Court of Appeal provides guidance on the "reflective loss" principle and its interaction with the Contracts (Rights of Third Parties) Act 1999

The Court of Appeal has held that the so-called "reflective loss" principle will not bar the claim of a shareholder, who is also a contractual promisee/beneficiary, in circumstances where the company in which the shares are owned has acquired the right to bring a claim in respect of the same contract against the same wrongdoer pursuant to s.1 of the Contracts (Rights of Third Parties) Act 1999 (1999 Act): Broadcasting Investment Group Ltd & Ors v Smith & Anr [2021] EWCA Civ 912.

In reaching its decision, the Court of Appeal overturned the High Court's judgment striking out the contractual promisee's claim (see our banking litigation blog post). The High Court had ruled that the company (of which the contractual promisee was a shareholder) acquired a right to enforce the contract in question pursuant to s.1 of the 1999 Act. Consequently, the promisee's claim, as a shareholder of the company, was barred by the rule in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 (often referred to as the reflective loss principle). The High Court found that s.4 of the 1999 Act, which preserves the rights of a promisee to enforce a contract, was subject to generally applicable legal principles including the rule in Prudential.

The Court of Appeal disagreed with the High Court's interpretation of s.4 of the 1999 Act. It held that, since the company's right to enforce the contract was conferred by the 1999 Act, it was subject to the terms and limitations imposed by that statute. Since the rule in Prudential was only engaged because of s.1 of the 1999 Act, it could not bar the promisee's right to enforce the contract as prescribed by s.4 of the 1999 Act. In the Court of Appeal's view, to interpret the rule in Prudential independently of the 1999 Act was entirely artificial, would sidestep the limitations imposed by s.4 designed to protect the rights of the promisee, and would effectively extinguish the promisee's right to enforce the contract, which was impermissible by statute.

This decision will be of interest for financial institutions following developments to the reflective loss principle, which was confirmed by the Supreme Court last year in Sevilleja v Marex Financial Ltd [2020] UKSC 31 (see our banking litigation blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule). The reflective loss rule plays an important part in the defence of claims brought against banks by shareholders (aside from claims brought under section 90 and 90A of the Financial Services and Markets Act 2000, which provide a statutory exemption).

Given that the outcome in the present case is to allow the concurrent claims of a shareholder and company against the same third party wrongdoer, some might argue that it has narrowed the scope of the reflective loss principle. However, the rationale supporting the decision is based on the effect of the 1999 Act and its very specific wording, and does not have wider application. Accordingly, the decision is unlikely to impact the scope of the reflective loss principle in a general sense, and is likely to be limited to the (unusual) fact pattern of cases where the company only has a claim as a result of s.1 of the 1999 Act, and the shareholder is a contractual promisee.

In addition, financial institutions are likely to welcome the helpful obiter comments from the Court of Appeal on the question of whether the reflective loss principle should bar the claim of an "indirect" shareholder, i.e. where there is a chain of shareholder ownership. On this point, the concurring judgment of Arnold LJ considered it "well arguable" that the rule in Prudential can apply to indirect shareholders in appropriate circumstances.

Background

The underlying facts of the dispute are complex, but relate to the development of a start-up company in the technology sector. In 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 had 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.

The liquidator of SS plc has, thus far, not indicated any intention to pursue any claims which SS plc might have in relation to the JV Agreement.

High Court decision

The High Court's reasoning is discussed in our previous banking litigation blog post.

In summary, the High Court struck out BIG's claims for both damages and specific performance in relation to the JV Agreement because the court found that BIG's claim was a paradigm example of a claim within the scope of the reflective loss principle, and therefore should be barred.

The High Court found that SS plc had a right to enforce the JV Agreement pursuant to s.1(1)(b) of the 1999 Act and therefore SS plc and BIG had concurrent claims. The High Court held that BIG's claim as a direct shareholder in SS plc fell within the scope of the rule in Prudential and was consequently barred. Further, the High Court held that s.4 of the 1999 Act, which states that s.1 of the 1999 Act does not affect any right of the promisee to enforce the terms of the contract, is subject to generally applicable legal principles and consequently, does not override the rule in Prudential.

The High Court ruled that Mr Burgess's claim to enforce the JV Agreement was not barred by the rule in Prudential and could proceed to trial, because he was an indirect or quasi-shareholder in SS plc, rather than a direct shareholder (aptly referred to as the "Russian Doll" argument). In the view of the High Court, Marex emphasised that the reflective loss principle bars only shareholders in the loss-suffering company and is a "highly specific exception of no wider ambit".

BIG appealed the High Court's decision to strike out its claims on two grounds: (i) the High Court's interpretation of both s.4 of the 1999 Act and Prudential; and (ii) whether Prudential bars claims for specific performance. In addition, Mr Smith cross-appealed the High Court's refusal to strike out Mr Burgess's claims in respect of the JV Agreement (i.e. the Russian Doll argument).

