House of Lords rules on auditors’ liability in fraud case

In a decision handed down just before the end of term, auditors have won an important House of Lords ruling limiting their liability in cases where a "one man" company is used as a vehicle for fraud: Moore Stephens (a firm) v Stone Rolls Limited (in liquidation) [2009] UKHL 39. The law lords dismissed by a majority of three to two a negligence claim brought against an audit firm for failing to detect a massive fraud at Stone & Rolls, a trading company that fell in the late 1990s – holding that the liquidators could not bring a claim for damages when the company itself was responsible for the fraud.

Background

The liquidator acting on behalf of Stone & Rolls Limited (the "Company") brought proceedings in the Commercial Court in December 2006 against Moore Stephens (the "Auditors") claiming that they had been negligent in conducting the Company’s audits in the years 1996, 1997 and 1998.

In particular, the Company alleged that the Auditors had breached their duty to act with reasonable skill and care in failing to detect and report to regulators a fraudulent scheme which was being perpetuated by Mr Zvonko Stojevic ("Mr Stojevic") using the Company as his vehicle. Had the auditors fulfilled their duty, it was said, the fraud would have been revealed and stopped. The fraud involved the Company obtaining payments under letters of credit by presenting to banks false documents in relation to fictitious commodity trading. The monies fraudulently obtained were subsequently taken out of the Company and passed to other participants in the scheme.

When one of the banks upon whom the fraud had been perpetrated sued the Company and Mr Stojevic in deceit, that bank was awarded substantial damages. However, the bank was unable to recover anything from Mr Stojevic and the Company was insolvent. As a result the Company went into liquidation and the liquidator brought the present claim against the auditors in an attempt to recover damages of almost US$174 million.

The Auditors sought summary judgment on, alternatively a strike out of, the Company’s claim on the basis that, even if they had been negligent (which they accepted for the purpose of the application) they had a complete defence based upon the public policy principle that a party in bringing a claim was not allowed to rely upon its own illegal behaviour (ex turpi causa non oritur actio ("ex turpi")).

The parties’ legal arguments

In support of the application, the defendant Auditors relied upon the fact that Mr Stojevic was the sole "controlling mind and will" of the Company, which was said to be a "one-man band". Thus, Mr Stojevic’s fraud was the Company’s fraud and the Company could not rely upon that fraud when bringing its claim against the Auditors. The Company was, the argument ran, barred from its claim by the operation of the ex turpi maxim.

In response, the Company sought to rely upon the principle in Re Hampshire Land Co [1896] 2 Ch 743, that where an officer or employee of a company commits a fraud upon the company itself then the knowledge of his own fraud is not the knowledge of the company. In Belmont Finance v Williams Furniture [1979] 1 Ch 250, the principle was put in terms that knowledge should not be attributed to the company where the company was the "victim" of the improper conduct of its officers. The Company further argued that, in any case, the ex turpi maxim did not provide a defence as the fraud was the "very thing" that the Auditors owed a duty to prevent.

The Commercial Court’s decision

The application came before Langley J who gave Judgment on 27 July 2007 ([2007] EWHC 1826 (Comm).

Langley J observed that the claim could not have been brought by Mr Stojevic himself, nor by his trustee in bankruptcy, and on the normal rules of attribution Mr Stojevic’s knowledge and wrongdoing was to be attributed to the Company as he was its "directing mind and will". He found that the Hampshire Land exception did not apply because the Company lost nothing to which it was ever entitled: it was the perpetrator of the fraud on the banks and the liability to which it was thereby exposed was not just the product of that fraud but the very essence of it (and the Company could not therefore be seen as "secondary victim" of the fraud). He nevertheless dismissed the application on the basis that the ex turpi principle could not bar a claim based on the commission of a fraud when the discovery and bringing to an end of that fraud was the "very thing" that the defendants had been charged to do.

The decision in the Court of Appeal

Lord Justice Rimer, with whom Mummery and Keene LJJ agreed, gave the decision of the Court of Appeal on 18 June 2008 ([2008] EWCA Civ 664).

