Privy Council confirms that the so-called "reflective loss" principle applies to ex-shareholders

The Board of the Privy Council has allowed an appeal in relation to the application of the so-called "reflective loss" principle, confirming that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought Primeo Fund v Bank of Bermuda (Cayman) Ltd & Anor (Cayman Islands) [2021] UKPC 22.

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents only 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 (see our blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule).

On the facts of the present case, the claimant suffered loss arising from a breach of obligation by a wrongdoer before it became a shareholder in a company. However, by the time the claimant brought its claims, it had become a member of the relevant company, which had its own claim for the same loss against the same wrongdoer. It was common ground that if the company succeeded in its claims, it would fully restore the value of the shares in the company held by the claimant. However, the Board found that the claimant's claims were not barred by the reflective loss principle. It emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, but must be applied as a substantive rule of law, focusing on the nature of the loss, which must be assessed at the time the loss is suffered.

This is a helpful clarification of the correct approach to the issue of timing. Since Marex, there have been conflicting decisions as to whether the rule against reflective loss will apply to a former shareholder, who is no longer a shareholder in the relevant entity at the time the claim is commenced. In particular, there has been a lot of focus in some quarters on a decision by Flaux LJ as a single judge of the Court of Appeal in relation to an application for permission to appeal in Nectrus Ltd v UCP plc [2021] EWCA Civ 57. In Nectrus, Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made.

The decision of the Board in Primeo Fund has put this question beyond doubt, expressly confirming that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very "odd results". While decisions of the Privy Council are not binding on English courts, they are regarded as having great weight and persuasive value (unless inconsistent with a decision that would otherwise be binding on the lower court). Given the questionable precedent value of Nectrus  and the constitution of the Board of the Privy Council in Primeo Fund, it is highly likely that the decision in Primeo Fund will be followed by the Court of Appeal the next time this issue arises in an English case.

The decision is considered in further detail below.

Background

The appellant (Primeo), was an open-ended mutual investment fund set up in 1994 and registered in the Cayman Islands, but now in liquidation. The respondents acted as Primeo's custodian and administrator from 1993.

From inception, Primeo placed a proportion of funds raised from investors with Bernard L Madoff Investment Securities LLC (BLMIS) for investment. Over time, Primeo increased the proportion of its fund which invested with BLIMIS until, by 1 May 2001, the whole of its fund was invested in this way either directly, or indirectly through two feeder funds called Herald Fund SPC (Herald) and Alpha Prime Fund Limited (Alpha).

On 1 May 2007, Primeo's direct investments with BLMIS were transferred to Herald, in consideration for new shares in Herald (the Herald Transfer). From that date, Primeo no longer had any direct investments with BLMIS, all investments were held indirectly via Herald or Alpha.

On 11 December 2008, the Ponzi scheme operated by Mr Madoff and BLMIS collapsed. Mr Madoff surrendered to the authorities in the United States and was charged with fraudulently operating a multi-billion dollar Ponzi scheme. Primeo was placed into voluntary liquidation on 23 January 2009.

Primeo brought claims in the Cayman Islands against its administrators and custodians, alleging breaches of duty.

Decisions of the Grand Court and Court of Appeal of the Cayman Islands

The Grand Court held that the administrators and custodians owed relevant duties to Primeo and breached those duties. However, the Grand Court dismissed Primeo's claims on the grounds that they infringed the reflective loss rule, on the basis that Herald and Alpha also had claims against the same defendants which covered the same loss, and if they made recovery on those claims that would eliminate any loss suffered by Primeo.

Each side appealed to the Court of Appeal of the Cayman Islands (on various issues), which dismissed Primeo's appeal against the Grand Court's finding that its claims were barred by the reflective loss rule.

Appeal to the Privy Council

The Board of the Privy Council gave directions to hear and determine the discrete issue as to the operation of the reflective loss rule (with another hearing to follow, dealing with other issues on appeal). The parties were agreed that Cayman Islands law regarding the reflective loss rule, was the same as English law.

The specific issues for the Board of the Privy Council to determine were as follows:

1. What is the relevant time to determine whether the reflective loss rule applies? Is it the time when the relevant claimant (here, Primeo) issued proceedings (by which time Primeo was a shareholder in Herald), or is it the time when the claimant acquired its causes of action (when Primeo was not a shareholder in Herald)?
2. If the time to determine whether the reflective loss applies is when the claimant acquired its causes of action, did Primeo nonetheless lose its right to claim for the losses it suffered and become subject to the reflective loss rule by reason of the Herald Transfer, by which it ceased to be a direct investor in BLMIS and became an indirect investor via its replacement shareholding in Herald?
3. The reflective loss rule operates where there is a common wrongdoer whose actions have affected both the claimant shareholder (Primeo) and the company (Herald/Alpha) – must the claims against the common wrongdoer be direct claims, and what degree of overlap between the claims of the shareholder and the company is required?
4. Were the Grand Court and Court of Appeal correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities?

