In Marex Financial Ltd v Sevilleja [2020] UKSC 31, the Supreme Court has allowed the appeal and fundamentally restricted what has to-date been referred to as the principle against the recovery of reflective loss, effectively overturning a string of previous Court of Appeal and High Court decisions.
Such was the significance of the case, and the contentiousness of the issues involved, that it was heard before a seven-justice bench with judgment only being delivered fourteen months after oral argument before the Supreme Court.
THE “RULE AGAINST REFLECTIVE LOSS”
This rule applies where both a company and its shareholder have a right of action against the same third party in relation to the same wrongdoing, and the shareholder is seeking to recover a drop in the value of its shares (or in distributions by it) which is a consequence of the loss sustained by the company itself.
In those circumstances, the law regards the shareholders’ loss as merely “reflective” of the company’s loss, and the shareholder is barred from recovering the drop in the value of its shares. This is the case whether or not the company takes any action against the third party.
The rule is often justified as a way to prevent “double recovery”. The logic argues that if both the shareholder and the company were able to make a claim, the shareholder would receive both the direct payment from the wrongdoer and the reward in the uplift of the value of its shares. In the same way, the wrongdoer would be doubly penalised, having to pay out twice in respect of the same loss – once to the shareholder and once to the company.
The rule was originally formulated in the case of Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204. However, in subsequent years, it has been applied in numerous cases, with the potential to apply to persons who are not shareholders, such as (as in the case of Marex Financial Ltd v Sevilleja), a creditor, or those who are both shareholders and creditors. It has even been suggested in the past that the rule could extend to claims made by employees.
This principle is grounded in the further fundamental company law principles that:
- it is for a company to decide whether to bring an action in respect of wrongs committed against it;
- shareholders entrust the management of a company, including its decision whether to litigate, to the company’s decision-making organs including, ultimately, the majority of members voting in general meeting;
- a minority shareholder cannot simply bring the company’s claim in a personal capacity. Rather, company law provides alternative means for shareholder redress if the majority abuse their powers (in particular by way of an unfair prejudice petition or derivative action).
In Johnson v Gore Wood (No.2) [2002] 2 AC 1, the House of Lords approved the principle enunciated in Prudential.
In the (much-cited) judgment in Johnson, however, it is suggested that the principle was based upon the avoidance of double recovery. In line with this, Johnson also suggested that the principle would bar a claim by a shareholder even if suing as a creditor of the company, if the shareholder’s loss were reflective of that suffered by the company. Hence, it would not merely bar a shareholder’s claim in its capacity as such for share-value losses.
In subsequent decisions, following the dicta in Johnson, including the suggested basis underlying the “rule” being the principle against double-recovery, the Court of Appeal has held that it:
- could bar claims by creditors even if not shareholders, if their loss were reflective of that suffered by the company (Gardner v Parker [2004] EWCA Civ 781; followed by the Court of Appeal in the instant case of Marex); and
- was subject to an exception where the wrongdoer had prevented the company from bringing its action (Giles v Rhind [2003] Ch 618). This exception was of uncertain scope, prompting further litigation including in the case of Perry v Day [2004] EWHC 3372 (Ch) which followed Giles.
THE FACTUAL BACKGROUND AND THE ARGUMENTS BROUGHT BEFORE THE SUPREME COURT
Marex Financial Ltd v Sevilleja involves two companies incorporated in the British Virgin Islands, owned and controlled solely by an individual, Mr Sevilleja. In 2013, Marex, a trade creditor of the companies, obtained a judgment against the companies for more than US$7.15 million (including costs).
Shortly after the judgment was handed down, Mr Sevilleja allegedly arranged for more than US$9.5 million to be transferred from the companies into his personal control, leaving the companies with no more than US$5,000 of disclosed assets from which to satisfy Marex’s award.
Marex brought proceedings directly against Mr Sevilleja, claiming that he had induced a violation of Marex’s rights under the court’s order and that he had intentionally caused Marex to suffer loss by unlawful means.
In response, Mr Sevilleja argued that Marex was barred from claiming against him, because the loss it was claiming was merely “reflective” of the two companies’ losses. As such, it was sustained that the claims against Mr. Sevilleja should have been brought by the two companies rather than Marex.
The main question before the Court was whether there was a principle against reflective loss barring claims by a creditor of a company against a director of that company in circumstances where the company itself had claims against the same director in respect of the same loss.
It is a principle of company law that where a person commits a wrong against both a shareholder and the latter’s company which causes the company a loss, then the shareholder cannot bring a claim in respect of any resultant diminution in the value of the shareholder’s shares or distributions from the company.
THE SUPREME COURT’S DECISION
By resolving the “as yet undecided question” [1] of whether the rule against reflective loss applies to claims by unsecured creditors, the judgment “will increase certainty in this area of the law” [12] and finally address the hope expressed in Johnson v Gore Wood (No. 2) [2003] EWCA Civ 1728 at [162] that: “the current will o’ the wisp character of the no reflective loss principle will be clarified before long”.
