Introduction

On 3 August 2015, the Privy Council handed down its judgment in Federal Republic of Brazil and another v Durant International Corpn and another [2015] UKPC 35, in which Lord Toulson, delivering the judgment on behalf of the Board, affirmed the doctrine known as “backward tracing”. The doctrine describes where the claimant’s property is traced into an asset the defendant already has and no direct connection can be established between the misappropriated trust funds and the assets acquired by the perpetrators.

Background

The Municipality of Sao Paulo (“Municipality”), being the effective claimant, brought proceedings in Jersey against the Defendants (“Durant” and “Kildare”), which were BVI companies controlled by the former mayor of the Municipality, Paulo Maluf (“PM”), and his son Flavio Maluf (“FM”). It was alleged that bribes totalling US$10.5 million, in connection with a major road building contract in Sao Paulo, had been paid to PM and then laundered through bank accounts belonging to FM and the two companies. The Municipality sought to trace into funds held by Durant and Kildare in order to recover the proceeds of these secret payments.

Chronology of the events can be summarized as follows:-

The Royal Court of Jersey found the Defendants liable to the Municipality as constructive trustees of US$10.5 million. This was upheld on appeal. When the case reached the Privy Council, the BVI companies no longer challenged the Jersey court’s finding that they were liable to the Municipality as constructive trustees. The dispute was over the extent of that liability. The Defendants argued that they were only liable for the lesser sum of US$7.7 million because the remaining US$2.8 million was paid into Account A to replenish it, after payment was made from Account A to Account B. One of the arguments raised by the Defendants was that the remaining US$2.8 million cannot be traced as there is no sound doctrinal basis for “backward tracing”.

Conventional tracing claims

The conventional doctrine of tracing involves rules which govern whether one form of property interest can properly be said to be regarded as substituted for another. It starts with the claimant’s original property interest and studies what has become of it. Thus, the equitable remedies of tracing required the “continued existence of the money”: In re Diplock [1948] Ch 465 at 521. And there could be no tracing remedy against an asset acquired before misappropriation of money took place, since a property interest cannot turn into, or provide a substitute for something which the holder already has: Bishopsgate Investment Management Ltd v Homan [1995] Ch 211. This explains the “no backward tracing” principle.

Privy Council decision

The Privy Council recognized that the authorities on backward tracing were inconclusive and it is ultimately a matter of judicial policy whether the law ought to allow backward tracing. Importantly, the Privy Council drew attention to the “increasingly sophisticated and elaborate methods of money laundering, often involving a web of credits and debits between intermediaries” and emphasized that the court “should not allow a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect.” Lord Toulson agreed with Sir Richard Scott V-C’s finding in Foskett v McKeown [1998] Ch 205 that the availability of equitable remedies ought to depend upon the substance of the transaction in question. If the court is satisfied that the various steps are part of a coordinated scheme, the strict order in which associated events occur should not matter. Under such circumstances, the court should look at the transaction overall rather than divide minutely the connected steps.

The Board therefore rejected the argument that there can never be backward tracing. But the claimant has to establish a co-ordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim, such as to warrant the court attributing the value of the interest acquired to the misuse of the trust fund. On the question of whether or not there was the necessary link, the Privy Council agreed with the Jersey courts’ finding that it was the defendants’ own pleaded case that the relevant payments into Account B were linked with the payments into Account A.

Implications

The decision is of particular importance to the victims of fraud or breach of trust claim, since the availability of proprietary remedies is often determinative as to whether a claimant is able to make a recovery or not. However, the Privy Council clearly had the unsecured creditors in mind, warning that the court should be very cautious before expanding equitable proprietary remedies in a way which may have an adverse effect on other innocent parties.  Particularly, the court expressly rejected the suggestion that money used to pay a debt can in principle be traced into whatever was acquired in return for the debt.