Revisiting the no reflective loss principle under the South African company law regulation: A reflective assessment through the lens of Hlumisa Investment Holdings (RF) Ltd v Kirkinis 2020 3 All SA 650 (SCA)

4 1 Factual matrix

The first and second appellants in this appeal were the first and second plaintiffs in the Gauteng Division of the High Court (the court a quo) and Hlumisa Investment Holdings (RF) Ltd and Eyomhlaba Investment Holdings, respectively.48 The first and second appellants are shareholders who own 1.73 per cent and 3.24 per cent, respectively of the issued share capital of African Bank Investment Holdings (ABIL) a listed Johannesburg Stock Exchange (JSE) company which is also a holding company that wholly owns African Bank Limited (the African Bank).49 The first to tenth respondents are either current or former ABIL and African Bank directors. The eleventh respondent is Deloitte and Touche (Deloitte), who acted as the auditor of both ABIL and the African Bank.50 The appellants made this appeal with leave of appeal of the Gauteng Division of the High Court (court a quo), Pretoria per Molopa-Sethosa J.51 The main point of contention was whether section 218(2) of the Companies Act,52 permits the claims by a shareholder concerning the diminution in the value of shares due to misconduct by directors.53 The second concern was whether shareholders had a claim based on a diminution in share value related to alleged misconduct by auditors.54

Initially, the appellants instituted an action in the court a quo in terms of section 218(2)55 read with sections 76(2)56 and 22(1)57 as well as section 7458 of the Companies Act on the one hand and on the other hand, section 46(3) of the APA.59 The appellants made two claims. In their claim against the directors (Claim A), the appellants alleged that between 2012 and 2014, and in breach of section 76(3) of the Companies Act, the directors failed to exercise their powers in good faith and in the best interests of ABIL and African Bank, which resulted in the business of ABIL and African Bank being carried out recklessly or with gross negligence in contravention of the provisions of section 22(1) of the Act.60 The significant losses as recorded by the Bank and ABIL, were through a share price drop from R28.15 per share as of April 2013 to 0.31 per share as of August 2014, computing a total diminution in the price per share of R27.84.61 The first and second appellants alleged to have lost R721,384,512 and R1,341,224,294 respectively, an amount obtained after multiplying the number of the shares they held and the diminution value in ABIL.62

In addition, the particulars of claim set out various instances of directors’ alleged misconduct.63 These include publishing false statements for both ABIL and African Bank, authorising publishing rights issues and prospectus with misleading information, contravening section 74 meetings, contravening section 45 financial assistance, and reckless accounting practices.64 The applicants based their claim against directors on section 218(2) of the Companies Act and provided that directors are liable to compensate the first and second plaintiffs for the damages they have suffered.65

The directors raised exceptions regarding the particulars of claim on three bases as follows.66 First, the directors excepted the fact that the claim by plaintiffs was premised on the defendants in their capacities of directors of ABIL and African Bank, in turn, such conduct is alleged to have resulted in losses and a share drop of ABIL, which indirectly caused loss to the plaintiffs.67 The directors further allege that ABIL and African Bank suffered a loss, and the plaintiffs’ claim is for loss reflected in the share drop of ABIL.68 In addition, the directors concluded that the plaintiffs failed to set out facts or alleged any basis (i.e. the pleadings lacked averments necessary to sustain a claim), entitling them to recover losses suffered by them as a consequence of the diminution in the share price of ABIL.69

Secondly, the defendants excepted the reliance by plaintiffs on section 218(2) of the Companies Act.70 In particular, section 218(2) states “Any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention”.71 The defendants averred that the plaintiffs alleged that the directors contravened sections 76(3), 22(1), 74 and 45 of the

Companies Act without necessary claims based on such contraventions.72 However, as apparent, the plaintiffs only alleged that the damages they suffered resulted from the diminution in value of ABIL shares, which resulted from losses sustained by African Bank and ABIL.73 Thus, according to the defendants the claim by the plaintiffs did not contain the allegations entitling the plaintiffs to rely on section 218(2) of the Companies Act, thus, the particulars of claim were excipiable.74

Thirdly, the directors excepted that in the amended claim the plaintiffs allege that the defendants authorised the publication of a prospectus containing false and misleading statements.75 The plaintiffs failed to allege that they relied on misrepresentation allegedly made by defendants, or that they acted on the strength of the misrepresentation and that they suffered damages because of the misrepresentation.76 Therefore, the defendants pointed out that the plaintiff’s particulars of claim lacked sufficient averments to sustain a cause of action based on misrepresentations hence the claim was excipiable.77

