In this week’s update: consideration of the rule against reflective loss, an FRC statement of intent on ESG challenges for companies, Stakeholder responses to the Government’s consultation on audit and corporate governance reforms, Companies House reintroduces same-day capital reductions and updates guidance on submitting returns on share buy-backs and the EU Platform on Sustainable Finance is seeking views on extending the EU’s sustainable finance taxonomy.

Covid-19 is affecting the way people conduct their business, retain their staff, engage with clients, comply with regulations and the list goes on. Read our thoughts on these issues and many others on our dedicated Covid-19 page.

Court reconsiders the rule against reflective loss

The Court of Appeal has considered how the rule against reflective loss applies to claims by an “indirect” shareholder and its interaction with the Contracts (Rights of Third Parties) Act 1999.

What happened?

Broadcasting Investment Group Ltd v Smith [2021] EWCA Civ 912 concerned a company established to act as a joint venture vehicle for a low-cost broadcasting business.

In broad outline, three individuals – a Mr Burgess, a Mr Smith and a Mr Finch – as well as several corporate vehicles, including Broadcasting Investment Group Ltd (BIG) were assumed to have entered into an oral agreement under which (among other things) they would establish a new vehicle (SS PLC) and Mr Smith would transfer shares in two operating companies to SS PLC. The vehicle was incorporated, with BIG investing directly as a shareholder and Mr Burgess investing indirectly through BIG. However, the shares in the operating companies were never transferred to SS PLC.

For more detail on the factual background to the claim, see our previous Corporate Law Update.

Mr Burgess and BIG claimed against Mr Smith for breach of contract, alleging that the failure to transfer the shares had caused a diminution in the value of BIG’s shares in SS PLC. (SS PLC had, by this time, been placed into liquidation and the liquidator had decided not to take legal action.)

The High Court denied BIG’s claims on the following basis:

  • Under the “rule against reflective loss” (also known as the “rule in Prudential”) (see our previous Corporate Law Update), a shareholder of a company cannot claim against a third party for loss which the company has a legal right to claim from that same third party and which merely reflects loss suffered by the company itself.
  • Although SS PLC did not exist when the agreement was concluded, once it was incorporated it gained a right to enforce the agreement as a third party by virtue of section 1 of the Contracts (Rights of Third Parties) Act 1999 (the 1999 Act).
  • Once SS PLC acquired that right, BIG, as a shareholder of SS PLC, was no longer able to claim against Mr Smith, because its loss merely reflected loss suffered by SS PLC. The rule against reflective loss applied.

However, the court did not deny Mr Burgess’ claim. His loss was also “reflective” (in the broad sense) of loss suffered by SS PLC, because that loss flowed through his shareholding in BIG. However, the High Court noted that the rule against reflective loss only prevented a “direct” shareholder from bringing a claim, not an “indirect shareholder”.

The parties appealed and cross-appealed on both these points.

What did the court say?

Taking the second point first, the Court of Appeal concluded that the rule against reflective loss did not prevent an “indirect” shareholder from bringing a claim for the same reasons as the High Court had given. However, it is worth noting two points on this:

  • The court’s comments are only persuasive (obiter), because it had already concluded that there was no basis for a claim in the first place. However, they are instructive and important to note.
  • Only two of the judges (Lady Justice Asplin and Lord Justice Coulson) reached this conclusion. One judge (Lord Justice Arnold) said it was “well arguable” that the rule could prevent a claim by an “indirect” shareholder.

However, on the first point, the Court of Appeal overturned the High Court’s decision. The judges noted that SS PLC’s right to enforce the agreement was created by section 1(1) of the 1999 Act when SS PLC was incorporated. They also noted section 4 of the 1999 Act, which states: “Section 1 does not affect any right of the promisee to enforce any term of the contract.

In this case, the “promisee” referred to in section 4 was BIG and the “right” was BIG’s right to enforce the contractual terms of the agreement against Mr Smith. The Court of Appeal said that the purpose of section 4 was to ensure that, by creating a right for SS PLC to enforce the contract under section 1, BIG’s existing right was not eliminated. As a result, BIG was in fact entitled to claim against Mr Smith.

