Big data, big risk – investing in a “largely theoretical” industry
Between 31 May 2012 and 26 March 2013, an Australian husband and wife (Mr and Ms Vinson), through their self-managed superannuation funds, invested $1,250,000 and $1,625,000 respectively in a company that never earned any operating revenue.
The company, Semantic Software Asia Pacific Limited (formerly Tralee Technology Holdings Pty Ltd) (Semantic), was a software company looking to establish itself in the big data field.
Last week, the Supreme Court of New South Wales (the Court) upheld a claim made by the couple’s superannuation funds (Ebbsfleet Pty Limited as trustee for Ebbsfleet Superannuation Fund (Ebbsfleet) and McGee Pty Limited as trustee for McGee Superannuation Fund (McGee)), that:
- Mr Mark Bradley, a director of Semantic with effective control of its business, and Semantic were both in breach of a promise made in 10 identical Share Issue Agreements, that the funds’ shares in Semantic would triple in value within 2 years of issue (the Representation); and
- Mr Bradley had no reasonable basis upon which to make the Representation, and thus was in breach of s 18 of the Australian Consumer Law i.e. engaging in misleading or deceptive conduct in trade or commerce.
As a result of these findings, the Court decided that Ebsfleet and McGee were entitled to:
- damages calculated to put the Ebbsfleet and McGee in the position that they would have been in had the promise been fulfilled (i.e. the shares had tripled in value within 2 years); and
- Compensation for loss suffered by reason of the misleading or deceptive conduct, calculated to the value of the investments of Ebsfleet and McGee.
Whether Mr Bradley and Semantic will have the funds available to pay out theses damages and compensation is a matter for time to tell. Interestingly, Mr Bradley represented himself and Semantic in these proceedings.
This case involved important questions of contractual interpretation and the valuation of patents, and the process and findings of the Court in these respects are detailed below. For full reasons see Ebbsfleet Pty Ltd as trustee for Ebbsfleet Superannuation Fund v Semantic Software Asia Pacific Ltd (No 3)  NSWSC 78.
Semantic was seeking private investment for growth, prior to pursuing a sale of its business. Its only material assets were two patents relating to data integration software, owned through a wholly-owned subsidiary of the company.
In May 2012, Mr Vinson received an Investor Pack, which was prepared by Semantic and included an Information Memorandum and two other documents described as the “Tralee Software Pre-IPO Offering”.
Mr Vinson then attended a meeting with Mr Bradley on 29 May 2012, and based on his conversation with Mr Bradley and the Investor Pack, he caused Ebbsfleet to subscribe for shares in Semantic and recommended Ms Vinson to do the same with respect to McGee.
Subsequently, 6.5 million shares in Semantic were issued to Ebbsfleet and McGee between 31 May 2012 and 26 March 2013.
The Share Issue Agreement
The shares in Semantic were issued pursuant to 10 identical Share Issue Agreements (Agreement).
Relevantly, each Share Issue Agreement provided for a guarantee (at clause 46) which included the following warranties:
“(1) by Mr Bradley, that the shares the subject of the agreement “shall triple in value within two years”;
(2) by Mr Bradley, that if the shares did not triple in value within two years he would transfer additional shares from his personal and/or beneficial shareholding sufficient to effect a tripling in value of the shares the subject of the agreement;
(3) by Semantic and Mr Bradley, that Mr Bradley was the beneficial owner of 53,362,987 shares (excluding options) in Semantic (there were then some 135 million ordinary shares on issue); and
(4) by Mr Bradley, that he would retain at least 10 million shares in his beneficial ownership until such time as the shares the subject of the agreement had a “freely tradable [sic] market value” of at least triple the purchase price.”
The warranty given by Mr Bradley in (1) above was in turn warranted by Semantic to be “true and accurate in all respects”.
In determining whether there had been a breach of these warranties, the Court had to consider whether clause 46 was limited or restricted by other provisions of the Agreement.
Time limits in respect of warranties
The Agreement included a limitation in clause 6.5 which stated that the warranties in schedule 1 were “limited in time to 12 months from the signing of the agreement and to a monetary value equal to the Purchase Price plus 25%”.
The Court noted that “there is a clear tension between that purported limitation and the warranty given by Mr Bradley” referred to in (1) and (4) above.
It decided that the limitation in clause 6.5 could not restrict clause 46 as it would destroy the effect of the warranties.
“If clause 6.5 had the effect of limiting the warranty in cl 46, it would be inconsistent with a fundamental promise made by Mr Bradley (and Semantic)…that the value of the shares would triple in two years.”
“A reasonable business person in the position of the parties would understand the specific promise made in cl 46 to qualify the generality of the limitation in cl 6.5.”
Do warranties (3) and (4) constitute an exhaustive list of remedies?
