If someone makes an investment decision based on your representations on what the future might hold, you may end up liable for the entirety of the investment if that future does not come true.
SMEs and start ups seeking investors, and investors considering investing in start ups would do well to heed the lessons laid out in Ebbsfleet v Semantic.1 The Court held that a failure by Semantic to deliver a promised tripling in the value of shares (issued to investors for $1.625M), breached Semantic’s warranty to its investors, and Semantic’s principal’s representation as to the tripling in value amounts to misleading and deceptive conduct.
The damages submissions are yet to be heard. However the Court has commented that the damages in relation to the breach of warranty are to be calculated to put the investors in the position they would have been had the promised tripling in value occurred (ie potentially $4.875M). The Court also noted that the loss suffered in relation to reliance on the representation would be the value of the investment – the $1.625M.
The investment opportunity and the promises made
Semantic’s principal, Mr Mark Bradley, sought funding through an Investor Pack described as a pre-IPO offering. The Investor Pack described the principal assets of Semantic as being two patents and one patent application in relation to software concerning ‘data integration’, held by a wholly owned subsidiary, and included statements that IBM were “studying Semantic for a ‘potential acquisition or partnership’” and that “we believe it is likely” that IBM (or another technology company) “will seek to purchase [Semantic] in 2012”.
After attending meetings with Mr Bradley and reading the Investor Pack, the Vinsons, through their companies Ebbsfleet Pty Ltd and McGee Pty Ltd (as trustees for their respective superannuation funds), subscribed for 6.5 million shares, for a total of $1.625 million dollars. The share issue agreements under which they did so included as warranties, representations that Mr Bradley made at their meeting (on his own behalf and on behalf of Semantic) that, amongst other things, the shares would triple in value within two years.
Two years later, Semantic was still in the process of developing its software, and had not secured any commitment from IBM (or any other technology company) in relation to an acquisition or partnership, and was operating at a serious loss in the millions of dollars each year. The Vinsons sued Semantic and Mr Bradley for breach of warranty, and misleading and deceptive conduct.
Breach of warranty - take care how you value your assets based on the future
To assess whether the warranty had been breached (and the representation as to share value was misleading and deceptive), each party engaged a forensic accountant to determine the value of the shares as at the end of the relevant two year period.
Semantic’s forensic accountant agreed that if the approach of valuing Semantic’s interest in the patents at no more than an amortised cost basis was correct, the shares in Semantic were of negligible value. The Vinsons’ forensic accountant attested that it would be unlikely that any other material value could be placed on the patents by an investor at the end of that two year period, given:
- The industry was still largely theoretical (as stated by [Semantic’s CTO]…)
- The Company did not appear to have a product that was available for commercialisation…
- The Company was not generating any operating revenues and there is no evidence in Mr Bradley’s Affidavit of any advanced discussions with any potential customers;
- Significant further costs will most likely need to be incurred in order to develop a product that can be commercialised.
- The Company will need to raise further capital to support the development of its products and the ongoing operations of the business. Such capital raisings will dilute the value of the shares held by any existing shareholders.”
The Court was persuaded by this, in particular noting that the evidence established:
- Semantic had earned no income from any of its patents
- Semantic had secured no contracts to commercialise any of the patents; and
- There was…no commitment from any large technology company, or at all, to acquire Semantic’s intellectual property or to invest in Semantic’s intellectual property.”
The Court accordingly found that Mr Bradley and Semantic were in breach of the warranty (and Mr Bradley’s representation was incorrect) that the shares would triple in value within two years.
The agreement included a time limitation on the warranties to 12 months, and a monetary limit equal to the purchase price plus 25%. However, the Court found that these limitations were inconsistent with the fundamental promise made by Mr Bradley and Semantic in the share issue agreement that the share value would triple in two years, as to apply either the time limitation or monetary limitation would remove any meaning from the warranty, and a reasonable business person would understand the specific warranty to override the general limitation.
Future representations – what do you need to know?
The Australian Consumer Law provides that if a person makes a representation as to the future and does not have reasonable grounds for doing so, the representation is misleading. In this case, Mr Bradley had led evidence that he had business connections with IBM, and had a number of times sought to engage IBM’s interest in the patents, with a view to seeking that IBM should licence the patents from, or buy the patents, or Semantic. However, the Court’s interpretation of IBMs statements, and the correspondence, was that IBM was politely declining the opportunity to engage with Semantic.
The Court accepted that it was Mr Bradley’s sincere belief that IBM (or another tech company) would in the next two years acquire Semantic, or its patents. However, the Court found that there were no reasonable prospects, based on the information at the time of the representations, that the belief would be fulfilled. Accordingly, the Court held that Mr Bradley (and Semantic) had engaged in misleading or deceptive conduct under the Australian Consumer Law by making the representation that the Semantic shares would triple in value within two years of the Vinsons’ investment.
The agreement contained an acknowledgement by the Vinsons that they had not been induced to invest by any representation or warranty other than as set out in the share issue agreement, and a disclaimer of liability in relation to the investment ‘advice’. However, the Court found that neither of these protected Mr Bradley, or Semantic, from any breach of the Australian Consumer Law in relation to the representation.
Investors: look for external evidence of value. If investment packs contain statements about value without itemising evidence of customer and supplier commitments, and you still want to go ahead, consider seeking warranties from the company (if the company has assets against which to claim) or its principals.
Start ups: hope isn’t enough. The Court’s view was that if you are seeking to demonstrate the value of your company, relying almost entirely on your intellectual property, value can be shown by earning an income, entering into commercialisation contracts, or having some form of commitment from any partner who you are using to demonstrate value. Sooner said than done, but the risk is that if you don’t, and you make representations or warranties as to the results that investment opportunities will deliver, you may be placed in a position where you have to pay it all back, or potentially return the investment value that should have been realised – and that this risk isn’t just one for your company, but you personally.
- Ebbsfleet Pty Ltd atf Ebbsfleet Superannuation Fund v Semantic Software Asia Pacific Ltd (no 3)  NSWSC 78.
The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020