Opinion ID: 895250
Heading Depth: 1
Heading Rank: 2

Heading: Bond purchases

Text: We turn first to the Funds' complaints that they would not have purchased Epic bonds had Grant Thornton disclosed the escrow irregularities.
One of the Funds, Cayman, bought bonds after Grant Thornton issued its 1999 audit report and before the Funds learned that Prudential would not renew Epic's credit facility. But Grant Thornton argues that Cayman, a potential investor, was not within its scope of liability when the audit report was published. To address this claim, we first examine the evolution of auditor liability law.

For over seventy years, state courts have debated the contours of liability when an auditor's negligent misrepresentation injures a third party. See generally, Jay M. Feinman, Liability of Accountants for Negligent Auditing: Doctrine, Policy, and Ideology, 31 FLA. ST. U.L.REV. 17 (2003); Jodi B. Scherl, Comment, Evolution of Auditor Liability to Noncontractual Third Parties: Balancing the Equities and Weighing the Consequences, 44 AM. U.L.REV. 255 (1994). For the first half of the twentieth century, the seminal case on auditor liability was Justice Cardozo's New York Court of Appeals opinion, Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931). In Ultramares, the court discussed what it termed the assault upon the citadel of privity. Ultramares, 174 N.E. at 445. The court refused to extend negligence's foreseeability principle to economic losses caused by an auditor's lapse, absent a bond so close as to approach that of privity. Id. at 446. The court coined a phrase that would echo through succeeding opinions nationwide: If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. Id. at 444. Over the ensuing decades, however, courts began to stray from Ultramares and expand auditors' scope of liability. These cases fall along a spectrum, with Ultramares on one end (requiring privity, or near-privity), and a handful of cases on the other (holding that mere foreseeability suffices to establish liability). The leading case in the latter camp is from New Jersey, H. Rosenblum, Inc. v. Adler, 93 N.J. 324, 461 A.2d 138 (1983). Likening a negligent audit to a defective product, the court held that the reasonably foreseeable consequences of the negligent act define the duty and should be actionable. Rosenblum, 461 A.2d at 145. Few states have adopted this approach, and Rosenblum itself was superseded by a 1994 statute replacing it with a near-privity standard, N.J. STAT. ANN. § 2A:53A-25. See, e.g., Touche Ross & Co. v. Commercial Union Ins. Co., 514 So.2d 315, 322 (Miss. 1987); Citizens State Bank v. Timm, Schmidt & Co., 113 Wis.2d 376, 335 N.W.2d 361, 366 (1983). New York and other states have drifted only cautiously from Ultramares's strict standard, adopting a near-privity predicate to auditor liability. The leading case behind this model is Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536, 493 N.Y.S.2d 435, 483 N.E.2d 110 (1985). Credit Alliance applied a three-part inquiry to determine whether an auditor and a third party have sufficient privity to implicate liability, namely: a particular purpose for the accountants' report, a known relying party, and some conduct on the part of the accountants linking them to that party. Id., 493 N.Y.S.2d 435, 483 N.E.2d at 119. In applying this test, the court held that even though the auditor was aware that the third party would receive the report, it was not liable because there was no allegation that [the auditor] had any direct dealings with plaintiffs, had specifically agreed ... to prepare the report for plaintiffs' use or according to plaintiffs' requirements, or had specifically agreed ... to provide plaintiffs with a copy or actually did so. Id. The high courts in Maryland, Montana, and Idaho have explicitly adopted Credit Alliance's reasoning. See Idaho Bank & Trust Co. v. First Bancorp of Idaho, 115 Idaho 1082, 772 P.2d 720, 722 (1989); Walpert, Smullian & Blumenthal, P.A. v. Katz, 361 Md. 645, 762 A.2d 582, 607 (2000); Thayer v. Hicks, 243 Mont. 138, 793 P.2d 784, 789 (1990). The American Law Institute's 1977 Restatement (Second) of Torts included a section on Information Negligently Supplied for the Guidance of Others. RESTATEMENT (SECOND) OF TORTS § 552. Section 552 offers a middle-ground approach to third-party auditor liability, providing that: [o]ne who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, 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. ... [T]he liability stated ... 