Stone and Rolls gathers some moss: ex turpi causa in Jetivia

Stone and Rolls gathers some moss: ex turpi causa in Bilta (UK) Limited (In Liquidation) and Ors v Jetivia and Anor [2013] EWCA Civ 968 (“Jetivia”)

Introduction

1. In Jetivia the Court of Appeal had to consider an appeal by two alleged co-conspirators, the sixth and seventh defendants (“the Appellants”) against the High Court’s refusal to strike out the claims against them. In issue was the application of the principle ex turpi causa non oritur actio (“ex turpi causa”) in actions brought by companies that have been used as vehicles for fraud, in the wake of the House of Lords’ decision in Stone and Rolls Limited v Moore Stephens. Jetivia contains some important indications as to how the Court of Appeal will set about deciding such cases in future.

Stone and Rolls Limited v Moore Stephens [2009] UKHL 39

2. Stone and Rolls Limited was used by a fraudster named Stojevic to extract money from a bank. The bank obtained a judgment for damages and Stone and Rolls Limited was wound up. Proceedings in negligence were brought by Stone and Rolls Limited against the company’s auditors, Moore Stephens. The claim was that the auditors had negligently failed to detect Stojevic’s fraudulent scheme at an early stage, allowing Stojevic to extract further money and thus cause Stone and Rolls Limited to incur further liability to the bank, which naturally stood to be the principal beneficiary of any recoveries made in the proceedings.

3. The auditors applied to strike out on the basis of ex turpi causa. At first instance Langley J dismissed their application ([2007] EWHC 1826 (Comm)). The Court of Appeal allowed the auditors’ appeal and struck out the claim ([2008] EWCA Civ 644). A further appeal by the company was dismissed: in the last case ever heard before the House of Lords it was decided by a 3 to 2 majority that the company could not sue the auditors.

4. The House gave a variety of reasons why ex turpi causa prevented (or, in the case of the minority, did not prevent) the claim from being brought, as a result of which the basis of the decision is unclear. It has been authoritatively said that “it is notoriously difficult to extract a ratio from the judgments in that case.”[1] The reasoning of the House of Lords is discussed further below.

Jetivia: facts and issues

5. In Jetivia the directors of Bilta (UK) Limited (“Bilta”) used Bilta to perpetrate a VAT fraud. The fraud involved the trading of carbon credits and resulted in Bilta’s owing VAT to HMRC of over £38m that was not paid. Bilta was wound up and proceedings brought by the liquidators against its former directors and against third parties who were alleged to have been involved in the conspiracy, including the Appellants.

6. Bilta’s pleaded case was that the defendants conspired to defraud and injure Bilta by depriving it of the money needed to meet its VAT liabilities incurred by trading carbon credits. However, the Appellants contended that the true victim was HMRC, and that Jetivia’s loss was “simply a secondary consequence of the fraudulent scheme it participated in” (Jetivia, Court of Appeal, [71]).[2]

7. The Appellants applied for the claim against them to be struck out on the ground that it was caught by ex turpi causa because Bilta had itself been party to the fraud of which it complained. This brought into play the scope and implications of the decision in Stone and Rolls as to the circumstances in which the fraudulent misconduct of a company’s directors will be attributed to the company so that ex turpi causa prevents it from bringing proceedings to recover losses stemming from the fraud.

8. At least arguably, the only distinction between the facts of Stone and Rolls and those of Jetivia was that Stone and Rolls was a claim against the auditors whose (alleged) negligence allowed the fraud to take place, while Jetivia was against the associates of the (allegedly) fraudulent directors themselves.

9. In Jetivia, as in Stone and Rolls, there was much discussion of the rule in Hampshire Land. This is derived from In re Hampshire Land Co Limited [1896] 2 Ch 743, a case in which it was held that a company was not prevented from bringing a claim for repayment of a loan by the fact that, at the time of the loan, one of the lender’s directors, a Mr Wills, who was also a director of the borrower, knew that the borrowing was not properly authorised by the borrower’s shareholders. Vaughan Williams J reasoned the case by analogy with a fraud, and said that:

   “if Wills had been guilty of a fraud, the personal knowledge of Wills of the fraud that he had committed upon the company would not have been knowledge of the society of the facts constituting that fraud; because common sense at once leads one to the conclusion that it would be impossible to infer that the duty, either of giving or receiving notice, will be fulfilled where the common agent is himself guilty of fraud.”

