Update: professional negligence

In one of the final decisions of the now defunct Appellate Committee of the House of Lords, a company's claim against its former auditors for failure to detect the company's own fraud was struck out. The decision, given at the end of July, will have led to a collective sigh of relief, and probably a more enjoyable summer holiday, for auditors up and down the country, especially given that Stone & Rolls v Moore Stephens [2009] UKHL 39, brought with the aid of third party litigation funding, was said to be only one of a number of potential claims raising similar issues.

The decision was, however, reached by a bare majority and the lords' opinions, almost 80 pages long, have laid fertile ground for further debate about the precise scope of the principle that a claimant cannot found an action upon his own wrongdoing (ex turpi causa non oritur actio).

The claim arose from a series of frauds whereby a number of banks were deceived into lending money to the company to fund sham transactions: the money was in fact paid to third parties controlled by or in league with one Mr Stojevic, who was, it was apparently common ground between the parties, effectively the sole controller and beneficial owner of the company. Moore Stephens had been appointed auditors of the company '“ at least partly, it was said, because the involvement of such a reputable firm would lend to the company an air of respectability. Eventually the frauds were discovered and the company, and Mr Stojevic, were successfully sued for over US$94m. The company was unable to pay and went into liquidation. The liquidators brought a claim in the company's name alleging that Moore Stephens' failure to spot the frauds had allowed the scheme to continue and had given rise, ultimately, to the company's liabilities to the defrauded banks.

Breach of duty

For the purposes of the strike out application it was conceded that Moore Stephens had been in breach of their duty as auditors and that absent that breach, the fraud would have been stopped sooner. However, they argued that the fraud was the company's own and that recovery was therefore precluded by the ex turpi causa principle.

The lords all agreed that the company was primarily, rather than vicariously, liable for the fraud of its controlling mind as against third parties. The company argued, however, that for the purposes of ex turpi causa, the company was not to be treated as having knowledge of the fraud. The fraud had been adverse to the interests of the company because it had ultimately resulted in its incurring liabilities to the banks that it could not meet; in that way, the vehicle for a perpetrator of the fraud had become a 'secondary victim' of it. Alternatively, it was argued that ex turpi causa could not defeat the claim in circumstances where the company's own fraud was one of the very things the defendants were under a duty to detect.

The majority of the lords disagreed, though for different reasons. All stressed that the auditors' duty was owed to the company. Lord Phillips, considering the ex turpi causa principle and the scope of the auditors' duty in the round, considered that, on the facts, all those whose interest the auditors were under a duty to protect were party to the illegal conduct that formed the basis of the claim, and the defence therefore applied. He rejected the 'secondary victim' contention. Implicitly, on Lord Phillip's reasoning, the 'very thing' argument could not arise as a matter of causation, because the company (in the person of Mr Stojevic) was already in fact aware of the matter the auditors were under a duty to report.

Lord Walker, with whom Lord Brown agreed, dismissed the 'very thing' argument in the context of a one-man company, pointing out that the underlying public policy was that a dishonest claimant should be denied a remedy irrespective of the defendant's fault. On the question of whether knowledge of the fraud should be attributed to the company, Lord Walker posited a 'sole actor' test which, he said, could also apply in cases where there was a single dominant director, even if there were other, subservient, directors. On the facts of the instant case, there was no secondary victim: Mr Stojevic and the company were one and the same.

Lord Brown, who delivered the shortest opinion and, in particularly trenchant terms, could not see how, in circumstances where Mr Stojevic effectively was the company, the company could possibly avoid being fixed with knowledge of his fraud by the so-called 'adverse interest rule'. If it could, he agreed with Lord Walker that there was an exception to the rule in the case of a 'sole actor'.

