Stone & Rolls Ltd (in liq) v Moore Stephens (a firm)

on appeal from:[2008] EWCA Civ 644

OPINIONS

OF THE LORDS OF APPEAL

FOR JUDGMENT IN THE CAUSE

Moore Stephens (a firm) (Respondents) v Stone Rolls Limited (in liquidation (Appellants)

Appellate Committee

Lord Phillips of Worth Matravers

Counsel

Appellant:

Respondent:

Michael Brindle QC	QC
Mark Simpson QC	Jonathan Sumption QC
David Murray	Tom Adam QC

(Instructed by Norton Rose LLP)

(Instructed by Barlow Lyde & Gilbert LLP)

Hearing dates:

10-12 FEBRUARY 2009

ON
THURSDAY 30 JULY 2009

HOUSE OF LORDS

OPINIONS OF THE LORDS OF APPEAL FOR JUDGMENT

IN THE CAUSE

Moore Stephens (a firm) (Respondents) v Stone Rolls Limited (in

liquidation) (Appellants)

[2009] UKHL 39

LORD PHILLIPS OF WORTH MATRAVERS

My Lords,

Introduction

1. Mr Stojevic is a fraudster. He used the appellant company, (“S&R”) as a vehicle for defrauding banks. The fraud was discovered and both S&R and Mr Stojevic were successfully sued for deceit by the principal victim, Komercni Bank SA (“the Bank”). The respondent, Moore Stephens, were S&R’s auditors. Moore Stephens accept that they owed S&R a duty to exercise reasonable skill and care in carrying out their duties as auditors. For purposes of the present argument they also accept that they were in breach of that duty and that, but for their breach, the fraud that Mr Stojevic was perpetrating through S&R would have ended earlier. In this action S&R seek to recover losses caused to them in consequence of the extension of the period of their fraudulent activity that they submit was caused by Moore Stephens’ breach of duty. Moore Stephens contend that this claim cannot succeed because it is founded on S&R’s fraud and is met by the defence commonly described by the Latin maxim “ex turpi causa non oritur actio” (“ex turpi causa”). Whether ex turpi causa provides a defence to the claim advanced by S&R is the preliminary issue raised by this appeal.

2. Although he was a ‘shadow director’ acting under power of attorney and the shares in S&R are held in the name of a family trust it has been common ground that Mr Stojevic was the sole directing mind and will and the beneficial owner of S&R.

3. I have had the benefit of reading in draft the opinion of each of your Lordships. Each has summarised the nature of the fraud perpetrated by Mr Stojevic through S&R. It involved S&R obtaining payments under letters of credit by presenting to banks false documents in relation to fictitious commodity trading. My noble and learned friend Lord Mance has explained in a little more detail how the fraud worked. When the fraud was ultimately discovered, the monies fraudulently obtained by S&R had all been paid away to other participants in the fraud. The damages awarded to the Bank against S&R and Mr Stojevic exceed $94 million. Neither defendant could satisfy the judgment. The liquidators have started the present action in the name of S&R in an attempt to recover damages for the benefit of S&R’s creditors, who are the banks defrauded by S&R. The claim for breach of Moore Stephens duty of care is brought in both contract and tort.

4. Mr Stojevic had planned to use S&R to perpetrate this fraud before Moore Stephens were engaged, indeed the engagement of Moore Stephens was part of his plot. S&R, which was not at the material time carrying on any significant business, had an auditor who was a sole practitioner based in Rotherhithe. Mr Stojevic decided to replace him with Moore Stephens as part of a strategy to make S&R appear respectable in the eyes of European Banks. In persuading Moore Stephens to become S&R’s auditors, Mr Stojevic gave a fictitious account of the business that S&R had been doing and of the business whose accounts Moore Stephens would be auditing.

5. My initial reaction to S&R’s claim was that, as a matter of common sense, it could not succeed. There were three reasons for this reaction. The first was that S&R are seeking to put themselves forward as the victims of fraud when they were, in fact, the perpetrators of the fraud. The true victims of the fraud were the banks. True it is that S&R are now subject to a paper liability to the Komercni Bank of over $94m, but common sense would suggest that this is not really a loss that they have suffered. They started with nothing and their alleged losses are sums that they acquired by fraud and then paid away as part of the same fraudulent transaction. If a person starts with nothing and never legitimately acquires anything he cannot realistically be said to have suffered any loss. This was the reasoning of Mummery LJ who, in a short judgment in the Court of Appeal, agreed with Rimer LJ that the claim of S&R should be struck out. Keene LJ agreed with both judgments. Mummery LJ concluded his judgment:

“119. Does common sense matter? Yes. It is contrary to all common sense to uphold a claim that would confer direct or indirect benefits on the corporate vehicle, which was used to commit the fraud and was not the victim of it, and the fraudulent driver of the fraudulent vehicle”.

The second reason why common sense led me, initially, to consider that S&R’s claim should not succeed was that Moore Stephens were also the victims of S&R’s fraud. They were induced to agree to act as S&R’s auditors by a fictitious and fraudulent account of S&R’s business, given to them on behalf of the company by Mr Stojevic, and they were deceived in carrying out their audits by accounts fraudulently prepared on behalf of the company, albeit that it is for present purposes to be assumed that they were negligent in not detecting the fraud. It does not seem just that, in these circumstances, S&R should be able to bring a claim in respect of the very conduct that S&R had set about inducing. The final reason of common sense that predisposed me against this claim was one which would not, unlike the other two, occur to the man in the street but might occur to a student with knowledge of the principles of the law of negligence. Looking at the realities, this claim is brought for the benefit of banks defrauded by S&R on the ground that Moore Stephens should have prevented S&R from perpetrating the frauds. Why, if this is a legitimate objective, should the banks not have a direct cause of action in negligence against Moore Stephens? One answer, I would suggest, is that a duty of care in negligence will only arise where this is fair, just and reasonable. It would not be considered fair, just and reasonable for auditors of a company to owe a duty of care to an indeterminate class of potential victims in respect of unlimited losses that they might sustain as a result of the fraud of the company. If it would not be fair, just and reasonable for the banks to have a direct claim, then it would not seem fair just and reasonable that they should achieve the same result through a claim brought by the company’s liquidators for their benefit. In a lecture to the Chancery Bar Association entitled “Common Sense and Causing Loss” given on 15 June 1999 Lord Hoffmann commented adversely on the practice of those judges who justify their decisions by reference to “common sense”. He suggested that this was far too often an unsatisfactory alternative to the identification of the relevant principles. The differences of opinion between the members of the committee underline the need to identify the relevant principles that apply in this case. It also underlines the difficulty of that task. The first step is to identify the issues raised by the parties.

The issues raised by the parties

6. This appeal arises out of a strike-out application in which only one of a number of possible defences to the claim is advanced. Mr Sumption QC for Moore Stephens has admitted that his clients owed S&R a duty to exercise reasonable care in relation to the auditing of S&R’s accounts and, for the purpose of these proceedings, that they were in breach of that duty. He submits, however, that S&R are precluded from claiming a remedy for that breach of duty by a defence of public policy, namely ex turpi causa. He submits that the nature and extent of this defence has been definitively determined by the decision of this House in Tinsley v Milligan [1994] 1 AC 340. It involves the application of what he has described as a “reliance” test. A claimant cannot succeed if, in order to make good his claim, he has to aver and rely upon his own illegal conduct. This principle, so he submits, is not based as it was once thought to be upon a disinclination by the courts to award a remedy in circumstances where this would be “an affront to the public conscience”. It is simply a principle that the court will not allow its process to be used to further an object which is, on its face, illegal. The principle applies automatically and inflexibly. The “effect of illegality is not substantive but procedural” – Tinsley v Milligan at p. 374. To apply the test you have to do no more than consider the essential averments of the particulars of claim. Mr Sumption submits that in Tinsley v Milligan this House reduced ex turpi causa to “the narrowest possible test for the public policy defence short of actually discarding it”.

7. Mr Sumption submits that the best explanation of the reason for the ex turpi causa defence is that suggested by McLachlin J in Hall v Hebert (1993) 101 DLR (4th) 129, at p.165:

“…to allow recovery in these cases would be to allow recovery for what is illegal. It would put the courts in the position of saying that the same conduct is both legal, in the sense of being capable of rectification by the court, and illegal. It would, in short, introduce an inconsistency in the law. It is particularly important in this context that we bear in mind that the law must aspire to be a unified institution, the parts of which – contract, tort, the criminal law – must be in essential harmony. For the courts to punish conduct with the one hand while rewarding it with the other, would be to ‘create an intolerable fissure in the law’s conceptually seamless web’: Weinrib – “Illegality as a Tort Defence” (1976) 26 U.T.L.J.28 at p. 42. We thus see that the concern, put at its most fundamental, is with the integrity of the legal system”.

8. Mr Sumption has accepted that the “reliance” test is subject to one important qualification. The unlawful conduct relied on must be that of the claimant himself, not conduct for which he is vicariously liable or which is otherwise attributed to him under principles of the law of agency.

9. The first answer to Mr Sumption’s case advanced on behalf of S&R by Mr Brindle QC founds on that qualification. He submits that S&R’s liability to the banks for Mr Stojevic’s fraud is vicarious. The second answer is that, whether the first answer is right or wrong, for the purposes of the application of ex turpi causa, Mr Stojevic’s fraud cannot be attributed to S&R. In support of this submission Mr Brindle relies (i) on a principle of the law of agency known as the Hampshire Land principle after the decision in In re Hampshire Land Company [1896] 2 Ch 743, and (ii) on the principles governing the attribution of actions and states of mind to companies identified in the speech of Lord Hoffmann in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500.

10. Both Mr Brindle’s first and second answers proceed on the premise that Mr Sumption’s “reliance” test is correctly formulated. They accept that the reliance test applies to the facts of this case and that, in applying it, a company has to be treated in the same way as a natural person. He has, however, an alternative and more fundamental answer to Mr Sumption. He submits that ex turpi causa does not provide a defence where the claimant’s illegal conduct was the very thing that the defendant was under a duty to prevent. Here again he founds his argument on jurisprudence that relates to natural persons.

11. Finally, and very much as a fall-back position, Mr Brindle submits that ex turpi causa applies only where this is “fair, just and reasonable” and that it is not fair, just and reasonable that the defence should apply in the circumstances that have given rise to this appeal.

