Court of Appeal confirms reflective loss rule will bar claims of former shareholders of a dissolved company because the principle must be determined at time of alleged loss

The Court of Appeal has upheld a decision of the High Court to strike 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] EWCA Civ 1943.

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed 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).

In the present case, the Court of Appeal agreed with the High Court that although the company had been dissolved, the claimants' claim fell within the ambit of the reflective loss principle. The decision puts the time at which the reflective loss rule falls to be assessed beyond doubt: it is the time when the claimant suffered the alleged loss and not at the time proceedings were brought.

This timing point has been the subject of uncertainty following the decision of Flaux LJ (as he then was) in Nectrus Ltd v UCP plc [2021] EWCA Civ 57. Sitting as a single judge of the Court of Appeal, Flaux LJ refused permission to appeal in Nectrus 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 when the claim is made. Although the Board of the Privy Council in Primeo Fund v Bank of Bermuda (Cayman) Ltd [2021] UKPC 22 found that Nectrus was wrongly decided, the High Court in the present case considered that it was bound by the decision (albeit distinguishing the present case from Nectrus on the facts). On appeal, the Court of Appeal took the opportunity to set the record straight, confirming that the Privy Council's decision in Primeo is the correct view.

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% of Motoriety 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.

High Court decision

The High Court found in favour of the defendant and granted its application to strike out the claim. The High Court's reasoning is discussed in our previous blog post here.

In summary, the High Court found that the claimants' claims satisfied all of the conditions (set out in Marex) needed for a claim to be barred by the reflective loss rule. The claimants' alleged losses were entirely derived from the claimed losses of Motoriety and were not separate and distinct losses. If Motoriety was restored to the register, the loss would still be in the company.

The claimants appealed.

Court of Appeal decision

The Court of Appeal upheld the High Court's decision to strike out the claim on the basis that all the losses claimed were barred by the reflective loss principle.

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

Grounds of appeal

Two of the claimants' grounds of appeal related to the applicability of the reflective loss principle. The first ground was that the issue was not suitable for summary determination because it raised fact-sensitive questions and the relevant law is uncertain and developing. The second ground was that the claimants' claims were not in any event barred by the reflective loss principle.

The "reflective loss" principle

The Court of Appeal drew the following points from its review of the authorities, in particular Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204, Johnson v Gore Wood & Co [2000] UKHL 65, Marex, Primeo, Allianz Global Investors GmbH v Barclay Bank plc [2002] EWCA Civ 353, and Nectrus:

1. The reflective loss principle applies where a shareholder brings a claim “in respect of loss which he has suffered in that capacity, 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” (Marex at paragraph 79);
2. A shareholder cannot escape the reflective loss principle merely by showing that he has an independent cause of action against the defendant. He must also have suffered separate and distinct loss, and the law does not regard a reduction in the value of shares or distributions which is a knock-on effect of loss suffered by the company as separate and distinct;
3. There need be no exact correlation between the shareholder’s loss and the company’s for the reflective loss principle to be applicable. The reflective loss principle can apply “where recovery by the company might not … fully replenish the value of its shares” (see Marex at paragraph 42). Equally, the company’s loss can exceed the fall in the value of its shares;
4. The reflective loss principle will not be in point if, although the shareholder’s loss is a consequence of loss sustained by the company, the company has no cause of action against the defendant in respect of its loss;
5. Nor will the “reflective loss” principle apply to a claim which is not brought as a shareholder but rather as, say, a creditor or an employee;
6. The Court has no discretion in the application of the reflective loss principle, which is a rule of substantive law;
7. The applicability of the reflective loss principle is to be determined by reference to the circumstances when the shareholder suffered the alleged loss, not those when the claim was issued (as confirmed in Primeo).

Although not emphasised in the judgment, proposition (7) had been the subject of uncertainty following the decision of Flaux LJ (as he then was) in Nectrus. Sitting as a single judge of the Court of Appeal, Flaux LJ 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 when the claim is made. In Primeo, the Board of the Privy Council found that Nectrus was wrongly decided, 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 (see our blog post).

