Legal issues of making financial forecasts in business

When a business is seeking to raise capital or advertise as being for sale financial forecasts are often made in a way so as to appeal to the target audience – investors or potential buyers.  In some cases however, the forecasts made do not translate into reality giving rise to potential legal consequences.  As forecasts are indicators often relied used by investors to make decisions on whether or not to invest, statements that are incorrect may amount to misleading and deceptive conduct under the Australian Consumer Law (ACL) (being Schedule 2 to the Competition and Consumer Act 2010 (Cth)) and have potentially serious legal consequences.

When making forecasts, it is possible to breach the following sections of the ACL:

• Section 18(1) – “a person must not, in trade or commerce, engage in conduct that is misleading or deceptive or is likely to mislead or deceive”; and
• Section 4 – “misleading representations with respect to future matters”.

In the context of making forecasts, section 4 needs to be considered with particular care.

Misleading representations with respect to future matters

Section 4 of the ACL provides:

“Misleading representations with respect to future matters

(1)  If:

(a)    a person makes a representation with respect to any future matter (including the doing of, or the refusing to do, any act); and

(b)    the person does not have reasonable grounds for making the representation;

(c)    the representation is taken, for the purposes of this Schedule, to be misleading.

(2)  For the purposes of applying subsection (1) in relation to a proceeding concerning a representation made with respect to a future matter by:

(a)     a party to the proceeding; or

(b)     any other person;

 the party or other person is taken not to have had reasonable grounds for making the representation, unless evidence is adduced to the contrary. “

To ascertain whether a representation is in regard to a future matter under section 4, you will need to consider:

• the terms of the representation;
• its context;
• whether the speaker has stated the grounds for making it; and
• whether the person making the statement has any control over the predicted event.

When will forecasts be misleading?

In determining whether forecasts are misleading, it is necessary to focus on the level of care taken by the maker of the statement.  In relation to forecasts:

• a representation is taken to be misleading if the maker does not have reasonable grounds for making it (at the time that is was made); and
• the maker is taken not to have had reasonable grounds unless contrary evidence is adduced.

In Awad v Twin Creek Properties Pty Ltd [2012] NSWCA 200, (Awad) Mr and Mrs Awad claimed they had purchased a residential property lot based on the representations made by Twin Creek Properties (Company).  The trial judge found in favour of the Awad’s, stating that while the Company had reasonable grounds for making statements regarding the number and size of the lot, they did not have reasonable grounds for stating the development would include a Peppers Resort.  This was on the basis that the Company could not adduce evidence that they had financial capacity to build the resort.  However, on cross-appeal, the Court of Appeal found in favour of the Company, stating that the trial judge had made errors relating to the sufficiency of the evidence tendered by the Company.

The burden of proving that the representation in the forecast was reasonable

One of principles from Awad is that if a party makes a representation, it will have the burden of showing and must plead that it had reasonable grounds for making it.  This followed the statement by French J in Western Australia v Bond Corp Holdings Ltd [1990] FCA 522 that there ‘is an obligation on a defendant to plead that it had reasonable grounds [to make the representation], and what those grounds were’.

In Awad, the Company did not plead to the reasonableness of any assumptions and it gave no particulars of any grounds which it claimed justified the making of the representations given by the Company.

In cases where statements are made about the future profitability of a business and that leading professionals had been retained to perform the assessment may be sufficient to absolve the maker of the statement from liability (see for example: Citrus Queensland Pty Ltd v Sunstate Orchards Pty Ltd (No 7) [2008] FCA 1364)).  In a proposed investment, the obtaining of professional assistance with the preparations of the forecasts would be expected.

Therefore, to “safely” make forecasts, the maker would be advised to keep records of the basis that forecasts were made and to keep those records should they later be required as evidence.  In addition, the maker of the statements must not be put on notice that any of the assumptions are incorrect.

Earnings forecasts

Forecasts are by their nature statements about future matters.  The question is whether the maker of the representation has “reasonable grounds” to make the forecast.

What are reasonable grounds?