12. The debate between the parties has largely centred on the nature

and effect of the Hampshire Land principle. Mr Sumption summarised
this principle as follows in oral argument:

“There is not to be imputed to a company a fraud which is being practised against it even if it is being practised by someone whose acts and state of mind in the ordinary way are attributed to the company.”

Mr Sumption submits that this principle does not prevent attribution to S&R of Mr Stojevic’s fraud which was directed not against S&R but against the banks.

13. Mr Brindle does not accept that the Hampshire Land principle is as narrow as this. He submits that it also applies in respect of fraud on the part of an agent of the company that is directed against a third party in as much as the fraud is likely ultimately to come home to roost with consequent detriment to the company. Thus the company is a secondary victim of the fraud. That is precisely what has happened in this case, for S&R has been held liable for Mr Stojevic’s fraud.

14. Mr Sumption has a fall back position that meets this argument. It turns on the fact that Mr Stojevic was, in effect, the sole shareholder in S&R and also solely responsible for S&R’s activities. Mr Sumption submits that where there is no human embodiment of the company other than the fraudster, attribution of the fraud to the company is inevitable.

The decisions of the Courts below

15. Both Langley J at first instance and the Court of Appeal accepted that the relevant issues were those that I have just described. Langley J rejected the first two answers advanced by Mr Brindle to ex turpi causa. He held that S&R were primarily, and not just vicariously, responsible for the fraudulent conduct and that the Hampshire Land principle did not apply. Mr Stojevic’s fraud was properly attributed to S&R. He accepted, however, Mr Brindle’s third answer. He held that ex turpi causa could not prevent a claim founded on fraud that would not have occurred had Moore Stephens properly complied with their “very duty” as auditors of the company.

16. Rimer LJ, in giving the leading judgment in the Court of Appeal, agreed that Hampshire Land did not apply, but for a different reason. He held that the critical question was whether it was right to treat S&R as the villain or the victim. In the former case the fraud would be attributed to S&R; in the latter case it would not. He held that S&R was the villain and not the victim, Hampshire Land did not apply and ex turpi causa was a defence to S&R’s claim. Thus he accepted Mr Sumption’s definition of Hampshire Land and rejected Mr Brindle’s wider definition.

17. Rimer LJ rejected Mr Brindle’s argument based on the principle that he described as “the very thing”. He accepted Mr Sumption’s submission that this was a principle that related to causation and that it did not displace the operation of the defence of ex turpi causa.

A Summary of my conclusions

18. In order to assist in following this lengthy opinion I propose at this stage to summarise my conclusions:

1)         Under the principle of ex turpi causa the court will not assist a claimant to recover compensation for the consequences of his own illegal conduct.

2)         This appeal raises the question of whether, and if so how, that principle applies to a claim by a company against those whose breach of duty has caused or permitted the company to commit fraud that has resulted in detriment to the company.

3)         The answer to this question is not to be found by the application of Hampshire Land or any similar principle of attribution. The essential issue is whether, in applying ex turpi causa in such circumstances, one should look behind the company at those whose interests the relevant duty is intended to protect.

4)         While in principle it would be attractive to adopt such a course, there are difficulties in the way of doing so to which no clear resolution has been demonstrated.

5)         On the extreme facts of this case it is not necessary to attempt to resolve those difficulties. Those for whose benefit the claim is brought fall outside the scope of any duty owed by Moore Stephens. The sole person for whose benefit such duty was owed, being Mr Stojevic who owned and ran the company, was responsible for the fraud.

6)         In these circumstances ex turpi causa provides a defence to the claim.

The duties of auditors

19. I agree with my noble and learned friend Lord Mance that the starting point for considering the issues raised by this appeal is the duties undertaken by Moore Stephens as auditors. I am grateful for his detailed and helpful analysis. I would summarise the position as follows. The leading authority is Caparo Industries Plc v Dickman [1990] 2 AC 603. The duties of an auditor are founded in contract and the extent of the duties undertaken by contract must be interpreted in the light of the relevant statutory provisions and the relevant Auditing Standards. The duties are duties of reasonable care in carrying out the audit of the company’s accounts. They are owed to the company in the interests of its shareholders. No duty is owed directly to the individual shareholders. This is because the shareholders’ interests are protected by the duty owed to the company. No duty is owed to creditors – Al Saudi Banque v Clarke Pixley [1990] Ch 313. The Auditing Standards require auditors who have reason to suspect that the directors of a company are behaving fraudulently to draw this to the attention of the proper authority. The scope of the duty of care owed by auditors is a matter to which I shall return later in this opinion. For present purposes it suffices to note that the duty is unquestionably imposed in the interests of, at least, the shareholders of the company.

Ex turpi causa

20. Ex turpi causa is a principle that prevents a claimant from using the court to obtain benefits from his own illegal conduct. In the years immediately before the decision in Tinsley v Milligan the courts had developed a flexible approach to the defence of illegality, applying the test of whether, having regard to the illegality involved in the case, it would “shock the public conscience” to afford the claimant the relief sought. This test has been said to have originated from the judgment of Hutchison J in Thackwell v Barclays Bank plc [1986] 1 All ER 676 although reference to shocking the public conscience can be traced back at least to the judgment of Salmon LJ in Gray v Barr [1971] 2 QB 554 at p. 581. Tinsley v Milligan involved a dispute between two single women as to title to a house. The house had been purchased with their joint funds, but put into the sole name of the appellant. The reason for this was to facilitate fraudulent claims by the respondent on the Department of Social Services. The respondent claimed that, as the property had been bought with joint funds it was held on a resulting trust under which she had an equitable interest. The appellant contended that the respondent was precluded from asserting her claim because of the illegal purpose of the arrangement. The Court of Appeal, by a majority, had found in favour of the respondent, applying a test of whether, having regard to the illegality, it would be “an affront to the public conscience” to grant the relief sought. This House was in agreement that this was not the correct test. There was not, however, unanimity as to the correct approach to illegality. Lord Keith of Kinkel and Lord Goff of Chieveley would have allowed the appeal on the basis that the respondent was not entitled to equitable relief because the effect of the illegality was that she did not come to the court with “clean hands”. The reasoning of the majority appears from the following passages of the speech of Lord Browne-Wilkinson at pp. 369, 375 and 377:

“… it is now clearly established that at law (as opposed to in equity), property in goods or land can pass under, or pursuant to, such a contract. If so, the rights of the owner of the legal title thereby acquired will be enforced, provided that the plaintiff can establish such title without pleading or leading evidence of the illegality. . . .

… A party to an illegality can recover by virtue of a legal or equitable property interest if, but only if, he can establish his title without relying on his own illegality.
. . .
…In a case where the plaintiff is not seeking to enforce an
unlawful contract but founds his case on collateral rights
acquired under the contract (such as a right of property)
the court is neither bound nor entitled to reject the claim
unless the illegality of necessity forms part of the
plaintiff’s case.”

21. The House in Tinsley v Milligan did not lay down a universal test of ex turpi causa. It was dealing with the effect of illegality on title to property. It established the general principle that, once title has passed, it cannot be attacked on the basis that it passed pursuant to an illegal transaction. If the title can be asserted without reliance on the illegality, the defendant cannot rely on the illegality to defeat the title. This principle had been applied in the case of personalty in Bowmakers Ltd v Barnet Instruments Ltd [1945] KB 65. The House held that it also applied in the case of both legal and equitable title to realty. The House did not hold that illegality will never bar a claim if the claim can be advanced without reliance on it. On the contrary, the House made it plain that where the claim is to enforce a contract the claim will be defeated if the defendant shows that the contract was for an illegal purpose, even though the claimant does not assert the illegal purpose in making the claim – see Alexander v Rayson [1936] 1 KB 169, approved by Lord Browne-Wilkinson at p. 370.

22. Hewison v Meridian Shipping Services Pte Ltd [2002] EWCA Civ 1821; [2003] PIQR P252 illustrates another situation in which ex turpi causa defeated a claim albeit that the illegality was not asserted by the claimant.

23.     In Cross v Kirkby (CA 18.2.2000) Beldam LJ remarked:

“I do not believe that there is any general principle that the claimant must either plead, give evidence of or rely on his own illegality for the principle to apply. Such a technical approach is entirely absent from Lord Mansfield’s exposition of the principle”

I agree with that observation.

24. In Tinsley v Milligan the ex turpi causa defence failed because the respondent did not need to plead the illegal agreement in order to establish her equitable title. Mr Sumption relies on the decision as establishing a general principle that is the converse of that applied by the majority of the House. This is that if the claimant has to rely on his own illegality to establish his claim the courts will never entertain the claim (“the reliance test”). I have already noted that Mr Sumption advanced one qualification to this rule – it only applies where the illegality is personal to the claimant, not vicarious. In the course of argument when dealing with United Project Consultants Pte Ltd. v Leong Kwok Onn [2005] SGCA 38; [2005] 4 SLR 214 he accepted another qualification. The illegality must involve turpitude. The defence may not apply where the claimant’s illegality consists of an offence of strict liability of which he is unaware. Those, as I shall shortly show, are valid qualifications to the defence of ex turpi causa in the context in which it is raised on this appeal. They are not, however, of general application to the defence of ex turpi causa.

25. Although Tinsley v Milligan does not establish a general rule that if a claimant founds his claim on his own illegal conduct, the defence of ex turpi causa will apply, earlier cases support this principle: Marles v Philip Trant & Sons Ltd [1954] 1 QB 29; Archbolds (Freightage) Ltd v S. Spanglett Ltd [1961] 1 QB 374. I do not believe, however, that it is right to proceed on the basis that the reliance test can automatically be applied as a rule of thumb. It is necessary to give consideration to the policy underlying ex turpi causa in order to decide whether this defence is bound to defeat S&R’s claim. As Lord Hoffmann recently remarked in Gray v Thames Trains Ltd [2009] UKHL 33; [2009] 3 WLR 167 at para 30:

“The maxim ex turpi causa expresses not so much a principle as a policy. Furthermore, that policy is not based upon a single justification but on a group of reasons, which vary in different situations”.

