In its judgment in Burnford & Others v Automobile Association Developments Ltd,1 the Court of Appeal has provided a useful summary of the current status of the 'reflective loss' principle – the rule that shareholders cannot bring a claim for diminution in the value of their shares where that diminution is a consequence of loss suffered by the company and in respect of which the company has a claim. The message is clear: despite there being a degree of uncertainly about its application in a very few cases, for the vast majority of cases the law is now settled, and despite its lack of popularity, the principle is here to stay.
The claimants were five former shareholders in Motoriety (UK) Ltd ('Motoriety'), a start-up company that provided a variety of car maintenance related services to motorists. The defendant, Automobile Association Developments Ltd ('AAD'), was a company in the Automobile Association group (the 'AA').
In 2015, Motoriety's shareholders were looking to expand Motoriety's business by finding a suitable investment partner enabling the expansion of the company's subscriber base. There were, according to the claimants, two potential investors: AAD and Solera Holdings Inc ('Solera').
After several months of negotiation, Motoriety, its shareholders and AAD entered into an investment agreement. Under the terms of the agreement, AAD agreed to subscribe for 50% of the shares and Motoriety's shareholders granted AAD an option to purchase the balance of the issued shares in the event that Motoriety's EBITDA reached a specified threshold. If AAD exercised the option it was to pay the shareholders an 'initial option payment' and an 'earn-out consideration', both based on a multiple of Motoriety's EBITDA.
Motoriety did not thrive following the transaction. It went into administration in 2017 and was dissolved in 2019.
The claimants alleged that they and Motoriety entered into the agreement in reliance on representations made by AAD that it would provide Motoriety with immediate access to the AA's customer base. Those representations were, they claimed, false and fraudulently made. The claimants contended that, had it not been for the misrepresentations, they and Motoriety would not have entered into the agreement but would have concluded the envisaged venture with Solera. They estimated that the equity value of Motoriety would, in those circumstances, have been between £46.9 and £59.2 million.
The claimants further alleged that AAD breached the terms of the agreement by recklessly producing a materially inaccurate business plan and by its conduct following the transaction, both of which undermined the venture. The claimants contended that, had it not been for the beaches of contract, Motoriety would have obtained immediate access to the AA customer base, that it would have met or exceeded the forecasts set out in the business plan, and would have surpassed the EBITDA call option threshold. The claimants estimated that the equity value of the company would, in those circumstances, have been between £98 million and £132 million. Further, they claimed AAD would have exercised its call option and paid the shareholders the initial option payment and the earn-out consideration. They estimated that the loss of those payments totaled over £31 million.
AAD denied the substance of the allegations but asserted, first, that the loss the claimants alleged that they had suffered was reflective loss and so was not recoverable by the claimants. AAD applied for the claim to be struck out on that basis.
The High Court granted the application and the claimants appealed.
The Court of Appeal's decision
Lord Justice Newey drew the following points from the key authorities on the 'reflective loss' principle:
- The principle applies where a shareholder brings a claim 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;
- A shareholder cannot escape the principle merely by showing that he has an independent cause of action against the defendant. He must also have suffered 'separate and distinct' loss, and the law does not regard a reduction in the value of shares or distributions which is a knock-on effect of loss suffered by the company as 'separate and distinct';
- There need be no exact correlation between the shareholder's loss and the company's for the principle to be applicable. The principle can apply where recovery by the company might not fully replenish the value of its shares. Equally, the company's loss can exceed the fall in the value of the shares;
- The principle will not be in point if, although the shareholder's loss is a consequence of loss sustained by the company, the company has no cause of action against the defendant in respect of its loss;
- Nor with the principle apply to a claim which is not brought as a shareholder but rather as, say, a creditor or an employee;
- The Court has no discretion in the application of the principle, which is a rule of substantive law;
- The applicability of the principle is to be determined by reference to the circumstances when the shareholder suffered the alleged loss, not those when the claim was issued.
Application of the 'reflective loss' principle to the loss of the claimants' share value
It was abundantly clear that, should the allegations of misrepresentation and breach of contract be made out, Motoriety would also have a claim against AAD in respect of them. Further, the claimants' alleged losses were entirely derived from the alleged losses of the company – their shares became worthless because of Motoriety's failure. Accordingly, while the claimants had a direct claim, they only had indirect, 'reflective' loss.
Application of the 'reflective loss' principle to the loss of the option payments
The claimants argued that this head of claim related to a contractual right that the claimants had but which Motoriety was not entitled to. Accordingly, they submitted, they were seeking compensation for loss in respect of which Motoriety could never have had a claim and which was therefore a 'separate and distinct' loss from the loss suffered by Motoriety.
The court rejected the argument. Lord Justice Newey, agreeing with the High Court judge, held that the initial option payment and earn-out consideration were simply a different way of valuing the shares: shares can in principle be assessed by reference to the company's anticipated future earnings, to the prospects of distributions to shareholders and to what the shares could be sold for. The claim for the loss of the claimants' share value related to the general market value of the shares, while the loss of the payments related to what the shares would have fetched if sold to AAD. Accordingly, again, the loss was indirect and 'reflective'.
The 'reflective loss' principle and the justifications for it has been the subject of much debate since its modern formulation in Prudential v Newman Industries.2 It has (often rightly) been criticised for leading to arbitrary and unjust results. The Supreme Court considered the rule in the glaring light of such criticism in its judgment in Sevilleja v Marex Financial Ltd.3 While this confirmed the existence of the rule and sought to narrow its scope to within reasonable confines, it was by no means the last word on the matter and some questions about its precise scope remained open.
In this case, the claimants argued that as the principle was uncertain and developing, the question as to its application to their claim could not be summarily determined but should be fully assessed at a trial. Mr Justice Newey firmly rejected this argument: the scope of the principle as drawn from the authorities set out above was certain; as the case fell squarely within decided points, the fact that there may be some questions about the precise scope of the principle in some cases was irrelevant.
This judgment should act as due warning to potential claimants: the core aspects of the 'reflective loss' principle are simply not up for debate.
1.  EWCA Civ 1943
2.  Ch 204
3.  UKSC 31
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