High Court tests newly narrowed scope of the “reflective loss” rule in first decision since the Supreme Court’s judgment in Marex

In the first decision to consider the so-called “reflective loss” principle since the Supreme Court’s judgment in Sevilleja v Marex Financial Ltd [2020] UKSC 31 earlier this year, the High Court has emphasised the newly narrowed scope of the rule: Broadcasting Investment Group Ltd & Ors v Smith & Ors [2020] EWHC 2501 (Ch).

As a reminder, the Supreme Court in Marex confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents shareholders from bringing a claim based on any fall in the value of their shares or distributions, which is the consequence of loss sustained by the company, where the company has a cause of action against the same wrongdoer. Marex confirmed the narrow ambit of the rule, which should be applied no wider than to shareholders bringing such claims, and specifically does not extend to prevent claims brought by creditors. For a more detailed analysis of the decision in Marex, see our blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule.

The issue arose in the present case on an application for strike out / reverse summary judgment by the defendant to a claim for alleged breach of a joint venture agreement. The court found that the claim brought by the first claimant - a direct shareholder in the company that suffered the relevant loss - was a paradigm example of a claim within the scope of the reflective loss principle. The court was prepared to determine this question finally and strike out the claim, on the basis that the reflective loss principle is a rule of law and it was not suggested that further relevant evidence might emerge at trial.

However, the more interesting aspect of the decision considered whether the reflective loss principle should bar the claim of the third claimant, who was a “shareholder in a shareholder” in the first claimant (conveniently described in the judgment as a “third degree” shareholder).

The nub of the argument was that the third claimant should be treated as a “quasi-shareholder” in the relevant company, by reason of the chain of shareholdings connecting him to that company. The defendant argued that the third claimant should not be put in a better position, for the purposes of the rule, than if he had actually been a shareholder in that company (i.e. than the first claimant).

However, the court rejected this argument, and held that the reflective loss rule did not operate to bar the claim of a “quasi-shareholder” in this way. The court was particularly impressed by the emphasis in Marex that the reflective loss rule bars only shareholders in the loss-suffering company and is a “highly specific exception of no wider ambit”. This sentiment was antipathetic to any incremental extensions of the rule beyond that described in Marex. The court therefore refused to strike out the claim of the “third degree shareholder”, which will proceed to trial.

Considering the implications of this decision in a financial services context, the robust confirmation and clarification of the reflective loss principle in Marex has generally been well-received by the market. Although the rule has certainly been pruned, there was a clear risk in Marex that the principle, as a binding rule of law, could be lost altogether. In its surviving form, the reflective loss rule will continue to play an important part in the defence of shareholder claims against banks (aside from claims brought under section 90 and 90A of the Financial Services an Markets Act 2000, which provide a statutory exemption).

The present decision could (at first glance) raise concerns of opening the door to novel claims against the bank. For example, where it is alleged that a corporate customer has suffered loss for which the bank is responsible, a claim could theoretically be brought by both that company and by a “quasi-shareholder”, where there is a chain of shareholder ownership in the relevant company. However, the “quasi-shareholder” must have an independent cause of action against the bank, and in most cases there should be good arguments to say that there is no contractual relationship and no duty of care is owed to a second or third degree shareholder.

Background

The underlying facts of the dispute are complex, but relate to the development of a start-up company in the technology sector. In broad summary, in October 2012 an alleged oral joint venture agreement (JV Agreement) was entered into by the claimants, the first defendant (Mr Smith), the second defendant (Mr Finch) and certain other parties. Under the terms of the JV Agreement, it was intended (among other things) that a joint venture vehicle would be set up, called Simplestream Group plc (SS plc), and that Mr Smith’s shares in two existing software companies would be transferred to SS plc.

SS plc was subsequently formed and its shareholders were Mr Smith, Mr Finch and the first claimant, Broadcasting Investment Group Limited (BIG). In alleged breach of the JV Agreement, the relevant shares were not transferred to SS plc, and SS plc subsequently entered creditors’ voluntary liquidation.

BIG brought a claim against Mr Smith and Mr Finch (and others) for breach of the JV Agreement, claiming specific performance as regards the transfer of shares to SS plc, or damages in lieu of specific performance. Alternatively, BIG claimed that it suffered loss by reason of the consequent diminution in the value of its shareholding in SS plc and loss of dividend income from SS plc.