10. The implication of this is often said to be that if a director is acting in fraud of the company he directs, the court will not attribute knowledge of his fraud to the company. As the Court of Appeal said in Jetivia, “the non-attribution to the company of its directors’ fraudulent conduct is said to rest upon what I shall refer to for convenience as the Hampshire Land principle” [39].

The Court of Appeal’s judgment in Jetivia

The contextual determination of attribution

11. The Court of Appeal’s lead judgment was given by Patten LJ. He pointed out that, although the appellants were not directors of Bilta, if their case were to succeed, the same case would be equally successful for Bilta’s directors (Jetivia, Court of Appeal, [26]). It was therefore appropriate to consider whether the actions of Bilta’s directors would fall to be attributed to Bilta, on the assumption that the directors were guilty of a fraud as alleged.
12. The court first noted that, in the context of proceedings brought by a third party against a company, the acts and intentions of the company’s directors will usually be attributed to it. The court cited El Ajou v Dollar Land Holdings [1994] 2 All ER 685; Royal Brunei Airlines v Tan [1995] 2 AC 378; McNicholas Construction Co Limited v Customs and Excise Commrs. [2000] STC 353; Morris v Bank of India [2005] 2 BCLC 328; Tesco Supermarkets v Natrass [1972] AC 152 on this point (see Jetivia, Court of Appeal, [29]-[34]). Moreover, in these “liability cases” the company cannot avoid liability by saying that it, too, was a victim of the fraud of its fraudulent agent.
13. In two such cases, McNicholas and Morris v Bank of India, the defendant company had itself suffered a secondary loss, namely its own liability to pay compensation for the loss caused to the claimant by the fraud. In each case the defendant company argued that, by application of the rule in Hampshire Land, knowledge of the agent’s dishonesty should not be attributed to the company, since the company was itself a victim, albeit only a “secondary victim” of the agent, and therefore should not be treated as a party to the conspiracy. However, this argument failed because it would prevent liability from ever being imposed on a company to compensate a third party victim of a fraud carried out by the company and “[t]he interests of the third party who is the intended victim of the of the unlawful conduct … take priority over the loss which the company will suffer through the actions of its own directors” (Jetivia, Court of Appeal, [34]).
14. However, where the company is claiming compensation from its agent, to attribute the director’s misconduct to the company so as to engage ex turpi causa would effectively negate the agent’s duties to the company. In this context it cannot be correct to treat the agent’s fraud as the company’s own act and it should “not matter whether the loss which the company seeks to recover arises out of the fraudulent conduct of its directors towards a third party … or out of fraudulent conduct directed at the company itself” (Jetivia, Court of Appeal, [35]).
15. The court referred to Belmont Finance v Williams [1979] Ch 250, in which the claimant company sued two of its directors for loss caused by a dishonest conspiracy and the trial judge held that the company could not recover against the directors because their guilt was to be attributed to it. The Court of Appeal reversed the trial judge’s decision because “the essence of the arrangement was to deprive the company improperly of a large part of its assets … [and] it is a well-recognised exception from the general rule that a principal is affected by notice received by his agent that, if the agent is acting in fraud of his principal … that knowledge is not to be imputed to the principal” (Belmont Finance at page 262; quoted by the Court of Appeal in Jetivia at [37]).
16. The court in Jetivia thus held that “the attribution of the conduct of an agent so as to create a personal liability on the part of the company depends very much on the context in which the issue arises” (Jetivia, Court of Appeal, [34], emphasis added).
17. The fundamental rule, therefore, is that “the law will not attribute the fraud or other unlawful conduct of the director to the company when it is itself the intended victim of that conduct.” Whether or not the company is to be treated as the victim is contextual: “[i]n a liability case the company will not be a victim for the purposes of the attribution rule. But where the company makes the claim based on the director’s breach of duty it is the victim and Belmont confirms that the law will not allow the enforcement of that duty to be compromised by the director’s reliance on his own wrong” (Jetivia, Court of Appeal, [42], emphasis added).
18. Thus, the court said in Jetivia, although it was held in the McNicholas case that the company’s secondary loss was not sufficient to prevent attribution of the directors’ misconduct so as to make it liable to a third party, “… it does not follow from this that secondary damage of the kind relied on unsuccessfully in the liability cases will not be sufficient to prevent attribution when it forms the subject matter of the action by the company against those whose breach of duty has caused it. In that context the damage is not secondary but primary and the company is the direct victim of the breach of duty relied on.”
19. As a result, “[i]t ought … not to matter whether the conspiracy alleged in these proceedings had as its object a VAT fraud on HMRC or is limited to depriving Bilta of the proceeds of sale from the [carbon credits] … [i]n neither case should it be open to the directors and their accessories to defeat the claim” (Jetivia, Court of Appeal, [45]).
20. This indicated that the appeal in Jetivia should be dismissed: the Appellants, being in the same position as Bilta’s directors, could not rely on the conspiracy to which they were parties to prevent, on the basis of ex turpi causa, the claim against them by Bilta.
21. “What remains,” said the court, “is whether there is anything in Stone and Rolls that requires us to reach a different conclusion” [45].

