Selling a lemon (and shares can be a lemon too!)

You might be trying to sell something, whether it be a second-hand surfboard, car or a financial product like a share in a company.  If that product is a lemon, what are the rules around selling it?  The product might be a lemon because:

  • the surfboard has previously been snapped in half and repaired;
  • the car has a major mechanical fault; or
  • for the share, the underlying company has constrained cash-flow and is subject to a threatened legal proceeding, which, if commenced, the legal costs of defending it would render the company insolvent.

As a starting point, the law’s ancient abiding position is buyer beware (or in Latin: caveat emptor).  An experienced surfer can typically tell when a surfboard has been snapped and repaired.  An inexperienced surfer should buy new or take a more experienced person with them when they inspect (or take the risk).  Any buyer of a car can have a mechanic do an inspection and report on any likely mechanical problems and the likely costs of repair (which can be factored into the price offered).  A buyer of shares can undertake due diligence, or for listed companies rely on the fact that the market has factored all relevant information into the prevailing price (the efficient capital market hypothesis, which has its limitations).

Does the law ever move away from buyer beware?  Yes, it does, but never just to protect a gullible buyer.

Australian law provides that a person must not engage in misleading and deceptive conduct in trade or commerce.

Let’s take the seller of a car (ignoring the need to a roadworthy certificate in some States).  Let’s say a car of that year and mileage typically sells for $20,000.  But if the car has a major mechanical fault then assume it will require $12,000 of repairs.  So as a lemon it is only worth $8,000.  If the seller advertises and sells the car for $8,000 and discloses the fault, then the buyer buys a lemon knowing it is a lemon.  After spending $12,000 to repair, the buyer has a car worth $20,000, which is the buyer’s total buy and repair price.  No one has been wronged and the law will make no intervention.

 

Let’s consider a different scenario.  Seller advertises and sells the car for $20,000.  Seller makes no disclosure about the fault.  Buyer buys a lemon not knowing it is a lemon.  The seller may have had trouble free motoring up to that point and may either be aware of the fault or unaware of it.  Let’s consider various scenarios and see how the law will likely decide:

  1. Seller makes no representation about the quality of the car.  The law makes no intervention;
  2. Buyer asks if the car has any problems and seller responds:
    1. “It has run beautifully for me up to now”.  The law makes no intervention.  That is a true statement.  As all the advertisements for superannuation products disclaim, “past performance is not a reliable indicator of future performance”;
    2. “You are welcome to get a mechanic to inspect”.  The law makes no intervention;
    3. “I am not a mechanic, but this has been a great car for me”.  This statement is true, so the law makes no intervention.  The seller’s statement itself points the buyer to what the buyer should do: i.e. get a mechanic to check it out;
    4. “I am not a mechanic, but this has been a great car for me.  I dunno, but I reckon you won’t have any problems for years and years”.  The car blows up around the corner.  There are two interesting aspects to this statement.  First, it is clearly expressed as just an opinion, and also from someone who is not technically qualified to really say (i.e. the seller is not a mechanic).  Second, it is a statement about future performance.  Regarding future events, the law simply requires that the person making the statement has a reasonable basis for making the statement.  If the seller is not aware of the fault, given the past performance of the vehicle then the seller likely does have a reasonable basis to make that statement.  If the seller is aware of the mechanical fault, the seller knows that the statement is not true and so the seller does not have a reasonable basis to make that statement.  The law would intervene;
    5. “This is a great car.  You won’t have any problems for years and years”.  The car blows up around the corner.  The representation is a positive one about the quality of the car and that nothing but trouble-free motoring lies ahead.  It is not expressed as an opinion.  The seller, not being a qualified mechanic, has no reasonable basis to make this prediction.  Whether the seller is or is not aware of the fault, likely the law will intervene as on an objective basis the car has a fault and blows up almost immediately, and certainly not years later.  Misrepresentations don’t depend on subjective knowledge of the person making the statement or an intent to deceive; it is still a misrepresentation because it isn’t true and there is no reasonable basis to make the prediction.