Mr Smith’s lawyers had argued that the purpose of section 4 was to prevent any risk that an existing contractual right would be destroyed by the creation of third party rights under the 1999 Act. However, it was not the 1999 Act which prevented BIG from claiming, but rather the rule against reflective loss. Section 4 had never been intended to prevent that rule from applying.

However, the court disagreed. The judges said that the rule against reflective loss could not be separated cleanly from rights created under section 1. If that were the case and the rule could extinguish an existing contractual right, section 4 would be “sidestepped”. It was not permissible to interpret the statute in any other way.

What does this mean for me?

The court’s comments on whether an “indirect” shareholder is barred by the rule against reflective loss are significant, as they leave this area of the law open. Should someone in a similar position to Mr Burgess bring a similar claim in the future, a court will not be required to follow the Court of Appeal’s comments in this case, and, although its conclusion will be persuasive, a court will be entitled to take Lord Justice Arnold’s “dissenting” comments into account.

The intersection of the 1999 Act and the rule against reflective loss is not likely to arise frequently, although this case shows that the 1999 Act can be engaged much more easily than might be expected.

There are some important takeaways from this case. A shareholder in a company who is looking to bring direct legal action against a third party should consider certain factors first.

  • Check for any overlap between the company’s and the shareholder’s rights. It is common for a joint venture agreement or investment agreement to provide rights in favour of both the company itself and one or more shareholders. Shareholders should bear in mind that, if 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 recovering personally.
  • Consider the impact of the Contracts (Right of Third Parties) Act 1999. It is common to exclude the 1999 Act from a written contract, albeit sometimes with exceptions in certain circumstances. So always consider carefully how (if at all) it is intended to apply, and articulate that clearly in the contract. But the Act also applies to oral contracts (as in this case) and contracts by conduct. It is important to examine all the factual circumstances to decide whether any third party rights have arisen. It might be that the rule against reflective loss never applies.
  • As we mentioned in our previous Corporate Law Update, in theory, the decision means that a shareholder could simply insert a single intermediate vehicle between themselves and the company to avoid becoming a direct shareholder to circumvent the rule. However, for the reasons set out above, this is not free from doubt and should be considered alongside any other factors pointing towards the use of an intermediate vehicle.

FRC publishes statement of intent on ESG challenges

The Financial Reporting Council (FRC) has published a statement of intent on environmental, social and governance (ESG) challenges facing companies.

In the statement, the FRC identifies several challenges to ESG reporting, which it breaks down into six “stages” of the reporting cycle.

  • Production. The paper acknowledges the challenges with measuring, managing and obtaining assurance on ESG data, particularly given there are multiple ESG thresholds and frameworks and information needs differ among stakeholders. However, it notes that reporting is often “aspirational” and “high level”, without providing information on progress or delivery.
  • Audit and assurance. Reported information should be robust and reliable. Any “lack of credibility” in ESG information can be addressed through independent assurance, but the FRC emphasises the importance of clarity over what is being assured and the level of assurance provided.
  • Distribution. Information should be accessible to interested parties. ESG information is often located in separate places at different dates and often not in an accessible or reusable format.
  • Consumption. ESG information is often difficult for users to obtain, is based on incomplete frameworks and differing methodologies and or is not timely. As a result, it is not as reliable as financial data and hampers effective decision-making by stakeholders.
  • Supervision. There is a need to supervise whether companies, auditors and assurance providers meet existing and future requirements. Increasing expectations entail a need for high standards and effective communication of regulatory expectations.
  • Regulation. International ESG standards need to work effectively alongside domestic frameworks, with any gaps at a national level being addressed. The UK’s regulatory framework often focuses on specific elements or challenges without embodying a clear, connected vision of the market. Greater coordination is required to ensure an effective reporting ecosystem.

To address these challenges, the FRC is proposing to take various actions in relation to each of these six stages. Key actions contemplated by the paper include the following.

