High Court tests newly narrowed scope of the “reflective loss” rule in first decision since the Supreme Court’s judgment in Marex

In the first decision to consider the so-called “reflective loss” principle since the Supreme Court’s judgment in Sevilleja v Marex Financial Ltd [2020] UKSC 31 earlier this year, the High Court has emphasised the newly narrowed scope of the rule: Broadcasting Investment Group Ltd & Ors v Smith & Ors [2020] EWHC 2501 (Ch).

As a reminder, the Supreme Court in Marex confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which 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. Marex confirmed the narrow ambit of the rule, which should be applied no wider than to shareholders bringing such claims, and specifically does not extend to prevent claims brought by creditors. For a more detailed analysis of the decision in Marex, see our blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule.

The issue arose in the present case on an application for strike out / reverse summary judgment by the defendant to a claim for alleged breach of a joint venture agreement. The court found that the claim brought by the first claimant – a direct shareholder in the company that suffered the relevant loss – was a paradigm example of a claim within the scope of the reflective loss principle. The court was prepared to determine this question finally and strike out the claim, on the basis that the reflective loss principle is a rule of law and it was not suggested that further relevant evidence might emerge at trial.

However, the more interesting aspect of the decision considered whether the reflective loss principle should bar the claim of the third claimant, who was a “shareholder in a shareholder” in the first claimant (conveniently described in the judgment as a “third degree” shareholder).

The nub of the argument was that the third claimant should be treated as a “quasi-shareholder” in the relevant company, by reason of the chain of shareholdings connecting him to that company. The defendant argued that the third claimant should not be put in a better position, for the purposes of the rule, than if he had actually been a shareholder in that company (i.e. than the first claimant).

However, the court rejected this argument, and held that the reflective loss rule did not operate to bar the claim of a “quasi-shareholder” in this way. The court was particularly impressed by the emphasis in Marex that the reflective loss rule bars only shareholders in the loss-suffering company and is a “highly specific exception of no wider ambit”. This sentiment was antipathetic to any incremental extensions of the rule beyond that described in Marex. The court therefore refused to strike out the claim of the “third degree shareholder”, which will proceed to trial.

Considering the implications of this decision in a financial services context, the robust confirmation and clarification of the reflective loss principle in Marex has generally been well-received by the market. Although the rule has certainly been pruned, there was a clear risk in Marex that the principle, as a binding rule of law, could be lost altogether. In its surviving form, the reflective loss rule will continue to play an important part in the defence of shareholder claims against banks (aside from claims brought under section 90 and 90A of the Financial Services an Markets Act 2000, which provide a statutory exemption).

The present decision could (at first glance) raise concerns of opening the door to novel claims against the bank. For example, where it is alleged that a corporate customer has suffered loss for which the bank is responsible, a claim could theoretically be brought by both that company and by a “quasi-shareholder”, where there is a chain of shareholder ownership in the relevant company. However, the “quasi-shareholder” must have an independent cause of action against the bank, and in most cases there should be good arguments to say that there is no contractual relationship and no duty of care is owed to a second or third degree shareholder.

Background

The underlying facts of the dispute are complex, but relate to the development of a start-up company in the technology sector. In broad summary, in October 2012 an alleged oral joint venture agreement (JV Agreement) was entered into by the claimants, the first defendant (Mr Smith), the second defendant (Mr Finch) and certain other parties. Under the terms of the JV Agreement, it was intended (among other things) that a joint venture vehicle would be set up, called Simplestream Group plc (SS plc), and that Mr Smith’s shares in two existing software companies would be transferred to SS plc.

SS plc was subsequently formed and its shareholders were Mr Smith, Mr Finch and the first claimant, Broadcasting Investment Group Limited (BIG). In alleged breach of the JV Agreement, the relevant shares were not transferred to SS plc, and SS plc subsequently entered creditors’ voluntary liquidation.

BIG brought a claim against Mr Smith and Mr Finch (and others) for breach of the JV Agreement, claiming specific performance as regards the transfer of shares to SS plc, or damages in lieu of specific performance. Alternatively, BIG claimed that it suffered loss by reason of the consequent diminution in the value of its shareholding in SS plc and loss of dividend income from SS plc.

The second claimant (VIIL) was the majority shareholder of BIG and the third claimant (Mr Burgess) was, in turn, the majority shareholder of VIIL. Mr Burgess brought parallel claims to those brought by BIG, on the basis that both BIG and Mr Burgess personally were alleged to be parties to, and therefore prima facie entitled to enforce, the JV Agreement.

Mr Smith applied for strike out / reverse summary judgment on the basis that the claims of BIG and Mr Burgess were barred by the rule against reflective loss, as recently affirmed by the Supreme Court in Marex.

At the date of the hearing to which the present judgment relates, the liquidator of SS plc had not indicated any intention to pursue any claims which SS plc might have in relation to the JV Agreement.

Decision

The court held that, while BIG’s claim to enforce the JV Agreement was barred by the rule against reflective loss first established in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204, and should be struck out, Mr Burgess’ claim was not barred by the same principle and could proceed to trial.

The court considered a number of other issues, but this blog post focuses on the court’s analysis of the reflective loss principle, being the first case to consider and apply the Supreme Court’s decision in Marex earlier this year.

Application of the Supreme Court’s decision in Marex

The application for strike out / summary judgment had been adjourned pending the determination of the appeal to the Supreme Court in Marex, which the court noted had clarified the law governing the reflective loss principle and made the task of considering the application at hand considerably more straightforward.

The court acknowledged that – strictly speaking – the application of the reflective loss principle to claims by shareholders was not a matter for decision in Marex, because the question before the Supreme Court considered the specific position of a creditor who was not a shareholder. Nevertheless, all members of the Supreme Court in Marex made it clear that it was necessary for them to review the scope of the principle in its entirety in order to decide whether it should be extended to creditors. It followed that the reasoning of the majority in Marex represents the law which must now be applied to all attempts to rely on the principle of reflective loss, whether the claims are by shareholders or others.

A detailed analysis of the Supreme Court’s decision in Marex can be found on our banking litigation blog. In summary, the Supreme Court (by a majority of 4-3) 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. 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.

Requirement for concurrent claim

The court’s starting position was to determine whether SS plc (theoretically) had a cause of action arising out of the JV Agreement. It said this was the logical first question, since the rule in Prudential is concerned only with concurrent claims, one of which must be vested in the company which has suffered the relevant loss. The court stated that, if SS plc did not have such a claim, then the application should fail.

In response to this preliminary question, the court found that SS plc had a contractual claim to enforce the JV Agreement by virtue of the s.1(1)(b) of the Contracts (Rights of Third Parties) Act 1999 (1999 Act), which provides that a person who is not a party to a contract may in his/her own right enforce a term of the contract if “the term purports to confer a benefit” on that person.

One of the terms of the JV Agreement pleaded by the claimants (and therefore of course taken as factually correct for the purpose of the application), provided that the shares to be transferred to SS plc would be held by the company beneficially, which in the court’s view, appeared ostensibly to bestow an advantage on SS plc for the purpose of s1(1)(b). This analysis was unaffected by the fact that the agreement in question was oral rather than written, and the court found on the facts nothing to suggest that the parties did not intend the term in question to be enforceable by SS plc, so as to engage s.1(2) of the 1999 Act and disapply s.1(1)(b).

Scope of the rule in Prudential / the reflective loss principle

Having concluded that SS plc had a concurrent claim to enforce the JV Agreement, the court turned to consider whether the rule in Prudential, as explained by Marex, barred : (1) the claim brought by BIG, a shareholder in SS plc; and/or (2) the claim brought by Mr Burgess, who was not a direct shareholder in SS plc.

(1) BIG’s claim

In the court’s judgment, BIG’s claim was a paradigm example of a claim that was within the scope of, and was therefore barred by, the rule in Prudential.

The court accepted that BIG’s claim was in respect of a loss suffered by SS plc, because:

  • BIG’s claim was to enforce the JV Agreement, and in particular, Mr Smith’s alleged obligation to transfer shares to SS plc.
  • BIG was a shareholder in SS plc and its loss was merely reflective of that suffered by SS plc, as was apparent from the claimants’ pleaded case.
  • Since SS plc and BIG had concurrent claims against Mr Smith, BIG’s claim was barred by the rule in Prudential.

The court confirmed that the rule in Prudential extended to both the claim for damages and to the claims for specific performance of the JV Agreement. In particular, the court noted Lord Reed’s explanation in Marex that one of the consequences of the rule in Prudential is that a shareholder cannot (as a general rule) bring an action against a wrongdoer to recover damages “or secure other relief” for an injury done to the company. There was no suggestion in Marex that any specific remedy, such as specific performance, is exempt from the rule; to allow otherwise would permit the avoidance of the rule in Foss v Harbottle.

(2) Mr Burgess’ claim

The court then turned to consider whether Mr Burgess’ claim was within the scope of the rule in Prudential.

The court said the real question here was whether, following Marex, the rule in Prudential can apply to bar the claim of someone who is not a shareholder in the company which suffers the relevant loss (i.e. SS plc). As explained above, Mr Burgess was not a shareholder in SS plc directly. He was the majority shareholder in VIIL, which was the majority shareholder in BIG, which was a shareholder in SS plc.

