The Court of Appeal has upheld a decision of the High Court to strike out a claim by the former shareholders of a dissolved company against an investor on the basis that all the losses claimed were barred by the reflective loss principle: Burnford & Ors v Automobile Association Developments Ltd [2022] EWCA Civ 1943.

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed that the reflective loss principle is a bright line legal rule, which prevents only 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, in respect of which the company has a cause of action against the same wrongdoer (see our blog post).

In the present case, the Court of Appeal agreed with the High Court that although the company had been dissolved, the claimants’ claim fell within the ambit of the reflective loss principle. The decision puts the time at which the reflective loss rule falls to be assessed beyond doubt: it is the time when the claimant suffered the alleged loss and not at the time proceedings were brought.

This timing point has been the subject of uncertainty following the decision of Flaux LJ (as he then was) in Nectrus Ltd v UCP plc [2021] EWCA Civ 57. Sitting as a single judge of the Court of Appeal, Flaux LJ refused permission to appeal in Nectrus and in doing so held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made. Although the Board of the Privy Council in Primeo Fund v Bank of Bermuda (Cayman) Ltd [2021] UKPC 22 found that Nectrus was wrongly decided, the High Court in the present case considered that it was bound by the decision (albeit distinguishing the present case from Nectrus on the facts). On appeal, the Court of Appeal took the opportunity to set the record straight, confirming that the Privy Council’s decision in Primeo is the correct view.

We consider the decision in more detail below.

Background

The claimants were former shareholders in a company called Motoriety (UK) Ltd (Motoriety), whose business was the exploitation of two software-based products for the motoring industry. In 2015, Motoriety wished to expand its customer base and entered into negotiations with Automobile Association plc (better known as “the AA”), on the basis that the AA could invest in the company. Motoriety and the claimants subsequently entered into an investment agreement with the defendant subsidiary company of the AA. The defendant agreed to subscribe for 50% of the share capital of Motoriety and the defendant had a call option for the remaining 50% of Motoriety for consideration produced by a formula contained in the agreement. On the same day, Motoriety granted the defendant a licence to use its software and associated intellectual property rights. In 2017, Motoriety went into administration and was bought from its administrators by another company in the AA group.

The claimants subsequently brought a claim against the defendant for fraudulent or negligent misrepresentation and/or for breach of contract. The claimants alleged that they had entered into the investment agreement and the licence agreement in reliance on false representations by the defendant. The claimants also alleged that the defendant breached implied terms of the investment agreement by pursuing a course of conduct that undermined the basis of the arrangements between the claimants, Motoriety and the defendant. The claimants alleged that this led to Motoriety going into administration. The claimants also pleaded an alternative breach of contract claim that, had it not been for the defendant’s breach of contract, the defendant would have exercised the call option and paid the consideration due.

The claimants sought damages for losses incurred as a result of the fraudulent/negligent misrepresentation and/or breach of contract. On the claimants’ misrepresentation claim, losses were claimed on the basis that, had the alleged misrepresentations not been made, the claimants and Motoriety would not have done the deal with the defendant, but would have entered into a venture with a third party company and the value of the claimants’ shareholdings would have increased accordingly. Similarly, in relation to the original breach of contract claim, the claimants claimed that if the contract had been properly performed, Motoriety would have thrived and the value of the claimants’ shareholdings would have increased. Alternatively, had it not been for the defendant’s breach of contract, the defendant would have exercised its call option, so that the claimants would have been entitled to the consideration provided for by that option. Three of the claimants also claimed for the loss of their initial investments in Motoriety.

The defendant denied the claim and brought an application to strike out the claim or for reverse summary judgment on the basis that all the losses claimed by the claimants were barred by the reflective loss principle.

High Court decision

The High Court found in favour of the defendant and granted its application to strike out the claim. The High Court’s reasoning is discussed in our previous blog post here.

In summary, the High Court found that the claimants’ claims satisfied all of the conditions (set out in Marex) needed for a claim to be barred by the reflective loss rule. The claimants’ alleged losses were entirely derived from the claimed losses of Motoriety and were not separate and distinct losses. If Motoriety was restored to the register, the loss would still be in the company.

The claimants appealed.

Court of Appeal decision

The Court of Appeal upheld the High Court’s decision to strike out the claim on the basis that all the losses claimed were barred by the reflective loss principle.

The key issues which may be of interest to financial institutions are set out below.

Grounds of appeal

Two of the claimants’ grounds of appeal related to the applicability of the reflective loss principle. The first ground was that the issue was not suitable for summary determination because it raised fact-sensitive questions and the relevant law is uncertain and developing. The second ground was that the claimants’ claims were not in any event barred by the reflective loss principle.

