Rule against reflective loss: A comparative analysis of English and Dutch law

Patrick Swain
Debevoise & Plimpton, London
pswain@debevoise.com

Christopher Boyne
Debevoise & Plimpton, London
cboyne@debevoise.com

Catalina Diaconeasa
Debevoise & Plimpton, London
cdiaconeasa@debevoise.com

Luke Duggan
Debevoise & Plimpton, London
lduggan@debevoise.com

Emille Buziau
Florent, Amsterdam
emille.buziau@florent.nl

Tiffany Zandbergen
Florent, Amsterdam
tiffany.zandbergen@florent.nl

Introduction

The rule against reflective loss has been formulated and applied in case law to date in both England and Wales, and the Netherlands. The suggestion that the rule is driven by an intention to avoid double recovery has been rejected in England and Wales, pursuant to the recent Supreme Court judgment in Marex. The avoidance of double recovery is, however, one of the considerations upon which the rule is based in the Netherlands.

While there are currently no exceptions to the rule in England and Wales, there is an exception under Dutch law, essentially, where the wrongdoer has breached a specific duty of care owed to the shareholder.

Minority shareholders in both jurisdictions may argue, under certain circumstances, that they have been unfairly prejudiced (in England and Wales) or that they are (what is commonly known as) ‘strangled shareholders’ (in the Netherlands). The only remedy awarded in such cases in the Netherlands is the compulsory acquisition of the ‘strangled’ shareholder’s shares, while in England and Wales, this is the most awarded – but not only – remedy.

The rule against reflective loss has been subject to criticism from academics and legal scholars in both jurisdictions: in England and Wales, the criticism has revolved around the ever-expanding nature of the rule until the recent Supreme Court judgment in Marex, while in the Netherlands, academics have voiced concerns that the rule is too restrictive and have proposed a more pragmatic approach to the rule.

1. Explain the rule against reflective loss in your jurisdiction and the rationale upon which it is based.

England and Wales

The rule against reflective loss was first explicitly set out by the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 and it provides that shareholders cannot bring a claim based on any fall in the value of their shares or distributions that is the consequence of loss sustained by the company in circumstances where the company has a cause of action against the same wrongdoer.

As to the rationale behind the rule, this was recently restated by the majority of the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31. Lord Reed (who delivered the lead judgment) stated that the basis for the rule is that, where a shareholder has suffered a diminution in the value of its shares, or a reduction in the amount of distribution that it receives from the company, as a result of actionable damage caused to the company by a wrongdoer, English law does not recognise that the shareholder has suffered a loss that is separate and distinct from the loss suffered by the company itself. In that case, the only legitimate claimant is the company itself.^[1]

Lord Reed expressly rejected the proposition that the rationale for the reflective loss principle was premised on preventing double recovery; therefore, the approach adopted by previous authorities that had held that this was the case^[2] was misconceived. The rule is a ‘substantive rule of law’ and not ‘a procedural rule concerned only with the avoidance of double recovery’. Although double recovery is an issue to which the courts need to be alive, it can be addressed through several procedural or substantive means without relying on the reflective loss principle.

The Netherlands

The rule against reflective loss in the Netherlands is the same as in England and Wales in that it prevents a shareholder from recovering a loss that is merely reflective of the company’s loss. Moreover, as is the case in England and Wales, if the company does not actually have a cause of action against the wrongdoer, then the rule against reflective loss would not operate in this case to bar the shareholders’ recovery and the usual rules on damages would apply.

However, the rationale behind the rule differs in the Netherlands, where the rule is based on considerations that include, but are not limited to, the following:

1. Direct compensation affects the order of priority between shareholders and creditors.
2. Direct compensation may affect the order of priority between individual shareholders.
3. Direct compensation may result in the third party compensating both the shareholder and the company, and/or double recovery.
4. The rule against reflective loss prevents litigation by too many individual shareholders (ie, the ‘floodgates’ argument).

2. Are there any exceptions to the rule against reflective loss in your jurisdiction? If so, which ones?

England and Wales

There are currently no exceptions to the rule against reflective loss in England and Wales. Prior to the Supreme Court’s decision in Sevilleja v Marex Financial Ltd [2020] UKSC 31, the courts developed an exception to the rule, namely that there were certain special circumstances where a shareholder could recover loss, flowing from the company’s loss, where the company was unable (rather than unwilling) to pursue its cause of action.

The case of Giles v Rhind [2002] EWCA Civ 1428 was the leading authority on this exception. In that case, Messrs Giles and Rhind were the directors of a food company and were parties, together with the company, to a shareholders’ agreement.

