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

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229.  Neither in Belmont Finance nor in Attorney General’s Reference (No 2 of 1982) is there any suggestion that the application of the principle in Hampshire Land depends upon there being some innocent constituency within the company to whom knowledge could have been communicated. Moreover, Attorney General’s Reference (No 2 of 1982) is direct authority to the contrary. The two defendants were charged with theft, consisting of the abstraction of the assets of companies, of which they were “the sole shareholders and directors” and “the sole will and directing mind” (pp.635D-F and 638F-G). They contended that the companies were bound by and had consented to the abstractions precisely because they were its sole shareholders, directors and directing mind and will (pp. 634E-F and 638F-H). The Court of Appeal acknowledged the rule of attribution attributing to a solvent company the unanimous decision of all its shareholders (p.640A-D), but roundly rejected its application to circumstances where the sole shareholders, directors and directing minds were acting illegally or dishonestly in relation to the company. The court cited Belmont Finance as “directly contradict[ing] the basis of the defendants’ argument” (p. 641B-C). The defendants’ acts and knowledge were thus not to be attributed to the companies - although there was no other innocent constituency within the companies. Another justification for this conclusion may be that the effect of the limitations recognised by Lord Hoffmann in Meridian (paragraph 221 above) is that in such situations there is another innocent constituency with interests in S & R, since it is not open even to a directing mind owning all a company’s shares to run riot with the company’s assets and affairs in a way which renders or would render a company insolvent to the detriment of its creditors.

230.  The second reason advanced by Mr Sumption is that, if the Hampshire Land principle could otherwise apply, the fraud here was committed on the banks, not on S & R. The Court of Appeal agreed with this submission. The company’s exposure when it was left “holding the baby” was merely a “secondary exposure” which was not enough to engage the principle: see paras. 72-73. In so reasoning, Rimer LJ was influenced by the fact that Mr Stojevic’s fraud would be (and was by Toulson J) attributed to S & R itself in the context of any claims by the banks against S & R. This distinction between personal and vicarious liability towards third parties could have been relevant if, for example, S & R had been prosecuted for fraud (see e.g. Attorney General’s Reference (No 2 of 1982) at p.640A-B) or if (more fancifully) there had been a general banking facility between Komercni Banka and S & R under which the latter’s liability depended upon whether it was personally as opposed to vicariously liable for the deception of Komercni Banka. But it is irrelevant in the present context where S & R is seeking recourse from persons who, whatever their status vis-à-vis the company in the eyes of the outside world, owe duties and have committed wrongs towards S & R. The truth behind the Hampshire Land principle as explained in Belmont Finance and Attorney General’s Reference (No 2 of 1982) is that such situations are different. They compel by their nature a separation of the interests and states of mind of the company and those owing it duties.

231.  In the present case, the focus is on the separate interests of S & R on the one hand and Mr Stojevic (and the auditors, though I consider their position more fully later) on the other. In this context, there is no difficulty about characterising the whole scheme as one of fraud on the company. The scheme treated the company as a mere tool or conduit and left it at the end with a large deficit, in complete disregard of Mr Stojevic’s duty to respect its separate identity and property. This is in no way to suggest that S & R did not incur liability to the banks. On the contrary, it is because Mr Stojevic quite wrongly involved it in a scheme of fraud of which this was one aspect that S & R is entitled to claim against him. (In fact of course, the liability which S & R incurred to its banks in deceit did not lead to S & R incurring the loss, or anything like the loss, it claims against Mr Stojevic - Mr Stojevic’s abstraction of the monies from S & R did that. I note that, in a passage (para. 5) with a biblical echo (I Timothy 6, 7), my noble and learned friend, Lord Phillips of Worth Matravers suggests that S & R started life with nothing, never legitimately acquired anything and cannot realistically be said to have suffered any loss. This either ignores the abstraction of S & R’s assets or wrongly assumes that a deficit rendering a company insolvent is not a loss.

