The Supreme Court’s judgment in Sevilleja v Marex Financial Ltd [2020] UKSC 31 has been eagerly anticipated by financial institutions and brings much needed clarity in respect of the so-called “reflective loss” principle, first established in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204.

By a majority of 4-3, the Supreme Court confirmed that the “reflective loss” rule in Prudential is a bright line legal rule of company law, which applies to companies and their shareholders. The rule prevents shareholders from bringing a claim based on any fall in the value of their shares or distributions, which is the consequence of loss sustained by the company, where the company has a cause of action against the same wrongdoer. However, the Supreme Court unanimously held that the principle should be applied no wider than to shareholders bringing such claims, and specifically does not extend to prevent claims brought by creditors. In doing so, the entire panel rejected the approach in cases since Prudential where the principle has been extended to situations outside shareholder claims, in a way that has been likened to a legal version of Japanese knotweed.

The majority of the Supreme Court (led by Lord Reed) emphasised that the rule is underpinned by the principle of company law in Foss v Harbottle (1843) 2 Hare 461: a rule which (put shortly) states that the only person who can seek relief for an injury done to a company, where the company has a cause of action, is the company itself. On this basis, a shareholder does not suffer a loss that is recognised in law as having an existence distinct from the company’s loss, and is accordingly barred.

The division of the Supreme Court focused on whether or not to reaffirm the “reflective loss” principle as a legal rule which prohibits a shareholder’s claim, which was the view of the majority, or whether it is simply a device to avoid double-recovery (and therefore a question that arises when it comes to the assessment of damages), which was the view of the minority.

Putting the decision in context, the reflective loss rule was one basis (amongst several others) on which the recent shareholder class action against Lloyds and five of its former directors (the Lloyds/HBOS Litigation) was dismissed by Mr Justice Norris (see our blog post on the decision here). The court held that – if the elements of the shareholders’ claim had been proven – any alleged loss suffered by shareholders as a result of a fall in the price of Lloyds shares was reflective of what the company’s loss would have been. Of course, in the securities litigation context, sections 90 and 90A of the Financial Services and Markets Act 2000 (the usual basis of a shareholder class action) provide a statutory exemption to the reflective loss rule.

Background

Mr Sevilleja was the owner and controller of two companies incorporated in the British Virgin Islands, Creative Finance Ltd and Cosmorex Ltd (the Companies), which he used as vehicles for trading in foreign exchange. Marex Financial Ltd (Marex) brought proceedings against the Companies in the Commercial Court for amounts due to it under contracts which it had entered into with them. In July 2013, Marex obtained judgment against the Companies in excess of US$5 million.

Marex alleged that Mr Sevilleja had stripped the Companies of assets, in breach of duties owed to the Companies, to prevent the judgment debt from being satisfied.

The Companies were placed into insolvent voluntary liquidation in the BVI by Mr Sevilleja in December 2013, with alleged debts exceeding US$30 million owed to Mr Sevilleja and others (allegedly persons and entities associated with Mr Sevilleja or controlled by him). Marex claimed to be the only non-insider creditor.

A liquidator was appointed in the BVI, but on Marex’s case, he was effectively in the pocket of Mr Sevilleja and had not taken any steps to investigate the Companies’ missing funds or to investigate the claims submitted to him, including claims submitted by Marex. Nor had he issued any proceedings against Mr Sevilleja.

Marex brought a claim against Mr Sevilleja directly, seeking damages in tort for: (1) inducing or procuring the violation of its rights under the July 2013 judgment; and (2) intentionally causing Marex to suffer loss by unlawful means. Marex sought and obtained an order giving permission for service of proceedings on Mr Sevilleja out of the jurisdiction.

The present appeal arose from Mr Sevilleja’s application to set aside the order to serve out. Mr Sevilleja argued that Marex did not have a good arguable case against him because the losses that Marex was seeking to recover were reflective of loss suffered by the Companies, which had concurrent claims against Mr Sevilleja, and were therefore not open to Marex to claim.

High Court decision

At first instance, the Commercial Court ruled in favour of Marex and held that the so-called rule against “reflective loss” did not bar Marex’s ability to show a completed cause of action in tort. Permission to appeal was granted only in relation to the ruling on reflective loss.

