This article series was written by Barri Mendelsohn (Partner), Jenny Willcock (Senior Associate), Daniel Jones (Trainee Solicitor) and Jennifer Reyes Au (Trainee Solicitor) in the KWM London office.
The principle of reflective loss found itself in front of the UK courts during the summer of 2020 in Sevilleja v Marex Financial Ltd  UKSC 31 (“Marex”) & Broadcasting Investment Group Ltd v Adam Smith  EWHC 2501 (Ch) (“Broadcasting”).
As an aide-memoire, reflective loss is the name given to a loss suffered by a company, which is inseparable from the loss suffered by shareholders, but for which only the company can bring a claim.
In July, the Supreme Court passed down a landmark judgment in Marex, which was then further considered and applied by the High Court in Broadcasting in September, which reversed the developments in the law over recent years whereby the reflective loss principle has been expanded to cover claims not only by shareholders, but also by creditors and employees.
Whilst the principle of reflective loss still remains in practice, it is now restricted to cases where shareholders seek to claim in their personal capacity as such and the UK Courts have confined the principle to narrow circumstances. When distinguishing between the two types of cases below:
Cases which are brought by a shareholders in respect of a loss which it has suffered in its capacity as a shareholder in the form of a reduction in share value or distributions, which is the consequence of loss sustained by the company and in respect of which the company also has a cause of action against the same wrongdoer; and
Cases which are brought against a wrongdoer which relate to a loss which does not fall within the type of case mentioned above, i.e. which is brought by a shareholder or anyone else and where a company also has a right of action in respect of substantially the same loss,
Marex now means that any shareholder claim against a wrongdoer will be barred by the rule against reflective loss in cases under (1) above, whereby in all other cases, which include claims by parties other than shareholders, the bar shall no longer apply. In Marex, as a creditor, it was permitted to bring a claim against a shareholder and was not barred under the rule of reflective loss.
Facts to Marex
Mr. Sevilleja owned and controlled two companies incorporated in the British Virgin Islands (the “Companies”) which he used as trading vehicles. Marex Financial Ltd (“Marex”), a creditor of the Companies, brought a claim against them for sums due under a contract and was awarded a judgment requiring the Companies to pay the requisite amounts under the contract. In response, Sevilleja transferred funds out of each of the Companies’ bank accounts into his own personal account to prevent the judgment from being satisfied before placing the Companies into voluntary liquidation.
This resulted in Marex bringing a claim against the Companies before the High Court in 2017. The High Court ruled in favour of Sevilleja on the basis that the reflective loss principle, which prevents shareholders of a given company from bringing a separate claim to that company for the same loss, could be extended to apply to creditors, preventing Marex from pursuing its claim against Sevilleja. This was partially upheld by the Court of Appeal in September 2020 which found that Marex could only claim for 10% of its losses which were held to be “reflective”. Marex therefore appealed to the Supreme Court.
The Supreme Court ruling
In a landmark decision, the Justices of the Supreme Court overturned the Court of Appeal’s ruling and found in favour of Marex by a majority of four to three (although some Justices questioned the validity of the reflective loss principle in its entirety, casting its future into doubt but for now the majority of four have ensured its survival).
In its leading judgment, the Supreme Court explained that the primary rationale behind the “reflective loss” principle is to prevent double recovery. Where a company has suffered a loss as a result of another party’s wrongdoing, that company is able to bring a claim to recover its losses. It would therefore follow that shareholders of the wronged company could also bring a claim for the loss of value to their shares caused by the other party’s wrongdoing i.e. a claim for a distinct and separate loss than that of the company.
However, the rule established in the 1982 case, Prudential, and affirmed by the Supreme Court in this case, prevents such “double recovery” from being possible. Concurrent cases cannot be brought by both a wronged company and its shareholders for the same loss, as a finding for the company has the double effect of restoring its losses and consequently restoring the value of the shareholders’ shares.
The Supreme Court found that as Marex were a creditor and not a shareholder, the Court of Appeal had erred in applying the Prudential rule as creditors were affected in different ways to shareholders. For example, in an insolvency situation, shareholders would only be able to recover a pro rata share of the company’s surplus assets, if any. Whereas the company’s loss could affect a creditor’s recovery of its debt in a number of ways, such as the effect on the value of its security, or the rules governing the priority of debts. The Supreme Court therefore found that reflective loss was not applicable to Marex as a creditor, and as such it was free to pursue its claim against Sevilleja.
