Mirror, Mirror on the Wall… Who is that?

Had the minority in the recent Supreme Court case of Sevilleja v Marex Financial Ltd  [2020] UKSC 31 got their way, an exciting new opportunity for shareholder activism would have emerged.^[1]

A shareholder would no longer be barred from bringing claims which seek to recover a sum equal to the diminution in the market value of its shares, or equal to the likely diminution in dividend. Traditionally, such claims have been barred due to a rule of law known as “reflective loss” such that “when a shareholder acquires a share he accepts the fact that the value of his investment follows the fortunes of the company and that he can only exercise his influence over the fortunes of the company by the exercise of his voting rights in general meeting”.^[2] The rule was established by the decision of the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd  (No 2) [1982] Ch 204 (Prudential) and the decision of the House of Lords in Johnson v Gore Wood & Co  [2002] 2 AC 1 (Johnson) which precludes recovery of loss, where the “loss” is merely a reflection of the loss suffered by the company.^[3]

The issue

The issue in Sevilleja v Marex, involving several BVI companies and a BVI liquidation, was whether the rule against reflective loss barred creditors of a company from claiming directly against a third party for asset-stripping the company. It was held that it did not. Reflective loss only applied to shareholders, and only to diminution in the value of their stock and diminution in the dividends paid.

Valuing shares

However, the logic behind reflective loss is flawed. Shareholder loss is calculably different to the loss by the company and is not necessarily a perfect “reflection” except in the most simple of capital structures, enterprises and undertakings (or assets). The starting point is: what is a share and what are the attributes that make it valuable? A share is not a proportionate part of a company’s assets.^[4] It does not confer on the shareholder any legal or equitable interest in the company’s assets.^[5] It is a right of participation in the company on the terms of the articles of association, which normally confer on a shareholder a number of rights, including a right to vote at general meetings, a right to receive distributions, and a right to share in its surplus assets in the event of its winding up. Shares may generate income and can be sold to others, and therefore a shareholder suffers a personal loss when the value of the shares or the amount of dividends paid decreases.

A share in a company has a market value which reflects the market’s estimation of the future business prospects of the company, not what its net asset position happens to be at any given point in time. There is no simple correlation between the value of a 1% shareholding and 1% of the net assets of the company. To suggest otherwise is to ignore the inherent nature of a share. This principle applies to a company whose shares are publicly traded as well as to a small private company. The shares in both public and private companies are marketable and their value reflects the view of the relevant market about the future prospects of the company. In the case of trading companies, common valuation methodologies for shares include application of price/earnings ratios and discounted cash flow models. What is important for the calculation of value under these methodologies is the future income or profits of the company, not its current net asset position. A company may be predicted to have strong prospects of future income or future profits which may support a high valuation of its shares even though its net asset value is relatively low. The predicted future income or profits of a trading company will reflect a judgment about its capacity to enter into new contracts in the future, which are not yet reflected in its balance sheet. When an investor buys a share, he pays both for a capital asset, namely the share itself, which is a marketable commodity, and for the right to participate in the future commercial performance of the company.^[6]

The principles of valuation have not, to be fair, been missed by the judiciary, and it must be stressed that the rule of law precluding reflective loss was driven by policy rather than calculable value theses. There was a concern that shareholders should not be vying in an unseemly manner to recoup losses when the company should probably do so on their behalf. Therefore, court deems that the loss suffered by a shareholder in relation to diminution in the value of shares or loss of dividends simply is to be regarded as irrecoverable in a case where the company has a parallel claim against the third party defendant.^[7] But why?

Double recovery

There is of course some reflection in the mirror. Some shareholder loss will be the same mirrored loss of the company, but not all. An easy way to deal with the overlap or “double recovery” is for a judge to simply rule that the same loss arising cannot of course be paid twice by any wrongdoer. In a personal injury claim, the party at fault does not pay both the subrogated insurer and the injured party. Alan Steinfeld QC contends that “[t]he law took a seriously wrong turn when in Prudential the court elevated what was a relatively simple everyday problem concerned with an assessment of damages into a principle of causation” and the court should “now think it over and wonder why it was ever thought to be necessary or just to have this rule at all”.^[8]

As Lord Sales points out: “The reflective loss principle was first identified and relied upon in the judgment of the Court of Appeal in Prudential in 1981. It is striking that this occurred so late in the development of the law, despite the existence of joint stock companies for a very long time and the passage of more than 80 years after the decision of the House of Lords clarifying the position of companies in Salomon v A Salomon & Co Ltd  [1897] AC 22”.^[9]

New Opportunities for shareholder claims

The claims that would be available to a shareholder if the reflective loss principle was one day abolished - perhaps in the offshore courts or the Hong Kong or Singapore court - would be to recover a sum equal to the diminution in the market value of its shares, or equal to the likely diminution in dividend. Shareholder activism is a way that shareholders can influence a corporation's behaviour by exercising their rights as partial owners. By granting shareholders the right to pursue their causes of action in court, they can actively hold wrongdoers, both internal and external to account, and improve shareholder value.

