Court of Appeal rejects illegality defence in claim against liquidator

The Court of Appeal has refused to allow a liquidator of a company that was the vehicle for a VAT fraud to rely on the defence of illegality in defending a claim for breach of duty under section 212 of the Insolvency Act 1986: Top Brands Ltd and others v Sharma (as former liquidator of Mama Milla Ltd) [2015] EWCA Civ 1140.

In delivering judgment, the Court of Appeal echoed the plea of the Supreme Court in Jetivia SA v Bilta (UK) Limited [2015] UKSC 23 for clarity as to the proper approach to the defence of illegality (see our previous blog post here), which is currently a matter of great uncertainty. However the court held that, whichever approach was correct, the defence clearly did not apply on the facts of the present case, as there was no need to rely on facts which disclosed illegality in order to bring the claim, and there was no inextricable link between the relief sought and the illegal actions of the company and its directors.

In Stone & Rolls Ltd v Moore Stephens [2009] 1 AC 1391, the House of Lords held that liquidators were prevented from claiming against a company’s auditors for failing to spot its sole director’s fraud (see post), but the Supreme Court in Jetivia v Bilta concluded that Stone & Rolls should be treated as turning on its own particular facts and not authority for any general principle. The present case is helpful in continuing the trend toward a limited application of the illegality rule, and the Stone & Rolls decision, which is good news for creditors of companies used as a vehicle for fraud. Tom Henderson, a senior associate in our dispute resolution team, considers the decision further below.

Background

Mama Milla Limited ("MML") was a supplier of toiletry products. By purchasing toiletries from outside the UK and selling them to UK trade customers without accounting for VAT on its outputs, MML perpetrated a VAT acquisition fraud to the value of not less than £1.5 million.  

Top Brands Limited and Lemione Services Limited were suppliers of products to MML. Both companies agreed to sell various products to MML and to deliver direct to MML's principal customer, SERT Plc. In line with these agreements, goods were delivered to SERT and it paid MML £548,074.56 (the "Sum") but MML did not make any onward payment to Top Brands or Lemione before entering into creditors' voluntary liquidation. Mrs Sharma was appointed as MML's liquidator. She wrongly believed that Top Brands and Lemione had not delivered any products to SERT and therefore SERT was entitled to the repayment of the Sum. Mrs Sharma made various payments to account for the Sum on what she believed were SERT's instructions. Top Brands and Lemione were left unpaid out of MML's assets.

Top Brands and Lemione initiated proceedings against Mrs Sharma for misfeasance under section 212 of the Insolvency Act, seeking an order that she contribute to MML's assets in an amount equal to the Sum. Mrs Sharma sought to rely on the illegality defence (the public policy principle that a party cannot bring a claim which relies on its own illegal act, also known as the ex turpi causa principle). She submitted that, in substance, this was a claim to recover criminal property, as the Sum was the subject of a criminal conspiracy between MML and its directors to perpetrate an acquisition fraud. 

The High Court dismissed the illegality defence and made the order sought. It found that Mrs Sharma had acted in breach of duty and negligently by making the payments without properly ascertaining MML's liabilities and distributing available monies on an equal basis between all creditors. 

Decision

The Court of Appeal referred to the uncertainty arising from various Supreme Court judgments as to the proper approach to a defence based on illegality. It invited the Supreme Court to address the issue as soon as appropriately possible.  The competing approaches discussed were:

1. The reliance approach: following Tinsley v Milligan [1994] 1 AC 340 a claim is barred only if the claimant needs to rely on facts which disclose illegality. Mrs Sharma argued that the reliance approach is restricted to claims in contract, claims to assert a property right and actions for conversion, none of which applied in the present case. 
2. The two stage test advanced by Mrs Sharma as the proper approach for tort claims:

• The loss claimed must be so closely or inextricably linked to the illegality that the court cannot permit recovery without appearing to condone illegality.
• The public policy of consistency (ie that the court will not permit the recovery of loss which gives the appearance of condoning illegal conduct) must not be outweighed by some countervailing public policy.   

In the event, the Court of Appeal did not need to state a conclusion on the correct approach as it was able to dismiss the illegality defence whichever iteration of the test was used.

First, applying the reliance approach, it was clear from the amended points of claim in the proceedings that there was no need for the claimants to rely on any facts which disclosed illegality on the part of MML.

Turning to the second test, the court rejected the submission that there was an inextricable link between the relief claimed and the illegal conduct. On the facts the illegality had no causative relationship to the loss claimed. It was "simply part of the background, and no more than a legally irrelevant aside".  The court did not accept that there was the necessary close connection, or inextricable link, on the ground that the Sum was criminal property as defined by section 340(3) of the Proceeds of Crime Act 2002. There was no finding that, prior to the receipt of the Sum by MML, there was an agreement amounting to a criminal conspiracy to commit a VAT fraud using the proceeds of the sale to SERT. Accordingly, the court had to assume that the Sum was paid pursuant to genuine and lawful contracts of sale.

With respect to the second limb of Mrs Sharma's approach, since the Court of Appeal found that there was no causative relationship between the loss claimed and the MML's fraudulent business, the public policy of not condoning illegality was irrelevant. Indeed, the court identified an alternative and more persuasive public policy on the facts: the requirement that liquidators properly collect and distribute assets of companies in accordance with the statutory scheme.