The court noted that, given the conclusion reached by Lord Reed, the answer to this question might appear obvious (emphasis added):

“The rule in Prudential is limited to claims by shareholders that, as a result of actionable loss suffered by their company, the value of their shares, or of the distributions they receive as shareholders, has been diminished. Other claims, whether by shareholders or anyone else, should be dealt with in the ordinary way.”

While Lord Reed limited the application of the rule, in terms, to claims by shareholders in the relevant loss-suffering company, it was argued that a number of the justifications underlying the rule applied with equal force to Mr Burgess’ claim. This was because Mr Burgess was in the position of “a shareholder in a shareholder” or of “a shareholder in a shareholder in a shareholder” (conveniently described in the judgment as “second degree” or “third degree” shareholders).

The court commented that the nub of the argument seemed to be that Mr Burgess should be treated as a “quasi-shareholder” in SS plc who, by reason of the chain of shareholdings connecting him to SS plc, could not be in a better position, for the purposes of the rule, than if he had actually been a shareholder in that company.

The court was not persuaded, and held that the rule in Prudential did not operate to bar Mr Burgess’ claim, for the following key reasons:

  1. The judgments of the majority of the Supreme Court in Marex make it clear that the rule only bars claims by shareholders in the loss-suffering company.
  2. The descriptions of the rule in the judgments of Lord Reed and Lord Hodge are antipathetic to any incremental extension of the rule to non-shareholders, whatever policy justifications may be advanced for such an extension.
  3. A “second degree” or “third degree” shareholder is not, in fact or in law, a shareholder in the relevant company. To blur that distinction would be to ignore the separate legal personality of the companies which form the intervening links in the chain between the claimant and the loss-suffering company. In the present case, none of the limited circumstances applied for the court to “pierce the corporate veil”.
  4. The rule in Prudential derives from the legal relationship between a shareholder and his/her company; and the rule is something which the shareholder contracts into when he/she acquires his/her shares. This reasoning cannot apply to a second degree or third degree shareholder who does not acquire shares in the relevant company and therefore never contracts into the rule so far as it affects recovery of losses by that company.

Interestingly, there does not appear to have been any discussion of the lack of connection between the claim brought by Mr Burgess (where the cause of action was a personal claim for breach of the JV Agreement to which he was a party), and the loss alleged to have been suffered, which arose separately through his indirect shareholding in SS plc. As a result of the failed application, Mr Burgess’ claim will proceed to trial, which may offer the opportunity to consider this issue.

Suitability for summary judgment

The court rejected the claimants’ suggestion that the application of the rule in Prudential is inherently unsuitable for summary determination because there is a discretion in the operation of the rule.

The court commented that both the application of the Prudential rule itself and the question of whether SS plc had an independent cause of action under the 1999 Act raised questions of law, which were suitable for determination on a strike-out / reverse summary judgment application (following the court’s observations in Easyair Ltd v Opal Telecom Ltd [2009] EWHC 339 (Ch)).

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High Court takes view in test case on breach of statutory duty under s.138D FSMA, in the context of repeat borrowings and an alleged breach of CONC

The High Court has recently considered a test case under s.138D of the Financial Services and Markets Act 2000 (FSMA), in the context of alleged breaches of statutory obligations under the Consumer Credit Sourcebook (CONC) for failing to take repeat borrowing into consideration when making lending decisions: Kerrigan v Elevate Credit International Limited (t/a Sunny) (in administration) [2020] EWHC 2169 (Comm). The court also considered a claim for an order under s.140B of the Consumer Credit Act 1974 (CCA) on the basis that the relationship between the lender and the borrower was unfair to the borrower.

The decision relates to claims against a payday lender, in which a group of sample claims (reflecting a wider group of claimants) were tried together. The court determined finally the allegations against the lender for breach of CONC, and although no final conclusions were reached in respect of individual claims under s.138D FSMA or s.140B CCA, the court provided some helpful guidance as to the merits of the arguments. The issues considered will be of interest to lenders and financial institutions more generally.

In summary, the High Court held that the lender’s failure to take repeat borrowing into consideration when making its lending decisions resulted in a breach of its obligations under CONC 5.2, in particular, the obligation that a creditworthiness assessment consider both the potential for the commitments under the credit agreement to adversely impact the customer’s financial situation and the ability of the customer to make repayments as they fall due.

On the key question as to whether breach of statutory duty under CONC was actionable under s.138D FSMA, the court emphasised that a borrower must show that damage was caused, both in fact and as a matter of law, by the lender’s breach of duty. The court reflected that it may be harder for a borrower to prove causation in circumstances where it may be said that – following a robust creditworthiness assessment – the borrower would likely have applied elsewhere to a third party lender able to extend the credit.

The court also provided guidance on the s.140B CCA claim, noting that the court will have regard to compliance with the CONC rules, which articulate the consumer protection objective. However, although important, a breach of the rules will not be the only factor considered when assessing fairness. In particular, where a borrower is dishonest in the information they provide as part of the loan application, to the extent it has a direct effect on the existence of the creditor-debtor relationship, this may undermine any claim by the borrower that the relationship was unfair.

For a more detailed discussion of the decision, please see our FSR blog post.

Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule

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
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Ceri Morgan
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High Court finds no implied contractual duties in connection with past business review

Since 2015 there has been a series of judgments in which claimant customers have (ultimately unsuccessfully) sought to impose contractual and tortious duties on financial institutions relating to the institution’s conduct of the 2012 past business review into the alleged mis-selling of interest rate hedging products (the “PBR”). The latest decision from the High Court represents good news for financial institutions in this context, finding that a bank owed no implied contractual duties to assess or compensate consequential loss claims under the PBR: Norham Holdings Group Ltd v Lloyds Bank plc [2019] EWHC 3744. The judgment, which was handed down in June 2019 but has only recently been made publicly available, demonstrates the robust approach the court is prepared to take to novel claimant arguments of this type.

In summary, the claimant alleged that a settlement agreement under the PBR in respect of direct losses, which expressly carved out claims for consequential loss from the scope of the settlement, should be construed as giving rise to an implied contractual duty on the bank to assess or compensate consequential loss claims under the PBR. The court rejected this contention, finding not only that the claimant’s construction of the particular language of the settlement was unnatural, but also that the imposition of such a duty would cut across the regulatory regime under which the PBR was established. The court also rejected an argument that the bank was estopped from contesting whether the swap was mis-sold in civil proceedings as a result of its assessment that redress was due under the PBR.

The latest decision is in line with two important previous authorities. In CGL Group Limited & Ors v Royal Bank of Scotland plc & Ors [2017] EWCA Civ 1073 (see our blog post), the Court of Appeal confirmed that the banks did not owe tortious duties to customers to conduct the PBR with reasonable skill and care, resolving previous inconsistent first instance decisions. Similarly, in Elite Property Holdings & Anor v Barclays Bank plc [2018] EWCA Civ 1688 (see our blog post), the Court of Appeal rejected the argument that a settlement agreement in respect of direct losses gave rise to implied contractual duties to carry out a detailed assessment of consequential loss and pay fair and reasonable redress if the claims were well founded. In both decisions, the Court of Appeal considered (among other matters) that it would undermine the regulatory and statutory regime to impose private law rights in such circumstances and there would need to be a clear expression of intention by the banks to undertake such duties – which there was not on the facts.

Given this previous higher authority, it is unsurprising that the claimant was unsuccessful in the present case, particularly as it bore close similarities to the claims rejected in Elite Property. However, the latest judgment serves to reiterate that the court will be reluctant to find that firms undertook any private law duties in the context of the PBR, absent clear expression of intention to do so. Furthermore, the court’s reasoning may apply to other formal past business reviews entered into voluntarily by agreement with the FCA and to section 404 of the Financial Services and Markets Act 2000 consumer redress schemes. Nevertheless, it would be prudent for firms to expressly exclude contractual and tortious duties when communicating with customers in respect of such reviews/schemes.

The court’s finding on estoppel will also be welcomed by banks, as it demonstrates that a bank’s offer of redress under the PBR will not (absent exceptional circumstances) prevent it from contesting mis-selling allegations in any subsequent litigation.

Background

The claimant, a property investment company, entered into a LIBOR interest rate swap in February 2008 with Lloyds Bank (the “Bank”). The claimant suffered losses under the swap as interest rates fell substantially following the financial crisis.

In June 2012, the Bank, along with a number of other banks, entered into an agreement with the FSA (now FCA) to conduct the PBR. The PBR terms required it to review past sales of interest rate hedging products in order to determine whether there had been any breach of regulatory requirements, and to compensate direct losses (referred to as basic redress”) where appropriate, as well as any consequential losses evidenced by customers (such as overdraft charges and additional borrowing costs).