232.  The same conclusion is indicated by authorities concerning schemes of fraud directly parallel to the present - that is, first, the defrauding of third parties and then the stripping from the company of its resulting assets for the benefit of its directing minds and beneficial owners: see RBG Resources plc v Rastogi, Brink’s- Mat Ltd. v. Noye and, from Ontario, Oger v. Chiefscope Inc. et al. (1996) 29 OR (3d) 215; upheld (1998) 113 OAC 373. In RBG Resources plc v Rastogi Laddie J held, in trenchant terms, that the company had an arguable claim against directors for trial in a claim involving a parallel scheme of fraud to the present (raising funds from financiers in respect of bogus trades and paying them over to fraudulent counter-parties): and, when the case went to trial before Hart J, the directors in question did not pursue any defence to the contrary and judgment was given against them: [2004] EWHC 1089 (Ch). The case was moreover similar to the present in that one of the fraudulent directors was regarded as the sole ultimate controlling shareholder: see [2002] EWHC 2782 (Ch), paras. 3 and 51. In support of his conclusion, Laddie J referred both to Belmont and Attorney General’s Reference (No. 2 of 1982) and to the company’s “fall-back position” (to which I return below) that “in the case of an insolvent company, the directors are not at liberty to ignore the interests of the creditors": Kinsela v. Russell Kinsela Pty Ltd. (In Liquidation) (1986) 4 NSWL 722, per Street CJ, cited with approval in West Mercia Safetywear Ltd. (in liq) v Dodd [1988] BCLC 250, 4 BCC 30 (CA). The fall-back position to which Laddie J referred is likely to have been made with particular reference to the fraudulent director’s position as sole controlling shareholder, to which I shall return.

233.  The fraud in Oger involved procuring the owners of a Mercedes car to hand over the car to the company on terms that the company would within 90 days either sell it or purchase it for $55,000, whereas the company’s principals and owners always intended to and did decamp with it or its proceeds (as well as it appears other cars or their proceeds). At first instance, Molloy J said bluntly that:

“…. the fraudulent actions of Barry and Vithoulkas [the principals] were for their own financial gain. The corporation was merely a tool or vehicle which they implemented as an instrument of their fraud and to give the scheme a veneer of respectability. There was no benefit to the company from their actions. Rather, they stripped from the company all of its assets, both in terms of cash and consigned vehicles, and then absconded with them, leaving the corporation an empty shell with nothing but liabilities. In my view, it cannot be said that Barry and Vithoulkas have in these circumstances acted as the ego of the company itself and for the benefit of the company so as to bring the identification principles into play.”

On appeal, the Court of Appeal dealt summarily with a submission that it could not be said that the actions constituted a fraud on the company, when, it was submitted, the corporation was set up for the very purpose of effecting their fraudulent scheme. The court said:

“There was no admissible evidence before the trial judge which would allow her to conclude that the corporation was set up with a view to perpetrating the frauds. Further, we do not read these comments of the trial judge as meaning anything other than Vithoulkas and Barry perpetrated a fraud on the corporation as a means of achieving personal gain. It does not detract from the main thrust of the judge’s finding that Barry and Vithoulkas were acting for their own benefit only.”

I agree with the last two sentences, and add that it cannot sensibly make any difference whether or not the corporation there or S & R here was originally incorporated with a view to perpetrating the relevant fraud. Whatever the motives with which it was incorporated, it was not a sham. Once incorporated as a separate legal entity, it was entitled to be respected as such - even (indeed especially) by those who created and became its directing minds, wills and beneficial owners - and was not to be treated as their puppet.

234.  In Arab Bank plc v. Zurich Insurance Co. [1999] 1 Lloyd’s Rep 262, 282-3 Rix LJ, and in Brink’s-Mat Ltd. v. Noye [1991] 1 Bank L R 68 (a case involving a scheme of fraud with analogies to the present) the Court of Appeal, considered that a company exposed to third party liability by fraud could be regarded as a victim of the fraud for the purposes of a claim against other persons allegedly in breach of duty to it. In distinguishing between primary and secondary victims, the Court of Appeal in the present case was, however, influenced by reasoning in McNicholas Construction Co. Ltd. v Customs and Excise Comrs [2000] STC 553 (Dyson J) and in Bank of India v. Morris [2005] 2 BCLC 328 (Court of Appeal). Both those cases were (as Rimer LJ noted) concerned with claims against the company by injured third parties, rather than claims by the company against others in breach of duty to it. So it is not clear why the Hampshire Land issue arose at all, and in my view the statements in them are of no assistance in resolving any issue of attribution in the present context.

