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Clearing the knotweed: a future path for reflective loss20 August 2020

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In its recent landmark decision in Sevilleja v Marex Financial Ltd¹, the UK Supreme Court has unanimously held that the so-called ‘reflective loss’ principle, barring claims against third parties which reflect loss suffered by a company, will only preclude claims by shareholders, and does not extend to claims by other creditors. The decision has provided welcome clarity regarding the scope of the ‘reflective loss’ principle and will have significant implications for company law.

Despite the reinstatement of a ‘bright line’ rule, the decision raises some further questions to which the courts are likely to return in the coming years.

"The decision has cut back what one academic commentator, cited in Marex, described as “some ghastly legal Japanese knotweed” by which even non-shareholder fraud claimants have been faced by reflective loss arguments."

The rule against recovery of ‘reflective loss’

It is a long-standing principle of English law, established in Foss v Harbottle², that where a company has a cause of action, the only person who can seek relief for injury done to the company is the company itself. That principle was applied in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2)³, where it was decided that a shareholder could not bring a claim against a third party for a diminution in value of its shareholding or a reduction in the distributions received by virtue of its shareholding, which merely ‘reflected’ the loss suffered by the company as a consequence of wrongdoing by the third party.

Subsequently, in Johnson v Gore Wood & Co⁴, Lord Millett commented that a share “represents a proportionate part of the company’s net assets, and if these are depleted the diminution in its assets will be reflected in the diminution in the value of the shares“. He went on to characterise the principle set out in Prudential as one precluding double recovery by shareholders and the company for the same loss.

This formulation resulted in an expansion of the application of the principle barring recovery of reflective loss from claims by shareholders based on a diminution in value of their shares or distributions, to claims by shareholders and other creditors whose claims are not based on any share ownership.

The background in Marex

Marex had brought successful proceedings against two companies owned by Mr Sevilleja, securing an English High Court judgment for US$5.5m, plus costs. However, beginning on or shortly after the judgment was handed down, Mr Sevilleja procured the transfer of substantially all of the company’s assets into his personal control. The judgment debt was then not paid.

The companies were placed into liquidation but, according to Marex, the liquidator (who was on retainer with a company associated with Mr Sevilleja) took no steps to investigate the missing funds or the claims of the various creditors, including Marex. The liquidation was effectively put on hold.

"Lord Reed observed that a diminution in value of a company’s net assets will not necessarily be reflected in the value of its shares."

Marex therefore sought damages in tort from Mr Sevilleja for (1) inducing or procuring the violation of its rights under the judgment of the English High Court and (2) intentionally causing it to suffer loss by unlawful means.

Mr Sevilleja challenged the jurisdiction of the English courts on a number of grounds, one of which being that the rule against reflective loss prevented Marex from showing a completed cause of action and, accordingly, Marex had no arguable case. That argument was rejected by the High Court but accepted by the Court of Appeal. The Court of Appeal, however, gave Marex leave to appeal to the Supreme Court.

The key issue before the Supreme Court was whether Marex, as an unsecured creditor of the companies, was precluded from recovering its losses from Mr Sevilleja by the operation of the rule against recovery of reflective loss.

The decision

Lord Reed, with whom the majority of the Supreme Court agreed, departed from the premise of Lord Millett’s speech in Johnson v Gore Wood that a share in a company reflects a proportionate part of the company’s net assets. Lord Reed observed that a diminution in value of a company’s net assets will not necessarily be reflected in the value of its shares.

Lord Reed also disagreed that the avoidance of double recovery was a satisfactory explanation of the rule in Prudential. In his view, the unique position of the shareholder by virtue of the rule in Foss v Harbottle is a critical part of the explanation. He commented:

By treating the avoidance of double recovery … as sufficient to justify the decision in Prudential, Lord Millett paved the way for the expansion of the supposed “reflective loss” principle beyond the narrow ambit of the rule in Prudential.