One of the terms of the shareholders’ agreement stated that the parties to it would not use confidential material relating to the company. Having resigned and sold his shares following a disagreement with Mr Giles, Mr Rhind breached the agreement and used confidential information to divert a contract from its former company to his new business. The company brought proceedings, but they were abandoned due to lack of finance. The company was placed in administrative receivership and was essentially rendered unable to pursue its claim for damages.

Mr Giles suffered losses as a result (eg, he lost the interest on loans he had made to the company). The duties allegedly breached by Mr Rhind were owed to the company, but they were also terms of the shareholders’ agreement to which Messrs Giles and Rhind were parties.

The Court of Appeal held that Mr Giles could pursue his claim for breach of the agreement, including damages for his loss being the diminution in the value of his shareholding, which would, in other circumstances, have been disallowed as reflective loss. The court determined that the rule against reflective loss should not apply in circumstances where a company is forced to abandon its claim by reason of impecuniosity attributable to the wrong that has been done to it, nor in any other instance where the wrongdoer has prevented the company from commencing legal proceedings.

However, the authorities giving rise to this exception were expressly overruled by the Supreme Court in Marex. It is now clear that ‘Giles v Rhind is dead for all intents and purposes on any straightforward interpretation of Marex’.^[3] The same would appear to be true of ingenious exceptions developed over the years to avoid the rule, such as by crafting relief to ensure awards were made for the benefit of the company and not the individual claimant shareholder.

The Netherlands

The rule against reflective loss in the Netherlands is subject to an exception, which was first introduced by the Supreme Court in the case of Poot/ABP in 1994 and further developed by the Supreme Court in the case of Tuin Beheer/Houthoff in 2007. In particular, in Poot/ABP, the court explained that the rule is subject to an exception in cases where (even if the company has a cause of action against the wrongdoer), the wrongdoer has breached a specific duty of care owed to the shareholder. This exception was subsequently supplemented by the Supreme Court in Tuin Beheer/ Houthoff (Supreme Court 16 February 2007, NJ 2007, 256). The Supreme Court explained that a shareholder who wants to claim reflective loss must prove the existence of additional circumstances, for example, that the third party intended to harm that shareholder in particular.

3. Is the rule against reflective law codified in your jurisdiction?

England and Wales

No, the rule against reflective loss is not codified in England and Wales. The rule has been developed in English case law.

The Netherlands

The rule against reflective loss is not codified in the Netherlands either. The rule has been developed by the judiciary.

4. What are the key cases regarding the rule against reflective loss in your jurisdiction? Why are these cases important?

England and Wales

The key recent decisions relating to the rule against reflective loss are: (1) the decision of the Supreme Court in Sevilleja v Marex [2020] UKSC 31; (2) the decision of the Court of Appeal in Broadcasting Investment Group Ltd v Smith [2021] EWCA Civ 912; (3) the decision of the Judicial Committee of the Privy Council in Primeo Fund v Bank of Bermuda (Cayman) Ltd & Anor (Cayman Islands) [2021] UKPC 22; and (4) the decision of the High Court in Breeze v Chief Constable of Norfolk Constabulary [2022] EWHC 942 (QB).

The above cases are important as, taken together, they confirm that:

• the rule against reflective loss could apply to direct shareholders, indirect shareholders and former shareholders of a company;
• the rule against reflective loss does not apply to creditors of a company, regardless of whether they are also shareholders in the company, so long as a creditor’s claim is not brought in its capacity as a shareholder;
• there is no exception to the rule against reflective loss where the company is unable to pursue its cause of action;^[4]
• the rule is a substantive one, as opposed to a procedural one concerned only with the avoidance of double recovery;^[5] and
• the relevant time to determine whether the rule applies is when the claimant suffered the loss arising from the relevant breach of obligation by the relevant wrongdoer.^[6]

The Supreme Court decision in Marex, in particular, has been instrumental with regard to clarifying the scope of the rule. In that case, Marex Financial Limited (‘Marex’) obtained a judgment from the English court against two companies incorporated in the British Virgin Islands (BVI) owned by Mr Sevilleja. Marex alleged that after the judgment was provided in draft, Mr Sevilleja took the opportunity to dishonestly asset-strip the BVI companies such that they would be unable to pay the judgment debt to Marex.

