Liability for Opinions – Omnicare

Putting Omnicare v Laborers District Counsel in Historical Perspective

Omnicare, Inc., et al. v. Laborers District Council Construction Industry Pension Fund et al. Argued November 3, 2014—Decided March 24, 2015

Copy of Decision: 1503-Omnicare

Overview

The author is a Certified Fraud Examiner and is critical of the common law involving fraud and deceit. Too often the common law allows the taking of money from victims through hyper-technical defenses and faulty logic. Most of this comes from the lack of sympathy the judges have shown for the fraud victim through the history of the development of the law of misrepresentation. One example is the liability for opinions expressed in contrast to facts expressed. The general common law allows the person who takes money through a false expression of opinion to keep the money if speaker believed her opinion. Omnicare, in the context of a registration statement, moves the law in a positive direction by creating liability for a factual omission imbedded in the opinion that would be necessary to correct a false impression.

Even though the Supreme Court did not delve in the history of the law, the 2015 Omnicare decision moved the court in a positive direction. The law on opinion testimony as fraudulent may be traced to the 1889 House of Lords decision of Derry v. Peek.¹Derry v. Peek, (1889) L.R. 14 App. Cas. 337 (House of Lords) which limited liability for misrepresentation to fact patterns involving scienter. Derry excluded from the definition of “scienter” misrepresentation made with an honest belief that the fact represented was true. Although Derry was seemingly accepted be most United States courts and was adopted by the Restatement of Torts, “some . . . rejected the rule of Derry v. Peek or never really accepted the holding of that case despite some judicial language seemingly to the contrary”.² Restatement (Second) of Torts, § 552C, “Comment on Subsection (1)” The Derry holding caused injustice in many situations and resulted in the development of different causes of action for misrepresentation on seemingly separate legal tangents.

To recover for losses due to misrepresentations causing pecuniary harm,³If physical harm results, other rules apply. See Restatement (Second) of Torts (St. Paul, MN: American Law Institute Publishers, 1977), §§ 310, 311. the plaintiff has access to at least four non-statutory common law tort theories of recovery⁴Breach of warranty is also available under contract law and is subject to contract law defenses. (E.g. Restatement (Second) of Contracts (St. Paul, MN: American Law Institute Publishers, 1981), §§ 304, 306). It is outside the scope of this paper which deals with tort and near tort remedies. In cases involving the sale of goods under Article 2 of the Uniform Commercial Code, most fact patterns actionable under the tort of Innocent Misrepresentation would also be actionable under the Code on the theory of breach of warranty. Unlike Innocent Misrepresentation, the measure of damages for breach of warranty includes compensation for benefit of the bargain and for consequential losses. Innocent Misrepresentation has the advantage of not being subject to Code defenses such as the parol evidence rule. 1) Restitution;⁵E.g. Restatement of Restitution (St. Paul, MN: American Law Institute Publishers, 1937), §§ 6, 8 2) Fraud (Deceit);⁶ E.g. Restatement (Second) of Torts, §§ 525-548A. 3) Negligent Misrepresentation;⁷E.g. Id. §§ 552 – 552B and 4) Innocent Misrepresentation.⁸E.g. Id. § 552C

The Supreme Court in Omnicare accepted Derry’s good faith exception (without mentioning Derry or its reasoning) but improved the odds of a misled investor recovering. The Court provided a reasonable opportunity for recovery for the investor who could prove a factual omission that would correct a misleading opinion.

The Omnicare case was brought by a pension fund (a “professional investor”) complaining of an opinion in the Omnicare prospectus that it had complied with all laws. However Omnicare received kickbacks from drug manufactures and was later successfully sued by the Federal Government. The prospectus made the following disclosure about the kickbacks:

“We believe our contract arrangements with other healthcare providers, our pharmaceutical suppliers and our pharmacy practices are in compliance with applicable federal and state laws.”

“We believe that our contracts with pharmaceutical manufacturers are legally and economically valid arrangements that bring value to the healthcare system and the patients that we serve.”

“Accompanying those legal opinions were some caveats. On the same page as the first statement above, Omnicare mentioned several state-initiated “enforcement actions against pharmaceutical manufacturers” for offering pay­ments to pharmacies that dispensed their products; it then cautioned that the laws relating to that practice might “be interpreted in the future in a manner inconsistent with our interpretation and application.” Id., at 96. And adja­cent to the second statement, Omnicare noted that the Federal Government had expressed “significant concerns” about some manufacturers’ rebates to pharmacies and warned that business might suffer “if these price conces­sions were no longer provided.” Id., at 136–137.”⁹Omnicare at 3

No disclosure of the basis for the belief expressed by the opinion was given.¹⁰The author believes this is a material omission

The Omnicare decision was made in two steps. First, the court analyzed whether a material misstatement was made and second, the court considered was a material omission occurred. The court held that the opinion was not a misstatement if Omnicare sincerely believed it.¹¹The court held that Omnicare made a “pure” statement of opinion and distinguished statements of opinion combined with a statement of fact. E.g. “I believe our TVs have the highest resolution available because we use a patented technology to which our competitors do not have access.” Omnicare at 8 Even if the pure opinion was proven later to be false, it was not a misstatement (but could contain an omission).¹²“. . . as we have shown, a sincere statement of pure opinion is not an “untrue statement of material fact,” regardless whether an investor can ultimately prove the belief wrong. That clause, limited as it is to factual statements, does not allow investors to second-guess inherently subjective and uncertain assessments. In other words, the provision is not, as the Court of Appeals and the Funds would have it, an invitation to Monday morning quarterback an issuer’s opinions.” Omnicare at 9

The court argued that a reasonable investor could believe that the opinion implied some sort of reasonable investigation. Unfortunately the example chosen by the court is erroneous: For example the statement “we believe our conduct is lawful” implies that a lawyer has been consulted. “If the issuer makes that statement without having consulted a lawyer, it could be misleadingly incomplete.”¹³Omnicare at 12 The investor is entitled to expect that the opinion fairly aligns with the information the company has at the time.¹⁴Id.

