Corporate Law Update
- The court clarifies that the “rule against reflective loss” does not bar a claim by an “indirect shareholder” of a company
- Companies House sets out its strategy for the next five years, as well as changes to expect in 2020/2021
- The FRC publishes a review of how companies held their AGMs during H1 2020
- The FRC publishes a report on compliance with the principles in its 2020 Stewardship Code
- A director of a company could not claim privilege over legal advice procured to further a deliberate breach of statutory duty
- The IFRS Foundation is consulting on the demand for a set of global sustainability standards for financial disclosures
- The Government is consulting on new powers to assist small businesses with recovering late payments
- ESMA provides an update on proposed changes to its Q&A on the Prospectus Regulation
Covid-19 is affecting the way people conduct their business, retain their staff, engage with clients, comply with regulations and the list goes on. Read our thoughts on these issues and many others on our dedicated Covid-19 page.
The High Court has held that the so-called “rule against reflective loss”, which prevents a shareholder from bringing a claim for a drop in the value of shares in a company where the loss merely reflects the company’s loss, does not apply to claims by indirect shareholders.
Broadcasting Investment Group Ltd v Smith  EWHC 2501 (Ch) concerned a company established to act as a joint venture vehicle for a low-cost broadcasting business.
The venture was conceived by a Mr Smith, who operated two pre-existing broadcasting businesses, and a Mr Burgess, who had experience in the sector and was able to procure outside investment.
The arrangements for the joint venture were to be as follows.
- A new holding company would be incorporated (which the judge refers to as SS PLC).
- 39% of SS PLC’s shares would be held by a separate company (BIG), which had already been incorporated as a co-investment vehicle for Mr Burgess and the external investors. A further 48% would be held by Mr Smith and the balance by external investors.
- Mr Smith would ensure that the shares in the pre-existing businesses were transferred to SS PLC.
Importantly, 51% of BIG’s shares were owned by another company (VIIL), whose shares were turn owned by Mr Burgess.
Mr Burgess claimed that he, Mr Smith, BIG and the external investors had entered into an oral “joint venture structure agreement” (JVSA) committing them to putting these arrangements in place. For the purposes of this particular decision, the court accepted that this agreement existed.
According to Mr Burgess, SS PLC was incorporated with its shares issued in the agreed proportions, but the shares in the pre-existing businesses were never transferred to SS PLC.
Mr Burgess and BIG brought proceedings against Mr Smith and others for breach of the JVSA, claiming that the failure to transfer the shares in the businesses had caused a diminution in the value of BIG’s shares in SS PLC. (SS PLC could not bring a claim, because it had since been placed into liquidation and the liquidator had decided not to take legal action.)
In response, Mr Smith argued that BIG’s and Mr Burgess’ claims were barred by the “rule against reflective loss” (see box below), because, if there had been a breach of the JVSA, any loss they had suffered merely reflected loss suffered by SS PLC and in respect of which it was entitled to claim.
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 so both have a claim against a 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.
The rule does not prevent a shareholder from recovering loss in other circumstances.
For some time, it had not been clear whether the rule was a facet of company law (reflecting the core principle that a company is a separate person that pursues its own claims) or an expression of the more general principle that a person cannot recover their loss twice (the “principle of double recovery”). (The logic behind the latter approach is that, if the shareholder could recover loss and, subsequently, the company also recovered, the shareholder would effectively be compensated twice over.)
However, in Sevilleja v Marex Financial Ltd  UKSC 31 (Marex), on which we reported in our previous Corporate Law Update, the Supreme Court confirmed that the rule applies “as a matter of law” and is not merely a means to prevent double recovery.
One consequence of this is that (generally speaking) a shareholder is also unable to claim for reflective loss where the company itself declines to claim, leaving the shareholder completely uncompensated. The court has said 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.
But the court also confirmed in Marex that (contrary to suggestions in previous decisions) the rule applies only to shareholders. In that case, the court found that the rule did not prevent a creditor of a company from bringing a claim against a third party.
Among the questions before the court, there were two of particular interest:
- Did SS PLC have a right of claim under the JVSA? If it did not, the rule could not apply, because the loss Mr Burgess and BIG were claiming for would not have been reflective of loss suffered by SS PLC.
Mr Burgess argued that, because SS PLC had been incorporated after the JVSA was entered into, it could not have been a party to it and so could not have had a right to claim under it.