Subsequently, the BVI companies went into liquidation. Marex obtained permission to serve English proceedings on Mr Sevilleja out of the jurisdiction (under the tort gateway). Mr Sevilleja issued an application challenging the jurisdiction of the English Courts. At first instance, the High Court dismissed the jurisdiction challenge and rejected Mr Sevilleja’s argument that, even if Marex otherwise had a cause of action in tort, the reflective loss rule barred its ability to recover compensation. The case then went to the Court of Appeal, which allowed Mr Sevilleja’s appeal holding that Marex’s claim to recover the judgment debt, together with interest and costs, was found to be barred by the rule against reflective loss. According to the Court of Appeal, the rule would apply to creditors who were not shareholders of the company in the same way as it had been applied to shareholder creditors. This was the first time that the rule was held to apply to an individual who was purely a creditor of a company.^[7]

Marex then appealed to the Supreme Court. Lord Reed (delivering the lead judgment) made it clear that the principle did not apply to non-shareholder creditors. The principle applied only ‘where claims are brought by a shareholder in respect of loss which he has 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’, irrespective of whether the company in fact recovers its loss in full. The Supreme Court therefore allowed Marex’s appeal.

The Netherlands

The key cases on the rule against reflective loss in the Netherlands are: (1) Supreme Court 2 December 1994, NJ 1995, 288 (Poot/ABP); (2) Supreme Court 16 February 2007, NJ 2007, 256 (Tuin Beheer/Houthoff); and (3) Supreme Court 12 October 2018, NJ 2021, 176 (Potplantenkwekerij).

The significance of the above cases is as follows:

• The rule against reflective loss was first formulated in the seminal case of Poot/ABP. The court held that the rule prevented shareholders from claiming reflective loss in the Netherlands. Instead, only the company’s board of directors should be able to recover the damage, thereby increasing the company’s value/mitigating any diminution in the value of the company’s shares. The Supreme Court in that case also introduced an exception to this rule, as set out above.^[8]
• The Supreme Court in Tuin Beheer/ Houthoff confirmed the rule as formulated in Poot/ABP. It also supplemented the exception to the rule against reflective loss.^[9]
• The case of Potplantenkwekerij is the most recent Supreme Court authority, which once again confirms the rule as formulated in Poot/ABP.

In Potplantenkwekerij, a Dutch municipality took several administrative decisions, preventing a company and its sole shareholder from developing a piece of land. The shareholder (but not the company) successfully challenged these decisions in court, on the grounds that the decisions of the municipality were unlawful towards the shareholder. However, given that the company did not challenge the administrative decisions, those decisions came into effect. This meant that there was no unlawful act towards the company itself.

In follow-up proceedings, the holding company (ie, the corporate shareholder) claimed damages from the municipality, including in respect of the diminution of the value of shares in the company. The Supreme Court rejected the municipality’s reliance on the Poot/ABP rule against reflective loss. The court held that the rule did not apply in this case because there was no unlawful act in relation to the company. Therefore, given that the company did not have a cause of action on the facts of this case, the rule was not engaged.

For the avoidance of doubt and consistent with the approach under English law, the rule against reflective loss in the Netherlands does not apply to creditors who bring claims in their capacity as creditors (as confirmed in Tuin Beheer/Houthoff), but it may apply to former shareholders, as well as indirect shareholder of a company (see, eg, the decision in Poot/ABP).

5. What remedies or protections (if any) are available to shareholders to vindicate their rights?

England and Wales

Undoubtedly, there will be cases where the company fails to pursue a right of action which, in the opinion of a shareholder, ought to be pursued, or compromises its claim for an amount which, in the opinion of the shareholder, is less than its full value. In those cases, and provided that that opinion is shared by a shareholder majority, that majority may be able to force the company to act by passing an appropriate resolution at a general meeting.

If the shareholder is in a minority and ‘if (put shortly) those in control of the company are abusing their powers’,^[10] the minority shareholders also have rights under the usual company law protections. These protections are available in situations where, for example, the directors of a company have breached the duties imposed on them by sections 171–177 of the Companies Act 2006 (‘CA 2006’) or where the affairs of the company are being or have been conducted in a manner that is unfairly prejudicial to the interests of its shareholders generally or some part of its shareholders.

In particular, the main company law protections available to shareholders are:

• the presentation of an unfair prejudice petition under section 994 of CA 2006;^[11]
• the bringing of a derivative action under section 260 of CA 2006;^[12] and
• the presentation of a petition for the winding up of the company on just and equitable grounds pursuant to section 122(1)(g) of the Insolvency Act 1986.^[13]

However, if the company’s powers of management are not being abused and the majority of shareholders properly approve of the company’s decision not to pursue the claim or its decision to enter into a settlement, then the minority shareholder will not be able to pursue a personal action, as the rule against reflective loss would bar that action.