The court held that “a reasonable investor generally considers the specificity of an opinion statement in making inferences about its basis. Compare two new statements from our ever-voluble CEO. In the first, she says: ‘I believe we have 1.3 million TVs in our warehouse.’ In the second, she says: ‘I believe we have enough supply on hand to meet demand.’ All else equal, a reasonable person would think that a more detailed investigation lay behind the former statement.”¹⁵Omnicare at 13-14 It is hard to understand the court’s reasoning here. The first statement is based on the corporation’s computerized inventory report and would take no investigation. The second would be based on a market study of future demand and require detailed surveys of all markets where the product is sold. Clearly the court erred in its choice of examples for the legal principle that “the reasonable investor generally considers the specificity of an opinion statement in making inferences about its basis.”

The court cites with approval the common law concept that “When “the facts are not equally known to both sides, then a statement of opinion by the one who knows the facts best . . . impliedly states that [the speaker] knows facts which justify his opinion”.¹⁶Omnicare at 15

Omnicare’s holding on omissions can be summarized by this quote:

And the purpose of §11 supports this understanding of how the omissions clause maps onto opinion statements. Congress adopted §11 to ensure that issuers “tell[ ] the whole truth” to investors. H. R. Rep. No. 85, 73d Cong.,1st Sess., 2 (1933) (quoting President Roosevelt’s message to Congress). For that reason, literal accuracy is not enough: An issuer must as well desist from misleading investors by saying one thing and holding back another. Omnicare would nullify that statutory requirement for all sentences starting with the phrases “we believe” or “we think.” But those magic words can preface nearly any conclusion, and the resulting statements, as we have shown, remain perfectly capable of misleading investors.¹⁷Omnicare at 16

The Omnicare decision is unusual for the Supreme Court because there were no dissenting opinions, just two concurring opinions. Justice Scalia does not think there is anything special about statements of opinion in a prospectus. He criticizes the court for almost reversing the common law rule: “The Court holds that a reasonable investor is right to expect a reasonable basis for all opinions in registration statements—for example, the conduct of a “meaningful . . . inquiry,”—unless that is sufficiently disclaimed.”¹⁸Scalia, Omnicare at 3 “It seems to me strange to suggest that a statement of opinion as generic as “we believe our conduct is lawful” conveys the implied assertion of fact “we have conducted a meaningful legal investigation before espousing this opinion.”¹⁹Scalia, Omnicare at 3 Scalia aligns himself with the generations of common law judges who had little sympathy for victims of fraud and misrepresentation. Scalia would allow the taking of their money with little legal protection. “Caveat emptor baby!”

The other concurring opinion was filed by Justice Thomas. He criticized the majority for reaching the omission issue on technical grounds. His view can be summarized as preferring legal technicalities that keep expensive litigation going over expedited access to justice.

In my opinion, the Omnicare court should have gone farther. Prospectuses are written by a team of lawyers and investment bankers who are paid to put the best image on the company within current case law. They are hired to make full disclosure. If the lawyers want to put an opinion in a prospectus, they should be required to disclose the basis for the opinion and disclose opposing opinions. The Supreme Court did not consider this line of reasoning and may have implicitly rejected it.²⁰“An opinion statement, however, is not necessarily mis­leading when an issuer knows, but fails to disclose, some fact cutting the other way. Reasonable investors under­stand that opinions sometimes rest on a weighing of com­peting facts; indeed, the presence of such facts is one reason why an issuer may frame a statement as an opin­ion, thus conveying uncertainty. See supra, at 6–7, 11. Suppose, for example, that in stating an opinion about legal compliance, the issuer did not disclose that a single junior attorney expressed doubts about a practice’s legality, when six of his more senior colleagues gave a stamp of approval. That omission would not make the statement of opinion misleading, even if the minority position ultimately proved correct: A reasonable investor does not expect that every fact known to an issuer supports its opinion statement.” Omnicare at 13.

Some Historical Perspective of How We Arrived at Omnicare

 

The Common Law Developed Remedies Over Time.

The English common law originated from a feudal society. Each lord has his own court. The king had his court. The corporations (churches, cities, and universities at the time) had their own courts. The courts tended to be parochial and each freeman wanted to be tried in his home court (the court of his lord). There was no appeal of a court’s decision in the modern sense. Rather a disappointed litigant asked a more powerful noble’s court to interfere.²¹ F. W. Maitland, The Forms of Action at Common Law (Cambridge: University Press, 1968), 11

Legal actions and suits were initiated by the purchase of a writ. With many courts came many writs, each rewarding its issuer with a fee. There was a financial incentive for the development of additional writs by the courts. Writs in courts of law were classified as real, personal, and mixed.

As time went by, the number of courts was also reduced and the power centralized primarily (for the purposes of this paper) into two courts that answered to the king; the courts of law and the Chancery. The primary cause was the king’s writs were more powerful and drew away business from the other courts.²²Maitland, Forms of Action, 9 The Chancery did not have the limitation on the number of types of writs it could issue as the law courts did. The Statute of Westminster II of 1285 expressly provided:

And whensoever from henceforth it shall fortune in the Chancery, that in one case a writ is found, and in like cases falling under like law, and requiring like remedy, is found none, the clerks of the Chancery shall agree in making the writ; or adjourn the plaintiffs until the next Parliament, and let the cases be written in which they cannot agree, and let them refer them until the next Parliament, and by consent of men learned in the law, a writ shall be made, lest it might happen after that the court should long time fail to minister justice unto complainants.²³Id. at 41

Little use of this statutory power was made until the end of the Middle Ages. Around this time lawyers begin using a writ called “Trespass upon the special case” which becomes known simply as “Case”. Several specialized writs developed as branches off Case including Assumpsit, Trover, Deceit, and Action on the Case for words (slander and libel).²⁴Id. at 41-42

The personal writs were combined by the Uniformity of Process Act of 1832 which required the 9 personal actions (Debt, Detinue, Covenant, Account, Trespass, Case, Trover, Assumpsit, and Replevin) to use a single writ. In the Real Property Limitations Act of 1833, Parliament reduced 60 named writs to 5.²⁵Id. at 6 Each writ has it particular idiosyncrasies. Initially substantive law was developed through legal procedure.²⁶“So great is the ascendancy of the Law of Actions in the infancy of Courts of Justice, that substantive law has at first the look of being gradually secrete in the interstices of procedure”. Id. at 1. As each evolved over time, separate causes of action developed that had no need to reconcile conflicting legal theories with one another. Eventually law and equity merged leading to scholarly attempts at reconciliation of the voluminous legal theories embedded in the writs.

