y ever signed any version of Z Best's prospectus, preliminary or otherwise.

Second, neither the preliminary nor final prospectus is a statement by E & Y.   The Bank has not alleged that E & Y “prepared” either prospectus.   The Bank, in fact, expressly alleges that the prospectus was prepared, edited and reviewed by a lawyer at the law firm of Hughes, Hubbard and Reed, one Mark Moskowitz.   Z Best's directors signed the final prospectus.⁴  Mere inclusion of a review report in a prospectus does not make the prospectus “expertised” by an accountant.

Third, analogizing to federal law, the review report was not a “part” of the registration statement and would not form the basis of a claim against E & Y under the federal securities laws:  “[A] report on unaudited interim financial information (as defined in paragraph (d) of this section) by an independent accountant who has conducted a review of such interim financial information shall not be considered a part of a registration statement prepared or certified by an accountant or a report prepared or certified by an accountant within the meaning of sections 7 and 11 of the Act.”  (Emphasis added.)  (17 C.F.R. § 230.436(c) (1982).)

Thus, we are constrained to hold that the prospectus is not a “writing signed by E & Y” sufficient to take it outside the statute as against E & Y.

B. The Review Report Makes No Representation Regarding Z Best's Creditworthiness

Beyond the fact that the review report is not a “signed writing,” the report itself specifically disclaims any right to rely on the content thereof such as the type of “reliance” the Bank claims to have made on the report.   The gravamen of the Bank's claim is that it relied on the financial information in the Z Best prospectus as fairly presenting Z Best's financial condition.   We find no such representation in E & Y's review report of October 3, 1986.   Nor do we consider the words set forth in Bank's third contention, attributable to E & Y in a review report, that “we are not aware of any material modifications that should be made to the consolidated interim financial statements” of Z Best to operate as a positive statement of Z Best's financial condition.

Because of the limited nature of the review involved, the E & Y report specifically declined to express an opinion on Z Best's financial statements as a whole.   Unlike an “audit” opinion,⁵ E & Y's review report never opined that any Z Best financial statement fairly presented the company's financial condition at any time and specifically stated:

“We have made a review of the consolidated balance sheet of ZZZZ Best Co., Inc. and subsidiaries as of July 31, 1986, and the related consolidated statements of income, stockholders' equity and changes in financial position for the three-month period ended July 31, 1986, in accordance with standards established by the American Institute of Certified Public Accountants.   A review of the consolidated financial statements for the comparative period of the prior year was not made.

“A review of interim financial information consists principally of obtaining an understanding of the system for the preparation of interim financial information, applying analytical review procedures to financial data, and making inquiries of persons responsible for financial and accounting matters.

“It is substantially less in scope than an examination in accordance with generally accepted auditing standards, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole.   Accordingly, we do not express such an opinion.

“Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with generally accepted accounting principles.”  (Emphasis added.)

Z Best also cautioned, in the text of the prospectus, against reliance on the unaudited review report:  “With respect to the unaudited interim consolidated financial statements for the three months ended July 31, 1986 included in this Registration Statement, Ernst & Whinney have reported that they have applied limited procedures in accordance with professional standards for a review of such information.   However, their separate report for the interim period ended July 31, 1986 included herein, states that they did not audit and they do not express an opinion on that interim financial information.   Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied ․”  (Emphasis added.)

Several federal courts have held in analogous circumstances that review reports by independent accountants cannot be the basis for fraud or negligence claims under either the federal securities anti-fraud statutes or state laws.   In Rich v. Touche Ross & Co. (S.D.N.Y.1976) 415 F.Supp. 95 the court dismissed plaintiff's securities and common law negligence/accountant's malpractice claims, stating:  “Two of these statements ․ were not audited by Touche Ross and are plainly marked ‘Unaudited.’   As to these financial statements, there can be no reliance upon misrepresentations by these defendant accountants.   We therefore find that the allegations relating to the unaudited financials fail to state a claim.”  (Id. at p. 98;  see also Andreo v. Friedlander, Gaines, Cohen, etc. (D.Conn.1986) 651 F.Supp. 877, 881 [Court barred fraud claim because, as here, “the type of review performed ․ does not give rise to the kind of duty which is a prerequisite for a finding of reckless disregard of the truth.”].)

Like the accountants in these cases, E & Y was hired only to review Z Best's interim financial statements.   Just as Rich and Andreo excluded direct claims by shareholders because of unjustified reliance on unaudited statements, the trial court here properly rejected alleged reliance by the Bank (inferentially a sophisticated lending institution) on unaudited financial statements.

