Case Name: MARIETTA SMALL, as Public Administrator, etc., Plaintiff and Appellant, v. FRITZ COMPANIES, INC., et al., Defendants and Respondents
Court: Supreme Court of California
Jurisdiction: California
Decision Date: 2003-04-07
Citations: 30 Cal. 4th 167
Docket Number: No. S091297
Parties: MARIETTA SMALL, as Public Administrator, etc., Plaintiff and Appellant, v. FRITZ COMPANIES, INC., et al., Defendants and Respondents.
Judges: 
Reporter: California Reports
Volume: 30
Pages: 167–212

Head Matter:
[No. S091297.
Apr. 7, 2003.]
MARIETTA SMALL, as Public Administrator, etc., Plaintiff and Appellant, v. FRITZ COMPANIES, INC., et al., Defendants and Respondents.
Counsel
Stull, Stull & Brody, Michael D. Braun, Marc L. Godino, Timothy J. Burke, Jules Brody and Mark Levine for Plaintiff and Appellant.
Orrick, Herrington & Sutcliffe, William F. Alderman and E. Anne Hawkins for Defendants and Respondents.
Wilson Sonsini Goodrich & Rosati, Boris Feldman, Douglas J. Clark and Cheryl W. Foung for Electronics for Imaging, Inc., as Amicus Curiae on behalf of Defendants and Respondents.
Skadden, Arps, Slate, Meagher & Flom, Raoul D. Kennedy, Garrett J. Waltzer, David E. Springer and Frances P. Kao for Ifilm Corp. and SGW Holding Inc., as Amici Curiae on behalf of Defendants and Respondents.
Munger, Tolles & Olson, Charles D. Siegal, George M. Garvey and Janice M. Kroll for Securities Industry Association as Amicus Curiae on behalf of Defendants and Respondents.
Richard I. Miller; Wilke, Fleury, Hoffelt, Gould & Birney, Matthew W. Powell, Paul A. Dorris, Daniel L. Baxter; Willkie Farr & Gallagher, Kelly M. Hnatt and Daniel B. Rosenthal for American Institute of Certified Accountants as Amicus Curiae on behalf of Defendants and Respondents.
Harvey Greenfield, plaintiff in the superior court, died while this case was pending here. We granted the motion of Marietta Small, the Public Administrator for the Estate of Harvey Greenfield, to substitute as appellant.

Opinion:
Opinion
KENNARD, J.
This is a stockholder's action charging that defendant corporation and its officers sent its stockholders a fraudulent quarterly financial report that grossly overreported earnings and profits. Plaintiff alleged that when the fraud was discovered, the price of the corporate stock dropped precipitously, causing injury to stockholders like himself. The trial court sustained a demurrer without leave to amend and entered judgment for defendants; the Court of Appeal reversed. We granted defendants' petition for review.
The petition for review raised only a single issue: "Should the tort of common law fraud (including negligent misrepresentation) be expanded to permit suits by those who claim that alleged misstatements by defendants induced them not to buy and sell securities?" This overstates the matter— this case does not involve any claim by persons who do not own stock and are fraudulently induced not to buy. It does, however, present the issue whether California should recognize a cause of action by persons wrongfully induced to hold stock instead of selling it. (For convenience, we shall refer to such a lawsuit as a "holder's action" to distinguish it from suits claiming damages from the purchase or sale of stock.)
We conclude that California law should allow a holder's action for fraud or negligent misrepresentation. California has long acknowledged that if the effect of a misrepresentation is to induce forbearance—to induce persons not to take action—and those persons are damaged as a result, they have a cause of action for fraud or negligent misrepresentation. We are not persuaded to create an exception to this rule when the forbearance is to refrain from selling stock. This conclusion does not expand the tort of common law fraud, but simply applies long-established legal principles to the factual setting of misrepresentations that induce stockholders to hold on to their stock.
This cause of action should be limited to stockholders who can make a bona fide showing of actual reliance upon the misrepresentations. Plaintiff here has failed to plead the element of actual reliance with sufficient specificity to show that he can meet that requirement. We therefore reverse the judgment of the Court of Appeal and remand the cause to that court, with directions to have the trial court sustain defendants' demurrer but grant plaintiff leave to amend his complaint.
I. Proceedings Below
"In reviewing a judgment of dismissal after a demurrer is sustained without leave to amend, we must assume the truth of all facts properly pleaded by the plaintiffs, as well as those that are judicially noticeable." (Howard Jarvis Taxpayers Assn. v. City of La Habra (2001) 25 Cal.4th 809, 814 [107 Cal.Rptr.2d 369, 23 P.3d 601].) Our opinion in this case should not be construed as indicating whether or not defendants actually committed fraud or negligent misrepresentation.
