MISSTATEMENT OF OIL AND GAS RESERVES BY A PUBLIC COMPANY - CAN YOU BE SUED IN THE UK?

1 Introduction

The US Securities and Exchange Commission (SEC) has launched an investigation into reserve reporting by major oil companies after Shell's recent admissions of misstatement of its oil and gas reserves, culminating in the fourth downgrade of the size of its proven oil and gas reserves this year.

The recent publicity surrounding Shell and its admitted misstatement of its reserves over a number of years has included references to the class suits being initiated in the United States. The issue revolves partly around the peculiarities of the SEC rules on reserve statements and oil and gas companies not quoted in the US may breathe a sigh of relief that they are not bound by those rules. Nevertheless, the question may arise whether a company not quoted in the US but quoted in the UK can be held liable to pay compensation to its shareholders for a misstatement of its reserves. This article highlights several of the principle ways in which a director and/or company can be held liable for such a misstatement to its shareholders both under statute and under common law and generally, including criminal liability.

2 Misleading Statements and Practices under s397 of the Financial Services and Markets Act 2000 ("FSMA")

S397 applies to a person (which includes both a company and a director) who recklessly makes (dishonestly or otherwise) a statement, promise or forecast which is misleading, false or deceptive in a material particular.

Under this section, a person is guilty of a criminal offence if he is reckless as to whether the statement will induce another person to enter into an agreement. For the purpose of s397, a person is reckless if he would have known that the statement was false or misleading had he made all reasonable enquiries. Therefore, if a director misstates the reserves of a company and it could be proved that on the strength of this statement an investor purchases shares in the company, the director and/or the company could face criminal liability.

3 Market Abuse under s118 of the FSMA

FSMA also creates civil penalties for market abuse under s118, which runs parallel to the criminal offence under s397. Under s118, market abuse is behaviour which:

The FSA has issued a code which provides guidance on what would constitute market abuse. The dissemination of information is included as potential market abuse. Therefore if a person (which again includes a company or an individual) does not take reasonable care to ensure that the statement relating to the reserves of the company is not false or misleading, he could be guilty of market abuse. It is important to note that this includes both action and inaction and the failure to make an announcement. The penalties for market abuse include a financial penalty imposed on the person as a fine, the making of a public statement about the behaviour, an injunction restraining market abuse or an order for restitution e.g. return of funds to a shareholder.

4 Negligence

Apart from claims under FSMA, there is also the possibility of a claim being made in negligence against either the directors or the company. Directors have fiduciary duties towards existing shareholders which include a duty of care. However, where the sums involved run into tens and maybe hundreds of millions of pounds, a claim against the directors may not be sufficient so that a claim against the company would be preferable. Let us suppose, therefore, that a company with a listing on the London Stock Exchange announces that it has seriously overstated its oil and gas reserves and its share price takes a sudden plunge. Can its shareholders make a claim against the company for the fall in value?

To make a successful claim any shareholder would need to clear the following hurdles.

4.1 Does the company owe a duty of care?

The first hurdle is to prove that there is a duty of care - is this the sort of case which the courts will entertain? There is no direct authority and the two most relevant cases fall either side of the line.

To succeed in showing that a duty of care exists where a misstatement may lead to economic loss, it is basically necessary to bring the case within the principles set out in the case of Hedley Byrne v Heller, namely that the maker of the statement knew, or a reasonable person in the position of the maker of the statement would know, that the statement would be relied upon and that the claimant is sufficiently proximate to the maker of the statement. It is this question of proximity which is used by the judges to limit the range of people who can make a claim and the persons against whom they can make a claim.

In the House of Lords decision in Caparo it was held that auditors could not be liable to shareholders for a misstatement in the annual report; their role was to report to the directors and they had no duty to the shareholders in general. In the later Chancery Division case of Possfund v Diamond it was held that there was an arguable case that an unlisted company had a duty to shareholders in respect of statements contained in a prospectus, even if the shareholders had not bought the relevant shares directly in the offering but in the aftermarket. However, it should be noted that in that case the claimant had bought shares both directly and in the aftermarket. That raised two issues, the first relating to shares bought in the offering and the second in respect of the shares bought in the aftermarket; in both cases the claimant was one of a small class of claimants. The judge summarised the law as being that it was not sufficient that the company could foresee that the statement would be relied upon, but there must be a stronger link and the imposition of the duty must be fair, just and reasonable. The reported case was decided only as a preliminary issue and there is no report of a subsequent full trial of the issue.

