The Court of Appeal has confirmed that continuing shareholders of a company in which a new investor took a 50% stake could not claim against the investor due to the “rule against reflective loss.
Three key take-aways
- A shareholder will not be able to claim against a third party for a drop in the value of their shares if the company in which they have invested also has the right to recover.
- This rule is broad and mandatory. The courts are unlikely to entertain claims that seek to recharacterise the loss by framing it in a different way (for example, as loss of earnings or opportunity, rather than a reduction in share value).
- Parties to an investment in a company should take care when structuring their respective rights and obligations and deal specifically with any potential overlap.
Burnford and others v Automobile Association Developments Ltd  EWCA Civ 1943 concerned a company that operated an online vehicle administration and service booking platform.
In 2015, the company’s shareholders entered into an investment agreement with Automobile Association Developments Ltd (AADL), a subsidiary of the Automobile Association (AA). Under that agreement, AADL took a 50% equity stake in the company and the shareholders granted AADL a call option over the remaining 50%.
In 2017, the company went into administration. Another company in the AA’s group subsequently bought the company’s business from the administrators at a price substantially lower than the company’s value at the time AADL had invested in it. The company was dissolved in 2019.
The company’s former shareholders brought claims against AADL. Specifically, they alleged that:
- AADL had made a number of fraudulent or negligent misrepresentations about the amount of business the AA would pass to the company; and
- AADL had breached the investment agreement by “pursuing a course of conduct that undermined the basis of the arrangements” between the parties and the company.
In response, AADL argued that the claims were barred by the so-called “rule against reflective loss”.
What is the rule against reflective loss?
It is a basic and fundamental tenet of English law that a company is a legal person separate from its shareholders, and that, where a company and its shareholders suffer a wrong, each of them is entitled to bring their own claim. However, this is modified by the “rule against reflective loss”.
The rule (also known as the rule in Prudential) applies where both a shareholder of a company and the company itself have suffered loss and both have a claim against the same third party in respect of the same “wrongdoing”.
In those circumstances, the shareholder is not permitted to claim for any diminution of the value of its shareholding in the company, or for any loss of distributions (e.g. dividends), which is “merely the result of a loss suffered by the company” and caused by that third party – so-called “reflective loss”. Instead, the right to claim damages lies with the company itself.
One consequence of this is that (generally speaking) a shareholder is unable to claim for reflective loss even if the company itself declines to claim, leaving the shareholder completely uncompensated. The courts have said that this is an economic risk that a person assumes as part of their agreement to hold shares in a company, deriving from the unique relationship between a company and its shareholders.
The rule does not prevent a shareholder from recovering loss in other circumstances, such as where a shareholder has suffered a loss that is “separate and distinct” from any loss the company has suffered.
In response, the former shareholders argued that the rule was not relevant, because:
- they were not shareholders of the company at the time they brought their claim against AADL; and
- they were claiming in respect of misrepresentations and contractual promises made directly to them, which was a separate and distinct claim from any claim the company might have.
The initial decision
The High Court agreed with AADL and dismissed the claim.
The judge said that it was not enough that the former shareholders had a separate cause of action from the company. Rather, they needed to show that the company had suffered a different loss in respect of which it was entitled to bring a claim. That was not the case here.
The judge also found that it did not matter that the former shareholders were no longer shareholders in the company. Although the company had been dissolved, there had been no change in its shareholders. If it were restored to the register today, the former shareholders would become shareholders again and would be treated as having been shareholders throughout its dissolution.
As a result, all the claims failed.
The former shareholders appealed to the Court of Appeal.
What did the Court of Appeal say?
The Court of Appeal upheld the High Court’s decision and rejected the former shareholders’ claims.
Lord Justice Newey, who delivered the court’s judgment, effectively affirmed the High Court’s conclusions. He highlighted two principal factors that proved fatal to the former shareholders’ claims (both the misrepresentation claims and the breach of contract claims):
- The company also had causes of action in relation to the former shareholders’ claims.
- The former shareholders had not suffered loss that was separate and distinct from that of the company. In both cases, the former shareholders’ loss simply reflected a diminution in the value of their shareholdings, which was “reflective” of the company’s loss.
Some of the former shareholders had claimed that their loss from the alleged misrepresentations arose because they had been unable to recover monies they had invested in the company, rather than a loss in the value of their shares. But the court was not persuaded and found that the inability to recover their investment was ultimately a facet of the fact that their shares in the company had lost any value.
A perhaps trickier analysis was whether the former shareholders could bring claims for loss of earn-out payments following the sale of the company. The former shareholders alleged that they would have received these payments had AADL not breached the investment agreement. They also raised a similar argument in relation to option payments under a related licence.
The former shareholders argued that the company itself would never have become entitled to the earn-out or option payments, and so the loss must have been separate.
Again, the court was not convinced. Rather than forming a distinct loss, the former shareholders were in fact claiming for the same loss – a diminution in the value of their shares – but simply calculated using a different mechanism (loss of potential earnings or distributions). This was merely another way of ascertaining the value their shares would have fetched on a sale.
As a result, the Court of Appeal dismissed the appeal.
What does this mean for me?
In affirming the High Court’s decision, the Court of Appeal’s judgment emphasises just how expansive the rule against reflective loss is.
The judgment is useful because it neatly brings together key principles relating to the rule against reflective loss.
- The rule applies where a shareholder claims for a loss they have suffered in that capacity in respect of which the company has a cause of action against the same wrongdoer.
- A shareholder cannot escape the rule merely by proving an independent cause of action. The shareholder must also have suffered “separate and distinct” loss.
- There is no need for an exact correlation between the shareholder’s loss and the company’s loss. The shareholder might well suffer greater loss than the company itself can recover.
- The rule does not apply to claims brought by a shareholder in some other capacity, such as a creditor or employee.
- The rule is mandatory. The courts cannot choose whether or not to apply it.
- When deciding whether the rule applies, the courts must look at the circumstances when the shareholder suffered the alleged loss, not when the claim was issued.
This decision shows the importance of structuring joint venture, investment and shareholders’ agreements properly. It is not uncommon to make the investee company itself a party to these arrangements and to give it the express benefit of certain contractual covenants. In doing this, however, shareholders must be careful to ensure that, rather than bolstering their investment, they are not in fact detracting from their rights by bringing the rule against reflective loss into play.
Parties who are negotiating any kind of investment in a company should consider taking certain steps.
- Clarify who the parties are. If the investee company is to be a party to the arrangements, the contractual documentation should reflect this and set out precisely which rights the company is to have and be able to enforce.
- Beware of overlap between company and shareholder rights. It is common for an investment agreement to provide rights in favour of both the company itself and one or more shareholders. This is, of course, fine and can be said to “cover all bases”. But shareholders should bear in mind that, where the company suffers a loss and has a right to recover it under the contract, the rule against reflective loss may prevent the shareholder from doing so itself.
- Deal with any potential deadlocks. The consequences of the rule against reflective loss are exacerbated where a company is “deadlocked”. In this situation, the company’s board may not be able to take action to recover losses suffered by the company, yet the shareholders will also be barred from claiming. Parties will need to think of ways to address this. This might include providing for a modified decision-making process in such a situation or providing a separate right of action for the shareholder that does not overlap with that of the company.