Supreme Court disentangles reflective loss principle
A key principle of English law is that double recovery of losses should be avoided. In company law a related concept has emerged, known as the principle of reflective loss. This prevents a shareholder in a company from suing a wrongdoer for the reduction in the value of shares or distributions when the loss suffered is a ‘reflection’ of a loss sustained by the company. The intention is to ensure equality between shareholders as a whole and to underline that each shareholder’s investment follows the fortunes of the company.
Over time, the reflective loss principle was expanded to also prevent creditors of companies bringing claims where the companies had concurrent claims. This extension of the principle has been subject to criticism and was likened by one legal academic to ‘some ghastly Japanese knotweed’. In Sevilleja (Respondent) v Marex Financial Ltd (Appellant), the UK Supreme Court undertook a detailed examination of the rule and confirmed that it only applies to claims by shareholders.
This is clearly helpful for creditors of companies, as it confirms that they are entitled to bring claims against the wrongdoers where they caused the company’s assets to be dissipated. However, the decision is disappointing news for shareholders because, when companies are practically restrained from bringing proceedings (for example because the company has insufficient funds to pursue a claim), shareholders are still unable to bring their own claims for the reduction in the value of their shares or dividends.
The claimant, Marex Financial Ltd (Marex) was owed over $5 million by two companies controlled by Mr Sevilleja. It obtained a judgment against the companies for recovery of the debt. Marex alleged that, after receiving a copy of the draft judgment, Mr Sevilleja diverted the companies’ assets to accounts controlled by him. Marex further alleged that Mr Sevilleja appointed a friendly liquidator to wind up the companies, who agreed not to pursue Mr Sevlleja to recover the assets.
Marex sued Mr Sevilleja directly to recover the debt. Mr Sevilleja was not resident in England and challenged the jurisdiction of the English court, arguing that Marex did not have a good arguable case against him because the losses it sought from him were reflective of losses suffered by the companies. The Supreme Court was required to consider whether the reflective loss principle applied to Marex’s claim.
History of the rule
The rule was first stated in 1982 by the Court of Appeal in Prudential Assurance v Newman Industries (No 2). That case involved fraudulent representations made to a company’s shareholders, which induced them to approve a company transaction. The shareholders applied to bring a derivative action against the wrongdoers and also brought personal claims, in their capacity as shareholders, for the loss of the value in their shares and dividend payments as a result of the harm the wrongdoer caused to the company.
The Court of Appeal held that where wrongdoing is alleged to have occurred against the company, the company is the party with the right to sue. It is ordinarily for the company managers and the majority of shareholders to determine when the company should sue a wrongdoer. Therefore, the Court held that shareholders could not bring a claim personally where their loss merely reflected the loss suffered by the company. This applied even if the company had decided not to pursue a claim against the wrongdoer.
Application to creditors
The rule was subsequently developed in Johnson v Gore Wood & Co in 2002. The then House of Lords considered that reflective loss was a principle of damages law which prevented claimants from recovering twice against the same defendant in relation to the same facts. Additionally, where a claimant had not been compensated because the company had decided not to pursue a claim itself, the chain of causation between the wrongdoer’s actions and the loss was broken. The Court therefore expanded the principle to cover claims brought by shareholders even when they were suing as creditors (for example, a claim as employees for lost wages because the wrongdoer’s actions had caused the company to become insolvent).
Later cases also expanded the principle to non-shareholder creditors, like Marex, who were no longer able to recover from an insolvent company and sought to bring a claim against a wrongdoer who caused the insolvency.
The Marex Supreme Court decision
The majority judgments restored the law to the position in Prudential Assurance: where the company and shareholders have the same claim against a wrongdoer, the shareholders cannot claim compensation for a loss which reflects the company’s loss. The rule does not apply to creditors (whether they are also shareholders or not).
Importantly, the Court held that the rule of reflective loss is one of company law and not a principle of damages. It is intended to prevent shareholders from circumventing the derivative action regime by bringing a personal claim instead. Therefore, it will not apply where only the shareholders have a right of action, and not the company (for example, where a contract has been concluded with shareholders and the company is not a party to it). Additionally, where the shareholders’ claim is based on a loss which is “separate and distinct” from the company’s loss, the rule will not apply. We anticipate that the definition of separate and distinct losses is likely to be the focus of future shareholder claims.
In reaching this decision, the Court overruled two cases where shareholders had been permitted to bring personal claims as an exception to the reflective loss rule because the company was practically disabled from bringing a claim. In Giles v Rhind the wrongdoer’s actions had caused the company significant losses, such that it was unable to pay security for costs and therefore unable to pursue civil proceedings. In Perry v Day the alleged wrongdoer was a director who had abused his power to prevent the company from bringing a claim against him. The Supreme Court held that both cases were incorrectly decided. This aspect of the judgment will be disappointing for shareholders of companies that do not bring a meritorious claim due to lack of funds or because the company’s managers or insolvency practitioners decide against it.
Interestingly, a minority of the judges would have abolished the rule against reflective loss entirely, on the basis that any risk of double recovery could be effectively managed by the court on a case-by-case basis. However, the majority’s more conservative approach is the current legal position.