UK: Combating The Threat From Within

With corporate fraud the subject of unprecedented attention because of financial scandals in the US, in this series of three articles we analyse the legal framework in the UK for detecting and combating fraud and suggest how, in practical terms, UK businesses can protect themselves.

The recent financial scandals in the US (Enron, Allied Irish Bank and World-Com) all stem from impulses that are not new. What is new is the context in which these events have occurred, namely against a background of heightened terrorist activity and, in particular, governments’ reactions to them. The response of governments has been tough and swift, with a view to protecting economies and maintaining investor confidence, so badly shaken in the months following 11 September 2001.

Governments have not always been so ready to intervene; in the past it was often left to the financial markets to absorb the effects of large-scale fraud. Now, however, governments are taking a hard-line approach. The spotlight is on regulators to tighten the reins on companies and big businesses. A higher premium than ever before is being placed on corporate governance. Put simply, employees and officers are being required to bear greater responsibility, and accountability, for the company or business for which they work.

All of this is set against a background of fundamental change to the context in which most businesses now operate. The last decade has seen increasing globalisation, a prolific increase in the use of electronic means to send and transfer information and money, coupled with growing sophistication in financial products and accounting. All of these factors have made it easier to perpetrate fraud and have, therefore, increased the risk of fraud immeasurably.

Now more than ever companies and their legal advisers need to be aware of the risks businesses face and the measures they can and, in many cases, must take to combat fraud. This article considers:

• The current law relating to fraud affecting UK businesses.
• Practical issues facing businesses that are potential or actual victims of fraud.
• Proposals for reforming UK law relating to fraud.

A recent survey conducted by KPMG indicates that over the period from 1 January 2002 to 30 June 2002 fraud cases in the UK have increased by over 150% compared with the same period last year, totalling some £255 million (KPMG Fraud Barometer, July 2002). This includes a surge in public sector fraud, such as tax and VAT evasion, as well as a steep rise in financial and banking scams.

At present there is no criminal offence of fraud in English law. As a consequence, a number of theft and deception offences and the common law crime of conspiracy to defraud are used to convict fraudsters. However, in the past four years new laws have been passed that aim to combat and help with the detection of fraud. They are:

• The Enterprise Act 2002.
• The Proceeds of Crime Act 2002.
• The Public Interest Disclosure Act 1998.

• The US Sarbanes-Oxley Act of 2002.

The relevant provisions of these Acts apply to a variety of persons, including employees, officers, corporate counsel, financial institutions and auditors.

The Enterprise Act 2002 (the 2002 Act), which received Royal Assent on 7 November 2002, contains provisions aimed at tackling corporate fraud that are intended to build upon those contained in the Competition Act 1998 (the 1998 Act), which was directed at preventing cartels.

By contrast with the 1998 Act, whose measures apply to companies, the relevant provisions of the 2002 Act apply to individuals. The offences are based on "dishonesty" and cover price-fixing, market-sharing, limitation of production and bid-rigging (section 188). It is expected that all of the competition law provisions in the 2002 Act will come into force in the spring or summer of 2003.

The new offence carries a maximum prison sentence of five years (section 190). It is anticipated that the Serious Fraud Office will be the lead prosecutor in England, Wales and Northern Ireland, with the Office of Fair Trading as an additional prosecutor for Scotland.

The Proceeds of Crime Act 2002 received Royal Assent on 24 July 2002 and the money laundering sections of the Act are expected to come into force in January. Its main features include:

• The major extension of the scope of money laundering offences.
• The introduction of various reporting requirements in respect of money laundering.
• The establishment of an Assets Recovery Agency (ARA).

Please also see our article Update on the Proceeds of Crime Act 2002.

The Public Interest Disclosure Act 1998 (PIDA) is aimed at providing protection for employees, thereby encouraging them to speak out about perceived incidents of corporate fraud. The benefits of "whistleblowing", as this practice is often termed, are that it may save the organisation both in financial and reputational terms.

