Through the looking glass: further reflections on reflective loss

Broadcasting Investment Group Ltd v Adam Smith [2020] EWHC 2501 (Ch)

Through the looking glass: further reflections on reflective loss

On 21 September, the first post-Marex decision on reflective loss was handed down in the case of Broadcasting Investment Group Ltd v Adam Smith [2020] EWHC 2501 (Ch).

As usually understood, the “reflective loss principle” is taken to mean that, where a shareholder has suffered loss in the form of a reduction in the value of its shares or a reduction in distributions, the shareholder is precluded from bringing a claim against a defendant where the company has also suffered loss and has a parallel claim against that defendant. In July of this year, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 3 provided clarification and limited the scope of the reflective loss principle. The Broadcasting Investment Group decision applies the relevant principles and gives guidance with regard to some aspects which the Supreme Court did not specifically consider, in the particular context of a diminution of value in a company that was not a party to the contract on which the claimant is suing.

Facts

The case concerned an oral joint venture agreement pursuant to which the First Defendant, an individual called Adam Smith, allegedly agreed to transfer shares in two broadcasting technology companies to a special purpose vehicle called SS Plc. One of the Claimants, BIG, was a company which, together with the Defendants, became a shareholder in SS Plc. The other two Claimants were BIG’s immediate holding company, VIIL, and a Mr Burgess who held a majority shareholding in VIIL and was also a director of both VIIL and BIG.

The Claimants alleged that the agreed transfer of shares into SS Plc never took place, in breach of the joint venture agreement. SS Plc went into creditors’ voluntary liquidation on 4 August 2015, and the Liquidator declined to pursue any claims which SS Plc may have in relation to the agreement. The Claimants sued the Defendants for specific performance of the joint venture agreement, alternatively for loss caused by diminution of the value of BIG’s shareholding in SS Plc and loss of dividend income due to breach of the agreement.

The decision handed down on 21 September concerned a strike-out application by Mr Smith, who argued that the claims by BIG and Mr Burgess to enforce the joint venture agreement were barred by the reflective loss principle on the basis that the only legally maintainable claim in that regard was vested in SS Plc.

The reflective loss principle and the “rule in Prudential” as interpreted by the Supreme Court in Marex

In July of this year, we reported on the Supreme Court decision in Sevilleja v Marex Financial Ltd [2020] UKSC 3. In that case, the Supreme Court limited the scope of the supposed rule against the recovery of reflective loss and confirmed that the principle does not apply to claims by creditors. The Supreme Court in Marex held that a creditor (Marex) who had suffered loss as a result of the director of Sevilleja (a BVI company which owed Marex a large sum of money) extracting virtually all assets from the company in order to thwart Marex recovering its debt, was entitled to sue the company even though it had no shareholding in it.

The decision clarified that the so-called “rule” against recovery of reflective loss in Prudential Assurance Co Ltd v Newman Industries Ltd [1982] Ch. 204 is more limited in its application than later cases had assumed. In Prudential, it was held that, where a shareholder has suffered loss in the form of a reduction in the value of its shares or a reduction in distributions, he should be precluded from bringing a claim against a defendant where the company has also suffered loss and has a parallel claim against that defendant. Subsequently, this so-called “rule in Prudential” had been interpreted to mean that claims brought by creditors who happened also to be shareholders in the company, and even by creditors who had no shareholding in the company at all, would also fail whenever the company itself has a concurrent claim available to it.

The Supreme Court in Marex confirmed that the rule in Prudential applies where the shareholder’s loss is the consequence of loss sustained by the company, in respect of which the company has a cause of action against the wrongdoer. However, it does not preclude a creditor, or a shareholder claiming to have suffered losses separate and distinct from those of the company, from pursuing the wrongdoer independently from the company. This is because in such cases the relevant loss is not related to the value of the company’s assets.

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Matters at issue in Broadcasting Investment Group v Smith

The strike-out application brought by Mr Smith clarifies a number of aspects of the operation of the reflective loss principle post-Marex in the specific context of a diminution of value in a company that was not a party to the contract on which the claimant is suing, and was not even in existence at the time that contract was concluded. In particular:

  1. One of the major bones of contention in the strike-out application was whether, despite not being a party to it, SS Plc was as a matter of law entitled to enforce the joint venture agreement under the Contracts (Rights of Third Parties) Act 1999 (the “Act”). Mr Smith contended that the agreement “purported to confer a benefit” on SS Plc and pointed out that section 1(3) of the Act expressly provides that the party on which a benefit is conferred need not be in existence when the contract is entered into. The Claimants countered that SS Plc had no independent cause of action against Mr Smith because the agreement did not “purport to confer a benefit on” SS Plc. SS Plc was, the Claimants submitted, simply the vehicle for the joint venture and nothing more, and there had been no intention to confer any benefit on it under the joint venture agreement.
     