In January 2014, the Bank concluded that there was insufficient evidence on file in relation to the swap to demonstrate compliance with regulatory requirements and offered a basic redress award to compensate direct losses (plus 8% interest) on the basis that the claimant should have been sold an alternative swap with different terms that would have incurred less losses (the counterfactual swap). The claimant accepted the basic redress award and elected that the Bank should also consider claims that it had suffered consequential losses. The parties signed a settlement agreement (the “Settlement”) to settle any claims for direct losses. The Settlement contained a broad full and final settlement clause covering all claims in respect of the swap except any claims for consequential loss.

In October 2016, the Bank offered a consequential loss award to the claimant for only part of the sums claimed by the claimant. This offer was rejected by the claimant, which subsequently issued proceedings in May 2017 alleging mis-selling of the swap and seeking consequential losses.

Preliminary issues

The instant judgment relates to the trial of two preliminary issues, being the claimant’s allegations that:

  1. Contractual entitlement. The claimant had a contractual entitlement to consequential loss assessed in accordance with the PBR basic redress findings, subject to proof of causation. This was on the basis that the Settlement should be construed as settling all pre-settlement causes of action in respect of the swap (including claims for consequential loss based on pre-settlement causes of action) – but carved out claims for consequential loss within the PBR.
  2. Estoppel. The Bank was estopped by convention from disputing that the swap was mis-sold (with the consequence that the court need only determine the amount of consequential loss), because it was assumed by the parties that the Settlement amounted to acceptance on the Bank’s part that the swap was mis-sold.

Decision

The court found in favour of the Bank on both of the preliminary issues.

Issue 1: Contractual entitlement

The court rejected the claimant’s argument that the Settlement created a contractual entitlement to consequential loss, for a number of reasons, including:

  • The claimant’s construction of the Settlement wording did not accord with the ordinary and natural meaning of the words (per Arnold v Britton [2015] UKSC 36). It required reading the exclusion of claims for consequential loss as relating solely to consequential loss claims considered within the PBR (rather than all causes of action in respect of consequential losses). The court rejected this construction and found that, if the Settlement had been intended to exclude solely PBR consequential loss claims, it would have said so expressly.
  • The alleged contractual duty owed to the claimant would cut across the regulatory regime and would be entirely at odds with the gratuitous nature of the PBR. The court drew support from the Court of Appeal’s reasoning in Elite Property in this regard.
  • Any purported contractual cause of action requiring the Bank to assess consequential loss in accordance with the PBR findings would merely replicate the Bank’s existing obligations to the FCA and would therefore fail for want of consideration.
  • The claimant’s argument undermined the commercial purpose of the PBR and the Settlement, as it implied that customers would be forced to abandon existing causes of action in respect of consequential loss, in order to accept a basic redress award. This would restrict customers that issue litigation to accepting the counterfactual findings of the PBR (in the claimant’s case, the counterfactual swap) and would prevent them from alleging fraud (which can obviate the need for losses to be foreseeable).

Issue 2: Estoppel

The court rejected the claimant’s estoppel by convention argument, as there was no unequivocal assumption by the parties that the Bank would not defend civil proceedings. The PBR made a much more limited finding that, on the limited information available to it, there had been insufficient evidence to demonstrate compliance with regulatory requirements. This was of no benefit to the claimant, as it had no cause of action based on breach of regulatory requirements, and in any event further information would be available in litigation.

Julian Copeman
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Dan Eziefula
Dan Eziefula
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Ceri Morgan
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High Court strikes out claims relating to the mis-selling of interest rate hedging products Supreme Court on contractual interpretation – striking a balance between the language used and the commercial implications

  • In Wood (Respondent) v Capita Insurance Services Limited (Appellant) [2017] UKSC 24, the Supreme Court has unanimously dismissed an appeal brought by Capita Insurance Services Limited (“Capita”) on the construction of an indemnity clause.
  • The Supreme Court emphasised that it did not seek, once again, to reformulate the guidance to the legal profession, noting that its judgments in Arnold v Britton [2015] AC 1619 and Rainy Sky SA v Kookmin Bank [2011] 1 WLR 2900 provide sufficient statements of this nature.
  • Rainy Sky and Arnold are often seen as pulling in opposite directions, with the former having given a greater role to commercial common sense in interpreting contracts, while the latter re-emphasised the importance of the natural meaning of the words used.
  • The present judgment, however, emphasises the common ground, commenting that they were in fact saying the same thing – namely that interpretation is a unitary exercise, in which a balance must be struck between the indications given by the language used (in both the clause under scrutiny and the remainder of the contract) and the implications of rival constructions (which is usually thought of as the business common sense approach).
  • Interestingly, Lord Hodge said that in striking a balance between these two tools to construction it does not matter which way round they are used, so long as the court balances the indications given by each.
  • The decision does however emphasise that the weight to be given to each tool will depend on the circumstances. Some agreements may be successfully interpreted by textual analysis, eg because they have been professionally drafted and their meaning is clear. Others may require a greater emphasis on the commercial background and implications to interpret a disputed provision.
  • It also emphasises, in line with Arnold, that business common sense can only be taken so far, remembering that one side may have agreed to something which with hindsight did not serve his interest. It is not the role of the court to save the parties from a bad bargain.

Background to the appeal

The appeal concerns an indemnity clause in a share purchase agreement (“the SPA”), for the sale and purchase of the entire issued share capital of Sureterm Direct Limited (“the Company”), a car insurance broker. The sellers of the Company were its managing director Mr Wood (together with other minor shareholders) (the “Sellers”). The buyers of the Company were Capita Insurance Services Ltd (the “Buyer”).

After the acquisition, the Company conducted a past business review in response to concerns that had been raised by its employees in relation to its sales processes and potential misselling of its products in the period prior to completion of the SPA. In accordance with its regulatory obligations, the Company then reported these findings to the FSA. This ultimately led to the FSA determining that the Company’s customers had been misled and that it should conduct a customer remediation exercise, which it did, resulting in the payment of £1.35 million in customer compensation.

The Buyer then brought a claim against the Sellers for losses they had suffered as a result of the misselling, relying upon the following indemnity in the SPA (the “Indemnity”):

“The Sellers undertake to pay to the Buyer an amount…to indemnify the Buyer… against all actions, proceedings, losses, claims, damages, costs, charges, expenses and liabilities suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by [the Company] following and arising out of claims or complaints registered with the FSA, the Financial Services Ombudsman or any other Authority against [the Company], the Sellers or any Relevant Person and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any insurance or insurance related product of service.”

The Sellers claimed that this loss was outside the scope of the Indemnity given that the requirement to remediate customers had not arisen as a result of a claim by the customers or a complaint by those customers to the FSA (but rather arose from the Company self-reporting the misselling).

At first instance, Popplewell J held that the Indemnity required the Sellers to indemnify the Buyer even if there had been no claim or complaint by a customer, primarily on the basis that it did not make business common sense for the clause to operate to exclude those claims. The Court of Appeal disagreed and found that liability under the Indemnity could not arise in the absence of any actual claim or complaint by a customer. (For a summary of the Court of Appeal’s decision ([2015] EWCA Civ 839), see our blog post on that decision here).

The Buyers appealed to the Supreme Court.

Judgment

The Supreme Court unanimously upheld the Court of Appeal’s decision, finding that the Sellers were not liable under the Indemnity given there had been no actual claim by customers or any complaint registered with the FSA in relation to the misselling.

In the lead judgment given by Lord Hodge (with whom the other Justices agreed) the court held that its primary task in contractual interpretation is to ascertain the objective meaning of the language in the contract.

Citing the Supreme Court’s decision in Arnold v Britton [2015] AC 1619 (which confirmed the approach in Rainy Sky SA v Kookmin Bank [2011] 1 WLR 2900), the court noted that where there are rival constructions, the court may have regard to business common sense as an aid to deciding between them. However, in striking a balance between indications given by the language used and the implications of the rival constructions based on business common sense, the court must consider the quality of drafting of the clause and must also be alive to the possibility that one party has struck a bad bargain.

Striking this balance involves an iterative process of considering each suggested interpretation against the provisions of the contract and its commercial consequences (Arnold citing In re Sigma Finance Corpn[2010] 1 All ER 571). Lord Hodge said, interestingly, that to his mind it did not matter whether this analysis begins with an examination of the plain language or with the factual background and implications given by rival constructions, so long as the court balances the indications given by each.

Lord Hodge emphasised that both the language and the commercial implications should be used as tools to ascertain the objective meaning of the agreement, and their use will vary according to the circumstances of the particular agreement. Some contracts can be successfully interpreted principally by textual analysis (because of their sophistication, or because they have been negotiated and prepared by skilled professionals), whereas others will require a greater emphasis on the factual matrix (because of their informality, brevity or the absence of skilled professional assistance).

The Indemnity

In applying these principles to the Indemnity, the court took the view that it was poorly drafted and its meaning was therefore “avoidably opaque”. It was therefore necessary to adopt the iterative process in order to examine the clause both through a textual analysis of the words in the context of the contract as a whole, and to consider whether the wider relevant factual matrix could provide guidance as to its meaning in light of the commercial effect of rival interpretations.

