Director liability for misleading statements

Shares are used to raise finance and in private companies based on valuations that can be creative. Directors will be understandably enthusiastic about the prospects of the business. But what happens if they cross the line and make statements about their company which are untrue?

Misleading Statements on business sale or when raising finance

In English Law misleading statements can give rise to both criminal and civil liabilities.

In terms of civil liabilities, investors may be able to bring a claim against the company or its directors if they can demonstrate they bought shares (or otherwise suffered a loss) because they relied upon a false or misleading statement made by the company or its directors.

In order to try to legally prevent claims or as a defence to a claim for misrepresentation or negligent misstatement, most investment agreements (indeed, most commercial contracts) will include an ‘entire agreement’ clause.

Entire Agreement Clause

An entire agreement clause seeks to prevent either party from relying upon anything which is not expressly set out in the contract signed by the parties.

In an investment or business sale context, such a clause would prevent investors from relying upon marketing information, statements made orally or in writing about the nature or value of the company or anything else which is not expressly set out by contract.  However, an entire agreement clause cannot protect the company or its directors from liability for fraudulent misstatements.

Fraudulent Misrepresentation

Fraudulent misrepresentation is usually a civil claim (although it can also be a criminal offence - see below) and the usual remedy sought will be money. An action for fraudulent misrepresentation requires 4 elements:

• The defendant makes a false representation to the claimant;
• The defendant knows that the representation is false or is reckless as to whether it is true or false.
• The defendant intends that the claimant should act in reliance on it.
• The claimant does act in reliance on the representation and, in consequence, suffers loss.

There is no fraudulent misrepresentation where the person making the statement honestly believes that what they are saying is true. Therefore, it can be difficult to prove that statements made are fraudulent. Even if it is difficult to prove fraudulent misrepresentation, if a director makes negligent misrepresentations, as opposed to fraudulent misrepresentations, a claim may still lie against the company and the company might in turn then seek to pursue the director for any losses it incurs.

Director personal liability for fraudulent misrepresentations

Where a director has made a fraudulent misrepresentation intending for another person to rely upon it, and that person does rely upon it and suffers a loss as a result, the director will be personally liable.

This is one of the advantages of bringing a claim for fraudulent misrepresentation, as it allows the claimant to elect whether to bring a claim against the company or its directors. In practice, it’s likely that the claim will be brought against whichever party has the most money.

Damages

The civil law remedies for misrepresentation are rescission (i.e. voiding) of the contract and/or damages. In the case of fraudulent misrepresentation the courts will attempt to put the claimant in the position they would have been had the fraud not taken place, even if the losses they experienced were not foreseeable at the time of the contract. This is a very powerful remedy.

Innocent or negligent misrepresentation may also give rise to damages and give the claimant the right to rescind the contract, provided such claims are not prevented by an entire agreement clause.

Criminal liability for directors mirespresentation or misleading statements

Criminal prosecutions by the police are relatively rare and often involve the most serious cases or where a significant number of investors have been misled. Proving criminal fraud by false representation under the Fraud Act 2006 is also difficult due to the fact dishonesty must be proven and the criminal standard of proof, beyond reasonable doubt, is more onerous. This is not to say that a private criminal prosecution can't be pursued and as a matter of tactics, the threat of possible criminal liability being explored can be useful as part of an overall strategy to pursue company directors for misrepresentation or misleading statements.

Shareholders action for misrepresentation 

Even if misrepresentation does not give an investor the right to rescind (cancel) the investment agreement,  the investor will be a shareholder and will still have the option to take legal action against directors who have misled them. For instance, by virtue of their position as shareholders they have various rights to ensure that they are not unfairly prejudiced by the directors of the company.

Breach of warranty claims against directors?

A warranty is a statement of fact (so in effect is a representation)  included either in a share purchase agreement or investor agreement. A misrepresentation is a pre-contract statement. Generally speaking, claims for breach of warranty would be made against the company in the case of an investor agreement and the selling shareholders in the case of a sale of the entire share capital of a company. Consequently, only where directors are also shareholders would they generally be at risk of personal liability for breach of warranty on a business sale.

Will Directors & Officers Insurance cover director misrepresentation?

Policy coverage and wording will vary between insurers but generally speaking most Director & Officer insurance poloicies will cover negligent misrepresentation but not fraudulent misrepresentation.

How we can help

If you are an investor or a business buyer and believe that you were misled by the sellers. either deliberately or through negligence, please get in contact. We are experienced in advising on the potential claims and tactics. We can also assist if you are a company director facing allegations of misrepresentation, misleading investors or director fraud.

Please do give us a call on 020 7438 1060.