Court of Appeal decision

The Court of Appeal (Lewison, Lindblom and Flaux LJJ) allowed Mr Sevilleja’s appeal (please see our litigation blog post for a summary of the decision).

The question for the Court of Appeal was whether the rule against reflective loss applies to claims by unsecured creditors who are not shareholders of the relevant company. In a unanimous decision, it held that the distinction between shareholder creditors and non-shareholder creditors was artificial and therefore the rule should apply equally to all creditors.

The Court of Appeal also considered the scope of the exception to the rule which applies where the company is unable to pursue a cause of action against the wrongdoer. It confirmed that this exception can only be invoked in limited circumstances, where the defendant’s wrongdoing has been directly causative of the impossibility the company faces in bringing the claim.

Marex appealed to the Supreme Court.

Supreme Court decision

The Supreme Court convened as an enlarged panel with the object of examining the rationale for the so-called “reflective loss” principle and providing greater coherence of the law in this area. In view of the significance of the case, the Supreme Court granted permission to the All Party Parliamentary Group on Fair Business Banking to intervene by oral and written submissions in support of Marex’s appeal.

The Supreme Court unanimously concluded that Marex’s appeal should be allowed. There was no disagreement within the court that the expansion of the so-called “reflective loss” principle was an unwelcome development of the law, and in the context of the present case would result in a great injustice. However, there was a clear division on the nature and effect of the “reflective loss” principle, with Lord Reed giving the majority judgment (with whom Lady Black, Lord Lloyd-Jones and Lord Hodge agreed) and a minority judgment given by Lord Sales (with whom Lady Hale and Lord Kitchin agreed).

Majority decision

The majority reaffirmed the rule in Prudential (often referred to as the “reflective loss” principle), as a rule of company law which, when it applies, prohibits a claim being brought by shareholders for the loss of value in their shareholding.

Lord Reed referred back to the origins of the reflective loss principle, in the case of Prudential, where the directors of a company were alleged to have made a fraudulent misrepresentation in a circular distributed to its shareholders, so as to induce them to approve the purchase of assets at an overvalue from another company in which the directors were interested. Prudential, which was a minority shareholder in the company, brought a personal and a derivative action against the directors. Prudential’s personal claim was disallowed on the ground that it had not suffered any loss distinct from its loss of value in its shareholding, with the following reasoning from the High Court:

“…what [the shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage. He cannot recover a sum equal to the diminution in the market value of his shares, or equal to the likely diminution in dividend, because such a ‘loss’ is merely a reflection of the loss suffered by the company.”

Lord Reed noted that this has been treated in subsequent cases as establishing the principle of “reflective loss” (most notably in Johnson v Gore Wood & Co [2002] 2 AC 1).

In an important clarification of the scope of this principle, Lord Reed confirmed as follows:

“…what the court meant, put shortly, was that where a company suffers actionable loss, and that loss results in a fall in the value of its shares (or in its distributions), the fall in share value (or in distributions) is not a loss which the law recognises as being separate and distinct from the loss sustained by the company. It is for that reason that it does not give rise to an independent claim to damages on the part of the shareholders.”

Lord Reed said that it is necessary to distinguish between:

  1. Cases where claims are brought by a shareholder in respect of loss which he/she has suffered in that capacity, in the form of a diminution in share value or in distributions, which is the consequence of loss sustained by the company, in respect of which the company has a cause of action against the same wrongdoer; and
  2. Cases where claims are brought, whether by a shareholder or by anyone else, in respect of loss which does not fall within that description, but where the company has a right of action in respect of substantially the same loss.

In cases of the first kind, Lord Reed said that the shareholder cannot bring proceedings in respect of the company’s loss, since he or she has no legal or equitable interest in the company’s assets. It is only the company that has a cause of action in respect of its loss under the rule in Foss v Harbottle. He said that the position is different in cases of the second kind, which would include claims (like Marex’s claim) brought by creditors of the company. This is because there is no correlation between the value of the company’s assets/profits and the loss which that party has suffered.