C. The Bank Cannot Avoid Section 1974 by Relying on Allegations of Fraud

 Bank's final attempt to avoid the bar of section 1974 is based upon an argument that the statute cannot be used to shield the perpetrator of a fraud.   The law is directly to the contrary.   In Seneca Communications, Inc. v. International Bank of California, supra, 103 Cal.App.3d at pp. 548–550, 163 Cal.Rptr. 176, the court held that section 1974 applies to all third party deceit actions, whether based on negligent or fraudulent misrepresentations:  “In arguing that section 1974 should not apply to cases of actual fraud, appellant has ignored the judicial analysis and interpretation of this statute as applied in California․  [¶] ․ “ ‘[T]his court takes careful note of the fact that the recommendation of the California Law Revision Commission—before the Legislature when making its 1970 amendment—traced in great detail the history and harsh effects of section 1974, and urged its repeal․  [¶] If the Legislature, with this bulwark of argument before it urging repeal of section 1974, saw fit instead only to amend it ․ then this court will do no more.   For to do so would involve judicial legislation.” ⁶

Contrary to the Bank's suggestion, Tenzer v. Superscope, Inc. (1985) 39 Cal.3d 18, 216 Cal.Rptr. 130, 702 P.2d 212, is not on point and does not undermine the Seneca decision.  Tenzer addressed the question of when a court would prevent “fraud” committed when a party refused to enforce an oral contract under certain circumstances.  Tenzer did not establish any new principle;  it merely employed a traditional quasi-contractual remedy based on the doctrine of unjust enrichment.

Moreover, the Tenzer decision was recently distinguished by the California Supreme Court in Phillippe v. Shapell Industries (1987) 43 Cal.3d 1247, 241 Cal.Rptr. 22, 743 P.2d 1279, certiorari denied 486 U.S. 1011, 108 S.Ct. 1742, 100 L.Ed.2d 205.   The Phillippe court noted that although “estoppel can be applied ‘to prevent fraud.’ ․ it was not speaking of actual fraud but the ‘fraud’ that inheres in situations where there is an unconscionable injury to the promisee under an invalid oral contract or unjust enrichment to the promisor.”  (Id. at p. 1262, 241 Cal.Rptr. 22, 743 P.2d 1279.)   Thus, contrary to Bank's contention, Tenzer applies only in the context of a quasi-contractual remedy, and is irrelevant here.   Therefore, the holding in Seneca, which specifically applies section 1974 to cases of actual fraud, even in the face of a contention that to apply the statute would shield the perpetrator of the fraud controls the case at bar.  Rader Co. v. Stone (1986) 178 Cal.App.3d 10, 223 Cal.Rptr. 806, also cited by the Bank, is similarly inapposite.   Unlike the present case, it deals with enforcement of an oral contract, not a claim for fraud.

The Bank's case is controlled by Seneca.   Whether denominated as fraud, negligent misrepresentation or professional negligence, the Bank's action falls squarely within the provisions of section 1974 and is barred;  E & Y's demurrer was properly sustained.

VII.

E & Y OWED NO DUTY TO THE BANK IN THIS INSTANCEA. State And Federal Law Preclude Imposition Of A Duty on E & Y on The Basis of A Review Report

 Traditionally, accountants have enjoyed immunity from liability to third parties with which they were not in privity such as the Bank in this instance.  (See Ultramares Corp. v. Touche (1931) 255 N.Y. 170, 174 N.E. 441.)   In International Mortgage Co. v. John P. Butler Accountancy Corp., supra, 177 Cal.App.3d 806, 223 Cal.Rptr. 218, however, the appellate court applied the “duty analysis” in determining whether to expand liability of auditors to third parties in the absence of privity.

The Butler case involved a plaintiff real estate developer, who allegedly relied upon negligently prepared financial statements on which an auditor had rendered an unqualified audit opinion.   Although there was no privity between plaintiff and the auditor, the Court of Appeal found that a duty existed under limited circumstances:  “[A]n independent auditor owes a duty of care to reasonably foreseeable plaintiffs who rely on negligently prepared and issued unqualified audited financial statements.” ⁷  (Emphasis added.)   (Id. at p. 820, 223 Cal.Rptr. 218.)   In essence, the court concluded that public consumption was the “end and aim” of “unqualified audited financial statements.”  (Id. at pp. 814–817, 223 Cal.Rptr. 218.)   Thus, the duty of auditors, like other professionals, is determined under an “end and aim” analysis.  (See Goodman v. Kennedy (1976) 18 Cal.3d 335, 343, fn. 4, 134 Cal.Rptr. 375, 556 P.2d 737.)

The trial court here found that the Bank was not the “end and aim” of E & Y's review work for Z Best.   Moreover, since a review report differs substantially from an auditor's opinion rendered after a full audit, Butler inversely bars the claim that the Bank is attempting to assert in this case.

The fact that review reports are qualitatively different from audit opinions is undisputed.   The American Institute of Certified Public Accountants (“AICPA”) standards cited by the Bank so indicate.   In addition, counsel for the Bank has conceded that the two are different.   The Securities Exchange Commission (“SEC”) has expressly declared that review reports are not to be deemed a “part” of a prospectus and that liability under section 12 of the Securities Act of 1933 (15 U.S.C. § 77l ) does not attach to review reports, even for investors who are the “end and aim” of the prospectus.  (See 17 C.F.R. § 230.436(c).)