The “reflective loss” principle

The Court of Appeal drew the following points from its review of the authorities, in particular Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204, Johnson v Gore Wood & Co [2000] UKHL 65, Marex, Primeo, Allianz Global Investors GmbH v Barclay Bank plc [2002] EWCA Civ 353, and Nectrus:

1. The reflective loss principle applies where a shareholder brings a claim “in respect of loss which he 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” (Marex at paragraph 79);
2. A shareholder cannot escape the reflective loss principle merely by showing that he has an independent cause of action against the defendant. He must also have suffered separate and distinct loss, and the law does not regard a reduction in the value of shares or distributions which is a knock-on effect of loss suffered by the company as separate and distinct;
3. There need be no exact correlation between the shareholder’s loss and the company’s for the reflective loss principle to be applicable. The reflective loss principle can apply “where recovery by the company might not … fully replenish the value of its shares” (see Marex at paragraph 42). Equally, the company’s loss can exceed the fall in the value of its shares;
4. The reflective loss principle will not be in point if, although the shareholder’s loss is a consequence of loss sustained by the company, the company has no cause of action against the defendant in respect of its loss;
5. Nor will the “reflective loss” principle apply to a claim which is not brought as a shareholder but rather as, say, a creditor or an employee;
6. The Court has no discretion in the application of the reflective loss principle, which is a rule of substantive law;
7. The applicability of the reflective loss principle is to be determined by reference to the circumstances when the shareholder suffered the alleged loss, not those when the claim was issued (as confirmed in Primeo).

Although not emphasised in the judgment, proposition (7) had been the subject of uncertainty following the decision of Flaux LJ (as he then was) in Nectrus. Sitting as a single judge of the Court of Appeal, Flaux LJ refused permission to appeal and in doing so held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made. In Primeo, the Board of the Privy Council found that Nectrus was wrongly decided, confirming that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought (see our blog post).

Notwithstanding the decision in Primeo, the High Court in the present case considered that it was bound by Flaux LJ’s decision in Nectrus, albeit the High Court considered that the present case was distinguishable on the facts from Nectrus. However, in the context of the present appeal, the court said that two further decisions of the Court of Appeal indicated that Primeo was the “correct view”, namely Allianz and a subsequent decision in the Nectrus litigation: UCP plc v Nectrus Limited [2022] EWCA Civ 949 (granting Nectrus’ application to reopen Flaux LJ’s decision and granting Nectrus permission to appeal).

Suitability for summary determination

The Court of Appeal was not persuaded that the reflective loss issue was unsuitable for summary determination on the basis that the law is uncertain and developing.

The Court of Appeal underlined that the reflective loss principle had recently been considered in depth by the Supreme Court in Marex, where its existence and scope were confirmed. Also, while the principle had been the subject of debate in a number of subsequent cases, the points aired in those cases did not give rise to any legal uncertainty relevant to the present case. The Court of Appeal went on to emphasise that it is also not the case that the court should not entertain a strike out or summary judgment application wherever an undecided question can be discerned in the relevant area of law.

The misrepresentation claim

The Court of Appeal found that the misrepresentation claim was wholly barred by the reflective loss principle and the High Court was right to strike it out. The applicability of the principle did not depend on any factual disputes.

The Court of Appeal highlighted that it was evident that if the allegations of misrepresentation were well-founded, Motoriety would itself have (or have had) a cause of action against the defendant in respect of them. There were multiple references in the particulars of claim to Motoriety having relied on all the alleged representations implying that they had been made to it as well as to the claimants. The Court of Appeal also considered that the loss of the claimants’ share value was a knock-on effect of loss suffered by Motoriety for which it would itself have (or have had) a cause of action and hence was not separate and distinct. The Court of Appeal concluded that, as per Marex, the claim is in this respect one relating to loss which the claimants would have suffered as shareholders “in the form of a diminution in share value…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”. It was thus barred by the reflective loss principle.

The breach of contract claim

The Court of Appeal found that the breach of contract claim was also barred in its entirety by the reflective loss principle and the High Court was right to strike it out.

The Court of Appeal said that any good faith obligations would have been owed to Motoriety as well as the claimants. The Court of Appeal could not see that the terms the claimants alleged would have been implied solely in favour of the claimants. If the terms were implied in the investment agreement, they would surely have been implied in favour of all the defendant’s counterparties, including Motoriety, the more so since they related to the conduct of the business which Motoriety was conducting. The Court of Appeal therefore considered that if the claimants had a contractual cause of action in respect of the matters they alleged, so would Motoriety. That being so, the claimants’ claim would be barred by the reflective loss principle unless they were alleging separate and distinct loss.

The Court of Appeal then noted that the loss of the claimants’ share value did not constitute a separate and distinct loss and the position was similar to the corresponding head of claim for misrepresentation. The loss in share value would be reflective of loss sustained by Motoriety in respect of which it would itself have (or have had) a cause of action against the defendant.