Mr Smith argued that the JVSA conferred a benefit on SS PLC – namely, the right to receive the shares in the two pre-existing businesses – and that it therefore had a right to enforce the JVSA as a third party under the Contracts (Rights of Third Parties) Act 1999 (the 1999 Act), even though it had not formally entered into it.
- Does the rule against reflective loss prevent an “indirect shareholder” from claiming?
Mr Burgess argued that, following the decision in Marex (see box above), only direct shareholders of a company are affected by the rule against reflective loss. If the rule did apply, it might prevent BIG from bringing a claim, but not Mr Burgess, who was a “shareholder of a shareholder of a shareholder” of SS PLC, rather than a direct shareholder.
Mr Smith, by contrast, argued that the same logic should apply to a “second-degree” or “third-degree” shareholder, such as Mr Burgess. Mr Burgess’ loss was, he argued, ultimately reflective of loss suffered by SS PLC, albeit it through a chain of legal entities.
Did SS PLC have a right to claim?
Yes (assuming that the JVSA existed and there was a breach). The JVSA had provided for SS PLC to be established to act as the vehicle for the joint venture and to hold the shares in the pre-existing businesses. This was enough to confer a benefit on SS PLC.
It was irrelevant that the JVSA was an oral, rather than a written, agreement. There was nothing in the 1999 Act to suggest that oral agreements were excluded from its scope.
Nor did it matter that SS PLC was incorporated after the JVSA was entered into, because section 1(3) of the 1999 Act specifically states that a third party who wishes to enforce a contract under the Act does not need to be “in existence” when the contract is entered into.
There was some discussion of whether the parties the parties needed to have “intended” to confer a benefit on SS PLC in order for the 1999 Act to apply, but, in the judge’s view, this was the wrong approach. The 1999 Act is engaged if a contract “purports” to confer a benefit. If it does, this creates a rebuttable presumption that the contract is enforceable by the third party, and it is up to the named contract parties to prove that they did not intend for the contract to be enforceable by third parties.
Having established that SS PLC had a right of claim, it was clear that the rule against reflective loss prevented BIG, as a direct shareholder of SS PLC, from bringing its claim.
Did the rule prevent Mr Burgess from claiming?
No. It was apparent from the Supreme Court’s decision in Marex, which had been delivered during the course of Mr Burgess’ claim, that the rule against reflective loss is limited to claims by shareholders.
The Supreme Court had made it clear that the rule arises because of “the unique position in which a shareholder stands in relation to [a] company”. It is a “highly specific exception” to the general rule that each person is entitled to claim for their own loss.
Although a “shareholder of a shareholder” – in the judge’s words, a “second-degree” or “third-degree” shareholder – has an indirect economic stake in a company, that person is not a shareholder of the company either in fact or in law. To treat them as a shareholder would be to ignore the separate legal personality of any intermediate companies in the corporate chain.
As a result, Mr Burgess was not prevented from bringing his own claim.
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 elaboration on the rule against reflective loss.
It is also a useful reminder of how, if parties are not careful, the 1999 Act can intervene with unforeseen consequences. It is possible (and standard practice) to exclude the 1999 Act, but that would have been difficult here, given the contract was formed orally. It was the very fact that the 1999 Act applied that meant the rule against reflective loss was invoked, preventing BIG from claiming.
More generally, the decision 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 joint venture or co-investment in a company should consider taking certain steps.
- Put the agreement into writing. There will come a point at which the proposed arrangements are sufficiently clear that they should be set out in writing. Failing to do so risks the possibility that an oral contract might arise, with the inherent uncertainties this brings.
- Clarify who the parties are. If the joint venture or 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.
- Deal with third parties. The contract should make it clear whether third parties can rely on and enforce it. Parties can exclude the 1999 Act if they wish. Typically they will do so, but often with exceptions allowing specific rights in the contract to be enforced by specified third parties.
- Beware of overlap between company and shareholder rights. It is common for a joint venture or 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 joint venture 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 the company’s.
In theory, shareholders could utilise the court’s decision that the rule does not bar an “indirect shareholder” from claiming to preserve their rights. Simply inserting a single intermediate vehicle between a shareholder and the company should, on the face of it, circumvent the rule. However, this is not free from doubt and it is conceivable that a court might distinguish this decision on its facts or look to pierce the corporate veil of an intermediate entity if it is being used abusively in any way.