Our research has disclosed no case in the more than 50 years since enactment of the first securities laws where a creditor was permitted to recover against an accountant based upon a review report contained in a public offering prospectus.   Federal courts have routinely held that review reports included in a prospectus cannot form the basis of claims by investors even under common law fraud or common law accountant negligence theories.  (See Rich v. Touche Ross & Co., supra, 415 F.Supp. 95, 98 [“[T]here can be no reliance upon misrepresentations by these defendant accountants” for statements that are “plainly marked ‘unaudited.’ ”];  Andreo v. Friedlander, Gaines, Cohen, etc., supra, 651 F.Supp. 877, 881 [Review examination “does not give rise to the kind of duty which is a prerequisite for a finding of reckless disregard of the truth.”].)

In brief, the trial court correctly sustained E & Y's demurrer.   Both California law under Butler and federal law preclude imposing a duty on E & Y to a remote third party based on the limited scope of a review report under the circumstances as alleged by the Bank in its SAC.

B. The Bank Did Not Rely And Could Not Have Reasonably Relied on E & Y's Review Report in Deciding to Extend Credit to Z Best

The Bank alleges that it relied on E & Y's oral “representations,” and that such reliance was justified because of E & Y's reputation.   Neither contention is sufficient to withstand demurrer.  “Justifiable reliance” is comprised of actual reliance, which is “reasonable.”  (Wilhelm v. Pray, Price, Williams & Russell, supra, 186 Cal.App.3d 1324, 1331–1332, 231 Cal.Rptr. 355.)   As a matter of law, this element of the Bank's negligence and fraud claims is absent.   This is true both because the Bank did not actually rely on E & Y and because any such reliance would have been unreasonable, as a matter of law.

1. The Bank Did Not “Actually” Rely on Any Representations by E & Y

 The allegations of the SAC make it clear that the Bank did not actually rely on E & Y's review report in making its credit decision.   The Bank alleges that it “reconsidered its decision with respect to the creation of a line of credit for ZZZZ Best” due to the preliminary prospectus.   In addition, the Bank details the extensive independent investigation it conducted between October and December 1986.

The Bank embarked upon an extensive series of meetings and discussions with Z Best.   It met with Z Best on at least four occasions, including at least one visit to Z Best's headquarters.   The Bank received and reviewed communications between Z Best and the SEC and received a copy of the final prospectus.⁸  The Bank received and reviewed several of Z Best's insurance restoration contracts and had at least one meeting with Mr. Thomas Padgett, who told the Bank that he represented an appraisal firm doing business with Z Best.   Throughout this entire period, the Bank was in telephone contact with Z Best “on virtually a daily basis.”   These allegations must be taken as true for purposes of a demurrer.  (Wilhelm v. Pray, Price, Williams & Russell, supra, 186 Cal.App.3d at p. 1330, 231 Cal.Rptr. 355.)

It is well established that, when a party has conducted its own investigation, there can be no reliance on any underlying representations.  (Id. at pp. 1331–1334, 231 Cal.Rptr. 355 [Allegations demonstrating intervening consultation with a party's own counsel preclude actual reliance upon representations of opposing counsel.].)

Furthermore, despite its own investigation, the Bank was still unwilling to extend a loan to Z Best and agreed to extend credit to Z Best only “contingent on the funding of the public offering.”   The pivotal role of the public offering in the Bank's decision is evident from the admissions of the Bank's counsel.   At the July 25, 1988, hearing the Bank's counsel stated:  “The entire point of this loan transaction, it wouldn't go forward unless that public offering was successful and likewise went forward, ․”

At the December 16, 1988, hearing, counsel for the Bank again advised the court:  “Absent the public offering going forward, [Z Best] wouldn't get the $7 million,” and “[the loan] was dependent on that public offering going forward.   They all go together.”

As detailed in the SAC, the Bank did not rely on representations by E & Y when going forward with the loan.   It relied on its own investigation and on the success of the public offering when it decided to lend $7 million to Z Best in December 1986.

2. Reliance on An Unsigned Review Report Is Unreasonable As A Matter of Law

 The Bank argues that the trial court erred because the reasonableness of its reliance on E & Y's alleged “representations” is a question for the jury.   The argument is misdirected.   Where, in circumstances such as the present, reliance is so misplaced or unwarranted, it cannot be reasonable as a matter of law.  (See e.g., Wilhelm v. Pray, Price, Williams & Russell, supra, 186 Cal.App.3d 1324, 1332, 231 Cal.Rptr. 355.)