The Netherlands

In the Netherlands, there is a statutory concept similar to the unfair prejudice petition in England and Wales, namely what is commonly known as the case of a ‘strangled shareholder’; the only remedy awarded in such a case under Dutch law is the compulsory acquisition of that shareholder’s shares. The test is whether a shareholder’s rights or interests are harmed in such a way that the shareholder can no longer reasonably^[14] be expected to continue to hold shares in the company (a ‘strangled shareholder’). The shareholder may file a claim against the majority shareholders and/or the company seeking the compulsory acquisition of the shareholder’s shares by the other shareholders at a value that is typically determined by court-appointed experts.

The test to assess whether the shareholder has been ‘strangled’ is an objective one: there is no need to show bad faith and/or an intention to cause prejudice on the part of the company or its majority shareholders. The usual cases in which a shareholder has succeeded in its claim have been those where: (1) the representative of the shareholder has been dismissed as a director of the company; (2) the directors have decided against declaring dividends, but at the same time have increased the directors’ salaries (unreasonably so); or (3) the company’s directors have transferred company assets at an undervalue, to related parties. In such cases, the strangled shareholder may claim the loss arising from the decrease in share value, pursuant to the actions of the company’s directors and/ or majority shareholders.

Aside from the ‘strangled shareholder’ scenario, shareholders may also be able to invoke their usual rights under Dutch law, depending on: (1) the percentage of their shareholding; and (2) the specific provisions in the company’s articles of association and/or shareholders’ agreement. For example, if the relevant shareholders hold the required number of shares, they could pass a shareholders’ resolution at a general meeting, instructing the company’s board to recover damage that was inflicted on the company, or even suspend or dismiss the relevant directors if they refuse to do so. Otherwise, the shareholders could make an application to court, seeking an order that the directors recover the loss or that the directors be replaced with interim directors who would then be in charge of recovering the relevant loss.

For the avoidance of doubt, it is not possible for the shareholders of a company to bring a derivative claim under Dutch law.

6. What trends have you identified in respect of the rule against reflective loss? How do you see this rule developing in the future?

England and Wales

In England and Wales, ‘the whole concept of reflective loss has been controversial and subject to judicial ebb and flow in so far as its scope and ambit are concerned since its inception in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2).’^[15] Indeed, prior to the Supreme Court decision in Marex, the expanding principle of reflective loss (and, in particular, subjecting non-shareholder creditors to the rule) had been compared to ‘some ghastly legal Japanese knotweed’, which promised to distort large areas of the ordinary law of obligations unless drastic steps were taken to prune it.^[16] Ultimately, in Marex, the majority were content to narrow the doctrine, whereas the minority advocated abolishing it. The recent decisions set out above^[17] have, however, clarified and defined the contours of the rule against reflective loss to a significant extent. Indeed, the Court of Appeal has recently rejected arguments that the law on reflective loss is too ‘uncertain and developing’ post-Marex.^[18] Nonetheless, given the range of novel fact patterns that could arise in the future, it may be that the application of the rule against reflective loss will be subject to further judicial fine-tuning.

The Netherlands

The rule against reflective loss and case law relevant to this rule have been the subject of a lively academic debate among Dutch legal scholars in recent years. In particular, since the remedy of ordering the compulsory acquisition of a ‘strangled’ shareholder’s shares^[19] was introduced in Dutch law in 2012, it has been argued that Dutch law should take a more pragmatic approach to the rule, as opposed to the arguably strict approach that the Supreme Court has been applying since the decision in Poot/ABP. It has also been suggested that compensation for reflective loss should not be excluded a priori.

In line with the more pragmatic approach mentioned above, Dutch legal scholars, such as Professor Levinus (Vino) Timmerman, have argued that additional exceptions to the rule against reflective loss should apply in the following circumstances:

1. where the minority shareholder claims compensation for reflective loss: this exception has been proposed by academics on the basis that minority shareholders are often powerless and are not able to direct the company’s board of directors to recover the damage inflicted on the company;
2. if the company at issue is a small company with a small number of shareholders: the ‘floodgates’ scenario regarding a multiplicity of proceedings by individual shareholders is not applicable in the case of small companies with only a small number of shareholders; therefore, it has been argued that the rationale for the rule against reflective loss^[20] does not operate here and that shareholders should therefore be able to rely on an exception to the rule; and/or
3. if the loss has crystallised: academics have argued that shareholders should be allowed to recover reflective loss in cases where the loss has crystallised, for example if the company has become insolvent.

Whether any of the above proposed exceptions will be considered and developed in future Dutch case law remains to be seen. As highlighted by Dutch academics, there is certainly merit in considering a less restrictive approach insofar as the rule against reflective loss is concerned.