Reflective on loss
August 2020
Rating system:
Reading time (mins): 7ish
Sophistication level (1 (idiot) – 10 (expert)): 8
Entertainment value (1 (turgid) – 10 (side-splitting)): 2 (lol)
This case was described by one of the Supreme Court judges, Lord Reed, as raising ‘one of the most important and difficult questions of law to come before the Supreme Court for some time’.
Background
Company law rule #1
A company is a separate legal entity. It has a corporate veil which famously can’t be pricked. It is ‘owned’ by its shareholders, and its value is reflected by the value of the shares owned by its shareholders. But the shareholders don’t manage the company. It is managed by its board of directors. As a default rule, company law says that a company’s affairs are to be managed by its directors, and that directors can be appointed and removed by a simple majority of shareholders (ie any shareholder or group of shareholders who between them own over 50% of the shares). But a company’s Articles of Association can set out all sorts of detailed and tailored rules which can say something different.
One of the fundamental principles of company law, which can be traced all the way back to the famous (to all law students) case of Foss v Harbottle in 1843, is that where a wrong has been done to a company it is the company itself which is the proper plaintiff – not any of its shareholders. The value of the shareholder’s shares may have gone down because of the damage to the company, but the principle is that the company should be able to claim for that damage, in which case the value of the shareholder’s shares will go back to normal.
There are also general contract law rules, such as those relating to mitigation of loss, which have developed over the years which have been designed to protect a defendant from suffering a double whammy by being sued by different people for the same loss. The idea is that the defendant shouldn’t be allowed to be sued separately by both the company and its shareholders for the same loss.
But over more recent decades a company law principle has developed known as the rule against reflective loss, which has become a strange mixture of the company law and contract law principles above. It has ended up totally confusing our courts.
The rule against reflective loss – where it all began
The rule is generally considered to be based on a Court of Appeal decision in 1982 (Prudential Insurance Co Limited v Newman Industries Limited), and was then developed by subsequent cases. The rule starts by setting out the basic Foss v Harbottle principle. But it then goes on to say that even if a shareholder would ordinarily have a direct cause of action against a defendant, if the company also has a cause of action against the defendant the shareholder can’t recover damages based on the loss in value of his shares in the company, or lost dividends the company might otherwise have paid him, as a result of damage done to the company by the defendant, eg its net assets have gone down. His ‘loss’ is merely a reflection of the loss suffered by the company. He doesn’t suffer a personal loss, as his only loss is through the company, in which he still has the same shares as he had before (unless anything else has changed). The shareholder doesn’t have the right to sue for his loss so long as the company has the right to sue for its loss. This goes further than the basic Foss v Harbottle principle because the shareholder isn’t just looking to back onto the company’s own right of action against the defendant – he has his own separate right of action against the defendant, for example based on a rule of tort such as where the defendant has been personally deceitful to the shareholder.
Exceptions and confusions
A small exception to the rule against reflective loss also developed. There was a case on 2003 (Giles v Rhind) where a defendant wrongly breached non-competition obligations to the company. The damage was such that the company could not afford to sue the defendant. The Court of Appeal allowed a shareholder to bring proceedings against the defendant on the grounds that it would be unjust to allow a wrongdoer to defeat a claim by shareholders on the basis that the claim was trumped by a right of action held by the company which his own wrongful conduct had prevented the company from pursuing. However, the test set by the court of “impossibility” for the company to bring the action in its name was a prohibitively high one and the exception has been applied sparsely since this decision.
Other cases also then confused things by saying that the main reason a minority shareholder can’t take an action is because company law is designed to ensure that it is the majority shareholders who control things. As a general rule under company law directors can be appointed or removed by whichever shareholders own a majority of the shares. If these majority shareholders don’t like something that has been done to the company they can arrange for the directors to take action (and if the existing directors refuse to, they can be removed and replaced by directors who will take action). If a minority shareholder happens not to like something that has been done to the company, he can’t do anything about it if he can’t persuade a majority of the shareholders to arrange for the board to take action.
This of course leads to the possibility that the majority shareholders might allow things to happen in relation to the company which are not in a particular minority shareholders’ interest. The simplest examples might involve where the company enters into arrangements directly with majority shareholders which are good for those shareholders but which cause the company loss.
How the law normally protects minority shareholders
There are various areas of company law which are designed to protect minority shareholders in these circumstances. The main areas are:
- A raft of duties which directors (whose appointment is generally controlled by the majority shareholders) owe to the company
- Derivative actions (covered by ss 260 to 264 Companies Act 2006) – a minority shareholder can persuade a court to rule that a company must take a particular action which the majority shareholders (through the directors they control) are failing to take (for example, to sue a director appointed by the majority shareholders for a breach of his duties)
- The right for minority shareholders to bring claims against a company’s controlling shareholders for ‘unfair prejudice’ under s 994 Companies Act 2006 – for conspiring to allow the company’s affairs to be run in a way which is unfairly prejudicial to a particular shareholder’s interests.
