Jersey: The Judicial Committee Of The Privy Council Confirms The Existence Of "Backwards Tracing"

Last Updated: 4 August 2015
Article by Paul Nicholls and James Turnbull

The Judicial Committee of the Privy Council (the Privy Council) has today handed down its landmark judgment, in The Federal Republic of Brazil and another (Respondents) –v- Durant International Corporation and another (Appellants) (Jersey) [2015] UKPC35, in which Advocate Paul Nicholls of Walkers appeared for the Appellants. The Privy Council confirmed that it is possible for a claimant to rely on the principle of "backwards tracing" in order to recover an asset, provided that a coordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim, looking at the whole transaction, can be established. The question of whether or not "backwards tracing" should be recognised was previously unsettled. Both the Royal Court and the Court of Appeal took the view that the outcome of a case ought properly to depend on its facts as opposed to whether or not the concept of "backwards tracing" is accepted in the abstract, a view endorsed by the Privy Council.

Preamble - Tracing

The doctrine of tracing involves rules by which to determine whether one form of property interest is properly to be regarded as substituted for another. It is therefore necessary to begin with the original property interest and study what has become of it. As Lord Toulson stated in his judgment in the present case, "if it has ceased to exist, it cannot metamorphose into a later property interest. If the money in a bank account has dwindled from £1,000 to £1, only the remaining £1 is capable of being substituted by something else; the £999 has ceased to exist. This explains "the lowest intermediate balance" principle". Similarly, a property interest cannot turn into (or provide a substitute for) something which the holder already has; the later acquisition cannot be the source of the earlier. This explains the "no backward tracing" principle.

The Appeal - facts

The Appellants (Durant and Kildare) were companies registered in the BVI. Kildare was a wholly owned subsidiary of Durant and both companies were, at the relevant time, under the practical control of Mr Paulo Maluf (Mr Maluf) and/or his son Mr Flavio Maluf. From 1993 to 1996 Mr Maluf was mayor of the Municipality of Sao Paulo (the Municipality).

The Appellants appealed to the Privy Council against a decision of the Court of Appeal of Jersey (upholding a decision of the Royal Court) that the companies were liable to the Municipality as constructive trustees of US$10,500,055.35 representing bribes paid to Mr Maluf in connection with a major public road building contract.

The facts giving rise to the appeal to the Privy Council were undisputed: in early 1998 Mr Maluf, or others on his behalf, received 15 secret payments, and that funds equivalent to 13 of those payments were converted to US dollars and paid into an account under the control of Mr Maluf junior in New York in the name of Chanani (the Chanani Account). The 13 payments spanned a period from 9 January to 6 February 1998 and amounted in all to US$10,500,55.35. Over the period of ten days from 14 to 23 January 1998 there were six payments from the Chanani Account to an account held by Durant in Jersey (the Durant Account). These payments totalled US$13,120,000.00. Over the period from 22 January to 23 February 1998 there were four payments from the Durant Account to an account held by Kildare in Jersey (the Kildare Account). These payments totalled US$13,500,000.00.

The Appeal - arguments

The Appellants' case was that their liability as constructive trustees was in the region of US$7.7m, and not for US$10.5m. They argued that:

(a) The last three payments into the Chanani Account identified as proceeds of bribery were made after the final payment from the Chanani Account to the Durant account and that those three payments could not therefore be traced to the Appellants because there could be no "backwards tracing"; and

(b) The Chanani Account was a mixed account; where a claimant's money is mixed with other money, and drawings are made on the account which reduce the balance at any time to less than the amount which can be said to represent the claimant's money, the amount which the claimant can thereafter recover is limited to the maximum that can be regarded as representing his money (the "lowest intermediate balance rule"). In this case, on two occasions, payments were made from the Chanani Account to the Durant Account of sums which exceeded the maximum that could be said to have come from the earlier bribes and must therefore have come from other sources.

The Respondents looked to trace the amount of US$10,500,055.35 to the Durant Account and thence to the Kildare Account. It was asserted that the full amount of those bribes was paid from the Chanani Account to the Durant Account. In the Respondents' submission, it was inaccurate to speak of tracing one asset into another; rather, the Court's should look at the substance of the transaction, not the form, and establish whether or not a sufficient transactional link exists. However, the Privy Council rejected the Respondents' submission that money used to pay a debt can, in principle, be traced into whatever was acquired in return for the debt, considering that argument to be too broad a proposition which would take the doctrine of tracing far beyond its established limits. Indeed, the Privy Council said that courts should exercise caution when expanding equitable property remedies in such a manner as to have an adverse effect on innocent parties. However, the Privy Council did acknowledge that there may be instances in which a close causal and transactional link exists between a debt incurring and the use of trust funds to discharge such a debt.

Appeal – decision

Whilst the Privy Council acknowledged that the Appellants' arguments were conceptually coherent and supported by a great deal of authority and academic writings, it agreed, in general terms, with the Respondents' submission that the substance (as opposed to the form) of the transactions should be examined.

Lord Toulson, delivering the judgment, stated:

"The development of increasingly sophisticated and elaborate methods of money laundering, often involving a web of credits and debits between intermediaries, makes it particularly important that a court should not allow a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect. If the court is satisfied that the various steps are part of a coordinated scheme, it should not matter that, either as a deliberate part of the choreography or possibly because of the incidents of the banking system, a debit appears in the bank account of an intermediary before a reciprocal credit entry. The Board agrees with Sir Richard Scott V-C's observation in Foskett v McKeown that the availability of equitable remedies ought to depend on the substance of the transaction in question and not upon the strict order in which associated events occur".

The Privy Council rejected the argument that there can never be backward tracing, or that the court can never trace the value of an asset whose proceeds are paid into an overdrawn account. However, it is for the claimant to establish a coordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim, looking at the whole transaction, such as to warrant the court attributing the value of the interest acquired to the misuse of the trust fund.

The Privy Council found that that the Royal Court and the Court of Appeal were justified in concluding that the necessary connection between the bribes and the receipts was proved and it therefore dismissed the appeal.

Comment

The Privy Council has made clear that much will turn on the substance of the transactions and the evidence submitted. Courts will therefore scrutinise all facts when considering tracing claims and it is therefore important that all those who hold monies on behalf of third parties are certain of the source of funds. Failure to do so may result in criticism from the Court and possible sanctions from the regulator.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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