A Study on the Legal Implications for Misstatements in the Prospectusin India Essay Example

penalties, both civil and criminal, for misstatements in a prospectus. These provisions also apply to brochures, pamphlets and other publicity material advertising the issue of securities. Basically, this essay researches the area of misstatements of prospectus and the remedies thereof, as provided for in the Companies Act.Specific cases may be inserted to clarify concepts. In addition, we will also consider the 2005 litigation of Danier Leather to capture the curious nuances of this area, though the case ended with a twist and a change in judgement.

Misstatemnets In Prospectus And Their Consequences

Our guiding principle when defining misstatements in the prospectus is provided by the ‘Golden Rule’ as to framing of prospectuses, laid down by V. C. Kindersley in New Brunswick & Canada Rly & Land Co. (V Muggeridge, (1860) I Dr. and Sm. 363) in the following words, Those who issue prospectus holding out to the public the great advantages which will accrue to persons who will take shares in a proposed undertaking, and inviting them to take shares on the faith of the representations therein contained, are bound to state everything with strict and scrupulous accuracy and not only to abstain from stating as fact that which is not so, but to omit no one fact within their knowledge, the existence of which might in any degree affect the nature of extent and quality of the privileges and advantages which the prospectus holds as inducement to take shares. If there is any misstatement of a material fact in a prospectus, or if the prospectus is wanting in any material fact, there may arise:

• Civil Liability
• Criminal liability.

Remedies against the Company

If there is a misstatement or

withholding of material information in a prospectus, and if it has induced any shareholder to purchase shares, he can:

• Rescind the contract;

Claim damages from the company, whether the statement is fraudulent or an innocent one. Rescission of the ContractAny person, who takes shares on the faith of statement of fact contained in a prospectus, can apply to the court for the rescission of the contract, if those statements are false or fraudulent or if some material information has been withheld. Application for the rescission must be sent within a reasonable time and before the company goes into liquidation. At the same time, the shareholder will have to surrender to the company the shares allotted to him. Consequently, his name is removed from the Register of members. The money invested is claimed back from the company along with interest.

The contract can be rescinded if the following conditions are satisfied:- The statement must be a material misrepresentation of fact. The misrepresentation is material when it is likely to influence a reasonable man in his judgment whether or not to apply of the shares. A ‘statement of fact' must be distinguished from a statement of opinion or expectation. For example, statements that affirm that the property of a company is worth a certain sum of money, or that due to the hard work and efficiency of directors the profits are expected to reach a certain figure, are simply opinions.

They cannot become ground for an action for rescission. But claims like, “the surplus assets, as appeared on the last balance sheet are more than Rs. 1 crore”, or allegations that certain persons have agreed to become directors’ of the

company, can be construed as material statements of fact. If such statements are proved to be false, a right of rescission arises. The statement must have induced the shareholder to take the shares.

Whether or not an applicant has been induced to take the shares by reason of the misrepresentation is a circumstantial question of fact.If the statement would influence a reasonable man, the court will readily infer that it influenced the applicant. If the applicant’s acts show that he did not rely on the statement, he is not entitled to rescind. The statement must be untrue. A statement included in a prospectus is deemed to be untrue if it is misleading in the form and context in which it is included.

Again, as per Sec 65, where the omission from a prospectus of any matter is calculated to mislead, the prospectus is deemed, in respect of such omission, to be a prospectus in which an untrue statement is included.Take the case of Rex V Lord Kylsant (1932). A prospectus was issued by a company stating that the company had paid a dividend every year between 1921 and 1927 (years of depression) thus giving the impression of a financially stable company. However, the company had in each of those years incurred considerable trading losses and was able to pay dividends only out of realized capital profits. This fact was suppressed.

Thus, the prospectus was ‘false in a material particular’ in that it conveyed a false impression. The deceived shareholder is an allottee. To this end, the shareholder must have relied on the statement in the prospectus. If a person purchases shares in the open market, he has no

rights against the company. In the case of Peek vs. Gurney (1873), a company had issued a prospectus containing false statements. ‘A’, relying on the prospectus, applied for and was allotted shares. Later, he sold these shares to Peek. The company was wound up and Peek had to pay nearly $100,000 as contributory. As such, Peek sought an indemnity for his loss from the directors at the time of the issue of the prospectus.

