fraud and misrepresentation

Fraud and Misrepresentation

In Cates v. Sparkman, the Texas Supreme Court held that one of the limited instances in which an individual shareholder is entitled to bring a claim against the corporation for damage to himself as shareholder is when the cororation commits “fraud.” 

A minority shareholder may be the victim of fraud and misrepresentation in his decision to join the venture and to purchase stock or in his decision to sell his stock. The cause of action in those two circumstances is very different. When parties come together to form a new company, or when a new minority shareholder joins an existing company, the law considers the parties to be strangers and to deal with each other at arms length, unless there is evidence to establish a relationship of trust and confidence. In an arm’s length transaction, neither party has a duty of fairness to the other, neither has a duty of full disclosure; rather both parties may seek to further their own interests at the expense of the other—so long as neither commits fraud or misrepresentation. When a minority shareholder sells his shares back to the corporation or to the majority shareholder, either voluntarily or as a result of a squeeze-out, then the parties are not strangers. Corporations function as trustees for the benefit of their shareholder’s ownership interests and owe quasi-fiduciary duties of fair dealing, impartiality, and disclosure. In the context of a redemption or repurchase of shares by the corporation, courts have held that the corporation must make full disclosure. Those same duties have been extended to directors and majority shareholders when they exploit their advantage of inside information and control over the corporation in paying less than a fair price.

Elements of Common-Law Fraud by Misrepresentation

Generally, common-law fraud has the following elements:

  1. The defendant made a misrepresentation of fact or false promise to the plaintiff.
  2. The misrepresentation was material.
  3. The misrepresentation was false.
  4. The defendant (a) knew the misrepresentation was false when he made it, or (b) did not know whether the misrepresentation was true or false, but made it recklessly as a positive assertion, or (c) had no intention to perform the promise at the time he made it.
  5. The defendant made the misrepresentation or promise with the intent that the plaintiff act on it.
  6. The plaintiff relied on the misrepresentation or promise.
  7. The misrepresentation or promise cause injury to the plaintiff.

Misrepresentations Constituting Fraud

Fraudulent misrepresentations must be statements of past or existing facts. The misrepresentation may be communicated to the plaintiff directly or indirectly, such as in a writing that the defendant knows that the plaintiff will see or through another person. The misrepresentation must be material, that is important to the plaintiff in making a decision. Mere opinions, even if wrong, are not misrepresentations that constitute fraud. Usually, opinions about the law, about value, or about future events are not misrepresentations, unless (a) the defendant knows that the opinion is false at the time he offers it, (b) the opinion is necessarily based on false facts, or (c) the defendant has special knowledge on which the plaintiff is relying, such as an attorney making a misrepresentation of the law. Predictions about future events or actions are not fraud. False promises are not fraudulent misrepresentations, unless the defendant knows that he has no intention to keep the promise when he makes it and the promise is definite and certain.

The Defendant’s State of Mind

The defendant must know that the misrepresentation is false in order to commit fraud, except that if the defendant makes a positive assertion of fact recklessly, without knowing whether it is true or false, but in such a way that indicate that he does know that it is true, then that may also constitute fraud. The defendant must also make the misrepresentation with the intent that the plaintiff rely on the representation, that is that the plaintiff take some actions as a result of the misrepresentation.

The Plaintiff’s State of Mind

The plaintiff must establish that it he did not know that the representation was false and that he entered into a binding contract because of the misrepresentation. The reliance must be justifiable. A plaintiff cannot prove fraud if he was aware of fact indicating that the representation was false. Generally, a plaintiff has no duty to investigate, but such a duty may arise if the plaintiff is on notice of facts that cause a reasonable person to be suspicious about the truth of the statement. Many contracts contain a disclaimer of reliance in which the plaintiff agrees that he has not relied on any representations not stated in the agreement. If the disclaimer is binding then it defeats the fraud claim. In order to be binding, the disclaimer must be clear and unequivocal, must have been part of the negotiations, and must relate to a point specifically discussed and negotiated by the parties. A standard merger clause or boiler plate disclaimer is not sufficient.

