The Perfect Fraud? Investing in private companies (Part 2) The unravelling…

A double-edged sword

In our last article, we highlighted the factors which made this almost the perfect fraud. In particular, one of the strengths of the fraud was Darren Shirlaw’s ability to bring investors into the fold as ‘partners’ and participants in the business. We observed that this meant that any expression of dissatisfaction or distrust would be seen as a betrayal of colleagues and friends. It also meant admitting personal loss of funds.

However, this aspect of the fraud was both its strength and its weakness as, once on the inside, cracks were visible for those that were able to access information. Perhaps Shirlaw’s biggest error was inviting Shirlaws’ newest investor, Jack Cohen (the Second Claimant), to become its next CEO. Mr Cohen’s position allowed him unfettered access to the Company’s financial information and investment portfolio (something which until then had been controlled by the Defendant). After 6 months of fact-finding within the business, Mr Cohen discovered that in his opinion “the cupboards were bare” and set about creating a business plan that would increase revenue and recapitalise assets.

By this time, the First Claimant, Mr Stead, was also conducting his own fact-find having become frustrated with the lack of quality business opportunities that had been promised by Shirlaw, and the lack of return on his investment.  The Company’s shareholders never received a dividend despite numerous promises at shareholder update meetings.

Unravelling the fraud

In order to prove fraudulent misrepresentation, it was necessary to not only prove that the representations as to value made by the Defendant were false, but that the Defendant made those representations knowingly, without belief in their truth, or recklessly as to their truth.

The Defendant had represented that the Company held assets worth circa £60m. In his evidence, Shirlaw maintained his belief in that figure and even stated: “…I believed that valuation to be conservative and that the minimum true valuation was closer to £120m.” As the judge pointed out in his judgment [1]: “At the heart of the claim is the question of how to value the Company.”

None of the Claimants are experts on company valuation, nor did they ever claim to be, but on a common-sense approach, no one could see how the assets listed amounted to £60m. During Mr Cohen’s fact-find, he discovered that of the 37 companies the Company was said to hold investments in, 8 were listed as having ceased trading or the relationship with the Company had been terminated, and 23 were not in fact owned by the Company as necessary paperwork had never been concluded. In his witness evidence, Mr Cohen described this as a “pivotal moment” and when he began to realise he had been duped.

All of the Claimants were shown filed accounts prior to investment. These accounts did not support the value alleged by the Defendant, however, Shirlaw claimed that an “asset-based valuation” was different to the norm and did not rely upon the usual principles of profit and loss but found value in off-balance sheet assets such as brand, intellectual property and investments held.

The intellectual property Shirlaw referred to were mainly training materials developed by him. There were no registrable intellectual property rights in these materials, but Shirlaw maintained they had a value which was demonstrated by the sale of licences around the world (Shirlaw claimed the Company had sold licences to permit use of these coaching materials in different countries).

The judge made the observation [2] that: “…Mr Shirlaw placed great emphasis on licence sales and the potential for selling further licences to populate the asset base.” Indeed, part of the Harford valuation was attributable to future licence sales. The Harford valuation assumed that licences would be sold across 9 territories for 2m local currency, and this was then discounted by 25% to arrive at a valuation figure of $15.6m. The problem was that total cash receipts for licence sales between 2009 and 2016 was just £590,532 against net costs of sale of £224,100, resulting in a net cash inflow of just £366,432 (of which £282,590 related to 2011 and earlier).

Shirlaw relied upon an alleged sale of a licence to the Middle East at $3m, when in fact, there was an initial payment of $800,000 but the balance was never received, and the licensee eventually demanded the $800,000 be repaid (something which Shirlaw was aware of). The judge concluded [3] that: “It is clear, and I find as fact, that there was no basis for relying on the Middle East licence as justifying the future projection of licence sales. It is also clear that there were no substantial licence sales…”.   Yet, Shirlaw had often used the sale of the Middle East Licence at $3m as evidence in support of the underlying value of the Company. The judge agreed with the Claimants’ expert that by the time the Claimants made their investments, this part of the Harford valuation ought to have been ascribed a nil or negligible value, and yet it remained unchanged in documents authored and presented by Shirlaw.

[1] At para 11

[2] At para 44

[3] At para 156

Passing the buck

The Defendant was never a registered director of either the Company or its subsidiaries (save for his own individual coaching company from which he sold his own time to coaching clients) and it is thought that this was a deliberate choice to avoid responsibility for his actions. Shirlaw maintained in evidence that he was not a member of the Board of directors and therefore could not be held accountable for the company valuation, which was approved by the Board.

The fact is that the Defendant assumed responsibility for the valuation and for communications with prospective investors. The judge accepted [4] that the Board set the value of the shares “…on the basis of information provided to it by Mr Shirlaw…”

[4] At para 96

Takeaways

What can you take away from this case when considering investments into private companies?

There are a multitude of risks inherent in investing in private companies which vary depending upon the stage of development of the company. However, the key to any investment is to carry out enough due diligence to satisfy yourself that the information you are being presented with is truthful.

In other words, dig under the fingernails of it and seek independent advice to ask questions that if answered satisfactorily, could give you peace of mind.

Here are some pointers to bear in mind:

• If something sounds too good to be true, it usually is so find out why;
• Beware of corporate structures that are held offshore or overly complex – ask questions about the structure and the reasons for it (there may be legitimate reasons for doing things a certain way which the company should be happy to explain to you);
• Check Companies House records – be wary of companies with senior executives that are not registered directors (again there may be valid reasons – but it is worth asking the difficult questions);
• If the value is not borne out by filed accounts in the public domain, seek further information on how the business is valued – instruct your own advisors to review documentation provided;
• Understand the customer / client base of the business you are investing in. Look to understand how that work flows, who has the right to claim the clients as their own, the likelihood of longevity of that work;
• Try and select the people you would like to speak to about the company you are investing in rather than allow others who are involved in the selling process direct you to who to speak to.

If you would like a copy of the judgment, please contact hello@tenetlaw.co.uk

Should you suspect that you are a victim of fraud or other wrongdoing or you are concerned whether an investment opportunity may be unclear (where fraud may be a possibility), please do not hesitate to get in touch at hello@tenetlaw.co.uk