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. Id. Of the various approaches taken by states, most have embraced the Restatement's formulation. See Feinman, 31 FLA. ST. U.L.REV. at 41 n. 165. Although the Restatement has been criticized, [10] it provides a window through which direct victims of auditor negligence can demand accountability without unleashing potentially unlimited auditor liability. The most thorough exponent of the Restatement's construct can be found in a 1992 case from the Supreme Court of California, Bily v. Arthur Young & Co., 3 Cal.4th 370, 11 Cal. Rptr.2d 51, 834 P.2d 745 (1992). After surveying the waterfront of auditor liability to third persons, the Bily court concluded that the Restatement approach: is most consistent with the elements and policy foundations of the tort of negligent misrepresentation. The rule expressed there attempts to define a narrow and circumscribed class of persons to whom or for whom representations are made. In this way, it recognizes commercial realities by avoiding both unlimited and uncertain liability for economic losses in cases of professional mistake and exoneration of the auditor in situations where it clearly intended to undertake the responsibility of influencing particular business transactions involving third persons. Id., 11 Cal.Rptr.2d 51, 834 P.2d at 769. For nearly two decades, we have similarly embraced the Restatement approach. See McCamish, Martin, Brown & Loeffler v. F.E. Appling Interests, 991 S.W.2d 787, 791 (Tex.1999); see also Fed. Land Bank Ass'n v. Sloane, 825 S.W.2d 439, 442 (Tex. 1991). In McCamish, we examined whether the absence of an attorney-client relationship precluded a third party from suing an attorney for negligent misrepresentation under Restatement section 552. McCamish, 991 S.W.2d at 788. We held that, under certain circumstances, section 552 causes of action can be brought by third parties against attorneys, just as they have been legitimately brought against auditors, accountants, and other professionals. Id. at 791. We explained that a section 552 cause of action is available only when information is transferred by an attorney to a known party for a known purpose. Id. at 794 (emphasis added). Under section 552, a known party is one who falls in a limited class of potential claimants, `for whose benefit and guidance [one] intends to supply the information or knows that the recipient intends to supply it.' Id. (quoting RESTATEMENT (SECOND) OF TORTS § 552(2)(a)). This formulation limits liability to situations in which the professional who provides the information is aware of the nonclient and intends that the nonclient rely on the information. Id. Unless a plaintiff falls within this scope of liability, a defendant cannot be found liable for negligent misrepresentation. McCamish has served as a guidepost for our courts of appeals in analyzing the tort of negligent misrepresentation, [11] in contrast to earlier decisions applying a broader standard. [12] We reaffirm today that McCamish represents Texas law under section 552 of the Restatement.
Cayman bought bonds in December 2000, allegedly in reliance on the 1999 audit report, issued in April 2000. Grant Thornton contends that Cayman, which had never before purchased Epic bonds, was indistinguishable from any other unknown potential investor, and thus outside Grant Thornton's scope of liability. Cayman counters that it falls within a limited class because few investors actually purchase high yield debt like the bonds at issue here. We find Cayman's argument unpersuasive. Epic's bonds were sold on the open market: that only certain investors bought them does not make those investors a limited group. As the United States Court of Appeals for the Fifth Circuit has explained, to interpret the `limited group' requirement as including all potential investors would render that requirement meaningless. Scottish Heritable Trust, PLC v. Peat Marwick Main & Co., 81 F.3d 606, 613 (5th Cir.1996) (applying Texas law). [13] Like the Fifth Circuit, we do not suggest that a potential purchaser can never be a member of a `limited group,' but the facts here do not support such a determination. See Scottish Heritable Trust, 81 F.3d at 614 (noting that potential investor with no previous connection to either the corporation or the accountant was not within such a group). Cayman had no prior connection to Epic or Grant Thornton, and predicating scope of liability on Grant Thornton's general knowledge that investors may purchase Epic bonds would eviscerate the Restatement rule in favor of a de facto foreseeability approachan approach [we] have refused to embrace. See id. The court of appeals in this case held that a fact issue precluded summary judgment on the limited class issue because appellants already owned Epic bonds and were not merely members of a large universe of potential investors. 203 S.W.3d at 615-16 (noting that authorities suggest that existing investors may fall within limited class). While this may have been true as to some of the Funds, it was not the case for Cayman, which did not buy bonds until December 2000. Because Cayman was not within a limited group when it bought bonds in December 2000, it was outside Grant Thornton's scope of liability. See McCamish, 991 S.W.2d at 794.