The majority therefore confirmed that the rule established in Prudential applies to cases of the first kind, but not the second. In doing so, Lord Reed and Lord Hodge emphasised the following key aspects of the rule:

  1. Rule of company law

Lord Reed said that the decision in Prudential established a rule of company law, which applies specifically to companies and their shareholders in particular circumstances. It has no wider ambit.

He noted that this rule is necessary in order to avoid the circumvention of the company law rule in Foss v Harbottle, which provides that the only person who can seek relief for an injury done to a company, where the company has a cause of action, is the company itself.

The judgment of Lord Hodge echoed Lord Reed’s statement that the rule in Prudential was a principled development of company law which should be maintained. In particular, he explained that the rule upholds the default position of equality among shareholders in their participation in the company’s enterprise: each shareholder’s investment “follows the fortunes of the company”; it maintains the rights of the majority of the shareholders; and it preserves the interests of the company’s creditors by maintaining the priority of their claims over those of the shareholders in the event of a winding up.

However, in the opinion of Lord Hodge, the principle should not be applied in other contexts, given the particular characteristics of a shareholding (and the rights and protections provided to shareholders), which justify the law’s refusal to recognise a diminution of value claim. The problems and uncertainties that have emerged in the law have arisen because the principle of reflective loss has broken from its moorings in company law.

  1. Distinct from double recovery principles

Lord Reed stated, categorically, that the avoidance of double recovery is not in itself a satisfactory explanation of the rule in Prudential.

Lord Reed noted the general position that, while two different persons can have concurrent rights of recovery based on different causes of action in respect of the same debt, the court will not allow double recovery (The Halcyon Skies [1977] QB 14, 32). This principle has its roots in the law of damages, and so it does not prevent the claims in themselves, but rather leaves the court to determine how to avoid double recovery in situations where the issue properly arises. For example, by giving priority to the cause of action held by one person with the claim of the other excluded so far as necessary (The Liverpool (No 2) [1963] P 64); or by subrogation (Gould v Vaggelas [1984] HCA 68); or the imposition on one claimant of an obligation to account to the other out of the damages it has received (O’Sullivan v Williams [1992] 3 All ER 385).

He said that Lord Millett in Johnson had incorrectly treated the avoidance of double recovery as sufficient to justify the decision in Prudential, which paved the way for the expansion of the reflective loss principle beyond the narrow ambit of the rule in Prudential. Lord Millett’s approach has in fact led in some cases, subsequent to Johnson, to a circumvention of the rule in Foss v Harbottle. For example, in Peak Hotels and Resorts Ltd v Tarek Investments Ltd [2015] EWHC 3048 (Ch), the court considered it arguable that the “reflective loss” principle – as explained by Lord Millett in Johnson – did not bar a claim for injunctive relief, even though the proceedings were brought by a shareholder who complained of a fall in the value of his shares resulting from loss suffered by the company in respect of which the company had its own cause of action. This was because the relief sought was not in damages and so there could be no danger of double recovery.

  1. Pragmatic advantages of a bright line legal rule

Lord Reed also emphasised the pragmatic advantages of a clear rule of law that only the company can pursue a right of action in circumstances falling within the precise ambit of the decision in Prudential. He referred to Lord Hutton’s speech in Johnson, saying that the rule in Prudential has the advantage of establishing a clear principle, rather than leaving the protection of shareholders of the company to be given by a judge in the complexities of a trial.

  1. Scope of personal claims by shareholders prohibited

The majority articulated the type of claim that will be prohibited by the rule against “reflective loss”. To fall within the rule, a claim must:

    • be brought by a shareholder;
    • relate only to the diminution in value of shares or in distributions which the shareholder suffers in his or her capacity as a shareholder;
    • result from the company having itself suffered actionable damage; and
    • be brought by the shareholder and the company against the same wrongdoer.

The majority confirmed that, where a shareholder pursues a personal claim against a wrongdoer in another capacity, such as guarantor or creditor of the company, the “reflective loss” rule has no application.

  1. Where the company does not bring a claim

Lord Reed stated that the rule in Prudential will apply even if the company fails to pursue a claim that a shareholder says ought to have been pursued, or compromises its claim for an amount which, in the opinion of a shareholder, is less than its full value.