In the United States, the Restatement of Laws, a project of the American Law Institute, began in the early part of the 20^th Century to lead the reconciliation attempts. The stated objective of the Restatement was to avoid “the abandonment of our common law system of expressing and developing law through judicial applications of existing rules to new fact combinations and the adoption in its place of rigid legislative codes”.²⁷Restatement of the Law of Torts, Volume II (St. Paul, MN: American Law Institute Publishers, 1934), ix In 1938, the Restatement (First) of Torts was published. It grouped all misrepresentations in business transactions together in Chapter 22 and placed the writ of Deceit in Division 4 under Fraudulent Misrepresentation.

The cause of action of Deceit narrowed its focus and increased it limitations over time.

The Writ of Deceit (Breve de Deceptione) has been in English law for over 800 years.²⁸ It was known in the time of King John around 1201. See Thomas Atkins Street, The Foundations of Legal Liability, Volume 1, Theory and Principles of Tort (New York: Edward Thompson Company, 1906), 375, citing Frederick Pollock and Frederic William Maitland, The History of English Law, Second Edition, Volume 2 (Cambridge University Press, 1898), 535 and Select Civil Pleas, pl. III It originally dealt with subversion of legal process such as obtaining a default judgment without service of process.²⁹ The first mention of “deceit” in Westlaw database UK-RPT-ALL is an anonymous case from 1422. A default judgment was entered because the sheriff did not serve the summons and land was lost. The parties to the case died and it appears the one year period to set aside a default has expired. Therefore the writ of deceit was no longer available. The remedy was to recover the value of the land from the sheriff for a false return of service. Anonymous, 145 E.R. 20 (Court of Exchequer, 1422). Over time the Writ of Deceit was completely incorporated into the action on the case in the nature of deceit. The cause of action was broad by modern standards. It included breach of legal ethics and legal malpractice (legal counsel colluding with opposing counsel or failing to appear at trial).³⁰ Street, Thomas Atkins, The Foundations of Legal Liability, Volume 1, Theory and Principles of Tort. New York: Edward Thompson Company, 1906, 376 If a person falsely claimed skill at shoeing horses and lamed the horse, an action was brought in case for deceit. If a farrier (specialist in horse hoof care) failed to cure an injured horse and the horse died, the farrier could be guilty of deceit. The cause of action also included malicious prosecution and abuse of legal process. It also included cheating at cards, use of forged documents, wrongfully acquiring money or property, seducing a woman while claiming to be unmarried, and pretending to be interested in marriage to obtain expensive gifts.³¹Id. Citations op. cit

With this history, one might expect the law of fraud to be friendly to change and flexible in its elements. Instead, over time its coverage narrowed. The law of deceit combined what is now three separate legal theories of liability 1) delictual³²Delictual liability is liability resulting from an action or failure to act as contrasted with a contractual violation. It is probably synonymous with “tortious”. See e.g. Joe Thompson, Delictual Liability, Fourth Edition (Glasgow: Tottel Publishing, 2009) on Scottish delictual law. liability for fraud; 2) delictual liability for false warranty; and 3) liability for breach of express or implied contractual warranty. Originally the law dealt with each theory similarly but eventually distinguished them. In a 1367 case, the defendant stole beef cattle and sold them. He did not give any warranty of title. The rightful owner recovered the cattle from the purchaser after payment. The court held that the purchaser could maintain an action in the nature of deceit for this fraud (fauxime) because the seller knew he did not have title to the cattle. In 1383, the plaintiff purchaser was allowed to use the Writ “Action on the Case in the Nature of an Action of Deceit” against a seller who made a false warranty.³³Street, Id. at 377-378. Citations omitted. Almost three hundred years later the common law narrowed the scope of Deceit by holding an express warranty was required for an action on the case involving allegedly counterfeit jewels.³⁴“If one sells clothes [e.g.], and doth warrant them to be so long, and they are not, an action on the case lies; but there ought to be an express warranty, and that ought to be made at the time of the sale, or else no action lies”. Southern v How, 123 E.R. 1248 (Court of Common Pleas, 1615), 1249. The law began to understand warranty as part of the law of contract and distanced it from other “deceits”.

In 1778, James Wilkins paid a large price for a mare which the seller David Stuart warranted was sound. The mare had windgalls and was not sound. The case was brought in assumpsit (contract) rather than deceit.³⁵ Stuart v Wilkins, 99 E.R. 15 (Court of King’s Bench, 1778). The court approved the use of assumpsit and explained the legal distinctions applicable at that time. If the seller knows of a latent defect, there is an implied warranty (perhaps actionable in assumpsit). If the seller does not know of the latent defect, there is only a cause of action if there is an express warranty. If the defect is not latent, the seller is not liable because the buy should use his senses to discovery the unsoundness. The law of warranty was moving in a different trajectory than the law of deceit.

The law of Deceit separated completed the separation from contract law with the rejection of the requirement of privity.

The modern law of Deceit was born in Pasley and Another v Freeman³⁶100 E.R. 450 (Court of King’s Bench, 1789) which further separated the law of contract from the law of deceit with the elimination of the requirement of privity of contract for an action in deceit. It is perhaps the first action on an opinion but the court did not distinguish fact from opinion.

In this action on the case in the nature of a writ of deceit, Defendant Freeman told Plaintiff Pasley that the buyer, John Christopher Falch, had good credit and could be trusted to pay for goods sold on credit. Believing the Defendant, Plaintiff Pasley delivered the goods and discovered that Falch had no money and could not pay for them. The court defined the issue as the “question is, whether an action thus founded can be sustained in a Court of Law” rather than a court of equity.³⁷Id at 452. Comment by Judge Buller

Judge Buller, arguing for the majority, held that it should not be a defense that the fraud was committed to benefit a third party. “The gist of the action is fraud and deceit, and if that fraud and deceit can be fixed by evidence on one who had no interest in his iniquity, it proves his malice to be the greater. . . . And if a man will wickedly assert that which he knows to be false, and thereby draws his neighbour into a heavy loss, even though it be under the specious pretence of serving his friend, I say ausis talibus istis non jura subserviunt.”³⁸“The laws are not here to serve such bold ventures.” This “wicked assertion” concept became known as “scienter”.

