20 November 2019 by and Corporate & Commercial Alert

Can a shareholder recover loss caused by a wrong done to the company in which it holds shares?

It is trite law that a company is a separate legal entity distinct from its shareholders. Shareholders enjoy the benefit of this primal distinction in that they cannot be sued as shareholders for the liabilities of the company. However, when a company suffers loss due to a wrongful act perpetrated against the company, the shareholders of that company also suffer as a result of the value of their shares decreasing.

The natural question then is whether a shareholder has a claim against a party which commits a wrong against the company? The short answer is that a shareholder does not have the right to claim for a reduction in the value of its shares that only reflects the loss suffered by the company itself.

The so-called reflective loss principle was succinctly articulated in Johnson v Gore Wood & Co [2001] 1 All ER 481 where Lord Bingham stated that:

“Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other to make good a diminution in the value of the shareholder’s shareholding where that merely reflects the loss suffered by the company.”

Lord Bingham did however identify two narrow exceptions, namely:

“Where a company suffers loss but has no cause of action to sue to recover that loss, the shareholder in the company may sue in respect of it (if the shareholder has a cause of action to do so), even though the loss is a diminution in the value of the shareholding.”

and

“Where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by breach of a duty independently owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed to it but neither may recover loss caused to the other by breach of the duty owed to that other.”

The Supreme Court of Appeal in London & others v Department of Transport, Roads and Public Works, Northern Cape & others (1035/2018) [2019] ZASCA 144 (30 October 2019) recently had to determine whether the shareholders of a company could institute an action for damages against the Department for an alleged breach of contractual duty owed by the Department to the company in which they held shares. That is, was the reflective loss principle applicable, non-suiting the shareholders, or could the shareholders have a claim against the Department for the diminution in value of their shares?

The facts in London essentially boiled down to an alleged breach by the Department of the contract between the company and the Department which caused the company to fail and led the shareholders to suffer loss. The Department’s response to the shareholders’ averments that they had a cause of action against the Department for a breach of the agreement (to which the shareholders were not a party), can be summarised as follows:

I. firstly, if any wrong was committed at all, it was not a wrong done to the shareholders of the company, whose shareholding remained unaffected by the legal breach of duty, but against the company;

II. secondly, the Department owed a contractual duty in terms of the agreement to the company and not to the shareholders; and

III. thirdly, there was no allegation in the shareholders’ particulars of claim that the loss allegedly suffered by them was separate and distinct from that suffered by the company and arose from a breach of legal duty independently owed to them as shareholders.

The Supreme Court of Appeal upheld that the reflective loss principle dictated that the shareholders were precluded from suing in their own right as the claim was based on a wrong done to the company. This is so even where the result was to diminish the value of the shareholders’ shares and even where the company had declined or failed to take steps to recover such loss. Accordingly, neither of the exceptions to the application of the reflective loss principle could come to the shareholders’ aid and no cause of action had been made against the Department.

When dealing with the law relating to the relationship between a company and its shareholders our courts recognise that a company is a separate legal entity from its shareholders and, accordingly, in the ordinary course, any loss caused to the company must be recovered by the company, and not by its shareholders on the basis of the diminution in the value of their shares. Our courts do seem to recognise the need for narrow exceptions to this principle, and therefore shareholders will be entitled to recover loss caused to the company and reflected in their shares if they have an independent cause of action against the wrongdoer. Our law (under section 165 of the Companies Act, 2008) also allows shareholders a derivative action to either compel the company to recover its own losses, or to do so on its behalf.

Although the London case does not introduce any new legal principles, it affirms the basic tenet upon which our corporation’s law and economic system is founded: that a company is autonomous from its shareholders. Shareholders enjoy the benefits of this separation in that liabilities of the company cannot be claimed from them. But they are also then bound by the logical consequence of the principle: shareholders must rely on the company to recover its own losses.

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