Supreme Court reformulates test for when a claim will fail due to illegality

The Supreme Court has established a new approach to the question of whether a defendant will be able to rely on the defence of illegality: Patel (Respondent) v Mirza (Appellant) [2016] UKSC 42. 

Under this new approach, the defence will apply if enforcing the claim would be harmful to the integrity of the legal system. In assessing whether that is the case, the court must consider:

1. whether the underlying purpose of the law which has been broken will be enhanced by denying the claim;
2. any other relevant public policy which may be affected by denying the claim; and
3. whether denying the claim would be a proportionate response to the illegality. 

The Supreme Court found that, under this new approach, a claimant will not ordinarily be debarred from enforcing a claim for unjust enrichment simply because the money he seeks to recover was paid for an unlawful purpose – though there may be rare cases where enforcing such a claim might be regarded as undermining the integrity of the justice system. In this case there were no such circumstances, and so the claimant succeeded in his claim for recovery of money paid under an illegal contract (for insider dealing) which was not ultimately performed.

This new approach replaces the test adopted by the House of Lords in Tinsley v Milligan [1994] 1 AC 340, under which a claim would be barred if the claimant had to rely on the illegality to bring the claim. The so-called reliance test has been much-criticised on the basis that it is arbitrary, uncertain and potentially unjust, in particular because the question of whether a claim could proceed depended on a procedural issue of how the case must be pleaded rather than the merits of the parties or questions of public policy.

On numerous occasions in recent years, the courts have identified the need for the Supreme Court to address the proper approach to the defence of illegality in an appropriate case (see for example this blog post on Jetivia SA v Bilta (UK) Limited [2015] UKSC 23). It is therefore welcome that the Supreme Court has clarified the law in this difficult area.    

That said, there is force in the view expressed by a minority of the Supreme Court that the new approach risks enabling the courts to apply the illegality principle in an inconsistent way and possibly beyond its proper limits.  There is a fear, succinctly expressed by Lord Sumption, that the new approach "converts a legal principle into an exercise of judicial discretion", in the process exhibiting all the vices of "complexity, uncertainty, arbitrariness and lack of transparency". It has however been authoritatively established as the correct approach to the law.

Tom Henderson, a senior associate in our dispute resolution team, considers the decision further below.

Background

The claimant, Mr Patel, provided the defendant, Mr Mirza, with £620,000 in order for Mr Mirza to bet on the movement of RBS shares. The arrangement to bet on the shares was formed on the basis that Mr Mirza was to receive insider information relating to a statement that was to be made by the Chancellor of the Exchequer about the Government's investment in the bank.

The insider information never materialized and no bet was made. Mr Patel sought to recover the £620,000 he paid to Mr Mirza. The claim was resisted by Mr Mirza on the basis that it should fail due to illegality, as the agreement amounted to an offence of insider dealing under section 52 of the Criminal Justice Act 1993.

High Court decision

At first instance, the judge applied the reliance test and held that Mr Patel's claim was unenforceable because he had to rely on his own illegality to establish it. The judge also found that Mr Patel was unable to bring himself within the so-called locus poenitentiae exception to the illegality defence, as he did not voluntarily withdraw from the illegal arrangement. Rather, the scheme did not go ahead because of matters outside of either party's control. 

Court of Appeal decision

The majority in the Court of Appeal (Rimer and Vos LJJ) agreed with the judge on the doctrine of reliance but found that Mr Patel fell within the locus poenitentiae exception as the illegal agreement was not performed and could not be performed. 

Gloster LJ agreed that Mr Patel should succeed but her reasoning differed. She did not apply the same rule and exception approach. Instead, she concluded that the illegality rule did not prevent Mr Patel from seeking restitutionary relief as he was not enforcing his contract with Mr Mirza and there was no public policy reason why the money should not be returned to Mr Patel.  There had been no exploitation of unpublished price-sensitive information and Mr Mirza was the more blameworthy of the two, being a finance professional with knowledge of insider dealing.  

Mr Mirza appealed to the Supreme Court.  

Supreme Court Decision

The Supreme Court unanimously dismissed Mr Mirza's appeal and held that Mr Patel was entitled to restitution of the £620,000.  Lord Toulson (with whom Lady Hale,Lord Kerr, Lord Wilson and Lord Hodge agreed) gave the lead judgment. Lords Neuberger Clarke, Mance and Sumption agreed with the result, but by separate reasoning. 

For the majority, Lord Toulson rejected the Tinsley v Milligan reliance test as arbitrary in that the question of whether the illegality prevented a claimant from obtaining relief depended not on the merits of the parties, the degree and centrality of the illegality, the policies underlying the illegality defence, but on a procedural issue of whether a party needed to rely on illegality in its pleading to advance its case. This risks resulting in inconsistent and unjust outcomes and should no longer be followed.

Lord Toulson said the illegality doctrine is at a crossroads between a strictly "rule based" approach and a more flexible "range of factors" based approach. The essential rationale of the illegality doctrine is that it would be contrary to the public interest to enforce a claim if to do so would be harmful to the integrity of the legal system. The integrity and harmony of the law require flexibility in assessing whether the defence should apply. The risk of applying a formal "rule based" approach is that it may produce disproportionate and unjust results. On that basis, he favoured a "range of factors" based approach. 

With that in mind, Lord Toulson explained that in order to assess whether the public interest will be harmed by enabling a claimant to recoup money paid under an illegal agreement, it is necessary to consider:

a) the underlying purpose of the prohibition which has been transgressed and whether that purpose will be enhanced by denial of the claim,

b) any other relevant public policy on which the denial of the claim may have an impact; and

c) whether denial of the claim would be a proportionate response to the illegality. 

When considering point (c) specifically, Lord Toulson explained that various factors would be relevant although he would not lay down a prescriptive list.  By way of example only, he said potential factors might include the seriousness of the conduct, its centrality to the contract, whether it was intentional, and whether there was marked disparity in the parties' respective culpability.

Lord Toulson went on to say that a claimant who satisfied the ordinary requirements of a claim for unjust enrichment should not be debarred from enforcing his claim by reason only of the fact that the money which he sought to recover was paid for an unlawful purpose. There may be rare cases where for some particular reason the enforcement of such a claim might be regarded as undermining the integrity of the justice system, but there were no such circumstances in this case.

Lord Neuberger, Lord Mance, Lord Clarke and Lord Sumption all agreed with the decision to dismiss the appeal, but by different reasoning. In essence, they concluded that the law should permit a party to an illegal arrangement to recover any sum paid under it, so long as restitution is possible. As Lord Mance put it, "illegality remains significant as a bar to relief, but only in so far as it is reliance in order to profit from or otherwise enforce an illegal contract. Reliance in order to restore the status quo is unobjectionable."

While Lord Neuberger went on to say he thought the approach adopted by Lord Toulson provided, to the extent it was possible to do so, reliable and helpful guidance on the illegality doctrine for the future, Lords Mance, Clarke and Sumption were critical of the "range of factors" based approach. All three were concerned that this approach would be too vague and potentially too wide, requiring courts to make value judgments in an unspecific and non-legal sense.  The existing law on illegality may be problematic, but, as Lord Sumption commented, "we would be doing no service to the coherent development of the law if we simply substituted a new mess for the old one."