The Court of Appeal broadly approved the reasoning of Langley J on the attribution issue. In particular, the Court of Appeal concluded that the Company "was itself the fraudster…Not the target of the fraud."

Turning to the "very thing" argument, Rimer LJ said it could not trump the ex turpi rule, which he described as "unforgiving and uncompromising". He said that the House of Lords’ exposition of that rule in Tinsley v Milligan [1994] 1 AC 340 admitted of "no discretion in the matter".

As such, the appeal was allowed and the claim was struck out.

The Judgment of the House of Lords

The Lords of Appeal delivered their Opinions on 30 July 2009. By a majority of three to two (Lord Scott and Lord Mance dissenting), the House upheld the decision of the Court of Appeal and dismissed the Company’s appeal.

Lord Phillips delivered the first Opinion. He found that the fraud was properly attributable to the Company as "Where those managing the company are using it as a vehicle for fraud, or where there is only one person managing all aspects of the company’s activities, there is no difficulty in identifying the fraud as the fraud of the company", ie there was no room for the application of the Hampshire Land exception in such circumstances. He indicated that he might have seen the point differently if there had been independent shareholders that had been "hijacked" by Mr Stojevic. In his view, the critical difference of opinion between the majority and the minority in this case was that the minority considered that the interests that the auditors undertook to protect included the interests of creditors. Whilst it was, in his view, arguable that the scope of the duty undertaken by the auditors of a company should extend to protecting the interest that the creditors have in the preservation of the assets of the company (which, he said, would require an extension of the principle in Caparo Industries plc v Dickman [1990] 2 AC 605), in this case all those whose interests formed the subject of the Auditors’ duty of care to the Company, namely the Company’s sole will and mind and beneficial owner Mr Stojevic, were party to the illegal conduct that formed the basis of the Company’s claim and in those circumstances ex turpi provided a defence: "it is very difficult to see how the law can rationally hold an auditor liable when the entire shareholder body and the entire management is embodied in a single individual who knows everything because he has done everything".

Lords Walker and Brown concurred with Lord Phillips, though, as the latter himself noted, they restricted their reasoning to the situation where the directing mind and will of the company was also its owner. Lord Walker said the Hampshire Land principle was akin to the US "adverse interest" exception to the normal rule of imputation, and that there was in turn a "sole actor" exception to the "adverse interest" exception. In his view, the "sole actor" principle applied where there was one single dominant director and shareholder, even if there were other directors or shareholders who were subservient to the dominant personality, or where there were two or more individual directors and shareholders acting closely in concert. He therefore concluded that individuals who for fraudulent purposes ran a "one-man" company (in the sense which he described) could not obtain an advantage by claiming that the company was not a fraudster but a secondary victim. He accepted that the situation of innocent shareholders "hijacked" by a fraudulent but dominant director would raise "difficult questions" as to which one would need to look closely into the facts in order to see whether it would be contrary to justice and common sense to treat the company as complicit. Lord Brown likewise confined the ex turpi defence in such circumstances to "one man company frauds" meaning that "where any innocent shareholders are involved, a claim against the auditors may well lie (through the company) at their suit": this could be for the innocent shareholders’ own loss suffered through the continuing fraud from the time when, following a diligent audit, it should have been uncovered and brought to an end.

Lord Scott said he found this "a very difficult case". In his view, the matter was not suitable for a strike out because, although the majority had proceeded on the basis that Mr Stojevic was the beneficial owner of the shares in the company, it appeared that he held indirectly through his family trust and a company incorporated in the Isle of Man. There were no factual findings as to ownership and it would be a matter for trial whether Mr Stojevic was in fact the absolute beneficial owner of the shares in the Company.