There are a few key takeaways from this:

  1. If you sell a lemon priced as a lemon, you will be ok;
  2. If you sell a lemon priced as an exotic fruit, then do not say anything about the quality of it, either innocently or knowing it is false;
  3. Unless you are a clairvoyant (and even if you think you are!), don’t make any statements about future performance.  The future is inherently uncertain (made very evident to us all as a result of coronavirus);
  4. If you are a buyer, ask lots of questions and independently investigate what you are buying; and
  5. If you are a seller and the buyer asks lots of questions, either refuse to answer, point to the ability of the buyer to undertake its own investigations, but certainly don’t deliberately bulls#*t, or make statements about quality that you are not qualified to make or have no reasonable basis to make.

So, is silence by a seller golden in this context?  Generally, yes, in the eyes of the law. It may make a potential buyer doubt the seller’s credibility and make that potential buyer not have the confidence to buy from the seller.  But legally, generally there is no legal issue in keeping quiet about known problems.

However, the law does recognise some circumstances when silence is not good enough.

A recent case in the NSW Supreme Court of Appeal didn’t allow the seller to just get away with silence (Porges v Adcock Private Equity Pty Ltd [2019] NSWCA 79).  A company Adcock was looking for a non-executive chairman.  It identified a Mr. Porges as a potential candidate.  Porges insisted that he could only take up that position if Adcock bought shares in a company he owned, Secure One Corporation, Inc.  Porges was an approximately 10% minority shareholder in Secure One, which was a technology start up incorporated in the British Virgin Islands.  Like most start-ups, it had limited cash resources and was going to require additional capital injected if it was going to thrive and grow.  Secure One got entangled in a dispute with another company.  The other company threatened to sue and eventually did.  Secure One ultimately won the legal case but was left with a $1m+ legal bill that it couldn’t afford to pay.  The legal firm struck a payment plan with its client and took security over Secure One’s principal assets, being certain patents.  When Secure One defaulted on repayment to the legal firm, Secure One ultimately lost its patents and became bankrupt.

At the time Porges was seeking to sell his shares in Secure One, he knew of the threatened legal claim and had lost confidence in the management of Secure One.  He didn’t disclose any of this to Adcock but did disclose company generated financial information that was positive.

Did Porges engage in misleading and deceptive conduct in not disclosing this negative information to Adcock?

The court reiterate the buyer beware maxim.  But the court looked to the broader context.  That context was that Adcock was looking for a chairman.  In that relationship, Adcock had to be able to trust Porges on an ongoing basis.  That relationship of trust indicated a reasonable expectation that if Porges knew information that went to the quality of the potential investment then he should disclose it.  Porges did know relevant information but didn’t disclose it.  So, the court held that Porges had engaged in misleading and deceptive conduct.

Whilst the buyer Adcock obtained a judgment for circa $1m, it involved a difficult trial and an appeal of that decision to reach this commercial certainty.  That outcome would likely have been a lot clearer and simpler if Adcock had asked Borges in writing one simple question: “Before we buy, tell us everything you know about Secure One that may impact the price you are asking us to pay”.

COVID-19 Carnage – Can I Get Out of My Contract?

COVID-19 is wreaking carnage in our society, making those infected either somewhat or significantly ill and sometimes even dying.  The government is endeavouring to limit the contagion in a bid to limit the number of people infected, as a desirable objective in itself, and so that our health facilities are not overwhelmed. The Australian government has banned non-essential outdoor meetings of greater than 500 people and non-essential meetings indoors of greater than 100 people.  It has also issued travel advisories for Australians not to travel overseas and for Australians overseas to return home. Music festivals and concerts are being cancelled.  International visitors need to self-isolate for 14 days and will be banned from this Friday.  Sporting events are being cancelled or being played in empty stadiums.  People are stockpiling perceived essentials like canned food and toilet paper, leaving supermarket shelves empty.

We have never had to deal with a pandemic in our lifetime and this uncertainty breeds anxiety and fear.  We are fearful for our health and the health of our family and friends, particularly the elderly.  We are also fearful of the potential economic consequences.  Concerts, sporting events, airlines and hotels are all being significantly and negatively impacted.  There are lay-offs and suspensions (Qantas standing down 2/3rds of its 30,000 workforce).  There are knock on effects for others, such as food producers, linen suppliers and taxi and Uber drivers as international tourism dwindles.  People are seeking to minimise their public interactions, so they are eating at home more and not frequenting cinemas.