Section 4 of the ACL states that if the maker does not have reasonable grounds to make a representation as to a future matter, the representation is taken to be misleading.  This does not mean that any forecast that does not turn out to realised will necessarily be misleading and deceptive, but rather whether, in the circumstances, there were “reasonable grounds” to make the statement.

For example, in Global Sportsman Pty Ltd v Mirror Newspapers Ltd (1984) 2 FCR 82, the Court stated:

“that a prediction proves inaccurate does not of itself establish that the maker of the prediction did not believe that it would eventuate or that the belief lacked any, or any adequate, foundation.”

Factors suggesting “reasonable grounds”

What are “reasonable grounds” will depend on the level of care on the maker of the representation.  For example, if a prediction is made by a professional it may convey to the recipient that the opinion is honestly held on rational grounds and involves the requisite expertise.  In Awad, it was stated that in relation to future predictions the ‘broader and more expansive the representation, the wider the responsibility for proof’.

At what point in time are “reasonable grounds” to be determined?

Whether a person had “reasonable grounds” to make a statement is determined at the time the statement is made and with the information available and relied upon at that time.  While in some circumstances, subsequent events may reveal the likelihood of a prediction occurring, as in Auswest Timbers Pty Ltd v Secretary to the Department of Sustainability and the Environment [2010] VSC 389, the Courts have warned against the dangers of hindsight (see for example McGrath v Aust Naturalcare Products Pty Ltd [2008] FCAFC 2 [148]).

In circumstances representations are made with disregard for their accuracy or where conflicting information is known, this this will be a strong ground against the reasonableness of the representation.

Expertise or professional forecasts

If the maker of a statement holds particular expertise or particular skill then they will generally be held to the level of accountability within that professional industry (see for example: Caffey v Leatt-Hayter [No.3] [2013] WASC 348).

Professionals who are engaged to make forecasts generally do so with the benefit of a professional association and the respective Australian Accounting Standard as a basis for example.  Therefore some forecasts can be somewhat conservative.  Notwithstanding their nature the basis of preparation and the assumptions on which they are made will clearly communicated.

Reliance on third party expertise

In a lot of cases forecast in relation to the profitability of a business may be prepared by accountants and business advisors who may specialise in preparing such documents.  Provided professionals had been retained and a person has no reason to doubt the competency of the expert then it may be adequate to rely on their forecast.  When relaying on information from a third party it is important to consider the relationship with that party, the reliability of the person making the statement any methods used to test their veracity.  Furthermore, information of a third party must always be relayed to a recipient accurately and fairly.

Sophisticated parties

Sophisticated parties in an investment with expertise in business may have reasonable grounds to make a forecast.  If forecasts or predictions are made within the context of the investment, you need to ensure that you have:

• reasonable grounds for making the forecasts;
• that you have taken reasonable care in preparing them;
• that you include a list of the assumptions which are used to develop the forecasts; and
• that you can prove that the basis for making them was accurate at the time the forecasts were made.

Takeaways

Any party involved in an investment or sale process, whether that be a capital raising or sale of a business itself, will need to ensure that it has a reasonable basis for making any representations it makes.  As any potential investors/purchasers will be relying on the representations made by the business, it is important that the representations are only made after a genuine belief is held that they are as accurate as can be.  Failure to take the necessary steps to found a genuine belief that there are reasonable grounds for making the statement can leave the maker of the statements open to litigation and costly damages.

Links and further references

Legislation

Australian Consumer Law

Competition and Consumer Act 2010 (Cth)

Cases

Awad v Twin Creek Properties Pty Ltd [2012] NSWCA 200

Auswest Timbers Pty Ltd v Secretary to the Department of Sustainability and the Environment [2010] VSC 389

Caffey v Leatt-Hayter [No.3] [2013] WASC 348

De Costi Seafoods (Franchises) Pty Limited and Anor v Wachtenheim and Anor (No 3) [2013] NSWDC 54 (3 May 2013

Global Sportsman Pty Ltd v Mirror Newspapers Ltd

McGrath v Aust Naturalcare Products Pty Ltd [2008] FCAFC 2 [148]

McPhillips v Ampol Petroleum (Vic) Pty Ltd

Further information about mergers and acquisition

If you need advice on how to ensure that your forecasts are reasonable or if you need to defend them, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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