He said the critical point is that the shareholder has not suffered a loss which is regarded by the law as being separate and distinct from the company’s loss, and therefore has no claim to recover it. It follows that the shareholder cannot bring a claim, whether or not the company’s cause of action is pursued.

Lord Reed justified this approach on the basis that shareholders entrust the management of the company’s right of action to its decision-making organs; and the company’s control over its own cause of action would be compromised, and the rule in Foss v Harbottle could be circumvented, if the shareholder could bring a personal action for a fall in share value (or distribution) consequent on the company’s loss, where the company had a concurrent right of action in respect of its loss.

The same will apply even where the wrongdoer has abused his or her powers as a director of the company so as to prevent the company from bringing a claim under which it could have recovered its loss. Lord Reed noted that shareholders (unlike a creditor or an employee) have a variety of other rights in this scenario, including the right to bring a derivative claim to enforce the company’s rights if the relevant conditions are met, and the right to seek relief in respect of unfairly prejudicial conduct of the company’s affairs.

A derivative action is an exception to the rule in Foss v Harbottle, and whether or not a shareholder can bring such an action depends on whether the relevant conditions are satisfied.

  1. The position of creditors

As will be clear from the above, the majority confirmed that the reflective loss rule does not apply to creditors. This is essentially because the potential concern arising from the rule in Foss v Harbottle is not engaged by claims brought by creditors, as distinct from shareholders.

However, Lord Reed noted that the principle that double recovery should be avoided may well be relevant to creditor claims (although this will not always necessarily be the case: in International Leisure Ltd v First National Trustee Co UK Ltd [2013] Ch 346 the company and a secured creditor had concurrent claims, but the double recovery principle was not engaged).

Lord Reed explained that how the court will address the risk of double recovery in creditor claims will depend on the circumstances, and did not mean that the company’s claim must automatically be given priority to that of the creditor. He also warned that the pari passu principle does not give the company (or its liquidator) a preferential claim on the assets of a wrongdoer, over the claim of any other person with rights against the wrongdoer, even if that claimant is also a creditor of the company. This means that a creditor can enforce his or her own right to recover damages from the wrongdoer concurrently with any action brought by the company. Lord Reed contrasted the situation where an insolvent company has made a recovery from the wrongdoer. In this situation, the proceeds will form part of the insolvent company’s assets available for distribution, where the pari passu principle may restrict the creditor’s receipt of a dividend.

Lord Reed also noted that double recovery arising in connection with creditors’ claims may be avoided by other means, such as subrogation.

In the light of the above, the majority held that the rule in Prudential had no application to the present case, since Marex was not a shareholder. Marex’s appeal was therefore allowed.

Minority decision

Lord Sales delivered the minority judgment. By contrast to the majority, in his opinion, the Court of Appeal in Prudential did not lay down a rule of law and (in any event) such a rule was not correct as a matter of principle. Whilst the rule would produce simplicity, this would be at the cost of serious injustice to a shareholder who (apart from the rule) has a good cause of action and has suffered loss which is real and is different from any loss suffered by the company.

In his view, the court in Prudential simply set out reasoning why it thought the shareholder in such a case in fact suffered no loss. However, he believed that that reasoning could not be supported, because in most cases shareholders suffer a loss which is different from the loss suffered by the company. In Lord Sales’ view, the whole premise of the “reflective loss” principle is flawed because it assumes correspondence between the losses suffered by company and shareholder. By contrast, in the real world, even if the company is successful (some time later) in recovering its loss, the shareholder whose shares were reduced in value by the wrong will not be restored to the position it would have been in but for the defendant’s wrongdoing. Whilst, as a matter of basic justice, the defendants should not be liable twice for the same loss, the correct approach to that issue would be to carefully assess whether the loss is indeed the same and if (and only if) it is the same, to be reflected in the calculation of each claimants’ loss.

In Lord Sales’ view, even if the “reflective loss” principle was appropriate in respect of shareholder claims, it could not be justified as a principle to exclude otherwise valid claims made by a person who is a creditor of the company. Accordingly, the minority also allowed Marex’s appeal.

Harry Edwards

Harry Edwards
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Ceri Morgan

Ceri Morgan
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