Although similar in their essential elements, fraud is more difficult to prove than negligent misrepresentation due to the added element of intent to deceive. Richter, S.A. v. Bank of America Nat'l Trust & Sav. Ass'n, 939 F.2d 1176, 1185 (5th Cir.1991) (applying Texas law); see also Perenco Nig. Ltd. v. Ashland Inc., 242 F.3d 299, 306 (5th Cir.2001) (applying Texas law). In Ernst & Young v. Pacific Mutual , we confirmed the intent standard for fraud under section 531 of the Restatement (Second) of Torts, [14] as a party's reason to expect that its representations will affect other parties' conduct. Ernst & Young, L.L.P. v. Pacific Mutual Life Ins. Co., 51 S.W.3d 573, 575 (Tex.2001). In that case, Pacific Mutual bought notes issued by InterFirst. Id. Pacific Mutual later sued Ernst & Young, an accounting firm, for releasing audit reports that allegedly misrepresented the financial strength of a company that merged with InterFirst. Id. Seeking to prove that Ernst & Young knew that third-party investors would rely on the audit reports, Pacific Mutual produced affidavits stating that it is a commonly known and accepted practice in the financial industry for investors ... to rely on representations like those made by Ernst & Young. Id. at 576. The court of appeals held that these affidavits alone presented a fact issue as to whether the auditor had reason to expect that institutional investors would rely on its representations. Id. at 577. We rejected that view, holding that the reason-to-expect standard requires more than mere foreseeability; the claimant's reliance must be `especially likely' and justifiable, and the transaction sued upon must be the type the defendant contemplated. Id. at 580. We observed that the evidence referred to what is commonly `known' or `expected' in the investment community, but we noted that even an obvious risk that a third person will rely on a representation is not enough to impose liability. General industry practice or knowledge may establish a basis for foreseeability to show negligence, but it is not probative of fraudulent intent. Id. at 581 (citation omitted). We held that the trial court properly granted summary judgment to the accounting firm, which had no relationship with the investors and no special reason to expect the investors' reliance on the audit report. Id. at 583. In this case, the court of appeals held that there was a fact issue regarding whether Grant Thornton had reason to expect that it was especially likely that [the Funds] would receive and rely upon Epic's audited financial statements. 203 S.W.3d at 612. The court based its determination on the Indenture's reference to Epic securityholders. Id. (noting that the Indenture provides Epic `shall file with the Commission and shall furnish to the Trustee and each Securityholder ... copies of the quarterly and annual reports and of the information, documents, and other reports...'). Even if this provision suggested that Grant Thornton may have been aware of existing bondholders as a limited class, a question we need not reach, it does not meet the requisite standard as to prospective purchasers, like Cayman, who claim to have relied on the 1999 audit report. Cayman's claim is like the one we rejected in Pacific Mutual, and it fails for the same reasons.
In 2001, several of the Fundsboth existing and prospective bondholders bought Epic bonds. The parties hotly dispute whether existing bondholders are within Grant Thornton's scope of liability. We need not resolve that disagreement, however, as we conclude that there was no evidence that those Funds justifiably relied on the audit reports or the negative assurance statement.