Companies House has published its strategy for 2020 to 2025 and its business plan for 2020/2021. Together, the two documents outline Companies House’s intended activities over the next five years, as well as its delivery plan for the first year of that strategy.
The key points from the documents are set out below.
- Quality of information. Companies House intends to make changes to enhance the reliability of the data it holds, and to act against people who misuse the register. In particular, it will seek powers to conduct “upfront checks” to deter false filings, something which the Government has already alluded to in its recent response paper (see our previous Corporate Law Update), and to make amending or removing inaccurate information easier.
- Identity verification. Again, as noted in the Government’s response paper, Companies House will develop solutions to allow it to verify the identity of people who set up, manage and control companies. It will seek a solution that achieves the “optimum balance” between the needs of register integrity and the burden on customers.
- Access to data. Companies House will continue to provide data to users free of charge through its website and API functionality. It will explore ways to make even more data available, increase the amount of searchable data and provide different ways to access data.
- Economic crime. Companies House intends to take a greater role in combatting economic crime through “active use of analysis and intelligence”. In particular, it intends to be more proactive in identifying suspicious activity and to collaborate with law enforcement agencies.
- Digitisation. Over the five-year period, Companies House aims to become a “fully digital organisation”. This may include not just expanding the ability to make filings online, but also existing voice recognition services, as well as implementing webchat and chatbot services. It will also begin to phase out paper reminders for accounts and confirmation statements.
In particular, during 2020/2021, Companies House intends to:
- develop a “simplified online journey for checking company data and submitting a confirmation statement where there have been no changes to that data”;
- create brand new digital services for higher volume transactions (such as those relating to insolvency) which are currently paper-only or subject to interim services introduced in response to Covid-19;
- begin to phase out the existing WebCheck and Companies House Direct (CHD) services, as part of migrating all data to its Companies House Service (CHS); and
- begin work to provide underlying data to customers, rather than simply PDF image files of forms that have been submitted.
The Financial Reporting Council (FRC) has published a review of the different ways in which companies held their annual general meetings (AGMs) in the first half of 2020 during the disruption caused by the on-going Covid-19 pandemic.
The review focussed on a sample of 202 AGMs held by FTSE 350 companies. The review found that AGMs generally fell into one of three models.
- Closed meetings, with only a small quorum attending (such as the chairman and company secretary). Shareholders were unable to attend, were instructed to vote in advance by proxy, and may or may not have been permitted to submit questions to the board in advance of the AGM.
- Open meetings with no interaction. Board members presented information to shareholders on the day by audiocast or webcast. Shareholders were able to submit questions to the board in advance of the AGM and were instructed to vote in advance by proxy.
- Open meetings with interaction. Shareholders were able to engage virtually with the board on the day of the AGM. They were able to submit questions both in advance of and during the AGM and could vote on the day using a voting app.
Using this methodology, the FRC has made the observations set out below.
- 163 companies (80.7% of the sample) held closed meetings. Of those companies, 81.6% made arrangements for shareholders to ask questions in advance. But 30 companies appeared to make no arrangements for shareholders to ask questions, which the FRC has called “disappointing”.
- 30 companies (14.9% of the sample) held open meetings. Of these, 60% were facilitated through webinar or audiocast and featured lived voting capabilities.
- 9 companies (4.5%) either adjourned their AGM or made no particular changes due to Covid-19.
- The review notes that many AGMs that took place in March and April were held as closed meetings, before the Corporate Governance and Insolvency Act 2020 (CIGA) came into effect and. CIGA allows companies to hold purely virtual general meetings up to 30 December 2020.
- The review also acknowledges that companies which held their AGMs later in the year had had more time to consider guidance issued by The Chartered Governance Institute about how to encourage shareholder engagement.
- The review highlights five examples of “poor practice” for closed meetings (such as setting unrealistic time frames for submitting questions or limiting the number of characters in a question) and five examples of “good practice” (such as posting Q&A on a website following the AGM).
- The FRC states that the best organised and executed virtual and hybrid meetings enabled increased participation from shareholders. It suggests striking a balance between asking questions in advance and allowing questions on the day, as board presentations will “inevitably lead to additional questions that cannot be anticipated in advance”.
