6.4.3.2 Common law tort of negligent misrepresentation

In Derry v Peek,1 the House of Lords held that in the absence of a breach of a fiduciary duty or contractual duty, the defendant commits a tort only if he had made a statement which he knew to be untrue. The defendant commits a tort as well if the defendant had acted recklessly as to the truth of his statement, i.e. he had made the statement not caring if the statement was true or false.2 In Le Lievre v Gould,3 the court decided that the tort of negligence did not apply in principle to negligent misstatements causing pure economic loss.

As already mentioned in the introduction to this chapter, common law jurisdictions are very reluctant to award damages for negligent misstatements causing pure economic loss apart from any contractual or fiduciary relationship. A fiduciary relationship was originally developed for the relationship between the beneficiary and the trustee. However, certain categories of relationships of trust and confidence have been qualified in equity as a constructive trust such that the rules on fiduciary relationship apply to these relationships as well. Therefore, the trustee owes a similar duty of care towards the beneficiary.

I will now give a brief historical overview of the legislation passed by Parliament in order to redress the ruling in Le Lievre v Gould. Under the Directors Liability Act 1890,4 directors, promoters and persons authorising the issue of a prospectus (or notice) are liable to pay compensation to all persons who subscribe for securities on the faith of this prospectus for the loss those persons sustained by reason of any untrue statement in the prospectus. These persons are liable even if their belief in the truth of the statement was honestly held but that belief had been arrived at carelessly (negligently).5

The repealed Companies Act 1948 supplemented these previous statutory provisions in three relevant cases:

As already noted in the introduction of this subsection, common law for a long time did not recognise liability for negligent misstatements. In Hedley Byrne & Co Ltd v Heller & Partners Ltd,8the House of Lords ruled that in common law there was no longer, in principle, a rule against liability in negligence for pure economie loss apart from any contractual or fiduciary relationship. In order to obtain damages based on the tort of negligent misrepresentation, the claimant must establish that the defendant owed him a duty of care not to cause losses of the kind caused by the breach of that duty.9 The defendant will only be held liable if he failed to take reasonable care and skill, to be determined by reference to members of the particular profession.10 The defendant can defend himself by presenting evidence that he followed a detailed verification procedure with respect to the prospectus contents.

The law imposes a duty of care, if the claimant can prove the following elements:

In Hedley Byrne, the claimants, who were advertising agents, asked their bankers to inquire into the financial stability of a company with whom the advertising agents were planning to contract. The claimants' bankers made enquiries at the defendants who were the company's bankers. The defendants gave favourable references but stipulated that these were "without responsibility". In reliance on these references, the claimants contracted with the company which resulted in a loss. The claimants brought an action for damages in negligence against the company's bankers.

The House of Lords restricted the class of potential claimants to those shown to have relied upon the correctness of the statements13 made. The House of Lords dismissed the claim, because of the aforementioned express disclaimer of responsibility there could not be in any event a duty of care. It must be emphasised that the basis to establish liability in negligence is the assumption of responsibility by the defendant. The responsibility is not being imposed by law but undertaken voluntarily by the defendant.14 For these reasons, a disclaimer of liability in respect of a statement or service may be sufficient to preclude any finding of an assumption of responsibility and reasonable reliance.15

As a consequence, the lead manager and/or the other sponsoring banks may be able to prevent being held liable for an untrue or misleading prospectus, if they include a disclaimer in the prospectus that they cannot be held liable for any false or misleading statements in the prospectus. Such a disclaimer could fall onder section 2(2) of the Unfür Contract Terras Act 1977 and for that reason, it might be disregarded by the court if the exclusion or restriction of the lead manager's and/or other sponsoring bank's liability for negligence does not satisfy the requirement of reasonableness. However, Schedule 1 to the Unfür Contract Terras Act 1977 excludes its application to any contract so far as it relates to the creation or transfer of securities or of any right or interest in securities.16 Therefore, the lead manager's disclaimer will be effective against a consumer-investor bringing a claim against the lead manager for breach of a duty of care, i.e. negligent misrepresentation, owed to him, especially in case the lead manager was extensively involved in drawing up the prospectus.17 However, in cases of fraud, the courts will disregard such disclaimers.