In this case, E & Y specifically disclaimed the type of reliance the Bank now argues that it placed on the review report.⁹  The review report plainly stated that E & Y had not performed the audit work necessary to form an opinion about Z Best's financial statements for an interim period, let alone its overall financial condition, and “[a]ccordingly, we [E & Y] do not express such an opinion.”   The prospectus cautioned readers that, because E & Y “did not audit” the interim financial statement for July 31, 1986, reliance on its review report “should be restricted.”   Under these circumstances, it is inherently unreasonable for the Bank, as an experienced user of financial statements, to rely on the E & Y review report as an assurance that Z Best was financially sound.

An analogous situation was presented in Podlasky v. Price (1948) 87 Cal.App.2d 151, 196 P.2d 608 disapproved on another point in Gagne v. Bertran (1954) 43 Cal.2d 481, 487, 275 P.2d 15.   In Podlasky, the plaintiff received a typewritten prospectus, containing financial information, which was qualified by a statement that the information was “ ‘based upon information from sources deemed reliable’ ” and which were “ ‘believe[d] to be correct, but we cannot assume responsibility for errors or omissions therein.’ ”  (Id. 87 Cal.App.2d at p. 159, 196 P.2d 608.)   The court found that reliance upon such financial information, in the face of this warning, was unreasonable and not justifiable.  (Id. at pp. 158–160, 196 P.2d 608.)

Even if a foreseeable third party obtained a copy of the prospectus and inadvertently relied upon unaudited financial statements contained therein, E & Y completely discharged any duty it may have owed by warning, in the text of its review report, that (1) it did not conduct an audit, and (2) it did not express an opinion on any of Z Best's financial statements.   This warning, together with Z Best's additional warning that reliance on its unaudited financial statements should be restricted, when coupled with the fact that all unaudited financial statements in the prospectus were clearly marked as such, defeats any claim of “reasonable reliance.”   Moreover, the Bank is a major financial institution with its own obligation to conduct a due diligence examination before lending money.   The Bank plainly knew the difference between audited and unaudited financial statements and will not be heard to assert the claims set out against E & Y in the SAC.

VIII.

DISPOSITION

The judgment is affirmed.   Costs of appeal are awarded to respondent.

I concur in the majority's holding Union Bank cannot base any cause of action on Ernst & Whinney's oral representations as to ZZZZ Best's financial condition.  Code of Civil Procedure section 1974 clearly bars such an action.

However, I find I must part company from my colleagues on the question whether the bank has stated viable causes of action against Ernst & Whinney based on Ernst & Whinney's written review report.   It appears to me the majority has uncritically adopted the arguments advanced by Ernst & Whinney on this appeal—arguments I find to have some fatal flaws as I will explain below.

I. THE COMPLAINT STATES A CAUSE OF ACTION FOR FRAUDULENT MISREPRESENTATION BASED ON ERNST & WHINNEY'S WRITTEN REVIEW REPORT

The bank's complaint alleges, inter alia, the statement by Ernst & Whinney in its written review report that it had made a review of ZZZZ Best “in accordance with standards established by the American Institute of Certified Public Accountants” is false or was made without reasonable grounds for believing it was true.¹  Furthermore, the complaint alleges that in issuing its report Ernst & Whinney concealed information about the financial circumstances of ZZZZ Best it had a duty to disclose.   The complaint goes on to allege Ernst & Whinney knew its statements were false but intended that Union Bank rely on the statements as if they were true and the bank justifiably relied on Ernst & Whinney's false representations in extending a $7 million line of credit to ZZZZ Best.

Ernst & Whinney contend the foregoing allegations do not support a cause of action for fraudulent misrepresentation because the facts are not pled with sufficient specificity and the facts as pled demonstrate the bank did not, and could not, reasonably rely on Ernst & Whinney's representations in the review report.

Ernst & Whinney's demurrer for uncertainty was based on the lumping together of the representations and acts of numerous defendants so that it could not be ascertained which defendant made which representation.   This is a valid criticism of the allegations in the complaint pertaining to oral misrepresentations.   However, this criticism in not applicable to the allegations pertaining to the written review report.   As to the review report, the complaint is very clear in alleging the false statements contained therein, Ernst & Whinney's knowledge of their falsity, its intent to cause the bank to rely on the statements, the bank's justifiable reliance and damages.

As to reliance, Ernst & Whinney argue the facts pled in the complaint show the bank did not rely on Ernst & Whinney's review report in extending credit to ZZZZ Best.   Ernst & Whinney point out the bank conducted an extensive investigation before making the loan.   Bank officials toured ZZZZ Best's headquarters, had numerous meetings with ZZZZ Best's officers and its attorney, and were in telephone contact with ZZZZ Best “on virtually a daily basis.”   The bank reviewed communications between ZZZZ Best and the Securities and Exchange Commission and received ZZZZ Best's final prospectus prior to making the loan.   The bank admits in its complaint the loan to ZZZZ Best was contingent on the funding of the public stock offering.

