Directors’ 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?
Who can private companies market shares to?
A private limited company is prohibited from offering its shares to the public. If you are receiving information relating to a potential investment opportunity in a private limited company the directors should either know you personally or have otherwise identified you as a sophisticated investor.
If you chose to buy shares in a private limited company, it’s very likely the subscription agreement will include a clause asking you to confirm that you are an experienced investor. This ensures the company won’t fall foul of rules against marketing investments to the public. Depending on the circumstances, it may still be open to you to bring a claim against either the company or its directors if you purchased shares in reliance of some false information.
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 prevent claims for misrepresentation or negligent misstatement, most subscription 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 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 in the subscription agreement.
Entire agreement clauses can significantly limit an investor’s ability to bring a claim against a company for an innocent misrepresentation or negligent misstatement. So, for example, if a business opportunity highlighted in promotional material fails to materialise through no fault of the company, an investor may be prevented from bringing a claim against the company for breach of contract.
Why use an entire agreement clause
A properly drafted entire agreement clause will protect directors and companies from innocent and negligent misstatements. However, they cannot protect the company or its directors from liability for fraudulent misstatements.
As a matter of law, an entire agreement clause cannot protect the company or its directors against liability for fraud. 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 in an investment context are indeed fraudulent.
However, the presence of an entire agreement clause in a share subscription agreement may mean that such an action is still the best option open to investors aggrieved about misrepresentations which predate their contractual relationship with the company.
Directors are personally liable for their 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.
The remedies for misrepresentation are rescission (i.e. voiding) of the contract and 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.
Other options – shareholders rights
Even if misrepresentation does not give an investor the right to rescind a subscription agreement, shareholders are still in a strong position to take 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.