The English High Court strikes out classic claim for reflective loss brought by a shareholder against its company’s professional advisers in the context of an IPO

The English High Court recently struck out a claim by a parent company (i.e., a shareholder of its subsidiary) for negligence and breach of retainer against a law firm in conducting due diligence and preparing for the subsidiary’s IPO, on the basis that the loss claimed by the parent company was reflective of the loss claimed by the subsidiary and therefore fell squarely within the confines of the reflective loss principle: Naibu Global International Company plc & Anor v Daniel Stewart & Company plc & Anor [2020] EWHC 2719 (Ch) (Naibu).

The Reflective Loss Principle

This case applies the principle of reflective loss that was recently confirmed and restated by the English Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 (see our London office’s banking litigation e-bulletin for a detailed discussion of this case: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule). According to this principle, a shareholder’s loss in respect of a diminution in share value is not, in the eyes of the law, damage which is separate and distinct from the damage suffered by the company, and is therefore irrecoverable by the shareholder. As a result, even if the shareholder has also, in addition to the company, been wronged by the defendant’s conduct and the company has not commenced proceedings against the defendant, any claim for damages brought by the shareholder  will be barred by this principle.

The Case

The claim in Naibu arose out of the dissipation of assets of a Chinese sportswear company, Naibu (China) Co Ltd (Naibu China), by its founder. Naibu China was wholly owned by Naibu (HK) International Investment Limited (Naibu HK), which in turn was wholly owned by Naibu Global International Company plc (Naibu Jersey).

Naibu Jersey was originally floated on the Alternative Investment Market (AIM) in London in 2012, but was subsequently delisted in 2015 following the dissipation of Naibu China’s assets and the closure of its factory. The shares of Naibu HK and Naibu Jersey in Naibu China became valueless as a result. A law firm was retained as the legal adviser to both Naibu China and Naibu HK in relation to the AIM flotation, and Naibu HK and Naibu Jersey argued that the law firm had acted negligently and in breach of their retainer in conducting due diligence and preparing for the IPO. Naibu Jersey alleged that it had incurred losses at different times which might be different in amount and nature from the losses sustained by Naibu HK.

The law firm argued that the loss claimed by Naibu Jersey was almost entirely reflective of the losses claimed by Naibu HK and was therefore irrecoverable under the principle of reflective loss.

Bacon J rejected Naibu Jersey’s argument, holding that the losses claimed by Naibu Jersey as the parent company were entirely reflected in the diminution in the value of its shareholding in its subsidiary, even though the amount of the losses caused to Naibu Jersey might not be identical to that caused to Naibu HK. Bacon J held that, if the application of the rule against reflective loss could be avoided by identifying different losses occurring at different times (as Naibu HK and Naibu Jersey sought to do) in order to argue that the losses of the two companies might not have been identical, that would entirely undermine the purpose of the rule. In particular, the supposedly separate category of losses named by Naibu HK/Naibu Jersey (i.e., disbursement of the proceeds of flotation) was, in reality, part of the same loss, representing the investment made by Naibu Jersey in Naibu China, through Naibu HK, the value of which was now reduced to nil. Accordingly, the correct legal position was that it is the nature of the loss, rather than the amount, that is decisive as to whether the reflective loss principle is engaged.

For a more detailed discussion of the case, please refer to our London office’s banking litigation e-bulletin here.

The Reflective Loss Principle in Hong Kong

A month before the English Supreme Court delivered its judgment in Sevilleja v Marex Financial Ltd [2020] UKSC 31, the Hong Kong Court of Appeal explored the same doctrine in Topping Chance Development Ltd v CCIF CPA Ltd [2020] HKCA 478, which was an application before the Hong Kong Court of Appeal to strike out a part of a claim brought by the plaintiff for infringing the rule against recovery of reflective loss. The Court of Appeal held that the two seminal authorities in Hong Kong on this point are Johnson v Gore Wood & Co [2002] 2 AC 1and Waddington Ltd v Chan Chun Hoo (2008) 11 HKCFAR 370.

In Topping Chance, the Hong Kong Court of Appeal considered, on the facts, whether the rule against recovery of reflective loss should not apply because the circumstances of the case were akin to the second exception to the rule set out by Lord Bingham in Johnson v Gore Wood & Co i.e., where a company suffers loss but has no cause of action to sue to recover that loss, the shareholders of that company may sue in respect of it (if the shareholder has a cause of action to do so), even though the loss is a diminution in the value of the shareholding.

The Hong Kong Court of Appeal held that the ‘no reflective loss’ principle is engaged not only where the company had the right to sue but also where it had declined or failed to sue, whether for lack of merits or lack of financial resources caused by the wrongdoer.  It is not concerned with barring causes of action but with barring recovery of types of loss.  It is based on the nature of the loss and what is important is that the company’s loss would be made good if the shareholder recovers from the defendant.

Although the facts in Topping Chance were different from those in Naibu (in that in Naibu both the company and the shareholder had a cause of action, whereas in Topping Chance, the Hong Kong Court of Appeal found that the company did not have a realistic claim), both courts looked at the nature of the loss in determining whether the ‘no reflective loss’ principle was engaged. Given that the principle in Hong Kong closely resembles that in England, if a similar factual situation as in Naibu were to arise in Hong Kong, the Hong Kong court is likely to follow the reasoning in Naibu, and hold that it is the nature of the loss, rather than the amount or its timing, that is decisive in determining whether the ‘no reflective loss’ principle is engaged.