[Rohan Deshpande practices as a Counsel at the Bombay High Court, and Karan Kamath is a 2020 B.A. LL.B. (Hons.) graduate from Symbiosis Law School, Pune. The authors would like to thank Mihir Naniwadekar for his comments on a draft version]
The UK Supreme Court in its decision dated July 15, 2020 in Sevilleja v. Marex Financial Ltd. had to determine whether the rule against ‘reflective loss’ barred a creditor from directly suing the director of a company for asset-stripping the company. Seven judges of the UK Supreme Court unanimously allowed the appeal and held that a creditor was entitled to recover damages in tort from a director.
Sevilleja, a director of two companies incorporated in the British Virgin Islands, was alleged to have induced violation and caused wrongful loss of Marex’s rights under a UK Commercial Court judgment which awarded payment of monies by these two BVI companies to Marex. After a confidential draft of the Commercial Court judgement had been shared with the parties, Sevilleja asset-stripped the London-based bank accounts of the BVI companies and obtained personal control over company funds so as to frustrate payment to Marex, and later placed these companies under liquidation in the BVI. Sevilleja contended that the claim in respect of dues under the Commercial Court judgement was barred by the rule against reflective loss, an argument that was rejected by the UK Supreme Court.
Rule against reflective loss and applicability to creditors
The rule, as devised by the Court of Appeals in Prudential Assurance Co. Ltd. v. Newman Industries Ltd. [(1982) Ch 204] states that if the company suffers losses leading to resultant diminution in its share price, then shareholders could not recover against such diminution from those responsible for the losses because, “… such a ‘loss’ is merely a reflection of the loss suffered by the company.”
The House of Lords had the occasion to consider this principle in Johnson v. Gore Wood & Co. In his leading speech, Lord Bingham confirmed that shareholders cannot recover against the diminution in share price, on the same basis as that adopted in Prudential: that the ‘loss’ was merely a reflection of the company’s loss. However, in his concurring speech, Lord Millet adopted a different and wider rationale, by using the principle of double recovery as the basis for the rule in Prudential. This principle states that if, in an insolvency action, for essentially the same debt two persons have concurrent claims based on separate causes of action, then courts should not allow double recovery of that debt (The Halcyon Skies [(1977) QB 14]).
Lord Millet theorised that a share is proportional ownership of a company’s assets and, thus, diminution in assets is proportionally that in shares. Thus, in insolvency, a company and its shareholder had concurrent claims, for what was fundamentally the same debt. When the company had settled an undervalued claim with a third person, then shareholders were barred by the principle of double recovery. However, shareholders could not be allowed to recover and bar the company instead, because of two ‘policy reasons’: (a) that directors who are also shareholders will be tempted to settle the company’s claim at a lower value, and then seek to recover the remaining debt as shareholders; and (b) that shareholders, by commencing or continuing proceedings for their claims, could frustrate liquidators’ attempts to settle company debts with third persons. Thereafter, without an explanation, he extended this reasoning to “… all other payments which the shareholder might have obtained from the company if it had not been deprived of its funds” and observed that payments to claimants other than shareholders should also be governed by the rule, as their loss was also indirect and reflective of diminution in assets.
Later cases followed this interpretation of Lord Millet and applied it to situations where claims were brought in capacities other than that of a shareholder. For example, in Gardner v. Parker, a shareholder brought claims, which included claims in his capacity as a creditor. The Court of Appeal, on the basis of Lord Millet’s interpretation, held that the rule against reflective loss extended to claims brought by shareholders in their capacity as a creditor seeking repayment of debt. Thus, the principle as originally envisaged as a restriction on claims qua shareholders was extended in its applicability to creditors and other claimants.
A course correction in Sevilleja
As stated above, the decision in Sevilleja was unanimous; however, the minority view of three judges (authored by Lord Sales) allowed the appeal on a larger question (discussed below). The majority view was authored by Lord Reed (with whom Lady Black and Lord Lloyd-Jones agreed, with Lord Hodge agreeing though he wrote a separate concurring opinion). Lord Reed held that the rule against reflective loss had no applicability outside of company law, and did not apply to a company’s unsecured creditors for claims in tort.