The Court of Appeal also considered that the reflective loss principle applied to the loss of the consideration from the call option the claimants claimed the defendant would have exercised. This loss related to what the claimants’ shares would have fetched if sold to the defendant following its exercise of the call option. The claimants’ allegation was that the defendant’s alleged breaches of contract meant that the claimants would not be paid anything for their shares and that reflected the fact that the breaches had brought about Motoriety’s failure such that there was no longer any prospect of either earnings or distributions. The loss claimed represented one way of measuring loss of share value. If the claimants’ case was correct, breaches of contract by the defendant caused Motoriety to fail and, in consequence, rendered the claimants’ shares worthless, both in the sense that they lost any value in the general market and in the sense that there was no longer any prospect of selling them to the defendant pursuant to the option. The Court of Appeal concluded that the claimants were therefore claiming in respect of loss “in the form of diminution in share value…which is the consequence of loss sustained by [Motoriety], in respect of which the company has [(or had]] a cause of action against [AAD]”. Further, there may or not be a precise correlation between the claimants’ loss and Motoriety’s, but no such correlation was required for the reflective loss principle to apply.

Accordingly, for all the reasons above, the Court of Appeal found in favour of the defendant and dismissed the claimants’ appeal.

The High Court has struck out a claim by the former shareholders of a dissolved company against an investor on the basis that all the losses claimed were barred by the reflective loss principle: Burnford & Ors v Automobile Association Developments Ltd [2022] EWHC 368 (Ch).

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents only 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, in respect of which the company has a cause of action against the same wrongdoer (see our blog post).

Although the company in the present case had been dissolved, the High Court found that the claimants’ claim fell within the ambit of the reflective loss principle.

The decision is of interest because of the High Court’s consideration of the question as to the time at which the reflective loss rule falls to be assessed. In Nectrus Ltd v UCP plc [2021] EWCA Civ 57, Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal refused permission to appeal and in doing so held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. However, in Primeo Fund v Bank of Bermuda (Cayman) Ltd [2021] UKPC 22 the Board of the Privy Council (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) concluded that Nectrus was wrongly decided. The Board confirmed that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought (see our blog post).

Notwithstanding the ruling of the Board of the Privy Council in Primeo, the High Court in the present case considered that it was bound by the decision in Nectrus, even though Flaux LJ’s decision in Nectrus was made as a single member of the Court of Appeal on an application for permission to appeal, and would therefore not normally have any precedent value.

In spite of this, the High Court then concluded that the present case was distinguishable on its facts from Nectrus and did, therefore, follow the Board of the Privy Council’s decision in Primeo. As such, even though the company in the present case was dissolved, the claimants’ claims were barred because their losses were suffered in the capacity of shareholders, in the form of a diminution in the value of their shareholdings, which was the consequence of loss sustained by the company in respect of which the company had a cause of action against the same wrongdoer.

This case suggests a judicial reluctance to follow Nectrus, which is not surprising given its uncertain precedent value and the Privy Council’s comments in Primeo. This may lead to further attempts to distinguish Nectrus in future cases, until the Court of Appeal has the opportunity to reconsider the issue properly.

We consider the decision in more detail below.

Background

The claimants were former shareholders in a company called Motoriety (UK) Ltd (Motoriety), whose business was the exploitation of two software-based products for the motoring industry. In 2015, Motoriety wished to expand its customer base and entered into negotiations with Automobile Association plc (better known as “the AA”), on the basis that the AA could invest in the company. Motoriety and the claimants subsequently entered into an investment agreement with the defendant subsidiary company of the AA. The defendant agreed to subscribe for 50% of the share capital of Motoriety and the defendant had a call option for the remaining 50%, for consideration produced by a formula contained in the agreement. On the same day, Motoriety granted the defendant a licence to use its software and associated intellectual property rights. In 2017, Motoriety went into administration and was bought from its administrators by another company in the AA group.

The claimants subsequently brought a claim against the defendant for fraudulent or negligent misrepresentation and/or for breach of contract. The claimants alleged that they had entered into the investment agreement and the licence agreement in reliance on false representations by the defendant. The claimants also alleged that the defendant breached implied terms of the investment agreement by pursuing a course of conduct that undermined the basis of the arrangements between the claimants, Motoriety and the defendant. The claimants alleged that this led to Motoriety going into administration. The claimants also pleaded an alternative breach of contract claim that, had it not been for the defendant’s breach of contract, the defendant would have exercised the call option and paid the consideration due.

The claimants sought damages for losses incurred as a result of the fraudulent/negligent misrepresentation and/or breach of contract. On the claimants’ misrepresentation claim, losses were claimed on the basis that, had the alleged misrepresentations not been made, the claimants and Motoriety would not have done the deal with the defendant, but would have entered into a venture with a third party company and the value of the claimants’ shareholdings would have increased accordingly. Similarly, in relation to the original breach of contract claim, the claimants claimed that if the contract had been properly performed, Motoriety would have thrived and the value of the claimants’ shareholdings would have increased. Alternatively, had it not been for the defendant’s breach of contract, the defendant would have exercised its call option, so that the claimants would have been entitled to the consideration provided for by that option. Three of the claimants also claimed for the loss of their initial investments in Motoriety.