Stockholder Harvey Greenfield filed this action in 1996 against Fritz Companies, Inc., a corporation, and against three officers: Lynn Fritz, the company president, chairman of the board, and owner of 39 percent of the common stock; John Johung, the chief financial officer and a director; and Stephen Mattessich, the corporate controller and a director. The action was filed as a class action on behalf of all shareholders in Fritz "who owned and held Fritz common stock as of April 2, 1996 through at least July 24, 1996, in reliance on defendants' material misrepresentations and omissions . . . and who were damaged thereby." The complaint alleged causes of action for common law fraud and negligent misrepresentation, and for violations of Civil Code sections 1709 and 1710, which codify the common law actions for fraud and deceit.
Before us is the validity of plaintiffs second amended complaint. It alleged that Fritz provides services for importers and exporters. Between April 1995 arid May 1996, Fritz acquired Intertrans Corporation and then numerous other companies in the import and export businesses. Fritz encountered difficulties with these acquisitions, and in particular with the Intertrans accounting system, which it adopted for much of its business. Nevertheless, on April 2, 1996, Fritz issued a press release that reported third quarter revenues of $274.3 million, net income of $10.3 million, and earnings per share of $29. The same figures appeared in its third quarter report to shareholders, issued on April 15, 1996, for the quarter ending February 29, 1996. According to plaintiff, that report was incorrect for a variety of reasons: the inadequate integration of the Intertrans and Fritz accounting systems led to recording revenue that did not exist; Fritz failed to provide adequate reserves for uncollectible accounts receivable; and Fritz misstated the costs of its acquisitions.
The complaint alleged that on July 24, 1996, Fritz restated its previously reported revenues and earnings for the third quarter. Estimated third quarter earnings were reduced from $10.3 million to $3.1 million. Further, Fritz announced that it would incur a loss of $3.4 million in the fourth quarter.
The complaint then set forth in detail the reasons why the original third quarter report was inaccurate: improper accounting for merger and acquisition costs; improper classification of ordinary operating expenses as merger costs; improper revenue recognition; improper capitalized software development costs; and failure to allow for uncollectible accounts receivable. It alleged that the individual defendants knew or should have known that the third quarter report and press releases were false and misleading. When defendants made these statements, "defendants intended that investors, including plaintiff and the Class, would rely upon and act on the basis of those misrepresentations in deciding whether to retain the Fritz shares."
The complaint further asserted that plaintiff and all class members received Fritz's third quarter statement, "read this statement, including the information related to the reported revenue, net income and earnings per share, and relied on this information in deciding to hold Fritz stock through [July 24, 1996]."
With respect to damages, the complaint alleged: "In response to defendant's disclosures on July 24, 1996, Fritz's stock plunged more than 55% in one day, dropping $15.25 to close at $12.25 per share . . . . Had defendants disclosed correct third quarter revenue, net income and earnings per share on April 2, 1996, as required by GAAP [generally accepted accounting practices], Fritz's stock price would likely have declined on April 2, 1996, and plaintiff and the Class would have disposed of their shares at a price above the $12.25 per share closing price of that day."
Defendants demurred to plaintiff's second amended complaint on two grounds: (1) "California law does not recognize any [cause of action] on behalf of shareholders who neither bought nor sold shares based upon any alleged misstatement or omission"; and (2) the complaint failed to "plead with the requisite specificity the facts alleged to constitute actual reliance." The trial court sustained the demurrer on the second ground only and entered judgment for defendants. Plaintiff appealed.
The Court of Appeal reversed. It held that the complaint stated causes of action for fraud and negligent misrepresentation and alleged actual reliance with sufficient specificity. (It did not decide whether the case should be certified as a class action.) We granted defendants' petition for review.
II. California Recognizes a Cause of Action for Stockholders Induced by Fraud or Negligent Misrepresentation to Refrain from Selling Stock
Defendants contend that California should not recognize a cause of action for fraud or negligent misrepresentation when the plaintiff relies on the false representation by retaining stock, instead of buying or selling it. We disagree.
" 'The elements of fraud, which gives rise to the tort action for deceit, are (a) misrepresentation (false representation, concealment, or nondisclosure); (b) knowledge of falsity (or "scienter"); (c) intent to defraud, i.e., to induce reliance; (d) justifiable reliance; and (e) resulting damage.' " (Lazar v. Superior Court (1996) 12 Cal.4th 631, 638 [49 Cal.Rptr.2d 377, 909 P.2d 981].) The tort of negligent misrepresentation does not require scienter or intent to defraud. (Gagne v. Bertran (1954) 43 Cal.2d 481, 487-488 [275 P.2d 15].) It encompasses "[t]he assertion, as a fact, of that which is not true, by one who has no reasonable ground for believing it to be true" (Civ. Code, § 1710, subd. 2), and "[t]he positive assertion, in a manner not warranted by the information of the person making it, of that which is not true, though he believes it to be true" (Civ. Code, § 1572, subd. 2; see Fox v. Pollack (1986) 181 Cal.App.3d 954, 962 [226 Cal.Rptr. 532] [describing elements of the tort]). When such misrepresentations have occurred in connection with the sale of corporate stock, the California courts have entertained common law actions for fraud or negligent misrepresentation. (E.g., Hobart v. Hobart Estate Co. (1945) 26 Cal.2d 412 [159 P.2d 958]; Sewell v. Christie (1912) 163 Cal. 76 [124 P. 713].)