- Although real-time voting using an app closely mirrors the procedure at a physical AGM, the FRC notes that this can increase costs for the company, and the associated security arrangements can make arrangements complex. It encourages the use of clear and simple voting systems and notes that in-app voting is likely to be more important where a company has retail investors.
- The FRC suggests that companies may wish to consider whether to “split” the AGM into two events, with one meeting for the board presentation and Q&A, and a separate meeting for voting on resolutions.
The review also contains an annex with best practice tips for companies when planning and conducting AGMs in the future.
Finally, the FRC has stated that it intends to work with Government to achieve clarity on whether general meetings can be held virtually under the Companies Act 2006 once the additional flexibility provided by CIGA expires. At the moment, it is unclear as a matter of law whether companies can hold virtual meetings outside the framework in CIGA, resulting in companies refraining from doing so.
What is the Stewardship Code?
The Code contains 12 principles which asset owners and asset managers should follow, as well six principles which service providers (such as investment consultants, proxy advisors and data providers) should follow, as part of good corporate governance and investor stewardship.
Compliance with the Stewardship Code is (in the main) voluntary, although FCA-regulated firms that manage investments for professional clients are required by the FCA’s Conduct of Business Sourcebook to publish the nature of their commitment to the Code.
The Code is supported by a list of “signatories” who have committed to comply with the Code. Asset managers and owners who wish to be included in the list of signatories will be able to apply for inclusion in 2021. Applicants must demonstrate how they apply the Code’s principles and meet the reporting expectations.
The 2020 version of the Stewardship Code was expanded to apply (for the first time) to classes of assets beyond merely listed securities, such as fixed income, private equity and infrastructure investments, as well as investments outside the United Kingdom.
What does the review show?
The FRC reviewed the reports of 18 asset managers and three asset owners from 2019 (before the 2020 version of the Code came into effect). However, 16 of the reports were intentionally prepared to comply early with the 2020 Code, and the remaining five showed sufficient alignment with the 2020 Code to merit inclusion in the review. Only one organisation was not an existing signatory to the Code.
The key observations of the FRC arising out of the report are set out below.
- Few reports consistently demonstrated the application of all of the Code’s principles or addressed all of its reporting expectations. The FRC says reporting needs to improve by reflecting on effectiveness of approach, demonstrating continuous improvement and disclosing outcomes.
- Statements in asset managers’ and owners’ reports need to be supported with specific evidence from the reporting period, and the rationale rather than just a general statement of approach.
- Reporting should clearly explain the asset manager’s or owner’s purpose and beliefs and provide distinctive reporting that connects this to their stewardship practice during the reporting period.
- Reporting should address all asset classes and geographies. If an asset manager’s or owner’s stewardship approach differs or is not as developed in some asset classes, it should explain this.
- Stewardship reports should be structured as a single document to give a clearer picture. Some organisations reported on a “principle-by-principle” approach, but others that followed their own structure tended to present their information in a more engaging way. In choosing a structure, an organisation should consider its audience’s needs.
- The FRC encourages asset managers and owners to think about how information could be displayed graphically and in ways that are helpful and interesting for readers.
- Finally, reports should be written in plain English and avoid jargon.
The FRC’s report also address observations specific to each of the 12 principles of the Stewardship Code that apply to asset managers and owners. Organisations looking to improve their reporting are advised to review the FRC’s observations on these principles.
The High Court has held that the directors of a company could not claim legal professional privilege in respect of legal advice given to them to further a fraudulent breach of their statutory duties.
Barrowfen Properties v Patel  EWHC 2536 (Ch) concerned a company whose shares were owned by three brothers, either through family trusts or (in one case) an intermediate company.
In short, in due course relations between the brothers broke down, and the company’s directors alleged that one of the brothers had committed a series of breaches of his statutory duties as a director under the Companies Act 2006.
In particular, they claimed that he had improperly written up the company’s register of members, forged letters of resignation, and attempted to place the company into administration when it was solvent so that he could purchase its sole asset.
The claimants asked the court to order the defendant director to disclose certain legal advice he had received in connection with these alleged acts. The defendant refused, claiming that the advice attracted legal professional privilege (LPP).
Legal professional privilege (LPP) allows a party to refuse to disclose legal advice to another party with whom it is engaged in legal proceedings. LPP divides into two specific types of privilege: legal advice privilege (LAP) and litigation privilege (LP).