The court gave considerable emphasis to the contractual context in this case. In particular, the court appears to have been influenced by the existence of warranties which, subject to a two year limitation, would have provided for compensation for losses which arose from the FSA redress scheme. The court observed that two years after completion was not an unreasonably short period of time in which to conduct an internal review for any relevant misselling/regulatory breaches in order to bring a claim under the warranties. The court considered that it is not contrary to business common sense for parties to agree wide-ranging warranties, which are subject to a time limit, and in addition to agree a further indemnity, which is not subject to any such limit but is triggered only in limited circumstances.

In this context, the court made interesting observations about the utility of business common sense to aid the construction of a contract which has plainly been the subject of negotiation by sophisticated parties:

“Business common sense is useful to ascertain the purpose of a provision and how it might operate in practice. But in the tug o’ war of commercial negotiation, business common sense can rarely assist the court in ascertaining on which side of the line the centre line marking on the tug o’ war rope lay, when the negotiations ended.”

While the agreement may have become a bad bargain for the Buyer, given their failure to bring a claim in time under the warranties, it is not the court’s role to construe the Indemnity in a way that improves their bargain.

Accordingly, the result may have been different had the Indemnity stood on its own (ie if the contract did not contain the warranties). In that event, it may have been anomalous to exclude loss caused by regulatory action that was prompted otherwise than by a customer claim or complaint (ie from the Company self-reporting). This reinforces the importance of construing the contract as a whole, within its wider context.

Comment

While the Supreme Court has sought to emphasise that it was not intending to restate the recent key authorities underpinning the common law position in relation to contractual interpretation, the court’s application of those principles in this case suggests a more balanced consideration of both the textual approach (focusing on the plain language of the contract) and the purposive approach of looking at the factual context to consider the commercial implications of the rival meanings. Perhaps the possible shift in emphasis is explained by the fact that, unlike in Arnold, the Supreme Court concluded very clearly that the clause was poorly drafted, which created difficulties both in the interpretation of the meaning of the plain language as well as the rival interpretations and their practical consequences. However, the fact that yet another case of contractual construction has reached the highest appellate courts highlights the difficulty in applying to individual clauses what the courts treat as the settled principles.

Harry Edwards
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O’Hare v Coutts: High Court dismisses mis-selling claim and clarifies standard of care required of financial advisors

Overview

In O’Hare v Coutts, the High Court dismissed a claim alleging that the defendant bank breached duties in contract and tort to use reasonable care and skill when recommending five investments that the claimants entered between 2007 and 2010.

The Court held that the bank’s duties when giving advice required proper communication and dialogue with the client regarding the proposed investment, in order to ensure the client understood the advice it was given and the risks arising from the recommended course of action. However, the Court found that the relevant approach in this context was not to assess the bank’s actions by reference to what a body of financial advisors would consider acceptable (the “Bolam test”). Rather, the Court would ask whether the bank had taken reasonable care to ensure the claimants were aware of any material risks. This approach, the Court said, takes into account the lack of any clear industry consensus about the extent of communication required and the fact the bank’s regulatory duties—which are “strong evidence of what the common law requires“—do not require reference to industry practice.

Another key issue was the extent to which it was appropriate for the bank to persuade the claimants to take more risks than they otherwise would. The Court could not find anything intrinsically wrong with persuasive salesmanship, provided the products sold were objectively suitable (in which regard the Court said the Bolam test is still applicable). Although, with the benefit of hindsight, the investments had not performed as well as the clients had wished, the Court nevertheless found that reasonable practitioners professing the expertise of the bank could properly have given the same advice the bank did. The Court therefore concluded that the investments were suitable and the claimants should take responsibility for their own investment decisions.

The case is also interesting for the following reasons:

  1. The bank did not call a pivotal witness, the claimant’s former relationship manager, but relied on his contemporaneous notes. The Court admitted the notes as hearsay evidence and declined to draw any adverse inferences in respect of the weight to be given to them because there was no procedural failure on the bank’s part. Nevertheless, the Court was not always prepared to favour the relationship manager’s written notes over the claimants’ oral evidence.
  2. The Court said that if the claims in contract and tort had succeeded, the claimants’ damages would be limited by the more restrictive test of remoteness under contract law.
  3. The Court found that the bank’s promise to apply discounts in favour of the claimants as a “gesture of goodwill” in settlement of a separate dispute constituted a binding legal settlement.

We discuss the decision in more detail below.

Background

Mr and Mrs O’Hare (the Claimants), whose joint net worth was in excess of £25 million, began their relationship with the bank in 2001. Their relationship manager from 2001 to 2008 was a Mr Kevin Shone, after which a Mr Ray Eugeni took over.

Although Mr O’Hare was an astute businessman, the Court did not accept that he was necessarily an experienced investor. The Court found that he was willing to accept some—but not too much—risk, provided he was properly informed about how much risk he was taking.

In 2007 and 2008, the Claimants invested over £8 million on the bank’s advice in three products from the bank’s new line of “Novus” funds (the Novus Investments). The bank classified these as “wealth generation products” (its most risky investment category). The result was a significant shift in the Claimants’ portfolio towards higher risk investment, concentrated in three untested hedge fund products. The Claimants alleged that the Novus Investments were unsuitable because the bank downplayed the substantial increase in risk, there was no capital protection, and the investments caused the Claimants to expose an unjustifiably high proportion of their wealth to loss.

In 2010, the Claimants invested a further £10 million in two additional products that the bank recommended: RBS International funds called Autopilot and Navigator (the RBSI Investments). Unlike the Novus Investments, the RBSI Investments were classified by the bank as “wealth preservation products” (the bank’s least risky investment category). However, the Claimants alleged the RBSI Investments were unsuitable because the bank should have advised against concentrating so much money in one institution and it should have recommended products other than those of it and its parent.

The market declined in value, following the 2008 financial crisis and the Claimants issued proceedings against the bank, alleging breach of contract and negligence on the part of the bank.

1. Suitability of the products: what standard of care is expected of financial advisors?

The bank undertook to advise the Claimants in their personal capacity, including working with them to understand their “circumstances, objectives and requirements” and to formulate “an investment strategy”. The bank was obliged to give its advice in writing, at such times as it considered appropriate (or otherwise as agreed). Because the bank had undertaken advisory duties, the Court considered whether the products had been suitable for the Claimants (as opposed to just whether the bank has correctly described them).

Uncontroversially, the Court found that the bank owed identical duties in tort and contract to use reasonable skill and care when recommending investments, to the standard of a reasonably competent private banker.

Were the Claimants adequately informed?

The Court held that in the context of giving investment advice, there must be proper dialogue and communication between adviser and client. The bank submitted that this ought to be assessed in line with the traditional test from Bolam v Friern Barnett Hospital Management Committee [1957] 1 WLR 583: namely, by reference to whether a body of financial advisors would consider the extent of its communications acceptable. The Court noted that the Bolam test had recently been overturned in a medical context (so far as the duty to explain is concerned), in favour of a duty to take reasonable steps to ensure the relevant patient is aware of any material risks (see Montgomery v Lanarkshire Health Board [2015] UKSC 11). In Montgomery, the Supreme Court said that a risk is material if, in the circumstances, (1) a reasonable person in the patient’s position would be likely to attach significance to it; or (2) the doctor is aware that the patient would be likely to attach significance to it.

In the context of duties to explain investment risks, the Court also preferred the Montgomery approach to Bolam, in particular because the expert evidence did not establish any industry consensus delimiting the proper role of a financial adviser in this regard. The Court supported its decision by reference to the regulatory regime, which is “strong evidence of what the common law requires“. In particular, the Conduct of Business Sourcebook (COBS), which apply where a sale is advised, includes a duty to explain in similar terms to Montgomery and, unlike Bolam, does not require reference to the opinion of a responsible body within the profession.

The Court went on to say that “compliance [with the COBS] is ordinarily enough to comply with a common law duty to inform, forming part of the duty to exercise reasonable skill and care; while breach of them will ordinarily also amount to a breach of that common law duty.” Accordingly, the Court observed that the content of the various COBS provisions relied on by the Claimants added nothing to the bank’s common law and contractual duty to ascertain the client’s requirements and to advise, including explaining and informing them, about suitable investments. In any event, the Court did not find that the bank had breached any COBS duties.

Applying the Montgomery approach first to the Novus Investments, the Court concluded that the bank’s sales presentations had “left no room for any suggestion that Mr O’Hare did not fully understand the Novus products”, including “an understanding of their higher risk classification as wealth generation products“.

Similarly, in relation to the (later) RBSI Investments, the Court concluded that Mr O’Hare was “fully aware that the capital would be at risk if RBSI should become insolvent but was happy to run that risk because, he reasoned, RBS was effectively state owned.” Likewise, the Court rejected the allegation that “insufficient information about the products (including costs and charges), and insufficient comparative information about alternatives, was provided“.

Were the investments objectively suitable?

Given the Court’s decision that the Claimants were properly informed, the case turned on whether the investments were objectively suitable for the Claimants (the case being one where it was not disputed that advice had been provided by the bank). In this context, the Court accepted that the Bolam test continued to apply, the relevant question being whether “reasonable practitioners professing the expertise of the defendants could properly have given advice in the terms they did“.