Generally, when a positive representation of fact is made the party receiving it is entitled to rely on it and need not conduct an independent investigation.  (West v. Great Western Power Co. (1940) 36 Cal.App.2d 403, 413–414, 97 P.2d 1014.)   Furthermore, the mere fact the plaintiff conducted some form of investigation or consulted with others does not rule out reliance as a matter of law.  (Blackman v. Howes (1947) 82 Cal.App.2d 275, 279, 185 P.2d 1019.)   The defendant's fraudulent statement need not be the sole factor on which the plaintiff relied.   It is enough to show the defendant's representation substantially influenced plaintiff's action, even though other influences operated as well.  (Wennerholm v. Stanford Univ. Sch. of Med. (1942) 20 Cal.2d 713, 717, 128 P.2d 522.)

Here, Ernst & Whinney made a positive representation of fact in its report.   It stated:  “We have made a review ․ in accordance with standards established by the American Institute of Certified Public Accountants.”   The bank conducted an investigation of ZZZZ Best's finances but there are no allegations in the complaint the bank reviewed the actual financial records.   Rather, its investigation consisted of consultations with ZZZZ Best's officials, attorney, accountant, customers and other sources of information.   One such source of information was the report prepared by Ernst & Whinney.   The fact the bank consulted with others is not dispositive of the reliance issue.   The bank may have relied on numerous factors in making the loan but if a “substantial factor” was the misrepresentation by Ernst & Whinney, then the accounting firm is subject to liability.  (Wennerholm, supra, 20 Cal.2d at p. 717, 128 P.2d 522;  Rest.2d Torts, § 546, p. 102.)

Ernst & Whinney argue next that even if the bank did rely on its report in making the loan such reliance was unreasonable as a matter of law.   Ernst & Whinney base this argument on the report's disclaimer which specifically states Ernst & Whinney did not audit ZZZZ Best's financial statements and expresses no opinion as to those statements.

This argument misses the point.   The bank does not allege Ernst & Whinney audited ZZZZ Best's financial statements.   The bank alleges Ernst & Whinney represented it conducted a review in accordance with standards established by the American Institute of Certified Public Accountants and, based on that review, Ernst & Whinney represented it was “not aware of any material modifications that should be made to [ZZZZ Best's] financial statements ․ for them to be in conformity with generally accepted accounting principles.”   The bank relied on the methodology of the review being in accordance with generally accepted accounting principles, as represented by Ernst & Whinney.   The bank was entitled to rely on this statement of unconditional fact.  (West v. Great Western Power Co., supra, 36 Cal.App.2d at pp. 413–414, 97 P.2d 1014.)

I do agree with the trial court below, however, the bank cannot state a cause of action for fraud based on nondisclosure of facts Ernst & Whinney may have discovered in the course of its review of ZZZZ Best's financial statements.   Ordinarily, the duty to disclose material facts does not arise absent a fiduciary relationship between the parties.  (Goodman v. Kennedy (1976) 18 Cal.3d 335, 346–347, 134 Cal.Rptr. 375, 556 P.2d 737.)   No such duty has been shown here.

II. THE COMPLAINT STATES CAUSES OF ACTION FOR NEGLIGENCE AND NEGLIGENT MISREPRESENTATION BASED ON ERNST & WHINNEY'S UNAUDITED FINANCIAL REPORT

The bank's complaint alleges negligence and negligent misrepresentation on the part of Ernst & Whinney in preparing and issuing its interim financial report on ZZZZ Best.   These causes of action are challenged by Ernst & Whinney on two grounds:  (1) Ernst & Whinney owed no duty of care to the bank in the unaudited review of ZZZZ Best's financial records and (2) subsequent criminal activity by others was a superseding cause of harm to the bank relieving Ernst & Whinney of any liability for its negligence.

For the reasons explained below I find these arguments unpersuasive.

A. An Accountant Owes a Duty of Care to Those Third Parties Who It Foresaw Would Rely on the Accountant's Unaudited Review of Interim Financial Information.

Ernst & Whinney argue an accountant's liability should be limited to users of unqualified audit reports and not expanded to users of unaudited materials such as the interim financial reviews issued in this case.   I can find no rational basis for such a distinction.   In my view, the same standard of care applies to Ernst & Whinney's work product whether that work product is an unqualified audit report or an unaudited interim financial review.   Furthermore, accountants owe a duty of care to known or intended users of financial statements whether they are audited or not.   Whether the bank relied on Ernst & Whinney's interim financial review and whether its reliance was reasonable are questions for the jury.  (See discussion supra, pp. 495–496.)

The standard of care required of persons who render professional service is stated in section 299A of the Restatement (Second) of Torts:

“[O]ne who undertakes to render services in the practice of a profession or trade is required to exercise the skill and knowledge normally possessed by members of that profession or trade in good standing in similar communities.”

Our Supreme Court has applied this standard to other professionals.  (See Neel v. Magana, Olney, Levy, Cathcart & Gelfand (1971) 6 Cal.3d 176, 188, fns. 21, 22, 98 Cal.Rptr. 837, 491 P.2d 421.)   I see no reason why it should not apply to the services of an accountant.