Forbearance—the decision not to exercise a right or power—is sufficient consideration to support a contract and to overcome the statute of frauds. (E.g., Schumm v. Berg (1951) 37 Cal.2d 174, 185, 187-188 [231 P.2d 39, 21 A.L.R.2d 1051]; Rest.2d Contracts,- § 90, 139; 1 Witkin, Summary of Cal. Law (9th ed. 1987) Contracts, § 214, p. 223.) It is also sufficient to fulfill the element of reliance necessary to sustain a cause of action for fraud or negligent misrepresentation. Section 525 of the Restatement Second of Torts states: "One who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation." (Rest.2d Torts, § 525, italics added.) Section 531 states the "general rule" that "[o]ne who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation, for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced." (Rest.2d Torts, § 531, italics added.) And section 551, subdivision (1) states: "One who fails to disclose to another a fact that he knows may justifiably induce the other to act or refrain from acting in a business' transaction is subject to the same liability to the other as though he had represented the nonexistence of the matter that he has failed to disclose . . . ." (Rest.2d Torts, § 551, italics added.)
California law has long recognized the principle that induced forbearance can be the basis for tort liability. (Marshall v. Buchanan (1868) 35 Cal. 264; Pollack v. Lytle (1981) 120 Cal.App.3d 931, 941 [175 Cal.Rptr. 81], overruled on other grounds in Beck v. Wecht (2002) 28 Cal.4th 289 [121 Cal.Rptr.2d 384, 48 P.3d 417]; Carlson v. Richardson (1968) 267 Cal.App.2d 204, 206-208 [72 Cal.Rptr. 769]; Halagan v. Ohanesian (1967) 257 Cal.App.2d 14, 17-19 [64 Cal.Rptr. 792]; see Pinney & Topliff v. Chrysler Corporation (S.D.Cal. 1959) 176 F.Supp. 801.) California has not yet applied this principle to lawsuits involving misrepresentations affecting corporate stock, but, as we shall explain, we should not make an exception for such cases. Most other states that have confronted this issue have concluded that forbearance from selling stock is sufficient reliance to support a cause of action. (See David v. Belmont (1935) 291 Mass. 450 [197 N.E. 83]; Fottler v. Moseley (1901) 179 Mass. 295 [60 N.E. 788]; see Smith v. Duffy (1895) 57 N.J.L. 679 [sub nom. Duffy v. Smith, 32 A. 371] [plaintiff fraudulently induced to buy stock could recover damages for period of retaining stock in reliance on same representation]; Continental Insurance Co. v. Mercadante (1927) 222 A.D. 181 [225 N.Y.S. 488]; Rothmiller v. Stein (1894) 143 N.Y. 581 [38 N.E. 718]; but see Chanoff v. U.S. Surgical Corp. (D.Conn. 1994) 857 F.Supp. 1011, 1108 [applying Connecticut law]; see generally Ratner, Stockholders' holding Claims Class Actions Under State Law After the Uniform Standards Act of 1998 (2001) 68 U. Chi. L.Rev. 1035, 1039 (hereafter Ratner).) Gutman v. Howard Sav. Bank (D.N.J. 1990) 748 F.Supp. 254, 264, upholding a holder's action based on forbearance under New York and New Jersey law, said: "Lies which deceive and injure do not become innocent merely because the deceived continue to do something rather than begin to do something else. Inducement is the substance of reliance; the form of reliance—action or inaction—is not critical to the actionability of fraud." (Fn. omitted.)
Indeed, defendants do not dispute that forbearance is generally sufficient reliance to permit a cause of action for fraud or negligent misrepresentation. Neither do they dispute that forbearance would be sufficient reliance if a stockholder were induced to refrain from selling his stock by a face-to-face conversation with a corporate officer or director. Borrowing a phrase from the United States Supreme Court opinion in Blue Chip Stamps v. Manor Drug Stores (1975) 421 U.S. 723, 745 [95 S.Ct. 1917, 1929-1930, 44 L.Ed.2d 539] (Blue Chip Stamps), however, defendants argue that all such cases are "light years away" from the world of stock transactions on a national exchange.
Defendants first assert that in the context of stock sold on a national exchange, a corporation cannot be found to have knowingly intended to defraud "an anonymous shareholder like plaintiff Greenfield," because no corporate officer or director had a face-to-face or personal communication with him. Nevertheless, although many fraud cases involve personal communications, that has never been an element of the cause of action. (See Committee on Children's Television, Inc. v. General Foods Corp. (1983) 35 Cal.3d 197, 218-219 [197 Cal.Rptr. 783, 673 P.2d 660] [fraud perpetrated by misleading advertisements on nationally broadcast television shows].) Fraud can be perpetrated by any means of communication intended to reach and influence the recipient.
