Guidance from the UK Supreme Court on the Principle of Reflective Loss

Introduction

In the recent case of Sevilleja v Marex Financial Ltd the UK Supreme Court sought to clarify the nature and extent of the reflective loss principle. This article outlines what the principle is and how it has developed. Subsequently, we analyse the decision and explore its implications.

What is reflective loss?

The English law principle of reflective loss dictates that when a company suffers loss caused by the actions of a third party, any loss that is suffered by shareholders as a result of the diminution in value of their shares and/or distributions is not distinct from the loss suffered by the company. This prevents shareholders from bringing claims against the third party.

The basis of the principle is the decision in Foss v Harbottle. Here the court held that where a wrong is inflicted on a company the proper claimant is the company itself (save for a few exceptions such as derivative actions).

Development of the principle of reflective loss

The rule was first formulated in the case of Prudential Assurance v Newman Industries and then considered later, most notably, by the House of Lords in Johnson v Gore Wood & Co. Whilst these cases confirmed the existence of the principle, ambiguity arose as to its extent following the judgement in Gardner v Parker. In this case Neuberger LJ suggested that the principle applied not merely to shareholders but other corporate stakeholders such as creditors. This was considered by the Supreme court in Sevilleja v Marex.

Sevilleja v Marex Financial Ltd

Merex Financial Ltd (‘Merex’) obtained a judgement against two companies which were owned and controlled by Mr Sevillja. Merex argued that Mr Sevillja transferred $9.5 million from the companies to his own personal control while the judgement was still in draft form. This meant the judgement could not be satisfied as the companies consequently went into liquidation. As a result Merex pursued Mr Sevillja for the outstanding sums in tort.

At first instance it was held that Merex’s claim was not barred by the reflective loss principle. However, the Court of Appeal disagreed. The Supreme Court unanimously decided that the reflective loss principle does not apply to creditors of a company and therefore upheld Merex’s appeal. Whilst the court was unanimous on this point the Justices disagreed as to the scope of reflective loss when claims are brought by shareholders against third parties.

The majority construed the principle of reflective loss narrowly. Under this interpretation shareholders are prevented from recovering losses suffered as a result of the diminution in value of their shares or distributions because such loss is not distinct from the loss which is suffered by the company. The minority went further to question the very foundations of the principle of reflective loss.

Implications

It was confirmed by the majority that shareholders bringing claims against third parties who caused damage which resulted in diminution in the value of their shareholding, and or distributions, are barred under the reflective loss principle. However, shareholders claiming some other form of loss are not. This is be particularly beneficial to those shareholders who also have a creditor relationship with the company.

Shareholders who do not have a creditor relationship with the company, may in exceptional circumstances, be able to invoke the reasoning of the minority to argue that the reflective loss principle does not apply. This is likely to be particularly relevant in procedural or case management disputes where the parties may merely have to establish they have an ‘arguable case.’

Third parties who may cause damage to a company are at greater risk of being pursued for resulting losses as creditors will not be barred under the reflective loss principle if they have a claim against that third party. Those at greater risk include directors, professional service providers and commercial agents.

With greater potential exposure to litigation the insurance activities of third parties will be affected. For example directors may have to pay greater premiums for their directors and officers (‘D&O’) policy cover.

Conclusion

To conclude, the judgement in Sevilleja v Marex Financial Ltd has narrowed the scope of reflective loss. The court affirmed that the principle is applicable in respect of shareholder claims for a fall in the value of shares and/or distributions where a third party defendant has caused damage to a company. However, shareholders acting other capacities for example as a creditor will not be prevented from bringing such claims because they are considered to be outside the scope of the principle. This will be welcomed by many shareholders, especially in the current economic climate of uncertainty and financial pressure, as they will now be able to pursue wrongdoers whose actions have diminished a company’s financial position.

For advice please contact us on info@barnes-law.co.uk