Corporate: The limits of reflective loss

Thanks to the recent judgment in Sevilleja v Marex Financial Ltd [2020] UKSC 31, all sorts of creditors may now be able to capitalise on the increased remedies available to them following this Supreme Court decision. It greatly reduces the scope of the so-called “reflective loss” principle that had been extended through case law over the years and, for determined and well-resourced creditors, who can prove what has been done by those traditionally shielded by corporate structures, there is now a way around the principle.

Sevilleja v Marex

Sevilleja owned two companies (registered in the British Virgin Islands) which were involved in foreign exchange trading. Marex was a creditor of both companies. Marex obtained a judgment against the companies but, following the issue of the judgment, Sevilleja allegedly arranged for funds held by both companies to be transferred elsewhere. He then placed the companies into liquidation, leaving Marex unable to recover the amounts due under its judgment debt.

Marex claimed the liquidation process was effectively on hold, that claims notified to the liquidator were not being investigated by him, and that no real efforts were being made to locate the missing funds or to take action against Sevilleja.

Marex therefore raised an action against Sevilleja personally, for inducing or procuring the violation of its rights in relation to the judgment, and also for causing Marex to suffer loss by unlawful means. In the Court of Appeal, Sevilleja had successfully argued Marex’s claim was barred by the “reflective loss” principle. In short, Marex was a creditor of the companies, it was essentially those companies that suffered the loss and therefore only those companies could bring such a claim. So far, so familiar…

However, having examined the previous decisions behind the principle, the Supreme Court significantly reduced its application to shareholders only.

Reflective loss

The Supreme Court considered Prudential Assurance v Newman Industries (No 2) [1982] 1 Ch 204 and Johnson v Gore Wood & Co [2002] AC 1, which were said to have established the principle. Prudential laid down a rule of company law that prevented shareholders from bringing claims for the diminution in share value (or in distributions to shareholders) where that loss was actually reflective of the loss to the company. This was held to be the case whether or not the company recovered its loss in full, and in accordance with Foss v Harbottle (1843) 2 Hare 461, which, in short, held that the only person who can seek relief for an injury done to a company, if the company has a cause of action, is the company itself.

The Supreme Court noted that Johnson “purported to follow” Prudential. However the majority also noted that the reasoning, particularly of Lord Millett, in Johnson was considered to take a wider approach than that originally advanced in Prudential and, effectively, acted as an enabler to subsequent, more controversial, cases and the “reflective loss” principle.

Holding that the reflective loss principle should be limited to shareholders only, the Supreme Court overturned Court of Appeal decisions extending its application to creditors. It is worth noting however that the rule only just remains for shareholders, with three out of the panel of seven on the Supreme Court favouring doing away with the principle altogether.

Lord Hodge thought that the expansion of the principle that reflective loss cannot be recovered has had “unwelcome and unjustifiable effects on the law”, and that, if the facts alleged by Marex were true, its application would result in great injustice.

The decision also covered the exception to the prohibition in Giles v Rhind [2002] EWCA Civ 1428, where a former shareholder director brought proceedings against a defendant who had conducted business in competition with the company (in breach of contractual obligations to the company and the claimant). The company was unable to sue due to the impecuniosity caused by the defendant’s wrongdoing. The claimant sought to recover losses including to the value of his shares. The Court of Appeal held that, where the wrong had made it impossible for the company to pursue a remedy against the wrongdoer, an exception existed to the reflective loss prohibition. However, the Supreme Court deemed that Giles was wrongly decided: the remedy in that situation was a derivative action.

What does this mean?

The decision has many implications. It creates a “bright line” rule, namely, that the reflective loss principle is now limited to shareholders who bring claims for the loss in value of their shares or distributions (where the company has a right to pursue a claim and the loss is a consequence of the company having suffered loss). The effect of the rule brings with it certainty as opposed to the unknown and increasing exceptions previously developed by case law in this area.

Boards are always supposed to consider when losses (and potential litigation) should be pursued for the benefit of the company as a whole, in order to avoid becoming exposed to risk themselves (e.g. through derivative actions). However, going forward, and in the right set of circumstances, creditors of a company who can prove wrongdoing (and Marex has still to prove Sevilleja’s wrongdoing), can now recover directly from misbehaving directors. No longer are they kept within the bubble of the usual insolvency process.