Under the Restatement's standard of care, the service the accountant renders, be it audit, interim review or something else, must be rendered with the skill and knowledge normally possessed by other accountants in the community.   The Supreme Court of Iowa addressed this very point in Ryan v. Kanne (Ia.1969) 170 N.W.2d 395 in which an accounting firm negligently prepared a balance sheet for a lumber business knowing it would be relied upon by unspecified lenders or investors.   The accounting firm claimed it owed no duty of care in preparing an uncertified financial statement of business operations upon which it affirmatively stated it expressed no opinion.   The Iowa Supreme Court disagreed and held the accountants did owe a duty of care, reasoning:

“Although in this profession a distinction is made between certified audits where greater time and effort are expended to verify book items, and uncertified audits where greater reliance is placed on book items, it is clear to us that accountants, or any other professional persons, must perform those acts that they agreed to do under the contract and which they claim have been done in order to make the determination set forth and presented in their report.   Their liability must be dependent upon their undertaking, not their rejection of dependability.   They cannot escape liability for negligence by a general statement that they disclaim its reliability.”  (Id. at p. 404.)

In other words, accountants are held responsible for the work they agree to do.   If they agree to perform a service less than a full certified audit they cannot be held responsible for missing things that would only appear in a full certified audit.   But as to items they agreed to do and state that they did do, but did not, the fact the report was not an unqualified certified audit does not relieve them from liability.

Ernst & Whinney emphasize the limited nature of the service they performed for ZZZZ Best and the disclaimer contained in their report.   I recognize significant differences exist between an unqualified audit report and the unaudited interim financial review at issue in this case.   But those differences are irrelevant to the existence of a duty.   When Ernst & Whinney agreed to provide unaudited accounting services for ZZZZ Best it undertook to exercise that degree of accounting skill possessed by other accountants in the community.  (Rest. 2d of Torts, supra, § 299A;  Robert Wooler Co. v. Fidelity Bank (1984) 330 Pa.Super. 523, 479 A.2d 1027, 1032.)   Its disclaimer limits its basis for liability but does not eliminate liability altogether.

The scope of the duty undertaken by Ernst & Whinney is defined in section 552 of the Restatement which provides in relevant part:

“(1) One who, in the course of his business, profession or employment ․ supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.   [¶] (2) ․ the liability stated in Subsection (1) is limited to loss suffered (a) by 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.”

Courts have generally relied on the Restatement's test in assessing the extent of an accountant's liability.  (See Wiener, Common Law Liability of the Certified Public Accountant for Negligent Misrepresentation (1983) 20 San Diego L.Rev. 233, 247–248.)   Under this test, accountants owe a duty of care to foreseen users of financial statements and to third persons who are members of a known or intended class of users.²

It is worth noting the first case to apply the Restatement rule on the scope of duty, Ryan v. Kanne, supra, was a case upholding damages for the negligent preparation of an unaudited financial report.  (170 N.W.2d at p. 404.)   See also Spherex, Inc. v. Alexander Grant & Co. (1982) 122 N.H. 898, 451 A.2d 1308, 1309, 1312 [accounting firm which prepared unaudited financial statement for loan applicant owed duty of care to lender it knew would receive the report];  Bonhiver v. Graff (1976) 311 Minn. 111, 248 N.W.2d 291, 299, 303 [accounting firm which prepared unaudited report on insurance company's solvency for state insurance commissioner owed duty of care to insurance agent it knew would rely on its report];  Lubin v. Sybedon Corp. (S.D.Cal.1988) 688 F.Supp. 1425, 1456 [accountants who prepared unaudited market study and profit projections liable to investors they knew would receive their report and rely thereon].

The majority cites two federal cases allegedly holding an unaudited review cannot be the basis for liability in a suit against an accountant for negligence.  (Rich v. Touche Ross & Co. (S.D.N.Y.1976) 415 F.Supp. 95;  Andreo v. Friedlander, Gaines, Cohen, Etc. (D.Conn.1986) 651 F.Supp. 877.)   In fact, what these cases hold is that an unaudited review cannot be the basis for claims of fraud based on federal securities laws.  (Rich v. Touche, supra, 415 F.Supp. at pp. 97–98;  Andreo v. Friedlander, Gaines, Cohen, Etc., supra, 651 F.Supp. at p. 881.)   In Rich, the court expressly stated, “plaintiffs appear to state a good claim under familiar principles of negligence or accountant's malpractice.”  (415 F.Supp. at p. 104.)   In Andreo, the court expressed no view as to the validity of plaintiffs' state law claims.   Rather it stated it was dismissing these claims because having dismissed the federal claims it had no basis for jurisdiction over the pendent claims.  (651 F.Supp. at p. 883.)

