Reflecting on reflective loss: ownership only counts if it's direct – or does it?
Published on 19th Jul 2022
After the Supreme Court's attempts in Sevilleja v Marex to clarify the application of the principle of reflective loss to those who are not direct shareholders, a recent Court of Appeal case has re-opened the debate when it comes to claims by indirect shareholders
Where a wrong has been done to a company, it is the company itself which is the proper claimant. Shareholders are prevented from recovering in connection with that wrong any loss that is merely a reflection of the loss suffered by the company (for example, a sum equal to the diminution in the market value of their shares).
This principle has been the cause of much frustration for many shareholder claimants over the years, and has been the subject of attack, attempted circumvention and innovative application. The application of this principle once again came under scrutiny recently by the Court of Appeal, and potentially re-opened the avenues to get around this issue.
The reflective loss principle is generally considered to be based on the decision of the Court of Appeal in Prudential Insurance Co Limited v Newman Industries Limited (No 2)  1 Ch 204 in which the court held:
"What [a 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."
The reflective loss principle has been developed and applied widely (with some degree of controversy) over the years since Prudential. In the House of Lords decision in Johnson v Gore Wood & Co (2002) Lord Millett described the rule in these terms (our emphasis):
"A company is a legal entity separate and distinct from its shareholders. It has its own assets and liabilities and its own creditors. The company's property belongs to the company and not to its shareholders. If the company has a cause of action, this represents a legal chose in action which represents part of its assets. Accordingly, where a company suffers loss as a result of an actionable wrong done to it, the cause of action is vested in the company and the company alone can sue."
That dicta has been applied to justify the exclusion of a claim by a shareholder and by others, whenever the company had a concurrent claim available to it.
However, in July 2020 the Supreme Court provided some welcome clarification in the matter of Sevilleja v Marex (2020), which reversed a decision of the Court of Appeal that applied the principle of reflective loss to an unsecured, judgment creditor of a company.
One of the first cases to consider the rule against reflective loss since Marex was, in late 2021, Broadcasting Investment Group Ltd v Smith (2021), in which the Court of Appeal set out a helpful summary of where the law now stands.
Decision in Broadcasting Investment Group Ltd v Smith
Pursuant to the terms of a purported oral agreement between BIG, BIG's indirect shareholder Mr Burgess, Mr Finch, Mr Smith and others, Mr Finch and Mr Smith were to transfer shares to a third party, SS Plc, of which BIG was a shareholder. Mr Finch and Mr Smith did not do so.
BIG, Mr Burgess and another brought a claim for specific performance of the agreement or damages for breach in the alternative. Mr Smith and Mr Finch applied to have the claim struck out on the grounds that it contravened the rule against reflective loss.
In declining to strike out Mr Burgess' claim at first instance, Mr Andrew Simmonds QC reasoned that Marex had confirmed that the rule against reflective loss was limited to claims by shareholders as a result of actionable loss suffered by their company, and that the rule did not apply to second degree/indirect shareholders as they were not shareholders of the company with the actionable loss and had not "contracted into" the rule so far as it affects recovery of losses by the subsidiary company.
However, he struck out BIG's claim as a "paradigm example" of the rule against reflective loss, reasoning that: (1) by virtue of the Contracts (Rights of Third Parties) Act 1999, SS Plc would have a concurrent claim with BIG against the claimants for breach of the agreement, (2) any loss suffered by BIG for that breach would be for diminution in share value reflective of the loss sustained by SS Plc.
The Court of Appeal overturned the High Court's decision (2020) in relation to BIG's claim. Even though BIG's loss would be "of the very nature described by Lord Reed [in Marex] as falling within the rule [against reflective loss]", section 4 of the Contracts (Rights of Third Parties) Act expressly provided that any rights created by it would not "affect any right of the promisee to enforce any term of the contract". In this case, section 4 did not affect BIG's right to enforce the contractual terms of the agreement against Mr Smith.
Osborne Clarke comment
Perhaps of greater interest is what the case leaves open than what it determines – how the principle interacts with indirect shareholders.
In overturning the strike out of BIG's claim, the Court of Appeal had already concluded that there was no basis for a claim on other grounds and so its comments on the lack of application of the principle to indirect shareholders were obiter, and as such are instructive and persuasive but not definitive.
However, it is still interesting that Lord Justice Arnold indicated his view that it was "well arguable that the rule in Prudential can apply to indirect shareholders in appropriate circumstances", and means this is still a space to watch.
Perhaps post-Marex, the law is not as certain as it seems. While it provides extremely helpful guidance on the application of the principle in general terms, it is important to keep in mind the context in which that decision was made. Marex was concerned with the application of the principle to creditors, rather than shareholders.
The rationale for not extending the principle from shareholders to creditors is clear. The shareholder-company relationship is unique, and the creditor-company relationship is in no way analogous. There is no link between the value of a creditor's debt and a company's performance assets in the same way as exists in shareholding. The same cannot be said for indirect shareholders, the value of whose shareholding will of course fluctuate in line with those of its subsidiaries.
For those corporate lawyers who hit upon the solution of simply inserting an intermediary special purpose vehicle between the shareholder and the company to ensure indirect shareholder status and rights to sue, unrestricted by the principle against reflective loss, it may be time to think again.