Directing minds and will who are also sole shareholders

235.  Does it make any difference to the result if the company’s directing mind(s) also own all its shares? Here it is necessary to return to the common law rule of attribution to which Lord Hoffmann referred in Meridian, that the unanimous decision of all the shareholders in a solvent company about anything that the company has power to do under its memorandum of association counts as a decision of the company. Lord Hoffmann cited Dillon LJ’s statement in Multinational Gas, p.288G-H, that “so long as the company is solvent the shareholders are in substance the company". In consequence, Kerr LJ said in Attorney General’s Reference (No 2 of 1982), p.640C-E, “the decisions alleged to have been taken negligently and breach of duty [in Multinational Gas] were the decisions of the company itself and - the transactions being intra vires the company’s memorandum - there was no basis for any claim by the liquidator".

236.  However, the limitations mentioned by Lord Hoffmann are important. The transactions must be within the company’s power under its memorandum of association; and it is only the unanimous decision of all the shareholders in a solvent company that can authorise or ratify an act that would otherwise constitute a breach of duty to the company, and make it the company’s. No argument was addressed to the House on the former limitation, which in the present context probably overlaps with the latter. Transactions entered into by directors amounting in substance to no more than the fraudulent abstraction of increasingly large sums from an increasingly insolvent company with no other assets are unlikely to be within the scope of the company’s powers; and the breach of duty involved in entering into such transactions cannot be answered by pointing to the directing mind’s ownership of all the company’s shares. This, as I have noted (para. 229 above), is what was decided by the Court of Appeal in Attorney General’s Reference (No 2 of 1982), a decision which was clearly right. In summary, at latest once directors know that a company is or would be insolvent, a disposition of the company’s assets in disregard of the general creditors of the insolvent company will be actionable by the company, whatever the shareholders may wish or approve: see also per Dillon LJ in West Mercia Safetywear Ltd. (in liq) v Dodd [1988] BCLC 250, 252, distinguishing the situation in Multinational Gas as one where the company was “amply solvent, and what the directors had done at the bidding of the shareholders had merely been to make a business decision in good faith, and act on that decision"; and also per Kerr LJ in Attorney General’s Reference (No 2 of 1982), p.640D-641C distinguishing Multinational Gas as not “concerned with allegations that the shareholders and directors had acted illegally or dishonestly in relation to the company".

237.  The current edition (2007) of Palmer’s Company Law Annotated Guide to the Companies Act 2006 states the position, at p 169:

“The scope of the common law duty requiring directors to consider the interests of creditors is more controversial. Cases support a variety of propositions, but the better accepted view is that a duty is owed by directors to the company (and not to the creditors themselves: Kuwait Asia Bank EC v National Mutual Life Nominees Ltd. [1991] 1 AC 187 at 217 PC; Yukong Line Ltd. v. Rendsburg Investments Corp (No 2) [1998] 1 WLR 294 [Toulson J]), and this duty requires directors of insolvent or borderline insolvent companies to have regard to the interests of the company’s creditors (West Mercia Safetywear Ltd. v Dodd [1988] BCLC 250 CA).”

238.  I agree with this analysis. The Court of Appeal was therefore also correct in West Mercia to hold that directors who know the company to be insolvent owe to the company an enforceable duty to have regard to the interests of the company’s creditors. In Yukong Line Toulson J was likewise right to consider that that would be so (p.314F-G). There, as in West Mercia, the directing mind and owner of a company which had incurred a large liability sought to put the company’s assets out of the reach of its creditor by transferring them to another of his companies. A claim by the creditor against the director failed on the basis that the director owed no direct fiduciary or other duty towards creditors. His liability was, as in West Mercia, to the company for disregard of the interests of its creditors. Far from undermining the integrity of the common law if such a liability were recognised and enforced, it would undermine the concept of separate corporate identity and the protection for creditors in insolvent situations at which company law aims, if a company were not entitled to claim against its directing mind and sole controlling shareholder in such a situation. The English cases of RBG Resources plc v Rastogi and others and Brink’s- Mat Ltd. v. Noye and the Canadian case of Oger v. Chiefscope Inc. et al. (cited above), in all of which the directing minds of the relevant companies were the only shareholders, reach the same conclusion.

