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July 25, 2018

UK Reflective Loss Rule Impedes Shareholder Recovery

Financial Services Law360 UK, Insurance Law360 UK

How can a shareholder recover loss caused by a wrong done to the company? The answer, as a recent U.K. High Court judgment discussed below illustrates, is often with great difficulty, particularly if the company is unwilling or unable to pursue the claim itself.

It is a long-established principle of English law that only a company against whom a wrong is said to have been committed can bring proceedings in respect of that wrong. This general rule, established by Foss v. Harbottle1 and premised on the fundamental tenet that a company is a distinct legal person, prevents a shareholder bringing a claim to recover a loss, such as diminution in share value or loss of dividends, that is merely reflective of a loss suffered by the company. If the company has legal standing to pursue the claim and recover the loss, then a shareholder will be barred from doing so itself, even if the company decides not to pursue the claim or fails even to consider whether or not to do so.

Among the principles underlying this rule is the need to prevent both (i) potential double recovery at the expense of the third party wrongdoer2 and (ii) recovery by a shareholder at the expense of the company's creditors and other shareholders.

Whilst the English courts have recognized exceptions to the reflective loss rule, they have often been interpreted narrowly. For example, in Giles v. Rhind3, the Court of Appeal held that a shareholder may be permitted to sue for what would otherwise be a reflective loss if the defendant had, by his own wrongdoing, rendered the company incapable of pursuing the claim itself. However, in Gardner v. Parker4, the court held that it is not enough merely to show that a company chooses not to pursue a claim, or decides to settle on comparatively generous terms, or is indirectly prevented from pursuing the claim, but that it must be established that the company's inability to claim is caused directly by the defendant's wrongdoing.

Breeze and Another v. Chief Constable of Norfolk

The case in question involved two claimants, Andrew Breeze and Dominic Wilson5, who had been the principal shareholders and directors of a company providing mental health services to the National Health Service. In November 2006, the pair were arrested by Norfolk Police on suspicion of misappropriating public funds as part of a fraud inquiry. Following a lengthy investigation, they were tried in April 2009 and acquitted in June 2009, the judge noting at trial that there was no evidence of any wrongdoing on their part. During the period between arrest and acquittal, the claimants' business had deteriorated to such an extent that it fell into receivership shortly after trial and was dissolved in February 2011. In bringing their action against Norfolk Police, the claimants argued that the demise of their business was caused by the police's protracted investigation and alleged malicious prosecution or misfeasance and they sought to recover the full value of their shares in their company, which by their estimate had been in the region of 30 million pounds.

The defendant, in an application to strike out the individuals' claim, relied on the reflective loss rule to argue that any loss the individuals had suffered (namely, the loss in the value of their shares) was merely reflective of the loss suffered by the company and so was irrecoverable.

The High Court held in favor of the defendant, noting that because the company would have had standing to sue Norfolk Police for misfeasance in public office, it followed that the claimants could not pursue their claim against the police in order to recover the value of their shares. This was notwithstanding that the court acknowledged that, in practice, the (by then, worthless) company would have been in no position to pursue the claim itself.6 In passing judgment, the High Court applied a broad interpretation to the reflective loss rule, to encompass any situation (including but not limited to a breach of duty owed to a company), where a company (whether or not it actually sues) has a cause of action in respect of an actionable wrong, which, if pursued to its fullest extent, would enable it to seek to recoup the loss.

The case above is an apposite demonstration of the challenges shareholders face in seeking to recover losses caused by damage done to the company itself. In particular, for minority shareholders lacking the ability to change the company's board to one more amenable to suing on the company's behalf, the route to recovery is unlikely to be smooth, underlying the importance of gaining wherever possible the benefit of robust contractual rights pursuant to a well-drafted shareholders' agreement and articles of association.7

  1. (1843) 67 ER 189.

  2. However, the prohibition on recovering reflective losses applies even where the facts preclude double recovery (Day v. Cook {2001} EWCA Civ 592).

  3. {2003} 1 BCLC 1, {2003} All ER (D) 340.

  4. {2004} 2 BCLC 554.

  5. {2018} EWHC 485 (QB).

  6. Note: It was only on the eve of the court hearing that the claimants introduced the argument that the actions of Norfolk Police caused the company to enter receivership in the first place, rendering it unable to sue for itself (and the receiver did not do so) and that, based on the Giles v. Rhind exception to the reflective loss rule, they should be allowed to bring their claim. Although the High Court found that the claimants' pleadings were insufficient at this stage, it did indicate that there was likely to be some merit to this line of argument and the claimants were given the opportunity to amend their pleadings accordingly. We wait to see whether the claimants pursue this line of argument.

  7. Note: Potential alternative courses of action for minority shareholders include (i) the "nuclear option" of petitioning the court to wind up the company on the ground that it is just and equitable to do so (s. 122(1)(g) of the Insolvency Act 1986); (ii) bringing a derivative claim on behalf of the company provided that the claim relates to wrongdoing by a director which has not been authorised or ratified by a shareholder majority (without reliance on the votes of the director in question); or (iii) petitioning the court for an order pursuant to section 994 of the Companies Act 2006 to protect members against unfair prejudice; however in the latter case, the court is unlikely to find that managerial decisions, such as whether or not to pursue litigation, amount to unfairly prejudicial conduct in the absence of a clear breach of duty by the directors or breach of a shareholder's legal rights under the company's constitution or statute.