Knowing receipt: when do solicitor’s fees cross the line?

The decision of the Supreme Court in Byers and others v Saudi National Bank ([2023] UKSC 51), handed down in December 2023, marked a key development in the law on knowing receipt and provided a welcome clarification of the relevant principles.

What is knowing receipt?

Knowing receipt is a claim in equity and will arise where a trustee transfers trust property beneficially owned by X to Y in breach of trust, and Y becomes aware of the breach before it disposes of or deals with the property.

The Court of Appeal in El Ajou v Dollar Land Holdings PLC (No 1) [1994] 2 All E.R. 685 provided guidance on the elements of a knowing receipt claim. A claimant must show:

• A disposal of their assets in breach of fiduciary duty.
• The beneficial receipt by the defendant of assets which are traceable as representing the assets of the claimant.
• Knowledge on the part of the defendant that the assets they received are traceable to a breach of fiduciary duty.

In Byers, a claim was brought against Saudi National Bank for knowing receipt. The facts of the case involved a complicated fraudulent scheme. In brief, shares had been transferred to the bank in breach of trust and the bank was on notice of that breach. Under Saudi law, the act of transferring the shares extinguished any third-party title to the shares, and so the bank obtained clear legal title to the shares as soon as those were transferred to it.

The Supreme Court found that, as the claimant’s interest in the shares had been extinguished by their transfer to the bank, its claim of knowing receipt must fail, despite the bank being on notice that the transfer of the shares had been in breach of trust.

Therefore, a claim for knowing receipt will only be successful where a claimant has a continuing proprietary interest in the assets. This decision is likely to be particularly relevant to banks and other financial institutions which regularly find themselves involved in these types of claims.

Some uncertainty remains following the decision in Byers regarding what constitutes ‘knowledge’ in the third limb of the test for knowing receipt set out above. The court found that the knowledge requirement is not met simply by having notice of the breach of trust, or because it would be unconscionable for the recipient to retain a benefit to the asset.

However, the court did not go on to address whether constructive knowledge would be sufficient and it was suggested this would require a separate test. It is likely that the court will need to provide further guidance on this point at a later date.

Solicitors’ fees

As solicitors we receive funds from clients in payment of legal services rendered, whilst checking the source of funds is one of the mandatory regulatory checks which we undertake, there is no way of ascertaining with certainty that the funds we receive are clear of third-party claims.

What happens when there is a third-party claim to funds we receive in payment of our fees and when is the line crossed into knowing receipt?

The leading case on this issue remains the Court of Appeal decision of Carl Zeiss Stiftung v Herbert Smith & Co (No.2) [1969] 2 Ch. 276. The facts in the case were that Carl Zeiss Stiftung (ECZS), an East German foundation, was in legal proceedings with a West German foundation of the same name (WCZS). ECZS’s position in the claim was that all of the assets and property of WCZS belonged to it, this was disputed by WCZS.

Before the trial, ECZS made an application for an account against the solicitors acting for WCZS, Herbert Smith, alleging that they had received funds from WCZS, and by reason of their acting the firm was on notice that WCZS’s money belonged to ECZS. There was no suggestion in the application that Herbert Smith had acted without integrity or honesty. Herbert Smith accepted receiving funds from WCZS on account of fees, costs and disbursements to be incurred in the claim and that they were aware of the nature of ECZS’ claims against WCZS.

At first instance, ECZS’ application was dismissed, finding that ECZS’ application sought to obstruct the course of justice, it was contrary to public policy, and that whatever the outcome of the main case provided that Herbert Smith acted honestly then they would not be accountable to ECZS for any of the funds they received against their fees. ECZS appealed this decision.

The Court of Appeal found:

1. A solicitor acting honestly in their capacity as a solicitor for their client was in no different position from any other agent acting for their principal. Solicitors were not to be taken to have knowledge of a trust merely because, in acting for their client, they were aware that there were third party claims against the client’s assets. The knowledge of this allegation did not amount to notice of a trust or notice of misapplication of trust funds. Accordingly, given Herbert Smith had no notice of a trust or that they had received trust funds from their client, they were not accountable to ECZS for the monies which had been paid to them by WCZS on account of costs, fees and/or disbursements.
2. A solicitor had no duty to assume that the claims against their client were true and there was no duty for a solicitor to make inquiries as to whether such facts were true.
3. The concept of a ‘want of probity’ provided a useful touchstone in considering circumstances which would give rise to a constructive trust. A solicitor who receives money from his client which belongs at law or in equity to a third party is not accountable as a constructive trustee to that third party unless he has been guilty of a wrongful act(s) in relation to that money. To act ‘wrongfully,’ the solicitor must be guilty of (i) knowingly participating in a breach of trust committed by his client, or (ii) intermeddling with the trust property otherwise than merely as solicitor and thereby becomes a trustee as a result of that conduct, or (iii) receiving or dealing with the money knowing that his client has no right to pay it over or to instruct a solicitor to deal with it in the manner proposed, or (iv) some dishonest act relating to the money.

ECZS’ appeal was dismissed and leave to appeal to the House of Lords refused.

Carl Zeiss Stiftung was considered and applied in the more recent case of AA v BB [2021] EWHC 1833 (Ch) and was confirmed to remain good law. Mr Justice Miles stated that “The principle to be taken from [Carl Zeiss Stiftung] is that there is a difference between notice of claims and notice of facts and that a solicitor will be protected from liability unless he knows that the claimant's proprietary claim is well-founded”.

Conclusions

Solicitors can take comfort in the decision of Carl Zeiss Stiftung and the more recent decision of AA v BB. Where funds are received from clients for payment of legal services, those fees will not be at risk of being clawed back simply because there are allegations that the funds which your client is using are held on trust for a third party.

Rather, solicitors will be treated in the same way as any other agent, there is no obligation on the solicitor to make their own enquiries as to the position regarding the funds and provided that the solicitor does not act wrongfully a constructive trust will not arise and they will not be liable for knowing receipt.