Both fraud and negligent misrepresentation require that the plaintiff show actual and justifiable reliance. Pacific Mutual, 51 S.W.3d at 577; Fed. Land Bank Ass'n v. Sloane, 825 S.W.2d 439, 442 (Tex.1991). In measuring justifiability, we must inquire whether, given a fraud plaintiff's individual characteristics, abilities, and appreciation of facts and circumstances at or before the time of the alleged fraud[,] it is extremely unlikely that there is actual reliance on the plaintiff's part. [15] Haralson v. E.F. Hutton Group, Inc., 919 F.2d 1014, 1026 (5th Cir.1990) (applying Texas law). Moreover, a person may not justifiably rely on a representation if `there are red flags indicating such reliance is unwarranted.' Lewis v. Bank of Am. NA, 343 F.3d 540, 546 (5th Cir.2003) (holding that plaintiff's decision to enter into transaction without undertaking additional investigation into tax consequences was not justifiable, given his access to professional accountants, the amount of money involved, and the ambiguous nature of the pertinent representation) (quoting In re Mercer, 246 F.3d 391, 418 (5th Cir.2001)). Accordingly, we must examine the timing of the relevant purchases. Obviously, bonds purchased before Epic hired Grant Thornton in March 2000 could not have been bought in reliance on the audit reports. [16] With respect to bonds purchased (by Pam Capital, Pamco, Prospect, and Cayman) after Deadman learned that Prudential would not renew Epic's credit arrangement, however, we agree with Grant Thornton that such reliance was unjustifiable. Deadman, an experienced bond investor with a bachelor's degree in finance and a masters in business administration, testified that Prudential's $2 million-per-week credit facility really was the lifeblood of the company. Without it, the company would have to shut down or replace it. Nonetheless, knowing that Epic had lost its primary source of funding, the Funds continued to buy bonds in April, May, and Juneeven after Epic failed to make its scheduled June 15 interest payment. [17] Deadman purchased these bonds at prices ranging from 23.5% to 30.25% of par valueprices that, Deadman admitted, reflected a substantial risk that the bonds would not be redeemed for face value. If these Funds relied on the 1999 or 2000 audit reports in making the 2001 purchases, that reliance would not have been justifiable in light of the Funds' knowledge that Prudential had cut off Epic's lifeblood.
Nor is there evidence that the Funds relied on the 1999 negative assurance statement. The statement verified that in making the examination necessary for certification of such financial statements nothing has come to [Grant Thornton's] attention which would lead [it] to believe that the Issuers have violated any provisions of Article 4, 5 or 6 of this Indenture insofar as they relate to accounting matters or, if any such violation has occurred, specifying the nature and period of existence thereof, it being understood that such accountants shall not be liable to any Person for any failure to obtain knowledge of any such violation.... Grant Thornton provided the statement to Epic in April 2000, but the statement was not part of Epic's public filing. It is undisputed that the Funds never received or reviewed the statement. Nevertheless, the Funds contend that because U.S. Trust, their escrow agent and trustee, received and relied upon that statement, then the Funds, in effect, relied on the statement by proxy. Grant Thornton contends that, until the court of appeals' decision in this case, Texas courts have never recognized such a vicarious reliance theory. Regardless, Grant Thornton argues, if U.S. Trust's reliance is to be imputed to the Funds, so too should U.S. Trust's knowledge of the escrow account irregularities. We agree with Grant Thornton. Although an agent's knowledge is generally imputed to its principal, the court of appeals declined to do so because U.S. Trust was an escrow agent and owed fiduciary duties to both the Funds and to Epic. Accordingly, the court held that Grant Thornton had not proved as a matter of law that imputation of U.S. Trust's knowledge was appropriate. 