The defendant denied the claim and brought an application to strike out the claim or for reverse summary judgment on the basis that all the losses claimed by the claimants were barred by the reflective loss principle.

Decision

The High Court found in favour of the defendant and granted its application to strike out the claim.

The key issues which may be of interest to financial institutions are set out below.

Developing area of the law

The claimants argued that it was inappropriate to deal with the reflective loss principle in a strike out application because this is a “fiendishly complex area of the law” which is “uncertain and developing”. However, the High Court did not accept this and, on the contrary, considered that Marex had restated and recast the principle. Even the “timing issue” (referred to below) which was raised by the decision in Nectrus was quickly resolved by the Privy Council in Primeo.

The High Court stated that Lord Reed’s judgment in Marex had made clear that claims by shareholders against third parties fell foul of the reflective loss rule where (and only where):

• The shareholder suffers loss,
• in the capacity of shareholder,
• 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.

All of these conditions needed to be satisfied for a claim to be barred by the reflective loss rule and, conversely, if any of them were not satisfied, the claim was not barred.

Independent wrongs

The claimants argued that their losses were caused by independent wrongs committed against them by the defendant. Their losses did not simply follow on from the loss of the company, reflected through their shareholdings in it. The representations were made to them personally and they were separate parties to the contract, such that they had “separate and distinct” losses from that of Motoriety.

However, the High Court noted that, as per Prudential Assurance Co v Newman Industries Ltd [1982] 1 Ch 204, shareholders may not recover a loss caused to the company by breach of the duty owed to the company. To allow otherwise, would subvert the rule that no shareholder can bring a claim on behalf of the company (as per Foss v Harbottle (1843) 2 Hare 461). With the above in mind, the High Court considered that the claimants had to show that Motoriety had not suffered the same loss. In fact, the claimants’ alleged losses were entirely derived from the claimed losses of Motoriety. They may have had a direct claim, but they only had an indirect loss.

The “timing” point

The claimants argued that the reflective loss rule did not apply because Motoriety had been dissolved before the commencement of the claim, and therefore they were no longer shareholders in it. In the claimants’ view, the reflective loss rule must be applied by reference to the time when the claims commenced, and not when the loss was suffered. The claimants relied on Nectrus in which Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal, refused permission to appeal. In doing so, he held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. The claimants argued that, although the Board of the Privy Council in Primeo (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) found that Nectrus was wrongly decided and confirmed that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought, this decision was not binding on the High Court. Conversely, the defendant argued that Nectrus was not binding on the High Court and was distinguishable in any event.

The High Court highlighted that Flaux LJ’s decision in relation to permission to appeal in Nectrus contained no express statement that it was establishing a new principle or extending the current law. It should therefore not ordinarily be cited before a court or bind another court. However, in Allianz Global Investors GmbH v Barclays Bank plc [2021] EWHC 399 (Comm), Sir Nigel Teare (sitting as a High Court judge) while acknowledging that remarks made when refusing (or granting) permission to appeal are ordinarily of no weight, stated that he had been informed that Flaux LJ’s intention was that his ruling may be cited. As such, the High Court in the present case proceeded on the basis that that was correct and therefore Flaux LJ’s decision was binding.

The High Court noted that, as per Willers v Joyce, it was obliged to follow an otherwise binding decision of the Court of Appeal in preference to a decision of the Privy Council. The High Court considered whether the “timing” point was merely obiter dicta and therefore not strictly binding, but concluded that Flaux LJ’s decision in Nectrus was based on four separate grounds which were all part of the binding ratio decidendi. One of the grounds was that it was “unarguable” that the reflective loss rule applied to a claimant who had ceased to be a shareholder at the date of the claim and the High Court was therefore bound by this part of the decision unless it could be distinguished.

The High Court did, however, find that Nectrus was distinguishable. In that case the shareholder had sold its shareholding at a reduced price, which meant that the company’s loss had in effect been “passed on” (pro rata) to the shareholder so the company could no longer claim that share of the loss. As per Allianz, it was clear that in such circumstances there was no risk of: (a) the rule in Foss v Harbottle being subverted as there would be no concurrent claims; and (b) double recovery. In the present case, there had been no sale of the shares at a reduced price, and no “passing on” of any part of the loss of the company. If Motoriety was restored to the register, the loss would still be in the company. As such, the High Court determined that it was not bound to follow Nectrus and was free to follow the decision in Primeo in finding that the reflective loss principle did bar the claimants’ misrepresentation and original breach of contract claim.