Court of Appeal decision

The Court of Appeal allowed BIG's appeal on the interpretation of the 1999 Act and held that the rule in Prudential was not engaged to bar its claim.

Given its primary ruling, the Court of Appeal did not consider in detail either BIG's alternative ground of appeal on the question of whether the rule in Prudential applies to claims for specific performance, or the cross-appeal.

Interpretation of the 1999 Act and Prudential

There was no dispute that SS plc acquired a right to enforce the JV Agreement pursuant to s.1(1)(b) the 1999 Act, with the result that both SS plc and BIG had concurrent claims for breach of contract against Mr Smith. Nor was it in dispute that BIG was a "contractual promisee" under the JV Agreement.

The question for the Court of Appeal was whether s.4 of the 1999 Act preserved BIG's right to enforce the JV Agreement, notwithstanding the concurrent claim of SS plc, because it provides that the contractual promisee's right to enforce the contract is not "affected" by s.1. In other words, did the creation of a right in SS plc under s.1 of the 1999 Act, destroy BIG's rights as contractual promisee because of the operation of the rule in Prudential?

BIG argued that if the right acquired by SS plc by virtue of s.1, prevented BIG as a shareholder of SS plc from pursuing its cause of action for breach of the JV Agreement because of the rule in Prudential, then the situation was analogous to a parasite killing its host. Conversely, Mr Smith submitted that s.4 of the 1999 Act could not be construed to mean that it abrogates the rule in Prudential and, as a result, subverts the principle of the autonomy of the company in Foss v Harbottle.

In the Court of Appeal's view it was clear from the natural meaning of the words in s.4 of the 1999 Act that the rights conferred on third parties by virtue of s.1 of the 1999 Act are in addition to any right the contractual promisee has to enforce th e contract (and that such a construction is consistent with the Explanatory Notes to the 1999 Act). This interpretation is consistent with the 1999 Act as a whole, which created only a limited and tightly constrained incursion into the rule of privity of contract. The legislation created rights and took "nothing away".

The Court of Appeal focused on the use of the word "affect" in s.4 of the 1999 Act, which provides that s.1 must not "affect" the promisee's right to enforce the contract. The Court of Appeal held that the proximate cause for BIG's rights being extinguished was s.1 of the 1999 Act, and not the rule in Prudential. The rule in Prudential was only engaged when s.1 of the 1999 Act enabled SS plc to enforce the JV Agreement. Treating the rule in Prudential as if it were independent to the right conferred by s.1 of the 1999 Act was entirely artificial and would effectively sidestep the limitations imposed by s.4, which protect the rights of the promisee. This interpretation would not only affect BIG's right to enforce the JV Agreement, but extinguish it completely – which it considered to be impermissible as a matter of statute. The Court of Appeal held that it would be a nonsense to interpret s. 4 of the 1999 Act in any other way.

The Court of Appeal also disagreed with the High Court's reasoning that s.4 of the 1999 Act was subject to "generally applicable legal principles, including (where applicable) the rule in Prudential", as this interpretation would defeat the purpose of s.4 of the 1999 Act. In this context, the Court of Appeal observed that SS plc's right to enforce the JV Agreement was conferred purely by statute and is therefore subject to the terms and limitations imposed by that statute.

It therefore concluded that BIG's claims under the JV Agreement were not barred by the rule in Prudential and were, to the contrary, expressly protected by s.4 of the 1999 Act.

Specific performance

The Court of Appeal did not consider this ground in detail given that it had allowed BIG's appeal on the grounds discussed above.

The Court of Appeal said that a "superficial consideration" of Lord Reed's reference in Marex to a shareholder being unable to bring an action against a wrongdoer to recover damages "or secure other relief for an injury done to the company", might lead to the conclusion that claims for specific performance also fall within the rule in Prudential. However, Asplin LJ highlighted that the matter was complex and was best left to a case where it was necessary to decide this issue.

The cross-appeal (the "Russian Doll" argument)

Again, the Court of Appeal did not need to consider the cross-appeal given its finding that the rule in Prudential was not engaged in the current case.

However, in a short concurring judgment given by Arnold LJ, he disagreed with the High Court's conclusion that the rule in Prudential was not engaged in relation to indirect shareholders (e.g. to prevent the claims of shareholders in a corporate shareholder).

Arnold LJ observed that it was "well arguable", in appropriate circumstances, that the rule in Prudential can apply to indirect shareholders. Although his comments on this point are obiter, and therefore not binding, Arnold LJ suggested that it was difficult to see why the rule in Prudential should not apply in such a scenario.