It’s worth noting that in many cases there are tailored rules entrenched in the company’s Articles of Association (which often are drafted and adopted in tandem with a shareholders agreement between the shareholders) which prevent majority shareholders from controlling particular board action. This could include things such as entrenched rights for different shareholders or classes of shareholders to appoint and remove their chosen directors; or rights of particular percentages of shareholders to veto certain board decisions. This does not seem to have been taken into account when setting out the main reasoning for the existence of the rule against reflective loss which I’ve mentioned above. But rather than feeling the need to re-address this, the law has instead developed to allow derivative actions and unfair prejudice actions to be brought by minority or majority shareholders if necessary.
Coming to a head
Anyway, the problem with the rule against reflective loss started getting worse in 2004 when the courts started saying that a shareholder could not even be able to bring an action in his capacity as an employee or creditor of the company (where the loss he suffered was a ‘reflection’ of the loss suffered by the company) unless the company itself was unable as a result of the wrong done to it to pursue its own claim.
And then this case came up, where the claimant was not even a shareholder in the company concerned… (Remember that it is only shareholders who have the ability to protect themselves by bringing s 994 unfair prejudice claims or ss 260-264 derivative actions.)
Recent case:
Two companies, Creative Finance Limited and Cosmorex Limited, were controlled by Mr Sevilleja. Marex Financial Ltd had contracts with the companies, and brought an action against them to recover sums due under the contracts. Marex was awarded damages and costs of over US$7m. Just before the decision was announced (but having seen a confidential draft of what it was going to say) Mr Sevilleja arranged (in breach of his duties as a director) to transfer over US$9.5m from the companies to himself. This left the companies with under US$5,000. Mr Sevilleja then put the companies into liquidation, with total debts of over US$30m. All the creditors other than Marex were connected to Mr Sevilleja. The liquidator didn’t have enough funds to investigate claims, to locate the missing funds or to issue proceedings against Mr Sevilleja.
Marex therefore brought proceedings directly against Mr Sevilleja in tort (broadly, intentionally causing loss to Marex by unlawful means, and violating Marex’s rights under the court’s damages award). Mr Sevilleja claimed Marex couldn’t do so because of the reflective loss principle – the loss suffered by Marex as a creditor of the companies was simply reflective of the loss suffered by the companies themselves – even though Marex was not a shareholder in the company. The High Court said that Marex could bring the claim. Mr Sevilleja appealed. The Court of Appeal allowed the appeal and said that Marex couldn’t bring the claims. It said the rule against reflective loss should apply to all creditors of the company, even if they were not shareholders. It also said that there were no legal issues preventing the company from pursuing its own claim against S, which would have been the only circumstances where it would have allowed M to bring the claim against S himself.
What did the Supreme Court say?
On 15th July 2020 the Supreme Court gave its verdict. They thought it such an important case that there were seven Supreme Court judges involved rather than the usual five.
The Supreme Court overturned the Court of Appeal’s decision.
In short, the Supreme Court ruled that a claim by a company’s creditor against a third party will not be barred where the damage suffered by the creditor reflects loss by the company, where the creditor was not also a shareholder.
Also, the Supreme Court overruled Giles v Rhind (see above). So there is no longer an exception to the doctrine against reflective loss where the wrongdoer has brought about the company’s lack of finances.
All 7 Supreme Court judges gave the same verdict. But the reasons given were different. They all agreed that the reflective loss rule had been taken much too far. Lord Reid described the development of the law as like a ‘ghastly legal Japanese knotweed’. But the majority (ie four judges, including Lord Reed) were happy just to narrow the doctrine of reflective loss. Whereas the other three judges actually said that they would have preferred to get rid of it altogether.
Thoughts:
- The case is good news for creditors, as it strengthens the role of economic torts and supports creditors faced with wrongdoing by third parties.
- This might be the beginning of the end for the reflective loss doctrine, and all the complications it has brought in.
- The case may open the door for creditors (or even shareholders if the whole reflective loss doctrine starts crumbling in the courts) to bring actions for recovery of losses directly against a company’s directors.
- It does beg the question of how the courts will apply other commercial law principles to avoid the prospect of unfair double recovery by different claimants (eg the company and one of its creditors, employees or shareholders) against the same defendant; particularly in the context of a company which goes into liquidation.
- Frankly this case raises a lot of issues and potential knock-on questions which are too complicated to give justice to in a friendly newsletter like this, and I wish I hadn’t started reporting on it…
Case: Sevilleja v Marex Financial Ltd [2020] UKSC 31