But defendants' principal argument is that in a case such as this involving a widely held, nationally traded stock, there are compelling policy considerations that argue against recognizing a holder's cause of action. In particular, they contend that allowing a holder's action will permit the filing of non-meritorious "strike" suits designed to coerce settlements (see Blue Chip Stamps, supra, 421 U.S. at pp. 739-742 [95 S.Ct. at pp. 1927-1929]; Mirkin v. Wasserman (1993) 5 Cal.4th 1082, 1107 [23 Cal.Rptr.2d 101, 858 P.2d 568] (Mirkin); Bily v. Arthur Young & Co. (1992) 3 Cal.4th 370, 401, 406 [11 Cal.Rptr.2d 51, 834 P.2d 745, 48 A.L.R.5th 835] (Bily)). We recognize the importance of the policy considerations defendants advance, but although those considerations may justify placing limitations on a holder's cause of action, they do not justify a categorical denial of that cause of action. In explaining the basis for this conclusion, we first examine the federal cases and statutes on which defendants rely, then the California cases, and finally defendants' specific policy concerns.
A. Federal Law
Congress enacted the first federal laws regulating securities in the early 1930's in response to the stock market crash of 1929. (See Ratner, supra, 68 U. Chi. L.Rev. at p. 1042.) The Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq.) "was designed to protect investors against manipulation of stock prices" and to that end established extensive disclosure requirements. (Basic Inc. v. Levinson (1988) 485 U.S. 224, 230 [108 S.Ct. 978, 982-983, 99 L.Ed.2d 194].) Under the authority granted by that act, the Securities and Exchange Commission in 1942 promulgated a regulation making it "unlawful for any person . [U] . to employ any device, scheme or artifice to defraud, [f] . . . [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made . . . not misleading, or ft[] . . . [t]o engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." (17 C.F.R. § 240.10b-5 (2002) (hereafter Rule 10b-5).) Lower federal courts implied a private right of action to enforce Rule 10b-5, and the United States Supreme Court eventually endorsed this view in 1988. (Basic Inc. v. Levinson, supra, 485 U.S. at pp. 230-231 [108 S.Ct. at pp. 982-983].)
In Birnbaum v. Newport Steel Corp. (2d Cir. 1952) 193 F.2d 461, the United States Court of Appeals for the Second Circuit interpreted Rule 10b-5 as aimed only at " 'a fraud perpetrated upon the purchaser or seller' of securities and as having no relation to breaches of fiduciary duty by corporate insiders resulting in fraud upon those who were not purchasers or sellers." (Birnbaum, at p. 463.) This interpretation of Rule 10b-5 barred holder's actions under that rule.
In 1975, the United States Supreme Court agreed that Rule 10b-5 did not permit holder's actions. (Blue Chip Stamps, supra, 421 U.S. at pp. 733, 749 [95 S.Ct. at pp. 1924, 1931-1932].) Its decision was based largely on two policy considerations: The danger of vexatious and meritless suits filed simply to extort a settlement (id. at pp. 739-740 [95 S.Ct. at pp. 1927-1928]) and the difficulties of proof that arise when the crucial issues may depend entirely on oral testimony from the stockholder (id. at pp. 743-747 [95 S.Ct. at pp. 1929-1931]).
But then the high court addressed the argument that complete nonrecognition of holder's actions would result in injustice by denying relief to victims of fraud. That injustice would not occur, the court observed, because its decision was limited to actions under Rule 10b-5; defrauded stockholders might still have a remedy in state court. The high court said: "A great majority of the many commentators on the issue before us have taken the view that the Birnbaum limitation on the plaintiff class in a Rule 10b-5 action for damages is an arbitrary restriction which unreasonably prevents some deserving plaintiffs from recovering damages which have in fact been caused by violations of Rule 10b-5. . . . We have no doubt that this is indeed a disadvantage of the Birnbaum rule, and if it had no countervailing advantages it would be undesirable as a matter of policy . . . ." (Blue Chip Stamps, supra, 421 U.S. at pp. 738-739 [95 S.Ct. at pp. 1926-1927], fn. omitted.) Then in a footnote, the court observed: "Obviously this disadvantage is attenuated to the extent that remedies are available to nonpurchasers and nonsellers under state law. [Citations.] Thus, for example, in Birnbaum itself, while the plaintiffs found themselves without federal remedies, the conduct alleged as the gravamen of the federal complaint later provided the basis for recovery in a cause of action based on state law. [Citation.] And in the immediate case, respondent has filed a state-court class action held in abeyance pending the outcome of this suit. [Citation.]" (Id. at p. 739, fn. 9 [95 S.Ct. at p. 1927].) In short, the high court's decision in Blue Chip Stamps, while recognizing policy considerations similar to those defendants advance here, did not view those considerations as justification for a total denial of relief to defrauded holders; it reasoned only that the federal courts could deny a forum to wronged stockholders who are not sellers or buyers without unjust consequences because these stockholders retained a remedy in state courts.