A few months after Marex, the UK’s High Court applied the Supreme Court’s ruling in Broadcasting, a case relating to an alleged oral joint venture between, amongst others, Broadcasting Investment Group and Mr. Smith. In its ruling, the High Court confirmed that the reasoning in Marex applied to all attempts to strike out claims based on reflective loss.
As the Broadcasting proceedings began before the judgment in Marex was handed down, it is telling that the original submissions in November 2019 from Mr. Smith, attempting to have the case thrown out by relying on the reflective loss principle, stated that it “prevents anyone other than a company from bringing claims for losses which are the same as or mirror losses suffered by that company."
By the time of the September 2020 judgment, referencing Marex, the judge was emphatic in his response, stating: “Whether or not that broad formulation was supported by the authorities at that time, it is clear now that it does not survive the decision of the Supreme Court in Marex.” Again, this serves to highlight the extent to which the clarification provided in the Marex judgment has gone to limit the scope of the reflective loss principle.
Broadcasting is due to be heard by the Court of Appeal so we will keep an eye on developments and provide any necessary updates in our next iteration of the Full English.
1. Reflective Loss
Marex demonstrated that the reflective loss principle, which prevents shareholders from bringing a concurrent claim to that of an injured company, does not apply to creditors (whether they are also shareholders or not). It was also stated that the reflective loss principle also does not prevent an individual connected to the loss-suffering company by a chain of shareholdings, but who is not, in fact or by law, a shareholder, from bringing a claim.
Whilst the Supreme Court’s decision in Marex allows creditors to breathe more easily, it has also left a number of questions unanswered for shareholders and only time will tell if market practice will change for parties. For example, when setting up joint venture arrangements, given that if a principle of reflective loss does exist, it is now to be narrowly confined to shareholder claims. Creditors are not fully in the clear as those who are shareholders will also be affected – whether a loss is caused by a drop in share value or a failure to pay will need to be examined.
Protections previously afforded by the reflective loss principle have now been significantly curtailed, leaving shareholders in a rather unenviable position. Previously, there had been an exception to the principle under Giles v Rhind, which stated that where a company’s financial troubles had been caused by a wrongdoer within the company, leaving the company unable to sue him/her, shareholders could pursue a claim. In Marex, this exception was overruled. Shareholders in this scenario would need to consider bringing a derivative claim or submitting an unfair prejudice petition.
With the exclusion of the Giles v Rhind principle, it will be interesting to watch what will happen in practice. For example, whether restrictive covenants will be contractually given between shareholders now and not in favour the company and how this affects any protection of the company’s goodwill overall. A company would not have a claim against a shareholder for breach of such covenants if such a claim would preclude another non-breaching shareholder from making a claim. Additionally, what rights shareholders will have (if any) to require a company to pursue a claim against a third party instead needs to be considered.
With the principle of reflective loss being underpinned by English law, how this will affect parties where a company is not incorporated in the UK is unknown. One would assume that it will be a point of the courts of the jurisdiction of incorporation of the company to determine whether the English law principle of reflective loss will be recognised and/or apply but we await to see case law in this regard.
2. Joint Ventures
With respect to joint ventures, how they are structured has taken on extra significance in light of the decision in Broadcasting. It is not uncommon to make the company itself a formal party to joint venture agreements in order to give it the express benefit of certain contractual provisions. Now, however, shareholders must be careful to ensure that in seeking to bolster their investment, they do not inadvertently detract from their rights by bringing the reflective loss principle into play. Consideration should be given to:
the overlap between company and shareholder rights;
rights of third parties;
clarifying who the parties are (particularly if the joint venture company is to be a party to the arrangements; and
how any potential decision-making deadlocks might be dealt with.
Whilst the Supreme Court has not been shy in challenging controversial areas of law recently, the principle of reflective loss lives to fight another day, albeit in a truncated form, but the Supreme Court may well attempt to abolish the principle entirely in due course.