Judge Grose dissented arguing “this action is as novel in principle as it is in precedent, that it is against the principles to be collected from analogous cases, and consequently that it cannot be maintained”.³⁹Id at 452. He objected to the lack of privity and the risk of a great increase of litigation. This case was “brought for the first time for a supposed injury, which has been daily committed for centuries past; for I believe there has been no time when men have not been constantly damnified by the fraudulent misrepresentations of others: and if such an action would have lain, there certainly has been, and will be, a plentiful source of litigation, of which the public are not hitherto aware”.⁴⁰ Id. at 451 This is a rare instance that a judge explained his reason for narrowing liability for deceit was to prevent litigation. There was just too much fraud for the courts. It stands to reason that this reason, though unstated, colored later decisions. It was left to future courts to limit these cases by distinguishing “fact” from “opinion”.

Pasley separated deceit from contract warranty fact patterns. From 1789 forward, an action on the case in the nature of deceit was recognized as a tort.⁴¹See Prosser, William, W. Page Keeton, ed., Prosser and Keeton on the Law of Torts, 5^th ed. Minneapolis: West Publishing Company, 1984, 728 As pointed out above, it took many years for the writers of treatises to turn Torts into a separate area of law by identifying causes of actions (like Deceit) that were recognized as separate torts.)) Damages for breach of implied or express warranty in assumpsit were benefit of the bargain. Damages for deceit were out of pocket losses.⁴² Modern courts often are confused on the right measure of damages confusing the assumpsit (contract) rule with deceit (tort). See Prosser at 728 Fearful of opening the floodgates of litigation, the court limited the action at law for deceit to situations where there was intentional misrepresentation.

Derry v. Peek narrowed the scope of deceit to intentional and reckless misrepresentations with its definition of scienter.

The key element of the cause of action of Deceit distinguishing it from other causes of action available for combating financial fraud is scienter.⁴³Some might argue that the requirement of intent distinguishes fraud from negligent misrepresentation. However the cases blur the line. Sometimes repeating a fact that one does not know whether to be true or not is ruled an intentional misrepresentation with scienter. When a court wants to hold a defendant guilty of deceit, courts have found recklessness under fact patterns most would call negligent. The 1889 House of Lords decision in Derry v. Peek became the justification for the modern law good faith exemption to scienter which was adopted by both the First and Second Restatement of Torts § 526. In this pericope, it will be discussed in depth, starting with the lower court decision in 1888.⁴⁴ (1888) L.R. 37 Ch. D. 541

Sir Henry Peek brought an action for deceit for misrepresentation in a prospectus issued in 1882. The defendants were Mr. W. Derry, the Chairman of the Board of Plymouth, Devonport and District Tramways Company, and its four other directors. At least four of the directors were paid £500⁴⁵£500 is £39,300 in today’s currency using retail price index and £213,000 using average earnings (from measuringworth.com) each by the company’s promoter, a clear violation of law.⁴⁶“[I]t is to be regretted that four gentlemen of mature age, of business experience, versed in the ways of the world, and occupying, all of them, positions of confidence, and some of them positions of dignity, should have permitted themselves to act as they did with reference to the sums they received from the promoters of this company; in the year 1882 above all, when the impropriety of directors accepting sums of money from promoters whom they were bound to watch in the interests of those shareholders whom it was their duty to protect, had become well-known by a series of decisions of this Court”. Id. at 555-556. They paid back the money prior to trial.⁴⁷Id. at 545. The inference was that the promoters had prepared the prospectus through solicitors and the directors were mere puppets.⁴⁸ Id. at 555.

The purpose of the company was to build a steam tramway between Plymouth and Devonport, passing through Stonehouse. The October 1882, prospectus section entitled in bold print “Incorporated by special Act of Parliament 45 & 46 Vict. authorizing the use of steam or other mechanical motive power” included the following paragraphs:

“One great feature of this undertaking, to which considerable importance should be attached, is, that by the special Act of Parliament obtained, the company has the right to use steam or mechanical motive power instead of horses, and it is fully expected that by means of this a considerable saving will result in the working expenses of the line, as compared with other tramways worked by horses.”

“Looking to the exceptional advantages offered by this undertaking, from the dense population of the towns it traverses, the unusually favourable conditions as to motive power open to the company, and the annual dividends earned by other companies which do not enjoy such special privileges, the directors have reason to believe that the enterprise will prove highly remunerative, and the shares now for subscription offer a very favourable opportunity for a sound and progressive investment.”⁴⁹ Id. at 543. Emphasis added. The first paragraph was partly in capital letters. Id. at 552.

These paragraphs were false. The use of steam power was subject to the approval of two corporations (Plymouth and Devonport) and a public agency, the Board of Trade. Approval was not obtained in part because of safety issues with some narrow streets and steep inclines. Peek bought £4,000⁵⁰£4,000 is £314,000 in today’s currency using retail price index and £1,710,000 using average earnings (from measuringworth.com). of stock. By the time of trial the company had been wound up and the stock was nearly worthless.

The directors defended the case on the theory of lack of reasonable reliance, honest belief in the truth of the statement, reliance on counsel, negligence on Peek’s part, and subsequent waiver of the claim by praising the directors at a shareholders’ meeting.

The practical aspects of the case made it difficult for the court. The defendants were men of standing in London and may have been members of the same clubs as some of the Justices. The defendants did not put any of the plaintiff’s money in their own pockets. The only benefited indirectly by funding the company. They gained the chance to become richer if the company was successful. If they were liable to the plaintiff, they may be financially ruined because of the large sum of money involved. A decision to impose liability would be very unpopular with the business community in London.