So, what if you are party to a contractual commitment and this new environment makes that contract unprofitable and untenable.  Can you get out of it?

The starting point is that a contract is a contract.  You are legally bound by it and must continue to honour it.

However, contract law has a doctrine of frustration that has the effect of terminating a frustrated contract.  This isn’t easy to establish.  Two requirements must be met.  First, there must be a radical change of circumstances such that the environment in which the contract is now to be performed is fundamentally different to when the contract was made.  Second, that fundamental change of circumstances must result in one party being incapable of performing its obligations (i.e. performance is impossible, or performance would be radically different from that which was originally undertaken).

Note the high thresholds here: “radical change”, “fundamentally different” and “incapable of performance”.

The test will not be satisfied if it makes one contractual party’s performance more difficult, or the result of the contract less profitable (or even unprofitable), or if it makes performance of a long-term contract impossible for only a short time.

Broadly speaking, the COVID-19 pandemic and the consequent restrictions of the government has resulted in a radical change of circumstances.  So, the first limb of the test will likely be satisfied.

But has that radical change of circumstances resulted in contractual performance becoming impossible (or radically different)?   As us lawyers are wont to say, that will depend on all the circumstances.  Take the case of someone renting a 140-seat capacity hall:

The terms of the hall rental are: Contractual impossibility?
For a one day hire for a wedding in a week’s time for 140 people. Yes, because of the government banning gatherings of more than 100 people indoors.
For a one month hire with no designated purpose. Uncertain, but likely no.
For 3 months for a band practice. No, the band can still practice (even if it was relying on gigs that are now cancelled to be able to pay the rent).
For 3 months to conduct functions. Possibly not, because functions for 90 people could still occur.
For 5 years to conduct functions. Unlikely, because COVID-19 bans are unlikely to be in place for 5 years or anything approaching 5 years.

If a contract is frustrated, then it is terminated.  The parties are released from their obligations.  In some States, notable NSW, Victoria and South Australia, there is specific legislation that regulates the outcome of a frustrated contract, largely spreading the loss between the parties to it.

If you are party to a contract significantly impacted by COVID-19, it is worth considering if the negative financial consequences of that contract can be avoided by resort to the doctrine of frustration.  As noted above, that will depend on all the circumstances and there are high thresholds.

Works of Artistic Craftsmanship

Works of Artistic Craftsmanship

 

Designs in 3D products generally do not enjoy copyright protection

In the intellectual property world, generally, if you industrially design a 3-dimensional product then unless you apply for a design registration for that product then you lose any copyright protection for that product once you industrially apply it (create more than 50 copies of it).  You must also apply for registration before you go public with it (i.e. make the application while it is still under wraps, and make sure it stays under wraps until you do so).

Copyright and design registration both provide monopoly rights to the underlying work.  However, copyright lasts significantly longer than a design registration: life of the author + 50 years for copyright; a straight 10 years for design registration.  Copyright arises automatically upon creation without the need for applying to the government for registration (in Australia, each design application costs $250 in government fees)

The policy of the government is clear.  Designs tend to be products that do things that have functional utility and a shorter period of monopoly rights is intended to allow the underlying product to be freely used by all sooner (hopefully to the benefit of society as a whole).

Exception: Works of Artistic Craftsmanship

One exception to the above is for works of artistic craftsmanship (WAC).  A WAC is typically a three-dimensional product, but it enjoys the benefit of longer copyright protection and no registration is required.  WACs are specifically referenced in the Copyright Act as a special category of works that enjoy copyright protection (paragraph (c) of the definition of “artistic work” in section 10 of the Copyright Act 1968).

That WACs are considered a special category of works enjoying special status of copyright protection traces its history to the arts and crafts movement of the 18th century and legislative reforms first in the UK which were then followed in Australia.  This history was traced by the High Court of Australia in a case involving a yacht (Burge v Swarbrick [2007] HCA 17).