The underlying policy

26. The policy underlying ex turpi causa was explained by Lord Mansfield in 1775 in Holman v Johnson 1 Cowp. 341, 343; 98 ER 1120, 1121:

“The objection, that a contract is immoral or illegal as between plaintiff and defendant, sounds at all times very ill in the mouth of the defendant. It is not for his sake, however, that the objection is ever allowed; but it is founded in general principles of policy, which the defendant has the advantage of, contrary to the real justice as between him and the plaintiff, by accident, if I may so say. The principle of public policy is this; ex dolo malo non oritur actio. No court will lend its aid to a man who founds his cause of action upon an immoral or an illegal act. If, from the plaintiff's own stating or otherwise, the

cause of action appears to arise ex turpi causâ, or the transgression of a positive law of this country, there the court says he has no right to be assisted. It is upon that ground the court goes; not for the sake of the defendant, but because they will not lend their aid to such a plaintiff. So if the plaintiff and defendant were to change sides, and the defendant was to bring his action against the plaintiff, the latter would then have the advantage of it; for where both are equally in fault, potior est conditio defendentis.

The policy can be subdivided into two principles in relation to contractual obligations:

(i)            The court will not enforce a contract which is expressly or impliedly forbidden by statute or that is entered into with the intention of committing an illegal act.

(ii)            The court will not assist a claimant to recover a benefit from his own wrongdoing. This extends to claims for compensation or an indemnity in respect of the adverse consequences of the wrongdoing – see Beresford v Royal Insurance Co Ltd [1938] AC 586.

It is the second principle that is in play on this appeal.

Qualifications to the second principle

27. The two qualifications recognised by Mr Sumption apply in respect of the second, but not the first principle. Thus they apply to the type of claim with which your Lordships are concerned. S&R are not seeking to enforce an illegal agreement. They are seeking compensation for the adverse consequences of having engaged in unlawful conduct. A number of authorities to which we have been referred support Mr Sumption’s acceptance that in these circumstances the defence of ex turpi causa will only apply where the claimant was personally at fault and thus where his responsibility for wrongdoing was primary rather than vicarious: Burrows v Rhodes and Jameson [1899] 1 QB 816; Hardy v Motor Insurers’ Bureau [1964] 2 QB 745 at p.760; Lancashire County Council v Municipal Mutual Insurance Ltd [1997] QB 897 at p. 908; United Project Consultants Pte Ltd v Leong

Kwok Onn [2005] 4 SLR 214. Furthermore, there has never been any suggestion that it is contrary to public policy for a company to insure against liabilities that it may vicariously incur as a consequence of the wrongdoings of its agents. Arab Bank plc v Zurich Insurance Co [1999] 1 Lloyd’s Rep 262 was such a case.

28. Thus Mr Sumption is correct to accept that, in the context of a claim for compensation for the adverse consequences of wrong-doing, ex turpi causa applies where the wrongdoing is personal, or primary, but not where it is vicarious.

The Consequences of Moore Stephens’ primary case

29. The consequences of Moore Stephens’ primary case are best considered in a case where the facts are not as extreme as those with which your Lordships are concerned. Assume that a company carries on legitimate business, owns legitimate assets and has shareholders who are not complicit in the conduct of the man who runs the company, “the directing mind and will” of the company. Assume that the directing mind and will, in breach of his duties to the company, involves the company in fraudulent trading and that this causes the company to sustain losses. On Moore Stephens’ primary case, as Mr Sumption accepted, a claim for damages for misfeasance against the directing mind and will would be defeated by the defence of ex turpi causa on the ground that the directing mind and will’s turpitude was attributed to the company.

30. Assume that the auditors of the company had negligently failed to identify the fact that the directing mind and will was acting fraudulently, with the consequence that his fraud was permitted to continue. The company’s claim against the auditors for the benefit of its shareholders, whose interests the auditors should have protected, would be barred by the very wrongdoing that the auditors’ negligence had permitted to occur.

31. Mr Brindle would avoid these consequences in one of two ways. First he says that the fraud of the directing mind and will does not fall to be treated as the fraud of the company for the purposes of ex turpi causa. This is because where the company becomes a victim of the fraud, although the fraud is directed at a third party, the Hampshire Land principle prevents the fraud from being attributed to the company. Alternatively he argues that where the fraud is “the very thing” that the defendant was under a duty to prevent, ex turpi causa does not apply at all.

The opinions of the Committee

32. My noble and learned friends Lord Walker of Gestingthorpe and Lord Brown of Eaton-under Heywood have not adopted the reasoning of Rimer LJ in finding in favour of Moore Stephens. They have based their decisions on Mr Sumption’s fall back position. Each has held that Hampshire Land does not apply, that Mr Stojevic’s fraudulent conduct is to be treated as the conduct of S&R and that ex turpi causa defeats S&R’s claim. In doing so, however, their Lordships have restricted their reasoning to the situation where the directing mind and will of the company is also its owner. This leaves open the question of whether ex turpi causa will bar a claim by a company with independent shareholders where those shareholders have been unaware that the directing mind and will of the company has been involving the company in fraud.

33. My noble and learned friend Lord Scott of Foscote considers that Mr Stojevic’s fraud would not be attributed to S&R so as to bar a claim by S&R against Mr Stojevic. This is because his fraud constituted a breach of the duty that he owed to S&R as an officer of the company. Lord Scott applies the same reasoning to the claim that is brought against Moore Stephens. They too, as auditors, owed duties as officers of S&R and the claim brought by S&R is for breach of those duties. In these circumstances, Mr Stojevic’s fraud should not be attributed to S&R. This result is not reached by the application of Hampshire Land on the facts of this case. Rather, so it seems to me, Lord Scott accepts the force of “the very thing” argument, at least where the very thing relates to a duty imposed on the defendant as an officer of the claimant company.

34. Lord Mance starts by considering what the position would have been as between S&R and Mr Stojevic if the latter had not been the sole shareholder in S&R. He concludes that if S&R had sued Mr Stojevic ex turpi causa would not have applied as there would be no question of Mr Stojevic benefiting from his own wrong and it would be nonsensical to attribute his wrong to the company in such circumstances. He also considers that Hampshire Land would apply in that situation, because S&R had to be considered as a separate legal entity from Mr Stojevic and Mr Stojevic’s conduct could properly be characterised as a fraud on S&R.

35. Lord Mance next turns to consider whether the position is affected by the fact that Mr Stojevic was sole shareholder in S&R. He concludes that had S&R been solvent there might have been difficulty in establishing any claim against Mr Stojevic. As, however, it was insolvent, Mr Stojevic was in breach of duty in failing to have regard to the interests of the creditors. S&R would have been able to sue him for breach of this duty and ex turpi causa could not be relied upon as a defence.

36. Lord Mance then considers whether S&R could have claimed against Moore Stephens if S&R had had independent shareholders rather than Mr Stojevic. Applying similar reasoning Lord Mance concludes that ex turpi causa could not defeat a claim against Moore Stephens for failing to detect the very fraud that was asserted by way of that defence.

37. Does it make a difference that Mr Stojevic was the sole shareholder in the company? Had S&R been solvent Moore Stephens would not have committed any actionable breach of duty in failing to draw the attention of the owner of the company to his own fraud. Lord Mance concludes that the critical factor is that S&R was insolvent. Just as Mr Stojevic was in breach of his duty to have regard to the interests of the creditors, so the auditors’ duty to the company extended beyond the interests of the shareholders to the interests of the creditors. Ex turpi causa affords no defence to breach of this duty.

38. Having summarised the conclusions reached by your Lordships I turn to consider the topic that has formed the central bone of contention between the parties, namely the application of the Hampshire Land principle.

Attribution and Hampshire Land

Attribution

39. The principles governing the attribution of conduct and states of mind to companies have been helpfully analysed by Lord Hoffmann in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500, an appeal to the Privy Council from New Zealand. The appellant company, Meridian, was an investment management company. Its chief investment manager and senior portfolio manager had acquired shares for the company without the knowledge of the managing director or the board of the company. The company was under a statutory obligation to give notice of this acquisition, but failed to do so. It appears to have been common ground that the company was only in breach of this obligation if it had knowledge of the acquisition in question. The issue was whether the company had the requisite knowledge.

40. At p. 506 Lord Hoffmann first dealt with what he described as the “primary rules of attribution” of acts of a company, namely those set out in the articles of association of the company or implied by company law. He then referred to the application to a company of the “general rules of attribution” that apply equally in the case of natural persons, such as principles of agency, estoppel, ostensible authority in contract or vicarious liability in tort.

41.     At p. 507 Lord Hoffmann commented:

“The company’s primary rules of attribution together with the general principles of agency, vicarious liability and so forth are usually sufficient to enable one to determine its rights and obligations. In exceptional cases, however, they will not provide an answer. This will be the case when a rule of law, either expressly or by implication, excludes attribution on the basis of the general principles of agency or vicarious liability. For example, a rule may be stated in language primarily applicable to a natural person and require some act or state of mind on the part of that person ‘himself’, as opposed to his servants or agents. This is generally true of rules of the criminal law, which ordinarily impose liability only for the actus reus and mens

rea of the defendant himself. How is such a rule to be
applied to a company?

One possibility is that the court may come to the conclusion that the rule was not intended to apply to companies at all; for example, a law which created an offence for which the only penalty was community service. Another possibility is that the court might interpret the law as meaning that it could apply to a company only on the basis of its primary rules of attribution, i.e. if the act giving rise to liability was specifically authorised by a resolution of the board or an unanimous agreement of the shareholders. But there will be many cases in which neither of these solutions is satisfactory; in which the court considers that the law was intended to apply to companies and that, although it excluded ordinary vicarious liability, insistence on the primary rules of attribution would in practice defeat that intention. In such a case, the court must fashion a special rule of attribution for the particular substantive rule. This is always a matter of interpretation: given that it was intended to apply to a company, how was it intended to apply? Whose act (or knowledge, or state of mind) was for this purpose intended to count as the act etc of the company? One finds the answer to this question by applying the usual canons of interpretation, taking into account the language of the rule (if it is a statute) and its content and policy.”

42. While initially Lord Hoffmann had spoken of attribution of acts here he spoke of attribution of an act or knowledge or a state of mind. Normally the attribution of an act will carry with it the attribution of knowledge of the act, but this is not necessarily the case as Lord Hoffmann made plain at p. 511:

“But their Lordships would wish to guard themselves against being understood to mean that whenever a servant of a company has authority to do an act on its behalf, knowledge of that act will for all purposes be attributed to the company. It is a question of construction in each case as to whether the particular rule requires that the knowledge that an act has been done, or the state of mind with which it was done, should be attributed to the company.”