203 S.W.3d at 617 (noting that Grant Thornton's authorities all involve agents operating for a single principal). But when, as here, there is a dual agent, operating with the consent and knowledge of both principals, the agent's knowledge is imputed to its principals. [18] Sirojni Dindial, U.S. Trust's officer in charge of the Epic account, testified that she was unaware of the escrow agreement and did not know that it appointed U.S. Trust as the escrow agent. The court of appeals held that this created a fact issue regarding U.S. Trust's knowledge of its role as escrow agent. Id. at 618. We disagree. U.S. Trust was a party to the escrow agreement: that a U.S. Trust employee was unaware of its existence does not create a fact issue as to the company's knowledge of its contract. Duncan v. Robertson, 129 Tex. 637, 105 S.W.2d 214, 216 (1937) (holding that `in the absence of fraud or imposition, a party to a contract, which has been voluntarily signed and executed by him, with full opportunity for information as to its contents, cannot avoid it on the ground of his own negligence or omission to read it' (quoting Indem. Ins. Co. v. Macatee & Sons, 129 Tex. 166, 101 S.W.2d 553, 557 (1937))). Finally, the court of appeals held that there was a fact issue regarding whether U.S. Trust was acting adversely to the Funds, precluding imputation of its knowledge to the Funds. 203 S.W.3d at 618 (noting that an agent's knowledge is not imputed to its principal if the agent has an adverse interest in not revealing it). Grant Thornton argues that there is no evidence that U.S. Trust's interests were adverse to the Funds' interests at all, much less that U.S. Trust was concerned only for itself. See Goldstein v. Union Nat'l Bank, 109 Tex. 555, 213 S.W. 584, 590-91 (1919) (holding that rule of imputation applies unless the agent's interests are so incompatible with the interests of his principal as practically to destroy the agency or to render it reasonably probable that agent will not act on his acquired knowledge nor disclose it to his principal). But even assuming the adverse interest exception applied, the Funds would not be able to claim U.S. Trust's reliance as their own while simultaneously asserting that its knowledge should not bind them. See id. at 591 (noting that `when a principal has consummated a transaction in whole or in part through an agent, it is contrary to equity and good conscience that he should be permitted to avail himself of the benefits of his agent's participation without becoming responsible as well for his agent's knowledge as for his agent's act') (quoting Irvine v. Grady, 85 Tex. 120, 19 S.W. 1028, 1029 (1892)). As one court has observed, in such situations: [T]he principal is impaled on the horns of a dilemma. If he disclaims the agent's act as unauthorized, he has no grounds to retain the fruits thereof; on the other hand, if he retains the fruits of the agent's act, after knowledge of the facts, he must in fairness be charged with the agent's knowledge. Great American Indemnity Co. v. First Nat. Bank of Holdenville, 100 F.2d 763, 765 (10th Cir.1938); see also 2 FLOYD R. MECHEM, A TREATISE ON THE LAW OF AGENCY § 1826, at 1412 (2d ed. 1914) ([W]here the agent is the sole representative of the corporation, the corporation can not [sic] claim anything except through him and that therefore if it claims through him, after notice of the facts, it must accept his agency with its attendant notice.). The Funds do not allegenor is there any evidencethat Grant Thornton colluded with U.S. Trust to defraud the Funds, such that the general rule of imputation would not apply. See Ft. Worth v. Pippen, 439 S.W.2d 660, 665 (Tex.1969); see also FDIC v. Shrader & York, 991 F.2d 216, 225 (5th Cir.1993). In fact, they argue quite the opposite: they repeatedly refer to U.S. Trust as a representative of the Funds, and they assert that U.S. Trust was relying on Grant Thornton to determine whether ... the Indenture had been violated. The Funds submitted testimony from U.S. Trust representatives, who stated that [U.S. Trust] relied on Epic's independent public accountants for this certification.... Had these accountants indicated that something had `come to their attention which would lead them to believe that the issuers have violated any provisions of Articles 4, 5, or 6 of the Indenture,' [U.S. Trust] would have taken whatever steps may have been required under the Indenture. Because the Funds may not substitute U.S. Trust's reliance for their own without also inheriting its knowledge, its claims based on the 1999 negative assurance statement fail. See Irvine, 19 S.W. at 1030 (observing that it is inequitable for the principal to avail himself of the agent's acts without being held to know what the agent knows).