In terms of the claim against Deloitte (claim B), the appellants alleged that when Deloitte was tasked to audit ABIL and African Bank between December 2012 and December 2014, Deloitte presented that the financial statements fairly presented the financial position of the Bank.78 However, the said statements were allegedly “false” since they did not reveal the true state of affairs of the Bank.79 The falsity was alleged to be a result of the deliberate, alternatively, negligent failure on the part of auditors to take sufficient steps to rectify and disclose to the investors and shareholders of African Bank and ABIL in contravention of section 46(3) of the Auditing Profession Act (APA).80 The plaintiffs alleged that Deloitte could reasonably be expected to know that the audit reports would induce them to act or refrain from acting in some way, as contemplated in section 46(3) of APA.81

Deloitte, however, made two exceptions to the allegations of the appellants.82 The first exception was that the plaintiffs were shareholders of ABIL, a holding company of African Bank.83 Deloitte argued that ABIL’s shareholders have no claim over any assets of ABIL and/or African Bank and merely have a personal right to participate in ABIL in terms of its MOI.84 Hence, the failure of Deloitte to discharge its duties pursuant to its appointment as an auditor constitutes a breach of duties to ABIL and African Bank and not ABIL’s shareholders.85

The second exception by Deloitte was based on the fact that it owed no legal duty to the plaintiffs as individual ABIL shareholders.86 Deloitte pointed out that the plaintiffs’ claim was a delictual claim for pure economic loss based on misstatements allegedly made by Deloitte in expressing audit opinions in respect of African Bank.87 At common law, a statutory auditor owes its legal duties to the company and the shareholders in a general meeting, not individual shareholders.88 Further the reliance on section 46 of APA does not change the common law position. Therefore, the appellants lacked the necessary allegations to sustain a cause of action.89 In summary, Deloitte argued that the claims by the appellants, if proven, were unsustainable at common law and could not be brought in terms of section 218(2) of the Companies Act.90

4 2 The reasoning of the court a quo

The court a quo sought the interpretation of sections 76(3) and 218(2) of the Companies Act in making its judgment in claim A that was made by the applicants.91 Section 76(3) requires the directors to, among other things, exercise their powers and perform their functions in good faith and proper purpose; in the best interests of the company, with the degree of care, skill and diligence expected of a person.92 Whilst, section 218(2) is widely worded in respect of individuals who fall in its ambit; however, it is restricted to apply to “damage suffered by that person as a result of that contravention”.93 Only the person who suffered damage as a result of particular contravention must be the person to invoke the claim of damages.94 The plaintiffs’ recourse to section 218(2) of the Companies Act was articulated as follows, the directors’ conduct constituted a breach of section 76(3) of the Companies Act resulting in the business of ABIL and African Bank being carried recklessly and with gross negligence.95

The court a quo correctly held that section 76(3) of the Companies Act does not deal with the liability of directors, but, section 77 of the Companies Act does.96 Molopa-Sethosa J correctly held that the liability of breaching section 76(3) must be brought in terms of section 77(2) of the Companies Act.97 The court a quo confirmed the principle in Gentoruco AG v Firestone SA (Pty) Ltd,98 that the generalia specialibus non derogant maxim which means that the general provisions do not derogate from special provisions.99 Therefore, the court a quo correctly held that the reliance on sections 218(2) and 76(3) would be a departure from a core principle of company law.100 In addition, the court a quo correctly rejected the reliance on section 22, by referring to section 77(3)(b) which deals with liability when losses are suffered by a company as a consequence of a director having carried the company’s business, despite knowing that it was in contravention with section 22.101

The court a quo also referred to Itzikowitz v Absa Bank Ltd102 particularly when discussing the principle of reflective loss. First, the underlying principle is that the company has a separate legal personality.103 Secondly, holding shares in a company merely gives shareholders the right to participate in the company in terms of the MOI, which remains unaffected by a wrong done to the company, and, in light thereof, a personal claim by a shareholder against a wrongdoer who caused loss to the company is misconceived.104 The above argument, therefore, reinforces the argument that the plaintiffs could not rely on section 218(2) of the Companies Act.105

The court a quo then decided on Claim B against Deloitte and related exceptions.106 The court a quo rejected the reasoning that plaintiffs sue for a loss caused by a third party (Deloitte) to African Bank which allegedly resulted in an equivalent loss to ABIL and the plaintiffs as minority shareholders.107 Accordingly, it was established that African Bank suffered the loss and the court a quo concluded that it was the proper plaintiff. 108

4 3 The reasoning of the Supreme Court of Appeal

The Supreme Court of Appeal undertook to decide on whether section 218(2) of the Companies Act provides a basis for a claim by the appellants, in their capacity as individual shareholders in ABIL, against the directors based on the contraventions by the directors of sections 22(1), 45 and 74 and breaches of section 76(3) of Companies Act.109 In addition, with regards to the alleged breaches of the auditors, to find out whether the applicants’ pleadings contain a sustainable cause of action in terms of section 46(3) of APA and section 218(2) of the Companies Act.110