However, in this particular context, the company could not be held liable to Peek. ?The omission of material fact must be misleading before rescission is granted. If a person protests the omission of a statement as the base for rescission, he must prove that such an omission projects what is stated as misleading. Consider the case of Coles vs. White City Greyhound Assn. Ltd. (1929) As the case goes, the prospectus in question described land as ‘eminently suitable’ for greyhound racing.However, before any related structures such as kennels or stands for the public could be erected, the local authority’s approval had to be obtained. As such, the local authority had denied approval.

Held in this light, the description of land was misleading and rescission was granted. The proceedings for rescission must be initiated immediately. As soon as the allottee discovers a misleading statement in the prospectus, due to which he had subscribed for shares, the allottee must sue the company instantaneously. This must be affected before the company goes into liquidation. Delay on this account may defeat this right of the allottee Damages for Deceit Any person induced by a fraudulent statement in a prospectus to invest in shares is entitled to sue

the company for damages. However, as with claiming rescission of the contract, he must attest the foundation in claiming damages for deceit.

Consequently, the plaintiff cannot both retain the shares and get damages against the company. He must show that he had repudiated the shares and has not acted as a shareholder after discovering the fraud or misrepresentation. Remedies against Directors, Promoters & ExpertsAs previously stated, the plaintiff can prosecute the company for civil liability or criminal liability or both. There are also other avenues that the appellant can resort to as we will examine, namely by virtue of Section 56 of the Companies Act and the General Law.

Civil Liability (Section 62)

Subject to the provisions of this section, any person who has been induced to subscribe for shares (or debentures) on the faith of a misleading prospectus has remedies against the company, and the directors, promoters and experts related to the issue. By law, the following persons are liable to pay compensation for any loss or damage sustained by the subscribers on the faith of a prospectus containing untrue statements:-

• Directors at the time of the issue of the prospectus;
• Persons who have authorized themselves to be named and are named in the prospectus either as director(s), or as having agreed to become a director(s), either immediately or after an interval of time;
• Persons who have authorized themselves to be named; Promoters of the company; and
• Persons who have authorized the issue of the prospectus.

Liability for damages for Misstatements in Prospectus (Section 62)

Every director, promoter and every person who authorizes the issue of the prospectus (no matter whether he had seen it or not) is liable

to pay compensation to the aggrieved party (who subscribes for any shares or debentures on the faith of the prospectus) for loss or damage he may have incurred by reason of any untrue statement in the prospectus.A person shall not be held liable if he puts up the following defenses:-

Withdrawal of Consent. A director is not liable if he withdrew his consent before the issue of the prospectus and it was still issued without his authority or consent;

Absence of Consent.

• Where a prospectus was issued without his knowledge or consent, and on becoming aware of its issue, he forthwith gave reasonable public notice of the fact, that he is not liable;
• Ignorant of Untrue statement.A director, etc. , may sometimes be ignorant of the untrue statement contained in the prospectus. If after the issue of the prospectus, and before allotment thence, he on becoming aware of any untrue statement withdrew his consent to the prospectus and gave reasonable public notice of the withdrawal and of the reasons therefor, he is not liable.
• In addition, other situations that can arise as regarding untrue statements:- a. Reasonable ground for belief.This holds where the statement is not made on the basis of authority of an expert or of a public official document or statement. If a director, has reasonable ground to believe that the statement was true and he, in fact, believed it to be true up to the time of allotment, he is not liable.

Nevertheless, it is not enough for a director to say that he was honest; he has to show that his honest belief was based on reasonable grounds. b. Statement of Expert.If the statement

is a correct and fair representation or extract or copy of the statement made by an expert who is competent to make it and had given his consent required by section 58 to the issue of the prospectus and had not withdrawn that consent before delivery of a copy of the prospectus for registration or, to the defendant's knowledge, before allotment; the director, etc. , will not be held liable.

Statement made by an official person or documentLikewise, if the statement is a correct and fair representation or extract or copy of an official document or is based on the authority of an official person, no liability accrues to persons associated with the prospectus issue. As such, in order to prove his innocence in the matter, and be absolved of any liability, the accused must provide evidence that he was not party to the issue of a misleading prospectus or that he must have attempted to withdraw his approval after discovery of such a divergence. Thus, having given his consent under section 58 to the issue of the prospectus, he must have:- 1.Subsequently withdrew his consent in writing before delivery of a copy of the prospectus for registration;

After delivery of a copy of the prospectus for registration and before allotment thereunder, he, on becoming aware of the untrue statement, withdrew his consent in writing and gave reasonable public notice of the withdrawal and of the reason therefor; 3. Proof that he was competent to make the statement and that he has reasonable ground to believe, and did up to the time of the allotment of the shares or debentures, believe, that the statement was true.Right to

recovery of Contribution. Every person who becomes liable to make any payment under Sec 62 may recover contribution, as in cases of contract, from other guilty persons who are liable for fraudulent misrepresentation in the prospectus.