The second claimant (VIIL) was the majority shareholder of BIG and the third claimant (Mr Burgess) was, in turn, the majority shareholder of VIIL. Mr Burgess brought parallel claims to those brought by BIG, on the basis that both BIG and Mr Burgess personally were alleged to be parties to, and therefore prima facie entitled to enforce, the JV Agreement.

Mr Smith applied for strike out / reverse summary judgment on the basis that the claims of BIG and Mr Burgess were barred by the rule against reflective loss, as recently affirmed by the Supreme Court in Marex.

At the date of the hearing to which the present judgment relates, the liquidator of SS plc had not indicated any intention to pursue any claims which SS plc might have in relation to the JV Agreement.

Decision

The court held that, while BIG’s claim to enforce the JV Agreement was barred by the rule against reflective loss first established in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204, and should be struck out, Mr Burgess’ claim was not barred by the same principle and could proceed to trial.

The court considered a number of other issues, but this blog post focuses on the court’s analysis of the reflective loss principle, being the first case to consider and apply the Supreme Court’s decision in Marex earlier this year.

Application of the Supreme Court’s decision in Marex

The application for strike out / summary judgment had been adjourned pending the determination of the appeal to the Supreme Court in Marex, which the court noted had clarified the law governing the reflective loss principle and made the task of considering the application at hand considerably more straightforward.

The court acknowledged that - strictly speaking - the application of the reflective loss principle to claims by shareholders was not a matter for decision in Marex, because the question before the Supreme Court considered the specific position of a creditor who was not a shareholder. Nevertheless, all members of the Supreme Court in Marex made it clear that it was necessary for them to review the scope of the principle in its entirety in order to decide whether it should be extended to creditors. It followed that the reasoning of the majority in Marex represents the law which must now be applied to all attempts to rely on the principle of reflective loss, whether the claims are by shareholders or others.

A detailed analysis of the Supreme Court’s decision in Marex can be found on our banking litigation blog. In summary, the Supreme Court (by a majority of 4-3) confirmed that the “reflective loss” rule in Prudential is a bright line legal rule of company law, which applies to companies and their shareholders. The rule prevents shareholders from bringing a claim based on any fall in the value of their shares or distributions, which is the consequence of loss sustained by the company, where the company has a cause of action against the same wrongdoer. However, the Supreme Court unanimously held that the principle should be applied no wider than to shareholders bringing such claims, and specifically does not extend to prevent claims brought by creditors. The majority of the Supreme Court (led by Lord Reed) emphasised that the rule is underpinned by the principle of company law in Foss v Harbottle (1843) 2 Hare 461: a rule which (put shortly) states that the only person who can seek relief for an injury done to a company, where the company has a cause of action, is the company itself. On this basis, a shareholder does not suffer a loss that is recognised in law as having an existence distinct from the company’s loss, and is accordingly barred.

Requirement for concurrent claim

The court’s starting position was to determine whether SS plc (theoretically) had a cause of action arising out of the JV Agreement. It said this was the logical first question, since the rule in Prudential is concerned only with concurrent claims, one of which must be vested in the company which has suffered the relevant loss. The court stated that, if SS plc did not have such a claim, then the application should fail.

In response to this preliminary question, the court found that SS plc had a contractual claim to enforce the JV Agreement by virtue of the s.1(1)(b) of the Contracts (Rights of Third Parties) Act 1999 (1999 Act), which provides that a person who is not a party to a contract may in his/her own right enforce a term of the contract if “the term purports to confer a benefit” on that person.

One of the terms of the JV Agreement pleaded by the claimants (and therefore of course taken as factually correct for the purpose of the application), provided that the shares to be transferred to SS plc would be held by the company beneficially, which in the court’s view, appeared ostensibly to bestow an advantage on SS plc for the purpose of s1(1)(b). This analysis was unaffected by the fact that the agreement in question was oral rather than written, and the court found on the facts nothing to suggest that the parties did not intend the term in question to be enforceable by SS plc, so as to engage s.1(2) of the 1999 Act and disapply s.1(1)(b).

Scope of the rule in Prudential / the reflective loss principle

Having concluded that SS plc had a concurrent claim to enforce the JV Agreement, the court turned to consider whether the rule in Prudential, as explained by Marex, barred : (1) the claim brought by BIG, a shareholder in SS plc; and/or (2) the claim brought by Mr Burgess, who was not a direct shareholder in SS plc.

(1) BIG’s claim

In the court’s judgment, BIG’s claim was a paradigm example of a claim that was within the scope of, and was therefore barred by, the rule in Prudential.