Alternative claim for breach of contract

The claimants argued that the alternative breach of contract claim fell outside the scope of the reflective loss rule because the loss consisted of the formula set out in the investment agreement to calculate the consideration due under the call option and because only the claimants, not Motoriety, had rights to the consideration under the call option. Therefore Motoriety never had a cause of action to claim compensation in respect of this head of loss.

The High Court found that this claim was also barred by the reflective loss rule. The claim satisfied all six of the conditions set out in Lord Reed’s judgment in Marex. The fact that the measure of the claimants’ loss was by reference to a contractual formula and different to the measure of the loss of the company was beside the point.

The initial investments claim

The claimants who claimed for the loss of their initial investments in Motoriety argued that this head of loss fell outside of the reflective loss rule because it did not reflect a diminution in the value of their shares.

The High Court agreed with the defendant’s argument that this was simply a “less ambitious” version of the same claim. Instead of claiming the difference between what the values of their shareholdings should have been and what they now were, the claimants were claiming the much smaller difference between what they paid for their shareholdings and what they now had. The High Court found that even though the claims were limited to the amounts paid for the shares, the loss suffered by the claimants was still the loss of their value and the loss of their value was still reflective of the loss to Motoriety.

Accordingly, for all the reasons above, the High Court found in favour of the defendant and granted its application to strike out the claim.

The Board of the Privy Council has allowed an appeal in relation to the application of the so-called “reflective loss” principle, confirming that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought Primeo Fund v Bank of Bermuda (Cayman) Ltd & Anor (Cayman Islands) [2021] UKPC 22.

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents only 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 (see our blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule).

On the facts of the present case, the claimant suffered loss arising from a breach of obligation by a wrongdoer before it became a shareholder in a company. However, by the time the claimant brought its claims, it had become a member of the relevant company, which had its own claim for the same loss against the same wrongdoer. It was common ground that if the company succeeded in its claims, it would fully restore the value of the shares in the company held by the claimant. However, the Board found that the claimant’s claims were not barred by the reflective loss principle. It emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, but must be applied as a substantive rule of law, focusing on the nature of the loss, which must be assessed at the time the loss is suffered.

This is a helpful clarification of the correct approach to the issue of timing. Since Marex, there have been conflicting decisions as to whether the rule against reflective loss will apply to a former shareholder, who is no longer a shareholder in the relevant entity at the time the claim is commenced. In particular, there has been a lot of focus in some quarters on a decision by Flaux LJ as a single judge of the Court of Appeal in relation to an application for permission to appeal in Nectrus Ltd v UCP plc [2021] EWCA Civ 57. In Nectrus, Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made.

The decision of the Board in Primeo Fund has put this question beyond doubt, expressly confirming that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very “odd results”. While decisions of the Privy Council are not binding on English courts, they are regarded as having great weight and persuasive value (unless inconsistent with a decision that would otherwise be binding on the lower court). Given the questionable precedent value of Nectrus  and the constitution of the Board of the Privy Council in Primeo Fund, it is highly likely that the decision in Primeo Fund will be followed by the Court of Appeal the next time this issue arises in an English case.

The decision is considered in further detail below.

Background

The appellant (Primeo), was an open-ended mutual investment fund set up in 1994 and registered in the Cayman Islands, but now in liquidation. The respondents acted as Primeo’s custodian and administrator from 1993.

From inception, Primeo placed a proportion of funds raised from investors with Bernard L Madoff Investment Securities LLC (BLMIS) for investment. Over time, Primeo increased the proportion of its fund which invested with BLIMIS until, by 1 May 2001, the whole of its fund was invested in this way either directly, or indirectly through two feeder funds called Herald Fund SPC (Herald) and Alpha Prime Fund Limited (Alpha).

On 1 May 2007, Primeo’s direct investments with BLMIS were transferred to Herald, in consideration for new shares in Herald (the Herald Transfer). From that date, Primeo no longer had any direct investments with BLMIS, all investments were held indirectly via Herald or Alpha.

On 11 December 2008, the Ponzi scheme operated by Mr Madoff and BLMIS collapsed. Mr Madoff surrendered to the authorities in the United States and was charged with fraudulently operating a multi-billion dollar Ponzi scheme. Primeo was placed into voluntary liquidation on 23 January 2009.

Primeo brought claims in the Cayman Islands against its administrators and custodians, alleging breaches of duty.

Decisions of the Grand Court and Court of Appeal of the Cayman Islands

The Grand Court held that the administrators and custodians owed relevant duties to Primeo and breached those duties. However, the Grand Court dismissed Primeo’s claims on the grounds that they infringed the reflective loss rule, on the basis that Herald and Alpha also had claims against the same defendants which covered the same loss, and if they made recovery on those claims that would eliminate any loss suffered by Primeo.

Each side appealed to the Court of Appeal of the Cayman Islands (on various issues), which dismissed Primeo’s appeal against the Grand Court’s finding that its claims were barred by the reflective loss rule.

