Dishonourable causes “ a bar to action: Moore Stephens v Stone Rolls Limited (in liquidation) (2009) UKHL 39Author : Charles Thornley

Public and Products Liability

On 30 July 2009, in one of its last decisions before becoming the Supreme Court of the United Kingdom, the House of Lords struck out a claim brought by liquidators of Stone & Rolls Limited (S&R) against its auditors Moore Stephens (Auditors) for breach of duty to act with reasonable skill and care in detecting S&R’s own fraudulent activity. The majority applied the principle of ex turpi causa non oritur actio (the Latin maxim meaning œfrom a dishonourable cause an action does not arise) to find that S&R should not benefit from its own illegal conduct.

The facts

S&R was owned and controlled by Mr Stojevic. He, through S&R, operated an elaborate Ponziesque scheme utilising letters of credit that lead various banks to believe they were financing bona fide commodity trades.  The letters did not relate to actual goods and once S&R had obtained the funds it would assign or forfeit the letters of credit to third parties under Stojevic’s control. The third parties reimbursed the banks for the maturing letters of credit and then sought larger letters of credit. This fraud continued until the third parties ceased repayment of the loans leaving the banks with large unsecured losses.

One of the defrauded banks was awarded damages in excess of US$94m against S&R and Stojevic. S&R could not pay the damages and was placed into liquidation. The liquidators discovered that Stojevic had stripped S&R of its assets. The liquidators (and creditors) of S&R considered that the Auditors should have detected Stojevic’s fraudulent activity. S&R (in liquidation) brought proceedings to recover about US$173m from the Auditors for failure to exercise reasonable skill and care in carrying out their auditing duties and for breach of contract.

The application

The Auditors sought orders striking out S&Rs claim. They contended that as S&R and Stojevic were one and the same entity for the purpose of carrying out of the fraud, his conduct should be imputed to S&R. The Auditors accepted for the purpose of the application that they were negligent but argued that S&R could not benefit from its own illegal conduct based on the ex turpi causa principle.

S&R relied on In re Hampshire Land Company (1896) 2 Ch.743 in opposing the Auditors’ application.  That case held that a company officer’s knowledge of his own fraud or breach of duty was not to be attributed to the company. S&R argued Hampshire Land meant Stojevic’s conduct could not be attributed to S&R and that the application of the ex turpi causa principle would be improper in circumstances where the fraud was œthe very thing the Auditors were brought in to prevent.

The decisions below

The Commercial Court, in dismissing the Auditors’ application, considered Hampshire Land was distinguishable because S&R lost nothing other than its fraudulent gains, but was more attracted by S&R’s argument that fraud was œthe very thing the Auditors were brought in to prevent.  The Court of Appeal agreed with the Commercial Court regarding Hampshire Land, but felt that ex turpi causa was such a powerful principle that it left no discretion to the court, so upholding the Auditors’ appeal.

House of Lords

By a 3-2 majority the House of Lords upheld the decision of the Court of Appeal, allowing the principle of ex turpi causa to defeat a claim of negligence brought by the corporate perpetrator of fraud against its own auditors for not discovering its own misconduct.

Lord Phillips wrote the majority opinion. He found that the fraud was properly attributable to S&R holding that where a single person managed all aspects of a company’s activities there was œno difficulty in identifying the fraud as the fraud of the company, so distinguishing Hampshire Land where that was not the case. He considered that the ex turpi causa principle had to apply in this instance. He was however careful to distinguish this matter from a situation where an auditor aided and abetted a scheme of fraud. Lords Walker and Brown concurred, being careful to hold that the ex turpi causa defence be restricted to situations where the company and the fraudulent actor were one and the same.

Lord Mance and Lord Scott disagreed.  They considered the Hampshire Land rule was applicable despite that matter not concerning a one-man company. They were also of the opinion that the Auditors owed a duty to protect the interests of S&R’s creditors by preserving the assets of the company. They considered that this duty existed because S&R was at each audit date insolvent. Lord Scott felt the application of the ex turpi causa principle should be different in a situation where a solvent company brings an action for the benefit of its shareholders as opposed to a situation where an insolvent company brings an action for the benefit of creditors.  The latter situation would not result in the perpetrator of fraud benefiting from the claim.

Lord Mance considered S&R to be a victim of the fraud and held that the ex turpi principle could not be used to defeat a claim for breach of duty to detect an officer’s fraudulent activities as œit 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.

Implications

This is a landmark decision on the application of the ex turpi causa principle. There is much else in the 130 page House of Lord’s decision that will be of interest to auditors and their insurers. However, for all its importance, the decision is limited in its application to cases involving fraud by a œone man company. That said, this is the area where smaller auditing firms and their insurers have real exposure.

A final thought: Would the decision have been different if the matter was litigated in Australia where causes of action would lie under the Trade Practices Act and ASIC Act? The answer has to be quite possibly

20/08/2009