The key issue was the extent to which it was acceptable for the bank to persuade clients to take more risk than they otherwise would (and conversely, when the bank would be required to step in and “save the clients from themselves”). Perhaps in a welcome recognition of commercial reality, the Court did not find anything intrinsically wrong with a financial advisor using persuasive techniques to induce a client to take risks (s)he would not take but for the adviser’s powers of persuasion, provided the risks were not so high as to be foolhardy (avoiding the temptation to use hindsight), the client could afford to take the risks, and the client showed itself willing to take the risks. Critically, the Court said that the duty of care must reflect a balance between the client taking responsibility for investment decisions (even mistaken ones) and the principle that the advisor must sometimes save the client from him/herself.

In considering the (earlier, higher risk) Novus Investments, the Court explicitly applied the Bolam test, ultimately agreeing with the bank’s expert witness that “competent practitioners at the time – avoiding hindsight – would not regard investment in the Novus products as foolhardy for persons in the position of the O’Hares, with their wealth and investment objectives“.

In contrast, the Court did not explicitly invoke the Bolam test in its analysis of the RBSI Investments. This may be because the capital-protected RBSI Investments involved de-risking and consequently, there was less scope for the Claimants to suggest that the products were objectively unsuitable. In any case, Mr Eugeni, in his unchallenged evidence for the O’Hares, said that after the 2010 RBSI Investments, he considered the portfolio suitable and well balanced. As such, the Court’s focus was on whether the O’Hares were properly informed about material risks relating to the RBSI Investments (in light of the fact such a large amount of money was being placed with a single banking institution).

On the evidence before it, the Court held that all of the investments in question were objectively suitable for the Claimants, who should therefore reasonably bear responsibility for their own mistaken investment decisions (even in light of the bank’s salesmanship).

2. The absent witness: will courts draw adverse inferences if key witnesses are not called?

A key factual issue relevant to suitability was the extent to which the Claimants were persuaded by their first relationship manager, Mr Shone to make higher risk investments than would be consistent with their unconditioned risk appetite.

Although he was a material witness, the bank did not call Mr Shone and instead chose to rely on his contemporaneous notes (which were referred to and implicitly adopted as true in the statements of two other Bank witnesses, both called orally). The bank explained that Mr Shone was a former employee and had indicated he was too busy to devote time to the proceedings.

The Court first accepted that the hearsay notes were admissible, by virtue of section 1 of the Civil Evidence Act 1995, which abolished the rule against the admissibility of hearsay in civil proceedings. Moreover, because they formed part of the agreed bundle and the Claimants did not give a written notice of objection in respect of them, paragraph 27.2 of Practice Direction 32 confirmed the notes would be admissible as evidence of their contents.

Section 2(4)(b) of the Civil Evidence Act 1995 provides that a failure to comply with the relevant procedural rules may be taken into account as a matter adversely affecting the weight to be given to hearsay evidence. Here, the Court declined to draw an adverse inference in respect of Mr Shone’s notes because it found that the Court had complied with its obligations under CPR 32 and 33 (given that the witnesses who referred to those notes gave oral evidence). It was open to the Claimants under CPR 33.4 to call Mr Shone for cross-examination, but they did not.

In terms of the weight given to those notes, the bank relied on Gestmin v. Credit Suisse [2013] EWHC 3560 (Comm), in which the High Court had held that the best approach for a judge to adopt in a commercial case is “to place little if any reliance at all on witnesses’ recollections of what was said in meetings and conversations, and to base factual findings on inferences drawn from the documentary evidence and known or probable facts.” Whilst the Court agreed that the approach in Gestmin is “very useful”, it did not accept that the effect of Gestmin was to cause Mr Shone’s notes to be admitted unchallenged (their accuracy having been disputed by the Claimants). Nor did it go so far as to mean Mr Shone’s notes should always be preferred to the oral testimony of the Claimants. Indeed, the Court ultimately preferred Mr O’Hare’s testimony that Mr Shone used persuasion on him over Mr Shone’s notes, which repeatedly described the Claimants as “keen”, without mentioning the exertion of persuasion or influence by the bank.

Although the tactical question of which witnesses to call will always be highly fact specific, this case illustrates the importance of complying with the procedural rules for adducing hearsay evidence in the absence of a witness (and considering whether to apply to cross examine an absent witness on whose hearsay evidence the other party relies).

3. The settlement agreement: when will “gestures of goodwill” be legally binding?

In 2008 and 2009, the Claimants complained that the bank had not properly explained the risk profile of another product called “Orbita Capital Return”, which had performed poorly. The bank had at that time rejected the Claimants’ complaint explaining why it considered that the product had not been mis-sold. Nevertheless, recognising the value of the Claimants’ business the bank agreed as a gesture of goodwill to apply a refund of $250,000 by way of a reduction in fees over a period of time in consideration for the Claimants forbearing to sue. Although Mr O’Hare gave evidence that the agreed currency was pounds sterling, the Court found that Mr O’Hare was genuinely mistaken and that the agreed currency was dollars, reflecting Mr Eugeni’s written notes.

In the proceedings concerning the other products, the Claimants sought to argue that this obligation remained outstanding. In doing so, they sought to exclude discounts that had been negotiated with the bank arguing that these discounts were separate and distinct from the $250,000 that the bank had agreed to pay.

The bank’s primary argument was that the “settlement agreement” was not binding; rather, it was merely a “gesture of goodwill” made without intention to create legal relations. The bank referred to Clarke v Nationwide Building Society [1998] EWCA Civ 469 in which a refund sent in “full and final settlement”, but described as a “goodwill gesture”, was held not to be binding.

The Court expressly declined to hold that Clarke provided authority for a general proposition that offers made as a gesture of goodwill are not capable, on acceptance, of binding the offeror. The Court noted that this was a question that depended on the circumstances of the case. Unlike Clarke, the bank’s offer was made in the context of a pre-existing contractual relationship. This placed a heavy onus on the bank to show that the parties did not intend to be legally bound, which it failed to discharge. Nevertheless, the Court held that the bank had complied with its side of the bargain by applying $250,000 worth of discounts, despite Mr O’Hare’s genuine belief that some of those discounts ought to have been excluded from the sum.

The Court’s approach to this issue highlights the risks in entering into settlements which are not formally documented, given the potential for later disagreement over their terms and the extent to which they have been satisfied. The difficulties here were exacerbated by the absence of evidence from key witnesses (both Mr Shone, who was not called, and Mr Eugeni, who had not given evidence about this point).

4. The damages issue: concurrent claims in tort and contract

Interestingly, the Court said that had the Claimants been successful, it would have confined damages to the more restrictive contractual test of remoteness (rather than the more generous tortious measure). The Court said that it would have taken this approach even in respect of the Novus Investments, where the Claimants’ contractual claim was time barred but its tortious claim was not. To do otherwise would be to allow the Claimants to benefit from their failure to bring the contractual claim less than six years before the cause of action arose and fly in the face of the fact that there was a contractual relationship between the parties.

This follows the approach in Wellesley Partners LLP v Withers LLP[2015] EWCA Civ 1146, where the Court of Appeal said that in cases of concurrent liability in tort and contract, the parties are not strangers and should be confined to the contractual measure of damages (since the contract reflects the consensus between the parties which ought to be reflected when dealing with issues of remoteness).

In this case, the Court doubted whether the distinction would make any real difference. However, in other circumstances, it might be relevant whether the financial advisor is liable for all foreseeable consequences of the breach (for instance, unexpected or catastrophic falls in the market) as opposed to merely loss that is within the reasonable contemplation of the parties at the time the contract is made.

Conclusion

O’Hare v Coutts provides helpful guidance about the extent of financial advisors’ duties to their clients. In particular, the decision erodes the Bolam test in the context of the duty to explain investment risks (as had already happened in cases of medical negligence): in cases where objectively suitable advice has been given, the extent of communications required is simply to take reasonable steps to ensure the client is aware of material risks. On the other hand, the decision affirms that the Bolam test still applies to the assessment of whether the advice given is objectively suitable (which requires reference to whether reasonable practitioners with the expertise of the defendant could properly have given the advice the defendant did).

This decision adds to the theme of recent cases, that make clear that informed investors must be prepared to accept responsibility for their own investment decisions, even where the advisor has used sales techniques to push a particular product or to encourage the investor to take more risk than s/he otherwise would.

The decision also serves to reinforce the basic proposition that evidence at trial should generally be given orally by the witness who proves the fact. Where this is not possible, contemporaneous hearsay notes (albeit admissible) may not be preferred to contradictory oral evidence. Parties who intend to adduce hearsay evidence should take steps to protect themselves by complying with the relevant procedures in the CPR. Equally, parties should consider giving written notice of objection to the admissibility of hearsay evidence which the other side seeks to include in agreed bundles, and consider applying to cross examine the relevant witness, where possible.

Finally, the decision clarifies the approach to damages in cases of concurrent liability in tort and contract. While it may not always be relevant, the Court’s approach of limiting damages to the more restrictive contractual test of remoteness could cushion a bank in circumstances where investments perform poorly due to unexpected or catastrophic changes in the market.

