The Supreme Court of Appeal in South Africa recently considered the concept of claims for reflective losses in South Africa, focusing on whether shareholders could hold directors liable, in terms of the Companies Act, 71 of 2008, for conduct which resulted in a decrease in the company’s share price. John Bell, Partner, Rui Lopes, Associate, and Nothando Mthimkhulu, Candidate Attorney, in the Dispute Resolution Practice at Baker McKenzie in Johannesburg, explain the details and outcome of this case.
The Supreme Court of Appeal (SCA) was recently tasked with considering the concept of claims for reflective losses in South Africa, in Hlumisa Investment Holdings (RF) Limited and Another v Kirkins and Others. The focus was whether shareholders could hold directors liable, in terms of section 218(2) of the Companies Act, 71 of 2008 (Companies Act), for conduct which resulted in a decrease in the company’s share price.
In this case, the plaintiffs were shareholders of African Bank Investment limited (ABIL) and the defendants were directors of ABIL and African Bank Limited (African Bank). The plaintiffs instituted action against the directors of ABIL, on the basis that, among other things: (i) certain financial statements and a prospectus contained false and/or misleading financial information; and (ii) the directors failed to vote against the provision of loans by African Bank in circumstances where the directors knew that the recipient would be unable to repay the loans, which amounted to a contravention of section 45 of the Companies Act.
The Plaintiffs alleged that the defendants, in their capacity as directors, conducted the business of ABIL and African Bank recklessly in contravention of s 22(1) and s 76(3)) of the Companies Act. The plaintiffs alleged that the breach of these provisions resulted in significant loss on the part of ABIL and African Bank, which resulted in the share price of ABIL decreasing by ZAR 27.84 per share.
The defendants took exception to the plaintiffs’ particulars of claim on the basis that they lacked the averments necessary to sustain a cause of action. This because the claim was one for reflective loss which is not sustainable in South African law. The plaintiffs, in order to formulate a cause of action, relied on section 218(2) of the Companies Act which stated that:
“Any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention.”
The High Court, being the court of first instance, upheld the exception and dismissed the plaintiffs claim. This decision was then appealed to the SCA.
In the SCA, the court noted that the issue to be decided in this matter was whether s 218(2) of the Companies Act provided a basis for a claim by the plaintiffs/appellants, in their capacity as individual shareholders in ABIL, against the directors, based on contraventions by the directors of section 22(1), 45 and 74, and breaches of the directors’ duties as provided for in section 76(3) of the Companies Act. The court cited Itzikowitz v ABSA (Itzikowitz), which held that the company had a distinct personality from that of its shareholders. The court noted that property vesting in the company was not the property of its members. This was described as the basis of the rule against the claim for reflective loss. From this premise, the court further held that the company, and not its shareholders, was the proper plaintiff in the circumstances. The court further held that, the duties owed by directors in terms of s 76(3) were owed to the company, not to individual shareholders. The company, in the event of a wrong done to it in terms of any of the provisions of that subsection, could sue to recover damages, and not the shareholders as it is the company that is suffering the damages.
The SCA in relying on the Itzikowitz decision held, with reference to a diminution in value of shares that, “Since the shareholder’s shares are merely the right to participate in the company on the terms of the memorandum of incorporation, which right remains unaffected by a wrong done to the company, a personal claim by a shareholder against the wrongdoer to recover a sum equal to the diminution in the market value of his or her shares, or equal to the likely diminution in dividend, is misconceived.”
The court further referred to Prudential Assurance Co Ltd v Newman Industries Ltd, which stated that:
“[W]hat [a shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage. He cannot recover a sum equal to the diminution in the market value of his shares, or equal to the likely diminution in dividend, because such a “loss” is merely a reflection of the loss suffered by the company. The shareholder does not suffer any personal loss. His only “loss” is through the company, in the diminution in the value of the net assets of the company, in which he has . . . shareholding.”
The SCA therefore upheld the decision of the High Court.
The position in this judgment is similar to a decision handed down in the United Kingdom (UK). The The UK Supreme Court, in the case of Sevilleja v Marex Financial Ltd (Marex Financial), cut down the scope of the rule against reflective loss and overruled a number of authorities which had expanded its reach over the last few decades.
In this case, the respondent (Sevilleja) owned and controlled two companies incorporated in the British Virgin Islands. Marex Financial, the appellant, brought proceedings against the companies for sums due under contract. At the Commercial Court, the appellant obtained judgment for over USD 5.5 million plus substantial costs amounting to USD 1.65 million. After receiving a confidential draft of the judgment in the case, and before it was handed down, the respondent transferred over USD 9.5 million of the company’s money to personal accounts. This in turn ensured that the company could not pay out the judgment and the appellant could not execute the judgment. The appellant brought fresh proceedings in the UK against the respondent, seeking damages for both procuring the violation of its rights under the commercial court judgment, and intentionally causing it to suffer loss by unlawful means.
The court here dismissed the application of the respondent, who then appealed to the Court of Appeal. The Court of Appeal held that the reflective loss principle barred most of the claim but granted the appellant permission to appeal to the Supreme Court of Appeal. On appeal, there were two issues to be decided by the court, namely:
- “Whether the No Reflective Loss Rule applies in the case of claims by company creditors, where their claims are in respect of loss suffered as unsecured creditors, and not solely to claims by shareholders; and
- Whether there is any and if so what scope for the court to permit proceedings claiming for losses which are prima facie within the No Reflective Loss Rule, where there would otherwise be injustice to the claimant through inability to recover, or practical difficulty in recovering, genuine losses intentionally inflicted on the claimant by the defendant in breach of duty both to the claimant and to a company with which the claimant has a connection, and where the losses are felt by the claimant through the claimant’s connection with the company.”
The court reached a unanimous decision, although this was through two different avenues. The court held that a claim by a company’s creditor against a third party was not barred where it reflected loss suffered by the company. The majority view narrowed the principle of reflective loss. The court held that there are two instances in which claims can be brought, namely:
- Claims brought by shareholders for losses suffered in that capacity, in the form of a diminution in share value or in distributions, which is the consequence of loss sustained by the company, in respect of which the company has a cause of action against the same wrongdoer, and
- Claims brought by a shareholder or by anyone else, in respect of loss which does not fall within that description, but where the company has a right of action in respect of substantially the same loss.
In the first instance, a shareholder has no claim as both the company’s and shareholder’s loss are regarded as being the same. Therefore, only a company may claim. In the second instance, recovery by a shareholder is allowed.
The court here referred to the principle laid out in Prudential Assurance v Newman Industries Ltd holding that, “the loss suffered by the shareholder is not the same as the loss suffered by the company. There is no necessary, direct correlation between the two.” Some argue however, that whether the shareholder suffered a loss that was different from that of the company is a matter of fact and should be decided on a case by case basis.
The court further questioned the justification for the reflective loss principle and whether it should still be recognized. Even if the principle was accepted, it should not be extended to cover a case involving loss suffered by a creditor of the company.
The above judgments provide clarity on the notion that directors do not owe a duty to shareholders but to the company itself. Section 218(2) of the Companies Act does not change the common law position and as such it cannot be relied on by shareholders to claim for reflective losses.