New Remedies for Creditors and Shareholders?
The decision of Sevilleja v Marex Financial Limited  UK SC31
On 15th July 2020 the Supreme Court has handed down a landmark decision in the case above which introduces the first significant modification of what is called the “no reflective loss principle” following the last time the questions were ventilated at the highest level, in the previous House of Lords authority of Johnson v Gore Wood  2 AC1. It is lengthy and complex, but of importance.
The Johnson decision established that where a company suffers an actionable loss, e.g. as a result of wrongdoing (e.g. breach of directors fiduciary duties, trading insolvent, etc), the company acquires an exclusive right of action for that, even where it has to be pursued by Insolvency practitioners in the company’s name. If the company’s loss results in a fall in the value of its shares the shareholders simultaneously acquire a concurrent right of action but the no reflective loss principle, (originally established in an earlier case called Prudential v Newman (1982) CH 204) was held to mean that because the shareholders’ loss mirrored the loss of the company then the shareholder could not sue in relation to that loss. The Courts wanted to debar any prospect of double recovery for the same loss, so debarring the shareholder claim seemed sensible.
But the no reflective loss principle also commonly caused a great deal of hardship where intending claimants were unable to pursue their remedies. The insolvencies were frequently so severe that the liquidators were not in a position to pursue any remedy in the company’s name if they wished to, or were unwilling to assign rights of action where they were appointed by the director responsible for the economic tort, whom they treated as their client. Therefor the shareholder – given and because of his capacity as shareholder, was unable to pursue any remedy.
This was to some extent alleviated in the 2006 Companies Act which permitted derivative actions which is a procedure whereby such a claim could be mounted, (usually on the basis that a wrongdoing director could be said to owe a direct duty of care to the shareholder who suffered a loss). However, the problem with derivative actions is that they were and are hedged with numerous conditions including seeking Court permission prior to launching any claim. This doubled the costs of the procedure to bring a claim, and gave the defense two bites at the charry of defending the matter. Permitting a derivative action to go ahead is a discretionary remedy, and the Courts have been very slow to allow many claims since 2006.
It appears obviously unjust to allow a wrongdoer to defeat a claim by shareholders based on his own wrongful conduct, and which had prevented the company from pursuing a claim because it was the cause of the insolvency, for instance. This was considered to be an exception in the rule in Johnson which was created in the case of Giles v Rhind  CH 618, however, in practice the Courts did not follow the exception in Giles.
I must declare an interest in that I was personally involved in pursuing a case to the Court of Appeal in the matter of Gardner v Parker  EWCA Civ 781 and to my chagrin it was the only case in the Court of Appeal that I have ever lost. We argued that Giles should be followed since the company’s misfortunes were caused by the defaulting director. But the Court of appeal refused to follow Giles, and also refused to recognize that Mr Gardner (who had also taken an assignment of the Company’s rights of action against Parker, from the Insolvency Practitioners who had no funds) therefor stood in the company’s shoes, and hence there was no opening for the no reflective loss principle to apply, even if he was, separately, a shareholder. The Court of Appeal considered it was constrained to follow Johnson (given it was a House of Lords authority) and deemed the no reflective loss principle to debar all elements of Mr Gardner’s claims.
To my delight, I have now been vindicated by the decision in Sevilleja and the Supreme Court has held that the decision in the Court of Appeal in 2004 was wrong (see paragraph 89). It is most gratifying to be proved right, even if only 16 years later!
Apart from my sense of personal triumph I remain unhappy because the only reason we did not achieve a successful remedy in 2004 was that the client had run out of funds and was unable to pursue a further appeal to the House of Lords which would have been necessary to reverse Johnson. In Sevilleja the Supreme Court has analysed Gardner v Parker and although it did not consider the decision flawed on every one of the original grounds of appeal, they did consider that there was merit in that part of our claims which were based upon the Claimant’s expecting repayments of debt, in his capacity as a creditor and not in his capacity as a shareholder. Gardner had triple capacity in that he was both a shareholder and a separately a creditor (for certain shareholder loans) and an assignee of the company’s claims. Mr Gardner was seeking recovery in relation both to the diminution of the value of his shareholdings and the loss of his loans, and also as assignee of those Companies claims. The Supreme Court now holds in Sevilleja that it should not have been barred as a reflective loss since the creditor claim is clearly distinguishable from the diminution in value claim of the shares. This is the fulcrum of their decision and the key theme in the various judgements delivered.
It is extremely common that in the funding of any company the capital required by the company is financed both by shares and by loans frequently with a significant loan element from both directors and shareholders and the decision of the Supreme Court is very welcome in that it opens the door for the recovery, notwithstanding misfeasance, unlawful action of the wrongdoer, and the no reflective loss principle.
To be clear, the principle has not been abolished, but merely modified so as to permit creditor claims. It is under attack however. Lord Sales in Sevilleja argued that the loss suffered by a shareholder is not a true mirror of the company’s loss, because the diminution in valuation of the shares is disconnected from the company’s loss by the valuation methodology used. It is not that the company is a simple cash box, where everything in the cash box mirrors the outside of that box. Any diminution in the value of shares does not march in step with the diminution of the company’s assets and there is extensive analysis of different ways of valuing the assets of a company including price earnings ratios, discounted cash flows, and other valuation methodologies which are not simple asset based ratios. The majority of the Judges however cling onto the no reflective loss principle, despite this.
In one celebrated article, Alan Steinfeld QC (the barrister who acted for our firm and Mr Gardner in 2004) contends that the law took a seriously wrong turn when in Prudential v Newman the Court elevated what was a relatively simple every day problem concerned with an assessment of damages (i.e. to ensure there was no double recovery as between the company and its shareholders) into a “principle of causation”. The reasoning of Lord Millett in the Johnson v Gore Wood decision comes in for some heavy criticism now in the Sevilleja decision, particularly in the passages where Millett referred to the no reflective loss principle as being an issue of causation (see paragraphs 185 to 187). Also at paragraphs 152 and 153, the question of the causation argument is queried in terms that it pre-supposes that a shareholder will suffer a reflective loss when the company decides (or is unable) to pursue its remedy, because the shareholder cannot recover this loss himself. However, that argument does not show why the shareholder should be disabled from claiming in the first place, particularly where there are direct duties of care owed.
These issues are complex, so much so that in Sevilleja the Court even quotes an article by Professor Tettenborn, who compares the no reflective loss principle to “some ghastly legal Japanese Knotweed, whose tentacles have spread alarmingly and which threatens to distort large areas of the ordinary law” (135 LQR at 182).
To cut through the Knotweed the conclusion I would offer is that now instead of being faced with the derivative action and nothing else (which requires a dual procedure, and double the costs because you have to apply to the Court for permission before you can issue the claim) in cases where there is a loan and the shareholder is also a creditor the door has been opened to admit those claims. Seeking assignment of the company’s claims from a liquidator or administrator remains possible, and perhaps best (to recoup as much as possible), where one can find them to be co-operative (which is sadly not often the case).
The Sevilleja decision is good news for investors and entrepreneurs and all those who, faced with a catastrophe, are looking for remedies and wish to pursue economic torts as against their perpetrators.