239.  In In re The Mediators, Inc. 105 F.3d 822 (USAC, 2nd Cir. 1997), the Court held inadmissible a claim by a creditors’ committee standing in the company’s shoes brought against the company’s sole shareholder, chief executive officer and chairman together with its bankers, lawyers and accountants for deliberately devising a scheme, which stripped the company of its assets in order to shield them from liquidation and from the company’s creditors, while rendering the company liable for the cost of so doing. The reasoning was that, in a case of a sole shareholder and decision maker, “whatever decisions he made were, by definition, authorised by, and made on behalf of, the corporation” (p.827) and that the company had “no standing to assert aiding-and-abetting claims against third parties for cooperating in the very misconduct that it had initiated” (p.826). This is not English law. But an important element to understanding this rule is that in American law “Where third parties aid and abet a fiduciary’s breach of duty to creditors - as is claimed here - the creditors may bring an action in their own right against such parties.” (p.825).

240.  In summary, it is no answer in English law to a claim by S & R against Mr Stojevic that Mr Stojevic had, as S & R’s sole directing mind and sole shareholder, authorised the scheme of fraud which to his knowledge made the company increasingly insolvent to the detriment of its existing and future creditors. For present purposes it is to be assumed (and in fact it seems clear) that Mr Stojevic must have known that, as a result of his scheme of fraud, S & R was (increasingly) insolvent at each audit date.

The auditors’ liability where the company’s directing mind is fraudulent

241.  I turn against this background to the auditor’s position. Leaving aside situations in which the directing mind(s) is or are the sole beneficial shareholder(s), it is obvious - although the Court of Appeal’s judgment is surprisingly silent on the point - that an auditor cannot, by reference to the maxim ex turpi causa, defeat a claim for breach of duty in failing to detect managerial fraud at the company’s highest level by attributing to the company the very fraud which the auditor should have detected. It would lame the very concept of an audit - a check on management for the benefit of shareholders - if the higher the level of managerial fraud, the lower the auditor’s responsibility. When Lord Bridge noted in Caparo that shareholders’ remedy in the case of negligent failure by an auditor to discover and expose misappropriation of funds by a director consisted in a claim against the auditors in the name of the company (p.626E), he cannot conceivably have had in mind that it would make all the difference to the availability of such a claim whether the director was or was not the company’s directing mind. The fact that a “very thing” that an auditor undertakes is the exercise of reasonable care in relation to the possibility of financial impropriety at the highest level makes it impossible for the auditor to treat the company itself as personally involved in such fraud, or to invoke the maxim ex turpi causa in such a case. Context is once again all, as Kerr LJ recognised in Attorney General’s Reference (No. 2 of 1982) at pp.640D-642H (see especially at p.642D). (I interpose that I do not read the discussion starting there at p.641E as proceeding on a basis inconsistent with that preceding it - I understand Kerr LJ there to have been addressing the factual question whether a jury would be bound to conclude that there was no dishonesty, which would arise if he were wrong in his legal analysis at pp.640A-641E.) Deception of auditors is the necessary stock-in-trade of fraudulent top management, as auditors and those responsible for auditing standards are and have long been very well aware. Lord Phillips’s statement (para.5) that “common sense” might suggest that S & R’s claim should fail because Moore Stephens were victims of deceitfully prepared company accounts must be categorically rejected. It would emasculate audit responsibility and the auditor’s well-recognised duty to approach their audit role if not as bloodhounds, then certainly as watchdogs - planning and performing their audit with the “attitude of professional scepticism” required by paragraphs 27 and 28 of Auditing Standard SAS 110 in relation to the possibility of fraud as well as of error in management representations and company records and documents.

242.  Auditing standards and procedures have changed significantly over the years. But the potential responsibility of auditors for negligent failure to detect accounting deficiencies or managerial fraud - leading the company to sustain further loss connected with such deficiencies or the continuation of such fraud - dates back to the early days of auditing: see e.g. In re London and General Bank (No 2) [1895] 2 Ch 673 (CA) (liability for a dividend voted by shareholders on the basis of misleading accounts on which the auditors failed adequately to report) and In re Thomas Gerrard & Son Ltd. [1968] Ch 455 (liability for dividends voted and tax liabilities incurred on the basis of accounts containing fraudulent inflation of the company’s profits by Mr Croston, its managing director and holder of 18,000 of its shares, which the auditors negligently failed to discover and report on). In the latter case, the auditors argued (somewhat faintly), that Mr Croston knew and was not misled about the true position and that the payment of the dividends and tax flowed from his or the directors’ actions (pp.469D-E and 471C-D). Pennycuick J gave short shrift to the argument (pp.477G-478G)