  • To work with partners to improve the use of quality non-financial information in the boardroom and to engage with investors and others to ensure that ESG information meets their needs.
  • To consider the role of the UK Corporate Governance Code in ensuring boards are taking appropriate account of ESG issues when considering of the long-term success of their company and to incorporate these issues into future versions of the Guidance on the Strategic Report.
  • To develop guidance on how companies reporting under UK GAAP can consider the impact of climate-related issues on their financial statements.
  • To work with companies and information users to ensure that the developing framework for audit and assurance of ESG information meets their needs.
  • To consider ESG-related amendments within future revisions of auditing and assurance standards and to monitor the need for guidance on ESG-related audit and assurance.
  • To encourage the electronic distribution of ESG data and the development of a digital tagging system where information is accessible and useable.
  • To monitor investors’ approaches to ESG within their UK Stewardship Code reporting and work with other regulators to build an effective market for considering ESG issues in stewardship.
  • To continue to influence the development of IFRS, via the UK Endorsement Board, where there are specific issues relating to ESG.

Stakeholder responses to audit and governance reforms published

Following the Government’s consultation on reforms to audit and corporate governance that was published in March 2021 (see our previous Corporate Law Update), stakeholder organisations have begun publishing their responses.

In its response, a joint working group of the company law committees of the Law Society of England and Wales and the City of London Law Society notes the need to ensure that any reforms are proportionate, do not duplicate existing regulation and align properly with the recommendations of the recent review, headed by Lord Hill, of the UK’s Listing Regime. The working group also notes that companies have been facing an increasing cost of compliance and volume of regulation. It recommends taking the opportunity to consider simplifying existing corporate governance and reporting requirements to provide clarity and consistency and to reduce concerns that the burden of meeting requirements might deter companies from establishing themselves or listing in the UK.

In its response, the Chartered Governance Institute of UK and Ireland (CGI) focuses on three key issues that need to be addressed:

  • The expectation gap: the difference between the political, press and public expectation of a company auditor’s role and what the auditor perceives their role to be. In particular, the CGI asks whether the role of an auditor should be to demonstrate that a company is not in imminent danger of failure or simply to check the accuracy of the information in its accounting records.
  • The delivery gap: the fact that (in the CGI’s words) “the percentage of audits . . . of a good standard is, simply, not good enough and it seems to be getting worse”. The CGI says that much more work is required to foster a greater spirit of professional scepticism among auditors.
  • The challenger challenge: the view that the inability of challenger audit firms to enter the market for larger companies is less due to the dominance of the so-called “Big Four” than to the fact that challenger firms lack capacity and have not gained the same level of trust as the Big Four.

Also this week…

  • Companies House resumes same-day capital reductions. Companies House has confirmed that it is aiming to re-introduce its same-day service for capital reductions through its “Upload a Document Service” this week. The service will enable users, for a premium fee, to fast-track submissions of Form SH19. Submissions must be made by 11:00 a.m. to be processed on the same day, and court orders cannot be attached. Applications received after this time will not be processed until the next working day.
  • Companies House updates guidance on filing share buy-back returns. Companies House has updated its guidance on filing Form SH03 (return on purchase of shares), which needs to be stamped to indicate that stamp duty has been paid, when a company buys back its own shares. The guidance confirms that the temporary measures put in place to deal with the Covid-19 pandemic have now been made permanent. Going forwards, a company should send an electronic version of Form SH03 to HM Revenue & Customs (HMRC) and pay the appropriate stamp duty. HMRC will then issue a letter confirming payment of stamp duty, which the company should send to Companies House together with Form SH03.
  • EU consults on extending green taxonomy. The EU Platform on Sustainable Finance has published two documents that explore the extension of the European Union’s existing taxonomy framework for sustainable finance. In a public consultation, the Platform asks for views on extending the taxonomy to cover significantly harmful (SH) activities and no significant impact (NSI) activities in relation to environmental sustainability. In a separate draft report, the Platform considers the merit in creating a “social taxonomy” focus on basic human needs and infrastructure. The Platform has asked for comments on both papers by 27 August 2021.