In the recent English case of Stone & Rolls Ltd (in liquidation) v Moore Stephens (a firm) [2009] UKHL 39, the liquidator of Stone & Rolls Limited (the “Company”) commenced proceedings against its former auditors, Moore Stephens (the “Auditors”), alleging that they had been negligent in failing to detect the fraudulent activities perpetuated by one Mr. Zvonko Stojevic (“Mr. Stojevic”) through the Company as a vehicle for defrauding banks.  It further alleged that had the Auditors spotted the fraudulent activities, the Company would not have exposed to the liabilities arising out of the fraud.  The Auditors applied to strike-out the action on the basis that the Company’s claim was met by the defence commonly described by the Latin maxim “ex turpi causa non oritur actio” (also known as “ex turpi causa”).  

The Company was a company in liquidation.  At all material times until its liquidation, the Company was controlled and indirectly owned by Mr. Stojevic.  Mr. Stojevic procured the Company to present false documents in relation to fictitious commodity trading to banks in order to obtain letters of credit.  Large sums of monies were drawn from the banks, which had all been paid away to other participants in the fraud for the benefit of Mr. Stojevic.  When the fraud was ultimately discovered, one of the banks successfully sued both Mr. Stojevic and the Company in deceit and was awarded damages in the sum of US$94 millions.  As the Company could not satisfy the judgment, it was put into compulsory liquidation.    

The Applicable Legal Principles   

Ex Turpi Causa Non Oritur Actio

Under the principle of ex turpi causa, the Court will not assist a plaintiff to recover compensation for the consequences of his own illegal conduct.  The underlying policy of the principle was explained by Lord Mansfields in an earlier case of Holman v Johnson (1775) 1 Cowp 341, 98 ER 1120 at 1121:-  

“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 causa, 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.”  

It is trite law that the defence of ex turpi causa will only apply where the plaintiff was primarily rather than vicarious liable for the illegal conduct.  

Rules of Attribution

Under the principle of agency, a company will be attributed with the knowledge of individual directors, employees and other agents who have authority to receive and communicate relevant information to the company.  In such cases, the company is deemed to be primarily liable for any acts committed by its directors, employees or other agents.  An exception to this rule is where the knowledge of the agent relates to his own breach of duty to his principal.  In such cases, the knowledge will not be attributed to the principal (Re Hampshire Land Co. [1896] 2 Ch 743) and the company is merely vicariously liable for any acts so committed.    

The Decisions of the Courts Below  

At first instance, Langley J agreed with the Auditors that Mr. Stojevic’s fraudulent conducts was properly attributed to the Company as he was the “directing mind and will” of the Company; and that the Hampshire Land exception did not assist the Company as it could not been seen as a “victim of fraud”.  That being said, Langley J refused to strike-out the action on the basis that the principle of ex turpi causa could not prevent a claim founded on fraud that would not have occurred had the Auditors properly complied with their “very duty” to uncover and report fraud as auditors of the Company (the “Very Thing Argument”).  

On appeal, the Court of Appeal overturned Langley J’s decision holding that the Hampshire Land exception would not ordinarily be available to protect a company from liability incurred as a result of fraud being practiced by its agents against a third party.  In this respect, Rimer LJ came to a conclusion that the mere fact that the Company had incurred liability to the banks was irrelevant and would not prevent Mr. Stojevic’s fraudulent conducts being imputed to the Company.  Turning to the Very Thing Argument, Rimer LJ opined that there is “no support in the authorities that we were shown for the proposition that if “the very thing” from which the defendant owed a duty to save the claimant harmless is, or includes, the commission of a criminal offence, the public policy defence based on the ex turpi causa principle will be overridden so as to enable the bringing of the claim that relies on the claimant’s illegality”.  In the present case, as the Company was party to, and not itself a victim of, the fraud, the Auditors owed no duty of care to the Company to take reasonable care to uncover and report its fraud.  Therefore, the claim against the Auditors ought to be struck out by the principle of ex turpi causa.    

The Decision of the House of Lords  

The House of Lords upheld the decision of the Court of Appeal to strike-out the action by a majority of three to two.  

The Majority Decision

Lord Philip, giving the leading judgment, found that “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”. That being said, his Lordship considered that the real issue was 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 was brought.  

By adopting the English House of Lords case of Caparo Industries plc v Dickman [1990] 1 All ER 568, [1990] 2 AC 605, his Lordship held the view that the auditors owed a duty to the company in the interests of its shareholders rather than its creditors.  In the present case, as all whose interests formed the subject of any duty of care owed by the Auditors to the Company, namely the Company’s sole will and mind and beneficial owner Mr. Stojevic, were party to the fraudulent conduct that formed the basis of the Company’s claim, the Auditors were entitled to rely on the principle of ex turpi causa to strike-out the Company’s claim.  

Lords Walker and Brown restricted their reasoning to situation where the directing mind and will of the company is also its owner i.e. a “one-man company”.  Their Lordships concluded where there was one single dominant director and shareholder, even if there are other directors or shareholders who are subservient to the dominant personality; or where there were two or more individual directors and shareholders acting closely in concert, any fraudulent conduct committed by the company’s agent was to be treated as that of the company and consequently the principle of ex turpi causa will defeat the company’s claim.  However, where innocent shareholder were “hijacked” by a fraudulent but dominant director, the Court would have to look closely at the facts to see if it would be contrary to justice and common sense to allow recovery.  

The Dissenting Judgments

Lord Scott and Mance considered that the Company had to be considered as a separate legal entity from Mr. Stojevic; and Mr. Stojevic’s fraud constituted a breach of the duty that he owed to the Company as an officer of the company.  In these circumstances, Mr. Stojevic’s fraud should not be attributed to the Company.  In any event, the Company was insolvent and would stay so regardless of the damages recoverable from the Auditors, there would be no question of Mr. Stojevic benefiting from his own wrong so as to invoke the principle of ex turpi causa.      

Comments

Although it now seems clear that auditors would not be liable to a claim by liquidator for failing to detect the fraudulent acts committed by a “one-man company”, it remains to be seen whether the principle of ex turpi causa will also bar a claim by a company with innocent independent shareholders or directors to whom the fraud could have been reported.