Decision of the Board of the Privy Council

The Board of the Privy Council concluded that Primeo's appeal in relation to the application of the reflective loss rule should be allowed. Each of the issues considered by the Board are discussed further below.

1. The timing issue

The Board confirmed that the reflective loss rule falls to be assessed as at the point in time when the claimant suffers loss arising from some relevant breach of obligation by the relevant wrongdoer, and not at the time proceedings are brought. On the facts of the present case, at the time Primeo suffered loss, it was not a shareholder in Herald and therefore its claim was not barred by the reflective loss principle.

The Board emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, and must be applied as a substantive rule of law. In this context, the majority in Marex said that the focus of the reflective loss rule is on the nature of the loss, which involves consideration of the capacity in which the claimant suffered the loss and the form of the loss. The Board concluded that the issue is one of the characterisation of the loss, which depends on its status (i.e. whether or not it is recognised by the law) at the time it is suffered.

In the Board's view, Nectrus Ltd v UCP plc [2021] EWCA Civ 57 was wrongly decided. In Nectrus, Flaux LJ presided as a single judge of the Court of Appeal over an application for permission to appeal. Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made, at a time when the loss claimed has crystallised.

As a consequence of its decision, the Board confirmed that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very "odd results".

2. The Herald Transfer issue

Having found that the reflective loss principle was not engaged following analysis of the timing issue above, the Board considered whether the outcome was affected by the Herald Transfer.

In Marex, Lord Reed and Lord Hodge explained the justification for the reflective loss rule as based on the fact that, by becoming a member of the company, the shareholder agrees to "follow the fortunes of the company" in relation to losses suffered by it as a result of wrongs done to the company, and agrees that the company will have the right to decide whether claims should be brought in respect of such wrongs.

The question then was whether the Herald Transfer precluded Primeo from pursuing the causes of action it had already acquired before the Herald Transfer, because of the "follow the fortunes" bargain.

The Board considered that this argument was unsustainable, because the “follow the fortunes” bargain is forward-looking, not backward-looking. It is directed to characterisation of loss suffered by a claimant after they become a shareholder in the company (and they then suffer loss of the requisite type arising as a consequence of a wrong done to the company), and is directed to limiting the ability of a shareholder to acquire a right of action from that time on.

In the Board's view, to apply the reflective loss rule to preclude a new shareholder from enforcing rights of action which had already accrued to them before they became a member of the company would be an unwarranted extension of the reflective loss rule. The Board noted that the issue of possible double recovery by Primeo on the one hand, and Herald and Alpha on the other, would have to be managed by a procedural mechanism.

3. The common wrongdoer issue

Primeo submitted that the Court of Appeal was wrong to apply the reflective loss rule in respect of claims against its former administrator, because neither Herald nor Alpha had any claim against the same corporate entity (different entities in the same group were involved in the provision of administration and custody services over the years to the various parties). Primeo made the same argument in relation to certain claims against its former custodian.

The Board agreed with Primeo, saying that it is an inherent part of the reflective loss rule that it only applies to exclude a claim by a shareholder where what is in issue is a wrong committed by a person who is a wrongdoer both as against the shareholder and as against the company. It noted that the separate legal identity of the administrator and custodian were of critical importance in the application of the reflective loss rule. The Board commented that to extend the reflective loss rule in these circumstances would be contrary to the decision in Marex, which was directed to keeping the operation of the rule within narrow parameters.

4. The merits issue

Given the Board's other findings, it was not necessary to decide whether the Grand Court and Court of Appeal were correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities.

However, the Board observed that those judgments were reached without the benefit of the decision in Marex, and adopting a materially different approach to the Supreme Court in that case. Accordingly, the Board warned that what the Grand Court and Court of Appeal said about this issue should not be treated as authoritative.

Note: In November 2023, the Privy Council handed down a judgment concerning liability and damages, limitation and contributory negligence. The Privy Council rejected Primeo's grounds of appeal, other than on the issues of reflective loss and HSBC's defence of contributory negligence. The result was that Primeo's appeal was allowed in part.