Untangling the Legal Knotweed: Reflective Loss Rule and Shareholder Remedies
By Prerna Mayea
A company may suffer losses as a result of the breach of duty which was owed to it by the management. In such cases, it is only the company who can sue for the loss suffered by it. However, a shareholder who is interested in the company may also suffer losses, however is barred from suing the wrongdoer for damages suffered by him under the rule of reflective loss.
Reflective loss rule states that the loss suffered by the shareholder is merely a ‘reflection’ of the loss suffered by the company.
A company may suffer losses as a result of the breach of duty which was owed to it by the management. In such cases, it is only the company who can sue for the loss suffered by it. However, a shareholder who is interested in the company may also suffer losses due to diminution in the market value of his shares or diminution in dividend. Such shareholder, however, is barred from suing the wrongdoer for damages suffered by him under the rule of reflective loss.
The reflective loss rule states that the loss suffered by the shareholder is merely a ‘reflection’ of the loss suffered by the company and in order to avoid the double recovery of losses the shareholder is prevented from bringing a claim.
DEVELOPMENT OF REFLECTIVE LOSS RULE
The rule originated in Prudential Assurance v. Newman Industries (No 2) [(1982) Ch 204] where the shareholders’ personal claim for the loss of the value in their shares and dividend payments was disallowed. It was further confirmed in the case of Johnson v. Gore Wood & Co. which expanded the scope of the rule to include shareholders suing in their capacity as a creditor. The rule was further extended to include non-shareholder creditors of companies within its scope and barred them from suing in cases where the company had concurrent claims. This expansion of the rule was criticized by the creditors and academicians.
In a landmark decision by the UK’s Supreme Court in Sevilleja v. Marex Financial Ltd (Marex Case), the defendant asset-stripped his companies in order to escape the payment of debt to Marex and pleaded that rule of reflective loss barred Marex’s claims. It was confirmed by a majority of 4:3 that creditors are not covered under the reflective loss rule. It affirmed that in cases where only the shareholder has a right of action or where the shareholder’s loss is separate and distinct from the company’s, the rule will not apply. It overturned the judgment in Giles v. Rhind by stating that the rule even applied when the company did not pursue a claim against the defendant. Even in cases where a company could not file a suit due to insufficiency of funds, shareholders were still restrained from bringing their own claims. The judgment has narrowed down the ambit of the reflective loss rule, thereby providing a safety net to the creditors who can sue the defaulting party even in cases where the company has a concurrent claim.
REFLECTIVE LOSS RULE IN OTHER COMMON LAW JURISDICTIONS
The courts in Hong Kong have applied the reflective loss rule in various cases and it forms a part of their law of the land. The potential liability here has been extended to not just the boards but also professional trustees and auditors, amongst others. For example, in Waddington v. Chan [(2008) 3 HKLRD 200], the Court of Final Appeal struck out the claim of an applicant who suffered loss in value of his shares due to diversion of assets by the settlor. Judgments by the UK Supreme Court are not binding in Hong Kong but are highly persuasive. This indicates that the courts in Hong Kong might as well reconsider the rule in their jurisdiction after the ruling in Marex’s case.
The judges in Singapore have also accepted the principle in various decisions. The decision by Singapore Court in Townsing v. Jenton Overseas Investment Pte Ltd was mentioned by the minority in Marex’s case wherein the bench stated that the principle of reflective loss will not apply to cases where the shareholder has a different cause of action than the company.
IMPLICATIONS FOR INDIA
Through a series of various, the proper plaintiff rule has been widely accepted in India. This rule has fostered from the case of Foss v. Harbottle [(1843) 2 Hare 461]. The rule states that in cases where a wrong has been alleged to be done to a company or any damages or money is due to the company, then the company is the proper plaintiff to file a suit in the court. This has been reiterated and confirmed in several Indian cases.
Shareholders have been provided with several rights such as the right to approach NCLT in cases of oppression and mismanagement, initiate class-action suits and derivative action on behalf of the company against the directors. However, it must be noted that in cases of a derivative action, the benefit is not accrued to the shareholders who filed the suit but to the company which had the cause of action. This further strengthens the argument for the reflective loss principle in India. Furthermore, India witnesses a backlog and pendency of cases and the applicability of the rule of reflective loss might help in curbing this issue to some extent by ensuring that double recovery is avoided as well. It furthers the maxim of Nemo debet bis vexari i.e. no person should be vexed twice for the same cause.
However, apprehensions had been raised by the minority in Marex’s case that there might arise situations where there is no direct correspondence between the loss suffered by shareholders and company. There are several instances where the company’s recovery of its loss has not resulted in restoration of the value of the shares. This would also mean that shareholders are under-compensated for a real and distinct loss. Moreover, directors own a fiduciary duty to shareholders under the Companies Act to act in good faith and best interest and exercise their duties with due and reasonable care, skill and diligence.
Contrary to the Marex case, there is limited jurisprudence in India deliberating upon a tort claim against the wrongdoers. The minority has opined in Marex’s case that procedural case-by-case approach should be used in light of relevant evidence to avoid the coincidence of claims and ensure justice to all the parties. The landmark decision surely provides clarity on the principle; however, the judgment only has a persuasive value in India. Therefore, there is a need to create a balance between the rights of the claimants and the protection of wrongdoers from being vexed twice.
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(This story has been written by Prerna Mayea, III Year, B.COM LLB (Hons.), Institute of Law, Nirma University.)