Privy Council confirms availability of backward tracing

"Happy is he who can trace effects to their causes", Virgil observed. Well, victims of fraud will certainly be happy with the Privy Council's decision in The Federal Republic of Brazil v Durant International Corporation (Jersey) [2015] UKPC 35. In an appeal from the Court of Appeal of Jersey, the Board confirmed the availability of "backward tracing". This enables claimant beneficiaries under a trust (including victims of a fraud relying on a constructive trust) to avoid the strict rules of equitable tracing by pointing to the substance of the overall transaction rather than its form.

While the Privy Council's decision is not binding as a matter of English law, it is persuasive and provides an indication of how the Supreme Court may decide the issue in the future.

Tom Wood, an associate in our corporate fraud and asset recovery team, considers the decision further below.

Background

The appeal concerned a claim by the Municipality of Sao Paulo against two BVI companies, which were controlled by the former mayor of the municipality (PM) and his son (FM). Bribes totalling $10.5 million (the "Bribe Proceeds") had been paid to PM and then laundered through accounts belonging to FM and the two companies. The Royal Court of Jersey had found the BVI companies liable to the Municipality as constructive trustees of US$10.5 million representing bribes paid to PM. This was upheld on appeal in Jersey.

In the Privy Council, the BVI companies did not challenge the Jersey court’s finding that they were liable to the Municipality as constructive trustees. The dispute was over the extent of that liability.

PM and FM had made three sets of payments to launder the Bribe Proceeds, using three accounts:

1. The Bribe Proceeds (i.e. $10.5 million) had been paid into an account controlled by FM ("Account A") in 13 instalments.
2. There were then six payments from Account A to an account held by the first BVI company ("Account B"), totalling $13.1 million.
3. Finally, there were four payments from Account B to an account held by the second BVI company ("Account C"), totalling $13.5 million.

The Municipality sought to trace the entire Bribe Proceeds through to Account C.

The issue was to do with the timing of the payments. The final three payments of the Bribe Proceeds made into Account A had been made shortly after the final payment from Account A to Account B. This meant that, at the point the full $13.1 million had been transferred out of Account A into Account B, only $7.7 million of the Bribe Proceeds had been paid into Account A. The remaining $2.8 million was paid into Account A a few days later.

On this basis, the BVI companies argued that the extent of their liability as constructive trustees should be limited to $7.7 million (rather than the full $10.5 million), as only this amount could be traced out of Account A. The Municipality, on the other hand, argued it was possible to trace backwards from the proceeds paid into Account B to the full amount of the Bribe Proceeds eventually deposited in Account A. They were all part of the same deal. The Jersey court had found for the Municipality.

Tracing v backwards tracing

Equitable tracing is a process which permits a claimant to identify one right as the substitute of another. It starts with the claimant’s original property and studies what has become of it. For example, if a fraudulent agent pays its principal’s money into an account in the name of a third party, the victim can trace its right against the fraudster into the fraudster's right against the third party. If the claimant’s property or its substitute disappears at any point along the way (e.g. money is dissipated by paying off a debt), the tracing process ends.

"Backward tracing", by contrast, describes where the claimant's property is traced to an asset the defendant already has. A typical situation is where the fraudster has taken a loan to pay for an asset, then diverted trust property to pay off the loan. Strictly speaking, the beneficiary's property has been dissipated: it has been used to extinguish a liability. However, backward tracing allows the beneficiary to claim the asset acquired by the fraudster with the loan money.

In the present case, this meant tracing the payments backwards – from funds held in Accounts B and C to the full amount of Bribe Proceeds ultimately paid into Account A. FM had used the later payments totalling $2.8 million to replenish Account A after making the payments to Account B.

The BVI companies argued this should not be allowed. The later payments into Account A could not be said to be the source of the earlier payments into Account B, and finding otherwise would contradict the principles of tracing.

Decision

The Board held that the Municipality could trace the full amount of the Bribe Proceeds into Account C, since backward tracing was permissible – a point that was previously unclear in English law (see for example the divided opinions of the Court of Appeal in Bishopsgate Investment Management v Homan [1995] Ch 211), but this decision is strongly persuasive authority that it should be available.

Ultimately, the Board recognised this was a matter of policy. The key concern was deterring and punishing fraud. The court should not allow "a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect". Fraudsters should not be permitted to orchestrate transactions with the aim of defeating claims. Backward tracing should therefore be available where a claimant could – looking at the transaction as a whole - establish a coordination between the depletion of trust property and the acquisition of the substitute property.

It was plain on the facts that the payments between Accounts A,B and C were all part of the same transaction. This transactional link was sufficient to permit backward tracing, meaning the BVI companies' liability extended to the full amount of the Bribe Proceeds.

Comment

This is a welcome decision for victims of fraud. By holding that the rules of equitable tracing should be more flexible – focusing on the substance of a transaction rather than its form - the law is better equipped to deal with complex schemes designed to launder money. Backward tracing also deals with the more technical problem arising where banks may have recorded a credit prior to a debit, even though the transfer of funds from one account to another was causally and transactionally linked (for example, where a cheque is credited to an account before the corresponding debit is entered by the paying bank).

There may be concerns that the decision creates uncertainty. The equitable rules of tracing have developed (some would say generously) to circumscribe the way in which claimants can evidence what has happened to their property. The test proposed for backward tracing is broad, and will inevitably mean more discretion on the part of judges. In other contexts, the English courts have rejected calls to focus less on form in the interests of achieving justice in a particular case (for example, English law does not recognise remedial constructive trusts). In this respect, the Privy Council's decision suggests a change of emphasis – from legal certainty to the need to fight fraud in the modern world and uphold fiduciary duties.

Finally, unsecured creditors will be concerned that, if the Privy Council's decision is followed, victims of fraud may be able to take advantage of a further weapon with which to assert proprietary claims, meaning they will enjoy priority if the fraudster is insolvent. The high evidentiary threshold recommended by the Board for backwards tracing (i.e. the need for a close causal and transactional link) would, however, ensure that backward tracing is only possible in the clearest instances where a corrupt deal has been made possible only through the misuse of trust property.