Director liability for misleading statements

Shares are often used to raise finance for private companies, where valuations can be subjective and ambitious projections may influence investment decisions. Directors are naturally enthusiastic about their company’s prospects, but what happens when they go too far and make false or misleading statements about the business?

Misleading Statements on business sale or when raising finance

In English law, misleading statements can give rise to both criminal and civil liability.

In terms of civil liability, investors may be able to bring a claim against a company or its directors if they can demonstrate that they acquired shares or otherwise suffered a loss as a result of relying on a false or misleading statement made by the company or its directors.

To manage the risk of claims for misrepresentation or negligent misstatement, many investment agreements and other commercial contracts include an ‘entire agreement’ clause.

Entire Agreement Clause

An entire agreement clause seeks to establish that the written contract contains the parties’ entire agreement, and may restrict their ability to rely on statements or arrangements made before the contract was signed.

In an investment or business sale context, such a clause may limit reliance on marketing materials, oral statements or written statements about the nature or value of the company, where these are not reflected in the contractual documents. However, an entire agreement clause does not automatically exclude liability for every pre-contract statement and cannot generally be relied upon to exclude liability for fraud. The effect of the clause will depend on its wording and the circumstances.

Fraudulent Misrepresentation

Fraudulent misrepresentation is a civil claim, although the same conduct may also amount to a criminal offence. The usual remedy sought in a civil claim is damages. A claim for fraudulent misrepresentation requires four 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 the representation.
• The claimant does rely on the representation and, as a consequence, suffers loss.

Fraudulent misrepresentation requires knowledge of falsity or recklessness; an honestly held belief that a statement is true will generally prevent a finding of fraud. Proving fraudulent misrepresentation can therefore be difficult. However, even where fraud cannot be established, a claim may still be available for negligent or other actionable misrepresentation, depending on the circumstances. A company may also seek to recover losses from a director where there is a separate legal basis for doing so.

Director personal liability for fraudulent misrepresentations

Where a director personally makes a fraudulent misrepresentation intending that another person should rely on it, and that person does so and suffers loss as a result, the director may be personally liable.

This can be significant for an investor because it may allow a claim to be brought against the director personally, rather than solely against the company. The appropriate defendant will depend on the facts, the legal basis of the claim and the available evidence, as well as the parties’ ability to meet any judgment.

Damages

The civil remedies for misrepresentation may include rescission (setting aside the contract) and/or damages, depending on the type of misrepresentation and the circumstances.

In cases of fraudulent misrepresentation, damages aim to compensate the claimant for the loss caused by the fraud. The assessment can include losses that would not necessarily have been recoverable under the more restrictive rules governing contractual damages. This can make a successful claim for fraudulent misrepresentation a powerful remedy.

Negligent or innocent misrepresentation may also give rise to remedies. Under the Misrepresentation Act 1967, damages may be available for certain non-fraudulent misrepresentations, and a claimant may be entitled to rescind the contract. In appropriate cases, a court may award damages instead of rescission. The availability of these remedies will depend on the facts and any applicable contractual restrictions.

Criminal Liability for Directors’ Misrepresentations or Misleading Statements

Criminal prosecutions are less common than civil claims and may arise in particularly serious cases, including where numerous investors have been misled. Under section 2 of the Fraud Act 2006, fraud by false representation requires a dishonest false representation, knowledge that it is or might be untrue or misleading, and an intention to make a gain or cause loss, or expose another to a risk of loss. The prosecution must prove the offence beyond reasonable doubt.

A private prosecution may be possible in appropriate circumstances, although the decision to pursue one requires careful consideration of the evidence, costs, procedural requirements and prospects of success. The possibility of criminal liability may form part of the wider strategic assessment of a dispute, but it should not be used as an unsupported threat or as a substitute for assessing the available civil remedies.

Shareholders action for misrepresentation 

Even where an investor cannot rescind (cancel) the investment agreement, they may remain a shareholder and have other potential routes to challenge the conduct of the company’s directors.

For example, a shareholder may be able to bring an unfair prejudice claim if the conduct of the company’s affairs has unfairly prejudiced their interests as a shareholder. Whether such a claim is available will depend on the conduct in question and its effect on the shareholder’s interests; misleading statements do not automatically establish unfair prejudice.

Breach of warranty claims against directors?

A warranty is a contractual statement of fact included in documents such as a share purchase agreement or an investment agreement. A warranty differs from a pre-contract representation, although the same statement may potentially give rise to both a warranty claim and a misrepresentation claim.

Directors will not ordinarily be personally liable for breach of warranty merely because they are directors. Their liability will depend on whether they gave the relevant warranty or whether another legal basis for personal liability exists.

Will Directors & Officers Insurance cover director misrepresentation?

Policy wording and coverage vary between insurers. Directors’ and officers’ (D&O) insurance may cover certain claims involving negligent misrepresentation, subject to the policy’s terms, exclusions and conditions. Fraudulent or dishonest conduct is commonly excluded, and cover may be affected by the nature of the allegations and any final findings. The relevant policy should therefore be reviewed before assuming that a claim will be covered.

How we can help

If you are an investor or business buyer who believes you were misled by a seller, whether deliberately or negligently, we can advise on potential claims, available remedies and the strategic options for resolving the dispute.

Please call us on 020 7438 1060.