An action for negligent misstatement arises where Party A has carelessly made a statement to Party B, where the relationship between the parties is such that Party A owes Party B a duty of care. A negligent misstatement claim is brought at common law in tort. The terms “negligent misrepresentation” and “negligent misstatement” are often confused. Generally, an action for any form of misrepresentation is between contracting parties, whereas an action for negligent misstatement may be invoked whether or not a contractual relationship exists.
For more detail, see Practice note, Negligent misstatement. For a checklist of the essential ingredients of a claim in negligent misstatement, see How to state your case: negligent misstatement.
The majority of professionals are aware that the provision of negligent advice or a negligent misstatement may expose them to liability. However, such professionals may not be aware of the extent of their potential liability. Negligent misstatement relates to a representation of fact, which is carelessly made, and is relied on by another party to their disadvantage. For some time it has been possible to claim for economic loss arising out of a negligent misstatement where no contractual or fiduciary relationship exists between the parties. This is provided however that a special relationship or a sufficient proximity1 exists between the parties.
Contents
Overview
Introduction
Objectives
1.0 What is Negligence?
2.0 Elements of the Tort of Negligence
3.0 Negligent Conduct — the Duty and Standard of Care
4.0 Negligent Misstatement
4.1 What are the Preconditions for Liability?
4.2 Exclusion Clauses and Disclaimers
5.0. Statutory Liability
5.1 Civil Liability Imposed by Statute
5.2 Capital Markets and Services Act 2007
5.3 Companies Act 1965
5.4 Reasonable Basis and ‘Know Your Client Rule
6.0 Summary
Appendix 1: Tort of Negligent Misstatement
Overview
Introduction
One must take reasonable care to avoid acts or omissions which one can reasonably foresee would be likely to injure one’s neighbour’ – Donoghue v. Stevenson [1932] AC 562.
The law relating to the negligence of fund management companies (and ‘experts’ generally) who owe a duty of care to others is an example of the area of law known as the law of tort.
Before we begin to examine this important area of the law relating to fund management it is important to understand the meaning of the term ‘tort’ and to understand its relationship with the law of contract we examined earlier.
In the case quoted above, a consumer of ginger beer alleged that she had become seriously ill as a result of drinking from an opaque bottle which was subsequently found to contain the remains of a snail. Since she had been given the bottle by a friend, and had not purchased the bottle herself, there was no contract between her and the retailer. Instead, she sued the manufacturer in tort for negligence. The House of Lords ultimately found that the manufacturer had a duty of care to the consumer of the ginger beer.
The case illustrates that a tort represents a civil wrong independent of contract. The law of tort protects the general rights of every person (which also includes the general rights of the contracting parties) which arise under the common law. The Law of tort allows compensation for losses suffered, and the remedy for a breach of tort is an action for damages.
Contrast with the Law of Contract
In a fund management context, there will normally be a contract between the fund management company and the investor client. The contract may, for example, include a requirement that the fund management company maintains various records of the investment portfolio belonging to the client. Should the fund management company fail to maintain these records there would be a breach of contract and, as we saw in the previous topic, the investor client would be entitled to claim compensation (damages) for the consequences of a breach of the promises the fund management company agreed to perform.
But what if the investor claims that the fund management company had been negligent in the investment of the funds? If there is no contract, the law of tort enforces the terms of the duty of care owed to the client. If there is a contract but no term of the contract covers the duty of care, again the law of tort enforces the terms of the duty of care.
In the situation where the terms of the contract do include an element describing the duty of care owed to the investor, the question arises as to whether the investor can obtain a remedy against the fund management company under the terms of the contract. If the contract prescribes a standard of care then the investor can enforce compliance with that standard of care under the contract and, in some cases, may also have a cause of action in negligence.
Proximity
As we have seen in the ginger beer case, the law of tort protects the rights of individuals who may or may not be a party to a contract. These rights are conferred under common law. In the absence of a contract the law of tort enforces the law’s judgment as to what the terms of the relationship should be.
The law of tort can, however, only be enforced where there is sufficient proximity (or closeness) to give rise to a duty of care. A trustee of a pension fund, whose investments are managed under a contract by a fund management company, would clearly be regarded as sufficiently close to bring an action for negligence. A beneficiary, or member of the pension fund, would also be sufficiently close to bring such an action even though he or she was not a party to the contract between the fund management company and the pension fund trustee. Should the trustee be unwilling to take action against the fund management company, the law of tort would allow the beneficiary or member to obtain a remedy for losses suffered by the negligence of the fund management company.