Stone and Rolls in the Court of Appeal

22. In reviewing Stone and Rolls the court in Jetivia first looked at the judgment of the Court of Appeal (Rimer LJ, who was a member of the Court of Appeal in Jetivia and a party to its unanimous judgment, had given the leading judgment in the Court of Appeal in Stone and Rolls).
23. The auditors had argued that, as Mr Stojevic was the controlling mind of Stone and Rolls Limited, his fraudulent conduct was prima facie attributable to the company and the company’s action for losses caused by that fraud was caught by ex turpi causa.
24. The company had argued that there could be no such attribution because the company was itself a victim of the fraud and under the rule in Hampshire Land this prevented attribution of Stojevic’s fraud to the company (Stone and Rolls, Court of Appeal, [23], [35]).
25. The auditors had responded in relation to (a) that the company could not rely on being the fraud’s victim because the true victim was the bank (ibid., [49]), and to (b) that the company could not rely on the rule in Hampshire Land because there was no other person at the company from whom the fraudulent director would wish to conceal his fraud (ibid., [45]).
26. Faced with these submissions in Stone and Rolls, the CA had found for the auditors. As to (a), the company was only a victim in the sense that it was exposed to a secondary liability to the bank, rather than being the intentional target of the fraud. The real target was the bank. Such secondary victimhood was not sufficient to allow the company to avoid attribution of the fraud by taking advantage of the Hampshire Land or the Belmont Finance principle (ibid., [72]).
27. However, as to (b) the Court of Appeal had rejected the auditors’ submission. It held that there was no reason in principle why a ‘one man company’ such as Stone & Rolls could not rely on the rule (ibid., [46]) although in the event Stone & Rolls could not do so because of the answer to (a). Thus the decision was that the rule in Hampshire Land could apply to a ‘one man company’ used for fraud but did not do so where the company was only a secondary victim. We will return to the ‘one man company’ argument below.
28. Comparing the facts of Stone & Rolls with those in Jetivia, the Court of Appeal said in Jetivia that Stone and Rolls’s auditors “were not party to a fraud on the company and owed no duty to its creditors. Mr Stojevic who had undoubtedly committed a breach of fiduciary duty against the company was not a defendant and his actions against [Stone and Rolls Limited] were not the subject matter of the claim” (ibid., [52]).
29. It isn’t clear why this should have made all the difference. Stone and Rolls and Jetivia were in each case “an action by the company against those whose breach of duty has caused it [secondary loss]” (Jetivia, Court of Appeal, [45]). Yet the action against the auditors in Stone and Rolls was held to fall foul of ex turpi causa, while that against the directors in Jetivia was not.

