Claim against investor under investment agreement was barred by rule against reflective loss

22 July 2022

The High Court has held that continuing shareholders of a company in which a new investor took a 50% stake were prevented from claiming against the investor due to the rule against reflective loss.

What happened?

Burnford and others v Automobile Association Developments Ltd [2022] EWHC 368 (Ch) concerned a company that operated an online vehicle administration and service booking platform.

In 2015, the company’s shareholders entered into an investment agreement with Automobile Association Developments Ltd (AADL), a subsidiary of the Automobile Association (AA). Under that agreement, AADL took a 50% equity stake in the company and the shareholders granted AADL a call option over the remaining 50%.

In 2017, the company went into administration. Another company in the AA’s group subsequently bought the company’s business from the administrators at a price substantially lower than the company’s value at the time AADL had invested in it. The company was dissolved in 2019.

The former shareholders of the company brought claims against AADL. Specifically, they alleged that:

  • AADL had made a number of fraudulent or negligent misrepresentations about the amount of business the AA would pass to the company; and
  • AADL had breached the investment agreement (as a related licence agreement) by “pursuing a course of conduct that undermined the basis of the arrangements” between the parties and the company.

AADL responded with a single defence: that the claims were barred by the so-called “rule against reflective loss”.

What is the rule against reflective loss?

It is a basic and fundamental tenet of English law that a company is a legal person separate from its shareholders, and that, where a company and its shareholders suffer a wrong, each of them is entitled to bring their own claim. However, this is modified by the “rule against reflective loss”.

The rule (also known as the rule in Prudential) applies where both a shareholder of a company and the company itself have suffered loss and both have a claim against the same third party in respect of the same “wrongdoing”.

In those circumstances, the shareholder is not permitted to claim for any diminution of the value of its shareholding in the company, or for any loss of distributions (e.g. dividends), which is “merely the result of a loss suffered by the company” and caused by that third party – so-called “reflective loss”. Instead, the right to claim damages lies with the company itself.

One consequence of this is that (generally speaking) a shareholder is unable to claim for reflective loss even if the company itself declines to claim, leaving the shareholder completely uncompensated. The courts have said that this is an economic risk that a person assumes as part of their agreement to hold shares in a company, deriving from the unique relationship between a company and its shareholders.

The rule does not prevent a shareholder from recovering loss in other circumstances, such as where a shareholder has suffered a loss that is “separate and distinct” from any loss the company has suffered.

In response, the former shareholders argued that the rule against reflective loss was not relevant, because:

  • they were not shareholders of the company at the time they brought their claim against AADL; and
  • they were claiming in respect of misrepresentations and contractual promises made directly to them, which was a separate and distinct claim from any claim the company might have.

What did the court say?

The court agreed with AADL and dismissed the claim.

The judge said that it was not enough that the former shareholders had a separate cause of action from the company. Rather, they needed to show that the company had suffered a different loss in respect of which it was entitled to bring a claim. That was not the case here.

The judge also found that it did not matter that the former shareholders were no longer shareholders in the company. Although the company had been dissolved, there had been no change in its shareholders. If it were restored to the register today, the former shareholders would become shareholders again and would be treated as having been shareholders throughout its dissolution.

As a result, all the claims failed.

What does this mean for me?

This was a decision on an application to strike out a claim and so does not carry the same force as a judgment following a full trial. Nevertheless, it is a useful confirmation on the rule against reflective loss as it is now understood.

The outcome was not particularly surprising. The former shareholders’ claims fell very neatly within the ambit of the rule against reflective loss.

However, this case shows the importance of structuring joint venture, investment and shareholders’ agreements properly. It is not uncommon to make the company itself a formal party to these kinds of agreements and to give it the express benefit of certain contractual covenants. In doing this, however, shareholders must be very careful to ensure that, rather than bolstering their investment, they are not in fact detracting from their rights by bringing the rule into play.

Parties who are considering entering into any kind of investment in a company should consider taking certain steps.

  • Clarify who the parties are. If the investee company is to be a party to the arrangements, the contractual documentation should reflect this and set out precisely which rights the company is to have and be able to enforce.
  • Beware of overlap between company and shareholder rights. It is common for an investment agreement to provide rights in favour of both the company itself and one or more shareholders. This is, of course, fine and can be said to “cover all bases”. But shareholders should bear in mind that, where 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 doing so itself.
  • Deal with any potential deadlocks. This problem is exacerbated where the company becomes “deadlocked”. In this situation, the company’s board may not be able to take action to recover losses suffered by the company, yet the shareholder will also be barred from claiming by virtue of the rule. The parties will need to think of ways to address this. This might include providing for a modified decision-making process in such a situation or providing a separate right of action for the shareholder that does not overlap with that of the company.