Hampshire Land

43.     Lord Walker has summarised the relevant authorities where the

Hampshire Land principle has been applied. The important point to note is that Hampshire Land is an exception to the normal rules for the attribution of an agent’s knowledge to his principal. It is not a rule about the attribution of conduct. Hampshire Land applies where an agent has knowledge which his principal does not in fact share but which under normal principles of attribution would be deemed to be the knowledge of the principal. The effect of Hampshire Land is that knowledge of the agent will not be attributed to the principal when the knowledge relates to the agent’s own breach of duty to his principal. The rationale for Hampshire Land has been said to be that it is contrary to common sense and justice to attribute to a principal knowledge of something that his agent would be anxious to conceal from him.

44. The cases demonstrate some confusion as to the precise nature and scope of the Hampshire Land principle and doubt has even been expressed as to whether it exists – see Bowstead & Reynolds on Agency 18th ed (2006, at 8-188 and 8-213 and Watts, “Imputed Knowledge in Agency Law – Excising the Fraud Exception” (2001) 117 LQR 300 at pp. 319-320. There is a tendency to confuse the Hampshire Land principle with a similar principle developed by the courts of the United States, referred to as “the adverse interest exception to imputation”.

45. The nature of what I shall call “the adverse interest rule” varies from state to state. It is an exception to the imputation principle under which both the knowledge and the conduct of an employee or agent are attributed to his principal where that person is acting in the course of his employment or within his apparent authority. Under the adverse interest rule the knowledge and conduct of an agent will not be attributed to the principal where the agent’s actions are adverse to the interests of his principal. In some States the agent’s conduct must be targeted against the principal if the rule is to apply. In others, the rule applies more widely, in circumstances where the agent’s conduct is done for his personal benefit and is adverse to the interests of his principal, but is not aimed against his principal. A helpful overview of United States law on this topic has been provided by Amelia T Rudolph and Elizabeth V Tanis in a paper entitled “Invoking In Pari Delicto to Bar Accountant Liability Actions Brought by Trustees and Receivers” (2008) ALI-ABA Study Materials.

46. The adverse interest rule would, so it seems to me, operate at least in some circumstances as a normal rule of attribution under established principles of the English law of agency, rather than as an exception to the norm. Under it an English court would not attribute to a company the act of its managing director in dishonestly transferring the company’s funds into his own account.

47. The operation of a similar principle in the context of the criminal liability of a company for the acts of its directing will and mind is to be found in the decision of the Canadian Supreme Court in Canadian Dredge & Dock Co Ltd v The Queen (1985) 19 DLR (4th) 314. In the course of giving the judgment of the court Estey J put the position as follows at p. 351:

“ Where the directing mind conceives and designs a plan and then executes it whereby the corporation is intentionally defrauded, and when this is the substantial part of the regular activities of the directing mind in his office, then it is unrealistic in the extreme to consider that the manager is the directing mind of the company…Where the criminal act is totally in fraud of the corporate employer and where the act is intended to and does result in benefit exclusively to the employee-manager, the employee-directing mind, from the outset of the design and execution of the criminal plan, ceases to be a directing mind of the corporation and consequently his acts could not be attributed to the company under the identification doctrine”.

This statement was made in relation to criminal charges brought against the company. It describes a principle of attribution that I would accept as applicable under English common law.

48.     I believe that Mr Sumption’s definition of the Hampshire Land

principle that I have quoted in paragraph 12 above more accurately describes the adverse interest rule. Confusion between the two principles has tended to obfuscate what, at the end of the day, is a question of attribution that is not difficult to answer on the facts of this case.

Attribution in this case

49. Mr Brindle submits that this case involves two questions of attribution. The first is whether S&R’s liability to the banks was primary or vicarious. The second is whether, for the purpose of ex turpi causa, Mr Stojevic’s fraudulent conduct falls to be attributed to S&R. These are two different ways of posing the same question. The purpose for which the question of attribution has to be answered is in order to decide whether the defence of ex turpi causa applies. If Mr Sumption’s reliance test is applied, the question that has to be answered is whether S&R is relying upon its own fraud, rather than fraud for which it is only vicariously liable, in order to found its claim. If the underlying principle of public policy is applied, the question that has to be answered is whether S&R is seeking to obtain compensation for the consequences of its own fraud rather than for the consequences of fraud for which it is only vicariously liable. To answer the question it is necessary to decide whether the fraud of Mr Stojevic falls to be treated as the fraud of S&R itself.

50. As between a company that has committed fraud and the victim of the fraud, the question of whether the company’s liability is primary or vicarious seldom, if ever, arises. As Estey J remarked in Canadian Dredge & Dock Co Ltd v The Queen, at pp 324-325:

“At common law there was no difficulty in finding liability in a corporation in the law of torts, even though the state of mind of the corporation was established by imputing to that corporation the intentions and the conduct of its servants and agents. Thus, in the law of torts, the courts from the earliest times found vicarious liability in the corporation on the principles of agency.”

In this case, however, it is necessary to distinguish between vicarious and primary liability for the purpose of considering the application of ex turpi causa. There is no way of doing this other than by applying the same approach as applies in other circumstances where this exercise is necessary. Indeed Bowstead & Reynolds at 8-188 identifies “the supposed fraud exception to the rules as to imputation of the agent’s knowledge to the principal” as one of the situations where it may be necessary to consider whether conduct ranks as the act of the corporation itself. The words of Lord Reid in Tesco Supermarkets Ltd v Nattrass [1972] AC 153 at 170 are directly in point:

“A living person has a mind which can have knowledge or intention or be negligent and he has hands to carry out his intentions. A corporation has none of these: it must act through living persons, though not always one or the same person. Then the person who acts is not speaking or acting for the company. He is acting as the company and his mind which directs his acts is the mind of the company. There is no question of the company being vicariously liable. He is not acting as a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company. If it is a guilty mind then that is the guilt of the company. It must be a question of law whether, once the facts have been ascertained, a person in doing particular things is to be regarded as the company or merely as the company’s servant or agent. In that case any liability of the company can only be a statutory or vicarious liability.”

51. Where those managing the company are using it as a vehicle for fraud, or where there is only one person who is managing all aspects of the company’s activities, there is no difficulty in identifying the fraud as the fraud of the company. Thus in Royal Brunei Airlines Sdn Bhd v Tan [1995] 2 AC 378, a case concerning a company, BLT, that was owned and managed by one man, Lord Nicholls of Birkenhead, when giving the advice of the Privy Council, observed at p. 393:

“Set out in these bald terms, the defendant’s conduct was dishonest. By the same token, and for good measure, B.L.T. also acted dishonestly. The defendant was the company, and his state of mind is to be imputed to the company.”

52. Lord Nicholls returned to this theme in Mahmud v BCCI [1998] AC 20 at p. 34 where he said this about BCCI:

“The bank operated its business dishonestly and corruptly. On the assumed facts, this was not a case where one or two individuals, however senior, were behaving dishonestly. Matters had gone beyond this. They had reached the point where the bank itself could properly be identified with the dishonesty. This was a dishonest business, a corrupt business.”

53. A similar issue of attribution arose in KR v Royal & Sun Alliance plc [2006] EWCA Civ 1454; [2007] 1 All ER (Comm) 161 in relation to a clause in a policy of liability insurance. The clause excluded the insurers’ liability in respect of: “Injury damage or financial loss which results from any deliberate act or omission of the insured…” The insured was a company that operated children’s homes. The issue was whether the clause exempted the insurers from liability in respect of the company’s liability for physical abuse perpetrated by the managing director and major shareholder in the company. The Court of Appeal held at paragraph 65 that the intention of the clause was to exclude liability for damage or injury caused by the deliberate acts of the person who was to be regarded as, in effect, the company, as opposed to the acts of those who were mere employees. As such it excluded liability in respect of the acts of the managing director:

“It is not just the case that he was managing director and majority shareholder of the company; he was [the company]. He treated the company as his own and nothing of consequence happened without his say so.”

54. In this case it might be said that S&R was not a business being carried on corruptly but rather that there was no business at all. Mr Stojevic, in the name of the company, was pretending to carry on a fictitious business. With false pretences and fabricated documents he was fraudulently inducing Komercni Bank and other banks to pay large sums to S&R. It might be argued that the adverse interest rule, as formulated by Estey J in Canadian Dredge & Dock Co Ltd v The Queen, applies, in that Mr Stojevic was, from the outset, acting pursuant to a criminal plan that was exclusively for his own benefit. Such an argument would, however, be fallacious. Mr Stojevic was using S&R for his own dishonest purposes, but in a manner that resulted in substantial payments being made to S&R. It has never been suggested that Mr Stojevic’s conduct did not fall to be attributed to S&R so as to render S&R liable in deceit. That S&R was properly held liable is the basis of S&R’s claim. The fraudulent business must be treated as the business of S&R carried on, in the first instance, to benefit S&R.

55. Mr Brindle submits that the Hampshire Land principle applies so as to prevent attribution in this case. For the reasons that I have given I do not consider that that principle has any application. Nor does the adverse inference rule apply so as to prevent the attribution of Mr Stojevic’s fraudulent conduct to the company. Mr Brindle has not suggested that the banks are not to be treated as the primary victims of the fraud that Mr Stojevic has caused S&R to commit. He submits, however, that the fraud should not be attributed to S&R because it has come home to roost, making S&R a secondary victim. Neither authority nor common sense supports this proposition. As Mr Sumption points out, a company that commits fraud is always liable to find itself a secondary victim in this way. Mr Brindle’s submission amounts, on analysis, to an argument that ex turpi causa should never prevent a company from recovering compensation for the consequences of fraud which those managing the company have caused it to commit. That submission falls to be considered in the context of the alternative way that Mr Brindle advances his case.

56. For the reasons that I have given I find that neither the Hampshire

Land principle nor the adverse interest rule prevents the attribution of
Mr Stojevic’s fraud to S&R.

The very thing

57. This argument is founded upon the fact that Mr Sumption has conceded that Moore Stephens owed a duty of care to S&R and that it is to be assumed for the purposes of the ex turpi causa issue that the duty of care has been broken. Mr Brindle’s argument is, in essence, that if a duty exists to take action that will prevent a claimant from committing an illegal act, the claimant must have a remedy for breach of that duty, otherwise the duty will be rendered nugatory. Mr Brindle relies on reasoning of Buxton LJ to this effect in Reeves v Commissioner of Police of the Metropolis [1999] QB 169. The relevant issue under consideration was whether, on the premise that suicide was to be treated as illegal conduct, ex turpi causa would bar a claim against the police for negligently permitting a prisoner to commit suicide. In holding that it would not Buxton LJ observed at p. 185:

“Here, the alleged turpitudinous act is the very thing that the defendant had a duty to try to prevent, imposed by a law of negligence which itself appeals to public conscience or at least public notions of reasonableness”

58. Mr Brindle’s argument is that fraud by S&R was one of the very things that Moore Stephens owed a duty of care to prevent. It follows that ex turpi causa should not defeat a claim for breach of that duty. I propose, when approaching Mr Brindle’s alternative argument, to consider it initially in relation to a solvent company with independent and innocent shareholders which suffers damage because its directing mind and will involves it in fraud.