In the present case, the bank alleges Ernst & Whinney knew ZZZZ Best would transmit Ernst & Whinney's report to the bank;  knew the bank would rely on it;  and intended the bank to rely on it.   These allegations satisfy the Restatement requirements of an actually foreseen user for whose benefit the accountant knows the information is intended and who will rely on it.   (Rest.2d Torts § 552;  Wiener, Common Law Liability [etc.], supra, 20 San Diego L.Rev. at p. 248.)   These allegations also satisfy the requirement a negligent misrepresentation must have been made with the intent to induce the plaintiff to rely on it.  (Christiansen v. Roddy (1986) 186 Cal.App.3d 780, 785–787, 231 Cal.Rptr. 72;  5 Witkin, Summary of Cal.Law, (9th ed. 1988) Torts, § 721, p. 820.)   Therefore, the complaint adequately alleges a duty to the bank on the part of Ernst & Whinney in preparing the interim financial statement.

B. The Complaint Does Not Establish The Criminal Acts of Barry Minkow or Others Were a Superseding Cause of Harm to the Bank.

The trial court took judicial notice of the fact Barry Minkow, founder of ZZZZ Best, and many of his associates had been convicted of crimes in connection with the operation of ZZZZ Best.   However, no facts pled in the complaint establish these criminal acts were a superseding cause of harm to the bank relieving Ernst & Whinney of any liability for its negligence.   If anything, the facts in the complaint suggest the criminal acts were precedent to, or concurrent with, Ernst & Whinney's alleged negligence.   The question whether an intervening act amounts to a superseding cause is a question of fact for the jury.  (Landeros v. Flood (1976) 17 Cal.3d 399, 411, 131 Cal.Rptr. 69, 551 P.2d 389.)

III. THE COMPLAINT SUFFICIENTLY ALLEGES ERNST & WHINNEY AIDED AND ABETTED AND CONSPIRED TO COMMIT A FRAUD AGAINST THE BANK

Although conspiracy to commit a tort is not a separate cause of action from the tort itself, alleging a conspiracy fastens liability on those who agree to the plan to commit the wrong as well as those who actually carry it out.   (Schick v. Lerner (1987) 193 Cal.App.3d 1321, 1327, 238 Cal.Rptr. 902.)   To successfully allege conspiracy to commit a tort the complaint must allege:  (1) the formation and operation of the conspiracy;  (2) the wrongful act done pursuant thereto;  and (3) the damage resulting from such act.  (Id. at pp. 1327–1328, 238 Cal.Rptr. 902.)  “The sine qua non of a conspiratorial agreement is the knowledge on the part of the alleged conspirators of its unlawful objective and their intent to aid in achieving that objective.”  (Id. at p. 1328, 238 Cal.Rptr. 902.)

Fraud must be specifically pleaded.  (Wilhelm v. Pray, Price, Williams & Russell (1986) 186 Cal.App.3d 1324, 1331, 231 Cal.Rptr. 355.)   It stands to reason then, conspiracy to defraud must also be specifically pleaded.  (See Schick v. Lerner, supra, 193 Cal.App.3d at p. 1328, 238 Cal.Rptr. 902.)   Ernst & Whinney contend the complaint in this action fails to plead with specificity a factual basis for the alleged knowledge and intent of the co-conspirators, including Ernst & Whinney.   It must be recognized, however, that because of the very nature of a conspiracy, “its existence must often be inferentially and circumstantially derived from the character of the acts done, the relations of the parties and other facts and circumstances suggestive of concerted action.”  (Schessler v. Keck (1954) 125 Cal.App.2d 827, 833, 271 P.2d 588.)   Few plaintiffs would be able to state at the pleading stage the exact date, place and time the conspirators formed the intent to defraud the plaintiff or who said what to whom.   Thus, while plaintiff's complaint must contain more than a bare allegation the defendants conspired, the complaint is sufficient if it appraises defendant of the facts and circumstances relied on to establish a conspiracy.  (Id. at p. 833, 271 P.2d 588;  Bradley v. Hartford Acc. & Indem. Co. (1973) 30 Cal.App.3d 818, 825, 106 Cal.Rptr. 718.)

The bank's complaint alleges the formation of the conspiracy and the role each conspirator played.   It alleges the wrongful acts done pursuant to the conspiracy.   And, it alleges the damage to the bank:  an uncollectable $7 million loan.   From the specific allegations in the complaint regarding meetings between the bank and the conspirators and statements made by various conspirators at those meetings it can reasonably be inferred the conspirators, including Ernst & Whinney, knew the object was to induce the bank to make a loan to ZZZZ Best based on false financial information and that they intended to aid in achieving that objective.

One aids and abets the commission of an intentional tort if he or she (a) orders or induces the tortious conduct knowing of the conditions under which the act is done or intending the consequences which ensue, or (b) knows another's conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other in engaging in that conduct.  (Pasadena Unified Sch. Dist. v. Pasadena Federation of Teachers (1977) 72 Cal.App.3d 100, 113, 140 Cal.Rptr. 41.)   This analysis applies equally to the aiding and abetting allegations.