Criminal Liability (Section 63)

Where a prospectus contains any untrue statement, every person who authorized the issue of the prospectus is punishable with imprisonment which may extend to 2 years, or with fine which may extend to Rs 50,000/- (By Act 53 of 2000, sec.23, for Rs 5000/-) or with both.The defendant will not be liable if he proves either:

• that the statement was immaterial, or
• that he had reasonable ground to believe that the statement was true.
• The punishment for issuing an application for shares or debentures that is not accompanied with a Memorandum containing salient features of a prospectus, is a fine which may extend to Rs 50,000 (sec 63(1)) Under Section 68, a person shall not:
• either knowingly or recklessly by making any statement, promise or forecast which is false, deceptive or misleading, or;
• y any dishonest concealment of material facts, induce or attempt to induce another person to enter into or to offer to enter into any of the following agreements, namely:

An agreement for acquiring, disposing of, subscribing for, or underwriting shares or debentures:

An agreement to secure a profit to any of the parties from the yield of shares or debentures, or by reference to fluctuations in the value of shares or debentures. If he does any of the above things, he shall be punishable with imprisonment for a term which may extend to 5 years, or with fine which may extend to Rs 1, 00,000, or

with both.Sec 68 is expected to serve as a sufficient deterrent to unscrupulous company promoters against making untrue and deceptive statements in a prospectus with a view to obtaining capital from the public Liability for damage for Non-compliance (Section 56) The omission from the prospectus of a matter required to be included by sec 56 may give rise to an action for damages at the instance of a subscriber for shares who has suffered loss thereby. This is even if the omission does not make the prospectus false or misleading.

The Act does not clearly state that the director, etc. will be liable, but this is implied. Liability under General Law. Under the general law, a shareholder can hold all or any of the persons responsible for the issue of a prospectus liable for any misstatement or fraud on their or his part if misstatement or fraud in the prospectus. According to Sec 17 of the Indian Contract Act, 1872, ‘fraud’ means and includes inter alia , the suggestion, as a fact, that which is not true by one who does not believe it to be true .

The fraudster also engages in active concealment of the falsity.A person can only be liable through fraud in a prospectus where he makes a statement to be acted upon by others, which is false and is made:-

• knowingly;
• without belief in its truth; and
• recklessly, not caring whether it was true or false.
• The remedy under general law is available where:–
• where the right of rescission as against the company is lost either through laches or negligence, and
• where the company goes into liquidation Global Watch – The Kerr
  

vs. Danier Leather Ltd.

Case In accordance with Canadian Law Background In May 1998, Danier made an initial public offering of its shares through a prospectus.In addition to providing the company’s actual results for the first three quarters of its 1998 financial year, Danier’s prospectus contained an earnings forecast for the company’s fourth quarter ending in June 1998. The final prospectus was filed on May 6, 1998. The offering closed on May 20, 1998 without any actual financial results for the fourth quarter being incorporated into the forecast or otherwise communicated to the public. An internal company analysis prepared after the final prospectus was filed but before the offering closed showed that Danier’s fourth quarter results were lagging behind its forecast.

Danier did not disclose its poor intra-quarterly results before closing. The shares were issued at a price of $11. 25 per share. On June 4, 1998 – less than two weeks after the distribution under the prospectus had closed – Danier issued a press release announcing that it had revised its earnings forecast for the fourth quarter downward due to unseasonably warm weather in most markets which had negatively impacted its sales of leather apparel.

Following the press release, the Danier share price declined significantly to a low of $8. 5 on June 9, 1998. On July 6, 1998 Danier released its actual fourth quarter results, announcing that it had substantially achieved its original earnings forecast. The Trial Decision The trial judge found that, as of the date of the prospectus, the earnings forecast did not contain a misrepresentation.