John Corrie
John Corrie
Partner
+44 20 7466 2763
Hywel Jenkins
Hywel Jenkins
Partner
+44 20 7466 2510
Ben Worrall
Ben Worrall
Associate
+44 20 7466 2385

FCA v Da Vinci: FSA uses court proceedings for the first time to obtain both financial penalties and permanent injunctions against a firm in a case of alleged market abuse

In Financial Conduct Authority v Da Vinci Invest and Others [2015] EWHC 2401 (Ch), the High Court granted the Financial Conduct Authority (the “FCA“) permanent injunctions and financial penalties for market abuse against two firms and three individuals. All but one of the Defendants was incorporated or resident abroad.  This decision represents the first time the FCA has obtained both injunctions and penalties against a firm by application to the High Court, rather than using its own regulatory enforcement powers.

The Defendants were found to have engaged in market abuse, having committed the manipulative trading strategy of ‘layering’ or ‘spoofing’, in contravention of section 118(5) of the Financial Services and Markets Act (“FSMA“). As well as permanent injunctions against all the Defendants, the Court imposed total financial penalties of over £7.5 million.

In reaching this decision, the Court has given some helpful guidance on its approach to market abuse claims, dealing in particular with: (a) its jurisdiction under section 129 and 381 of FSMA to impose financial penalties and injunctions respectively; (b) the mental element required to constitute market abuse under section 118(1) and (5) FSMA, together with the attribution of such acts to corporate entities; (c) standard of proof; (d) what constitutes market manipulation under section 118(5) FSMA; and (e) available defences.

We consider this guidance in more detail below and comment on the likely impact of this decision for financial institutions.

Factual Background

The First Defendant was an English company, Da Vinci Invest Limited (“DVI“), which carried on business as an investment and fund manager from a branch office in Switzerland. In mid-2010, DVI entered into a joint venture with three traders from Hungary (the “Traders“, also Defendants), who previously had trading accounts suspended by Swift Trade for suspected manipulative trading. Under the arrangement, DVI would provide capital for trading, while the Traders traded in stocks using contracts for differences (“CFD“). Profits were split 50/50 between DVI and the Traders.

Trading began in August 2010, with the Traders using a bank’s direct market access (“DMA“) system, and DVI undertaking financial responsibility to that bank for the CFD trading, including providing collateral to cover any losses. By the end of December 2010, various suspicious activity referrals relating to DVI’s account were made to the Financial Services Authority (the “FSA“, the precursor to the FCA) by both the bank providing the DMA services and the platform on which the trades were taking place. The bank subsequently terminated the agreement to provide DMA services and the entire business relationship with DVI.

Following this termination, DVI established DMA trading and other facilities with an alternative supplier, and the Traders began trading again in February 2011. At this point, in addition to trading for DVI, the Traders also began trading for Mineworld Limited (“Mineworld“, another Defendant), a company incorporated in the Seychelles owned and controlled by the Traders.

The second period of trading also led to further alerts to the FSA from the trading platform referring to potential market abuse. The FSA began formal investigations in May 2011, and in mid-July the FSA issued Court proceedings against all the Defendants.

Decision

The Court found that there had been market abuse, determining the following issues:

(a) Jurisdiction and procedural objections

The claim was brought under section 129 and 381 of FSMA, two provisions which permit the FCA to apply to the Court to obtain financial penalties and injunctions respectively. DVI put forward various submissions as to why it was inappropriate for the FCA to use Court proceedings as opposed to regulatory proceedings in respect of the financial penalties. The Court concluded that there was no material difference between an application to the Court under section 129 FSMA and a decision by the FCA to impose a regulatory penalty under section 123 FSMA. The points considered included:

  • DVI claimed it was ultra vires for the FCA to bring a claim for financial penalties without giving a warning notice, as would have been required under the regulatory regime pursuant to section 123 FSMA. This was rejected by the Court, as the only provisions the FCA had to be mindful of were those in section 129 of FSMA, and there are no requirements for notice under this section.
  • DVI alleged that the interpretation of the Market Abuse Directive (the “Directive“) prevents more than one body from being authorised to impose penalties for market abuse. This was also rejected by the Court, as the Directive is a minimum harmonisation directive. There was nothing in the relevant articles of the Directive which would prevent the UK empowering the Court from imposing penalties.
  • Of greater weight was the fact that section 123 FSMA provides a specific defence to a person faced with the imposition of a penalty by the FCA, whereas section 129 FSMA contains no such express restriction on the power of the Court. The Court held that section 129 FSMA should be read so that the Court may not impose a penalty if it is satisfied that a section 123 FSMA defence applies.
  • The Court also rejected the submission that it was potentially unfair to bring Court proceedings due to the unlimited financial penalty capable of being imposed by the Court, as opposed to a penalty from the regulator, which would be determined by reference to a detailed framework. The Court noted that even in regulatory proceedings, the regulator is not bound by the penalty framework, but in any case the FCA had requested the Court to take an approach consistent with the regulatory framework.

The Court also rejected DVI’s claim that the power of the Court to impose a penalty under section 129 FSMA was only exercisable where the Court had actually granted an injunction under section 381 FSMA. This conclusion was reached on the plain wording of section 129 FSMA and for compelling practical reasons, to ensure that parties are engaged in only one set of proceedings in which all relevant factual/legal issues can be determined.

(b) Mental element and attribution in market abuse cases

The Court first considered the statutory reference to “behaviour” in the definition of market abuse at section 118(1) and (5) FSMA. DVI argued that this meant that acts could not be attributed to a corporate entity unless they were acts of the “directing mind and will” of the company, or carried out at that individual’s direction/specific knowledge/consent. In contrast, the FCA contended that whether market abuse had occurred was purely objective requiring no mental element. The Court agreed with the FCA, stating that the behaviour amounting to market abuse under section 118(5) FSMA does not require an investigation of the state of mind of the person committing the behaviour. This was the conclusion reached by the Court of Appeal in relation to the meaning of a previous version of section 118 in Winterflood Securities Limited v FSA [2010] EWCA Civ 423.

On this basis, the Court went on to consider how a corporate person could be found to engage in offending behaviour for the purpose of section 118. It concluded this question can be answered simply by reference to the general rules of attribution which are derived from the law of agency. The Court commented that this conclusion made sense in the context of modern trading on regulated markets. It would be contrary to the current market abuse regime if companies could escape liability for the actions of their employees if directors and senior management, as the “directing mind and will” of the company, did not have detailed knowledge of the day to day activities.

Applying those conclusions to the facts of the instant case, the Court held that the result was “very clear“. The behaviour of the Traders was, for the purpose of section 118, also the behaviour of DVI and Mineworld. The Court confirmed, however, that FSMA does permit a company to adduce evidence of the belief of other natural persons and/or of relevant steps taken by other persons on behalf of the company as part of a statutory defence.

(c) Standard of proof

It was agreed by the parties (after some initial dispute) and the Court that the civil standard of proof on the balance of probabilities applied to the various factual issues arising in the case (taking into account any inherent improbabilities).

(d) Market manipulation

In considering whether there had been market manipulation, the Court confirmed that it would take into account Article 4 of the Directive and the Code of Market Conduct section of the FSA/FCA Handbook. On the evidence before the Court, it was “entirely satisfied” that the Traders jointly engaged in market manipulation within section 118(5) FSMA on behalf of DVI and Mineworld. Examples of manipulative behaviour included:

  • placing orders predominantly on one side of the book and then moving orders to the other side in a “saw-tooth” pattern, consistent with conduct intended to influence supply and demand;
  • high proportion of wash-trades (trades not resulting in a change of beneficial ownership) by the Traders; and
  • a significant number of orders being placed within a short time span, representing a high proportion of the volume of transactions.

These examples all correspond with indicia of manipulative trading as set out in the FCA’s Code of Market Conduct, and all the expert evidence presented to the Court concurred with a finding of market abuse.

(e) Available defences

Finally, the Court examined whether any of the Defendants could establish a defence that they believed, on reasonable grounds, that their behaviour did not constitute market abuse or that they took all reasonable precautions and exercised all due diligence to avoid behaving in such a way.

The Court found that on the facts, the Traders and Mineworld (as the corporate entity used for trading in 2011) must have known what they were doing, and that they were well aware that their behaviour was improper. As such, no defence was available for them. With respect to DVI, the position was less straightforward, as none of the senior management actually directed the market abuse undertaken by the Traders. However, the Court found that DVI’s failure to carry out proper background checks of the Traders or to understand the Traders’ strategy went beyond negligence, it was irresponsible and reckless. DVI was therefore also not able to establish a defence.

Accordingly, the Court imposed penalties of over £7.5 million and granted permanent injunctions against all of the Defendants.

Accepted market practices

The Court also noted, and in doing so declined to follow the remarks of the Upper Tribunal in Hobbs v FSA (FS/2010/0024), that for a matter to constitute an “accepted market practice” for the purposes of the exception in section 118(5) FSMA, the FCA must have undergone a formal acceptance procedure as envisaged by Article 1.5 of the Market Abuse Directive and Article 3 of the 2004 Implementing Directive.