Lord Scott pointed out that Mr Stojevic, who was not a director, had acted pursuant to a power of attorney which could not have extended so as lawfully to authorise him to use the Company as a vehicle for defrauding the banks: everything done by the Company at the direction of Mr Stojevic and in pursuance of his fraudulent scheme must have been ultra vires his powers under the power of attorney, which meant that the company was a victim of his fraudulent scheme. Lord Scott pointed out that there was no case in which the "sole actor" exception to the Hampshire Land principle had been applied to bar an action by a company against an officer (the auditor also being an officer for the purposes of, for example, a misfeasance claim under section 212 of the Insolvency Act 1986) for breaches of duty that had caused or contributed to loss to the company as a result of the company engaging in illegal activities. He said that Mr Stojevic would not be able to avoid a section 212 misfeasance claim by invoking the ex turpi rule and the "sole actor" principle, and the Auditors should be in no different position.

Lord Scott also drew a distinction between a cause of action in negligence brought by a solvent company, where any damages recovered would be for the benefit of the shareholders, and a similar cause of action brought by an insolvent company, where damages would benefit creditors. Where a solvent company suffered loss as a result of unlawful activity directed by a director who was also a shareholder, loss which should have been avoided if the auditors had reported properly, the ex turpi rule could not bar the company’s claim against the director and the auditors and the action, if successful, would via contribution proceedings leave the delinquent director (qua shareholder) no better off. Where, as here, the company was insolvent, no such complication would arise, there would be no prospect of Mr Stojevic recovering anything and there was therefore no reason of public policy where ex turpi should bar the claim.

Lord Mance focused on the separation of legal personality as between the Company and Mr Stojevic. He said a claim by the Company against Mr Stojevic would not be barred in the ex turpi rule. Likewise, it was "clear beyond doubt" that a company could sue its auditors for negligent failure to detect and report fraud by a company’s directing mind where (at the very least) the company had innocent shareholders. However, he added that there was no authority for the proposition that the Hampshire Land principle only applied where there was an "innocent constituency" of officers/shareholders to whom knowledge of the fraud could have been (but was not) communicated.

In Lord Mance’s view, the fraud here was a fraud on the Company and he said there were many authorities dealing, first, with the defrauding of third parties and then with the stripping from the company of its resulting assets obtained for the benefit of the directing minds and beneficial owners. In those cases, the company was seen as the victim in the action by the company. As a matter of English law, therefore, it was no answer to the claim to say that Mr Stojevic was the company’s sole directing mind and sole shareholder.

Lord Mance said an auditor could not, by reference to the ex turpi rule, defeat a claim for breach of duty in failing to detect managerial fraud at the company’s highest level by attributing to the company the very fraud which the auditor should have detected: "It would lame the very concept of an audit – a check on management for the benefit of shareholders – if the higher the level of managerial fraud, the lower the auditor’s responsibility". He said the Hampshire Land principle was also relevant here, as it illustrated that the interests of the Company and of Mr Stojevic had to be distinguished, precisely because it was among the Auditors’ functions to ensure to the former a degree of protection against the latter.

Lord Mance, like Lord Scott, pointed out that in an insolvency situation there was no prospect of the fraudster getting the benefit, qua shareholder, of a successful damages claim. He said that, if the issue arose in a solvent company situation, English law would find a way to address it, for example by enabling the company to impound the delinquent manager/shareholder’s share of the distribution.

The fact that the Company was insolvent at each audit date was, in Lord Mance’s view, critical: the issue was whether the auditors’ duty to the company extended, like the directors’ beyond the protection of the interests of shareholders in a situation where the auditors ought to have detected that the company was (in fact, as a result of a fraud which the auditors ought to have discovered) insolvent. Lord Mance said it would not be inconsistent with Caparo to hold auditors liable in these circumstances because neither Caparo nor any of the other audit cases addressed auditors’ liability for failure to pick up a fraudulent scheme rendering the company increasingly insolvent. He emphasised Lord Oliver’s statement in Caparo that an auditor’s duty was, first of all, "to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing". Lord Mance pointed out that the company’s claim in such circumstances was for precisely the same loss as the loss which a company with some shareholders innocent of involvement in top management’s fraud would be entitled to claim from negligent auditors who had failed to detect and report the fraud. He added that it could not be said that the care to be expected of the Auditors varied according to whether all of the Company’s shares were owned and/or controlled by Mr Stojevic: recovery did not depend on the happenstance of whether or not all of the Company’s shareholders were involved in the fraud.