Stone and Rolls in the House of Lords

30. The court in Jetivia first noted Lord Phillips’ view in Stone and Rolls that the applicability of ex turpi causa was bound up with the scope of the auditors’ duty, which was owed to the company’s shareholders and not to its creditors and that, since the sole shareholder was himself party to the fraud, ex turpi causa provided a defence. Accordingly Lord Philips had considered that the claim against the auditors should be struck out (Jetivia, Court of Appeal, [54-55]).
31. Lords Walker and Brown had accepted the argument that the Court of Appeal had rejected in relation to question (b) before that court, that the rule in Hampshire Land has no application in “sole actor” cases where there is no person to whom the fraud could be reported (ibid., [56]-[63]). Stone and Rolls Limited could not take advantage of the rule in Hampshire Land because it was within the “sole actor” exception. Accordingly the fraud of Mr Stojevic was to be attributed to Stone and Rolls Limited and the claim struck out.
32. These three opinions thus together constituted the majority that had determined the decision of the House of Lords. Lords Scott and Mance, in the minority, had made the following points.
33. Lord Mance had said that the attribution of knowledge was “irrelevant in contexts like the present, where [Stone and Rolls Limited’s] claim is not that there were others within the company who relied on misleading statements by Mr Stojevic, but rather that Mr Stojevic’s actions were in breach of his duties to [Stone and Rolls Limited] and that, had Moore Stephens detected them, no further breaches of duty would have been possible” (Stone and Rolls, House of Lords, [228]; Jetivia, Court of Appeal, [66]). He had “expressly rejected the submission that the sole actor exception should be imported so as to bar a claim by a company against its sole director and shareholder” (Jetivia, Court of Appeal, [68]).
34. He had also rejected the Court of Appeal’s ratio, that the company was disqualified from suing by the fact that it was a secondary and not a primary victim of the wrongdoing. He had relied on Arab Bank Plc v Zurich Insurance Co [1999] 1 Lloyds Rep 262 as authority for the proposition that “a company exposed to third party liability by fraud could be treated as a victim of the fraud for the purposes of a claim against other persons allegedly in breach of duty to it.”
35. Lord Scott had said that if Mr Stojevic were sued by the company, he could not “reduce his liability for breach of duty to [Stone and Rolls Limited] by attributing to [Stone and Rolls Limited] his own dishonesty, praying in aid the ‘sole actor’ exception and the application of the ex turpi causa rule” (Stone and Rolls, House of Lords, [110]; Jetivia, Court of Appeal, [65]). Extending this to the auditors, he had then added that “It is not clear to me why Moore Stephens, or any other officer of [Stone and Rolls Limited] whose breach of duty had contributed to the liabilities to which [Stone and Rolls Limited] is now subject, should be in any different position, so far as attribution to [Stone and Rolls Limited] of Mr Stojevic’s dishonesty is concerned, to that of Mr Stojevic himself” (ibid., [111]) but this part of his judgment was not referred to in Jetivia). He had otherwise expressed general agreement with the reasoning of Lord Mance.

The decision in Jetivia

36. The Appellants in Jetivia made two arguments. The first was that Bilta could only prevent the attribution of the directors’ fraud to itself, and therefore avoid falling foul of ex turpi causa, if it was the true victim of the fraud, but that in fact HMRC was the true victim and so the fraud was attributable to Bilta. This was essentially the argument that as the loss was secondary the claim was barred on the basis of the Court of Appeal’s decision in Stone and Rolls.
37. This argument was rejected. The Court of Appeal was “bound by the decision … in Belmont Finance … to hold that a director even of a one-man company can be held liable to account for breaches of fiduciary duty which he commits against the company.” The basis of this was that:

    “[a]s Lord Scott and Lord Mance point out in their speeches in Stone & Rolls, the fact that the fraudulent director is the directing mind and will of the company has never been regarded as an answer to a claim by the company against the directors for a breach of duty committed against the company … in that context the company is to be treated as the victim even though the loss which it suffers from the breach may be the compensation which it has had to pay to a third party who has been damaged by the fraud” (Jetivia, Court of Appeal, [75], emphasis added).

38. Thus, the fact that the loss was secondary did not prevent a claim against the directors in respect of the fraud that caused the loss.
39. The Appellants’ second argument was that Bilta was a one-man company that was prevented from taking advantage of the rule in Hampshire Land by the ‘sole actor exception’ recognised by Lords Walker and Brown in Stone and Rolls. The Court of Appeal rejected this also:

    “[78] … Both Lord Walker and Lord Brown decided the appeal in Stone & Rolls on that basis. But Lord Phillips expressed no concluded view upon it and Lord Scott and Lord Mance were strongly opposed to its importation into English law.