Appeal to the Privy Council

The Board of the Privy Council gave directions to hear and determine the discrete issue as to the operation of the reflective loss rule (with another hearing to follow, dealing with other issues on appeal). The parties were agreed that Cayman Islands law regarding the reflective loss rule, was the same as English law.

The specific issues for the Board of the Privy Council to determine were as follows:

1. What is the relevant time to determine whether the reflective loss rule applies? Is it the time when the relevant claimant (here, Primeo) issued proceedings (by which time Primeo was a shareholder in Herald), or is it the time when the claimant acquired its causes of action (when Primeo was not a shareholder in Herald)?
2. If the time to determine whether the reflective loss applies is when the claimant acquired its causes of action, did Primeo nonetheless lose its right to claim for the losses it suffered and become subject to the reflective loss rule by reason of the Herald Transfer, by which it ceased to be a direct investor in BLMIS and became an indirect investor via its replacement shareholding in Herald?
3. The reflective loss rule operates where there is a common wrongdoer whose actions have affected both the claimant shareholder (Primeo) and the company (Herald/Alpha) – must the claims against the common wrongdoer be direct claims, and what degree of overlap between the claims of the shareholder and the company is required?
4. Were the Grand Court and Court of Appeal correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities?

Decision of the Board of the Privy Council

The Board of the Privy Council concluded that Primeo’s appeal in relation to the application of the reflective loss rule should be allowed. Each of the issues considered by the Board are discussed further below.

1. The timing issue

The Board confirmed that the reflective loss rule falls to be assessed as at the point in time when the claimant suffers loss arising from some relevant breach of obligation by the relevant wrongdoer, and not at the time proceedings are brought. On the facts of the present case, at the time Primeo suffered loss, it was not a shareholder in Herald and therefore its claim was not barred by the reflective loss principle.

The Board emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, and must be applied as a substantive rule of law. In this context, the majority in Marex said that the focus of the reflective loss rule is on the nature of the loss, which involves consideration of the capacity in which the claimant suffered the loss and the form of the loss. The Board concluded that the issue is one of the characterisation of the loss, which depends on its status (i.e. whether or not it is recognised by the law) at the time it is suffered.

In the Board’s view, Nectrus Ltd v UCP plc [2021] EWCA Civ 57 was wrongly decided. In Nectrus, Flaux LJ presided as a single judge of the Court of Appeal over an application for permission to appeal. Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made, at a time when the loss claimed has crystallised.

As a consequence of its decision, the Board confirmed that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very “odd results”.

2. The Herald Transfer issue

Having found that the reflective loss principle was not engaged following analysis of the timing issue above, the Board considered whether the outcome was affected by the Herald Transfer.

In Marex, Lord Reed and Lord Hodge explained the justification for the reflective loss rule as based on the fact that, by becoming a member of the company, the shareholder agrees to “follow the fortunes of the company” in relation to losses suffered by it as a result of wrongs done to the company, and agrees that the company will have the right to decide whether claims should be brought in respect of such wrongs.

The question then was whether the Herald Transfer precluded Primeo from pursuing the causes of action it had already acquired before the Herald Transfer, because of the “follow the fortunes” bargain.

The Board considered that this argument was unsustainable, because the “follow the fortunes” bargain is forward-looking, not backward-looking. It is directed to characterisation of loss suffered by a claimant after they become a shareholder in the company (and they then suffer loss of the requisite type arising as a consequence of a wrong done to the company), and is directed to limiting the ability of a shareholder to acquire a right of action from that time on.

In the Board’s view, to apply the reflective loss rule to preclude a new shareholder from enforcing rights of action which had already accrued to them before they became a member of the company would be an unwarranted extension of the reflective loss rule. The Board noted that the issue of possible double recovery by Primeo on the one hand, and Herald and Alpha on the other, would have to be managed by a procedural mechanism.

3. The common wrongdoer issue

Primeo submitted that the Court of Appeal was wrong to apply the reflective loss rule in respect of claims against its former administrator, because neither Herald nor Alpha had any claim against the same corporate entity (different entities in the same group were involved in the provision of administration and custody services over the years to the various parties). Primeo made the same argument in relation to certain claims against its former custodian.

The Board agreed with Primeo, saying that it is an inherent part of the reflective loss rule that it only applies to exclude a claim by a shareholder where what is in issue is a wrong committed by a person who is a wrongdoer both as against the shareholder and as against the company. It noted that the separate legal identity of the administrator and custodian were of critical importance in the application of the reflective loss rule. The Board commented that to extend the reflective loss rule in these circumstances would be contrary to the decision in Marex, which was directed to keeping the operation of the rule within narrow parameters.

4. The merits issue

Given the Board’s other findings, it was not necessary to decide whether the Grand Court and Court of Appeal were correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities.