The application of the Hedley Byrne test by the English courts in the 1960s, 1970s and 1980s led to a widening of the range of circumstances in which economie loss could be recovered. The House of Lords relied on the concept of reasonable foreseeability to determine the existence of a duty of care.18 If the defendant could reasonably foresee that his negligent behaviour would cause losses to the claimant, the defendant's duty of care is established. The lower English courts applied the test of reasonable foreseeability in claims against accountants and auditors based on alleged inaccuracies in accounts.19

In Caparo,20 the House of Lords sought to restrict the seemingly unlimited expansion of liability in negligence to existing categories of claims and forms of tort. It adopted a three-stage test that must be met in order to impose a duty of care on the defendant.

Furthermore, the House of Lords adopted an incremental approach with respect to the extension of duties of care; new categories of cases in which a duty of care may be held to exist should be developed by analogy with existing established categories.22

The requirement of sufficient proximity is of utmost importance to establish liability for negligent misstatements. Whether proximity exists depends on three crucial factors:

In the recent case Commissioners for Customs and Excise v Barclays Bank Plc,24 the Court of Appeal held that it is helpful to apply in turn all of the abovementioned tests, bearing in mind that the Courts have taken a more cautious approach to imposing a duty of care where pure economie loss is claimed without physical damage to property and taking consideration of the dominant legal policy in determining whether the law recognises a duty of care. Finally, the crucial question is whether it is für, just and reasonable to impose a duty of care; legal scholars suggest courts should look at applicable regulatory standards, as policy considerations, in determining the existence of a duty of care owed by professionals in the financial sector.25

In the Caparo case, the claimants relied on the annual accounts of a company when they acquired shares in that company. The third defendant was the auditor who performed an inquiry into the company's annual accounts. The House of Lords ruled that the auditor owes a duty of care towards shareholders of the company as a body26 and not towards any other investing member of the public because there was not sufficient proximity between the parties. The House of Lords made a distinction between reliance by a shareholder on the auditor's report which negligently undervalued the company's assets with the result that the shareholder lost part of the value of his existing holding of shares even before he decided to sell his shares at the lower market price and losses allegedly suffered from the purchase of overvalued shares. The House of Lords:

Thus, the House of Lords upheld that a sale of shares held by a shareholder in a company on the basis of an auditor's report falls within the auditor's duty of care whereas the acquisition of additional shares on the basis of the same report does not fall within the auditor's duty of care.28

Caparo test applied to negligent information in prospectus

On the basis of the aforementioned criteria, we can reasonably assume that the issuer as well as its directors can be held liable for tort of negligence with respect to misrepresentations in the prospectus. The duty of care follows from the special relationship between the issuer and its directors and the general investor community. Therefore, the issuer and its directors have, or should have, the reasonable general investor in mind when they draw up the prospectus. Furthermore, it can be argued that on the basis of the FSA Prospectus Rules, the issuer33 and its directors34 assumed responsibility for the information in the prospectus. However, the mere supply of information by directors is not sufficient to establish an assumption of responsibility onder the common law; some additional indications for this assumption have to be present.35 The difficulty for the claimant to obtain damages is to prove that he in fact relied on the information in the prospectus when he made his investment decision.

In Al-Nakib Investments v Longcrofi,36 the court strictly applied the Caparo test to determine the scope of the duty of care. In this case, a prospectus was issued by a public limited company to invite subscriptions for shares in its subsidiary company. Shortly afterwards, the directors of the parent company, in a letter accompanied by the prospectus, announced to its shareholders a rights issue entitling them to subscribe for one share in the subsidiary for every five held in the parent company, in association with an offer of shares in the parent on a similar basis.

The court held that in relation to a statement a duty of care giving rise to liability for economie loss would only arise if the maker of the statement was aware, or ought to have known, that the recipient would rely upon it for the specific purpose of entering into a particular transaction. Accordingly, the court held that since the prospectus had been issued specifically to enable shareholders to consider the rights offer, the duty of care owed to the claimants by the defendants for that purpose did not extend to a situation where reliance was placed on the prospectus for the purpose of buying shares in the open securities market.