Defendants here also refer to later federal legislation. In 1995, Congress, over presidential veto, passed the Private Securities Litigation Reform Act of 1995 (hereafter sometimes referred to as PSLRA) (Pub.L. No. 104-67 (Dec. 22, 1995) 109 Stat. 737). The PSLRA arose from congressional concern that the "current system of private liability under the federal securities laws d[id] not adequately distinguish between meritorious and frivolous claims." (Sen. Com. on Banking, Housing, and Urban Affairs, Subcom. on Securities and Investment, Staff Rep. on Private Securities Litigation (May 17, 1994) p. 13, as cited in Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action (1998) 50 Stan. L.Rev. 273, 290.) "Congress enacted the PSLRA to deter opportunistic private plaintiffs from filing abusive securities fraud claims, in part, by raising the pleading standards for private securities fraud plaintiffs." (In re Silicon Graphics Inc. Securities Litigation (9th Cir. 1999) 183 F.3d 970, 973.) To this end, the PSLRA imposed a heightened pleading requirement, requiring plaintiffs in Rule 10b-5 cases to "state with particularity facts giving rise to a strong Inference that the defendants acted with the required state of mind." (15 U.S.C. § 78u-4(b)(2).) Later, concerned that plaintiffs were evading the PSLRA by filing in state court, Congress in 1998 passed the Uniform Standards Act, which preempts state court class actions based on untrue statements or omissions in connection with the purchase or sale of a security. (15 U.S.C. § 77p(b).) The recent Sarbanes Oxley Act of 2002, which imposes numerous restrictions on corporate accounting practices, does not restrict private causes of action, but instead extends the period for filing suit. (15 U.S.C. § 7201 et seq.)
The two statutes on which defendants rely, the PSLRA and the Uniform Standards Act, do not affect state court holder's actions; the PSLRA governs only actions in federal court, and the Uniform Standards Act by its terms applies only to suits involving the purchase or sale of stock. As defendants note, both acts demonstrate that Congress in 1995 and in 1998 viewed stockholder class actions with considerable suspicion. Yet Congress did not abolish stockholder class actions under Rule 10b-5: by requiring specific pleading, it attempted to bar abusive suits while permitting meritorious suits. The Sarbanes Oxley Act of 2002 shows Congress's recent concern to reduce procedural barriers to meritorious suits.
B. California Decisions
Neither the California Legislature nor the California electorate through its initiative power has enacted measures limiting stockholder actions. In 1996, two competing initiatives were defeated at the polls; one would have deterred stockholder suits, the other would have encouraged such suits. (Compare Ballot Pamp., Primary Elec. (Mar. 26, 1996) text of Prop. 201, pp. 68-70; with Ballot Pamp., Gen. Elec. (Nov. 5, 1996) text of Prop. 211, pp. 95-96.)
Defendants, however, rely on two decisions of this court that have cited policy concerns in limiting liability to stockholders: Bily, supra, 3 Cal.4th 370, and Mirlan, supra, 5 Cal.4th 1082.
In Bily, a majority of this court held that an accounting firm was not liable in negligence to persons who relied on its audit to purchase corporate stock. The decision weighed the advantages and disadvantages of recognizing such a cause of action (Bily, supra, 3 Cal.4th at pp. 396-407), and concluded that lenders and investors may not recover for negligence (id. at p. 407) but may recover for fraud (id. at p. 376) and negligent misrepresentation (id. at p. 413). The majority explained: "By allowing recovery for negligent misrepresentation (as opposed to mere negligence), we emphasize the indispensability of justifiable reliance on the statements contained in the report. . . . [A] general negligence charge directs attention to defendant's level of care and compliance with professional standards established by expert testimony, as opposed to plaintiffs reliance on a materially false statement made by defendant. . In contrast, an instruction based on the elements of negligent misrepresentation necessarily and properly focuses the jury's attention on the truth or falsity of the audit report's representations and plaintiffs actual and justifiable reliance on them. Because the audit report, not the audit itself, is the foundation of the third person's claim, negligent misrepresentation more precisely captures the gravamen of the cause . . . ." (Ibid., fn. omitted.) Bily thus supports our conclusion here that California recognizes a holder's action based on fraud or negligent misrepresentation.