From a practical point of view, this means that an aggrieved investor such as a pension fund trustee who has contracted with a fund management company has to
decide whether any action for alleged negligence should be brought under the law of tort or for breach of contract. Consequently, it is common for contracts between a fund management company and an investor to exclude contractual liability for negligence. Even if there is no contract a fund management company may be able to exclude liability for negligence by using an appropriately worded disclaimer.
In this topic we will examine the concept of negligence and the duty of care owed by professionals such as fund management companies. In the context of negligence we will examine two aspects particularly relevant to fund management companies — negligent conduct and negligent misstatement (or negligent advice).
Objectives
At the end of this topic you should be able to:
• define the tort of negligence in relation to a fund management company
• list essential elements in the tort of negligence
• describe the duty and standard of care applicable to a fund management company
• list the preconditions for a successful claim for damages
• list the responsibilities of an licensed person imposed by statute.
1 What is Negligence?
The concept of negligence describes some activity (such as the discretionary investment of the funds of an investment portfolio) or the making of a statement (such as the giving of investment advice to the trustee of a pension fund) which falls below the standard regarded as normal or acceptable in society. Negligence covers many areas of activity, including road accidents, factory accidents, injuries caused by defective products and financial damage or loss.
Traditionally, a person could only take action in the tort of negligence when they suffered physical damage as a result of a negligent act, such as that described earlier where the plaintiff became ill after drinking a bottle of ginger beer. However, the question of whether damages are recoverable for negligent advice or a negligent misstatement causing financial (rather than physical) damage has been a vexed one and courts have been reluctant to make persons liable in tort for such negligence.
Today, however, it is more likely that a plaintiff will be successful in a claim for purely economic loss for negligent conduct or negligent misstatement, providing the general principles of negligence are satisfied. In this topic we are concerned with the legal redress available to an investor client who has suffered financial damage perhaps as a result of bad investments made by a fund management company (under a discretionary investment mandate) or as a result of bad investment advice given by a fund management company (under a non-discretionary investment mandate). The fund management company’s negligence may be in respect of its conduct (action or lack of action) or by its misstatement. The fund management company’s alleged negligence resulting in financial loss would result in the investor seeking damages for a breach of tort.
2 Elements of the Tort of Negligence
To successfully make out a case in negligence, the plaintiff (investor) needs to prove:
• that the defendant (fund management company) owed the investor a legal duty of care
• that the fund management company failed to meet the standard expected under that duty of care
• that as a result, the investor suffered a loss.
The onus of proving negligence is on the person who asserts it, i.e. the investor.
3.0 Negligent Conduct — the Duty and Standard of Care
A duty of care is an essential element in the tort of negligence, but its existence is not an absolute warranty of success. A fund management company does not guarantee that his or her investment decisions made on behalf of a client are absolutely correct (unless it is done so expressly in a contract — an unlikely event). A negligent breach of the duty of care must be shown.
Actionable negligence is the neglect of the use of ordinary care or skill towards a person to whom a duty of care is owed. This raises the question as to what standard of care is required. In law, the ‘reasonable person’ concept defines the standard. Therefore, if a person professes to be someone with particular skills, the law requires them to show such skill as any ordinary member of the profession to which he or she belongs, or claims to belong, would display.
Professionals such as fund management companies must use reasonable care and skill. In other words, they must not be negligent. Negligence means failure to do some act which a reasonable person in the circumstances would do. But where there is a situation that involves the use of some special skill or competence, the test as to whether there has been negligence or not is the standard of the ordinary skilled person exercising and professing to have that special skill. It may be that performance tables and similar analyses of investment expertise can be helpful in assessing the level of the ‘ordinary skilled person’ who is a professional fund management company.
However, deciding the standard of care that should be observed by a fund management company in a particular situation is not simple — particularly in fast-moving securities markets where investment decisions are often judged with the benefit of hindsight and where no two investor circumstances are precisely similar.