Claim by the company against the directing will and mind

59. Lord Scott and Lord Mance consider that a company must be able to bring a claim against a director who, in breach of duty, causes the company damage by involving it in fraud. I sympathise with their reaction. Imagine a group of investors who float a company to own and operate a yacht commercially. They engage a skipper to whom they entrust the management of the business. In breach of duty he charters the yacht to drug smugglers, with the consequence that the vessel is seized and confiscated. It would seem contrary to justice if the company could not bring an action against the skipper for misfeasance for the benefit of the shareholders. Why should the skipper be entitled to pray in aid the very thing that his breach of duty had brought about? On what principled basis can one avoid the application of ex turpi causa in such circumstances?

60. Lord Mance considers that Hampshire Land can be pressed into service. For the reasons that I have given I do not agree. It makes no sense to say that the fraud should not be attributed to the company. The fact that fraud has been attributed to the company is the very thing about which the company is complaining. The company’s complaint is that its directing will and mind has infected it with turpitude. If ex turpi causa is not to apply in such circumstances, the reason should simply be that the public policy underlying it does not require its application.

61. One can readily reach that conclusion where all the shareholders are innocent. Recovery from the directing mind and will does not result in any individual recovering compensation for his own wrong. The position becomes unclear, however, if some of the shareholders were complicit in the directing mind and will’s misconduct. Lord Mance states that in such circumstances some process designed to achieve the ends of justice would “without doubt” prevent the fraudulent shareholders from profiting from their dishonesty. Lord Mance may well be right, but it is not apparent to me that the law provides a mechanism for achieving this. What would seem to be involved would be a lifting of the veil of incorporation in order to ensure that shareholders who were complicit in the illegal manner of operating the company would not be able to share in the recovery from the directing mind and will. This would, I believe, be without precedent.

62. The situation becomes more complicated when one considers a claim against auditors, such as that with which this appeal is concerned, by a company that has independent shareholders. Here the argument is that auditors should not be entitled to pray in aid the very illegality that their breach of duty has permitted to occur. The same problem arises where some of the shareholders are complicit in the fraud being perpetrated on the banks by the directing mind and will. But more intractable is the problem of contributory negligence. The duty owed by the auditors to the company is a duty of care. It would not seem just for a company to make a full recovery of damages against auditors for the benefit of banks which have themselves negligently failed to carry out appropriate “due diligence” before advancing monies to the company. Mr Brindle recognised this, for he opened his case by submitting that any apparent unfairness in holding Moore Stephens liable to S&R would be met by contribution under the Law Reform (Contributory Negligence) Act 1945. But it is not easy to see how the Act would apply. Moore Stephens’ liabilities would reflect S&R’s liabilities to the banks and the damages paid by Moore Stephens would be paid, indirectly to the banks. Lack of care on the part of the banks in their dealings with S&R ought to be taken into account for the purposes of contributory negligence. Yet such lack of care could not be prayed in aid by S&R in answer to claims framed by the banks in deceit – Standard Chartered Bank v Pakistan National Shipping Corpn (Nos 2 and 4) [2002] UKHL 43; [2003] 1 AC 959. Nor is there any obvious mechanism by which such lack of care could be relied upon by Moore Stephens in answer to the claim brought by S&R.

63. My Lords, I would not think it right to hold as a matter of general principle that ex turpi causa does not apply to a claim by a company against its auditors for failing to detect that the company has been operating fraudulently unless it were demonstrated how the difficulties to which I have referred could be resolved. There has been no such demonstration in this case. Thus I am not able to join Lord Scott and Lord Mance in concluding, for the reasons that they have given, that ex turpi causa does not apply to S&R’s claim. At the same time, I have not been persuaded by Mr Sumption’s primary case that the reliance

test, or the principle of public policy that underlies it, would necessarily defeat S&R’s claim if S&R were a company with independent shareholders that had been “high-jacked” by Mr Stojevic. In that, at least, I believe that I share common ground with all your Lordships.

The significance of the fact that S&R was a “one man company”

64. I turn to consider Mr Sumption’s fall back position. This applies to what, by way of shorthand, is described as a “one man company”, that is a company where the sole shareholder is also the person who runs the company or, if there is more than one shareholder, where the shareholders together run the company. Mr Sumption argued that where all who have ownership and control of a company are complicit in a fraud carried out by the company there is no room for the application of the Hampshire Land principle. In support of this argument he drew attention to United States jurisprudence that establishes a “sole actor” exception to the adverse interest rule.

65. Lord Brown and Lord Walker have based their decision on Mr Sumption’s fall back position. Lord Walker identifies the reason for the Hampshire Land principle to be that it would be “unjust to its innocent participators (honest directors who were deceived, and shareholders who were cheated)” to fix a company with its directors’ fraudulent intention. Where there are no honest directors or shareholders there is “ex hypothesi no innocent participator”. It follows that there is no room for the application of Hampshire Land.

66. Lord Scott and Lord Mance do not accept this analysis. They would include among the “innocent participators” the creditors of a company in circumstances where the company is insolvent or is threatened with insolvency. They postulate that the duty owed by auditors is owed for the benefit of these participators also, and that ex turpi causa should not defeat a claim brought for their benefit.

67. For the reasons that I have already given, I consider that the real issue is not whether the fraud should be attributed to the company but whether ex turpi causa should defeat the company’s claim for breach of the auditor’s duty. That in turn depends, or may depend, critically on whether the scope of the auditor’s duty extends to protecting those for whose benefit the claim is brought.

68. One fundamental proposition appears to me to underlie the reasoning of Lord Walker and Lord Brown. It is that the duty owed by an auditor to a company is owed for the benefit of the interests of the shareholders of the company but not of the interests of its creditors. It seems to me that here lies the critical difference of opinion between Lord Walker and Lord Brown on the one hand and Lord Mance on the other. Lord Mance considers that the interests that the auditors of a company undertake to protect include the interests of the creditors.

69. I was initially doubtful as to whether it would be right to decide this strike out application on the basis that the interests of creditors fall outside the scope of the duty of care that auditors owe to a company. I was concerned that such an approach was precluded by Mr Sumption’s concession of the existence both of a duty and, for the purposes of argument, a breach. In oral submission however, Mr Sumption made it plain that his concession in respect of the duty owed by Moore Stephens was a limited one.

70. Mr Sumption conceded that Moore Stephens owed a duty to S&R to ensure, so far as reasonable care permitted, that S&R’s accounts showed a true and fair view of its affairs. He conceded that, for the purpose of the strike out application, it should be assumed that Moore Stephens was in breach of this duty. He further conceded that, had they performed this duty, they would have discovered the fraud that was taking place. Finally he conceded that Moore Stephens would then have reported the fraud to the authorities, which would have brought S&R’s operations to a halt. Thus, as a matter of causation, the assumed breach of duty resulted in the losses sustained by S&R as a result of the continuing fraud. What Mr Sumption did not accept, however, was that reporting the fraud to the authorities formed any part of the duty owed to S&R.

71. Mr Sumption submitted that the duty owed to a company by its auditors was exclusively for the benefit of its shareholders. No duty was owed to creditors. The duty of the auditors to exercise due care when reporting on the accounts enabled the shareholders to hold the management of a company to account. Accounting standards and duty to the public went beyond the auditor’s duty to the company. Indeed it overrode the duty of confidentiality that would otherwise be owed to the company. It was this public duty that might require an auditor to “shop” a company if there was reason to think that it was involved in crime. Mr Sumption submitted that “against that background 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”.

72. Those submissions were largely founded on the decision of this House in Caparo. While the plaintiff in that case was a company, its primary claim was in its capacity as purchaser of the shares in a public company (“Fidelity”) of which the defendants were the statutory auditors. The claim was in the tort of negligence. The plaintiff alleged that the defendants had been negligent in auditing Fidelity in that they had approved accounts which, inter alia, overvalued the assets of the company. The plaintiff alleged that, foreseeably, reliance on the audited accounts had led it to pay an excessive amount for the shares of Fidelity in a successful take-over bid. The question of whether the defendants owed a duty of care to the plaintiff was tried as a preliminary issue.

73. After lengthy consideration of authorities dealing with the duty of

care in relation to negligent misstatements Lord Bridge of Harwich
remarked at p. 623:

“These considerations amply justify the conclusion that auditors of a public company’s accounts owe no duty of care to members of the public at large who rely upon the accounts in deciding to buy shares in the company. If a duty of care were owed so widely, it is difficult to see any reason why it should not equally extend to all who rely on the accounts in relation to other dealings with a company as lenders or merchants extending credit to the company. A claim that such a duty was owed by auditors to a bank lending to a company was emphatically and convincingly rejected by Millett J. in Al Saudi Banque v. Clarke Pixley…”

74. At p. 626, after considering the provisions in the Companies Act 1985 that relate to auditors, Lord Bridge added:

“No doubt these provisions establish a relationship between the auditors and the shareholders of a company on which the shareholder is entitled to rely for the

protection of his interest. But the crucial question concerns the extent of the shareholder’s interest which the auditor has a duty to protect. The shareholders of a company have a collective interest in the company’s proper management and in so far as a negligent failure of the auditor to report accurately on the state of the company’s finances deprives the shareholders of the opportunity to exercise their powers in general meeting to call the directors to book and to ensure that errors in management are corrected, the shareholders ought to be entitled to a remedy. But in practice no problem arises in this regard since the interest of the shareholders in the proper management of the company’s affairs is indistinguishable from the interest of the company itself and any loss suffered by the shareholders, e.g. by the negligent failure of the auditor to discover and expose a misappropriation of funds by a director of the company, will be recouped by a claim against the auditors in the name of the company, not by individual shareholders.

I find it difficult to visualise a situation arising in the real world in which the individual shareholder could claim to have sustained a loss in respect of his existing shareholding referable to the negligence of the auditor which could not be recouped by the company.”