Bily's holding denying a cause of action for negligence rested on the premise that auditors, because they contract only with the corporation, owe no duty of care to the stockholders. (Bily, supra, 3 Cal.4th at p. 376.) That reasoning cannot be applied in this case. A corporation has a statutory duty to furnish stockholders with an annual report (Corp. Code, § 1501, subd. (a)); furnishing a report that is false, misleading, or improperly prepared is a breach of duty. Officers and directors owe a fiduciary duty to stockholders. (Tenzer v. Superscope, Inc. (1985) 39 Cal.3d 18, 31 [216 Cal.Rptr. 130, 702 P.2d 212]; Jones v. H. F. Ahmanson & Co. (1969) 1 Cal.3d 93, 109-110 [81 Cal.Rptr. 592, 460 P.2d 464]; Fisher v. Pennsylvania Life Co. (1977) 69 Cal.App.3d 506, 513 [138 Cal.Rptr. 181].) A controlling stockholder, such as defendant Lynn Fritz here, also owes fiduciary duties to minority stockholders. (Jones v. H. F. Ahmanson & Co., supra, at pp. 109-110.) Thus the complaint alleges breach of duties that are already well established in California law.
In Mirkin, a majority of this court rejected the "fraud on the market" doctrine used in federal cases under Rule 10b-5. That doctrine makes it unnecessary for buyers or sellers of stock to prove they relied on a defendant's misrepresentations, on the theory that whether or not they relied the misrepresentation influenced the market price at which they later bought or sold. (See Basic Inc. v. Levinson, supra, 485 U.S. 224.) By rejecting the "fraud on the market" doctrine, Mirkin held that a plaintiff suing for fraud or negligent misrepresentation under California law must prove actual reliance. (Mirkin, supra, 5 Cal.4th at pp. 1090-1098.) The court carefully noted that its decision did not deprive the plaintiffs who did not actually rely on the misrepresentation of a remedy for fraud, for they retained remedies under both state and federal securities laws that presumed reliance on material misrepresentations. (Id. at p. 1090, citing federal Rule 10b-5, Corp. Code, § 25000, 25400, & Bowden v. Robinson (1977) 67 Cal.App.3d 705, 714 [136 Cal.Rptr. 871].)
Mirkin involved a suit by a seller of securities. But Mirkin impliedly recognized that holders also have a cause of action under California law when it noted that if it had adopted the fraud on the market doctrine, persons could sue on the ground that they missed a favorable opportunity to sell stock "because the market was affected by negligent misrepresentations that they never heard." (Mirkin, supra, 5 Cal.4th at p. 1108, italics added.) The italicized language implies that holders retain a cause of action if they can prove actual reliance on a misrepresentation instead of fraud on the market.
In contrast to Mirkin, supra, 5 Cal.4th 1082, the complaint before us asserts that plaintiff read the false financial statement and relied on it. And, unlike the buyers of securities who sued in Mirkin, persons who hold stock in reliance upon misrepresentations are totally dependent for redress upon state common law causes of action. They have no remedy under either federal Rule 10b-5 or Corporations Code sections 25000 and 25400, because all of these provisions are limited to suits by buyers or sellers of securities.
In sum, the federal and state decisions and actions we have examined recognize the danger that shareholders may bring abusive and nonmeritorious suits to force a settlement from the corporation and its officers, bút they do not view that danger as justifying outright denial of all shareholders' causes of action. To the contrary, when courts deny relief to the plaintiff before them, they affirm that the plaintiff could seek redress in another forum (Blue Chip Stamps, supra, 421 U.S. at p. 739, fn. 9 [95 S.Ct. at p. 1927] [plaintiff could sue in state court]; Mirkin, supra, 5 Cal.4th at p. 1090 [plaintiff could sue in federal court]; or that the plaintiff could prevail by bringing a cause of action for fraud or negligent misrepresentation instead of one for ordinary negligence (Bily, supra, 3 Cal.4th at pp. 376, 407).
C. Defendants ' Policy Arguments
Our examination of the specifics of defendants' policy contentions also yields the conclusion that they may justify limiting a holder's cause of action but do not justify total denial of the cause of action. Each of defendants' policy contentions shares the same defect. Defendants do not argue that a holder's suit for fraud is intrinsically unjust; instead, they claim that some of those suits will be nonmeritorious, or frivolous, or will be filed solely to coerce a settlement, or will raise problems of pleading or proof. And instead of offering a proposal to separate the wheat from the chaff, defendants contend that we should deny holders a cause of action entirely, thus rejecting the just and the unjust alike. Yet defendants' own authorities confirm the validity of state court holder's actions and suggest that any proposal to limit them should be more discriminating than outright denial of the cause of action.
With respect to defendants' first concern, that allowing a holder's action will lead to the filing of nonmeritorious "strike" suits, commentators distinguish between two opposite undesirable outcomes: (a) allowing a plaintiff to obtain a large settlement or judgment when no fraud occurred, and (b) denying redress when fraud actually occurred. (They refer to these outcomes as "type I error" and "type II error," respectively.) (See Painter, Responding to a False Alarm: Federal Preemption of State Securities Fraud Causes of Action (1998) 84 Cornell L.Rev. 1, 71; Stout, Type I Error, Type II Error, and the Private Securities Litigation Reform Act (1996) 38 Ariz. L.Rev. 711 (hereafter Stout).)