I suggest some hypothetical claims that may be brought if the dissenters’ view in the Supreme Court were to one day prevail:

• A wrongdoer might owe obligations in contract or tort to the shareholder of a company where breach of those obligations results in loss to the shareholder which is suffered in the form of a reduction in the value of its shares in the company or a diminution of dividends which it receives. For example, there is deliberate action by the wrongdoer, unlawful as against an intermediate party - the company - but aimed at inflicting harm on the shareholder, based on the principle recognised in OBG Ltd v Allan  [2007] UKHL 21.
• A company might have a claim against a wrongdoer for loss of profits as well as loss of assets, but the recoverable profits which might be awarded as compensation by a court are not necessarily the same as the market’s estimation of future profits which supports the market value of a share in that company. The loss suffered by the shareholder is not the same as the loss suffered by the company, and it does not follow that eventual recovery by the company will have the effect of eliminating the loss suffered by the shareholder.
• Where a company can recover for its losses, for example, for depletion of its assets stolen by the wrongdoer and consequential loss of profits. The shareholder should be allowed to recover for diminution in the value of its shares, which is a function of how the market values those shares, and for loss of dividends it might have received but for the wrong in relation to itself. These shareholder losses may have some relationship to the losses suffered by the company, but are not the same as those losses.
• Knowledge in the market that the company had been made a victim of the wrong might have the effect of undermining market confidence in its management, thereby reducing the market value of shares in it even if the company made a full recovery of what it had lost.
• A further claim might arise if a shareholder can prove that, but for the defendant’s wrongful actions which gave rise to independent causes of action vested in the company and in the shareholder respectively, he would have been paid a dividend or his shares would have had a higher value which he could have realised in the market. It does not follow that if the company sues to vindicate its rights and is successful years later in obtaining a judgment against the third party defendant and in obtaining execution of that judgment that it would, in the changed circumstances then prevailing, choose then to make the same dividend payment it would have made previously but for the defendant’s wrongdoing. Nor does it follow that the value of the shares held will automatically be restored to what it would have been previously but for the defendant’s wrongdoing.

In all of these hypotheticals above, since the company’s recovery may not put the shareholder back in the position he would have been in but for the defendant’s wrongdoing, there is no true mirrored loss and, it cannot be said that it is the decision of the company whether to sue or not which has a determinative causative effect as to whether the shareholder suffers loss from any wrongdoing. In many cases the company’s recovery of its loss will not have the effect of restoring the value of the shares.

As Lord Sales so eloquently puts it in his dissenting judgment: “If a shareholder has a valid cause of action against the third party defendant in respect of different loss which he has in fact suffered, it is not open to a court to rule it out as a matter of judicial fiat”.^[10] The problem is that as of today, it is. This should change.

^[1] 4:3. Majority: Lord Reed, Lady Black, Lord Lloyd-Jones and Lord Hodge. Minority: Lord Sales, Lady Hale and Lord Kitchin.

^[2]Prudential Assurance Co Ltd v Newman Industries Ltd  (No 2) [1982] Ch 204 at 224

^[3] Further, and of tangential relevance to reflective loss, a chose in action which is truly only one that a company has an interest in, can only be brought by the company - a shareholder has no right to seek to vindicate the company’s cause of action: Foss v Harbottle  (1843) 2 Hare 461.

^[4]Short v Treasury Comrs  [1948] 1 KB 116

^[5]Macaura v Northern Assurance Co Ltd  [1925] AC 619

^[6] See para 145 of Sevilleja v Marex

^[7] See paras 9, 28-39 and 52 of Sevilleja v Marex

^[8] (2016) 22 Trusts & Trustees 277, at 285

^[9] See para 133 of Sevilleja v Marex

^[10] See para 118 of Sevilleja v Marex