PIDA was introduced after a series of financial scandals in the late 1980s and early 1990s that had resulted in public inquiries. Those inquiries revealed that often people within the organisations knew of the potential dangers but for a variety of reasons were either unwilling to raise the alarm or did not know how to go about doing so. For example, the Bingham Inquiry into the collapse of Bank of Credit and Commerce International (BCCI) found that the fraud, estimated at nearly £2 billion, was allowed to continue because of an "autocratic environment" in which no-one dared to speak up.

The organisation Public Concern at Work (PCaW) was instrumental in securing support for PIDA. It was founded in 1993 and provides confidential legal advice to employees to help them raise their concerns. PCaW also provides training for employers on good governance and the implementation of effective whistleblowing policies.

PIDA seeks to protect workers who raise concerns in a responsible way and encourages employers to respond appropriately and to separate the message from the messenger. Recent court decisions involving PIDA demonstrate that its provisions are being rigorously applied and responsible whistleblowers protected (for example, see Bladon v ALM Medical Services ET 25 April 2000 and Edgar v Meteorological Office [2002] ICR 149).

The non-statutory Turnbull Committee Report, published a year after PIDA, also addresses the issue of whistleblowing. It recommends, as part of its guidance to directors of listed companies on risk management, that every company should adopt a whistleblowing policy. In doing so, it goes slightly further than PIDA.

On 30 July 2002 President Bush signed into law the Sarbanes-Oxley Act (SOX). SOX contains measures so far-reaching that they rival those introduced following the 1929 US stock market crash. The ambit of SOX is not restricted to the US. A literal reading of SOX would mean that almost all of its provisions would apply to any issuer who files periodic reports with the Securities and Exchange Commission (SEC), including UK companies with secondary listings in the US.

The aim of SOX is to boost investor confidence in the US market, deter and punish corporate and accounting fraud and corruption, bring wrongdoers to justice and, at the same time, provide protection for employees who attempt to bring fraud to the attention of those with responsibility for dealing with it. It demands the enhancement of financial disclosure, greater accountability of corporate executives, independence of the auditing process and punishment for improper conduct by senior company executives.

One of the measures aimed at combating fraud is a provision requiring the SEC to make rules requiring in-house and external lawyers to notify the audit committee, a committee of independent directors or the board of directors itself of a material violation of securities law or breach of fiduciary duty which senior executives do not appropriately respond to (section 307). The rules are due to be adopted by 26 January 2003. A lawyer who violates these duties may be censored or disbarred from practising by the US SEC.

Although President Bush has promoted SOX as a tonic to purge corporate America of its past misdeeds, enabling businesses and investors alike to recover confidence, those directly affected by it are less enthusiastic, with many feeling that SOX will simply lead to increased litigation and bureaucracy and a reluctance on the part of executives to take on the massive responsibility now inherent in the top company roles. The full impact of SOX in the UK is, however, not yet clear and the UK government is continuing to lobby in the US for exemption for UK companies.

PRACTICAL ISSUES IN DEALING WITH FRAUD

A number of practical issues face businesses that are potential or actual victims of fraud. The fraud may have been confined to the business itself (for example, an employee with his hand in the till). Equally, it may extend to clients and customers of that business. Inevitably, different considerations arise depending upon the nature and extent of the fraud.

Fraud, whether perpetrated by the employee or a third party, is a fact of life for businesses, which have to take responsible steps to protect themselves and to comply with the increasingly complex anti-fraud legislation. The starting point in determining how to prevent or minimise the risk of fraud must be knowing and understanding your business, and who you are doing business with. Armed with this knowledge, businesses can put in place a tailor-made system for:

• Fraud prevention (risk management rules and internal controls, an anti-fraud and corruption policy and a code of conduct for employees).
• Fraud detection (appropriate management structures, segregation of responsibilities and a whistleblowing policy).
• Fraud investigation (an investigation/ disaster plan).

The process of preventing fraud is not a static one nor one that can be implemented in isolation. It is necessarily an evolving process, and one that must respond and adapt to the changing needs and demands of the business and the environment in which it operates.

Fraud can be perpetrated in any number of ways. Likewise, its existence can come to light by a number of means, for example:

• The setting up and monitoring of rigorous internal controls systems.
• Chance (for example a tip-off).
• A review by internal or external auditors.
• The mysterious disappearance of an employee (this is how Nick Leeson’s fraud in Barings came to light).

