High Court strikes out shareholders' claim barred by the reflective loss rule

The High Court has struck out a claim by the former shareholders of a dissolved company against an investor on the basis that all the losses claimed were barred by the reflective loss principle: Burnford & Ors v Automobile Association Developments Ltd [2022] EWHC 368 (Ch).

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, in respect of which the company has a cause of action against the same wrongdoer (see our blog post).

Although the company in the present case had been dissolved, the High Court found that the claimants' claim fell within the ambit of the reflective loss principle.

The decision is of interest because of the High Court's consideration of the question as to the time at which the reflective loss rule falls to be assessed. In Nectrus Ltd v UCP plc [2021] EWCA Civ 57, Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal refused permission to appeal and in doing so held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. However, in Primeo Fund v Bank of Bermuda (Cayman) Ltd [2021] UKPC 22 the Board of the Privy Council (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) concluded that Nectrus was wrongly decided. The Board confirmed 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 (see our blog post).

Notwithstanding the ruling of the Board of the Privy Council in Primeo, the High Court in the present case considered that it was bound by the decision in Nectrus, even though Flaux LJ's decision in Nectrus was made as a single member of the Court of Appeal on an application for permission to appeal, and would therefore not normally have any precedent value.

In spite of this, the High Court then concluded that the present case was distinguishable on its facts from Nectrus and did, therefore, follow the Board of the Privy Council's decision in Primeo. As such, even though the company in the present case was dissolved, the claimants' claims were barred because their losses were suffered in the capacity of shareholders, in the form of a diminution in the value of their shareholdings, which was the consequence of loss sustained by the company in respect of which the company had a cause of action against the same wrongdoer.

This case suggests a judicial reluctance to follow Nectrus, which is not surprising given its uncertain precedent value and the Privy Council's comments in Primeo. This may lead to further attempts to distinguish Nectrus in future cases, until the Court of Appeal has the opportunity to reconsider the issue properly.

We consider the decision in more detail below.

Background

The claimants were former shareholders in a company called Motoriety (UK) Ltd (Motoriety), whose business was the exploitation of two software-based products for the motoring industry. In 2015, Motoriety wished to expand its customer base and entered into negotiations with Automobile Association plc (better known as "the AA"), on the basis that the AA could invest in the company. Motoriety and the claimants subsequently entered into an investment agreement with the defendant subsidiary company of the AA. The defendant agreed to subscribe for 50% of the share capital of Motoriety and the defendant had a call option for the remaining 50%, for consideration produced by a formula contained in the agreement. On the same day, Motoriety granted the defendant a licence to use its software and associated intellectual property rights. In 2017, Motoriety went into administration and was bought from its administrators by another company in the AA group.

The claimants subsequently brought a claim against the defendant for fraudulent or negligent misrepresentation and/or for breach of contract. The claimants alleged that they had entered into the investment agreement and the licence agreement in reliance on false representations by the defendant. The claimants also alleged that the defendant breached implied terms of the investment agreement by pursuing a course of conduct that undermined the basis of the arrangements between the claimants, Motoriety and the defendant. The claimants alleged that this led to Motoriety going into administration. The claimants also pleaded an alternative breach of contract claim that, had it not been for the defendant's breach of contract, the defendant would have exercised the call option and paid the consideration due.

The claimants sought damages for losses incurred as a result of the fraudulent/negligent misrepresentation and/or breach of contract. On the claimants' misrepresentation claim, losses were claimed on the basis that, had the alleged misrepresentations not been made, the claimants and Motoriety would not have done the deal with the defendant, but would have entered into a venture with a third party company and the value of the claimants' shareholdings would have increased accordingly. Similarly, in relation to the original breach of contract claim, the claimants claimed that if the contract had been properly performed, Motoriety would have thrived and the value of the claimants' shareholdings would have increased. Alternatively, had it not been for the defendant's breach of contract, the defendant would have exercised its call option, so that the claimants would have been entitled to the consideration provided for by that option. Three of the claimants also claimed for the loss of their initial investments in Motoriety.

The defendant denied the claim and brought an application to strike out the claim or for reverse summary judgment on the basis that all the losses claimed by the claimants were barred by the reflective loss principle.

Decision

The High Court found in favour of the defendant and granted its application to strike out the claim.

The key issues which may be of interest to financial institutions are set out below.

Developing area of the law

The claimants argued that it was inappropriate to deal with the reflective loss principle in a strike out application because this is a "fiendishly complex area of the law" which is "uncertain and developing". However, the High Court did not accept this and, on the contrary, considered that Marex had restated and recast the principle. Even the "timing issue" (referred to below) which was raised by the decision in Nectrus was quickly resolved by the Privy Council in Primeo.

The High Court stated that Lord Reed's judgment in Marex had made clear that claims by shareholders against third parties fell foul of the reflective loss rule where (and only where):

• The shareholder suffers loss,
• in the capacity of shareholder,
• in the form of a diminution in share value or in distributions,
• which is the consequence of loss sustained by the company,
• in respect of which the company has a cause of action,
• against the same wrongdoer.

All of these conditions needed to be satisfied for a claim to be barred by the reflective loss rule and, conversely, if any of them were not satisfied, the claim was not barred.

Independent wrongs

The claimants argued that their losses were caused by independent wrongs committed against them by the defendant. Their losses did not simply follow on from the loss of the company, reflected through their shareholdings in it. The representations were made to them personally and they were separate parties to the contract, such that they had "separate and distinct" losses from that of Motoriety.