243.  In Galoo Ltd. v. Bright Grahame Murray [1994] 1 WLR 1360 auditors were allegedly negligent in failing to detect fraudulent overvaluation of Galoo Ltd.’s stock by Mr Sanders, who was clearly the directing mind of Galoo Ltd. and its 100% parent. The claim was that, but for such negligence, both companies would have been wound up in 1986 instead of in 1993 and would have avoided losses made in subsequent adverse trading in that eight year period. The claim was rejected on grounds of causation (the losses were caused by the subsequent adverse trading, and the “but for” link to the auditors’ negligence was insufficient). There was no suggestion that Mr Sanders’ knowledge of or involvement in the fraud could defeat it.

244.  More recently, in Sasea Finance Ltd (in liquidation) v KPMG (formerly KPMG Peat Marwick McLintock [2000] 1 All ER 676, the auditors were alleged to have failed to report promptly during the audit evidence of impropriety by two dominant figures in the group (neither however then a director). The auditors argued that it would have been no use to report to senior management consisting of the two dominant figures. In response, the Court of Appeal noted that there were six directors of whom no criticism was made and, in any event, that the Auditing Guidelines of the Institute of Chartered Accountants (Feb 1990 ed.)

“acknowledge that there may be occasions when it is necessary for an auditor to report directly to a third party without the knowledge or consent of the management. Such would be the case if the auditor suspects that management may be involved in, or is condoning, fraud or other irregularities and such would be occasions when the duty to report overrides the duty of confidentiality".

The Court of Appeal cannot have thought such a duty in shareholders’ interests would only exist if senior management below the level of the company’s directing mind or board were complicit in the fraud.

245.  It is in principle therefore no answer to an auditor who has failed to discover fraud to point to involvement or knowledge on the part of the company’s directing mind. This conclusion is justified on grounds paralleling those applicable between the company and its directing mind (see paras. 224-232 above). That is not surprising, since both senior management and auditors owe duties to the company intended to protect shareholders’ interests, and such duties must be enforceable. The two sets of relationship are essentially complementary, although the duty is in one case primary and in the other confirmatory. However the present scheme of fraud is categorised, it cannot in the context of the audit engagement be attributed to the company itself, so as to relieve the auditors from their duty or prevent the company complaining of its breach. Again, this is so as a matter of general principle having regard to the nature of the roles and duties undertaken. Again, however, it can be supported by reference to the Hampshire Land principle, which, in this context also, means that the interests and activities of S & R and of Mr Stojevic must be distinguished, precisely because it was among Moore Stephens’s functions as auditor to ensure to the former a degree of protection against the latter.

246.  In view of some observations made by my noble and learned friend, Lord Brown of Eaton-under-Heywood (in paras. 202-203) I add a word on the nature of an auditor’s potential liability for negligent failure to detect, report and so stop a continuing course of management fraud. This was one of a number of topics on which the House did not hear argument, and some authorities relevant to it were not therefore cited. But in principle, the auditor is potentially liable for further frauds committed in the same course of management fraud. An auditor may argue that loss suffered by a continuing scheme of fraud which the auditor ought to have detected was outside the scope of the auditor’s duty or too remote or that there was a break in the chain of causation, but success in such an argument may be unlikely in circumstances where, ex hypothesi, the auditor was negligent in failing to detect the same continuing scheme. The relevant considerations were canvassed by Evans-Lombe J in Barings Plc v Coopers & Lybrand [2003] EWHC 1319 (Ch) at paragraphs 816-838. Hobhouse J’s comments in Berg (discussed below) and the case of Galoo (paragraph 243 above) have nothing to do with this question. In both those cases, the losses and insolvency were caused by subsequent adverse trading decisions unconnected with the fraud. (Galoo is no doubt the case to which Lord Hoffmann referred extra-judicially on this point in his Chancery Bar lecture Common Sense and Causing Loss of 15 June 1999.)

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