Fraud and Misrepresentation in Minority Shareholder Investments

The typical fraud and misrepresentation claim with public stock is that the financial information regarding the company was false and that the plaintiff either over paid or would not have invested had he known the trust. That claim is sometimes made with respect to closely-held corporations, where the minority shareholder is buying in more as an investor. However, in most cases, the minority shareholder is involved in starting a company with others or is coming in at an early stage, in which case the value of the company and its past financial performance are rarely the chief concern. Certainly, if the minority shareholder is lied to about the debt of the company or other factors that are important to his decision, then there may be a claim for fraud and misrepresentation.

A much more common situation occurs when the minority shareholder is told that he is an owner, and the company or majority shareholder later claims that he never was. Also parties creating new corporations frequently make promises regarding how they will treat each other in the future: that dividends or tax distributions will always be paid, that each will always have a job, that each will always be on the board of directors. Those false promises may be the basis for a claim of fraud and misrepresentation only if the defendant did not intend to perform the promise at the time he made it. If the defendant did intend to perform the promise and later changed his mind, then he merely breached a contract. However, most defendants will deny having ever made the promise. The Texas Supreme Court has held that the denial of having made the promise in the first place constitutes evidence that the defendant never intended to perform. Therefore, if the plaintiff can prove that the defendant did make the promise, and the defendant denies having done so, then the plaintiff has established a case of fraud and misrepresentation.

Benefit of the Bargain Remedy for Fraud and Misrepresentation

If the defendant fraudulently induced the plaintiff to invest his time, talent, and treasure into a closely-held corporation based on representations that the plaintiff was a shareholder (when he never was) or that the plaintiff would receive distributions of profit commensurate with his ownership interest, then the plaintiff is entitled to the value of the benefit of his bargain as money damages. Benefit of the bargain is the difference between the value as represented and the value as received. In the case of an investment in the stock of a closely-held corporation, the benefit of the bargain would be measured by the value of closely-held stock with the attributes that the defendant promised and misrepresented, less the value of the same stock as delivered. For example, minority shares that pay out, in salary, dividends, or other types of distributions, a guaranteed share of the profits are worth the present value of that stream of income, which can be calculated and projected by an expert based on the past financial performance and earning power of the corporation. The same stock with no payout will have little or no value.

One caveat: in order to receive benefit of the bargain, the plaintiff must have had an enforceable contract. If the shareholder does not have a written employment agreement that cancels the at-will employment relationship, then he remains an at-will employee even though he relied on a fraudulent misrepresentation to the contrary. In such a case, the shareholder probably could not claim benefit of the bargain damages that relied on continued employment. However, such a victim of fraud and misrepresentation would still be able to claim the out of pocket remedy.

Out of Pocket Remedy for Fraud and Misrepresentation

The out-of-pocket measure of damages is the amount the shareholder paid minus the value of what he actually received. In most cases, the initial cash investment is minimal. However, in most cases, the minority shareholder pays for his shares with his sweat, by investing the value of his services into the corporation and receiving less than he would expect if he were working as an employee for someone else. Quite often, the minority shareholder is squeezed out just at the point that the sweat equity investment has paid off and the corporation is becoming profitable. In these cases, the shareholder might have a claim for the fair value of his services (quantum merit) as the measure of his damages for fraud and misrepresentation.

Punitive Damages and Attorneys’ Fees for Fraud and Misrepresentation

Punitive damages are recoverable for common-law fraud and misrepresentation claims, but attorneys’ fees generally are not.

Statutory Fraud

Section 27.01 of the Texas Business and Commerce Code provides an additional remedy for fraud involving stock in a corporation. The title to the stock must pass. Therefore, the plaintiff has a claim if he buys or sells stock in reliance of fraud and misrepresentation, but if the fraud is a false promise to convey stock, which the plaintiff never receives, then he does not have a claim under the fraud statute. The elements of statutory fraud are identical to those of common law fraud, with one important exception: the plaintiff is not required to prove that the defendant knew the misrepresentation was false when made. The fraud statute also adds an additional claim against one who is benefited by not disclosing that a third party’s misrepresentation was false. The plaintiff is entitled to actual damages, measured the same way as common-law fraud, and to attorneys’ fees and recovery of certain expenses. If the plaintiff proves that the defendant acted with “actual awareness” of the false representation or promise, then the plaintiff is also entitled to punitive damages.