When fraud is discovered, a company must implement a process aimed at establishing what has happened; reporting where necessary (for example, by making an announcement under the continuing obligations of the UK Listing Authority’s Listing Rules); stabilising the business; maximising recovery; and (ultimately) learning from the experience. The efficiency of this process may well determine whether the business survives or not, depending on the scale of the problem. Identifying the pitfalls is far from easy and tends to be case specific.

Pitfalls: For fraud investigation to serve one of its primary purposes, maximising the recovery of misappropriated assets, it is vital that:

• Evidence gathered is admissible in any subsequent litigation.
• Applications for freezing injunctions and disclosure orders are not jeopardised by the methods used to collect evidence.

A company must therefore address the issue of how best to gather evidence and information in the context of a fraud investigation at the outset.

Once a business has discovered that it has been the victim of a fraud, it will usually wish to take steps to recover misappropriated assets as quickly as possible. Very often, this will involve seeking interim relief in the form of freezing injunctions, related search and disclosure orders and, in exceptional cases, gagging orders to preserve the position pending the outcome of any litigation. The procedure is set out in Part 25 of the Civil Procedure Rules (CPR) and the supporting practice direction. The disadvantage to a claimant who fails at this first hurdle should not be underestimated.

The eventual determination of the litigation may be some way off, depending on the legal and factual complexities of any proceedings brought and whether the proceedings are defended. For a complicated matter with an estimated trial length of over four weeks, the trial can be 18 months away from the date of issue of the claim form.

The following have been shown to be problematic in the context of gathering evidence to support applications for interim relief:

• Use of pretext calls (that is, calls whereby the caller seeks to extract information by pretending to be something or someone he or she is not) (see Dubai Aluminium Co Ltd v Al Alawi [1999] 1 All ER 703).
• Intercepting telephone calls (see St Merryn Meat Ltd & Others v Hawkins & Others [2001] CP Rep. 116).
• Activities that involve a breach of the Data Protection Act 1984 (since replaced by the Data Protection Act 1998) (see Dubai Aluminium and Memory Corp v Sidhu (No 1) (1999) 96(24) ChD and [2000] 1 WLR 1443).
• Activities that involve a breach of the European Convention on Human Rights (now largely incorporated into UK law by the Human Rights Act 1998) (see St Merryn Meat).

Potential claimants should be aware of the following adverse consequences:

• Discharge of freezing injunctions and related search orders (see St Merryn Meat).
• Loss (at an early stage) of legal professional privilege attaching to documents created during the investigative process (see Dubai Aluminium). In that case Rix J said: "But it seems to me that criminal or fraudulent conduct for the purposes of acquiring evidence in or for litigation cannot properly escape the consequence that any documents generated by or reporting on such conduct, and which are relevant to the issues in the case, are discoverable and fall outside the legitimate area of legal professional privilege. It is not as though there are not legitimate avenues which can be sought with the aid of the court to investigate (for instance) banking documents."
• Evidence obtained illegally may not be given full weight (see Memory Corp). In that case Robert Walker LJ said: "Certainly, the court should not condone any illegal conduct. But the court’s general attitude to evidence obtained by questionable means… indicates that the court may admit such evidence without condoning illegality, although the court always has to decide what weight to give it."

More generally evidence gathered improperly:

• Can be detrimental to the success of any subsequent litigation, particularly if freezing injunctions and related search orders have been discharged as a consequence.
• Is likely to give rise to protracted court applications to ascertain the admissibility of the evidence.

Court applications to deal with the admissibility of evidence or the means by which it has been gathered, to which considerable resource inevitably needs to be devoted, simply divert attention away from the real issues. Careful planning at an early stage of a fraud investigation should reduce such risks significantly.

