“When Will My Reflection Show Who I am Inside?”- Reflective Loss in a Shareholder Context

INTRODUCTION

“When will my reflection show who I am inside?” is the climax from the song “Reflection”, sung by Fa Mulan in the much-beloved Disney movie, Mulan (the animated movie; not the live-action movie, which is not so beloved), after a failed matchmaking session.  

As with many unexpected coincidences in life, Fa Mulan’s famous question above is also asked by shareholders when they suffer a diminution in their shareholding.  In the premises, will their loss be “reflected” in the sense that they cannot claim for the losses suffered by the company?  Or will their reflection show what their losses are inside? (No pun intended.)

WHAT IS THE REFLECTIVE LOSS PRINCIPLE?

As aptly described by YA Datuk Nallini Pathmanathan FCJ in the recent Federal Court case of Auspicious Journey Sdn Bhd v Ebony Ritz & 5 Ors (Civil Appeal No.: 02(f)-53-06/2019(W)), the reflective loss principle:

“dictates that a personal claim may only be brought by a member against the directors of a company where he can demonstrate 1) a breach of duty owed to him personally and 2) personal loss separate and distinct from that suffered by the company.  Thus, no action lies at the suit of a member suing in that capacity to make good a diminution in the value of his shareholding, where it is merely a reflection of the loss suffered by the company.“

HISTORICAL ORIGINS AND THE SUBSEQUENT APPLICATION

The roots of the reflective loss principle can be traced back to Foss v Harbottle (1843) 67 ER 189 (“Foss v Harbottle“), while subject to specific exceptions; the plaintiff in an action in respect to a wrong alleged to have been committed against a company is the company. 

In Foss v Harbottle, two shareholders, Richard Foss and Edward Turton, commenced a legal action against a company’s promoters and directors, alleging that they had misused company assets and property. The Court rejected such claims, holding that the proper plaintiff was the company, and not individual shareholders.

Here Wigram VC explained, in reference to the shareholders assuming the power to sue:

“It was not, nor could it successfully be, argued that it was a matter of course for any individual members of a corporation thus to assume to themselves the right of suing in the name of the corporation. In law the corporation and the aggregate members of the corporation are not the same thing for purposes like this; and the [491] only question can be whether the facts alleged in this case justify a departure from the rule which, prima facie, would require that the corporation should sue in its own name and in its corporate character, or in the name of someone whom the law has appointed to be its representative.”

In dismissing the claim, the Court established, among others, the “proper plaintiff rule”.

At the foundation of the rule in Foss v Harbottle is the principle that a company is a separate and distinct legal entity, thus leaving shareholder losses as separate events. In short, these foundational elements form the basis of the principle against reflective loss, arising in the seminal case of Prudential Assurance v Newman Industries No. 2 [1982] Ch 204 (“Prudential“).  

Malaysian cases have referenced and approved of the above judgements In the Court of Appeal case Pioneer Haven Sdn Bhd v Ho Hup Construction Co Bhd & Anor and Other Appeals [2012] 3 MLJ 616 (“Pioneer Haven“) the new board of directors of Ho Hup Co Bhd filed suit to have the joint development agreement voided, on the grounds of, among others, a failure to obtain shareholder approval, pursuant to s 132C of the Companies Act 1965.

The Court of Appeal, in deciding whether Ho Hup Co Bhd is the proper plaintiff to sue, explained the following:

“[161] Bearing in mind that the company being a legal person is distinct from its members, whose individual identities are substantially merged in the corporate structure, the rights and liabilities arising out of the company’s affairs are channeled through the company.”

“[162] For example, if there are liabilities, the company’s creditors are not able in general to sue the members for the company’s debts.

[163] Likewise, as far as rights were concerned, where wrongs were done to the company, in general, the cause of action belonged to the company (ie Bukit Jalil, in this case) and an individual member (such as Ho Hup), has no standing to enforce it. Moreover, members were in general, bound by the decision of the majority of their number.”

“[164] The above principle embodies the ‘proper plaintiff rule’, as articulated in Foss v Harbottle (1843) 2 Hare 461 (Vice-Chancellor’s Court, England) ie, that the proper the plaintiff in a suit for the enforcement of a corporate right, is the company itself.”

WHAT DOES LAW SAY?

In Prudential, the Defendants, in breach of their duties as the director of the company, transferred assets at an undervalued rate to an affiliated company. To facilitate such, the defendant secured the company to issue a misleading circular to its shareholders. This act of wrongdoing not only caused a loss to the company as a whole (a devaluation of its net asset value) but also a hypothetical loss to the valuation of the plaintiffs’ shareholdings.

However, the Court, in respect of the availability of the plaintiffs to file suit, stated that:

“In our judgment the personal claim is misconceived. It is of course correct, as the judge found and Mr. Bartlett did not dispute, that he and Mr. Laughton, in advising the shareholders to support the resolution approving the agreement, owed the shareholders a duty to give such advice in good faith and not fraudulently. It is also correct that if directors convene a meeting on the basis of a fraudulent circular, a shareholder will have a right of action to recover any loss which he has been personally caused in consequence of the fraudulent circular; this might include the expense of attending the meeting. But what he 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 of the value of net assets of the company, in which he has (say) a 3% shareholding. The plaintiff’s shares are merely a right of participation in the company on the terms of articles of association.

The shares themselves, his right of participation are not directly affected by the wrongdoing. The plaintiff still holds all the shares as his own absolutely unencumbered property. The deceit practised upon the plaintiff does not affect the shares; it merely enables the defendant to rob the company ….”

