Court reconsiders the rule against reflective loss

20 July 2021

The Court of Appeal has considered how the rule against reflective loss applies to claims by an “indirect” shareholder and its interaction with the Contracts (Rights of Third Parties) Act 1999.

What happened?

Broadcasting Investment Group Ltd v Smith [2021] EWCA Civ 912 concerned a company established to act as a joint venture vehicle for a low-cost broadcasting business.

In broad outline, three individuals – a Mr Burgess, a Mr Smith and a Mr Finch – as well as several corporate vehicles, including Broadcasting Investment Group Ltd (BIG) were assumed to have entered into an oral agreement under which (among other things) they would establish a new vehicle (SS PLC) and Mr Smith would transfer shares in two operating companies to SS PLC. The vehicle was incorporated, with BIG investing directly as a shareholder and Mr Burgess investing indirectly through BIG. However, the shares in the operating companies were never transferred to SS PLC.

For more detail on the factual background to the claim, see our previous Corporate Law Update.

Mr Burgess and BIG claimed against Mr Smith for breach of contract, alleging that the failure to transfer the shares had caused a diminution in the value of BIG’s shares in SS PLC. (SS PLC had, by this time, been placed into liquidation and the liquidator had decided not to take legal action.)

The High Court denied BIG’s claims on the following basis:

  • Under the “rule against reflective loss” (also known as the “rule in Prudential”) (see our previous Corporate Law Update), a shareholder of a company cannot claim against a third party for loss which the company has a legal right to claim from that same third party and which merely reflects loss suffered by the company itself.
  • Although SS PLC did not exist when the agreement was concluded, once it was incorporated it gained a right to enforce the agreement as a third party by virtue of section 1 of the Contracts (Rights of Third Parties) Act 1999 (the 1999 Act).
  • Once SS PLC acquired that right, BIG, as a shareholder of SS PLC, was no longer able to claim against Mr Smith, because its loss merely reflected loss suffered by SS PLC. The rule against reflective loss applied.

However, the court did not deny Mr Burgess’ claim. His loss was also “reflective” (in the broad sense) of loss suffered by SS PLC, because that loss flowed through his shareholding in BIG. However, the High Court noted that the rule against reflective loss only prevented a “direct” shareholder from bringing a claim, not an “indirect shareholder”.

The parties appealed and cross-appealed on both these points.

What did the court say?

Taking the second point first, the Court of Appeal concluded that the rule against reflective loss did not prevent an “indirect” shareholder from bringing a claim for the same reasons as the High Court had given. However, it is worth noting two points on this:

  • The court’s comments are only persuasive (obiter), because it had already concluded that there was no basis for a claim in the first place. However, they are instructive and important to note.
  • Only two of the judges (Lady Justice Asplin and Lord Justice Coulson) reached this conclusion. One judge (Lord Justice Arnold) said it was “well arguable” that the rule could prevent a claim by an “indirect” shareholder.

However, on the first point, the Court of Appeal overturned the High Court’s decision. The judges noted that SS PLC’s right to enforce the agreement was created by section 1(1) of the 1999 Act when SS PLC was incorporated. They also noted section 4 of the 1999 Act, which states: “Section 1 does not affect any right of the promisee to enforce any term of the contract.

In this case, the “promisee” referred to in section 4 was BIG and the “right” was BIG’s right to enforce the contractual terms of the agreement against Mr Smith. The Court of Appeal said that the purpose of section 4 was to ensure that, by creating a right for SS PLC to enforce the contract under section 1, BIG’s existing right was not eliminated. As a result, BIG was in fact entitled to claim against Mr Smith.

Mr Smith’s lawyers had argued that the purpose of section 4 was to prevent any risk that an existing contractual right would be destroyed by the creation of third party rights under the 1999 Act. However, it was not the 1999 Act which prevented BIG from claiming, but rather the rule against reflective loss. Section 4 had never been intended to prevent that rule from applying.

However, the court disagreed. The judges said that the rule against reflective loss could not be separated cleanly from rights created under section 1. If that were the case and the rule could extinguish an existing contractual right, section 4 would be “sidestepped”. It was not permissible to interpret the statute in any other way.

What does this mean for me?

The court’s comments on whether an “indirect” shareholder is barred by the rule against reflective loss are significant, as they leave this area of the law open. Should someone in a similar position to Mr Burgess bring a similar claim in the future, a court will not be required to follow the Court of Appeal’s comments in this case, and, although its conclusion will be persuasive, a court will be entitled to take Lord Justice Arnold’s “dissenting” comments into account.

The intersection of the 1999 Act and the rule against reflective loss is not likely to arise frequently, although this case shows that the 1999 Act can be engaged much more easily than might be expected.

There are some important takeaways from this case. A shareholder in a company who is looking to bring direct legal action against a third party should consider certain factors first.

  • Check for any overlap between the company’s and the shareholder’s rights. It is common for a joint venture agreement or investment agreement to provide rights in favour of both the company itself and one or more shareholders. Shareholders should bear in mind that, if the company suffers a loss and has a right to recover it under the contract, the rule against reflective loss may prevent the shareholder from recovering personally.
  • Consider the impact of the Contracts (Right of Third Parties) Act 1999. It is common to exclude the 1999 Act from a written contract, albeit sometimes with exceptions in certain circumstances. So always consider carefully how (if at all) it is intended to apply, and articulate that clearly in the contract. But the Act also applies to oral contracts (as in this case) and contracts by conduct. It is important to examine all the factual circumstances to decide whether any third party rights have arisen. It might be that the rule against reflective loss never applies.
  • As we mentioned in our previous Corporate Law Update, in theory, the decision means that a shareholder could simply insert a single intermediate vehicle between themselves and the company to avoid becoming a direct shareholder to circumvent the rule. However, for the reasons set out above, this is not free from doubt and should be considered alongside any other factors pointing towards the use of an intermediate vehicle.