Evidence from others: There are extensive forms of third party disclosure remedies available both at common law and in equity. Very often these will be the starting point in any fraud investigation and form the backbone of resulting litigation. The best known of these are:

• The Norwich Pharmacal jurisdiction (see Norwich Pharmacal Co v Commissioners of Customs and Excise [1974] AC 133): which enables disclosure to be obtained from a third party who has, usually entirely innocently, become mixed up in a scheme to defraud the claimant. In effect it amounts to an equitable right to disclosure to assist the victim by providing disclosure to identify the wrong-doers.
• The Bankers Trust jurisdiction (see Bankers Trust v Shapira [1980] 1 WLR 1274): an extension of the Norwich Pharmacal jurisdiction, which compels a person with knowledge of the whereabouts of property belonging to the claimant, in effect trust property, to give the "fullest assistance" to the beneficiary, which includes disclosure of documentation and information.

The CPR also provide for pre-action disclosure and disclosure against third parties, potentially useful tools for gathering evidence for use in litigation to recover misappropriated assets (CPR Part 31). CPR Rule 31.18, however, makes it expressly clear that the third party disclosure rules do not limit any other powers that the court has to order disclosure against third parties.

The avenues available under CPR Part 31 are briefly discussed below.

• Pre-action disclosure. This is available in all mainstream commercial disputes, including those in which fraud is alleged, where the court is satisfied that:

Pre-action disclosure may, however, remove the element of surprise, and therefore will not be appropriate in many fraud cases. Further, it is essential for applicants who seek pre-action disclosure in support of allegations of fraud to frame their application in a specific, cogent and focused manner (see Herbert Black and Others v Sumitomo Corporation and Others, unreported, 26 July 2001 and Court of Appeal [2001] EWCA Civ 1819, referred to in our last briefing, in which it was held that disclosure could be appropriate where there was not necessarily enough evidence to make out a prima facie case but there was a reasonable basis for making an intended claim).

Pre-action disclosure can be used in addition to the disclosure orders granted ancillary to freezing and tracing injunctions.

• Third party disclosure. Third parties may hold documents that could be of assistance to a company in the subsequent prosecution of civil fraud claims. Disclosure against third parties is readily available by virtue of CPR 31.17. However, it cannot be used in advance of the commencement of proceedings.

The court may make an order only where it is satisfied that the documents sought "are likely to support the case of the applicant or adversely affect the case of one of the other parties to the proceedings" and if "disclosure is necessary in order to dispose fairly of the claim or to save costs".

Companies have a greater chance of making a successful application for third party disclosure following a Court of Appeal decision this year (Three Rivers District Council & Others v Governor & Company of the Bank of England [2002] EWCA Civ 1182).

LAW REFORM

This year a number of recommendations and proposals have been made for the reform of UK law that could impact on the detection and prosecution of fraud.

The Law Commission has recommended introducing a single crime of fraud (Report No. 276, 30 July 2002). The Commission considered that a single offence would greatly simplify the law relating to fraud and make it easier for the lawyers and the police to determine who has committed a crime and who has not, which should make prosecution easier. It is also important that the offence is more readily comprehensible to juries and fair to potential defendants.

The Commission stated that the statutory offences existing at the time of the report were too specific to offer a general description of fraud; while the common law offence of conspiracy to defraud is so wide that it offers little guidance on the difference between fraudulent and lawful conduct. It recommended that fraud be defined as the circumstances where "a person dishonestly makes a false representation, or wrongfully fails to disclose information, or secretly abuses a position of trust with intent to gain or cause loss or expose another to the risk of loss."

The Home Secretary has suggested that the new offence would be coupled with the establishment of a new National Fraud Squad, dedicated to combating fraud. This would unite the fraud squads of the 43 police forces in England and Wales and absorb the Serious Fraud Office (SFO) which is currently responsible for investigating large and complex financial crimes. The proposal follows lobbying by Rosalind Wright, director of the SFO, and the City of London Police Commissioner, Perry Nove.

The government is considering certain proposals for reform of company law that are aimed at combating fraud (White Paper "Modernising Company Law" 16 July 2002). They include:

• The mandatory rotation of audit firms after five years instead of seven and restricting audit firms from offering non-auditing services to their clients.
• Introducing a statutory statement of directors’ general duties.
• Requiring large companies to provide an Operating and Financial Review, which would constitute a narrative report on the company’s business, its performance and future plans that must be signed by the directors.
• Placing a legal obligation on directors to volunteer relevant information to the company’s auditors and giving auditors the statutory right to ask for company information from employees and certain contractors.

© Herbert Smith 2003

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