Page 366 in the case of Prudential Assurance v Newman Industries No. 2 [1982] Ch 204

What may be seen from the extract is simple. Firstly, that the loss suffered by a company is separate from that of the shareholder, therefore, the case that “he cannot… recover damages merely because the company in which he is interested has suffered damage”. Secondly, a loss suffered by a shareholder via a diminution in value cannot be seen or considered a personal loss; thus, such cannot be claimed or brought via a shareholder’s personal action. 

It is important to note that these finding where applied and accepted within Malaysia, in cases such as Pioneer Haven, and specifically within the case of Mak Siew Wei v Yeoh Eng Kong & Other Appeals [2020] 1 MLJ 258 (“Mak“) where the Court went on to quote the passage previously cited. Here, the plaintiff was a director and substantial shareholder of Scan Associates Bhd, who alleged misrepresentations and deceit regarding the company’s financial statuses. The learned Nallini Pathmanathan JCA (as her Lordship then was) went on to adopt and approve the principle against reflective loss, highlighted Prudential. 

Furthermore, the question was again asked in in Foo Toon Yeong & Ors v Jonah Wong Ching Hang [2019] 6 MLJ 640 where the Court of Appeal dismissed the Appellants’ claim as they had no capacity to sue. The Court of Appeal agreed with the Respondent’s submission, resting primarily on the decision in Pioneer Haven, where it was held that “when a wrong is done to the company, the company itself is the only person who can sue”.   Hanipah binti Farikullah JJCA discussed at length the dicta in Prudential and Johnson v Gore Wood & Co [2000] UKHL 65, which found following in Mak and concluded a company can only recover the loss that it suffered (not a shareholder), even if the conduct complained about gave the shareholder and not just the company, a cause of action:

“[29] As a general rule, the company is the proper claimant in an action to recover the loss that itself has suffered. A shareholder cannot in substance avoid that rule by bringing a personal claim to recover damages for loss in the value of his shares merely because the company in which he is interested has suffered damage, even if the conduct of which he complains gave him personally, and not the company alone, a cause of action.

…

[34] In the light of these principles, in our view, the plaintiffs are not the proper parties to sue for a debt owed by GLBSB to FTE. We agreed with the defendant’s submission that if FTE wants to recover monies owed to it by GLBSB, FTE should file the claim, not the plaintiffs. In that regard, it is undisputed that the plaintiffs consider themselves to be FTE, and they assume that since they collectively own FTE, they have a right to sue the defendant, which is a serious misconception.”

WHAT DOES MAREX SAY?

The United Kingdom Supreme Court revisited the parameters of the reflective loss principle in Marex v Sevilleja [2020] UKSC 31 (“Marex“).  In short, a creditor brought an action in Marex, where one Mr Sevilleja owned and controlled 2 companies which he used for foreign exchange trading. Marex brought contract claims against the companies and obtained a judgement for USD 5.5 million. Prior to the judgment being handed down, Mr Sevilleja ensured that the companies’ coffers were emptied and rerouted to be under his control, being a breach of his fiduciary duties to the company.  The United Kingdom Supreme Court then discussed the reflective loss principle but say that “the rule in Prudential has no application to the present case, since it does not concern a shareholder.“

In Marex, the Court further clarified the parameters of the reflective loss principle by setting out 2 cases where this principle may be argued, the 1st case concerns a shareholder whilst the 2nd case concerns a creditor (the reflective loss principle applies to the former only):

“[79] Summarising the discussion to this point, it is necessary to distinguish between (1) cases 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, and (2) cases where claims are brought, whether 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.

[80] In cases of the first kind, the shareholder cannot bring proceedings in respect of the company’s loss, since he has no legal or equitable interest in the company’s assets: Macaura and Short v Treasury Comrs. It is only the company which has a cause of action in respect of its loss: Foss v Harbottle. However, depending on the circumstances, it is possible that the company’s loss may result (or, at least, may be claimed to result) in a fall in the value of its shares. Its shareholders may therefore claim to have suffered a loss as a consequence of the company’s loss. Depending on the circumstances, the company’s recovery of its loss may have the effect of restoring the value of the shares. In such circumstances, the only remedy which the law requires to provide, in order to achieve its remedial objectives of compensating both the company and its shareholders, is an award of damages to the company.

…

[84] The position is different in cases of the second kind. One can take as an example cases where claims are brought in respect of loss suffered in the capacity of a creditor of the company. The arguments which arise in the case of a shareholder have no application. There is no analogous relationship between a creditor and the company. There is no correlation between the value of the company’s assets or profits and the “value” of the creditor’s debt, analogous to the relationship on which a shareholder bases his claim for a fall in share value. The inverted commas around the word “value”, when applied to a debt, reflect the fact that it is a different kind of entity from a share.

… [81] Most importantly, even where the company’s loss results in the creditor also suffering a loss, he does not suffer the loss in the capacity of a shareholder, and his pursuit of a claim in respect of that loss cannot therefore give rise to any conflict with the rule in Foss v Harbottle.”

Within the Malaysian sphere, Marex was applied in Lee Yee Wuen v Lee Kai Wuen & Ors [2020] MLJU 1902, where S Nantha Balan JCA struck out the appellants impugned prayers due to the reflective loss principle seen above. His Lordship remarked:

“[100] However, the recent decision of the Supreme Court of the United Kingdom in Marex has departed from Johnson and has stated quite unequivocally that the rule in Prudential does not apply to a claimant who is a creditor of the companies (non-shareholder).

CONCLUSION

The reflective loss principle bars shareholders from claiming losses suffered by the company.  If the company suffered losses, the company is the proper plaintiff in commencing the claim.  

As for Fa Mulan’s question on “when will my reflection show who I am inside?” (as in can the persons/entities involve claim losses), the answer would be a resounding “no” to a shareholder; and “yes” to a creditor.