It is certainly arguable that, in the case of a statement by a company listed on a stock exchange of a matter which is clearly highly relevant to the value of the shares, there are grounds for the imposition of the duty of care. It would be a policy decision for the courts and such a case could go all the way to the House of Lords. The result might also be different depending upon whether the claimant is a private individual, who might be expected to rely more heavily on the company's statements or a professional investor such as a pension fund. The judges would also bear in mind that successful claims against the company would themselves have an adverse effect on the value of the shares and consequently adversely affect the interest of other shareholders. It is therefore not possible to say with certainty that the courts would impose a duty of care in such a case.

4.2 Has there been a breach of the duty of care?

In contrast with the United States, where the rules on reporting of reserves are strict, the UK accounting rules are noticeably more flexible. The directors are required to make a judgment and can rely on interpretation of the available data and their own judgment regarding commercial factors such as future oil and gas prices, or the level of pipeline tariffs still to be negotiated. To be guilty of negligence in such circumstances the company must have made an assessment of its reserves which no reasonably experienced oilman would have made. If, as is common among companies other than the majors, the company has commissioned a reserves report from an independent expert and acted on that report, a finding of negligence against the company would be difficult to obtain. If the Caparo decision in relation to auditors is followed, the independent expert is unlikely to be held to have a duty of care to shareholders although the company itself have a claim against such expert.

4.3 Has the reserves misstatement has been relied on?

Investors may have bought shares in the market or simply decided not to sell. Alternatively they might claim that, although they already held shares, if they knew the real state of the reserves they would not have held the shares. When deciding whether to invest in shares on a stock market, investors rely on a number of factors and not just on the company's own statements. Professional investors will take into account factors such as their assessment of the track record of the company and its directors and their own views on commercial factors. They will also be aware that reserves estimates can be mistaken; they may rely partly on the judgment of brokers knowledgeable about the company. Even so, statements of reserves are important factors in any decision on a company's value and the courts are likely to find that to some degree at least the claimant relied on the reserves value stated by the company.

4.4 Has loss been suffered?

The starting point will be the difference between the value of the shares immediately before the admission of the overstatement and their value at the time of the claim. However, the courts are unlikely to ignore events subsequent to the date of the claim and if the shares recover in value that could affect the amount of damages ultimately awarded. The true measure of the loss is likely to be the difference between the value which the shares would have had at the date of assessment if the overstated reserves had been correct and the actual market value of the shares at the time of assessment of the damages.

5 Conclusion

As English lawyers, we cannot predict what the result of the class action against Shell in the US will be. If a similar case were brought against a company quoted only on the LSE the Company and its directors may face criminal liability and fines and the shareholders may be compensated under the FSMA. The result may depend in the end on the standard of reserve reporting with which the company had to comply and therefore the standards against which the shareholders were viewing the numbers. Should the shareholders be forced, for whatever reason, to pursue a claim in negligence they will have to overcome some more substantial hurdles to make a successful claim. However, the message is clear: if the directors have reason to believe that their reserves estimates should be revised, they must do so publicly at the first opportunity (see also the article below on prompt notification of major new developments which are not public knowledge, below). It will also be the responsibility of the non-executive directors to ask some more searching questions in future. As always, the safest course is to have an independent review of the company's reserves.

Details of Charles Russell's energy team can be found at http://www.cr-law.co.uk/services/energy/index.asp

If you require further information on any matter covered in this note, please contact your principal contact at Charles Russell or Simon Gilbert, Katy Knight, Clive Hopewell or Alexander Keepin (London), Francis Rundall or Richard Norton (Cheltenham) or Geoff Sparks (Guildford) or Geoff Hewitt or Gordon Clark (London Energy Team) on 0207 203 5000.

Please note that the summaries above are a general indicative guide only. They are not exhaustive. This information has been prepared by the firm as a service to our clients. As it is a general guide, we recommend that you seek professional advice before taking action. No liability can be accepted by the firm for any action taken or not taken as a result of this information. The firm is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Law Society. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.