Owing to this formulation of the reflective loss principle, Lord Reed noted, shareholders have been able to claim in circumstances where the company had been prevented from continuing its own claim (Giles v Rhind⁵). Conversely, creditors have been precluded from bringing claims (as creditors) against companies of which they happen to also be shareholders (Gardner v Parker⁶).

"Lord Sales considered that while Lord Reeds' bright line rule might allow for a simple and speedy resolution of disputes, the price to be paid was too high."

In Lord Reed’s view, those cases had been wrongly decided. He considered that the critical point in Prudential was that the shareholder had not suffered a loss which was regarded by the law as being separate and distinct from the company’s loss, and therefore had no cause of action to recover it. However, where a claim is brought by a creditor, or indeed a shareholder, for something other than a diminution in share value or distributions, Lord Reed considered that the rule in Prudential would not apply since there is no correlation between the company’s loss and the creditor’s loss. While the risk of double recovery may arise, Lord Reed considered that how it should be avoided would depend on the circumstances, and the risk of double recovery would not necessarily mean that the company’s claim should be given priority.

Lord Sales (with whom two other Justices agreed) agreed with this conclusion, but for different reasons. In his view, Prudential did not lay down a rule of law that the court deems loss suffered by a shareholder in relation to diminution in share value or loss of dividends to be irrecoverable where a company has a parallel claim against an alleged wrongdoer. Instead, the question was whether the shareholder has suffered a loss as a matter of fact, and while a shareholder’s claim for diminution in share value might have some relationship to the losses suffered by the company, Lord Sales did not consider they were the same. He considered that Lord Reeds’ bright line rule gave undue priority to the interests of other shareholders and creditors of the company, and while it might allow for a simple and speedy resolution of disputes, the price to be paid was too high. Nevertheless, he concluded that even if the reflective loss principle were to be preserved in relation to claims by shareholder claimants, it should not exclude otherwise valid claims made by a creditor of the company.

Having thus concluded that the rule in Prudential uniquely applies to a shareholder in its capacity as a shareholder, the Supreme Court found that Marex (which was not claiming as a shareholder) fell outside the rule against recovery of ‘reflective loss’ and could continue its claim.

"Serious doubt was cast upon the preservation of the principle even in this more limited form by some of the members of the Court."

Comment

The Supreme Court’s clarification and narrowing of the scope of the ‘reflective loss’ principle will have significant ramifications in the realm of company law. The decision has cut back what one academic commentator, cited in Marex, described as “some ghastly legal Japanese knotweed” by which even non-shareholder fraud claimants have been faced by reflective loss arguments. This will be welcome news to creditors whose claims may have been threatened by the previous formulation of the principle.

However, the decision leaves certain questions unanswered. In particular:

  1. It is now clear that the rule only excludes claims brought by shareholders on the basis of a reduction in the value of their shares or distributions. However, the precise meaning of ‘distributions’ to shareholders for these purposes is unclear: does it apply only to dividends, or might it apply to other forms of contingent reward which are affected by losses incurred by the company?
  2. The Supreme Court left open the question of whether the ‘reflective loss’ principle is a substantive or a procedural rule. The question is particularly significant in the cross-bordercontext, in which the company, shareholder and dispute resolution forum may be in different jurisdictions. In such circumstances, substantive and procedural questions may fall to be decided according to different legal systems, leaving open the question of whether the ‘reflective loss’ principle follows the law of the place of incorporation of the company, or of the forum.

Furthermore, though the Supreme Court was unanimous in its conclusion, the reasoning of its members differed materially, and serious doubt was cast upon the preservation of the principle even in this more limited form by some of the members of the Court. It remains to be seen whether they will have their chance to re-examine the issue again.

[1] [2020] UKSC 31

[2] (1843) 2 Hare 461

[3] [1982] Ch 204

[4] [2002] 2 AC 1

[5] [2002] EWCA Civ 1428

[6] [2004] EWCA Civ 781

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