The court accepted that BIG’s claim was in respect of a loss suffered by SS plc, because:

• BIG’s claim was to enforce the JV Agreement, and in particular, Mr Smith’s alleged obligation to transfer shares to SS plc.
• BIG was a shareholder in SS plc and its loss was merely reflective of that suffered by SS plc, as was apparent from the claimants’ pleaded case.
• Since SS plc and BIG had concurrent claims against Mr Smith, BIG’s claim was barred by the rule in Prudential.

The court confirmed that the rule in Prudential extended to both the claim for damages and to the claims for specific performance of the JV Agreement. In particular, the court noted Lord Reed’s explanation in Marex that one of the consequences of the rule in Prudential is that a shareholder cannot (as a general rule) bring an action against a wrongdoer to recover damages “or secure other relief” for an injury done to the company. There was no suggestion in Marex that any specific remedy, such as specific performance, is exempt from the rule; to allow otherwise would permit the avoidance of the rule in Foss v Harbottle.

(2) Mr Burgess’ claim

The court then turned to consider whether Mr Burgess’ claim was within the scope of the rule in Prudential.

The court said the real question here was whether, following Marex, the rule in Prudential can apply to bar the claim of someone who is not a shareholder in the company which suffers the relevant loss (i.e. SS plc). As explained above, Mr Burgess was not a shareholder in SS plc directly. He was the majority shareholder in VIIL, which was the majority shareholder in BIG, which was a shareholder in SS plc.

The court noted that, given the conclusion reached by Lord Reed, the answer to this question might appear obvious (emphasis added):

“The rule in Prudential is limited to claims by shareholders that, as a result of actionable loss suffered by their company, the value of their shares, or of the distributions they receive as shareholders, has been diminished. Other claims, whether by shareholders or anyone else, should be dealt with in the ordinary way.”

While Lord Reed limited the application of the rule, in terms, to claims by shareholders in the relevant loss-suffering company, it was argued that a number of the justifications underlying the rule applied with equal force to Mr Burgess’ claim. This was because Mr Burgess was in the position of “a shareholder in a shareholder” or of “a shareholder in a shareholder in a shareholder” (conveniently described in the judgment as “second degree” or “third degree” shareholders).

The court commented that the nub of the argument seemed to be that Mr Burgess should be treated as a “quasi-shareholder” in SS plc who, by reason of the chain of shareholdings connecting him to SS plc, could not be in a better position, for the purposes of the rule, than if he had actually been a shareholder in that company.

The court was not persuaded, and held that the rule in Prudential did not operate to bar Mr Burgess’ claim, for the following key reasons:

1. The judgments of the majority of the Supreme Court in Marex make it clear that the rule only bars claims by shareholders in the loss-suffering company.
2. The descriptions of the rule in the judgments of Lord Reed and Lord Hodge are antipathetic to any incremental extension of the rule to non-shareholders, whatever policy justifications may be advanced for such an extension.
3. A “second degree” or “third degree” shareholder is not, in fact or in law, a shareholder in the relevant company. To blur that distinction would be to ignore the separate legal personality of the companies which form the intervening links in the chain between the claimant and the loss-suffering company. In the present case, none of the limited circumstances applied for the court to “pierce the corporate veil”.
4. The rule in Prudential derives from the legal relationship between a shareholder and his/her company; and the rule is something which the shareholder contracts into when he/she acquires his/her shares. This reasoning cannot apply to a second degree or third degree shareholder who does not acquire shares in the relevant company and therefore never contracts into the rule so far as it affects recovery of losses by that company.

Interestingly, there does not appear to have been any discussion of the lack of connection between the claim brought by Mr Burgess (where the cause of action was a personal claim for breach of the JV Agreement to which he was a party), and the loss alleged to have been suffered, which arose separately through his indirect shareholding in SS plc. As a result of the failed application, Mr Burgess’ claim will proceed to trial, which may offer the opportunity to consider this issue.

Suitability for summary judgment

The court rejected the claimants’ suggestion that the application of the rule in Prudential is inherently unsuitable for summary determination because there is a discretion in the operation of the rule.

The court commented that both the application of the Prudential rule itself and the question of whether SS plc had an independent cause of action under the 1999 Act raised questions of law, which were suitable for determination on a strike-out / reverse summary judgment application (following the court’s observations in Easyair Ltd v Opal Telecom Ltd [2009] EWHC 339 (Ch)).

Note: In November 2020, the Court of Appeal allowed the claimant's application for permission to appeal. The Court of Appeal hearing took place on 25 May 2021.