Reflective loss

Eilís Ferran, OECD, 16 October 2013

The issue

• Corporate law– Company can sue– For the board, not shareholders, to

decide whether company will sue– But, in very limited circumstances,

shareholder (or indirect shareholder) can bring a derivative claim on company’s behalf

– Derivative claim = compensation for harm to company

– Shareholder cannot sue personally unless

• (i) it has an independent cause of action, and

• (ii) the harm it has suffered is independent from the harm to the company (no reflective loss)

shareholder

Aggressor

Operatingcompany

The issue

• Investor-state dispute settlement

– Shares are assets entitled to investment protection

– Shareholder can claim

– Indirect shareholder (holding co) may also have a claim

– Shareholder claims not generally barred by reflective loss principle (typical BITs)

Shareholder Aggressor

Operating company

Holding Co

The issue

• The interface between ISDS and corporate law• Inconsistencies in approach• Corporate law stresses the distinction between

the corporate entity and its shareholders • Corporate law is consistent with general

international law (Barcelona Traction)• Piercing the veil of incorporation is possible, but

rare– Prest v Petrodel Resources (2013) UK Supreme Court,

citing Barcelona Traction

Clarifying the terminology – from a corporate law perspective

• Derivative claim– By a shareholder, for company’s benefit

• Reflective loss– Where a shareholder has a personal cause of action– And company also has a cause of action – The shareholder’s loss is reflective of the company’s loss

(derivative loss – but this can lead to confusion)

• Contrast– “An action for a ‘direct injury’ is premised upon the third party

having breached an obligation owed directly to the shareholder rather than just to the company, whereas in an action for ‘reflective loss’ the shareholder is suing for the diminution of the value of its shares caused by acts of the third party directed to the company itself.” (Douglas)

The no reflective loss principle in corporate law – elaboration

• Shareholder and company both have a cause of action – Shareholder’s loss must be independent of company’s

loss; otherwise barred

• When is loss reflective?– Diminution in value of shareholding or loss of a

dividend: reflective rather than independent– Other payments the company would have made to a

shareholder if it had not been deprived of its funds (including payments qua employee) are also reflective loss

– Fine judgments may be required

Corporate law and reflective loss: a recent example

• Sale and purchase transaction• Shareholder in Seller Co concerned that Buyer Co

would not pay purchase price• Shareholder obtained third party guarantee of the debt

owed to Seller Co• Purchase price was not paid • Shareholder could not enforce guarantee because its

loss was reflective - Seller Co would lose its claim under the share purchase agreement if the guarantors paid out under the guarantee

Suen Kwai Kam v Zhong Hua International Holdings Ltd and others [2013] HKEC 457

Reflective loss and civil procedure

• Strike out

• Decision on preliminary issue

• Decided on the trial of the action

• Burden of proof on the defendant who asserts that the principle is an answer to the claim against it

The no reflective loss principle in corporate law – why?

• Claimant can recover compensation only for its own loss

• The company’s loss is not the shareholder’s loss, and vice versa

– Separate legal entity

The no reflective loss principle in corporate law – why?

• Policy bar; matter of principle; no discretion allowed

• Justice to the defendant: shielding from multiple suits; preventing double recovery

• Shareholder claim subordinated to company claim for reasons of creditor protection

Corporate finance: repayment rank order

•Secured debt

•Unsecured debt

•Subordinated debt

•Preference shares

•Ordinary shares (common equity)

Hierarchy of claims and structural subordination

• Bank lends to Sub• Bank’s claim against Sub for

repayment of loan ranks ahead of Parent’s claim to Sub’s residual assets

• Sub’s claim against Aggressor is part of the assets on which Bank has prior claim

• For Parent to be able to sue Aggressor for reflective loss would invert the normal hierarchy

• Bank (creditor) would be structurally subordinated to Parent (shareholder)

AggressorBank

Parent

Sub

No reflective loss and corporate governance

• Responsibility for preservation of corporate assets lies with management

• Shareholders should not re-open managerial decisions, eg, to compromise corporate claim

• Derivative claim procedure for indefensible managerial decisions

• No reflective loss principle supports centralized management

• Shareholder equality– Assets that belong to the company should be shared

rateably among shareholders

Reflective loss and creditors’ claims• There is a hierarchy of claims among creditors (secured, unsecured, subordinated)• The principle of pari passu distribution applies in insolvency• Should a creditor be barred from recovering in respect of reflective loss?

– Gardner v Parker [2004] EWCA Civ 781, Neuberger LJ

…there is no logical reason why [the rule against reflective  loss] should not apply to a shareholder in his capacity as a creditor of the company expecting repayment of his debt. Indeed, it is hard to see why the rule should not apply to a claim brought by a creditor (or indeed, an employee) of the company concerned, even if he is not a shareholder. ... it is hard to see any logical or commercial reason why the rule against  reflective  loss should apply to a claim brought by a creditor or employee, who happens to be a shareholder, of the company, if it does not equally apply to an otherwise identical claim by another creditor or employee, who is not a shareholder in the company

• But other English cases have indicated that secured creditors are not barred by the reflective loss principle

• The position as regards unsecured creditors remains open in England• Other jurisdictions (Singapore, Hong Kong, US)

The no reflective loss in corporate law – convincing?

• Hierarchy of claims matters in cases of asset insufficiency

• If solvency is in doubt, assets should be preserved for creditors, not paid out to shareholders

• But what if solvency is not in doubt?• Double recovery – but what if company cannot

recover (eg, procedural limitation or compromise)

• Centralized management• Judicial economy

Qualifications on the no reflective loss principle in corporate law

• If the shareholder has a claim, but company does not– Shareholder may be able to sue even though loss is reflective

• If the company cannot pursue its claim because of the wrongful act of the defendant– Shareholder may be able to sue – but jurisdictions differ on this point

• Waddington Ltd v Chan [2008] HK Court of Final Appeal

• Discretionary application of the no reflective principle – Shareholder claim permitted provided it would not (i) unfairly expose

the defendant to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons• But not widely accepted

• Alternative shareholder remedies– Unfair prejudice or oppression: shareholders may be bought out a

price that reflects the value of the shares prior to oppressive events

Reflective loss in corporate law: taking stock

• Some areas of uncertainty/difficulty

• Some qualifications

• Important not to ignore alternative remedies that may operate as functional equivalents to allowing claims for reflective loss

• But, overall, corporate legal systems of developed economies are remarkably similar in their treatment of reflective loss

Implications for ISDS?

A corporate lawyer’s perspective

• NAFTA, arts 1116-1117: broad correspondence with domestic corporate law

• Company recovery regimes• Deemed company claims: ICSID, art 25(2)(b)• Typical BITS: results that are surprising from a corporate law perspective

– Overlapping claims – multiple shareholders, corporate claims– “Double bites”– Double recovery– Inconsistent outcomes– Judicial economy considerations– Creditor interests potentially at risk– Minority shareholder interests potentially at risk

• Alternative techniques, eg, consolidation, as partial and imperfect substitutes for the reflective loss principle?

Tackling reflective loss in ISDS

• A non-exhaustive list of issues– Policy contexts: differences between ISDS and domestic

corporate law– Governments may favour allowing reflective loss to minimize

costs– Thresholds for access to corporate recovery mechanisms?– Claims to be barred by the reflective loss principle: shareholders

and creditors?– Boundary line - what is reflective, what is independent loss?– Exceptions? – Procedural considerations – reflective loss as a preliminary

objection or as part of the merits; implications for review of decisions