Shareholders, holding companies and beneficiaries of trusts who suffer losses through a diminution in the value of their shareholding/trust interest are often prevented from pursuing actions to recover those losses by the “Reflective Loss Principle.”
The principle is clearly part of the law of Hong Kong, and its application is complex. But a recent landmark ruling by the Supreme Court in the United Kingdom in Sevilleja v. Marex Financial Limited [2020] UKSC 31 has rejected the broad application of the principle developed over the years, and questioned its justification and whether it should still be recognized. This calls into question whether it will remain an impediment to recovery by claimants in Hong Kong and elsewhere.
This has significant implications for the potential liability of directors and officers, professional trustees, auditors and other advisors, and may lead to a materially higher risk of liability.
In detail
What is the Reflective Loss Principle?
The principle is: where a company suffers a loss caused by a breach of duty owed to it – only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity to make good a diminution in the value of their shareholding where that merely reflects the loss suffered by the company. It applies notwithstanding that the company may have declined or failed to sue: the principle is not concerned with barring causes of action but with barring recovery of types of loss.
However, the principle doesn’t limit the right of a shareholder to sue where (1) the company has no cause of action, even where the loss is a diminution in the value of the shareholding, or (2) a shareholder suffers a loss separate and distinct from that suffered by the company. Each may sue to recover the loss caused to it, but damages may be limited by the rules preventing a double recovery.
Recent application in Hong Kong
The Hong Kong Courts have relied on the principle to strike out claims in the past. But recently, in Topping Chance Developments Ltd v. CCIF [2020] HKCA 478 (June 2020), the Hong Kong Court of Appeal, dealing with a claim brought by the holding company for the negligent audit of its subsidiaries, indicated that the complexities of the principle are such that it is unlikely that a claim would be struck out at an interlocutory stage.
The Marex Financial decision
Marex Financial had obtained judgments against two companies in the British Virgin Islands (BVI) controlled by Mr Sevilleja.
Mr Sevilleja then allegedly stripped assets from those companies, allegedly to evade enforcement of those judgments.
Marex Financial then sued Mr Sevilleja personally for his conduct. Mr Sevilleja sought to bar the claim on the basis of the principle; that is, Marex Financial’s loss was merely reflective of the loss incurred by the BVI companies, and therefore could not be pursued. The U.K. Court of Appeal agreed, holding that the principle applied to claims by creditors of a company, and hence Marex Financial was barred from suing.
The U.K. Supreme Court unanimously rejected that ruling. It held that the cases developing the principle were wrongly decided. The majority held that the rule, properly understood, is a rule of company law; not a general rule as to the recovery of loss. It applies in only limited situations to prevent a shareholder from claiming in respect of a diminution in the value of their shares, or a diminution in distributions they would otherwise receive from the company, where that diminution merely reflects the loss suffered by the company due to a wrong done to it and for which the company could bring its own claim. It did not prevent Marex Financial, as a creditor of the victim companies, from pursuing Mr Sevilleja directly.
The minority opinion went further, questioning whether the rule should still be recognized at all. In particular, the minority criticized the “bright line” maintained by the majority opinion as producing simplicity at the cost of potentially serious injustice to a shareholder who has suffered loss which is different from that suffered by the company.
Implications of the decision for boards, trustees and other service providers in Hong Kong
The principle is clearly a part of the law of Hong Kong, and serves to limit the potential liability of boards, professional trustees, auditors and others to claims by shareholders or beneficiaries for losses they may have suffered. But the Marex Financial judgment raises a real issue in Hong Kong and elsewhere: will it survive here and, if so, what is its scope? Will the potential for liability expand?
Decisions of the U.K. Supreme Court are not binding in Hong Kong, but are highly persuasive. Therefore, it is foreseeable that the Court of Final Appeal may, in the right case, reconsider the principle in light of the Marex Financial judgment.
The situation is therefore in a state of flux – with implications for boards, professional trustees, auditors and, of course, their insurers.
It is therefore important that trustees and others look to strategies to help mitigate this uncertainty. Where possible or appropriate, it may be time to revisit engagement terms, trust deeds or the like. For example, in another important recent case (Zhang Hong Li v. DBS Bank and others, November 2019, a case about trustee liability) the Court of Final Appeal has made it clear that the duties of a trustee must be assessed in light of the express terms of the trust deed, and that well-drafted limitation, exclusion or exoneration clauses in the trust deed will be effective to protect the trustee from liability. That case arose from claims in relation to risky investment decisions made on behalf of an investment company owned by the trust.
This article is contributed by Gary Seib, Partner, Dispute Resolution, and Clement Chui, Senior Associate, at Baker McKenzie