The first claimant, which was a shareholder in the parent company, took up the rights offer and acquired further shares in the subsequent market transactions. Compensation for the losses incurred due to untrue or misleading statements in the prospectus in the latter transactions cannot be claimed from the defendants, because they owed no duty of care to the claimants. The prospectus was not directed to purchasers in the secondary market and therefore the defendant cannot be held liable on the tort of negligence for misrepresentations therein. After the publication of interim reports by the parent on behalf of the subsidiary, the first and second claimants acquired additional shares in the market. The defendants owed no duty of care towards the claimants for misleading statements in the interim reports, because the court held that also the interim reports had been addressed to the claimants with respect to the rights offer transaction.

By reference to the existing liability in tort for negligent misrepresentation as established in Hedley Byrne, Justice Lightman ruled in Possfund v Diamond37as follows:

Justice Lightman also ruled that it was arguable that persons responsible for the issue of a modern prospectus owed a duty of care to purchasers in the aftermarket. Furthermore, the court ruled that whether the defendant were to be taken to have assumed a duty of care towards any particular claimant or class of claimants is in all cases to be objectively established by the claimant proving either express communication to him of such intention or that he reasonably relied on the material representation and believed that the representor intended him to act upon it.

In this case the defendant, Diamond, was a director of a company that issued a prospectus in connection with the flotation of its shares on the Unlisted Securities Market. The first claimants, Possfund Custodian Trustee and Britel Fund Trustee Ltd, subscribed for the defendant's shares at the IPO and made further share purchases on the aftermarket. The second claimant, Irene Maud Parr, did only acquire shares in the aftermarket.

The claimants alleged that the prospectus materially misrepresented the company's financial position by substantially understating its liabilities, and that in fact the shares had no value. The claimants sought to recover damages for negligence against the directors, auditors and financial advisers of the company in respect of the alleged misrepresentations in the prospectus.

Furthermore, the claimants alleged that despite the Caparo-doctrine, the prospectus must be examined in the light of changed market practice and philosophy current at its date of preparation and circulation. Furthermore, they claim that there has been developed and generally recognised an additional purpose, an additional perceived intention on the part of the issuer and the other parties to a prospectus, namely to inform and encourage aftermarket purchasers, and that this is the basis for the pleaded purpose attributed by the claimants to the prospectus.

Justice Lightman accepted this argument and ruled that if the aforementioned can be established at full trial then it is at least arguable that a duty of care is assumed and owed to those investors, who, as intended, rely on the contents of the prospectus in making such purchases. As already noted, the time span between the publication of the prospectus and the transaction is a crucial factor in determining whether the claimant can prove that the false or misleading information in the prospectus was material and in fact influenced the investor's mind and upon which the investor reasonably relied when making his investment decision. Furthermore, it is doubtful whether it can be established that there is sufficient proximity between the issuer who published the prospectus and investors who acquired securities in the after-market. Even though these investors did rely on the information, the prospectus was not directed to them.38 Moreover, Lightman's ruling was not affirmed by any higher judicial authority.

The question is how to interpret the conflicting rulings in Al-Nakib and Possfund. Some English scholars, in my view, correctly argue that in the context of modern capital markets law, the persons responsible for the preparation of the prospectus owe a duty to protect the investment community at large, initial sub scribers and after-market purchasers alike, against losses incurred by investors due to false or misleading information.39

A listed issuer of securities owes a continuing duty to provide accurate, comprehensive and timely information so as to allow investors to make an informed assessment of their performance.40 If a listed issuer violates this duty, he should not be able to rely on the defence that the after-market purchaser cannot rely on the statements in the prospectus. In fact, the financial market participants were not provided with correct information and, therefore, they have necessarily to rely on the prospectus as their only source of (reliable) information.

Concluding, when representations are made to a specific person for specific purposes, it is sufficient to establish a duty of care on the part of the representator that he should have reasonably foreseen that the persons concerned would rely on his representation for the purposes in question. However, when the representations are made to the public at large or to special classes of the public, e.g. investors, it is necessary to establish proximity between the representator and the representee beyond the mere foreseeability of reliance by the representee to render it für, just and reasonable that such a duty of care can be imposed in respect of the representation. The latter requirement serves to protect the defendant against potentially far-reaching foreseen, but unintended, consequences.

On the basis of English case-law, the issuer and its directors can be held liable for misleading information in the prospectus. The lead manager, the other sponsoring banks, the accountants and auditors can also be held liable for their respective inquiries into the information provided in the prospectus. However, the claimants must prove gross negligence on the part of these persons when they made their inquiries. The latter requirement makes it difficult for investors to obtain damages from the enquirers.