The Supreme Court’s decision in Sevilleja v. Marex Financial Ltd, 15 July 2020, fundamentally restates the doctrine of reflective loss in company law so that:
- A claim by a company’s creditor against a third party will not be barred where it reflects loss suffered by the company, even if the creditor is also a shareholder; and
- There is no longer an exception to the doctrine where the wrongdoer has brought about the company’s impecuniosity.
The facts of the case are straightforward, at least in outline. Mr Sevilleja owned and controlled two BVI companies. Marex obtained judgments against the companies. Sevilleja allegedly then stripped the companies of their assets, making them insolvent. Marex issued proceedings against him for economic torts, including intentionally causing it to suffer harm by unlawful means. On an application for permission to serve out of the jurisdiction, the judge held that the claim was arguable, but the Court of Appeal reversed him, saying that the doctrine of reflective loss barred Marex’s claim as a creditor of the companies for loss which was reflective of the loss caused to the companies by Sevilleja.
The Supreme Court has unanimously held that the claim is not barred by reflective loss, but it reaches this conclusion by two different routes. The majority view (Lord Reed) narrows the doctrine of reflective loss; the minority (Lord Sales) would abolish it.
The rule in Foss v. Harbottle
To begin at the beginning …
The rule in Foss v. Harbottle (1843) 2 Hare 461 is one of the most important, but least understood, rules of company law. It states that, where loss is caused to a company and the company has a cause of action, only the company itself may sue. The rationale is company autonomy. A share is a right of participation in a company on the terms of the company’s constitution. The constitution vests the management of the company in the board of directors and the ultimate decision-making power in the general meeting. It is for the constitutional organs of the company to decide whether or not to bring, compromise or abandon litigation against third parties. This would be subverted if a disgruntled shareholder could bring a claim against the wishes of the majority. An exception is made for derivative claims, that is claims which a shareholder may bring for the benefit of the company, e.g. where the wrongdoers have control of the board and the general meeting.
Prudential v. Newman
In Prudential Assurance Co Ltd v. Newman Industries Ltd (No 2)  Ch 204 the Court of Appeal applied and extended this rule. A shareholder sued two directors who had defrauded the company. The shareholder sought to bring a derivative claim, but the Court of Appeal rejected this. The shareholder also sought to sue for loss caused to the value of its shares by the directors’ breaches of duty to the company. The court held that the shareholder’s loss merely “reflected” the company’s loss. The inverted commas are important, as will become clear.
Lord Reed explains Prudential on the basis of a rule that loss suffered by a shareholder, which is merely the result of loss suffered by the company, cannot be recovered from the wrongdoer, because in the eyes of the law the loss is not treated as separate and distinct from the loss suffered by the company. The rule applies even if the company chooses not to sue, provided that it has a valid claim. It does not apply where the company has no right of action, nor where the shareholder’s loss is not the result of loss to the company.
Johnson v. Gore Wood
In Johnson v. Gore Wood & Co  2 AC 1 the House of Lords followed Prudential but interpreted it in different ways. Lord Bingham gave the orthodox interpretation, as set out above. Lord Millett held that the rationale was in the rule against double recovery (or double proof in an insolvency). This is a general rule, not confined to company law. It ensures that a claimant does not recover more than 100% of his loss and that a defendant does not pay more than 100%.
Lord Millett held that Mr Johnson’s claim as director-shareholder infringed the rule against double recovery in claiming, not only for the diminution in the value of his shareholding, but also for the value of a pension policy which the company had set up for his benefit. By contrast, Lord Bingham treated the loss in respect of the pension as part of the loss suffered by Mr Johnson as a shareholder, since the pension was to be paid out of company profits.
The Court of Appeal in Sevilleja relied on and extended Lord Millett’s analysis so as to cover loss suffered by Marex as a creditor, even though Marex was not a shareholder. In reversing the Court of Appeal, both the majority and the minority of the Supreme Court launched an extraordinary and sustained attack on Lord Millett’s reasoning.
Lord Reed explains that the rule against double recovery is not a sufficient basis for the rule in Prudential. The diminution in the value of a share in a company does not necessarily correlate to the loss caused to the company itself. This is because market sentiment may cause the value of shares to fall by either more or less than the loss caused to the company. Hence the importance of the inverted commas around “reflect”. Both losses have the same cause, but the amounts of the loss are not necessarily identical. If the impact on the shareholders is greater than the impact on the company, the rule against double recovery should not prevent the shareholder from suing for that excess. That is why the rule in Prudential is formulated as a rule of law that the shareholder’s loss is not treated as separate and distinct.
The rule in Prudential is not infringed where a person sues as creditor, whether or not he is a shareholder. This is because the creditor’s action does not subvert the rule in Foss v. Harbottle. In such a case, the only restriction is the rule against double recovery.
Giles v. Rhind overruled
The doctrine is therefore narrower than the Court of Appeal had thought, but it is also inflexible. In Giles v. Rhind  Ch 618 the Court of Appeal had created an exception to Prudential where the wrongdoer had caused the company to become impecunious and therefore unable to sue him. The Supreme Court has now held that there is no such exception and that Giles v. Rhind would undermine the authority of the company’s constitutional organs to decide whether or not to sue. The way to prevent injustice in appropriate cases is for the shareholder who has suffered loss to bring either a derivative claim or an “unfair prejudice” petition.
Should the doctrine of reflective loss be abolished?
Lord Sales, who gave the minority judgment, proposes a more radical solution. He would abolish the doctrine of reflective loss in its entirety. This has some attraction, in that rules of law which rely on legal fictions are generally undesirable. Reflective loss is based on a legal fiction, given that the loss suffered by the shareholders may in fact be greater or less than the loss suffered by the company. Lord Sales would permit the shareholder to sue for his own loss, but he would meet the justifications for the rule expressed by Lord Millett in the following ways:
- He would assess the shareholder’s loss as being the diminution in the value of the shares, taking into account the impact on the value of the shares of the company’s right of action against the wrongdoer: this would prevent double recovery;
- He would use the court’s powers of case management to ensure that any claim which the company wished to bring was heard at the same time; and
- He would allow the wrongdoer to be subrogated to the shareholder’s rights against the company, once the wrongdoer has compensated the shareholder in full: this would prevent any windfall.
However, for the time being at least, the doctrine of reflective loss lives to fight another day, but in truncated form.
17 July 2020
Disclaimer: this article is not to be relied on as legal advice. The circumstances of each case differ and legal advice specific to the individual case should always be sought.
© David Halpern KC, July 2020
David Halpern KC is a Chancery commercial Silk at 4 New Square and is recognised in the directories as a leader in property litigation and professional negligence. He also sits as a Deputy Judge in the Chancery Division.