On 21 April 2023, the Hong Kong Court of Appeal (CA) released its judgment Power Securities Co Ltd v Sin Kwok Lam  HKCA 594, which provided certainty on the application of the bar against reflective loss for shareholders.
Mr Sin was the sole shareholder and director of Best Year Enterprises Ltd (Best Year) and Enhance Pacific Ltd (EPL) and chairman of First Credit Finance Group Ltd (First Credit). In February 2016, Best Year entered into an agreement with Power Securities Co Ltd (Power Securities), under which Power Securities acted as Best Year’s securities broker and provided credit to Best Year for its dealings in securities via a margin securities trading account (the Margin Account), secured by a deposit of 180 million First Credit shares (the pledged shares).
In September 2017, as a result of a drop in First Credit’s share price, a margin shortfall occurred in the Margin Account, and the entire sum owing (about HK$55 million) became immediately due and payable. Power Securities liquidated the pledged shares, but a debit balance of approximately HK$29 million remained owing. In March 2018, Mr Sin sold his shares in Best Year and EPL and ceased to be the director of these companies.
Mr Sin argued that the fall in First Credit’s share price was the result of a conspiracy to drive down the share price by way of illegal market manipulation. Since Mr Sin was no longer a shareholder in Best Year and EPL, he argued that his loss was not reflective of Best Year or EPL’s loss, as his loss would not be made good if Best Year and/or EPL were able to recover their own loss.
Rule against reflective loss
Under the rule against reflective loss, a shareholder’s claim for loss is not recoverable against a third party where the claim only reflects loss suffered by the company, and the company also has a claim against the third party. Where the loss was suffered in capacities other than as shareholders (for example, as creditors or employees of the company), there have been conflicting views on whether the rule against reflective loss also applies.
The answer depends on the underlying rationale for this rule. Two have been put forward by the leading authorities:
- The “proper plaintiff” rule, which states a claim for relief for an injury done to the company should be brought by the company itself. The “proper plaintiff” rule precludes claims by individual shareholders, but does not apply to claims by creditors.
- The avoidance of double recovery for the same loss. This rationale is wider and precludes claims by shareholders, creditors and employees of a company alike.
A recent UK Supreme Court case, Sevilleja Garcia v Marex Financial Ltd  UKSC 31, held that the avoidance of double recovery did not justify the rule against reflective loss, and that this rule remained applicable to cases of company law (but not to the general law of damages) by reason of the “proper plaintiff” rule. In that case, the Supreme Court unanimously held that the rule against reflective loss should be applied no wider than to shareholders bringing such claims, and specifically does not extend to prevent claims brought by creditors. For further details, please see our earlier blog post and our London office’s blog post on this topic.
In Hong Kong, the leading case is Waddington Ltd v Chan Chu Hoo (2008) 11 HKCFAR 370. Interestingly, in that case, the Court of Final Appeal (CFA) refers to the avoidance of double recovery as a rationale for the reflective loss rule. Notably, this CFA decision was rendered more than 10 years before the clarification finally came in Sevilleja Garcia.
The CA went into some detail examining the justification for the rule against reflective loss. In conclusion, the CA considered it was bound by the CFA’s decision in Waddington. That said, the CA emphasised that the fact that the reflective loss rule was justified by the avoidance of double recovery did not turn the principle into a mere procedural rule concerned only with the avoidance of double recovery. The CFA held in Waddington that a shareholder cannot claim for loss which was merely reflective of the loss suffered by the company as a “matter of principle”, i.e. the rule is one of principle, not of procedure. The CA therefore also held that the rule barring reflective loss applies when the cause of action is accrued and not at the time when a claim is made.
In applying these principles, the CA held that the loss Mr Sin claimed was the diminution in value of the shares of Best Year and EPL caused by alleged market manipulation of the First Credit share price in September 2017. As the diminution crystallised before trading in First Credit was suspended in November 2017 (i.e. before Mr Sin sold his shares), the nature of his loss was reflective loss. The fact Mr Sin made his claim after he sold the shares did not make any difference to the nature of his loss as the bar applied at the time when the loss was suffered, not when the claim was made.
As such, the CA found that the lower court judge was right to strike out the actions on the reflective loss rule and dismissed the joint appeals.
For more information, please contact Gareth Thomas, Partner, Rachael Shek, Partner, Jojo Fan, Partner, Peter Ng, Senior Associate, or your usual Herbert Smith Freehills contact.