The “Reflective Loss” Principle (the “Principle”)
This well-established international common law principle provides that a shareholder has no capacity to make a claim for recovery for the diminution of the value of his shares where that merely reflects the loss suffered by the company i.e. the diminution of the total value of its assets. Only the company is the proper claimant in this context. The defining authority is the English Court of Appeal decision Johnson v Gore Wood & Co  2 AC 1 (“Johnson”).
The policy reason for this Principle is that:-
“the court must…ensure that the company’s creditors are not prejudiced by the action of individual shareholders and that a party does not recover compensation for a loss which another party has suffered” (36C Johnson).
The Hong Kong Courts have vigorously applied the Principle and continue to do so after the reform of the Companies Ordinance in 2014.
In Giles v Rhind  EWCA Civ 1428 (“Giles”), the English Court of Appeal applied an exception to the Principle, by which the minority shareholder can seek compensation for such ‘reflective’ loss where the company itself is unable to pursue an action against the wrongdoer and that inability was caused by the wrongdoer (who in Giles, caused the downfall of its business and caused the Company to become insolvent then fought off an action brought by the Company causing it to discontinue when it could not meet an order to provide security for costs).
The rationale behind formulating this exception was the opposing policy consideration raised in Johnson, namely the “importance of the Court ensuring that a party who has in fact suffered loss is not arbitrarily denied compensation” (36C Johnson).
The Hong Kong Courts have not gone so far as to apply the Giles exception to date.
The biggest hurdle for shareholders seeking to rely on the Giles exception was establishing the company’s complete inability to bring its own claim which is directly caused by the alleged wrongdoing. For example, the court rejected the applicability of Giles in Gardner v Parker  EWCA Civ 781, holding that the company’s administrative receivership “did not, of itself, prevent that company from starting an action, as is evidenced by the existence of the s. 423 (Insolvency Act 1986; court order to avoid transactions at an undervalue)” and that there was not enough evidence to show that “any such impecuniosity had been caused by the wrong doing alleged” (¶61 Gardner).
In Waddington Ltd v Chan Chun Hoo  11 HKCFAR (“Waddington”) in the Court of Final Appeal in Hong Kong, Lord Millet NPJ (one of the judges in Johnson) gave the leading judgment while sitting as a non-permanent judge in the Hong Kong Court of Final Appeal. He made the observation that “Giles and Perry were wrongly decided and should not be followed in Hong Kong” (¶88 Waddington), stating “It is impossible not to share the determination of the Court of Appeal [in Giles] not to allow a defendant who has been guilty of such conduct to escape liability”, the company’s discontinuance of its own proceedings in that case (by reason of administrative receivership) should not have granted the shareholder the right to bring its own action where the Court “could have given the shareholder leave to apply to direct the administrative receiver to bring the action” (¶85 - 86 Waddington).
The English Courts have since made a re-evaluation of the Giles exception in St. Vincent European General Partner Ltd v Robinson and others  EWHC 1230 (“St. Vincent”) where the English High Court most recently cited the Waddington case to criticise the applicability of Giles, reiterating that the “rule against recovery of reflective loss [as set down by Johnson] involves no exercise of discretion” (¶70 St. Vincent).
Irrespective of the policy sensitive rationale behind the Giles exception (to ensure that there are no wrongs without a remedy), the Court highlighted that “where [a derivative action] is possible, the company cannot be regarded as disabled from bringing a claim to make good the director’s wrongdoing” (¶92 St. Vincent). Derivative actions, which can only be instituted with leave of the court, generally however require considerable time, cost and effort to complete, often to the prejudice of minority shareholders with limited financial resources.
In another English case, in the meantime, Latin American Shipping Co. v Maroil Trading Inc.  EWHC 1254, a freezing order against the defendants’ assets was continued despite the claimant shareholder making a claim in relation to loss suffered by the companies.
The claimant shareholder alleged that the two companies’ disputes with a third party were settled by the defendants in breach of express and implied terms of two shareholders’ agreements in respect of the companies. The defendants applied to discharge a freezing order for breach of the Principle. The court dismissed the application.
Two key features in this case allowed a new apparent “loophole” to the Principle:-
- the claimant shareholder had its own cause of action arising from the shareholder agreements, separate from the loss suffered by the companies; and
- the remedy sought was specific performance, requiring the defendants to restore payments to the companies, rather than pay damages to the claimant.
The Court acknowledged that the Principle was based on company autonomy, such that a party does not recover compensation for a loss which another party has suffered, the need to protect creditors of the company from prejudice by the action of individual shareholders and the need to prevent double recovery but held that the orders sought were consistent with these considerations as they recognized that the payee was sought to be the company and not the shareholder.
In conclusion, Waddington has clarified that Hong Kong Courts will vigorously protect the Principle to protect the interests of the Company and its creditors, and that the Giles exception is not applicable in Hong Kong.
The approach adopted in Latin American Shipping, on the other hand, has not yet been tested in the Hong Kong Courts. While the attempt in that case to exclude the Principle by procedural measures is novel, the facts of the case are not. It appears that shareholders in the future can prospectively circumvent the Principle by entering into a shareholders’ agreement which can afford themselves a cause of action separate from the company’s and greater protection from unauthorized dealings, further, by then seeking a remedy consistent with the Principle, for monies to be paid to the company rather than the shareholders themselves.
Author: Barry Hoy
Research: Shane Cheng