The decision is consistent in principle with earlier authorities, especially Johnson v Gore Wood (No. 1) [2002] 2 AC1 and Gardner v Parker [2004] 2 BLCL 554. It is argued that “it is difficult to see why a claim by a creditor who has one share in a company should be barred by the rule against reflective loss whereas a claim by a creditor who is not a shareholder is not. That point is well illustrated by the example of a creditor who owns shares in the company, whose claim is initially barred by the rule, but, on this hypothesis, if he sells the shares, the rule no longer bars his claim. That makes no logical or legal sense at all” [33].
The judgment has also put to bed the suggestion that the rule against reflective loss does not apply to certain causes of action. The applicability of this rule depends on the nature of the loss, irrespective of the cause of action.
The decision on the Giles v Rhind exception is also noteworthy. This case emphasizes the narrowness of the exception, only applicable “where as a consequence of the actions of the wrongdoer, the company no longer has a cause of action and it is impossible for it to bring a claim or for a claim to be brought in its name by a third party such as Marex in the present case” [57].
However, at least two points remain still unresolved. The first goes to the correctness of two first instance decisions that the rule against reflective loss can be side-stepped by the shareholder or creditor seeking injunctive relief or specific performance in favour of the company: see Peak Hotels and Resorts Ltd v Tarek Investments Ltd and Ors [2015] EWHC 3048 (Ch.) and Latin American Investments Ltd v Maroil Trading Inc & Anr [2017] EWHC 1254 (Comm.). The second point, touched upon by this case, is whether the rule against reflective loss, with its origins in company law, might nonetheless also apply to an individual’s creditor pursuing a claim for loss which is, on analysis, for diminution of the individual’s assets caused by the wrongdoer.
CONCLUSION: WHAT DOES IT MEAN FOR CREDITORS?
Cases such as this, can make it difficult to understand the state of the law. However, for the time being, the majority judgment delivered by the Court is binding.
Creditors, however, can be relieved, as it is now clear that a creditor can claim against a third party, even if the debtor company also has a claim against that third party, provided the claim is brought by the creditor in that capacity and relates to the debt owed by the company. However, if the creditor is also a shareholder, they will need to work out whether the loss is caused by a drop in share value or arises merely out of a failure to pay the debt.
A shareholder who is considering bringing a claim should discuss the following practical points arising from Marex with its legal advisers:
- is the shareholder seeking to recover a drop in the value of its shares? If so, it will be important to examine whether the loss is merely “reflective”;
- does the shareholder’s loss arise in consequence of a loss to the company? If so, it is likely to be unrecoverable, even if it exceeds the loss suffered by the company. However, in some cases, the shareholder’s loss may be totally distinct from any loss suffered by the company (and so recoverable), even if the loss is caused by the same person;
- if the loss is merely “reflective”, are there any other options open to the shareholder? Does he/she have any power to require the company’s directors to take action against a third party? If they refuse to do so or they settle for too low an amount, can the shareholder bring a derivative claim on behalf of the company against its directors for breach of their duty to the company, or even a personal claim for unfair prejudice?
- if none of the above helps, does the shareholder have any alternative rights of claim against the third party that would not be barred as a reflective loss? For example, does the shareholder have the benefit of a separate indemnity or covenant to pay, which could be enforceable as a debt?
CONCLUSION: WHAT DOES IT MEAN FOR BANKS?
Prior to this decision, the rule against reflective loss was perceived to be used to prevent the former owners of insolvent businesses, who have allegedly suffered a loss at the hands of their creditors, from pursuing claims against those creditors.
The All Party Parliamentary Group on Fair Business Banking intervened in Marex. It clearly had the banks in mind when it spoke of creditors. To reinforce this, its press release provided examples “even when the misconduct of the creditor, such as the mis-sale of an interest rate hedging product or the treatment of businesses such as those in RBS Global Restructuring Group (“GRG”) has caused the insolvency, the bank receives the benefit of the insolvency and the shareholders, directors and other creditors lose everything through no fault of their own”.
The banks should have in mind that:
- this decision leaves creditors with a clearer path to pursuing the banks following a company’s insolvency;
- however, it’s important to emphasise that there would still need to be wrongdoing by a bank such that the claim could be founded. In the Marex decision itself, the case was about a director stripping two companies of their assets following judgment granted against them. He intentionally caused the companies to suffer loss by unlawful means.
POINTS TO TAKE AWAY
This is one of the most important company and commercial law decisions of the last thirty years.
It will be welcomed by many: the “rule” against reflective loss had increasingly few friends, worked injustices in practice (including in Marex), and some of the claimed theoretical underpinnings of it were open to question.
The decision of the majority of judges of the Court is also clear. It removes areas of uncertainty created by previous authorities, including the extent of the wrongdoer-prevention exception to the “rule”.
Equally, the Court’s dramatic cutting-back of the rule leaves a series of knock-on questions to be resolved by courts including as to how to prevent double-recovery where the company law principle is not engaged. That is not least given the number of cases either litigated or decided on the basis of what Johnson represented the law.
Please find the ruling here: Marex Financial Ltd v Sevilleja [2020] UKSC 31.
For more information, and any guidance or advice on drafting and negotiating your company and commercial documents, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.