  2. A related point was whether the diminution of BIG’s shareholding in SS Plc was merely reflective of the loss suffered by SS Plc. Mr Smith argued that it was, while BIG insisted that the fact that its claim was based on its contract with Mr Smith rather than on any loss to SS Plc (which was not a party to that contract) took its claim outside the scope of the “rule in Prudential“. For the purposes of that rule, BIG argued, contractual claims were a “class apart” if the relevant company was not a party to the contract on which the claimant was suing.
     
  3. Another issue the Court had to grapple with was whether the claim by Mr Burgess (as opposed to that by BIG, the direct shareholder in SS Plc) fell foul of the “rule in Prudential” as being a claim by a “third-degree shareholder” such as Mr Burgess (i.e. a shareholder in a shareholder in a shareholder). Mr Smith submitted that although Mr Burgess was not a direct shareholder in SS Plc, his claim could only be reflective of the loss sustained by SS Plc because he was a shareholder in VIIL, which was in turn a shareholder in BIG, which was a shareholder in SS Plc. Mr Smith argued that this made Mr Burgess a “quasi-shareholder” in SS Plc and should not be put in a better position than BIG, the direct shareholder. Mr Burgess, for his part, contended that the “rule in Prudential” only applied to direct shareholders in the loss-suffering company.
     
  4. Finally, the parties disagreed over whether the “rule in Prudential” applies to claims for specific performance.

Decision in Broadcasting Investment Group v Smith

Andrew Simmonds QC, sitting as a Deputy Judge of the High Court, held as follows:

  1. The joint venture agreement did “purport to confer a benefit” on SS Plc for the purposes of the Act. There was no evidence that the parties did not intend the transfer of the shares to be enforceable by SS Plc. Thus, SS Plc had a concurrent claim to enforce the joint venture agreement, and the claim by BIG fell foul of the “rule in Prudential“.
     
  2. Contractual claims are not a “class apart” for the purposes of the “rule in Prudential” where the relevant company is not a party to the contract. The Supreme Court in Marex cannot have intended to suggest that the loss must have resulted “merely” from a loss actionable at the suit of the company – otherwise, the shareholder would have no cause of action at all, there would be no concurrent claims and the case would not be in Prudential territory.
     
  3. The rule in Prudential does not apply to claims by second- or further-degree shareholders. Marex makes it clear that the rule only bars claims by shareholders in the loss-suffering company itself. A second- or third-degree shareholder such as Mr Burgess is not, in fact or in law, a shareholder in the relevant company, and to blur that distinction is to ignore the separate legal personality of the companies in the intervening chain between the claimant and the loss-suffering company. The “rule in Prudential” derives from the legal relationship between a shareholder and his company, in that a shareholder investing in a company entrusts the company (ultimately, the majority of the members voting in general meeting) with the right to decide how his investment is to be protected.
     
  4. The rule in Prudential does apply to claims for specific performance; Lord Reed said in Marex that “a shareholder cannot, as a general rule, bring an action against a wrongdoer to recover damages or secure other relief for an injury done to the company“.
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Applying these principles, BIG’s claim was struck out, but Mr Burgess’ claim was permitted to proceed to trial.

Comment

The clarification provided in BIG v Smith is likely to be of particular relevance to those routinely dealing with joint venture companies and special purpose vehicles incorporated for no other purpose than to be a holding company for a particular venture. One context in which this frequently happens is where a business is floated on a particular stock exchange, or as part of a securitisation. In such circumstances, the SPV created to effect the flotation or securitisation may well not yet have been incorporated at the time the agreement pursuant to which it is to be set up is concluded. The same is true for the not uncommon situation where (as on the facts of BIG v Smith) a joint venture agreement is concluded which provides for an SPV to be set up as the joint venture holding company.

It is now clear that in such circumstances, despite the Supreme Court’s recent limiting of the effect of the “rule in Prudential“, a shareholder in the SPV will not be able to claim against a party alleged to have caused loss by diluting the SPV’s value. This is the case even though the claim is based on a contract concluded before the SPV was in existence. If the contract “purports to confer a benefit” on the SPV (which, as the facts of BI v Smith show, can be the case even if the SPV is nothing more than a holding company or joint venture vehicle), it will have a claim against the wrongdoer which is concurrent with that of its shareholders, and the “rule in Prudential” will apply. This is so even if the claim is for specific performance of the contract rather than for damages.

However, the above will not preclude claims by shareholders higher up the chain. This is a perhaps somewhat surprising side-effect of the reasoning on which the “rule in Prudential” was based, namely the fact that shareholders entrust a company with their investments, can exercise their voting rights and therefore must follow the fortunes of whatever the company decided to do, whereas anyone other than a direct shareholder is not in that position. The decision may, in appropriate cases, inspire corporate constructions designed to ensure that there is a “quasi-shareholder” available to sue the wrongdoer, should the SPV (or more likely its Liquidators) decide not to take action. On the basis of the BIG v Smith decision, in appropriate circumstances such a construction may work, but only if the quasi-shareholder has an independent (contractual or tortious) cause of action against the wrongdoer.


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