In deciding what standard of care should be observed in a particular situation, it seems that all those facts that would influence the actions of a ‘reasonable’ fund management company should be taken into account. These facts would include the foreseeable consequences of a fund management company’s investment decisions and the impact of those decisions on investors to whom a duty of care was owed. This does not mean that the ‘reasonable person’ should seek to eliminateall the risk of damage.
In observing a duty of care, the following elements should be considered by the ‘reasonable’ fund management company:
• the risks inherent in the conduct
• the seriousness of possible injury
• the opportunities of reducing or avoiding the risk.
We shall return to the steps that the fund management company can take to reduce liability for damage through alleged negligent conduct when we examine the issues of risk management, compliance and due diligence in a later topic. It should be noted at this stage that the standard of care required of a fund management company is a dynamic concept, i.e. that professional standards have a tendency to change to a higher and more exacting standard over time.
4.0 Negligent Misstatement
The law of negligent misstatement is comparatively new, but has been expanded considerably in recent years. In essence, it provides that in some circumstances an honest person who has negligently made a misstatement may be liable to compensate another person for any loss caused by the misstatement.
In the fund management industry, investment advice is given and many reports and statements issued to existing and prospective investors and their advisers. Care must be taken to ensure that statements are not inaccurate as they may be relied upon by an investor. For the purposes of the tort of negligence, a matter of fact or an expression of opinion can amount to a statement. Even silence, combined with circumstances which give that silence significance, can also amount to a statement.
The tort of negligent misstatement covers the situation where injury (for which a person can claim compensation) is financial and is caused by misstatement, not by an act. For example, careless misstatements by a fund management company in relation to a non-discretionary investment client which may induce the trading of securities and result in financial loss, may make the fund management company Liable in tort to the person who suffered the loss.
In Malaysia, a person may be liable for damages as a result of negligent misstatement, not only under the law of tort, but also under statute. (See section 5 below.)
If fraud is involved there will clearly be an action for deceit.
4.1 What are the Preconditions for Liability?
Liability in tort for negligent misstatement can arise only in the following circumstances:
• Where one person owes a duty to another person to exercise care. This can be based on:
– the known or apparent skill and competence of the maker of the statement, or
– the fact that the maker of the statement intends it to operate as a direct inducement to act, i.e. that the maker intends the recipient to rely on the statement.
• The duty of care has been breached, i.e. the maker of the misstatement has been negligent.
• If the statement was not made as an inducement to act, whether it was reasonable for the recipient, nevertheless, to rely on it.
• The person has suffered loss or damage as a result of relying on the misstatement.
4.2 Exclusion Clauses and Disclaimers
In the Hedley Byrne case described in Appendix 1, the bank put a disclaimer on its report. This disclaimer was effective to exclude liability and the claim against the bank failed.
The disclaimer of liability was effective because it destroyed the very thing from which liability was said to flow; an undertaking to apply skill or a holding out of skill, or circumstances arising such that a person would reasonable rely upon the advice given.
A person giving advice may be able to avoid liability if before, or at the time of, giving the advice, the person makes it clear that he or she accepts no responsibility for his or her statement. A disclaimer may be effective for misstatements made negligently, but not ones made dishonestly.
There are some important points to be remembered about disclaimers:
• disclaimers will always be construed strictly against the party trying to rely on them
• the more tightly worded the disclaimer, the more strictly it will be construed. If a disclaimer is very broadly worded it would probably be too general to be effective; if it is very tightly worded so that it covers everything, it could be construed to attack the heart of the relationship between the parties and it may therefore be held to be ineffective. So, an effectively drafted disclaimer would fit somewhere between these extremes.
Where a contractual relationship exists between parties it is possible for them to agree in their contract that neither one will be liable to the other in tort in specified circumstances. There is no reason in principle why liability for negligent misstatement cannot be effectively excluded by a clause in the contract (i.e. an exclusion clause).
5.0 Statutory Liability
5.1 Civil Liability Imposed by Statute
What we have considered so far has been liability for misstatement imposed by common law. Remedies for losses arising from misstatements by licensed persons or any other persons are also available under statute.
Detailed discussions of the provisions about misstatements are discussed later in this course. Liability for misstatement under the Capital Markets and Services Act, the Companies Act, and the specific provisions for misleading recommendations, however, warrant closer examination.