Both the trial and the appellate courts struggled with the type guilty knowledge required to prove Deceit. The trial judge found that the statement in the prospectus was “not an accurate statement of the legal position of the company”. If the action had been for rescission of a contract, the trial judge stated he would probably have held for the plaintiff.⁵¹Id. The Omnicare court was dealing with a rescission claim but made no distinction between rescission cases and cases where damages must be proven to have been caused by the defendant. Innocent misrepresentation was clearly sufficient to set aside a contract under established law.⁵²The original complaint included a count of contract rescission against the Company but was voluntarily withdrawn due to the insolvency of the Company. There was no privity of contract with the directors so no rescission action could have been brought. However, since the action was in Deceit, intentional fraud must be proven. “If a man makes a statement knowing it to be untrue, and believing it not to be true, there is no question that it is a fraud. If he makes a positive assertion without having any belief on the subject one way or the other, that is also fraud”. Fraud could also be found a third way: “if [a defendant] has made statements which in fact are untrue, recklessly; that is, without any reasonable grounds for believing them to be true, or under circumstances which shew that he was careless, whether they were in fact true or false.”⁵³Id. at 544 The trial court found the directors had reasoned that even though the prospectus may be wrong “as a matter of law, . . . as a matter of business [it was] . . . perfectly correct. The consent of the two corporations were practically done and there was no question the Board of Trade would approve.⁵⁴Id. at 557 This did not amount to fraud:

Now, in my judgment, having seen the directors and come to the conclusion that they did, every one of them, believe that they had the right stated in the prospectus, am I to say that their belief was so unreasonable, and so unfounded, and their proceedings so reckless or careless that they ought to be fixed with the consequences of deceit? In my judgment I think not. Mercantile men dealing with matters of business would be the first to cry out if I extended the notion of deceit into what is honestly done in the belief that these things would come about, and when they did not come about make them liable in an action of fraud. I cannot, therefore, under these circumstances, come to the conclusion that this was fraudulent in any sense which would render these Defendants liable to an action for deceit.⁵⁵Id. at 558

On appeal three judges wrote opinions. Justice Cotton opined that the good faith belief that the consents would be granted “does not make true that statement which in fact they made . . .”.⁵⁶Id. at 573 He held the defendants liable. “It is not that I attribute to them any intention to commit fraud, but they have made a statement which was incorrect, to induce the Plaintiff to act upon it without any sufficient reason for making that statement, without any sufficient reason for believing it to be true. Therefore they are liable”.⁵⁷Id. at 578

Justice Sir J. Hannen argued that fraud need not imply great moral turpitude:

But I must venture to express my opinion that the expression “legal fraud,” which has been in constant use by Judges for very many years, is, to say the least, an exceedingly convenient expression; that is to say, it is an expression which very clearly conveys an idea, which is the object of language, and it appears to me to mean this: that degree of moral culpability in the statement of an untruth to induce another to alter his position, to which the law attaches responsibility. And that is, as I think, where a man makes an untrue statement for the purpose mentioned without reasonable cause for believing it to be true. No doubt the word “fraud” is in common parlance reserved for actions of great turpitude, but the law applies it to lesser breaches of moral duty; and it appears to me the making of any statement upon which others are intended to act without reasonable ground for stating it, and without reasonable ground for believing it to be true, is a breach of moral duty, though it may not be one of such dark complexion as to blast the character of the man forever who does it. It is not necessary that there should be that amount of wrong in order to give a legal remedy.⁵⁸Id. at 582

Justice Hannen did not accept that making false statements in good faith was not “legal fraud”. If good faith were a defense, it “would lead to very dangerous consequences, for then persons in the position of the Defendants would be at liberty to deceive others to the extent that they could succeed in deceiving themselves”.⁵⁹Id. at 583. This is precisely the problem faced in Omnicare. It was partly resolved by adding a duty of reasonable investigation to the statutory requirement that there be no material omissions. Justice Hannen also did not accept the business fact versus legal fact distinction:

It appears to me that nothing can morally justify a man in stating a thing as a fact, as existing at present, because he expects that it will exist in the future. And when Mr. Justice Stirling says that mercantile men dealing with matters of business would be the first to cry out if he extended the notion of deceit into what is honestly done in the belief that these things would come about, I can only say that there are two classes of mercantile men. There are those who have lax notions of the duty of taking care to be accurate, and those who are scrupulously careful to observe this duty; and it is the opinion of the latter class to which I attach most importance.⁶⁰Id. at 584

Justice Lopes believed that the law required moral fault:

This is an action of deceit. It is true that there are different degrees of moral delinquency, but I know of no fraud which will support an action of deceit to which some moral delinquency does not belong. An action for deceit will not lie for an innocent misrepresentation, for such misrepresentation is not fraudulent. On the other hand, a slight degree of what I will call moral obliquity will suffice to render a misrepresentation fraudulent in contemplation of law. And let me say this is what I understand by the expression which is so often used in the authorities, and which has been referred to by Sir James Hannen, I mean the expression “legal fraud”. I will endeavour shortly to state what I believe to be the result of the cases. The law I venture to say is well settled and well understood. I think the result of the cases amounts to this. If a person makes to another a material and definite statement of a fact which is false, intending that person to rely upon it, and he does rely upon it and is thereby damaged, then the person making the statement is liable to make compensation to the person to whom it is made—first, if it is false to the knowledge of the person making it; secondly, if it is untrue in fact and not believed to be true by the person making it; thirdly, if it is untrue in fact and is made recklessly, for instance without any knowledge on the subject, and without taking the trouble to ascertain if it is true or false; fourthly, if it is untrue in fact but believed to be true, but without any reasonable grounds for such belief. I believe that to be a fair statement of what the result of the cases is.

The case was appealed to the House of Lords⁶¹Derry v. Peek, (1889) L.R. 14 App. Cas. 337 (House of Lords). who reversed the Court of Appeal and adopted the trial court’s decision. Five Lords heard the case. Lord Herschell’s decision is the most important because it was adopted by the Restatement (Second) of Torts (1977).⁶² See Reporter’s Notes to § 526: “This Section adopts, in general effect, the opinion of Lord Herschell in Derry v. Peek, 14 A.C. 337, 374 (1889). The decision has been accepted and followed in numerous American cases . . .” . The first Restatement of Torts had the same wording for the rule but did not include the Recorder’s note. Lord Bramwell argued against use of the expression “legal fraud” as “a mischievous phrase, and one which has contributed to what I must consider the erroneous decision in this case”.⁶³Derry (1889) at 346 He found that the prospectus contained an untrue statement and the defendants knew the truth. “But it does not follow that the statement was fraudulently made. There are various kinds of untruth.”⁶⁴Id. at 348 In this case the directors relied on counsel, had no fraudulent intent, and they could have told the truth:

Now, consider the case here. These directors naturally trust to their solicitors to prepare their prospectus. It is prepared and laid before them. They find the statement of their power to use steam without qualification. It does not occur to them to alter it. They swear they had no fraudulent intention. At the very last they cannot see the fraud. There is their oath, their previous character unimpeached, and there is to my mind this further consideration: the truth would have served their purpose as well. “We have power to use steam, etc., of course with the usual conditions of the approval of the Board of Trade and the consent of the local authorities, but we may make sure of these being granted, as the Board of Trade has already allowed the power to be inserted in the Act, and the local authorities have expressed their approbation of the scheme.”⁶⁵Id.