The Supreme Court of Appeal extensively relied on case law, especially on the rule against claims by shareholders for reflective loss.111 The Supreme Court of Appeal upheld the decision in Itzikowitz that separate legal personality is not a mere technicality. Therefore, it is trite law that the assets of a company are distinct from its shareholders.112 In addition, in Prudential Assurance Co Ltd v Newman Industries Ltd,113 it was held that “what a shareholder cannot do is to recover damages merely because the company in which he is interested has suffered damage”.114 Further, the Supreme Court of Appeal referred to Garcia v Marex Financial Ltd,115 where Flaux LJ upheld the no reflective loss principle in line with Lord Millet’s conclusions in Johnson v Gore,116 and these are not repeated here.

The Supreme Court of Appeal went on to quote Blackman, Jooste, and Everingham’s view,117 on the rule against the reflective loss principle.118 The authors assert that the rule against double recovery is justified because allowing personal actions subverts the rule in Foss v Harbottle.119 The authors further postulate that the depreciation of shares because of the harm done to the company will cause shareholders to suffer indirect harm.120 Accordingly, when harm is caused directly to A (e.g. a company) and indirectly to B (e.g. the company shareholders), the law gives a claim for compensation to A.121 It is so because if the compensation is given to B, then A’s creditors would be prejudiced.122 In addition, it may result in a multiplicity of claims that may be small sums.123 Therefore, the law should ensure that A does not suffer loss and in turn B will not suffer loss, because, if the financial position of A is not affected then the financial position of B would not be affected.124

More so, the Supreme Court of Appeal referred to Novatrust Limited v Kea Investments Limited.125 It held that in situations where wrongdoers control the company, they could be prevented from continuing to take such steps through derivative actions.126 Derivative actions are regulated in the UK by Part 11 of Chapter 1 of the Companies Act 2006 and in South Africa by section 165 of the Companies Act.127 However, derivative actions were not an issue in this appeal.128 I submit that the failure of the appellants to invoke the derivative actions in the court a quo and the Supreme Court of Appeal was fatal to their case and had they pleaded in accordance with the derivative actions they would have succeeded in their application.

The Supreme Court of Appeal held that a submission by the appellants which attempted to show that diminution in value of the appellants’ shares from inter alia, losses suffered by African Bank and ABIL, is fallacious.129 No doubt, on the appellants’ version of events, that ABIL would have a claim against the directors, and at common law, the existence and viability of that claim precluded personal claim by the shareholders.130 However, the shareholders failed to assert oppression by a majority of shareholders and no hint of a derivative action, or that ABIL was hindered or obstructed in pursuing a claim against directors.131 Accordingly, the Supreme Court of Appeal correctly held that when section 218(2) of the Companies Act is interpreted within the context of the ethos under sections 5 and 7 of the Companies Act132 it is not applicable in relation to the claim of the appellants against the directors.133 In rejecting the applicants’ claim the Supreme Court of Appeal held that section 1 of the Companies Act defines a company as a separate juristic person and such is not a mere technicality but foundational to company law.134

The Supreme Court of Appeal further correctly held that the duties owed by the directors in terms of section 76(3) of the Companies Act are owed to the company and not individual shareholders.135 Further, in circumstances of a wrong done to the company in terms of that subsection’s provisions, the company is the proper plaintiff to sue for damages.136 Section 77(2)(a) provides that a director of a company may be held liable for breaches of fiduciary duties resulting in any loss or damage sustained by the company.137 The Supreme Court of Appeal correctly held that reliance on sections 22(1), 45, and 76(3) of the Companies Act was unsustainable and upheld the decision of the court a quo.138

On claim B, the appellants argued that the directors mismanaged the Bank’s affairs, resulting in the company sustaining significant losses.139 Deloitte was the Bank’s auditor and was obliged to perform this function with reasonable care and skill.140 The appellants argued that the Bank audits by Deloitte in 2012 and 2013 were false and did not reveal losses sustained, however, Deloitte presented them as fairly representing the Bank’s financial position.141 Such false reports were due to failure to perform the audit with the requisite reasonable care and skill.142 The applicants based the claim on the fact that the Bank suffered a primary loss, thus, Deloitte must accept that it wrongfully and negligently or deliberately caused the loss.143 Ordinarily, the Bank would have had statutory and contractual claims against the directors and Deloitte for recovery of the Bank’s loss.144 As pleaded, ABIL suffered a loss in the second degree, a reflection of the Bank’s loss.145 The appellants as shareholders of ABIL, thus, suffered losses in the third degree.146 They only suffered because of ABIL’s loss.147 The Supreme Court of Appeal reiterated that claims for reflective loss by a shareholder are generally untenable.148 I reiterate that had the appellants invoked derivative actions in either the court a quo or Supreme Court of Appeal they could have succeeded in their claim to a larger extent.149