This question was important because, in November 2013 Mr Bradley and his wife had transferred their majority interest in Semantic to a family trust – therefore putting Mr Bradley in a position where he could no longer transfer additional shares to the investors if the share value did not triple in value.
The Court concluded that if the clause was interpreted as providing an exclusive list of remedies, and the shares are now worthless, the promises in clause 46 would also be rendered worthless.
It was held that a reasonable business person would not have understood cl 46 to operate in this way because:
- the clause does not state that the transfer of additional shares is to be an exclusive remedy; and
- to interpret the clause in this way would deprive cl 46 of any substantial value.
Did the shares triple in value? Assessing the value of patents.
In its balance sheet Semantic accounted for its interest in the patents owned by a subsidiary as “intangible assets” on an amortised cost basis, which was appropriate in the circumstances.
Ms Smith, a forensic accountant, gave evidence that:
“I consider it unlikely that an informed and knowledgeable investor in the Company would place any material value on the Patents, given:
- the industry was still largely theoretical…;
- The Company did not appear to have a product that was available for commercialisation…;
- The Company was not generating any operating revenues…;
- Significant further costs will most likely need to be incurred in order to develop a product that can be commercialised…; and
- The Company will need to raise further capital to support the development of its products and the ongoing operations of the business. Such capital raisings will dilute the value of the shares held by any existing shareholders…
…In my opinion, any further value associated with the Patents was too ‘blue sky’ to be attributed a value by a knowledgeable and informed investor. Accordingly, it is also my opinion that no value should be attribute to the Patents in an Asset Based Approach”.
This opinion was accepted by the Court as “inherently probable”.
Concurrent evidence provided by Ms Smith explained that a patent will usually be valued by reference to the income it is likely to generate. The Court held that the evidence established that:
- “Semantic had earned no income from any of its patents;
- Semantic had secured no contracts to commercialise any of the patents; and
- there was no commitment from any large technology company, or at all, to acquire Semantic’s intellectual property or to invest in Semantic’s intellectual property.”
Semantic’s interest in the patents was therefore valued at no more than was recorded on an amortised cost basis and therefore, the shares were at all relevant times since issue of negligible or of no value.
It was therefore established that Mr Bradley and Semantic had breached clause 46 of the Agreement, as the Representation that the shares would triple in value was incorrect.
Australian Consumer law
“Section 4(1) of the Australian Consumer Law provides that if a person makes a representation as to a future matter, and does not have reasonable grounds for making the representation the representation is taken to be misleading for the purposes of the proscription in s 18 of the Australian Consumer Law against engaging in misleading or deceptive conduct in trade or commerce.”
Whether or not a representation was made on reasonable grounds is an objective test to be determined:
- “as at the date of the representation”; and
- “by reference to the information that was available at the time that the statement was made”.
Mr Bradley suggested a number of facts relating to potential future patent registrations and a potential acquisition of an interest in Semantic’s Intellectual Property by IBM, as reasonable grounds for making the Representation. However, the Court held that this was not a sound or reasonable basis, particularly where Semantic:
- “had no income;
- had secured no contracts to commercialise its products; and
- had not obtained commitment from any large technology company, or anyone, to acquire its intellectual property or invest in Semantic”.
The text of the Information Memorandum also emphasised the dealings that Semantic had purported to have had with “industry leaders” in the technology space and the Court found these to be overstated and misleading as there was no reasonable prospect that anything would come from these dealings.
Mr Bradley and Semantic had therefore engaged in misleading or deceptive conduct for the purpose of s 18 of the Australian Consumer Law.
Reliance and causation
The Court was satisfied that whilst Mr and Ms Vinson understood that there could be a relationship between return and risk, the evidence strongly indicated the probability that they relied on the Representation and promises made by Mr Bradley and Semantic.
But for the warranties and the Representation, the Court was satisfied that Mr and Ms Vinson would not have caused Ebbsfleet or McGee to invest in Semantic.
Investing in early stage companies is inherently risky
Sophisticated investors in start-ups or early-stage ventures recognise the level of risk associated with this asset class, and seek to diversify their exposure across a portfolio of investments. Whilst the investors in this case obtained legally enforceable promises about the future value of the shares they purchased, the extent to which they will recover their losses remains to be seen.
Interestingly, as a the date of publication, Semantic’s website contains the following statement addressed to prospective investors (despite the Court’s finding that the shares issued to the investors in this case were of negligible or no value):
“This is a serious opportunity for safe, well above average returns on investment typical of world leading software companies at the beginning of their early high growth phase. You will profit substantially from an increasing share price based on:
- revenue from our product, our software services, and our “Semantic Academy” education program
- revenue from global software companies licensing our software, and online subscribers
- the growing value of our patent portfolio
- a NASDAQ IPO, or a trade sale, in 2018.”
In light of the Court’s finding, this is one of those cases where the old maxim of “buyer beware” is especially relevant.