Justice Bramwell found that the prospectus was “honestly done” by the defendants. He then adopted a subjective definition of “truth”. Truth is what is believed by the speaker:

I agree the law applies it to all breaches of the moral duty to tell the truth in dealing with others; but that duty cannot be honestly broken. To be actionable, a breach of that duty must be dishonest. Nay, it is a man’s duty sometimes to tell an untruth. For instance, when asked as to a servant’s character, he must say what he believes is the truth, however he may have formed his opinion, and however wrong it may be.⁶⁶Id. at 352.

Lord Fitzgerald adopted the trial court’s opinion that there is a distinction between business truth and legal truth. Only dishonesty about business truth is actionable in Deceit:

My Lords, I have, though with difficulty, arrived at the conclusion that the statement in the prospectus, that by the special Act the company had the right to use steam power, was not untrue in a popular or business sense.⁶⁷ Id. at 355 . . . . The conclusion I have arrived at, my Lords, is that this paragraph of the prospectus, though inaccurate in point of law in one particular, seems on the whole to have been morally true.⁶⁸Id. at 356

Lord Herschell began his decision by distinguishing cases where a person “within whose special province it lay to know a particular fact” gave an erroneous answer. He used a trustee as example. He did not discuss the fact that directors as well as trustees have fiduciary duties and directors have access to facts unavailable to most shareholders. He held without explanation that a mistake by a trustee belongs “in an altogether different category from actions to recover damages for false representation, such as we are now dealing with”.⁶⁹ Id. at 360

Next, Lord Herschell pointed out that “[a]n action of deceit is a common law action, and must be decided on the same principles, whether it be brought in the Chancery Division or any of the Common Law Divisions, there being, in my opinion, no such thing as an equitable action for deceit”.⁷⁰Id. citing with approval Justice Cotton in Arkwright v Newbould, 17 Ch. D. 320. Therefore, the law of Deceit must be rigidly applied and there is no place for application of the maxims of equity in pursuit of justice.

Lord Herschell then made his critical distinction: making a false statement recklessly or without care whether it is true or false is Deceit but making a false statement through negligence (“want of care”) which is believed to be true is not Deceit.⁷¹Id. at 361 He disagreed with Justice Cotton that there is a duty on a person who makes statements which are to be relied upon by others “to take care that he has reasonable ground for the material statements which are contained in that document which he prepares and circulates for the very purpose of its being acted upon by others”.⁷²Id.) He criticized Justice Cotton for language that made persons “liable to an action those who make untrue statements, however innocently”.⁷³Id. at 362

Lord Herschell pointed out that Deceit required no privity of contract under the ruling of Pasley v. Freeman but that case expressly limited liability to those who knew the statement was false.⁷⁴Id. at 363 He approved the holding of Haycraft v. Creasy⁷⁵(1801) 162 E.R. 303 (Court of King’s Bench). Note that courts had not yet come up with the opinion versus fact distinction to allow the perpetrator to keep the money taken from the deceived. that held the statement “I can assure you of my own knowledge that you may credit Miss R. to any amount with perfect safety” was a false statement when the speaker did not know whether his statement was true. This was recklessness because the speaker could not claim he knew the statement to be true. Although it is be hard to understand how Derry and the other directors could claim that they knew their prospectus statements to be true, Lord Herschell offered no further explanation.

Lord Herschell recounted the holdings of prior cases including Taylor v Ashton⁷⁶(1843) 152 E.R. 860 (Court of Exchequer). which was an action against directors of a bank who misrepresented the financial condition of the bank thereby inducing the plaintiff to buy shares. The jury found gross negligence but not fraud. Since there was no contract between the directors and the plaintiff, only a fraudulent statement was actionable and the plaintiff had no remedy. The bank was allowed to take the victims money through misrepresentation. A false statement made through gross negligence did not state a cause of action. If however, the statement was made for a deceitful purpose (e.g. through a “fraudulent” statement), even negligent statements are actionable.⁷⁷Derry (1889) at 367

Lord Herschell then describes the holding of Evans v. Edmonds⁷⁸ (1853) WL 9024 (Court of Common Pleas). which he believed supported his holding. He quotes Justice Maule:

If a man having no knowledge whatever on the subject takes upon himself to represent a certain state of facts to exist he does so at his peril, and if it be done either with a view to secure some benefit to himself or to deceive a third person he is in law guilty of a fraud, for he takes upon himself to warrant his own belief of the truth of that which he so asserts. Although the person making the representation may have no knowledge of its falsehood the representation may still have been fraudulently made.⁷⁹Derry (1889) at 368

Lord Herschell interpreted this quotation to mean that if a person makes a false statement but has no knowledge of the falsehood and believes it to be true, he not liable. However, it is difficult to reconcile Justice Maule’s quotation with the holding in Derry. The directors intended to secure a benefit for themselves (sell stock to make their company more valuable) and (if they are to be believed) either did not take the time or effort to understand that the right to build the tram was conditional or alternatively believed the conditions to be inconsequential details. Could it not be said they had no knowledge on the subject and represented the facts to be true at their own peril as in Evans? Were not the directors in Derry ignorant of the fact that the conditions in the company’s charter were significant and could derail the company’s business plans?

Lord Herschell reviews further cases and concludes that a speaker need not have a reasonable belief in the truth. If the speaker subjectively but unreasonably believed the statement was true he is not guilty of Deceit. Lord Herschell does not distinguish between facts which are material and fact which are immaterial. The directors thought the conditions were for obtaining the permits were immaterial when they were obviously very material facts. He quotes from Reese Silver Mining Co. v. Smith.⁸⁰ (1866-67) L.R. 2 Ch. App. 604

If persons take upon themselves to make assertions as to which they are ignorant whether they are true or untrue they must, in a civil point of view, be held as responsible as if they had asserted that which they knew to be untrue.⁸¹Derry (1889) at 370-71

Since the directors did not know the conditions were material, they should be held liable under this standard. Lord Herschell did not agree. He turns Reese on its head and held the defendants must be conscious that they did not know.