The applicants based their claims on sections 46(2) and 46(3) of APA.150 The Supreme Court of Appeal held that the appellants failed to connect how and why their claims were justified, in other words, they failed to establish wrongfulness.151 In their pleading on claim B appellants did not rely on section 218(2) of the Companies Act.152 However, the appellants contended that they were entitled to rely on that section if such reliance could be inferred.153 They then referred to section 30(2)(a) of the Companies Act, which provides that the annual financial statements of companies like ABIL and African Bank must be audited if read with the definition of “audit” in section 1 of the Companies Act, it must mean in accordance with prescribed or applicable auditing standards.154 The appellants contended that the auditors contravened section 30(2)(a) of the Companies Act.155 Therefore, they argued that they rely on section 218(2), however, the Supreme Court of Appeal held that such reliance is fallacious.156 The Supreme Court of Appeal correctly held that the duty of auditors is primarily owed to the company, hence, liability by Deloitte to shareholders in the circumstances of this case is untenable.157 Accordingly, the Supreme Court of Appeal dismissed the appeal with costs for all the above reasons.

4 4 A critical assessment of the decision in Hlumisa

It is trite law that directors owe fiduciary duties to the company and not any stakeholder including shareholders and directors.158 The approach in both the court a quo and the Supreme Court of Appeal decisions is sound, and it appropriately rejects the approach adopted in Mthimunye-Bakoro v Petroleum and Oil Corporation of South Africa (SOC) Ltd,159 wherein the said case the court erred in upholding that directors owe fiduciary duties to fellow directors. The Hlumisa case not only clarified the law but it now provides the correct approach and reinforced a position that directors owe their fiduciary duties only to the company. In Hlumisa, the court a quo and the Supreme Court of Appeal correctly maintained that directors and auditors owe fiduciary duties to the company, not shareholders. Accordingly, the premise logically reached the conclusion that shareholders cannot claim a diminution of their shares based on reflective loss.

I applaud the court a quo and the Supreme Court of Appeal’s use of foreign guidance in articulating the no reflective loss principle, in this context, as shown above.160 It is submitted that tracing the evolution of principles and seeking guidance from other foreign jurisdictions is important in identifying the weaknesses and strengths of different approaches. I further submit that the judgments of the court a quo and the Supreme Court of Appeal are consistent with the policy rationales behind regulating the no reflective loss principle as presented in the Johnson case above161 and these will not be repeated here.

This article has shown that the approach of both the court a quo and Supreme Court of Appeal is to a larger extent supportive of the no reflective loss rule. The court a quo and the Supreme Court of Appeal demystified the position of the no reflective loss principle in South African law and it seems to be clearer now. It is submitted that the court a quo and the Supreme Court of Appeal were correct when they held that the appellants were mistaken when they pleaded their claims in terms of section 218(2) of the Companies Act without substantiating the cause of action and the link thereof. The detailed reasoning is not repeated here. On the contrary, it appears the appellants were ill-advised when they omitted to invoke section 77 of the Companies Act, a provision that holds directors personally liable when they breach inter alia; their fiduciary duties and/or other duties as within the Hlumisa case’s context, sections 76(3), 22(1), 45, and 74.162 I submit that should the appellants invoke section 77 of the Companies Act, they would have increased their chances of succeeding in their claim.

More so, the court a quo and the Supreme Court of Appeal correctly pointed out that the failure by the appellants to invoke the section 165 remedy was fatal to the appellant’s claim. Since section 165 was not pleaded the court a quo and the Supreme Court of Appeal could not decide based on section 165. It is trite law that courts only decide on the pleadings in front of them, because, should the courts decide on the facts and issues that are not in front of them then they stop being neutral arbiters. In support of the conclusions by the court a quo and the Supreme Court of Appeal, the Hlumisa case has offered good law that offers guidelines on how to treat the no reflective loss rule. It is submitted that had the appellants pleaded the section 165 remedy it is highly likely that both the court a quo and the Supreme Court of Appeal were going to decide in favour of the appellants. The court a quo and the Supreme Court of Appeal reinforced the principle that both directors and auditors owe fiduciary duties to the company and claims for breaches of fiduciary duties to a company that leads to diminution of shareholders’ share value can only be correctly instituted by the company. Therefore, Hlumisa stands to be one of the case laws that solidifies the position of the no reflective loss principle in South Africa. Further, Hlumisa entrenches the confirmed principle of separate legal personality by confirming that the property of the company belongs to the company and that the company can sue and be sued in its own name.163