The High Court held that the key elements to decide if a design having utilitarian purposes is nonetheless a work of artistic craftsmanship, and thereby protected by copyright, are as follows:

  • This law was principally designed to protect craftsmen such as silversmiths, potters, woodworkers, hand-embroiders and many others;
  • The law is designed to protect real artistic effort in the field of industrial design;
  • There needs to be a real or substantial artistic element;
  • There is no antithesis between utility and beauty, between function and art;
  • Craftsmanship…implies a manifestation of pride in sound workmanship – rejection of the shoddy, the meretricious, the facile;
  • Artistic form should…be an emanation of regard for materials on the one hand and function on the other;
  • Whether a product can be regarded as a work of artistic craftsmanship will depend on if “there is considerable freedom of design choice relatively unconstrained by the function or utility of the article so produced”; and
  • “Determining whether a work is a “work of artistic craftsmanship” does not turn on assessing the beauty or aesthetic appeal of the work or on assessing any harmony between its visual appeal and its utility.  The determination turns on assessing the extent to which the particular work’s artistic expression, in its form, is unconstrained by functional considerations.”

The last sentence is the key test.

In the Burge case, the High Court held that the yacht was not a work of artistic craftsmanship.

State of Escapes’ Tote Bag

The opposite result was reached by Justice Davies in the Federal Court in September 2019 in State of Escape v De Rozario.  In that case, Justice Davies granted an injunction against a copier knocking off State of Escapes’ perforated neoprene Escape Bag (pictured below).  Now, there is nothing new about tote bags, and State of Escape does not enjoy monopoly rights to tote bags.  But theirs is unique, being made of perforated neoprene and also having sailing rope as part of its construction.  Justice Davies has not issued reasons for his decision, but given the injunction was granted she must have been satisfied that the Escape Bag was a work of artistic craftsmanship.

blanchard legal post

This is a great outcome for an Australian company coming out with an original design which proves popular with consumers and then faces parasitic competition from the supplier of a knock-off who invests no money in R&D or a creative process.  The original designer usually has the concern to ensure its product is high quality and sometimes that all or some of the product is made sustainably (the knock off supplier typically has no such concern, it is only interested in a product that looks similar and typically sold at a lower price point).

Tragic injury, economics and justice

Life is uncertain and involves risk.  Some people like taking risks and some are more risk-averse.  Some people are risk-averse in some areas of their life (e.g. financially conservative) yet take risks in others (politically active and participates in protests and risks arrest).

Some people love taking physical and sporting risks.  Most noticeably, extreme sports, like rock climbing, downhill skiing and big wave surfing.  After years of practice, people develop their skills and back those skills and their judgement in participating.  How fast can I go into that hairpin corner on my motorbike?  Can I solo climb that rock wall without ropes?  Can I ride that 30’ wave?

Despite the skill and talent, accidents inevitably occur.  Sometimes claiming lives, sometimes with horrific and irreversible damage, such as quadriplegia or paraplegia.  Nothing can change that.  But these people’s lives change dramatically, and they need lots of medical support/intervention and ongoing care.  That all costs money.

If a person suffers this type of injury as a result of a car accident, then the compulsory personal injury insurance that comes with the vehicle registration will provide cover, up to predesignated limits.

If the tragedy occurs out in the surf or out on a mountain, then there isn’t such an obvious defendant or insurer to seek compensation from.  Plaintiff lawyers have often sought to sue someone to try to help provide for injured people.  Judges often receive bad raps in public discourse, such as the nuanced job of sentencing criminals is an easy target for media and public outrage over too lenient sentencing (and sometimes they are too lenient, but mostly they probably get it right).  In the civil cases seeking compensation for injured people, lawyers argue that a sign warning of the risks should have been erected, or the beach closed on that day.  Judges, seeing a plaintiff with apparent deep pockets or backed by an insurer on the one hand, and a tragically injured plaintiff on the other, have found some degree of negligence and awarded compensation.  Totally understandable on an individual case-by-case basis, and seemingly in keeping with our sense of compassion.

But the money has to come from somewhere, and premiums go up or insurance can’t be obtained.

A case in the 2000s changed the law in Australia.  A young man, presumably after a night of revelling on New Year’s Eve, went to go for a swim at Bondi beach early on New Year’s Day.  Possibly still under the influence of alcohol or other intoxicants.  He dived headfirst into a sand bar and suffered paraplegia.  His lawyers sued the local council seeking multi-millions of dollars compensation on the basis that signage should have pointed out the risk of diving into shallow sandbars to beach users.  This was potentially going to bankrupt the local council.  Governments and public sentiment considered that people who are participating in day to day activities, let alone extreme sports, need to accept personal responsibility for the inherent risks.  The law was changed to, broadly speaking, providing that people who participate in recreational activities can’t just sue somebody else if an accident inevitably happens.