Lord Herschell then attempted to distinguish this quotation from Arkwright v Newbold: ⁸² (1881) L.R. 17 Ch. D. 301 (Court of Appeal).

A man may issue a prospectus or make any other statement to induce another to enter into a contract, believing that his statement is true, and not intending to deceive; but he may through carelessness have made statements which are not true, and which he ought to have known were not true, and if he does so he is liable in an action for deceit; he cannot be allowed to escape merely because he had good intentions, and did not intend to defraud.⁸³Derry (1889) at 3723

This quotation seems to clearly negate the good faith defense but Lord Herschell was unconvinced. He refused to accept that the directors should have known the prospectus was inaccurate. He stated, “On the whole I have come to the conclusion that this, although in some respects inaccurate, and in some respects not altogether free from imputation of carelessness, was a fair, honest, and bonâ fide statement on the part of the defendants, and by no means exposes them to an action for deceit.”⁸⁴Id. at 373 He reasoned:

A man who forms his belief carelessly, or is unreasonably credulous, may be blameworthy when he makes a representation on which another is to act, but he is not, in my opinion, fraudulent in the sense in which that word was used in all the cases from Pasley v. Freeman down to that with which I am now dealing.⁸⁵Id. at 369

Unlike current law, Lord Herschell did not believe that intent to deceive was required to prove fraud.

Thirdly, if fraud be proved, the motive of the person guilty of it is immaterial. It matters not that there was no intention to cheat or injure the person to whom the statement was made.⁸⁶Id. at 374

Lord Herschell rejected negligence investigation as grounds for fraud. “In my opinion making a false statement through want of care falls far short of, and is a very different thing from, fraud, and the same may be said of a false representation honestly believed though on insufficient grounds”.⁸⁷Id. at 375 He left an opening for future case where the belief was so unreasonable the court would not be convinced of the speaker’s good faith.⁸⁸ “I can conceive many cases where the fact that an alleged belief was destitute of all reasonable foundation would suffice of itself to convince the Court that it was not really entertained, and that the representation was a fraudulent one”. Id. Also deliberate ignorance is not good faith: “. . . , if I thought that a person making a false statement had shut his eyes to the facts, or purposely abstained from inquiring into them, I should hold that honest belief was absent, and that he was just as fraudulent as if he had knowingly stated that which was false”.⁸⁹Id. at 376

Lord Herschell was uncomfortable with his decision and thought Parliament should become involved:

I have arrived with some reluctance at the conclusion to which I have felt myself compelled, for I think those who put before the public a prospectus to induce them to embark their money in a commercial enterprise ought to be vigilant to see that it contains such representations only as are in strict accordance with fact, and I should be very unwilling to give any countenance to the contrary idea. I think there is much to be said for the view that this moral duty ought to some extent to be converted into a legal obligation, and that the want of reasonable care to see that statements, made under such circumstances, are true, should be made an actionable wrong. But this is not a matter fit for discussion on the present occasion. If it is to be done the legislature must intervene and expressly give a right of action in respect of such a departure from duty. It ought not, I think, to be done by straining the law, and holding that to be fraudulent which the tribunal feels cannot properly be so described. I think mischief is likely to result from blurring the distinction between carelessness and fraud, and equally holding a man fraudulent whether his acts can or cannot be justly so designated.⁹⁰Id. Congress has become involved by passing Section 11 of the Securties Act of 1933 but the courts are still applying Lord Herschell’s opinion.

When he considered the facts, he exonerated all the defendants. He had this to say on the illegal payments 4 of the 5 directors took from promoters:

I may say that I approach the case of all the defendants, except Wilde, with the inclination to scrutinise their conduct with severity. They most improperly received sums of money from the promoters, and this unquestionably lays them open to the suspicion of being ready to put before the public whatever was desired by those who were promoting the undertaking.⁹¹Id. at 377-78

Nevertheless, he decided to not create a negative inference from taking the illegal payments. He then finds a way to believe that the directors acted in good faith:

It might well be that the fact that the consent of the Board of Trade was necessary would not dwell in the same way upon their minds, if they thought that the consent of the Board would be obtained as a matter of course if its requirements were complied with, and that it was therefore a mere question of expenditure and care.⁹²Id. at 378

The most difficult defendant to excuse was Mr. Wilde, a solicitor who must have known that the need for approvals from two corporations and a public agency was a material fact. Lord Herschell excuses him in this manner:

I will take first that of Mr. Wilde, whose conduct in relation to the promotion of the company is free from suspicion. He is a member of the Bar and a director of one of the London tramway companies. He states that he was aware that the consent of the Board of Trade was necessary, but that he thought that such consent had been practically given, inasmuch as, pursuant to the Standing Orders, the plans had been laid before the Board of Trade with the statement that it was intended to use mechanical as well as horsepower, and no objection having been raised by the Board of Trade, and the Bill obtained, he took it for granted that no objection would be raised afterwards, provided the works were properly carried out.⁹³Id.

Lord Herschell, recognized the statements are untrue but does not want to adopt two standards of “truth”, one for the law and one for business. He concluded this way:

I have a strong conviction that a reasonable man situated as the defendants were, with their knowledge and means of knowledge, might well believe what they state they did believe, and consider that the representation made was substantially true.⁹⁴Id. at 380

The Restatement of Torts § 526 may not completely incorporate the Derry decision.

It is not easy to categorize the decision in Derry. Lord Herschell held there is a moral duty to be strictly factual in a prospectus and the duty should in some respect become a legal duty.⁹⁵Id. at 376 He believed he was obligated to follow precedent which did not attach liability if the breach was merely negligent.⁹⁶Id. Derry v. Peek can be understood to apply a two part test: 1) the misrepresentation must not be intentional or reckless but be merely negligent and 2) the maker must believe the statement in utmost good faith. More cynically, it can be view as an effort by the House of Lords to avoid making 5 London gentlemen insolvent.