75. Lord Oliver of Aylmerton also gave detailed consideration to the role of auditors in the light of the relevant statutory provisions. The following passages from his opinion at pp. 630 and 631 are of particular relevance:

“It is the auditors’ function to ensure, so far as possible, that the financial information as to the company’s affairs prepared by the directors accurately reflects the company’s position in order, first, to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing (by, for instance, declaring dividends out of capital) and, secondly, to provide shareholders with reliable intelligence for the purpose of enabling them to scrutinise the conduct of the company’s affairs and to exercise their collective powers to regard or control or remove those to whom that conduct has been confided….

Thus the history of the legislation is one of an increasing availability of information regarding the financial affairs of the company to those having an interest in its progress and stability. It cannot fairly be said that the purpose of making such information available is solely to assist those interested in attending general meetings of the company to an informed supervision and appraisal of the stewardship of the company’s directors, for the requirement to supply audited accounts to, for instance, preference shareholders having no right to vote at general meetings and to debenture holders cannot easily be attributed to any such purpose. Nevertheless, I do not, for my part, discern in the legislation any departure from what appears to me to be the original, central and primary purpose of these provisions, that is to say, the informed exercise by those interested in the property of the company, whether as proprietors of shares in the company or as the holders of rights secured by a debenture trust deed, of such powers as are vested in them by virtue of their respective proprietary interests.”

76. Both Lord Bridge and Lord Oliver cited with approval the decision of Millett J in Al Saudi Banque v Clarke Pixley [1990] Ch 313. That was an action brought in negligence against the auditors of a company by a number of banks. They alleged that they had relied upon favourable auditors’ reports, negligently given, in advancing money to the company. Some of the banks were already creditors of the company at the time that the reports were made. The question of whether the auditors owed a duty to the banks was tried as a preliminary issue. Millett J held that no duty was owed, relying in part on the reasoning of the majority in the Court of Appeal in Caparo [1989] QB 653. He held that the necessary proximity between the banks and the auditors was not established. He went on, however, to hold that it would not be just and reasonable to impose such a duty on the auditors. This was because breach of the duty would expose the auditors to liability for sums advanced by the banks to the company of an indeterminate amount, which would be unknown to the auditors and unforeseeable by them.

77.     Mr Sumption also relied upon the decision of Hobhouse J. in

Berg, Sons & Co Ltd v Mervyn Hampton Adams and Others [2002] Lloyd’s Rep PN 41. The relevant claim in that case was brought by a company in liquidation (“Berg”) against its auditors (“Dearden Farrow”) for negligently failing to qualify the accounts of the company, as a consequence of which the company incurred further liabilities. The

company had only one active director, a Mr Golechha, who was also the ultimate beneficial owner of all the shares in the company. At p. 44 Hobhouse J outlined the nature of Berg’s case:

“The essence of the claim made by the first Plaintiffs, Berg, against Dearden Farrow is that Mr Surrey ought not to have accepted the statements made, and the assurances given, to him by Mr Golechha. It is no part of the Plaintiffs’ case that Mr Golechha, nor any director or shareholder of Berg, was in any way misled by anything which Dearden Farrow said or did; nor is it alleged that Mr Golechha, or any member of the company, in any way relied upon anything Dearden Farrow said or did. It further is not alleged that Mr Golechha was not fully aware of all relevant facts and considerations. Under these circumstances, it will be appreciated that there are serious further difficulties in the way of formulating and substantiating the claim of Berg against the Defendants. The existence of a contractual duty to exercise proper skill and care in and about the audit owed by the Defendants to Berg is not in dispute. But whether, assuming that there has been some breach, there is on any view a right to recover anything more that nominal damages is very definitely in dispute. The Defendants submit that the first Plaintiffs’ claim is misconceived and cannot succeed even if some breach of contract is established.”

78. Hobhouse J considered the implications of the decision in Caparo

on the duty of care owed by auditors and reached the following
conclusion:

“It also follows that the purpose of the statutory audit is to provide a mechanism to enable those having a proprietary interest in the company or being concerned with its management or control to have access to accurate financial information about the company. Provided that those persons have that information, the statutory purpose is exhausted. What those persons do with the information is a matter for them and falls outside the scope of the statutory purpose. In the present case the first Plaintiffs have based their case not upon any lack of information on the part of Mr Golechha but rather upon the opportunity that the possession of the auditor’s certificate is said to

have given for the company to continue to carry on business and to borrow money from third parties. Such matters do not fall within the scope of the duty of the statutory auditor.”

79.     At p. 53 Hobhouse J referred to an accurate statement of the

Hampshire Land principle in Bowstead on Agency (15th edition, 1985),
Art 102:

“Where an agent is party or privy to the commission of a fraud upon or misfeasance against his principal, his knowledge of such fraud or misfeasance, and of the facts and circumstances connected therewith, is not imputed to the principal.”

He commented, at p 54:

“In the present case it has not been proved that there was any fraud by Mr Golechha in relation to the 1981 audit, still less that at that time Mr Golechha was practising any fraud upon his principal, Berg. There was no entity which it can be said he misled or in relation to which it can be said that he was acting fraudulently in relation to the audit in October 1982. However one identifies the company, whether it is the head management, or the company in general meeting, it was not misled and no fraud was practised upon it. This is a simple and unsurprising consequence of the fact that every physical manifestation of the company Berg was Mr Golechha himself. Any company must in the last resort, if it is to allege that it was fraudulently misled, be able to point to some natural person who was misled by the fraud. That the Plaintiffs cannot do.”

80. This comment demonstrates that Hampshire Land had no application to the facts of that case, but it has wider implications. Taken with the other passages in the judgment to which I have referred, it supports Mr Sumption’s proposition that 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. If that

proposition is correct, it follows that any breach of duty on the part of Moore Stephens will not sound in damages because it has caused no loss.

81. I have had difficulty in this case in distinguishing between questions of duty, breach and actionable damage and, indeed, it is questionable whether it is sensible to attempt to distinguish between them. In Caparo at p. 627 Lord Bridge stated:

“It is never sufficient to ask simply whether A owes B a duty of care. It is always necessary to determine the scope of the duty by reference to the kind of damage from which A must take care to save B harmless. ‘The question is always whether the defendant was under a duty to avoid or prevent that damage, but the actual nature of the damage suffered is relevant to the existence and extent of any duty to avoid or prevent it:’ see Sutherland Shire Council v. Heyman, 60 A.L.R. 1, 48, per Brennan J. Assuming for the purpose of the argument that the relationship between the auditor of a company and individual shareholders is of sufficient proximity to give rise to a duty of care, I do not understand how the scope of that duty can possibly extend beyond the protection of any individual shareholder from losses in the value of the shares which he holds.”

Lord Oliver made a similar comment at p. 651:

“It has to be borne in mind that the duty of care is inseparable from the damage which the plaintiff claims to have suffered from its breach. It is not a duty to take care in the abstract but a duty to avoid causing to the particular plaintiff damage of the particular kind which he has in fact sustained.”

82.     These comments were made in relation to duty of care in tort. In

Banque Bruxelles Lambert SA v Eagle Star Insurance Co Ltd (sub nom South Australia Asset Management Corpn v York Montague Ltd) [1997] AC 191 Lord Hoffmann held that precisely the same reasoning applied to a duty of care in contract. He said at p. 211:

“A duty of care such as the valuer owes does not however exist in the abstract. A plaintiff who sues for breach of a duty imposed by the law (whether in contract or tort or under statute) must do more than prove that the defendant has failed to comply. He must show that the duty was owed to him and that it was a duty in respect of the kind of loss which he has suffered. Both of these requirements are illustrated by Caparo Industries plc. v. Dickman [1990] 2 A.C. 605. The auditors’ failure to use reasonable care in auditing the company’s statutory accounts was a breach of their duty of care. But they were not liable to an outside take-over bidder because the duty was not owed to him. Nor were they liable to shareholders who had bought more shares in reliance on the accounts because, although they were owed a duty of care, it was in their capacity as members of the company and not in the capacity (which they shared with everyone else) of potential buyers of its shares. Accordingly, the duty which they were owed was not in respect of loss which they might suffer by buying its shares.”

83. Mummery LJ held that Moore Stephens owed no duty of care to S&R, “a fraudster in the total grip of another fraudster”. Although Mr Sumption has renounced any reliance on this holding, it is one with which I have sympathy. Moore Stephens were retained by Mr Stojevic by deception and with the object of enhancing the apparent respectability of S&R for the purposes of his proposed fraud. The details of the business that he retained Moore Stephens to audit were wholly fictitious. If these motives and this dishonesty are to be attributed to S&R, as it seems to me they must be, then it is at least arguable that the illegal purpose of the contract under which Moore Stephens were retained rendered it unenforceable at the suit of Moore Stephens by reason of the application of the principle in Alexander v Rayson [1936] 1 KB 169. More fundamentally, if party A, by deceit, induces party B to agree to play a part in a venture that is wholly fictitious, I find it hard to see how this can give rise to any duty on the part of party B.

84. If I put those reservations on one side and assume that Moore Stephens undertook a contractual duty to S&R to exercise due care in relation to the auditing of S&R’s accounts, the question arises of whether that duty extended further than the exercise of reasonable care in the provision of information to the directors and those who had a

proprietary interest in the company. The authorities relied upon by Mr
Sumption lead to the conclusion that it did not.

85. The exercise of an auditor’s duties to a company will, in some situations, have the effect of preserving the assets of the company. Such preservation will, whenever there is a risk that the company’s assets may prove inadequate to meet its liabilities, protect not merely the interests of the shareholders but those of the creditors. 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. So to hold would involve departing from, or at least extending, the reasoning of this House in Caparo. Such an extension would not, however, assist S&R in this case. To recover damages in this case S&R would have to establish that the scope of the duty undertaken by Moore Stephens extended to taking reasonable care to ensure that the company was not used as a vehicle for fraud and that this duty was owed for the benefit of those that the company might defraud. I see no prospect that such a duty could be established.

86. The scope of Moore Stephens’ duty is not directly in issue on this appeal. What is in issue is whether ex turpi causa provides a defence to S&R’s claim that Moore Stephens was in breach of duty. That is not, however, a question that I have been able to consider in isolation from the question of the scope of Moore Stephens’s duty. I have reached the conclusion that all whose interests formed the subject of any duty of care owed by Moore Stephens to S&R, namely the company’s sole will and mind and beneficial owner Mr Stojevic, were party to the illegal conduct that forms the basis of the company’s claim. In these circumstances I join with Lord Walker and Lord Brown in concluding that ex turpi causa provides a defence.