However, the Board observed that those judgments were reached without the benefit of the decision in Marex, and adopting a materially different approach to the Supreme Court in that case. Accordingly, the Board warned that what the Grand Court and Court of Appeal said about this issue should not be treated as authoritative.

The Court of Appeal has held that the so-called “reflective loss” principle will not bar the claim of a shareholder, who is also a contractual promisee/beneficiary, in circumstances where the company in which the shares are owned has acquired the right to bring a claim in respect of the same contract against the same wrongdoer pursuant to s.1 of the Contracts (Rights of Third Parties) Act 1999 (1999 Act): Broadcasting Investment Group Ltd & Ors v Smith & Anr [2021] EWCA Civ 912.

In reaching its decision, the Court of Appeal overturned the High Court’s judgment striking out the contractual promisee’s claim (see our banking litigation blog post). The High Court had ruled that the company (of which the contractual promisee was a shareholder) acquired a right to enforce the contract in question pursuant to s.1 of the 1999 Act. Consequently, the promisee’s claim, as a shareholder of the company, was barred by the rule in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 (often referred to as the reflective loss principle). The High Court found that s.4 of the 1999 Act, which preserves the rights of a promisee to enforce a contract, was subject to generally applicable legal principles including the rule in Prudential.

The Court of Appeal disagreed with the High Court’s interpretation of s.4 of the 1999 Act. It held that, since the company’s right to enforce the contract was conferred by the 1999 Act, it was subject to the terms and limitations imposed by that statute. Since the rule in Prudential was only engaged because of s.1 of the 1999 Act, it could not bar the promisee’s right to enforce the contract as prescribed by s.4 of the 1999 Act. In the Court of Appeal’s view, to interpret the rule in Prudential independently of the 1999 Act was entirely artificial, would sidestep the limitations imposed by s.4 designed to protect the rights of the promisee, and would effectively extinguish the promisee’s right to enforce the contract, which was impermissible by statute.

This decision will be of interest for financial institutions following developments to the reflective loss principle, which was confirmed by the Supreme Court last year in Sevilleja v Marex Financial Ltd [2020] UKSC 31 (see our banking litigation blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule). The reflective loss rule plays an important part in the defence of claims brought against banks by shareholders (aside from claims brought under section 90 and 90A of the Financial Services and Markets Act 2000, which provide a statutory exemption).

Given that the outcome in the present case is to allow the concurrent claims of a shareholder and company against the same third party wrongdoer, some might argue that it has narrowed the scope of the reflective loss principle. However, the rationale supporting the decision is based on the effect of the 1999 Act and its very specific wording, and does not have wider application. Accordingly, the decision is unlikely to impact the scope of the reflective loss principle in a general sense, and is likely to be limited to the (unusual) fact pattern of cases where the company only has a claim as a result of s.1 of the 1999 Act, and the shareholder is a contractual promisee.

In addition, financial institutions are likely to welcome the helpful obiter comments from the Court of Appeal on the question of whether the reflective loss principle should bar the claim of an “indirect” shareholder, i.e. where there is a chain of shareholder ownership. On this point, the concurring judgment of Arnold LJ considered it “well arguable” that the rule in Prudential can apply to indirect shareholders in appropriate circumstances.

Background

The underlying facts of the dispute are complex, but relate to the development of a start-up company in the technology sector. In 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 had 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.

The liquidator of SS plc has, thus far, not indicated any intention to pursue any claims which SS plc might have in relation to the JV Agreement.

High Court decision

The High Court’s reasoning is discussed in our previous banking litigation blog post.

In summary, the High Court struck out BIG’s claims for both damages and specific performance in relation to the JV Agreement because the court found that BIG’s claim was a paradigm example of a claim within the scope of the reflective loss principle, and therefore should be barred.

The High Court found that SS plc had a right to enforce the JV Agreement pursuant to s.1(1)(b) of the 1999 Act and therefore SS plc and BIG had concurrent claims. The High Court held that BIG’s claim as a direct shareholder in SS plc fell within the scope of the rule in Prudential and was consequently barred. Further, the High Court held that s.4 of the 1999 Act, which states that s.1 of the 1999 Act does not affect any right of the promisee to enforce the terms of the contract, is subject to generally applicable legal principles and consequently, does not override the rule in Prudential.

The High Court ruled that Mr Burgess’s claim to enforce the JV Agreement was not barred by the rule in Prudential and could proceed to trial, because he was an indirect or quasi-shareholder in SS plc, rather than a direct shareholder (aptly referred to as the “Russian Doll” argument). In the view of the High Court, Marex emphasised that the reflective loss principle bars only shareholders in the loss-suffering company and is a “highly specific exception of no wider ambit”.