The Reporter for § 526 of the Restatement in his comments states Lord Herschell’s decision is the basis for this definition of scienter:

526. Conditions Under Which Misrepresentation Is Fraudulent

 A misrepresentation in a business transaction is fraudulent if the maker (a) knows or believes the matter to be otherwise than as represented, or (b) knows that he has not the confidence in its existence or non-existence asserted by his statement of knowledge or belief, or (c) knows that he has not the basis for his knowledge or belief professed by his assertion.

It is not clear that the outcome in Derry would be the same under § 526. Applying § 526 (a), the director knew the corporation had not received the required approvals. Is simply believing the approvals are mere formalities enough to justify a falsehood? It is therefore possible the Derry misrepresentations are prohibited by § 526 (a). Under § 526 (b), can the directors be said to be confident that the approvals had been given when they knew they had not been? It is therefore doubtful the statement can pass muster under § 526 (b). Under § 526 (c), the directors would have needed a factual basis for their statement. They had none. It was clear conjecture. Therefore, despite the Reporter’s comment to the contrary, it is possible Derry fact pattern would be actionable under § 526 (c). Reasonable lawyers can disagree.

The Common Law has taken the wrong road in financial fraud cases.

Financial fraud has increased as humanities’ means of communication has improved. The need for legal protections has therefore also increased. The latest advance in communications is the Internet which exposes every connected person in the world to a plethora of fraudulent schemes designed separate them from their money. This is merely the natural progression of an historical trend. As western civilization shook off feudalism, trade grew on land and sea. At trade grew, financial fraud grew. After the emergence of the printing press, it was not long before newspaper advertising facilitated fraudulent schemes throughout western societies. The first “Internet” was the post office. In the 19^th century, the United States Post Office built the roads between cities and town and supplied newspapers at a penny per pound. A primary source of newspaper revenue consisted of advertisements misrepresenting the products being offered.⁹⁷A major source of revenue for U.S. fraudsters in the 1890s was the sale of penis enlargement and impotency cure medications. See Wayne E. Fuller, Morality and the Mail in Nineteenth Century America (Chicago: University of Illinois Press, 2003), 239. Most of the fraud on the Internet can be traced back to postal frauds and other confidence games with long histories. The clear trend is for increase international connectivity and therefore an increase in fraud.

Poverty and financial necessity are sometimes motivation for fraud. If world poverty levels were decreasing rapidly, there would less reason to advocate change to civil laws governing misrepresentation. There is no indication that poverty will disappear anytime soon.

Society is ambivalent toward fraud.

If human culture uniformly rejected fraud, it could be argued that peer pressure would eventually eliminate fraud. However, most humans have conflicting view. Some thieves are cheered, others are booed. For every Robin Hood there is a Bernie Madoff. Often when newspaper headlines expose unethical behavior in business, our leaders urge strict compliance with ethics and often propose stronger laws. There is also a major counter-trend. People enjoy watching movies like Ocean Eleven glamorizing fraud. Many believe that victims of fraud deserve what they get because they were too gullible or not as careful as they should have been. Most people cherish the belief that they are too bright to be caught in a sting. The tension in the law between a desire for complete honesty and a lack of sympathy for a too-gullible victim reflects societal norms.

Public Policy should protect society from all misrepresentations.

If honesty in business transactions is to be encouraged, the law should not erect barriers that protect those who misrepresent. How can the law justify allowing a business to profit from misrepresentations merely because the victim cannot prove the misrepresentation was intentional? Why should a person who honestly believed an untruth benefit by taking someone else’s money? How can a company that decides to use opinions to raise money from investors be allowed to benefit if the opinion turns out to be false? As Justice Blackmun wrote, “It seems to me, however, that an investor can be victimized just as much by negligent conduct as by positive deception, and that it is not logical to drive a wedge between the two . . . .”⁹⁸Dissent in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 216 (1976). Like Lord Herschell, Justice Blackmun called for legislative action. Congress responded with Section 11 of the Securities Act. The courts responded by tempering the new rules with deficient common law rules.

Conclusion

Public policy should be tuned to minimizing the use of dishonest statements to gain a business advantage. Sadly, this is not the law throughout the county or the law of the Restatement (Second) of Torts. Fortunately, some states have attempted to be leaders in the effort to promote honestly in business. Even though limited to contracts, Section 1668 of the California Civil Code declares unlawful as against public policy “[a]ll contracts which have for their object, directly or indirectly, to exempt any one from responsibility for his own fraud, or willful injury to the person or property of another, or violation of law, whether willful or negligent ….” In 1872, California enacted Civil Code § 1710 which defines deceit as “. . . 2. The assertion, as a fact, of that which is not true, by one who has no reasonable ground for believing it to be true.” Although there is surprising little use of this statute, a few courts have affirmed the rule: “Fraud in this state includes not only intentional misrepresentation, but may also consist of a negligent misrepresentation”.⁹⁹Clar v. Bd. of Trade of San Francisco, 331 P.2d 89, 94 (Cal. App. 1st Dist. 1958).

The Federal Government has passed similar legislation including Federal securities laws. The courts have attempted to limit the required honesty though barriers like scienter and the “opinion” versus “fact” distinction.

Little progress will be made in the effort to promote ethics in business until the errors of the common law relating to misrepresentation are fixed. There should be no privilege to gain financial advantage through falsehoods merely because the victim cannot prove the speaker did not believe the falsehood or that it was made negligently. It should not take four causes of action to provide a remedy. If the United States is serious about combating fraud, if the Sarbanes Oxley Act and the Dodd-Frank Acts point in the direction of ethics in business, how can courts continue to force the legal system to be bound by 19^th century “reluctant” ethical standards of London gentlemen?((The U.K. may have overruled at least part of Lord Herschell’s decision in Deek v Perry with the Misrepresentation Act of 1967. It applies to contracts and provided damages for misrepresentation in the inducement unless the maker honestly believed on reasonable grounds that the statement was true. The difficulty is that is exactly what Lord Herschell held in Deek; the directors honestly believed the approval was given on reasonable grounds because it was a mere technicality. We need a legal system that requires strict honesty when money is raised from investors. The courts should stop making excuses for dishonesty and creating legal loopholes. Although Omnicare moved the law closer to honesty, it did not go far enough.

Liability for Opinions – Omnicare