For example, in New South Wales there is the Civil Liability Act 2002 (NSW).  That Act provides some defences to a claim for negligence:

  • Section 5L: “A person (the defendant) is not liable in negligence for harm suffered by another person (the plaintiff) as a result of the materialisation of an obvious risk of a dangerous recreational activity engaged in by the plaintiff”.
  • Section 5M: “A person (the defendant) does not owe a duty of care to another person who engages in a recreational activity (the plaintiff) to take care in respect of a risk of the activity if the risk was the subject of a risk warning to the plaintiff”.

 Some businesses are focussed on supplying specialised product to people who participate in extreme sports.  As part of their marketing, they organise events around these sporting activities.  For example, right now the Hawaiian surf season is running, including running in big waves over shallow reefs.  Event organisers try to protect themselves with various layers of protection, including having participants signing waivers of liability (that typically include a risk warning), having adequate public risk insurance and in Australia using the defences in these recreation activities laws.

 Judges have to apply the law.  Plaintiff’s lawyers still try to obtain compensation for their injured clients.  In a recent Australian case, a young woman participated in a horse-riding event and tragically suffered quadriplegia.  Her lawyer sued the event organiser, seeking to get around the recreational activity defences, including because there had been earlier injuries during the event and some participants thought the course was unsafe and requested the event organisers to call the event off.

The NSW Supreme Court held in November 2019 that, despite the circumstances, the young woman was participating in an inherently dangerous activity, unfortunately, the inherent risk came about and that a suitable risk warning had been given,  The judge, therefore, applied the defences and no compensation was payable (Tapp v Australian Bushmen’s Campdraft & Rodeo Association Ltd [2019] NSWSC 1506).

This provides certainty for event organisers.  Unfortunately, there is still a young woman with very serious and permanent injuries (although she has gone on to compete as a Paralympian).

(It is worth noting that if the injured person had life insurance or total and permanent disability insurance as part of his or her superannuation, that some compensation may have been available through this.)

Recent Sale of Business

I was asked in mid-October to act for the owners of a registered training organisation (RTO) to assist with its sale. A basic term sheet had been signed with the buyer and they both wanted to complete before the end of the month. Due diligence was underway, but unfortunately there was not a confidentiality deed in place. That was the first item to address.

Next was preparing the share sale agreement (SSA). The broker had a version of a SSA that was tailored to the peculiar RTO regulatory environment. That needed just a bit of a shift to be a little more in the seller’s favour, a tad (!) of tightening, including adding some warranties from the buyer and addition of a buyer’s guarantor. It also required a mechanism to calculate and adjust for the net position vis-à-vis receivables and payables, provision for a tax estimate for trading up to completion and otherwise allowing the seller to dividend to itself the net cash/profit out of the company.

The buyer didn’t appoint a solicitor until 3 days before scheduled completion (not so helpful). Those solicitors then sought a range of changes (many of which were agreed), but also a $50,000 holdback to address a variety of issues and also sought a range of liquidated damages based on perceived technical compliance issues in the RTO regulatory framework. This broad hold back was resisted, although a 10k holdback was agreed for 30 days just to cover if there were additional debtors than were adjusted for. We also resisted the request for liquidated damages, principally because the seller was very on the ball and could quickly address the technical issues raised or could demonstrate that the perceived issues really had no merit and that not hold back was appropriate.

The share sale agreement was signed on 30 October with completion following later in the day (but critically, before the end of month). The buyer and its solicitor were located in Melbourne and the seller in Brisbane (and me on the Gold Coast). Completion occurred by the exchange of a scan of the share transfer and other documents, with original documents to be exchanged in due course.

Besides successfully completing a transaction within a compressed timeline, there is one other very gratifying aspect to assisting the sellers. The sale was for a generous six-figure sum. I have never met the sellers face to face, but they are a husband and wife team. I am not privy to their financial position but receiving a generous six-figure sum has to help them and their family get ahead in life. Of course, that payday was for many years of hard work and running a successful and profitable business.

Total legal fees will be south of $10k, and roughly 1.5% of the transaction value.