5.2 Capital Markets and Services Act 2007
The Capital Markets and Services Act 2007 (CMSA) contains a number of provisions
which cover liability for misstatement:
• s.177 prohibits the making of a statement or dissemination of information that is false or misleading
• s.178 prohibits a person from improperly inducing another person to deal in Securities
• s.179(c) prohibits a person from making untrue statements or omitting to state a material fact for a purchase or sale of securities s.199 imposes civil liability on a person who contravenes s.177, 178 or 179
If a person suffered a loss or damage as a result of behaviour that would constitute an offence under s.177, 178 or 179, that person could bring an action for compensation under s.199, whether or not the other person has been charged, or whether or not a contravention has been proved.
In addition, civil liability can arise concerning recommendations by licensed persons or any other persons. This is discussed in Section 5.4 below.
5.3 Companies Act 1965
The Companies Act contains certain provisions for which civil rights of action are given to persons who have suffered a loss. These are as follows:
• s.46 gives subscribers or purchasers of shares or debentures who act on the basis of a prospectus, a right of action against the directors, promoters or others authorising the issue of the prospectus, for compensation for loss or damage sustained by reason of any untrue statement or willful non-disclosure of a material matter in the prospectus
• s.364, 364A and 366 also impose criminal liability for false and misleading statements, false reports and fraudulently inducing people to invest money.
5.4 Reasonable Basis and ‘Know Your Client Rule
Sections 91 and 92 of the CMSA, provide that a person may bring a claim against a licensed person, in some circumstances, for loss suffered in reliance upon advice given or nondisclosure of certain information.
Note that a recommendation can be made expressly or by implication.
Liability
Essentially these sections render a licensed person liable to compensate a person if the licensed person:
• Has made a recommendation (whether orally or in writing) and has not disclosed the nature of any relevant interest in, or interest in the acquisition or disposal of, those securities. Such interests include the fees or benefits (e.g. underwriting fees) the licensed person will receive (whether directly or indirectly), other than a commission or fee from the client, arising from giving the advice and that may reasonably be expected to be capable of influencing the licensed person in making the recommendation.
• Makes a securities/futures recommendation to a person who may reasonably be expected to rely on it without having a reasonable basis for making the recommendation and the client in reliance on the recommendation, does, or omits to do, a particular act and suffers loss as a result (see s.92 of the CMSA).
An licensed person will not be regarded as having a reasonable basis for making a securities recommendation unless:
– it has, for the purpose of ascertaining that recommendation is appropriate, taken all practicable measures to ascertain that the information possessed and relied upon by the licensed person concerning the client’s investment objectives, financial situation and particular needs are accurate and complete;
– it has given such consideration to, and conducted such investigation of, the subject matter of the recommendation as may be reasonable in all circumstances; and
– the recommendation made is based on such consideration and investigation.
Defences
It is a defence to a prosecution for contravention of s.91:
– if the person making the recommendation did not know, and could not reasonably have been expected to know, of the interest when making the recommendation (s.91(2))
– if that person was merely a co-director and was not involved in the making of that recommendation (s.91(3)(c))
It is a defence to a contravention of s.91 and 92:
– if a reasonable person in the client’s circumstances could have been expected to have done the act (or omission) in reliance on the recommendation even if the licensed person had complied with s.92
6.0 Summary
We began this topic by considering the tort of negligent misstatement. It is only in recent years that the tort of negligence has been applied by the courts to the written or spoken word of a licensed person.
We traced the development of this tort by considering leading cases. In the securities industry damages for the tort of negligence arise from a misstatement, rather than an action which is negligent, resulting in financial, rather than physical, loss.
We concluded this topic by looking at the additional liability for damages imposed by statute, in particular the CMSA concerning a licensed person who makes a recommendation about securities or futures contracts who may reasonably be expected to rely upon it without having a reasonable basis for making that recommendation.
Appendix 1: Tort of Negligent Misstatement
Development of Law
What follows is a summary of the key cases that have charted the development of the tort of negligent conduct and misstatement. It is interesting to note the way the law, based on the principles set out in Donoghue v. Stevenson, started by moving away from that case and has now come full circle. It is also interesting that some key cases are remembered because the person seeking damages lost: these cases are good examples of how the outcome of a case is less important than the
principles it applies.