    [79] My own view is that in the context of a claim by the company against its fraudulent directors, the rule has no place in English law …

    [80] Lord Walker considered that the adoption of the sole actor exception could be justified as being in line with what the English courts have decided in the liability cases. But that, in my view, ignores the contextual difference between the two situations … I prefer the analysis of Lord Scott and Lord Mance …”

40. So in Jetivia the “sole actor exception,” which had been applied in Stone and Rolls, was held to not apply to an action against the Appellants, who although not directors, were in a position analogous to that of the directors. What was the difference? The Court of Appeal said that:

    “[81] There is … a significant difference between the liability of an auditor for failing to notify the company about what was taking place and a conspiracy against the company by its directors and others to deprive it of its assets. The claim against the auditors was a claim against a third party who owed no fiduciary duties as such to the company or its creditors based on what in the context of that claim was secondary damage caused to the company by a separate breach of duty on the part of the company’s own director. It is therefore readily distinguishable from what we have to consider. The decision in Stone & Rolls should be confined in my view to the claim and the facts in that case.”

41. However, the Court of Appeal made no effort to explain why it made all the difference for the purposes of attribution that that the auditors were not fiduciaries, or that their breach of duty was separate from the conspiracy itself. The suggestion of Lord Scott, that there was no basis for distinguishing for these purposes between the auditors and the directors, was not directly referred to by the court of Appeal in Jetivia. But it is not easy to see why he was wrong.

Where does Jetivia leave Stone and Rolls?

42. The Court of Appeal did not say that Stone and Rolls was wrongly decided by the House of Lords, but it came very close. The comment that the decision in Stone and Rolls “should be confined … to the claim and the facts in that case” (Jetivia, Court of Appeal, [81]) suggests the Court of Appeal, at least, will distinguish Stone and Rolls whenever it can.
43. The application of the ‘sole actor exception’ relating to a ‘one man company’ to claims against directors and accessories as in Jetivia, was rejected. Since the ‘sole actor exception’ was only adopted by two members of the House of Lords, the Court of Appeal was not bound to apply it and refused to do so.
44. While the Court of Appeal did refer to some differences between the facts of Stone and Rolls and those of Jetivia, they do not seem to be compelling. The fact that the auditors in Stone and Rolls were not parties to the fraud does not mean that they were not in breach of duty to the company. By the Court of Appeal’s own reasoning in Jetivia, Stone and Rolls’s loss ought to have been recoverable whether the loss was primary or secondary.
45. While it may have been that the auditors in Stone and Rolls did not owe a duty to creditors, they certainly did owe a duty to the company. Moreover, the decision in Stone and Rolls (including that of Lord Phillips) was based on ex turpi causa, not merely on the scope of the auditors’ duty.
46. So Stone and Rolls is the law, but so is Jetivia and the precise principle of distinction between them is hard to identify. Certainly the Court of Appeal was not explicit about the basis of it in Jetivia itself. However, an attempt has been made to identify it in one case, to which we now turn.

Madoff Securities International Limited (In Liquidation) v Stephen Raven & Ors [2013] EWHC 3147

47. In this case proceedings were brought in England by the London investment firm of Bernard Madoff, whose US business spectacularly collapsed when it became revealed as a Ponzi scheme. The UK company, however, had a legitimate business, albeit that it was in liquidation when the proceedings were brought.
48. The defendants were various former directors of the claimant and an Austrian businesswoman who had received money from the claimant while it had been under Bernard Madoff’s control. It was common ground that the defendants had not been party to Mr Madoff’s fraud. However, various payments (including the payments to the Austrian defendant) were alleged to have been permitted by the defendant directors unlawfully and/or in breach of duty.
49. The relevance of the case is that the defendants took an ex turpi causa point. This failed on the primary basis that the claim was not based on the Ponzi scheme itself and so the claimant did not rely on any unlawfulness. But the question also arose whether the unlawful conduct of Bernard Madoff was to be attributed to the claimant in the context of its claim. Popplewell J, having observed that “it is notoriously difficult to extract a ratio from the facts of [Stone and Rolls]” (Madoff, [314]), grappled with this question.
50. There was no basis for applying the ‘sole actor’ exception to the rule in Hampshire Land, because the claimant in Madoff was not a one man company as it “had independent and innocent shareholders at all times” and “active independent directors” (Madoff, [314]).
51. But the defendants also contended that it did not matter that the case was not within the sole actor exception, because the rule was not engaged in the first place. This was said to be because the claimant was only a secondary victim, and not the target, of Bernard Madoff’s fraud.
52. In approaching this submission Popplewell J noted that in Stone and Rolls the Court of Appeal and two of the majority of the House of Lords had held that the company’s status as a secondary victim did not prevent attribution of the fraud to the company. In Jetivia, however, the Court of Appeal had held that the fact that the company was a secondary victim was sufficient to engage the rule in Hampshire Land and thus prevent attribution of the fraud to the company (Madoff, [316]-[317]).
53. He went on:

    “The balance of this authority suggests that the Hampshire Land principle is not triggered where the company is used as an instrument of a fraud targeted against a third party victim, resulting in loss to the company only as a secondary victim, in circumstances where the attribution is invoked by those not party to the relevant fraud. That would allow the attribution of Bernard Madoff’s fraudulent knowledge and conduct to MSIL for the purposes of the ex turpi causa defence in the present case.

    (Madoff, [318], emphasis added)

54. Because the defendants were innocent of the fraud, they were entitled to ‘invoke the attribution,’ so the rule in Hampshire Land did not apply and the ex turpi causa defence would have succeeded, had the requirement of reliance been met.

Conclusion

55. Stone and Rolls is a fairly recent decision at the highest level and is clearly of binding authority. The question after Jetivia, however, is: what is the scope of that authority? The Court of Appeal’s view that the decision “should be confined to the claim and the facts in that case” (Court of Appeal, Jetivia, [81]) implies that it is limited to claims against auditors. However, it is not clear why such claims should be barred as ex turpi causa when claims against directors and their accomplices are not so barred. Lord Scott’s question as to why the auditors in Stone and Rolls should be in any different a position from that of the directors themselves continues to be pertinent.
56. Popplewell J’s attempt to reconcile the cases on the basis of a test whether the defendant is party to the relevant fraud is laudable but open to question. For one thing, it does not confine the decision in Stone and Rolls to “the claim and the facts in that case” (Jetivia, Court of Appeal, [81]) but rather extends it beyond auditors potentially to other cases where the defendant, whatever his fault, has not been party to the fraud in which the company was involved. So to that extent it is at odds with the decision in Jetivia.
57. Another problem is the intrinsic difficulty of Popplewell J’s reasoning. Why should the application of ex turpi causa, a doctrine that is in principle based on the behaviour of the claimant, should turn out to depend on the behaviour of the defendant? This oddity is reflected in the language of Popplewell J, who talks rather oddly of “the attribution” being “invoked” by the defendant.
58. On the other hand, the line identified by Popplewell J appears likely to be reasonably easy to draw in practice. Moreover, the notion that a negligent defendant should be in a better position than a fraudulent defendant contains a certain crude justice. So his approach is not without some attraction.
59. It is submitted, however, that the better view is that Stone & Rolls was wrongly decided, as appears to have been the view of all three judges in the Court of Appeal in Jetivia, as well as Lords Mance and Scott. On this basis, the compromise suggested by Popplewell J is also wrong in principle, and seems unlikely to be accepted by the Court of Appeal in any relevant case involving a non-auditor defendant who was not a party to the fraud. Thus, it is submitted that, pending consideration of the question by the Supreme Court, the Court of Appeal should and will confine the decision in Stone and Rolls closely to the claim and the facts in that case.

Alexander Pelling
XXIV Old Buildings
31 March 2014

[1] See Popplewell J, Madoff Securities International Ltd (In Liquidation) v Raven & Ors [2013] EWHC 3147 at [314], discussed further below.

[2] The alleged conspiracy is described at Jetivia, [10]. In essence, Bilta bought carbon credits from traders outside the UK, and so did not pay VAT on the purchases. Bilta then sold the carbon credits on to co-conspirators that were UK-based traders who were registered for VAT, which eventually disposed of them into the market. These sales by Bilta were taxable supplies and Bilta incurred VAT liabilities in respect of them. However, the money payable to Bilta was in fact paid to a co-conspirator entity such as Jetivia that was located outside the UK. In this way the sale price was never paid to Bilta and the VAT element was never received by HMRC.