Comment

This is a landmark decision, in that it is the first time in this jurisdiction that the ex turpi rule has been applied to defeat a claim in negligence against auditors. The mere fact that it has been shown that the ex turpi rule can operate in this way is itself good news for auditors.

That said, the decision is likely to be of limited application:

• Both Lord Phillips and Lord Walker emphasised that this was an "extreme" case on its facts.
• The reasoning of the majority was limited to the situation where the fraud is that of a "one man" company. Looking at the speeches of the majority as a whole, this probably means a company where there are no "innocent" shareholders (ie no shareholders who are not complicit in the conduct of the fraudster). Lord Walker posited the negative test of a company which has no individual concerned in its management and ownership other than those who are, or must (because of their reckless indifference) be taken to be, aware of the fraud or breach of duty.
• As Lord Mance pointed out, whether a company is a "one man" company or not may itself be unclear, particularly where there is a web of nominee or trust shareholdings. The evidence on that issue alone may be sufficiently unclear to prevent this ruling being used again on a strike-out.

The limited application of the House of Lords’ ruling means that it is the auditors of small, privately-held companies who have most to cheer from this decision. Auditors of listed companies, in particular, are unlikely to be affected.

That said, it is the small companies dominated by individuals which may be thought to present the greatest fraud risk to investors and counterparties. Lord Mance began by saying "The world has sufficient experience of Ponzi schemes operated by individuals owning "one man" companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies’ activities", and he concluded with a warning that is particularly pertinent in the current climate where the Madoff scheme and other investor frauds have been exposed:

"The…result espoused by the majority of your Lordships will weaken the value of an audit and diminish auditors’ exposure in relation to precisely those companies most vulnerable to management fraud. The (too topical) lesson for creditors or depositors might be said to be that they should not expose themselves to one-person companies, at least without extensive due diligence."

Another significant feature of their Lordships’ Opinions was the analysis of the auditors’ duty of care in an insolvency context. Lord Mance posited that the duty of auditors, like that of directors, could extend to protecting the interests of creditors where the auditors ought to have detected that the company was insolvent (or, possibly, potentially so) as a result of a fraud which the auditors ought to have spotted. Lord Phillips’ comments on this were illuminating in that:

• he appeared to think that this would involve an extension of Caparo principles, whereas (as Lord Mance demonstrated) neither Caparo nor any other reported decision on an audit had dealt with this issue, which was therefore open on the authorities; and
•  he himself said "It is arguable that the scope of the duty undertaken by the auditors of a company should extend to protecting the interest that the creditors have in the preservation of the assets of the company", without expressly limiting that idea to an insolvency context.

Their Lordships’ comments on this issue are probably obiter, and it will therefore continue to be arguable that, at least in an insolvency (and, possibly, a near-insolvency) context, the auditors’ duty should extend to the protection of creditors. In the current economic environment, this may provide food for thought for office-holders looking to recover something for creditors where the assets of a failed company are insufficient to provide a satisfactory payout. That said, particularly with the heightened attention being given by audit teams to "going concern" issues in the current climate, it is difficult to see a situation, short of fraud, in which auditors would fail to spot the insolvency or near insolvency of an audit client at the report stage; and, in a fraud environment, the principles of attribution discussed here would again be in play and the "one man" company rule could operate as an obstacle to an audit negligence claim.

Finally, this decision brings to an end one of the largest and highest profile actions yet run in this country with the aid of commercial third party funding. The funders in this case, believed to be IM Litigation Funding, can now expect to be ordered to pay the auditors’ costs of the action. It remains to be seen whether this reverse will have a negative impact on third party funders’ appetite for litigation risk in this jurisdiction.