Candler v. Crane, Christmas a Co (1951)2 KB 164 (Plaintiff Lost)
Until 1964 the law said that, except in very exceptional circumstances or in cases where there was a contractual relationship, damages could not be recovered for financial injury. The facts in Candler’s case were as follows.
A firm of accountants prepared the financial statements of a limited company, knowing that the documents would be shown to a potential investor. The documents, which did not represent the true state of affairs, were relied on by the investor who suffered financial toss as a result. On appeal the court held that, in the absence of a contract, the firm owed no duty of care to the investor.
Lord Denning, however, disagreed with the rest of the court, saying that a duty of care was owed in tort and not in contract and that there should be no difference between physical damage and financial damage.
Hedley Byrne & Co v. Heller ft Partners Ltd (1964) AC 465 (Plaintiff lost)
The decision of the court of Appeal in Candler’s case was much criticised and in 1964 the House of Lords, in Hedley Byrnes case, approved the dissenting judgement of Lord Denning and unanimously agreed that Candler’s case was Wrongly decided’. The facts of Hedley Byrne’s case were as follows.
Hedley Byrne requested its own bank to enquire through a second bank on the financial stability of a company. The second bank prepared a report upon which Hedley Byrne acted, but lost money as it contained erroneous and. misleading information. The second bank headed its report with the words: ‘For your private use and without responsibility on the part of this bank or its officials’. In view of these words disclaiming liability, the House of Lords held that no duty of care was accepted by the second bank and none arose. Therefore, the claim by Hedley Byrne for damages to compensate for financial loss, resulting from negligent misstatement, failed.
The House of Lords, however, also considered what the legal position would have been had the report not carried a disclaimer and held that, in appropriate circumstances, a duty of care would arise where an innocent, as opposed to a fraudulent, misrepresentation was made; the fact that the sole damage was a financial loss did not affect the question of liability.
The court considered that persons possessed of some special skills, such as doctors. had long been held liable for their negligent acts in tort even when they had not acted for a fee and, therefore, could not be sued in contract. This liability was based on a relationship similar to contract, the basis being either a holding out of the possession of a skill and a willingness to use it or an express or implied undertaking of responsibility. The court ruled that the same principle applied to liability for negligent advice.
Some of the judges in Hedley Byrne formulated a much wider proposition. Where a person was in a position in which others could reasonably rely upon that person’s judgement, skill and ability to give advice and make enquiries, and that person took it upon himself or herself to give advice and allow it to be passed on to others that would rely on it (or who should have known from the circumstances that others would rely on it) a legal duty to use care in giving the advice would arise. Thus the basis of the decision was that a special relationship existed between the parties.
Hence, the House of Lords in the Hedley Byrne decision held that a person giving advice or information could be liable to a third party where it was not unreasonable for that third party to rely on the information or advice. The relevance of this decision in the context of companies and securities law is important as many reports and statements are prepared by professional people for
companies whose securities may be traded on the basis of this information. The decision in the Hedley Byrne case intimated that a duty of care was owed by the provider of the information, not only to the immediate recipient but also to others who might reasonably rely on it.
This decision has been cited with approval in Chin Sin Motor Works Sdn. Bhd. & Anor. v. Arosa Development Sdn. Bhd. a Anor. [1992] 1 MU 235.
Mutual Life a Citizens Assurance Co Ltd v. Evatt (1968)122 CLR 628 (Plaintiff Lost)
In the MLC case, Mr Evatt sought damages against MLC whose officers, in response to his enquiry, had advised him it was safe to invest in a subsidiary of MLC. It failed shortly afterwards and Evatt suffered financial loss.
The court said that it was essential for the person making the statement to have claimed that he or she possessed special skills and competence. The officers of MLC had not expressly professed any special skill or competence nor could any profession or expertise be implied from their position. Mr Evatt’s claim, therefore, failed.
Esso Petroleum v. Mardon [1976] QB 801 (Plaintiff Won)
There may be a duty of care where one person with specialist knowledge or skill makes representations to another by way of advice, information or opinion with the intention of inducing that person to enter into a contract.
This case involved a negligent estimate by Esso concerning the likely throughput of a filling station. The throughput was the subject of a lease agreement for the filling station.
It was held that a court action for negligent misstatement is possible, in addition to action for a breach of a warranty incorporated into the contract between the parties.