Entrepreneurs, startups and SMEs could find valuable lessons in the recent decision of Ebbsfleet v Semantic [1]. In that decision, the New South Wales Supreme Court found that representations made by Semantic Software Asia Pacific Limited (Semantic) to prospective shareholders had not been fulfilled and amounted to misleading and deceptive conduct.

Semantic , made a number of representations about its future in meeting with and distributing investment packs to potential shareholders Mr and Mrs Vinson, including that the value of shares in Semantic would triple within two years and that shareholders would realise significant benefits in 2012 (in the form of a potential trade sale to IBM or another technology company).

On the back of those representations, Mr and Mrs Vinson entered into share issue agreements with Semantic and invested approximately $1,625,000.00 via their entities Ebbsfleet Pty Ltd (Ebbsfleet) and McGee Pty Ltd (McGee). Those share issues agreements included warranties that specified the value of the shares would triple within two years and, if they did not, Semantic’s CEO (Mark Bradley) would transfer his own shares to the purchasers to effect a tripling in value. The share issue agreements also contained acknowledgments that the purchasers had not been induced to invest in Semantic by any representation or warranty and a disclaimer of liability in relation to investment advice.

Two years passed and Semantic had not secured any commitment from any other technology company and was operating at an ever increasing loss, in excess of a million dollars each year. Ebbsfleet and McGee commenced proceedings against Semantic and Mr Bradley for breach of warranty and misleading and deceptive conduct pursuant to the Australian Consumer Law.

In response, Semantic and Mr Bradley argued that they had reasonable grounds for making the representations, including as a result of various discussions with IBM. However, the Court found that those discussions did not justify Mr Bradley’s optimistic representations and that the representations overstated those dealings. The Court also found that the acknowledgement and disclaimer did not protect Mr Bradley or Semantic from any breach of the Australian Consumer Law in relation to the representations.

The Court ultimately found that the value of the shares was negligible and that the value of the patents held by Semantic was no more than the costs recorded in Semantic’s financial statements (including because Semantic had earned no income from the patents, had secured no contracts to commercialise the patents and had no commitment from any large technology companies). Accordingly, the Court found that Mr Bradley and Semantic had breached the warranties and the representation that the shares would triple in value within two years.

Whilst damages are yet to be calculated, the Court commented that the loss suffered for misrepresentation would amount to the value of the investment, that is $1,625,000.00, and that damages for the breach of warranty were intended to put the investors in the position they would have been had the promised tripling in value occurred (i.e. potentially $4,875,000.00).

Takeaway points:

  • do not make representations or warranties as to the future success of the company without a reasonable basis for doing so;
  • take care in the wording of any such representations or warranties to ensure they do not overstate the position;
  • having a sincere belief that your company will be prosperous is not enough, evidence will be required to show a reasonable basis for such representations;
  • when making future representations regarding the value of a company, be very careful that the value will be supported by independent experts – it is all too easy for people within the company to adopt a “blue sky” view of the company’s value;
  • avoid guarantees as to the future prosperity of the company or return on investment being written into contracts with partners or investors, especially where such prosperity or return is dependent upon a variety of factors outside the control of the company; and
  • if you fail to do the above, your company, and you personally, may be held responsible for returning the investment or compensating the investor.