Lord Reed observed: “The rule in Prudential is limited to claims by shareholders that, as a result of actionable loss suffered by their company, the value of their shares, or of the distributions they receive as shareholders, has been diminished.” Since the law did not recognise this loss as legally distinct from that of the company, the rule had restricted applicability to shareholders, and other claims by shareholders or other persons for losses which did not fall within this description were stated to be permissible “… even if the company has a right of action in respect of substantially the same loss.”
In so far as Lord Millet’s broader interpretation of the rule in Johnson, Lord Reed disagreed with it for several reasons. Firstly, it was not axiomatic that share value was proportional to value of company’s assets. Secondly, the rule in Prudential was a corollary of the rule in Foss v. Harbottle – that when a company is wronged, the proper claimant is the company itself, and not shareholders in their personal capacity. Instead, Lord Millet improperly relied on the principle of double recovery, holding that once the company had recovered, albeit an undervalued claim, then shareholders ought to be prevented from making a second claim. Thirdly, the rationale for applying the rule to shareholders when their claims arise otherwise than in their capacity as shareholders blurred the distinction of corporate personality and carved an exception to Salomon v. Salomon without any pressing reasons. For example, in Gardner, the claim qua creditor was barred because the creditor was also a shareholder, piercing the corporate veil. The benefit of corporate personality cannot be denied to a shareholder without due justification.
Thus, the view expressed by Lord Bingham in Johnson was stated to be preferable, and the common law development based on Lord Millet’s view was deemed to be erroneous and later precedents were held to be wrongly decided as far as they applied the same.
Implications for India
The company as the proper plaintiff rule in Foss v. Harbottle has been widely applied in India. Reference may be made inter alia to the decision of the Federal Court in Satya Charan Law v. Rameshwar Prasad Bajoria, wherein it was recognised as “well-settled” that, “in order to redress a wrong done to a company or to recover monies or damages alleged to be due to the company, the action should prima facie be brought by the company itself.”
It may be noted that there is limited jurisprudence available in India in relation to a claim for damages in tort against a company or its directors. Nevertheless, no restriction barring creditors from recovery based on the principle of reflective loss (which existed in the UK prior to the decision in Sevilleja) has been applicable in India.
However, the clarity provided by Sevilleja and its resultant impact on the common law is likely to affect future judicial deliberation if a claim in tort is brought by creditors before the Indian courts. This would be significant, as a claim for damages in tort against directors personally or against a company would have to be agitated as a claim at common law. The extant statutory regime is confined to specific claims by creditors against a company while it is undergoing corporate insolvency resolution process (CIRP) or liquidation under the Insolvency & Bankruptcy Code, 2016 (IBC).
In the course of these proceedings under the IBC, creditors can approach the National Company Law Tribunal (NCLT) under section 47 of the IBC seeking voidability of undervalued transactions entered into by the company. Under section 49 of the IBC, in case of an undervalued transaction deliberately entered into by a company with an intent to defraud and keep the assets of the company beyond the reach of a claimant, the NCLT can pass appropriate orders including restoring the position prior to the transaction. Lastly, during CIRP or liquidation, if it is found that any business of the company has been carried on with intent to defraud creditors or for any fraudulent purpose, the NCLT may, on application by the resolution professional of the company, make an order that persons who were knowingly parties to the carrying on of such business shall be liable to contribute to the assets of the company. The benefit of any such orders would, however, enure to the company, and not to the individual creditor.
The decision in Sevilleja marks a substantive departure from the principle evolved in Prudential and extended to other claimants in Johnson and later cases. It is pertinent to note that while the seven judges of the UK Supreme Court were unanimous in holding that the rule against reflective loss had no applicability to creditors, their views were divided concerning the continued applicability of this rule to shareholders. The majority view confirmed the previous position in respect of shareholders, holding that shareholders could not separately sue for diminution in the value of their shareholding which was consequent to the loss suffered by a company due to the acts of its director. The majority opined that such loss did not attain the character of damages in law.
On the other hand, the minority view (authored by Lord Sales) expressed that the reflective loss principle had no applicability either to the law of damages or to company law. The minority sought to distinguish the straightjacketed approach in Prudential and noted that there may be cases where a shareholder suffers a loss which is distinct from that suffered by the company. Adoption of a case by case approach after taking into account expert evidence on valuation of shares was advocated, without resorting to exclusion of claims merely based on the rule. Therefore, the conflicting opinions expressed in Sevilleja in context of the rule being applicable to shareholders are likely to ignite further debate in the future.
– Rohan Deshpande & Karan Kamath