However, between that date and the closing of the offering, senior management came into possession of information concerning the

company’s actual fourth quarter results to date that made the earnings forecast objectively unreasonable.The trial judge concluded that although this information about the fourth quarter results did not amount to a “material change” requiring an amendment to the prospectus under section 57 of the Act, the information was a “material fact. ” As such, section 130 of the Act imposed a separate and continuing obligation on the company to disclose material facts arising after the date of the prospectus but before the closing of the distribution. Failure to disclose such material facts would result in the prospectus containing a misrepresentation.The trial judge concluded that the failure of Danier to disclose information about the actual fourth quarter results caused the earnings forecast to constitute a misrepresentation as of the closing date because the forecast had ceased to be objectively reasonable as of that date.

The trial judge awarded damages of $2.35 per share, The trial judge did not require individual shareholders to demonstrate an actual loss caused by the misrepresentation. The Court of Appeal DecisionThe Court of Appeal found that the trial judge had made three fundamental errors. First, the trial judge erred in finding that section 130 of the Act imposed a continuing obligation on issuers to disclose material facts that occur after the date of the prospectus but prior to the closing date. The Court of Appeal concluded that sections 56 and 57 of the Act constitute a complete code of prospectus disclosure obligations, both for compliance purposes and for purposes of determining civil liability under section 130 of the Act.

Second, the Court of Appeal found that the trial judge had erred in concluding that

the prospectus contained an implied representation that the earnings forecast was objectively reasonable. Finally, the Court of Appeal held that, even if the trial judge were correct that the prospectus contained an implied representation that the earnings forecast was objectively reasonable, the trial judge erred by failing to grant deference to the business judgment of Danier’s senior management in determining whether the forecast was within a range of reasonableness.The Supreme Court of Canada Decision On October 12, 2007 the Supreme Court of Canada released its much anticipated decision concerning whether Danier Leather and two of its senior officers were liable under section 130 of the Act for failing to disclose material facts that became known to them after the filing of the prospectus at issue but before the closing of the offering. The Court of Appeal of Ontario had reversed that decision, dismissing the plaintiffs’ action.

The following key points can be drawn from the Supreme Court of Canada’s decision: After a prospectus has been filed, there is no obligation on issuers to update the prospectus to disclose material facts that do not amount to a “material change. ”

A material change is limited to changes in the issuer’s business, operations or capital. The concept is not intended to capture factual developments that may have an impact on the results that the issuer’s business or operations is able to generate but which are external developments that do not amount to a material change to the issuer’s business, operations or capital. Issuers have no statutory obligation to make timely disclosure of intra-quarterly results of operations per se, absent a material change.

Disclosure decisions are not entitled to judicial deference.

It is also worth noting that as a result of the Supreme Court’s decision, underwriters need not change their practices to establish a due diligence defense. This can be contrasted to the change in practice that emerged immediately after the trial judge’s decision. At that time, it was generally thought prudent to conduct a pre-closing bring-down due diligence session with management.

Conclusion… Of late, the problem with prospectuses is not so much about untrue statements as it is with inadequate disclosure of material facts and risks. Many of the issue highlights in a prospectus like ‘latest and proven technology’, ‘assured market’, ‘low break-even point’, ‘assured dividend’, etc that lure naive investors require specific substantiation. And sometimes, various factors that should guide an investor in making informed decisions such as market competition, anticipated project performance, project risks, etc may be ignored or vaguely hinted at.Many investors have had the bitter experience of committing their savings on the basis of rosy prospectuses of companies only to lose everything invested. As such, the loopholes must be plugged in and the scope of prospectus disclosure widened to provide apt and adequate data needed for investors to analyze the prospectus and accurately assess the risks involved in investing in a particular company.

In India, though, the safeguards provided against prosecutions are rather weak and that is not considering the infamous time lag of our judiciary system.Hardly any worthwhile case has so far been instituted against misstatements in the prospectus. However, things are changing. SEBI is an important body empowered to shape investor protection..

A recent decision taken by the Government was that while directors, promoters, and every other person who authorizes the issues

of prospectus shall bear full responsibility for the contents therein; merchant bankers shall exercise due diligence, independently verifying the prospectus’ contents and reasonableness of the views expressed and certifying to this effect to the SEBI. The revised Companies Act announced recently can also be a possible milestone . More stringent laws could enhance investor protection by increasing the scope of accountability of companies.

Bibliography:

• ND Kapoor- eLEMENTS OF mERCHANTILE lAW Taxmann's Company law www.proquest. com www. ebsco. com