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

by | May 12, 2020 | Uncategorized |

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”.