CONCLUSION

The implications of this case go far beyond one bank and one accounting firm.   The rule the majority announces here about the absence of a duty, if followed by other California courts, could insulate all accountants from responsibility for representations made about and in their written review reports.

This state and this nation have entered an era where many innocent citizens, taxpayers, bondholders, and shareholders alike, are being asked to bear the financial burden for fraudulent business arrangements—and often the resultant failure of banks and similar institutions—they had nothing whatsoever to do with.   How can we ask them to do so if the courts let off the hook those, including accountants, who are not totally innocent—indeed whose own actions may have contributed to the perpetration of the fraud and to the ensuing losses.

This case happens to involve a still healthy bank victimized by a scam, allegedly facilitated by a haphazardly prepared, erroneous accountant's report.   The next case could well involve a bank or savings and loan pushed into insolvency by a similar fraud—or series of frauds—one or all of them facilitated by haphazardly prepared, erroneous accountants' reports.   As between innocent taxpayers and negligent (or worse) accounting firms, who should bear the cost of that insolvency?

For all of these reasons, I would reverse and remand the matter to the trial court with directions to overrule the demurrer of Ernst & Whinney as to the counts of the complaint related to fraud, negligent misrepresentation, negligence, and conspiracy to defraud based on the interim review report.

FOOTNOTES

1.   Ernst & Young is the successor-in-interest to Ernst & Whinney.   Ernst & Young and Ernst & Whinney will hereinafter be referred to as “E & Y.”

2.   The Bank alleges that another CPA, defendant Greenspan & Co., audited Z Best and rendered an unqualified opinion on Z Best's financial statements for periods prior to E & Y's involvement.   That audit opinion was included in Z Best's prospectus.

FN3. All references herein are to the Code of Civil Procedure unless otherwise specified..  FN3. All references herein are to the Code of Civil Procedure unless otherwise specified.

4.   The prospectus was prepared and filed with the SEC as a statement of management.

5.   By our comments in this opinion, we do not mean to imply that an “audit” opinion inevitably results in liability on the part of the certifying account to relying third parties.   That issue is before the California Supreme Court in Bily v. Arthur Young & Co. (1990) 222 Cal.App.3d 289, 271 Cal.Rptr. 470.   Petition for review granted October 18, 1990.  274 Cal.Rptr. 371, 798 P.2d 1214.   Accordingly, we express no opinion on the issue and do not speculate on the reasons underlying the grant of review by our Supreme Court.

6.   In a footnote, the court discussed the Law Revision Commission's “case against section 1974” in which the Commission noted that the previous court decisions were harsh and ambiguous in applying section 1974 to both negligent and fraudulent misrepresentation.   The court noted, however, that “even faced with [the Law Revision Commission's] explicit argument the Legislature did not see fit to narrow the scope of the statute so as to exclude either of these types of misrepresentations.”  (Seneca Communications, Inc. v. International Bank of California, supra, 103 Cal.App.3d at p. 550, fn. 8, 163 Cal.Rptr. 176.)

7.   But see footnote 5.

8.   The Bank alleges that it received the final prospectus “shortly after it was issued on December 9.”   However, “shortly after” is vague.   The SAC does not make clear whether the Bank received the final prospectus before or after it extended the line of credit on December 17.

9.   As pointed out above, although the Bank now argues that it relied on the written review report, it did not so allege in the second amended complaint.

1.   See discussion of negligent misrepresentation at pages 493–495, infra.

2.   The earliest cases restricted an accountant's liability for negligence to those in privity with the accountant.   Justice Cardoza's opinion in Ultramares Corp. v. Touche (1931) 255 N.Y. 170, 174 N.E. 441 is the most often cited example of this view.   Today, New York is one of the few jurisdictions still clinging to the privity requirement.  (See Credit Alliance v. Arthur Andersen & Co. (1985) 65 N.Y.2d 536, 537, 493 N.Y.S.2d 435, 483 N.E.2d 110.)   More recently courts have moved beyond the Restatement's foreseen user test and have adopted a foreseeable user test which extends the duty of care to any reasonably foreseeable user of the statement.  (Rosenblum v. Adler (1983) 93 N.J. 324, 461 A.2d 138;  Citizens State Bank v. Timm, Schmidt & Co. (1983) 113 Wis.2d 376, 335 N.W.2d 361.)   The foreseeable user test was adopted in International Mortgage Co. v. John P. Butler Accountancy Corp. (1986) 177 Cal.App.3d 806, 818, 223 Cal.Rptr. 218.   Because the complaint in the present case states a cause of action under Restatement section 552, it is unnecessary to explore the limits of the duty owed by an accountant to a third party.

FRED WOODS, Associate Justice.

LILLIE, P.J., concurs.