However, the High Court noted that, as per Prudential Assurance Co v Newman Industries Ltd [1982] 1 Ch 204, shareholders may not recover a loss caused to the company by breach of the duty owed to the company. To allow otherwise, would subvert the rule that no shareholder can bring a claim on behalf of the company (as per Foss v Harbottle (1843) 2 Hare 461). With the above in mind, the High Court considered that the claimants had to show that Motoriety had not suffered the same loss. In fact, the claimants' alleged losses were entirely derived from the claimed losses of Motoriety. They may have had a direct claim, but they only had an indirect loss.

The "timing" point

The claimants argued that the reflective loss rule did not apply because Motoriety had been dissolved before the commencement of the claim, and therefore they were no longer shareholders in it. In the claimants' view, the reflective loss rule must be applied by reference to the time when the claims commenced, and not when the loss was suffered. The claimants relied on Nectrus in which Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal, refused permission to appeal. In doing so, he held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. The claimants argued that, although the Board of the Privy Council in Primeo (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) found that Nectrus was wrongly decided and confirmed 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, this decision was not binding on the High Court. Conversely, the defendant argued that Nectrus was not binding on the High Court and was distinguishable in any event.

The High Court highlighted that Flaux LJ's decision in relation to permission to appeal in Nectrus contained no express statement that it was establishing a new principle or extending the current law. It should therefore not ordinarily be cited before a court or bind another court. However, in Allianz Global Investors GmbH v Barclays Bank plc [2021] EWHC 399 (Comm), Sir Nigel Teare (sitting as a High Court judge) while acknowledging that remarks made when refusing (or granting) permission to appeal are ordinarily of no weight, stated that he had been informed that Flaux LJ's intention was that his ruling may be cited. As such, the High Court in the present case proceeded on the basis that that was correct and therefore Flaux LJ's decision was binding.

The High Court noted that, as per Willers v Joyce, it was obliged to follow an otherwise binding decision of the Court of Appeal in preference to a decision of the Privy Council. The High Court considered whether the "timing" point was merely obiter dicta and therefore not strictly binding, but concluded that Flaux LJ's decision in Nectrus was based on four separate grounds which were all part of the binding ratio decidendi. One of the grounds was that it was "unarguable" that the reflective loss rule applied to a claimant who had ceased to be a shareholder at the date of the claim and the High Court was therefore bound by this part of the decision unless it could be distinguished.

The High Court did, however, find that Nectrus was distinguishable. In that case the shareholder had sold its shareholding at a reduced price, which meant that the company's loss had in effect been "passed on" (pro rata) to the shareholder so the company could no longer claim that share of the loss. As per Allianz, it was clear that in such circumstances there was no risk of: (a) the rule in Foss v Harbottle being subverted as there would be no concurrent claims; and (b) double recovery. In the present case, there had been no sale of the shares at a reduced price, and no "passing on" of any part of the loss of the company. If Motoriety was restored to the register, the loss would still be in the company. As such, the High Court determined that it was not bound to follow Nectrus and was free to follow the decision in Primeo in finding that the reflective loss principle did bar the claimants' misrepresentation and original breach of contract claim.

Alternative claim for breach of contract

The claimants argued that the alternative breach of contract claim fell outside the scope of the reflective loss rule because the loss consisted of the formula set out in the investment agreement to calculate the consideration due under the call option and because only the claimants, not Motoriety, had rights to the consideration under the call option. Therefore Motoriety never had a cause of action to claim compensation in respect of this head of loss.

The High Court found that this claim was also barred by the reflective loss rule. The claim satisfied all six of the conditions set out in Lord Reed's judgment in Marex. The fact that the measure of the claimants' loss was by reference to a contractual formula and different to the measure of the loss of the company was beside the point.

The initial investments claim

The claimants who claimed for the loss of their initial investments in Motoriety argued that this head of loss fell outside of the reflective loss rule because it did not reflect a diminution in the value of their shares.

The High Court agreed with the defendant's argument that this was simply a "less ambitious" version of the same claim. Instead of claiming the difference between what the values of their shareholdings should have been and what they now were, the claimants were claiming the much smaller difference between what they paid for their shareholdings and what they now had. The High Court found that even though the claims were limited to the amounts paid for the shares, the loss suffered by the claimants was still the loss of their value and the loss of their value was still reflective of the loss to Motoriety.

Accordingly, for all the reasons above, the High Court found in favour of the defendant and granted its application to strike out the claim.

Note: The Court of Appeal has now had the opportunity to consider the question of when the reflective loss rule falls to be assessed, affirming the Board of the Privy Council's decision in Primeo, removing any final uncertainty as to the position of the law on this point and consigning Nectrus to an unusual footnote in history. In Allianz Global Investors GmbH & Ors v Barclays Bank plc & Ors [2022] EWCA Civ 353, the Court of Appeal found that the reflective loss principle must be assessed at the time the shareholder suffers loss, when the value of their shareholding is diminished by reason of damage to the company. Losses arising from diminution in value of the shareholding, for which there is no claim as a result of the rule in Prudential, cannot be converted into actionable loss by the subsequent action of selling the shares.

In April 2022, the claimants applied to the Court of Appeal for permission to appeal.

In May 2022, the Court of Appeal allowed the claimants' application for permission to appeal.