Shareholder claims and the “no reflective loss” rule

Economic uncertainty often gives rise to sharp fluctuations in share prices, even among those companies that are perceived to be the stalwarts of the business landscape. Any reduction in the value of their shares will be of concern to shareholders particularly if they perceive the cause to be actions or decisions of the company with which they do not agree. As such, the continued climate of economic uncertainty, exacerbated by Brexit, is likely to give rise to an increase in shareholder activism and potential disputes.

Generally speaking, however, claims open to shareholders in this scenario are not straightforward. In particular, such claims are restricted due to the “no reflective loss” rule, which has traditionally prevented shareholders from bringing claims where their loss merely reflects the loss suffered by the company.

The recent case of Sevilleja Garcia v Marex Financial Ltd [2018] EWCA Civ 1468 provided a timely reminder of the application of the rule. While the question before the court was whether the “no reflective loss” rule extended to claims brought by a non-shareholder creditor, the decision is instructive because the court considered the development and rationale behind the rule in making its decision.

The origins of the rule come from the decision in Prudential Assurance v Newman Industries (No. 2) [1982] 1 Ch 204, in which the court said: “what [the shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage. He cannot recover a sum equal to the diminution in the market value of his shares, or equal to the likely diminution in dividend, because such a “loss” is merely a reflection of the loss suffered by the company. The shareholder does not suffer any personal loss. His only “loss” is through the company, in the diminution in the value of the net assets of the company, in which he has (say) a three per cent shareholding. The plaintiff’s shares are merely a right of participation in the company on the terms of the articles of association. The share themselves, his right of participation, are not directly affected by the wrongdoing. The plaintiff still holds all the shares as his own absolutely unencumbered property. The deceit practised upon the plaintiff does not affect the shares; it merely enables the defendant to rob the company.” The rationale was to avoid subverting the “proper plaintiff” rule in Foss v Harbottle (1843)2 Hare 461.

Subsequent authorities have confirmed that the rule extends beyond the diminution of the value of shares; it extends to the loss of dividends and all other payments which the shareholder might have obtained from the company had it not been deprived of its funds.

Following consideration of the authorities, the court in Sevilleja Garcia concluded there were four considerations which justified the rule against reflective loss

• The need to avoid double recovery by the claimant and the company from the defendant.
• Causation – if the company chooses not to claim against the wrongdoer, the loss to the claimant is caused by the company’s decision and not by the defendant’s wrongdoing.
• The public policy of avoiding conflict of interest; particularly that if the claimant has a separate right to claim it would discourage the company from making settlements.
• The need to preserve company autonomy and avoid prejudice to minority shareholders or other creditors.

The court also considered whether the exception, recognised in Giles v Rhind [2002] EWCA Civ 1428, applied so that the rule of reflective loss does not bar a shareholder/creditor from bringing an action against the wrongdoer where the company is unable to pursue an action itself. It was decided that the exception is a narrow one and only applies 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. The impossibility must be a legal one – a factual impossibility, such as lack of funds, would not be sufficient. If the impossibility is cured by an injection of funds by a shareholder or creditor or the company’s claim being assigned to a third party the exception will not apply.

The right to take any action for any wrongdoing to the company therefore lies with the company itself and the decision as to whether to pursue an action against a wrongdoer will be taken by the directors. That is not to say there is no recourse for shareholders who believe they or the company have been wronged; well-established options are available including those set out briefly below. But the relief available under each of these does not generally subvert the rule of reflective loss and will not necessarily make the shareholder “whole”, but they are likely to cause inconvenience and expense to the company.

• Unfair prejudice claim (section 994, Companies Act 2006 (CA 2006)): This is often the most useful tool, particularly for a minority shareholder. A shareholder may bring an action for relief where the affairs of the company are being conducted in a manner that is unfairly prejudicial to the member’s interests as a member. This will apply to actual or proposed acts or omissions.
  
  Generally the courts will not interfere with commercial decisions, but examples of actionable conduct may include: (i) breaches of fiduciary duty on the part of the company’s directors prejudicing the interests of the members; (ii) mismanagement which is serious considering the scale of financial loss arising and the frequency and duration of the acts and omissions; and (iii) improper failure to pay dividends or payment of excessive remuneration.
  
  The court has a wide discretion to make such orders as it sees fit to remedy the unfair prejudice, including: (i) ordering the sale/ purchase of the petitioner’s shares on terms to be determined by the court; (ii) regulating the conduct of the company’s affairs; (iii) requiring the company to refrain from or carry out an act; and (iv) authorising proceedings be commenced in the name of the company. The most common remedy is likely to be an order for the petitioner to be bought out. In practice, while this might be the least disruptive from the company’s perspective, it should be born in mind that the court has a wide discretion when setting the terms of the sale.
  
  
• Derivative claim (Part 11, CA 2006): Generally, shareholders can, subject to obtaining court approval, bring a derivative claim on behalf of the company (against a director, third party or both) for an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company. Again, the parameters of this claim reflect the proper claimant rule: the proper claimant in wrongs committed against a company is the company itself and any proceeds will belong to the company.
  
  
• Petition for winding up on just and equitable grounds (section 122, Insolvency Act 1986): Shareholders (among others) satisfying certain conditions may petition for the winding up of the company on the grounds that to do so would be just and equitable. Common examples of just and equitable grounds include: (i) loss of “substratum” – the original purposes of the company have been fully achieved or may no longer be pursued; (ii) deadlock which is not contemplated by the articles of association; and (iii) where the conduct of directors or other managers in relation to the management of the company’s affairs leads to a justifiable loss of confidence from the shareholder. Obviously this is not an action to be brought lightly and the court will consider other options available before ordering the winding up of an otherwise healthy company.

The decision provides an important illustration of the limits of claims that may be brought by a shareholder in respect of loss suffered by a company. While it is trite that the liability of a shareholder is limited, being a shareholder in any company comes with inherent risks. Most significantly, the shareholding may reduce in value due to acts or omissions which are entirely (or significantly) outside of the shareholder’s control and in many cases the shareholder will not have a personal remedy.

It is important for shareholders to appreciate in relation to any wrongdoing by third parties what claims properly lie with the company and what claims the shareholder may bring in their own right. As the court’s decision demonstrates, where a diminution in shareholdings is attributable to loss caused to the company by a third party, it is the company which will generally have the claim, not the shareholders themselves. However there are means for shareholders to challenge decisions by the directors and any shareholder claim will likely be lengthy and expensive for the company. As such, directors should be conscious of the actions shareholders can take and attempt resolve any shareholder discontent before it escalates.