Supreme Court confirms the rule against reflective loss

27 July 2020

The Supreme Court has reviewed the so-called “rule against reflective loss” in a series of judgments that perhaps raises more questions than it settles.

What happened?

Sevilleja v Marex Financial Ltd [2020] UKSC 31 concerned two companies incorporated in the British Virgin Islands (BVI) which were owned and controlled solely by an individual, Mr Sevilleja. In 2013, Marex, a trade creditor of the companies, obtained judgment against the companies for more than US$7.15 million (including costs).

Shortly after the judgment was handed down, Mr Sevilleja allegedly arranged for more than US$9.5 million to be transferred from the companies into his personal control, leaving the companies with no more than US$5,000 of disclosed assets from which to satisfy Marex’s award.

Marex brought proceedings directly against Mr Sevilleja, claiming that he had induced a violation of Marex’s rights under the court’s order and that he had intentionally caused Marex to suffer loss by unlawful means.

In response, Mr Sevilleja argued that Marex was barred from claiming against him, because the loss it was claiming was merely “reflective” of the two BVI companies’ losses. Rather than Marex, it was the two BVI companies that should be claiming against Mr Sevilleja.

What is the “rule against reflective loss”?

Put simply, the rule applies where both a company and its shareholder have a right of action against the same third party in relation to the same wrongdoing, and the shareholder is seeking to recover a drop in the value of its shares (or in distributions by it) which is a consequence of the loss sustained by the company itself.

In those circumstances, the law regards the shareholders’ loss as merely “reflective” of the company’s loss and the shareholder is barred from recovering the drop in the value of its shares. This is the case whether or not the company in fact takes any action against the third party.

The rule is often justified as a way to prevent “double recovery”. If both the shareholder and the company were able to claim, so the logic goes, the shareholder would receive both a direct payment from the wrongdoer and an additional reward in the uplift of the value of its shares. In the same way, the wrongdoer would be doubly penalised, having to pay out twice in respect of the same loss – once to the shareholder and once to the company.

The rule was originally formulated in the case of Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204. However, in subsequent years, it has been applied in numerous cases, with the potential to apply to persons who are not shareholders, such as (in this case) a creditor, or who are both shareholders and creditors. It has even been suggested in the past that the rule could extend to claims by employees.

The Court of Appeal agreed with Mr Sevilleja and barred Marex’s claim. From Marex’s perspective, this posed a problem: the two BVI companies had been placed in liquidation and were operating under the auspices of their liquidator whom, according to Marex, Mr Sevilleja had deprived of the resources needed to bring any claims against him.

Even if the companies did bring claims, Marex would need to prove in the companies’ liquidation alongside its other creditors, who were all persons associated with Mr Sevilleja.

Marex therefore appealed to the Supreme Court. This gave the Supreme Court a welcome opportunity to review the both the rationale for and the extent of the rule against reflective loss.

What did the court say?

The court agreed unanimously with Marex, finding that the rule against reflective loss did not apply where the person claiming was a creditor, and not a shareholder, of a company.

However, the court was split 4-3 in its reasoning and, in particular, in its opinion on the fundamental basis for the rule against reflective loss.

All seven of the judges agreed that the rationale for the rule given in previous cases was flawed. They said it was rarely possible to say that a loss suffered by a company would result in an equal and equivalent drop in the value of the company’s shares. That could happen only in the most simple of scenarios: where the value of the company’s shares reflects exactly the value of its assets – in other words, where they are valued on a strict “net asset value basis”.

But the judges all noted that the value of a company’s shares will often be based on other factors, such as its prospects and reputation and supply and demand for its shares. A drop in the value of a company’s shares could exceed any loss suffered by the company, such as if the very existence of a claim indicates poor management by the company’s directors, so depressing investor confidence.

However, this is where their agreement ended.

The rule is here to stay

A bare majority of the judges, led by Lord Reed, said that the rule was a hard and fast tenet of company law. It had developed out of the Prudential case as a way to prevent shareholders from by-passing one of the fundamental concepts of company law: that a company is a legal person separate from its shareholders (the so-called “rule in Foss v Harbottle”).

According to Lord Reed, by signing up to take shares in a company, a shareholder agrees that its fortunes will be tied to those of the company and entrusts the management of the company to its decision-making organs (i.e. its board of directors). If the value of the shareholder’s shares drops because of some wrong done to the company, the shareholder must suffer that loss.

In those circumstances, the shareholder does not incur a loss that is regarded by the law as “separate and distinct from the company’s loss”, and so the shareholder has no claim. This means that, even if the drop in share value exceeds the company’s loss, the shareholder cannot recover it.

The rule shouldn’t exist

Lord Sales, leading the minority judgment, took a different approach. In his view, the rule (if it exists) is not a novelty of company law; rather, it is a way of guarding against double recovery.

The courts can achieve this in various ways, including by taking payments to the company into account when calculating a shareholder’s loss, preventing a shareholder from claiming until the company has had a chance to do so, or joining a shareholder and company into the same legal proceedings.

On this basis, a shareholder would be entitled to claim against a third party, even if the company also has a claim. It would be up to the courts to decide how to award damages. The likely end result is that the shareholder could recover a drop in the value of its shares, less any increase in the value of those shares as a result of the company receiving any payment. That increase might not be the same as the amount of the payment to the company.

To deny a shareholder any claim at all, according to Lord Sales, would be to deprive the shareholder of a personal right of claim without sufficient justification.

Effectively, although Lord Sales didn’t say as much, this would amount to abolishing the rule against reflective loss entirely and relying purely on principles preventing double recovery.

What does this mean for me?

Cases such as this, with differing judgments, can make it difficult to understand the state of the law going forward. However, for the time being, the majority judgment delivered by Lord Reed is binding.

This means that, not only does the rule against reflective loss persist, but it is even stronger than before. In effect, there are virtually no exceptions to the rule.

Indeed, the Supreme Court specifically overturned previous cases, such as Giles v Rhind [2003] Ch 618 and Perry v Day [2005] 2 BCLC, in which courts had said that a shareholder could claim where the wrongdoer had, by their actions, deprived the company of the ability to bring its own claim. From now on, a shareholder will not be able to recoup a drop in the value of its shares, whether or not the company can bring a claim itself.

Creditors, however, can breathe more easily. It is now clear that a creditor can claim against a third party, even if the debtor company also has a claim against that third party, provided the claim is brought by the creditor in that capacity and relates to the debt owed by the company. However, if the creditor is also a shareholder, there will need to be an exercise of working out whether loss is caused by a drop in share value or arises merely out of a failure to pay the unpaid debt.

The judgment gives rise to the following practical points, all of which a shareholder who is considering bringing a claim should discuss with its legal advisers:

  • Is the shareholder seeking to recover a drop in the value of its shares? If so, it will be important to examine whether the loss is merely “reflective”.
  • Does the shareholder’s loss arise in consequence of a loss to the company? If so, it is likely to be unrecoverable, even if it exceeds the loss suffered by the company. However, in some cases, the shareholder’s loss may be totally distinct from any loss suffered by the company (and so recoverable), even if the loss is caused by the same person.
  • If the loss is merely “reflective”, are there any other options open to the shareholder? Does it have any power to require the company’s directors to take action against a third party? If they refuse to do so or they settle for too low an amount, can the shareholder bring a derivative claim on behalf of the company against its directors for breach of their duty to the company, or even a personal claim for unfair prejudice?
  • If none of that helps, does the shareholder have any alternative rights of claim against the third party that would not be barred as reflective loss? For example, does the shareholder have the benefit of a separate indemnity or covenant to pay, which could be enforceable as a debt?