Comment

Whilst the fines imposed in this case were not as large as other recent cases, the penalties were significant because the FCA chose to enforce by commencing High Court proceedings to obtain both a fine and an injunction against all the Defendants. The reasons for the FCA choosing this approach were not discussed in the case, but presumably include the enforceability of Court orders outside of the jurisdiction (for example, under the Recast Brussels Regulation, Lugano Convention and Hague Convention) and the practical convenience of dealing with matters in one set of proceedings where both a fine and injunction were sought. It seems likely that injunctions will remain to be used in cases such as these, where there is clear recklessness on behalf of the parties, or a real risk that the market abuse will continue.

Looking towards the future, market abuse and in particular the type of market abuse that arose in this case, will continue to be under scrutiny. A new EU Market Abuse Regulation (“MAR“) will apply from 3 July 2016. It will apply to a wider range of securities and certain types of algorithmic and high-frequency trading will be expressly forbidden.  HM Treasury have not to date clarified whether they propose to retain the defences currently set out in section 123 of FSMA (which are not replicated in the text of MAR).

In addition, the new Markets in Financial Instruments Directive (“MiFID II“) is due to come into application in 2017 (although this may now be delayed to 2018). It will introduce new authorisation requirements for firms undertaking certain types of high frequency and algorithmic trading, and also deals with direct access. The FCA has not indicated whether action against the second DMA provider is in contemplation, but under MiFID II, DMA providers will be required to monitor (and report where appropriate) transactions effected by their DMA clients for infringements of the rules of the trading venue, disorderly trading conditions or conduct that may involve market abuse. Whilst it is unlikely that MAR or MiFID II would have affected the result in this case, the increased scope and the enhanced reporting, notification and procedural requirements may well lead to an increased volume of FCA enforcement and/or High Court proceedings.

Karen Anderson
Karen Anderson
Partner
+44 20 7466 2404
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

“Topping up” of Ombudsman awards through the courts not allowed: Court of Appeal overturns High Court decision

The Court of Appeal has handed down an important judgment holding that complainants who had accepted a Financial Ombudsman Service (“FOS”) determination were barred from bringing court proceedings in relation to the same cause of action under the legal principle of res judicata.

In doing so, the Court of Appeal overruled a High Court decision that complainants to the FOS would be able to accept a determination awarding them the statutory maximum award (now £150,000) and then subsequently claim for damages above that amount through the courts.

Clark v In Focus Asset Management & Tax Solutions Ltd [2014] EWCA Civ 118

The High Court decision in Clark v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669 (QB) (“Clark”) (please see our earlier e-bulletin here) had caused concern in the financial services industry as it had seemingly allowed complainants the opportunity to accept a FOS award in order to build a “war chest” with which to bring litigation proceedings through the courts.

The Court of Appeal decision will be welcomed by the financial services industry because it prevents complainants who accept FOS awards from having “two bites of the same cherry”. The decision also removes the uncertainty as to the finality of FOS determinations which has existed since the High Court decision in Clark was handed down because it was in direct conflict with a previous High Court decision on the issue.

The Court of Appeal’s decision leaves open the possibility that, where a complainant has two distinct causes of action, they may be able to submit one to the FOS, while bringing concurrent or subsequent court proceedings in relation to the other. Such examples are likely to be relatively rare and would in any event have already entitled parties to bring two separate sets of litigation proceedings on the established principles. In such cases, to have the court proceedings struck out, the burden of proof will lie with the respondent firm to demonstrate to the court that the causes of action of the FOS complaint and the litigation proceedings are the same. However, even if a party with two separate causes of action did bring legal proceedings after having accepted a FOS award, they would not be entitled to double recovery of the same losses.

Conflicting High Court decisions

In December 2012, the High Court in Clark decided that a party who had accepted an award of compensation pursuant to a determination of the FOS and had been paid the statutory maximum award (then £100,000, now £150,000) by the firm, could subsequently bring a damages claim through the courts to recover the full loss they had suffered over and above the FOS award.

In the earlier case of Andrews v SBJ Benefit Consultants Ltd [2010] EWHC 2875 (Ch) (“Andrews”) (which was decided on very similar facts to Clark), the High Court decided that once a complainant had accepted an award pursuant to a FOS decision, the doctrine of merger applied. This doctrine provides that once a decision has been given by a judicial body on a cause of action, that cause of action is extinguished and a second set of court proceedings for losses incurred under the same cause of action but not yet claimed cannot then be brought.

The conflict in these judgments of the High Court hinged on the finding that a decision of the FOS was a decision of a judicial body, such that the doctrine of merger would apply to its decisions. In Andrews, HHJ Barratt QC determined that the FOS was such a judicial body; in Clark, Cranston J held that it was not. The reasoning relied on by Cranston J in the High Court was that the FOS was not a judicial body because it dealt with complaints, which were distinct from legal causes of action. Accordingly, the FOS complaint had not merged into the court proceedings as they did not both concern legal causes of action to be determined by a judicial body.

The High Court’s decision was appealed to the Court of Appeal.

Decision of the Court of Appeal

Summary

Concluding in favour of the appellant financial adviser in the case, the Court of Appeal applied the doctrine of res judicata to rule that acceptance of a FOS award, for whatever amount, precludes a complainant from then bringing legal proceedings to pursue a claim based on the same cause of action.

Critical to the Court of Appeal reaching this decision were its findings that: (i) a FOS determination is judicial in nature such that the doctrine of res judicata applies to it; and (ii) Parliament’s intentions in establishing the FOS scheme under the Financial Services and Markets Act 2000 (“FSMA”) were that it should be an expeditious and cost-free means of dispute resolution for consumers and, as such, its decisions should be final. Importantly, the Court of Appeal held that nothing in the FSMA prevented the doctrine of res judicata applying to FOS determinations.

Identifying same cause of action crucial to establishing res judicata

In order for res judicata to apply, the action brought before the court must be based on the same cause of action as the complaint brought before the FOS. In the case before the Court of Appeal, this presented no problems. However, the Court of Appeal noted that there may be situations where a complainant who has accepted a FOS award might nevertheless be able to bring legal proceedings because the cause of action (or, perhaps, the type of loss) in the legal proceedings differs from that which had been considered by the FOS (even though the causes of action might arise from substantially the same facts).

In particular, the Court of Appeal noted that a complaint to the FOS might not always appear to equate directly with a cause of action where a complaint is not very well particularised by the complainant (for example, because they do not have legal advice and have simply set out facts as they see them). In such circumstances, because the FOS must give reasons for its decision, it should nevertheless be able to discern what cause of action a complaint is in fact based on, or, if not, it should investigate to establish this and formulate its decision accordingly.

Further, where res judicata is put forward to strike out court proceedings, the burden of proof in establishing that the FOS decision and the court proceedings are based on the same cause of action will lie with the financial services provider. Accordingly, the complainant will have the benefit of any doubt.

FOS as a judicial body

The Court of Appeal held that the FOS was a judicial body for the purposes of the doctrine of res judicata. In reaching that conclusion, the Court noted, among other things, that the FOS must reach its decisions on the basis of what is fair and reasonable, rather than on strict legal principles. However, the Court did not consider that this precluded the FOS from being a judicial body for the purposes of res judicata, particularly because, to be valid, a FOS decision must not be perverse or irrational, and must take (proper) account of the law.

The FOS intervened in the proceedings in order to clarify that it considered itself to be a judicial body for the purposes of the application of the doctrine of merger or res judicata.

Court proceedings only precluded once FOS determination is accepted

A FOS decision is only binding on the parties once it is accepted by the complainant. However, a decision of the FOS which is not accepted by the complainant is not binding and so the doctrine of res judicata cannot apply to it. This means that a complainant may well still seek to obtain a FOS determination in its favour, decline to accept it, and then seek to use it as evidence in its favour in court proceedings.

The courts are not likely to consider determinations of the FOS persuasive, but an adverse FOS decision (and any accompanying recommendation to pay a higher amount of compensation than the statutory maximum) may encourage firms to enter into settlements with their customers.

3. Comment

The Court of Appeal’s decision brings a welcome degree of certainty back to the finality of FOS determinations.

While there is still scope for a complainant to accept an award and then bring legal proceedings if the causes of action and/or the types of loss are different, such circumstances are likely to be limited. Financial firms may be able to take steps to avoid this occurrence by ensuring that, in their response to a complaint, all causes of action arising from the particular set of facts on which a complaint is based are very clearly identified so as to maximise the prospects of demonstrating that the FOS has taken them into account when reaching its decision.

The decision also increases certainty for firms in that, once a FOS award has been accepted, complainants cannot take the same matter to court, even if the FOS has made a recommendation to pay compensation above the statutory maximum.

Equally, this may force some complainants with high value claims to consider at the outset whether a FOS complaint is worth pursuing (notwithstanding the costs involved and the perception of the FOS as a more consumer-friendly forum) or whether litigation is the only viable option.

Hywel Jenkins
Hywel Jenkins
Partner
+44 20 7466 2510
Ajay Malhotra
Ajay Malhotra
Associate
+44 20 7466 7605
David Dowell
David Dowell
Partner
+44 20 7466 7467

High Court rules that Ombudsman awards may be “topped up” through court action

The High Court has decided that a party who accepts a FOS determination awarding them the statutory maximum award (now £150,000) can subsequently claim for damages above that amount through the courts.

