In a recent decision, the Court of Appeal has clarified the ambit of the so-called rule against reflective loss, which has traditionally operated to prevent shareholders from bringing claims where their loss merely reflects the loss suffered by the company: Carlos Sevilleja Garcia v Marex Financial Limited  EWCA Civ 1468.
The question for the Court of Appeal was whether the rule 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 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.
Catherine Emanuel and Eliot Leggo consider the decision further below.
The rule against reflective loss originates from the decision in Prudential Assurance v Newman Industries (No 2)  1 Ch 204 where a minority shareholder sued two individual directors in respect of a fraud on the company. The shareholder’s claim failed because he had suffered no personal loss: any loss to the value of his shareholding was merely a reflection of the financial loss suffered by the company.
Since the decision in Prudential Assurance, the scope of the rule has expanded. In Johnson v Gore Wood  2 AC 1, the House of Lords held that the rule is not limited to claims brought by a shareholder in his capacity as such, but also applies to claims brought by a shareholder in his capacity as an employee or creditor.
In the present case, Creative Finance Limited and Cosmorex Limited (collectively, the “Companies”) were companies incorporated in the British Virgin Islands and were the principal trading vehicles of the defendant/appellant, Carlos Sevilleja Garcia (“Mr Sevilleja”), for foreign exchange trading. The Companies were clients of a foreign exchange broker, the claimant/respondent, Marex Financial Limited (“Marex”).
In 2013, the Commercial Court awarded Marex damages of in excess of US$5 million against the Companies. A freezing order was also granted against the Companies.
Subsequently, however, the disclosure of assets by the Companies following the freezing order revealed that the Companies held only US $4,392.48. Marex claimed that Mr Sevilleja had dishonestly asset-stripped the Companies. Marex therefore alleged that Mr Sevilleja had committed the torts of: (i) knowingly inducing and procuring the Companies to act in wrongful violation of Marex’s rights under the 2013 judgment; and (ii) intentionally causing loss to Marex by unlawful means.
At first instance, the Commercial Court ruled in favour of Marex and held that the 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.
The Court of Appeal considered two main issues on the rule against reflective loss: (i) the correct ambit of the rule against reflective loss; and (ii) the ambit of the exception where the company is unable to pursue a cause of action against the wrongdoer, established in Giles v Rhind  EWCA Civ 1428. Flaux LJ delivered the leading judgment, with which Lewison and Lindblom LJJ agreed.
Correct ambit of the rule against reflective loss
Flaux LJ explained that the original rationale for the decision in Prudential Assurance was that allowing an individual claim by a shareholder whose loss is merely reflective of the company’s loss would subvert the “proper plaintiff” rule in Foss v Harbottle (1843) 2 Hare 461. He noted that if the principle had rested there, it would only be applicable to claims by a shareholder seeking to pursue causes of action which are not his but the company’s.
However, in light of a number of subsequent authorities (including the House of Lords decision in Johnson v Gore Wood) Flaux LJ concluded that there were four considerations which justified the rule against reflective loss:
- The need to avoid double recovery by the claimant and the company from the wrongdoer;
- Causation, since (as Lord Millett clarified in Johnson v Gore Wood) if the company chooses not to bring a claim against the wrongdoer, the loss to the claimant is caused by the company’s decision and not the defendant’s wrongdoing;
- The public policy of avoiding conflicts of interest, in particular that if the claimant had a separate right to claim it would discourage the company from making settlements; and
- The need to preserve company autonomy and avoid prejudice to minority shareholders and other creditors.
Recognising these broader justifications, Flaux LJ considered that drawing a distinction between shareholder creditors and non-shareholder creditors was artificial and anomalous. He pointed out that:
“as a matter of logic and principle, it is difficult to see why a claim by a creditor who has one share in a company should be barred by the rule against reflective loss whereas a claim by a creditor who is not a shareholder is not. That point is well illustrated by the example of a creditor who owns shares in the company, whose claim is initially barred by the rule, but, on this hypothesis, if he sells the shares, the rule no longer bars his claim. That makes no logical or legal sense at all.”
Flaux LJ said that the need to avoid prejudice to other creditors (referred to at iv above) applies with particular force to any creditor of a company, whether a shareholder or not. If an unsecured creditor such as Marex was able to pursue a claim in relation to the asset stripping of the company, that would bypass and subvert the pari passu rule applicable in liquidation, as the claimant creditor could make a full recovery of its debt to the prejudice of the other creditors. By contrast, if the liquidator was to pursue the company’s claim against the wrongdoer, it could thereby replenish the company’s assets which would then be available for distribution to the general body of creditors.
Accordingly, Flaux LJ concluded that there was no basis for maintaining the distinction between shareholder creditors and non-shareholder creditors. The rule against reflective loss therefore applied in this case unless the claim fell within the exception recognised in Giles v Rhind.
Giles v Rhind exception
Broadly, the Giles v Rhind exception applies where the company is unable to pursue an action against the wrongdoer, usually because the wrongdoer controls the company. In Marex, Flaux LJ emphasised that the exception can only apply in limited circumstances, where the defendant’s wrongdoing has been “directly causative of the impossibility the company faces in bringing the claim”. In such circumstances, the rule against reflective loss does not bar an action by a shareholder/creditor against the wrongdoer.
Flaux LJ further clarified that “the impossibility or disability must be a legal one and what might be described as factual impossibility is insufficient.” Accordingly, lack of funds on the part of the company will not satisfy the threshold for impossibility where an injection of funds by a third party shareholder or creditor would resolve the issue, or where the third party could take an assignment of the company’s claim. In Flaux LJ’s view, the exception is only applicable where, as a consequence of the actions of the wrongdoer, the company no longer has a cause of action and it is impossible for it to bring a claim or for a claim to be brought in its name by a third party.
On the facts of the present case, Flaux LJ found that Marex could not establish that the wrongdoing of Mr Sevilleja made it impossible for the Companies to pursue a claim against him and therefore the Giles v Rhind exception was inapplicable.
As a result, Marex’s claim to recover the judgment debt was barred by the rule against reflective loss. Flaux LJ noted, however, that this outcome would not leave Marex without a remedy since Marex could procure the liquidator to pursue the Companies’ claim against Mr Sevilleja in the British Virgin Islands or it could take an assignment of the Companies’ claims.
The decision in Marex brings some helpful clarification to the rule on reflective loss.
Counsel for Marex had submitted that, through the decisions in Johnson v Gore Wood and Gardner v Parker  EWCA Civ 781, the law had effectively taken a wrong turn in extending the ambit of the rule beyond its original justification in Prudential Assurance. Marex submitted that “two wrongs do not make a right” and that the Court of Appeal should put the law back on the right course by refusing to extend the rule against reflective loss beyond shareholders to creditors who are not shareholders.
Those arguments were rejected for the reasons summarised above. In addressing the submission that the law had taken a wrong turn, Lewison LJ (who agreed with Flaux LJ) delivered a concurring judgment emphasising the role and importance of precedent. He explained: “It is not a question, in this court, whether ‘two wrongs make a right’ as Mr Choo Choy put it. Rather it is a question of coherence in the law. If the coherent application of the law in the current state of the authorities is wrong, it is for the Supreme Court to put it right.”
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An appeal against this decision was heard by the Supreme Court in May 2019. Judgment is currently awaited.