87.     For these reasons I would dismiss this appeal.

LORD SCOTT OF FOSCOTE

My Lords,

Introduction

88. I have found this a very difficult case. Three of my noble and learned friends, Lord Phillips of Worth Matravers, Lord Walker of Gestingthorpe and Lord Mance have prepared and circulated lengthy opinions, totalling very nearly 200 paragraphs but reaching differing conclusions. Lord Phillips and Lord Walker have concluded that the ex turpi causa principle provides a complete defence to this action and that the appeal by Stone & Rolls Ltd (in liquidation) (“S & R”) against the striking out of its action should therefore be dismissed. Both take the view that the fraud and dishonesty of Mr Stojevic is properly to be attributed to S & R. Lord Mance, however, has concluded that this action, brought by S & R against its auditors, Moore Stephens, for contractual and tortious negligence, cannot be defeated, at least at the present strike-out stage, by that attribution. My Lords I have come to the same conclusion as Lord Mance and without, as I hope, adding unnecessarily to the length of the opinions of your Lordships, I must explain why.

267. The decisions in Caparo and Al Saudi Banque establish that auditors’ duties are normally limited to the protection of the company’s interests for the benefit of its shareholders. There was no question of any insolvency on the facts of Caparo. The facts in Al Saudi Banque were closer, and the scheme of fraud remarkably similar, to the present. But the claimants were the banks, and their claim was dismissed on the basis that the auditors had not been appointed by them and “were under no statutory obligation to report to them” (p.336E). In both Caparo and Al Saudi Banque, the concern was about the uncertain and unknown exposure in respect of third party investment or lending which would follow from permitting third party claims.

268. Other than in special situations, therefore, auditors owe no direct duties towards third parties. But none of the above cases addresses the present situation of a claim by the company against its auditors for failure to pick up a fraudulent scheme rendering it increasingly insolvent. But in Caparo, both Lord Bridge and Lord Oliver recognised the company’s standing to bring claims for loss which it has suffered by its officers’ fraud (see para 214 above); and, further, Lord Oliver described an auditor’s duty as being, first of all, “to protect the company itself from the consequences of undetected errors, or, possibly, wrongdoing”, before identifying a second duty “to provide shareholders with reliable intelligence” (para 214 above).

269. In my opinion it is in no way inconsistent with Caparo or Clarke Pixley to hold auditors responsible to the company they audit in the present circumstances. I underline four points in this connection. First, the concern about indefinite exposure to third parties does not exist in the context of a claim by the company. S & R’s claim is to recover its

own (not its creditors’) loss by reason of the continuing scheme of fraud. Loss to the company is not the same as loss to its creditors, although there may or may not be an overlap. An insolvent company may by fraud raise £1m from bank A which it uses in a Ponzi type scheme to pay off a borrowing from bank B. Bank A is £1m worse off, and bank B £1m better off. But the company itself is no worse off from the continuing fraud. It is liable to pay bank A £1m, but it has benefited by £1m by paying off bank B using bank A’s £1m. Of course if (as here) it raises £1m by fraud and pays only £500,000 to bank B and if its directing mind makes off with the other £500,000, then the company is £500,000 worse off due to the continuation of the fraud, but that is and remains its own loss. Secondly, S & R’s claim is for precisely the same loss as 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 (paras 249 to 255 above). Thirdly, it cannot be suggested that the care to be expected of Moore Stephens as auditors varied according to whether all of S & R’s shares happened to be owned and/or controlled by Mr Stojevic. Their express contractual duty was under Auditing Standard SAS 110.10 and 110.12 to report to a proper authority without delay where suspected or actual fraud cast doubt on the integrity of directors. This duty in fact exists under SAS 110 irrespective of whether there are or are not independent shareholders of integrity. Auditors would not in any event necessarily have any idea whether any such shareholders exist.

270. Fourthly, quite apart from the express provisions of Auditing Standard SAS 110, a situation of insolvency introduces new considerations for reasons previously explained. The identity of interest which normally exists between a company and its shareholders ceases, and the duties of auditors, like those of directors, must recognise this. The company as a legal personality continues and the auditors’ duty continues to be, in Lord Oliver’s words in Caparo, “to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing”. If, in Hobhouse J’s words in Berg, “those in charge of the affairs of a company or in control of it are acting contrary to the principles governing insolvency”, then the auditors can no longer treat them as representing the company, and must take other action - according to SAS 110 “without informing the directors in advance”. In reality, a public report to shareholders (however many of them were involved in the fraud) would itself bring matters to an end. Resignation – and it is part of S & R’s pleaded case that Moore Stephens should, after detecting the fraud, have resigned as well as reported it to the authorities - would by statute have involved an express duty on the part of Moore Stephens to report to creditors: s.394(1) of the Companies Act (para 215 above). I believe that it would in any event probably be

auditors’ professional and common law duty to report suspicions of fraud to the proper authorities. But Auditing Standard SAS 110 puts this beyond doubt. Even if Moore Stephens had been aware that directors known or suspected to be acting fraudulently were the beneficial owners of all the company’s shares, they would under SAS 110 still have been obliged to report the circumstances to regulators or other authorities, without informing management in advance, in order to protect the interests of the company. In fact, as I have said, auditors may often not know whether or not all such directors own all the shares. It would be a strange policy and law that exempts auditors from all responsibility to the company, according to the chance that the directors on whose integrity they undertake to report prove to be the sole “beneficial owners” of all the company’s shares.

271. It follows that in my opinion Moore Stephens cannot invoke the maxim ex turpi causa or deny causation by reference to the knowledge of and involvement in the fraud of Mr Stojevic, if Moore Stephens ought with proper skill and care to have detected that S & R was subject to a continuing scheme of fraud in circumstances in which S & R was insolvent and being rendered increasingly so. Under English law, S & R is thus in my opinion entitled to pursue its present claim against Moore Stephens.

272. American cases appear to have taken a different view on this particular point under Texan and Pennsylvanian state law: Federal Deposit Insurance Corpn. v. Ernst & Young and Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. 267 F.3d 340 (3rd Cir. 2001): see para 261 above. They come from a different legal background, one where creditors may at least in some States have direct remedies, and their reasoning does not answer the considerations which lead me to a different conclusion. For the reasons I have given, I do not consider that they represent English law.

Contributory fault

273. The last matter on which I wish to comment – though not to reach any conclusions - is the question of contributory fault. Mr Brindle opened his oral submissions by accepting that it would be open to the court to apportion fault between the company and its auditor if recovery against the auditor were permitted in respect of fraud by the company’s directing mind. It suited Mr Brindle’s case to present Moore Stephens’ defence of ex turpi causa as an extreme and novel response to the

present situation, and to proffer at the outset the more balanced discretionary possibility of a reduction of the claim on account of the company’s contributory fault. However, I regret that, as part of the whole picture, the House has not heard full argument on this aspect. (Indeed, I consider that the House’s resulting inability on this appeal to review the complete picture is a further reason for not determining the whole claim against Moore Stephens at this stage. If contributory negligence is available as a defence, it would cater for or assuage concerns about the general appropriateness of allowing recovery expressed in some of the majority judgments.) The starting point would be to consider the extent to which contributory fault is available in respect of non-fraudulent management failings, either the very failings which the auditors ought with care to have identified or different management failings which nonetheless contributed to the same loss as that which the auditor’s negligence allowed to occur. The House’s decision in Reeves makes clear that, in a simple two-party situation, it is possible for recovery, for breach of a duty to prevent the very thing complained of happening, to be reduced on a broad brush basis on account of the claimant’s conduct in bringing about the thing. In Professional Negligence by Jackson & Powell (6th Ed. 2007), chap 17, a number of authorities are cited in which contributory fault has also been recognised as a ground for reduction of liability in auditor’s negligence claims.

274. However, the obvious conundrum, if the fraud of top management is not attributed to the company for the purpose of the maxim ex turpi causa, is why it should be attributed to the company for the purpose of contributory fault under the Law Reform (Contributory Negligence) Act 1945. Mr Brindle’s justification for doing this is that, when considering the allocation of fault to the company under the Act, the court is in effect considering a claim against the company. But, even if a “fault” is in this way equated with a claim, the question arises in the context of an audit of a solvent company, how management fraud may be balanced against an auditor’s negligence, when an auditor’s primary responsibility is in respect of innocent shareholders, whose conduct will not usually be susceptible to criticism. And a similar difficulty arises about weighing the significance of fraud by a directing mind who is also sole beneficial shareholder, if, as I consider, the auditor may be answerable to the company for negligent failure to detect and report on such a fraud. Despite such problems, contributory fault, including Leeson’s fraud which the judge had held (rightly or wrongly, I need not consider) to be attributable to the company, was recognised as a ground for a substantial reduction in recovery against the auditors in Barings Plc v. Coopers & Lybrand [2003] EWHC 1319 (Ch). The subject was also discussed by the Full Court of South Australia in Duke Group Ltd. v

Pilmer 73 SASR 180 (1999) (reversed in part on a different point at [2001] BCLC 773). The court there concluded that, while the company’s directors’ knowledge of their own fraud on the company would not be attributed to the company, the company could and would nonetheless be liable vicariously for such directors’ misconduct and treated as at fault on the same basis, for the purposes of enabling negligent auditors to reduce their liability in tort. (This was a Pyrrhic victory, since at the time contributory negligence was not available in Australia in relation to the concurrent contractual claim against the auditors.) The Full Court’s reasoning was avowedly pragmatic and it relied as it said on its “view that this is the fairer and more appropriate outcome”. There is obvious attraction in such pragmatism in the present context. Not having heard argument on any such aspects, I say no more.

Conclusion

275. For the reasons I have given, I consider that this appeal should be allowed on the ground that Moore Stephens’s duty was to the company, that it is not sufficient for Moore Stephens to argue that every relevant emanation of the company consisted of Mr Stojevic as its directing mind and sole shareholder, if Moore Stephens failed in breach of duty to the company to detect the continuing scheme of fraud being pursued by Mr Stojevic and to detect that the company was (in fact, due to such scheme of fraud) insolvent or potentially so. In that context, Moore Stephens cannot attribute to the company itself, for the purpose of invoking against it the maxim ex turpi causa, the knowledge of and involvement in the fraud of Mr Stojevic which (it is for present purposes to be assumed) they ought to have detected and reported to regulators or other proper authorities in the company’s interests. What would have happened upon such detection and report is simply a matter of causation.