The Court concluded the doctrine of merger does not apply to FOS decisions. This ruling is in direct conflict with a previous High Court decision (in Andrews) which held that, once a consumer had accepted a FOS decision, its cause of action merged with that decision and could not be pursued further. The firm is seeking permission to appeal this decision and it is therefore possible that it will be overruled by the Court of Appeal on appeal.

The decision may encourage potential claimants with claims of over £150,000 to seek to use the FOS process in the first instance as a means of securing an award with which to fund subsequent litigation claiming the balance of their losses. However, assuming the FOS agrees to determine a complaint likely to exceed the statutory maximum award, such claimants would run the risk that if they accept a FOS award and the recent decision is overruled or not followed, they may be barred from claiming the balance of their losses through the courts.

The Decision

In December 2012, the High Court in Clark v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669 (QB) decided that a party who had accepted a favourable Financial Ombudsman (FOS) decision and had been paid the statutory maximum award (then £100,000, now £150,000) by the firm could subsequently bring a damages claim for the full loss they have suffered over and above the FOS award.

Mr and Mrs Clark (the Complainants) had made a complaint to the FOS that financial advice given to them by In Focus Asset Management & Tax Solutions Ltd (the Firm) was inappropriate.  That advice had allegedly caused them losses of in excess of £500,000.

The FOS upheld the complaint and decided that the Firm should pay compensation in accordance with a formula to put the Complainants back in the position they would have been in had the allegedly inappropriate advice not been given.  However, the FOS’s award was capped at the statutory maximum of £100,000 (in January 2012 this statutory maximum award was increased to £150,000).  The FOS made a recommendation that the Firm should pay the full amount of compensation derived from the formula but warned the Complainants that they “may not be able to enforce a greater amount [than the statutory maximum award] in the courts.”  The Complainants accepted the FOS’s award but added a manuscript rider to the pro forma acceptance form stating: “we reserve the right to pursue the matter further through the civil court“.

The Firm paid the statutory maximum FOS award but did not pay the recommended compensation above this level.  The Complainants banked the cheque for £100,000 and subsequently brought a claim in the County Court for their alleged losses, giving credit for this payment.  However, HHJ Barratt QC granted the Firm’s application to strike the claim out, following the High Court decision in Andrews v SBJ Benefit Consultants Ltd [2010] EWHC 2875 (Ch).

In Andrews (which was decided on very similar facts to Clark v In Focus), HHJ Pelling QC, sitting as a Deputy Judge in the High Court, decided that once a complainant accepts a FOS decision, the doctrine of merger applied to any subsequent court proceedings brought in respect of the same facts.  The doctrine of merger provides that a party which has obtained a final judgment in a tribunal of competent jurisdiction is precluded from later recovering in court a second judgment for the same relief in respect of the same subject matter.  Andrews relied on the reasoning of the Court of Appeal in R (on the application of Heather Moor & Edgecomb Limited) v FOS and Lodge[2008] EWCA Civ 642 in which it was decided that the FOS was a court or tribunal for the purposes of Article 6 (the right to a fair trial) of the European Convention on Human Rights (ECHR).

The decision in Andrews was widely considered by legal and insurance commentators to have provided much needed clarification to the expected legal position in an area with little relevant case law.

However, in Clark v In Focus Mr Justice Cranston considered that Andrews was incorrectly decided on the issue of whether the doctrine of merger applied to FOS determinations.  Mr Justice Cranston said that the Court in Andrews had ignored an obiter statement in Heather Moor in which Rix LJ had said that the FOS is “dealing with complaints, and not legal causes of action, within a particular regulatory setting“.  This comment, in Mr Justice Cranston’s view, showed that there was a distinction between the cause of action being considered in the court case and the matter that had been determined by the FOS.  Accordingly the doctrine of merger did not apply.

Mr Justice Cranston also rejected the reasoning that the FOS should be treated as a tribunal for the purposes of the merger doctrine because it was a tribunal for the purposes of ECHR (as per the decision in Heather Moor). In addition, the Court decided that the acceptance of the award by the complainants as being “final and binding” was “final” only in the sense of being the conclusion of the FOS process rather than in the sense that the complainant could not take further proceedings.  Mr Justice Cranston said that it seemed to him that it was not inconsistent with the aims of the statutory framework of FOS for a complainant to use a FOS award to finance the legal costs of bringing court proceedings.

Interestingly, the Judge held that, if in fact the merger doctrine did apply to FOS decisions (contrary to his primary conclusion), the words written by the Complainants on the pro forma acceptance form for the FOS award (“we reserve the right to pursue the matter further through the civil court“) did not mean that they had not given their “final” acceptance of the FOS determination and would not assist them in arguing that merger had not occurred.

The Firm is seeking permission to appeal the High Court’s decision to the Court of Appeal.

It is worth noting that this decision only affects whether the Firm’s application for strike out of the claim was successful.  Even if the Complainants are ultimately successful in proving negligence, there is no guarantee that the Court will use the same formula as the FOS to determine the quantum of their loss.

Conclusions

If the High Court’s decision in Clark v In Focus is upheld, this may have the effect of encouraging complainants with claims larger than the statutory maximum FOS award to utilise the FOS in the first instance with a view to building a “war chest” of legal costs before commencing court proceedings respect of the balance of their claim.  Complainants may also seek to adduce the FOS judgment in support of their court case, particularly given that it is quite common for the FOS to recommend a higher award than its statutory limit.

A key consequence of this judgment is that the FOS procedure can no longer be seen as an ‘alternative’  to court.  From a regulatory perspective, the FOS may therefore face a higher volume of claims from complainants with higher value claims.  This may possibly be counteracted if the FOS considers (or firms are able to persuade it) that such cases are better dealt with by the courts given their size and complexity, and should therefore be dismissed by the FOS without considering the merits (which is a ground for dismissal under DISP 3.3.4R(10)).

We anticipate that this decision is likely to have moot impact on complaints that have a value around the level of, or that may moderately exceed, the maximum statutory award. This is because the FOS may agree to determine such cases and the complainant may be keeping alive their option to pursue subsequent court proceedings.   However, quantification of financial and investment loss often gives rise to difficult issues (which may in some cases, of course, have given rise to the complaint in the first place).  The precise level of loss may not be known when the complaint is first made to the FOS.  It would be an unfortunate consequence of this decision if the FOS adopted a more cautious stance to agreeing to determine complaints and dismissed more complaints on the basis that they might exceed the FOS’s statutory limit.  This would defeat the legislator’s objective of establishing a scheme for resolving lower value financial claims quickly, informally and without recourse to the courts.

More generally, the High Court’s decision in Clark v In Focus appears to place significant weight on Rix LJ’s statement in Heather Moor that the FOS is “dealing with complaints, and not legal causes of action, within a particular regulatory setting“.  The context of Heather Moorwas a challenge, by way of judicial review, to a FOS decision on grounds that the FOS was required to determine complaints in accordance with English law but had failed to do so, instead making a decision by reference to what the FOS considered to be fair and reasonable.  Rix LJ’s statement was made in the context of distinguishing the FOS, which determines complaints by reference to its “fair and reasonable” jurisdiction, and a judge, who determines legal claims and is bound to apply the law in all its particulars.  There are, of course, strong public policy reasons for this distinction: lower-value financial claims may not merit the full vigour of the legal process and the FOS scheme provides an alternative dispute resolution mechanism to those who cannot afford (or choose not to pay for) it.  There are also strong public policy reasons for resolving such claims efficiently and informally, which the statutory framework establishing the FOS recognises when providing for a “scheme under which certain disputes may be resolved quickly and with minimum formality …”  The decision in Clark v In Focus relies on the principle that the doctrine of merger applies only to causes of action, but a cause of action is (merely) the factual situation which entitles one person to obtain a remedy from a court against another person.  It is not clear why a complaint before the FOS should not be treated as encompassing that factual situation so that the doctrine of merger does apply.  In addition, a complainant is not required to accept a FOS decision (and can instead bring court proceedings), but where he does so, it would seem to meet another aspect of public policy – the need to bring disputes to a final end – for the complainant to be barred from taking his complaint further in a different forum.

It is also interesting to note that the Judge in Clark v In Focus did not consider the fact that DISP 3.3.4R allows, but does not compel, the FOS to dismiss a complaint without considering the merits if the subject matter: (i) has been the subject of court proceedings where there has been a decision on the merits or (ii) is currently the subject of court proceedings.  This reflects the fact that the FOS’s jurisdiction to consider complaints is wider than the legal causes of action but the complaint may be equivalent to or encompass the legal cause of action in a given case.

The financial services industry is not likely to welcome the prospect that claimants can now have ‘two bites of the cherry’ nor the lack of clarity now introduced into this area until the Firm’s efforts to appeal are resolved.  In any event, given that there are now two conflicting High Court decisions, determination of the issue by the Court of Appeal would be desirable.

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
 
Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
 
Hywel Jenkins
Hywel Jenkins
Senior Associate
+44 20 7466 2510
Ajay Malhotra
Ajay Malhotra
Associate
+44 20 7466 7605