Notwithstanding the decision in Primeo, the High Court in the present case considered that it was bound by Flaux LJ's decision in Nectrus, albeit the High Court considered that the present case was distinguishable on the facts from Nectrus. However, in the context of the present appeal, the court said that two further decisions of the Court of Appeal indicated that Primeo was the "correct view", namely Allianz and a subsequent decision in the Nectrus litigation: UCP plc v Nectrus Limited [2022] EWCA Civ 949 (granting Nectrus' application to reopen Flaux LJ's decision and granting Nectrus permission to appeal).

Suitability for summary determination

The Court of Appeal was not persuaded that the reflective loss issue was unsuitable for summary determination on the basis that the law is uncertain and developing.

The Court of Appeal underlined that the reflective loss principle had recently been considered in depth by the Supreme Court in Marex, where its existence and scope were confirmed. Also, while the principle had been the subject of debate in a number of subsequent cases, the points aired in those cases did not give rise to any legal uncertainty relevant to the present case. The Court of Appeal went on to emphasise that it is also not the case that the court should not entertain a strike out or summary judgment application wherever an undecided question can be discerned in the relevant area of law.

The misrepresentation claim

The Court of Appeal found that the misrepresentation claim was wholly barred by the reflective loss principle and the High Court was right to strike it out. The applicability of the principle did not depend on any factual disputes.

The Court of Appeal highlighted that it was evident that if the allegations of misrepresentation were well-founded, Motoriety would itself have (or have had) a cause of action against the defendant in respect of them. There were multiple references in the particulars of claim to Motoriety having relied on all the alleged representations implying that they had been made to it as well as to the claimants. The Court of Appeal also considered that the loss of the claimants' share value was a knock-on effect of loss suffered by Motoriety for which it would itself have (or have had) a cause of action and hence was not separate and distinct. The Court of Appeal concluded that, as per Marex, the claim is in this respect one relating to loss which the claimants would have suffered as shareholders "in the form of a diminution in share value…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". It was thus barred by the reflective loss principle.

The breach of contract claim

The Court of Appeal found that the breach of contract claim was also barred in its entirety by the reflective loss principle and the High Court was right to strike it out.

The Court of Appeal said that any good faith obligations would have been owed to Motoriety as well as the claimants. The Court of Appeal could not see that the terms the claimants alleged would have been implied solely in favour of the claimants. If the terms were implied in the investment agreement, they would surely have been implied in favour of all the defendant's counterparties, including Motoriety, the more so since they related to the conduct of the business which Motoriety was conducting. The Court of Appeal therefore considered that if the claimants had a contractual cause of action in respect of the matters they alleged, so would Motoriety. That being so, the claimants' claim would be barred by the reflective loss principle unless they were alleging separate and distinct loss.

The Court of Appeal then noted that the loss of the claimants' share value did not constitute a separate and distinct loss and the position was similar to the corresponding head of claim for misrepresentation. The loss in share value would be reflective of loss sustained by Motoriety in respect of which it would itself have (or have had) a cause of action against the defendant.

The Court of Appeal also considered that the reflective loss principle applied to the loss of the consideration from the call option the claimants claimed the defendant would have exercised. This loss related to what the claimants' shares would have fetched if sold to the defendant following its exercise of the call option. The claimants' allegation was that the defendant's alleged breaches of contract meant that the claimants would not be paid anything for their shares and that reflected the fact that the breaches had brought about Motoriety's failure such that there was no longer any prospect of either earnings or distributions. The loss claimed represented one way of measuring loss of share value. If the claimants' case was correct, breaches of contract by the defendant caused Motoriety to fail and, in consequence, rendered the claimants' shares worthless, both in the sense that they lost any value in the general market and in the sense that there was no longer any prospect of selling them to the defendant pursuant to the option. The Court of Appeal concluded that the claimants were therefore claiming in respect of loss "in the form of diminution in share value…which is the consequence of loss sustained by [Motoriety], in respect of which the company has [(or had]] a cause of action against [AAD]". Further, there may or not be a precise correlation between the claimants' loss and Motoriety's, but no such correlation was required for the reflective loss principle to apply.

Accordingly, for all the reasons above, the Court of Appeal found in favour of the defendant and dismissed the claimants' appeal.