When Congress enacted the Private Securities Litigation Reform Act of 1995 and the Uniform Standards Act of 1998, it was almost entirely concerned with preventing nonmeritorious suits. (Stout, supra, 38 Ariz. L.Rev. 711.) But events since 1998 have changed the perspective. The last few years have seen repeated reports of false financial statements and accounting fraud, demonstrating that many charges of corporate fraud were neither speculative nor attempts to extort settlement money, but were based on actual misconduct. "To open the newspaper today is to receive a daily dose of scandal, from Adelphia to Enron and beyond. Sadly, each of us knows that these newly publicized instances of accounting-related securities fraud are no longer out of the ordinary, save perhaps in scale alone." (Schulman et al., The Sarbanes-Oxley Act: The Impact on Civil Litigation under the Federal Securities Laws from the Plaintiffs' Perspective (2002 ALI-ABA Cont. Legal Ed.) p. 1.) The victims of the reported frauds, moreover, are often persons who were induced to hold corporate stock by rosy but false financial reports, while others who knew the true state of affairs exercised stock options and sold at inflated prices. (See Purcell, The Enron Bankruptcy and Employer Stock in Retirement Plans, Congressional Research Service (Mar. 11, 2002).) Eliminating barriers that deny redress to actual victims of fraud now assumes an importance equal to that of deterring nonmeritorious suits.
Defendants argue that under plaintiff s theory an entire universe of potential investors could state a class action for fraud any time a stock price fluctuated. If stock prices went up, investors could allege that they had elected not to purchase shares based on a company's inadequately optimistic forecasts. If stock prices dropped, investors could allege that they decided not to sell (or not to buy "put options") based on unduly optimistic disclosures. This argument overstates the case, however. We are here concerned not with the universe of potential investors who might decide to buy Fritz's stock, but with the more limited group of owners of that stock who actually relied on false representations. Although any owner can file suit when the price of a stock drops, to survive a demurrer to the complaint the owner must allege fraud with specificity. (Lazar v. Superior Court, supra, 12 Cal.4th at p. 635.) A pleading that merely alleges a decline in the market price of stock obviously does not state a cause of action.
Defendants further argue that even if a plaintiff adequately pleads reliance, proof of reliance will often depend on oral testimony: The stockholder will testify that he read the financial statement but there may be no written record that he did so; he will testify that he decided not to sell the stock, and perhaps that he told his broker, or a friend, or a spouse, of his decision, but there may be no writing to evidence this fact. Thus, defendants are concerned that they will have no way to rebut false claims of reliance.
A corporation's financial report invites shareholders to read and rely on it. Some undoubtedly will do so. The possibility that a shareholder will commit perjury and falsely claim to have read and relied on the report does not differ in kind from the many other credibility issues routinely resolved by triers of fact in civil litigation. It cannot justify a blanket rule of nonliability.
There are, moreover, strong countervailing policy arguments in favor of allowing a holder's cause of action. "California . . . has a legitimate and compelling interest in preserving a business climate free of fraud and deceptive practices." (Diamond Multimedia Systems, Inc. v. Superior Court (1999) 19 Cal.4th 1036, 1064 [80 Cal.Rptr.2d 828, 968 P.2d 539].) When corporate financial statements are revealed to be false or misleading, the harm done may extend well beyond the particular investors who receive those statements. Financial institutions will hesitate to loan money to corporations if they cannot trust the corporate books, and the refusal of lenders to advance funds can doom a corporation, harming its stockholders, creditors, and employees. Potential investors, learning of one corporate fraud, will fear there may be others yet unrevealed, and may discount the price of that corporation (and possibly other corporations) below what the bare financial data would warrant. The resulting losses can have economy-wide consequences in terms of loss of employment and failure of investor confidence in the stock market. (See Stout, supra, 38 Ariz. L.Rev. at pp. 713-714; House Com. on Fin. Services, The Enron Collapse: Impact on Investors and Financial Markets, 107th Cong., 1st Sess. (Dec. 12, 2001).)
Civil Code section 3274 declares that in California money damages are not only the prescribed remedy "for the violation of private rights" but also "the means of securing their observance." Because of the limited resources available for enforcing the Security and Exchange Commission's mandatory disclosure system, "private litigation has been frequently recognized as performing a useful augmentative deterrent, as well as a compensatory role." (Seligman, The Merits Do Matter (1994) 108 Harv. L.Rev. 438, 456.) "The SEC repeatedly has noted that government regulation alone is not sufficient to keep markets honest. It has consistently stated that the private civil remedy is a key element in establishing a trusted market in which individuals and pension funds could safely invest." (Labaton, Consequences, Intended and Unintended, of Securities Law Reform (1999) 29 Stetson L.Rev. 395, 401.) Denying a cause of action to persons who hold stock in reliance upon corporate misrepresentations reduces substantially the number of persons who can enforce corporate honesty.