Separate identities

The dissenters, by contrast, held that the separate identities of Mr Stojevic and the company were of crucial importance. Lord Scott held that Mr Stojevic had been acting outside the powers conferred on him by the power of attorney that gave him effective control of the company. Although not affecting the company's liability as against third parties, the distinction meant that the company was itself a victim of its director's fraudulent scheme and there would have been nothing to prevent the company bringing proceedings for misfeasance against Mr Stojevic. It was not clear why the auditors should be in any better position. Furthermore, Lord Scott was not satisfied on the facts that Mr Stojevic was the company's sole beneficial owner.

For Lord Mance, the reasoning of the majority had the undesirable result of excusing auditors from taking due care in scrutinising the activities of one-man companies, which were often behind fraudulent Ponzi-style schemes. The defrauded creditors would have no recourse, since the auditors owed them no duty. To get around that problem, he held that the fact that the company was insolvent at the date of the audit was critical: once the company was insolvent, the identity of interest between it and its shareholders ceased; the duty of its directors was to preserve its assets for the benefit of its creditors; and the duty of its auditors was to protect the company itself from the consequences of errors or wrongdoing. In those circumstances, he said, the company was entitled to pursue a claim, which, although it was genuinely the company's claim, ultimately would be for the benefit of the creditors.

Where, then, does the decision leave matters? Two things, at least, are clear: (i) the ex turpi defence can apply to claims against auditors; and (ii) it will do so to bar a one-man company used by its directing mind and owner to perpetrate a fraud from suing its auditors for failing to detect that fraud. Further, that principle probably also applies to companies with 'one single dominant director and shareholder' / 'no individual concerned in [their] management and ownership other than those who are, or must (...) be taken to be, aware of the fraud or breach of duty' (paragraph 161, per Lord Walker, giving the example of an inactive spouse).

Otherwise, however, the extent to which ex turpi will apply to claims against auditors is not clear and not decided. Companies with innocent minority shareholders or majority shareholders 'hijacked' by a fraudulent but dominant managing director, for example, were adverted to by Lords Phillips (paragraph 63) and Walker (paragraph 192) in terms which suggest that they may not be able to sue. Lord Walker, for example, would, it seems, ask whether it would be 'contrary to justice and common sense to treat the company as complicit' (paragraph 192). Lord Brown, by contrast, would appear to allow such companies to sue, confining the defence of ex turpi strictly to companies without innocent shareholders (see paragraphs 201 and 203 in particular) and, although he was part of the minority, Lord Scott's focus on whether Mr Stojevic was 'absolutely beneficially entitled' to the company (e.g. paragraph 113) suggests that he agrees with Lord Brown in this respect.

More generally, the closeness of the decision and differing approaches even among the majority also do little to clarify when claims against other professionals will be barred by ex turpi. Further litigation on these issues is bound to follow.

Related cases

• In Clark v Lucas Solicitors [2009] EWHC 1952 (Ch), solicitors acting for a property developer gave to the buyer of property that formed only part of a site the standard undertaking to discharge existing charges over it. The solicitors were ordered to pay the full sum due to discharge an existing mortgage, even though the loan had related to the development of the site as a whole and was accordingly for more than twice the purchase price of the subject property.
• The court was held properly to have exercised its discretion to extend time for service of the claim form to allow further investigations into breach in Imperial Cancer Research Fund v Ove Arup & Partners Ltd [2009] EWHC 1453 (TCC) but not in City & General (Holborn) Ltd v Structure Tone Ltd [2009] EWHC 2139 (TCC), in which Imperial Cancer Research Fund was considered.
• In Pickthall v Hill Dickinson LLP [2009] EWCA Civ 543, the claimant had started his claim when, as an undischarged bankrupt, the cause of action had not been vested in him. It was not assigned to him until after the expiry of the limitation period. The court struck out the claim as an abuse of process, refusing to permit an amendment to plead the assignment and 'rescue' the expired claim.
• In Webster v Sandersons Solicitors [2009] EWCA Civ 830, amendments to a claim by the shareholder of a company were disallowed in so far as they related to the company's losses; the case contains a useful summary of the principles of reflective loss.