LAP applies to confidential communications between a lawyer and their client which come into existence for the dominant purpose of giving or receiving legal advice about what be done in a particular legal context.
LP applies to confidential communications between a lawyer and a client, or between the lawyer or the client and a third party, which are made for the dominant purpose of litigation which is pending, contemplated or existing.
In this case, the defendant director claimed both LAP and LP.
The law surrounding LPP, and the requirements for successfully claiming it, are complex, and parties need to take specific and careful steps to ensure LPP is preserved at all times. There are various circumstances in which LPP can be “lost” or in which a party is prevented from relying on it.
One such scenario is where the allegedly privileged material is brought into existence to further a criminal or fraudulent purposes. Under what is known as the “iniquity exception” (or "fraud exception"), a party is not able to rely on LPP in these circumstances.
In response the claimants argued that the defendant should not benefit from LPP, because the legal advice in question had been brought into existence to further fraudulent purposes, namely deliberate and deceptive breaches by the defendant director of his statutory duties. They argued that the “iniquity exception” (see box above) applied.
The court had to decide whether the iniquity exception applied to a breach of a director’s statutory duties under the Companies Act 2006.
What did the court say?
The court agreed that the iniquity exception can apply to breaches of statutory duty under the Companies Act 2006. Specifically, the judge noted that the exception is engaged where:
- breaches of sections 172 to 175 and 177 of the Companies Act 2006 are alleged against a director; and
- the allegations involve “fraud, dishonesty, bad faith or sharp practice or where the director consciously or deliberately prefers his or her own interests over the interests of the company and does so ‘under a cloak of secrecy’”.
He noted that it had been well established by previous decisions that the exception does not apply merely in cases of crime or fraudulent misrepresentation, but to fraud “in a relatively wide sense”.
In this case, he found that all of the breaches of duty had been committed deliberately, dishonestly and/or in bad faith. As a result, the defendant director was required to disclose copies of the legal advice he had been provided.
Although the judge referred specifically to only five of the seven statutory duties of directors, it will surely be the case that the exception can apply to dishonest breaches of the other two duties.
What does this mean for me?
The term “iniquity” is arguably more apt than “fraud” to describe the exception, as generally it is not necessary to prove that there was a starkly fraudulent motive. Deliberate and intentional behaviour that falls short of fraud is capable, in appropriate cases, of engaging the exception.
For companies and their boards who are investigating potential breaches of duty by a director, the decision shows that there is value in vigorously resisting a claim for LPP where the company believes that the director asserting privilege has acted dishonestly, deliberately or (potentially) recklessly.
Conversely, a director who is considering taking a particular course of action should think very carefully before doing so if they have received legal advice that the action could amount to a breach of duty. Apart from the (perhaps obvious) fact that the action could in fact amount to a breach, rendering the director personally liable, if the advice was procured to further that breach, the director may be required to turn it over to a claimant, further undermining his or her own position.
Also this week…
- IFRS Foundation consults on sustainability standards. The IFRS Foundation, the body responsible for promoting International Financial Reporting Standards (IFRS), has published a consultation to assess demand for global sustainability standards and, if there is, the extent to which the Foundation might contribute to them. Questions on which the Foundation is seeking views include whether to prioritise climate-related financial disclosures before proceeding to broader sustainability reporting and whether any disclosures should be subject to audit. The consultation is open until 31 December 2020.
- Government consults on more powers to assist small businesses. The Government is consulting on giving the Small Business Commissioner (SBC) further powers to assist small businesses by providing effective mechanisms for redress in respect of late payments. These would include the power to issue monetary awards or impose binding payment plans where payments to small businesses have been unreasonably delayed or withheld. The consultation is being run as an on-line questionnaire and will close on 24 December 2020.
- ESMA provides update on revisions to prospectus Q&A. The European Securities and Markets Authority (ESMA) has published an update on the proposed revisions to its questions and answers (Q&A) on the Prospectus Regulation. The update sets out which Q&A ESMA intends to update shortly, which it intends to refer to the European Commission for review, and which will simply be deleted. ESMA has also confirmed that the previous recommendations of the former Committee of European Securities Regulators (CESR) remain in place for specialist issuers, and that it will be addressing them in the future.