BIG appealed the High Court’s decision to strike out its claims on two grounds: (i) the High Court’s interpretation of both s.4 of the 1999 Act and Prudential; and (ii) whether Prudential bars claims for specific performance. In addition, Mr Smith cross-appealed the High Court’s refusal to strike out Mr Burgess’s claims in respect of the JV Agreement (i.e. the Russian Doll argument).

Court of Appeal decision

The Court of Appeal allowed BIG’s appeal on the interpretation of the 1999 Act and held that the rule in Prudential was not engaged to bar its claim.

Given its primary ruling, the Court of Appeal did not consider in detail either BIG’s alternative ground of appeal on the question of whether the rule in Prudential applies to claims for specific performance, or the cross-appeal.

Interpretation of the 1999 Act and Prudential

There was no dispute that SS plc acquired a right to enforce the JV Agreement pursuant to s.1(1)(b) the 1999 Act, with the result that both SS plc and BIG had concurrent claims for breach of contract against Mr Smith. Nor was it in dispute that BIG was a “contractual promisee” under the JV Agreement.

The question for the Court of Appeal was whether s.4 of the 1999 Act preserved BIG’s right to enforce the JV Agreement, notwithstanding the concurrent claim of SS plc, because it provides that the contractual promisee’s right to enforce the contract is not “affected” by s.1. In other words, did the creation of a right in SS plc under s.1 of the 1999 Act, destroy BIG’s rights as contractual promisee because of the operation of the rule in Prudential?

BIG argued that if the right acquired by SS plc by virtue of s.1, prevented BIG as a shareholder of SS plc from pursuing its cause of action for breach of the JV Agreement because of the rule in Prudential, then the situation was analogous to a parasite killing its host. Conversely, Mr Smith submitted that s.4 of the 1999 Act could not be construed to mean that it abrogates the rule in Prudential and, as a result, subverts the principle of the autonomy of the company in Foss v Harbottle.

In the Court of Appeal’s view it was clear from the natural meaning of the words in s.4 of the 1999 Act that the rights conferred on third parties by virtue of s.1 of the 1999 Act are in addition to any right the contractual promisee has to enforce th e contract (and that such a construction is consistent with the Explanatory Notes to the 1999 Act). This interpretation is consistent with the 1999 Act as a whole, which created only a limited and tightly constrained incursion into the rule of privity of contract. The legislation created rights and took “nothing away”.

The Court of Appeal focused on the use of the word “affect” in s.4 of the 1999 Act, which provides that s.1 must not “affect” the promisee’s right to enforce the contract. The Court of Appeal held that the proximate cause for BIG’s rights being extinguished was s.1 of the 1999 Act, and not the rule in Prudential. The rule in Prudential was only engaged when s.1 of the 1999 Act enabled SS plc to enforce the JV Agreement. Treating the rule in Prudential as if it were independent to the right conferred by s.1 of the 1999 Act was entirely artificial and would effectively sidestep the limitations imposed by s.4, which protect the rights of the promisee. This interpretation would not only affect BIG’s right to enforce the JV Agreement, but extinguish it completely – which it considered to be impermissible as a matter of statute. The Court of Appeal held that it would be a nonsense to interpret s. 4 of the 1999 Act in any other way.

The Court of Appeal also disagreed with the High Court’s reasoning that s.4 of the 1999 Act was subject to “generally applicable legal principles, including (where applicable) the rule in Prudential“, as this interpretation would defeat the purpose of s.4 of the 1999 Act. In this context, the Court of Appeal observed that SS plc’s right to enforce the JV Agreement was conferred purely by statute and is therefore subject to the terms and limitations imposed by that statute.

It therefore concluded that BIG’s claims under the JV Agreement were not barred by the rule in Prudential and were, to the contrary, expressly protected by s.4 of the 1999 Act.

Specific performance

The Court of Appeal did not consider this ground in detail given that it had allowed BIG’s appeal on the grounds discussed above.

The Court of Appeal said that a “superficial consideration” of Lord Reed’s reference in Marex to a shareholder being unable to bring an action against a wrongdoer to recover damages “or secure other relief for an injury done to the company”, might lead to the conclusion that claims for specific performance also fall within the rule in Prudential. However, Asplin LJ highlighted that the matter was complex and was best left to a case where it was necessary to decide this issue.

The cross-appeal (the “Russian Doll” argument)

Again, the Court of Appeal did not need to consider the cross-appeal given its finding that the rule in Prudential was not engaged in the current case.

However, in a short concurring judgment given by Arnold LJ, he disagreed with the High Court’s conclusion that the rule in Prudential was not engaged in relation to indirect shareholders (e.g. to prevent the claims of shareholders in a corporate shareholder).

Arnold LJ observed that it was “well arguable”, in appropriate circumstances, that the rule in Prudential can apply to indirect shareholders. Although his comments on this point are obiter, and therefore not binding, Arnold LJ suggested that it was difficult to see why the rule in Prudential should not apply in such a scenario.