Finally, as this court said in Emery v. Emery (1955) 45 Cal.2d 421, 430 [289 P.2d 218], "[e]xceptions to the general principle of liability (Civ. Code, § 3523 ['For every wrong there is a remedy.']) . are not to be lightly created . . . ." We have recognized some exceptions, notably in cases where it would conflict with the need to protect the finality of adjudication (see Cedars-Sinai Medical Center v. Superior Court (1998) 18 Cal.4th 1, 10-11 [74 Cal.Rptr.2d 248, 954 P.2d 511]), or in which the defendant owed no duty to the person injured (e.g., Bily, supra, 3 Cal.4th 370). But the reasons for those exceptions do not apply here. Persons claiming that, for reasons of policy, they should be immune from liability for intentional fraud bear a very heavy burden of persuasion, one that defendants here have not sustained. We recognize, however, that the risk of encouraging nonmeritorious suits justifies using the requirement for specific pleading to place limits on the cause of action. (See Cedars-Sinai, supra, 18 Cal.4th at pp. 13-14.) We explain those limits in the next part.
III. Adequacy of Plaintiff's Pleading of Reliance
Defendants here attack plaintiffs pleading indirectly. Instead of arguing that plaintiffs complaint does not adequately plead reliance, defendants' brief argues that this court should reject a holder's cause of action because it raises troublesome questions of pleading and proving reliance. For the reasons stated in part II. of this opinion, defendants' arguments are insufficient to justify an absolute denial of a holder's cause of action. For the guidance of the parties and future litigants, however, we will discuss the adequacy of plaintiffs complaint.
Ideally, what is needed is some device to separate meritorious and non-meritorious cases, if possible in advance of trial. California's requirement for specific pleading in fraud cases serves that purpose (Committee on Children's Television, Inc. v. General Foods Corp., supra, 35 Cal.3d at pp. 216-217). "In California, fraud must be pled specifically; general and conclusory allegations do not suffice. [Citations.] 'Thus " 'the policy of liberal construction of the pleadings . . . will not ordinarily be invoked to sustain a pleading defective in any material respect.' " [Citation.] This particularity requirement necessitates pleading facts which "show how, when, where, to whom, and by what means the representations were tendered." ' " (Lazar v. Superior Court, supra, 12 Cal.4th at p. 645.)
California courts have never decided whether the tort of negligent misrepresentation, alleged in the complaint here, must also be pled with specificity. But such a requirement is implied in the reasoning of two decisions (Committee on Children's Television, Inc. v. General Foods Corp., supra, 35 Cal.3d at p. 216; B.L.M. v. Sabo & Deitsch (1997) 55 Cal.App.4th 823, 835-837 [64 Cal.Rptr.2d 335]) and was asserted expressly in Justice Moslc's dissenting opinion in Garcia v. Superior Court (1990) 50 Cal.3d 728, 748 [268 Cal.Rptr. 779, 789 P.2d 960]. Because of the potential for false claims, we hold that a complaint for negligent misrepresentation in a holder's action should be pled with the same specificity required in a holder's action for fraud. (We express no view on whether this pleading requirement would apply in other actions for negligent misrepresentation.)
In the trial court and the Court of Appeal, defendants claimed that plaintiffs assertion of having relied on defendants' misrepresentations was insufficient. We agree that in view of the danger of nonmeritorious suits, such conclusory language does not satisfy the specificity requirement. In a holder's action a plaintiff must allege specific reliance on the defendants' 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.
Plaintiffs who cannot plead with sufficient specificity to show a bona fide claim of actual reliance do not stand out from the mass of stockholders who rely on the market. Under Mirkin, supra, 5 Cal.4th 1082, such persons cannot bring individual or class actions for fraud or misrepresentation. They may, however, be able to bring a corporate derivative action against the corporate officers and directors for harm caused to the corporation. (Sutter v. General Petroleum Corp. (1946) 28 Cal.2d 525, 530 [170 P.2d 898, 167 A.L.R. 271].) Because a plaintiff in a derivative action is suing on behalf of the corporation, he or she need not show personal reliance.
Plaintiff here did not attempt to bring a derivative action, however. His complaint does not allege injury to the corporation or a wrong common to the entire body of stockholders, but only to those stockholders who actually relied on defendants' misrepresentations. Thus the complaint must stand or fall on the allegations of personal reliance.
We conclude that plaintiff did not adequately plead reliance in this case. But because the requirement we set forth here has not been stated in previous cases, plaintiff should be given leave to amend his complaint to make the necessary allegations.
The judgment of the Court of Appeal is reversed, and the cause is remanded for further proceedings consistent with this opinion.
George, C. J., Werdegar, J., and Moreno, J., concurred.
The trial court has the initial responsibility whether to certify this case as a class action. It has not yet ruled on the matter. Consequently, we do not discuss whether class certification is appropriate.
Unless otherwise indicated, Fritz refers to Fritz Companies, Inc., not to Lynn Fritz, its president and chairman of the board.
We express no view on whether the facts as alleged in the complaint imply a wrong to the corporation, or whether the corporation, by perpetrating a fraud on the market, wronged the entire body of stockholders.