276. The company’s ability to recover its own loss in such circumstances is in my view not only also right in principle, but also desirable. It means that recovery does not depend on the happenstance of whether or not all the company’s shareholders were involved in the fraud. Whether a company is a one-person company or not may itself also be unclear, until one has penetrated a web of nominee or trust shareholdings. The result I reach reflects the various categories of person interested in the company, with whom in mind the auditors ought to plan and conduct their work. The contrary 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. That is neither attractive nor realistic as an answer, when one- person companies can be large financial enterprises offering banking facilities to or inviting deposits or investments from many ordinary members of the public. It is in relation to exactly such companies that auditors ought to be encouraged to exercise the skill and care anyway due, rather than to feel that the risks of incurring liability to the company for a negligent audit are reduced. For completeness and not because it in any way influences my conclusion, I note that auditors are now also able to enter into fair and reasonable liability limitation agreements under ss.534-538 of the Companies Act 2006, though how far this is proving acceptable to their client companies or others I am unaware.

277. I would therefore allow this appeal, and restore the judge’s order dated 11 September 2007 dismissing Moore Stephens’s application for summary judgment on, or to strike out, the claim against them and giving directions for the further conduct of the proceedings.. The critical issue dividing the House is ultimately whether auditors, who should, in the performance of their contractual and tortious duties towards a company, have detected and (under the express terms of their engagement) then have reported to the appropriate authorities a scheme of fraud by top management rendering the company as a separate legal person increasingly insolvent, owe any enforceable duty towards the company to do this, so avoiding further loss to the company. In my opinion, they do.

Annex

Overseas authority on attribution

(para 248)

i.          Canadian Dredge & Dock Co. Ltd. v The Queen (1985) 19 DLR (4th) 314 was decided by the Canadian Supreme Court, after reference to English case-law including Tesco Supermarkets Ltd. v Nattrass. It concerned a criminal prosecution. Not surprisingly in this context, the Supreme Court took a limited view of the circumstances in which the company could disclaim the acts and state of mind of its directing mind. Estey J described these as being “when the directing mind ceases completely to act, in fact or in substance, in the interests of the corporation”, or “where all of the activities of the directing mind are directed against the interests of the corporation with a view to damaging that corporation, whether or not the result is beneficial economically to the directing mind”. Only then, might there “be said to be fraud on the corporation” or an act “totally in fraud of the corporate employer” (p.351). Two comments may be made. First, the language of fraud on a company was being used in the unfamiliar context of a charge against the company. In such a context, as I have said, the hurdle for disclaimer of responsibility was, not surprisingly, set high. Second, the phraseology developed in the judgment and used in subsequent Canadian cases (and some other common law cases: see e.g. In re The Mediators, Inc., paras. 6-7, discussed in paragraph 239 above, and Duke Group Ltd. v Pilmer 73 SASR 180 (1999), para.632. indicates a test which is both more rigid and more extreme than that which English law would adopt, particularly since the Privy Council’s decision in Meridian.

ii.         Despite the first point, the reasoning in Canadian Dredge has been transposed in Canada to the context of an auditor’s negligence claim in a first instance decision. Hart Building Supplies Ltd. v. Deloitte & Touche [2004] BCSC 55 was a case where Mr Larson, a director and the directing mind and a 15% shareholder, had falsified Hart’s inventory records and inflated its profits by false invoices “to try to help Hart’s business”, and so misled the auditors. The company’s claim was brought at the instance of its innocent 85% shareholder against the auditors for negligence. The judge in applying “the law as set out in Canadian Dredge” took principles which may be appropriate when determining a company’s liability to the third party and applied them, without question, to the different situation of a

company seeking redress from a third party on the face of it in breach of duty to the company. For reasons I have given, this does not represent English law, and it has also been subjected to trenchant Canadian critique: Emaciating the statutory audit – a comment on Hart Building Supplies Ltd. v. Deloitte & Touche by Ass. Prof. Darcy MacPherson, University of Manitoba: (2005) 41 Can Bus LJ 471.

iii.        Australian authority has adopted a more sceptical attitude to the scope and appropriateness of application of Canadian Dredge in the audit context: Edwards Karwacki Smith & Co. Pty. Ltd. v Jacka Nominees Pty. Ltd. (1994) 15 ACSR 502, where the Supreme Court of West Australia, after reviewing inter alia Canadian Dredge, refused summary disposal of a claim against auditors for negligently failing to discover that the directing mind of a “one-man company” had been fraudulently concealing the true state of the business and so fraudulently inducing investors in it.

iv.        American authority is copious and less easy to digest (as well appears from the May 2008 continuing legal education study paper of the American Law Institute and Bar Association which the House was shown). Various broad approaches emerge. One takes the general law’s theory of attribution or “imputation” and subjects it to an “adverse interest” exception (itself stated in differing terms, some resembling the Canadian Dredge test, others considerably more nuanced), which is then in turn subject to a “sole actor” exception. Another suggests that, in the context of a professional duty to check upon and report fraud such as the audit duty, either the general theory of imputation or the ex turpi causa doctrine (known in the United States as the in pari delicto defense) itself requires modification.

v.         The early case of Cenco Inc. v. Seidman & Seidman 686 F 2d 449 (1982) (USCA, 7th Circ.) concerned a claim by a still solvent company to recover damages from auditors who had failed to discover a fraud at top management and board level, consisting of inflating the value of inventory, and so of stock which was used to buy up other companies. Speaking for the court and applying the common law of Illinois, Judge Posner upheld the trial judge’s directions to a jury which had led the jury to dismiss Cenco’s claim. He differentiated fraud by top management involving theft from the company from the actual fraud which involved “turning

the company into an engine of theft against outsiders”. The case is therefore distinguishable from the present, which I would, for reasons indicated in paras 230 to 234, place in the former category for the purposes of the company’s claim against Mr Stojevic or its auditors. Judge Posner went on to say that, even in deciding how to treat the latter category, the Illinois courts would be guided by “the underlying objectives of tort liability”. Holding that these justified the judge’s directions, he adopted a two- pronged “cost-benefit” analysis. To allow recovery would, first, benefit stockholders without differentiating between innocent and guilty stockholders and, second, shift the loss to all stockholders (who the court said were “slipshod in their oversight [of their chosen board] and so share responsibility for the fraud”), thus, in the court’s view, reducing the incentive for stockholders to hire and monitor honest stockholders (pp.455-456).

vi.        In Schacht v. Brown 711 F 2d 1343 (1983) (also USCA, 7th Circ.), top management had fraudulently continued an insurance company in business past its point of insolvency and systematically looted it of its most profitable and least risky business and income, aggravating its insolvency. Cenco was distinguished on various grounds: first, as decided under Illinois law, whereas the issue in Schacht arose under federal law and the court could say that “we therefore write on a clean slate and may bring to bear federal policies in deciding the estoppel question”; second, on the ground that the fraud in Schacht, including the “Pyrrhic ‘benefit’” of its artificially prolonged life, was not sufficient to engage the Cenco analysis of a company operating as the engine of fraud on others; and, third, on the ground that the two-pronged analysis adopted in Cenco led in Schacht to a different answer, because in Schacht the company was insolvent, there was no indication that the fraudulent top management would benefit from any recovery and “no evidence here of the existence of large corporate shareholders capable of conducting an independent audit, as in Cenco, and whose lack of investigatory zeal would be rewarded by a decision favourable to the [liquidator]” (p.1349).

vii.       Similar thinking appears in (a) In re Jack Greenberg Inc. (Larry Waslow, Trustee v. Grant Thornton LLP) (U.S. Bankruptcy Court, E.D. Penn., Phil. Div.) 240 BR 486 (1999), where the court emphasised that “while the imputation doctrine may be applied in auditor liability cases, the doctrine was not crafted with that purpose in mind” and should be allowed “to be invoked

only where the objectives of tort liability dictate” (p.508); (b) NCP Litigation Trust v. KPMG LLP 901 A.2d 871 (N.J. 2006), where the Supreme Court of New Jersey differentiated between shareholders engaged in a fraud involving inflation of profits and other innocent shareholders, holding that imputation could only be asserted to preclude recovery by the former, disagreed with the suggestion in Cenco that “imputation must be applied to shareholder suits to deter future such wrongdoing”, noted differences between Illinois and New Jersey law, and, referring to Schacht, also concluded that the management’s fraud “inflating a corporation’s revenues and enabling a corporation to continue in business ‘past the point of insolvency’ cannot be considered a benefit to the corporation”, but that, even if it could, “any benefit would not be a complete bar to liability, but only a factor in apportioning damages” (p.888); and (c) In re Sunpoint Securities, Inc. (U.S. Bankruptcy Court, E.D. Texas, Tyler Div.) (377 BR 513 (2007).

viii.      One, though by no means the only, strand of the reasoning in Schacht and Jack Greenberg, involves a possible distinction between situations of solvency and insolvency. This is controversial in American law, particularly in the light of s.541 of the Federal Bankruptcy Code (according to which the bankruptcy estate “is comprised of ….. all legal or equitable interests of the debtor in property as of the commencement of the case”), and there is authority rejecting such a distinction in cases covered by s.541: Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. 267 F.3d 340 (3rd Cir. 2001). Earlier authorities had rejected the defence of in pari delicto as an answer to claims by receivers against negligent auditors: Federal Deposit Insurance Corpn v. O’Melveny & Myers 61 F.3d 17, 19, (1995) and Scholes v. Lehmann 56 F. 3d 750, 754, (1995). The court in Lafferty distinguished these authorities on the ground that receivers are not within s.541 (Lafferty, p.358). However, in a still more recent decision, Knauer v. Jonathon Roberts Financial Group, Inc. 348 F.3d 230, (2003) the Court of Appeals for the Seventh Circuit has taken the view that receivers do stand in the shoes of the company in relation to entities deriving no benefit from the fraud, as opposed to direct beneficiaries of the fraud.

ix.        The “cost-benefit” analysis and other techniques deployed in American case-law do not find any easy match in English law. Case-law in some states permitting direct claims against auditors by injured third parties (including creditors) also complicates any

appreciation of the practical significance of American authority: see e.g. Bily v. Arthur Young & Co. 3 Cal.4th 370 (1992). However, the general message in the recent case-law that I have examined is one of increasing reluctance to hold that top management fraud provides a defence to a negligent auditor, and this at least corresponds with my conclusions as to the right approach in principle in English law.