UK: Liability Of Company Auditors

Last Updated: 23 April 2009
Article by Laurence Harris and Emma Richardson

The Court of Appeal's unanimous judgment in Moore Stephens (a firm) v Stone & Rolls Ltd (in liquidation)1 is a welcome decision for auditors and their insurers. It confirms that an auditor is not liable for losses that arise from liabilities incurred by a company towards third parties caused by a company's fraud, where the fraud is perpetrated by the "sole directing mind" of the company.

The longstanding legal principle of ex turpi causa non oritur actio (the ex turpi principle), which means that "no court will lend its aid to a man who founds his cause of action on an immoral or illegal act"2 , was the subject of much discussion in the Judgment of the Court of Appeal delivered on 18 June 2008, which overturned the High Court's decision. The case has received a great deal of publicity as it is one of the first substantial cases in England and Wales in which the Claimant, the liquidator, was financed by a third party funder.

Background

Whilst Stone & Rolls Ltd (the Company) was in operation it was controlled and indirectly owned by Mr Zvonko Stojevic, a Croatian businessman. It was alleged that Mr Stojevic used the Company as a means to commit fraud against several banks. The fraud consisted of the presentation of false documents to the banks which allowed the Company to draw down on letters of credit. This enabled large sums of money to be directed through the Company and applied elsewhere for the benefit of Mr Stojevic (and others). The frauds gave rise to numerous liabilities by the Company to a number of banks, including a Czech bank, Komercni Banka AS (the Bank).

The Bank sued Mr Stojevic and the Company for this alleged deceit.3 Together, Mr Stojevic and the Company were found liable for the fraud and ordered to pay substantial damages to the Bank. Following the Judgment in that case, the Company could not pay the damages and went into provisional liquidation. The liquidators of the Company subsequently brought a claim against Moore Stephens (the Firm), its auditors. Their principal argument was that the Firm had negligently failed in the course of its audits to detect and report the fraudulent behaviour of Mr Stojevic. The Company's claim was for approximately US$174 million.

The Firm denied any breach of duty and issued an application for summary judgment on the claim or, alternatively, for the claim to be struck out. The Firm argued that the Company was essentially seeking to recover a loss caused by its own fraud and therefore the Company could not succeed because of the public policy argument expressed in the ex turpi principle. At first instance the High Court drew a distinction between the Company and Mr Stojevic in relation to the frauds committed and concluded that the Company was as much a victim. The Firm appealed.

The Issues

The Court of Appeal had two main issues to consider:

The Attribution Issue

The Company argued that the ex turpi principle did not prevent the Company from suing for recovery of its own losses caused by Mr Stojevic in relation to the frauds because the Company was itself a victim of the frauds and knowledge of the frauds should not therefore be attributed to the Company.

The "Very Thing" Argument

Secondly, the Company argued that the defence the Firm argued (the ex turpi principle) could not be relied upon to prevent the claim against it when the detection of dishonesty was the "very thing" that the Firm was retained to do.

Judgment of the Court of Appeal

The Court of Appeal unanimously upheld the appeal and found against the Company on both issues.

The Court of Appeal rejected the argument that the Company was the victim of fraud and attributed Mr Stojevic's actions to the Company. The Court of Appeal believed that there was no prospect of the Company establishing at trial that it was the victim of the fraud. Lord Justice Rimer stated;

"Mr Stojevic was not engaged in a fraud on, or directed at, the company. He was using it as the vehicle for a fraud of its own directed at the banks. It was the company which tendered the fraudulent documents to the banks and it was the company that was dealing dishonestly with them."

The Company had sought to rely on the principle established in Re Hampshire Land Co4, which prevents fraud being attributed to a company in a situation where the fraudster has directed the fraud against the company itself. This argument was rejected by the Court of Appeal because the principle can only be relied upon when the company is itself a victim of the fraud being perpetrated.

The Court of Appeal held that the Company's claim was barred by the ex turpi principle. The Court unanimously agreed that there was no room for discretion in the application of the ex turpi principle, as recognised in Tinsley v Milligan:

"the principle is not a principle of justice; it is a principle of policy, whose application is indiscriminate and so can lead to unfair consequences as between the parties to litigation. Moreover the principle allows no room for the exercise of discretion by the court..."5

Finally, the Court of Appeal dismissed the Company's argument that the Firm should not have the benefit of the ex turpi principle because the "very thing" they were retained to do was to prevent the fraud as there was no authority to support it.

Comment

As it currently stands this decision is clearly supportive for auditors and their insurers, since it shows that companies involved in fraud may be prevented from pursuing recovery actions against auditors arising from such companies' own fraudulent actions. Nevertheless, its application will depend on the extent to which, in any given case, it is established that the individual responsible for the perpetrated fraud was the "sole directing mind and will" of that company. Indeed, it was the Company's principal argument that it was, for practical purposes, a "one man company". The reason why the Firm's defence succeeded was because the dishonesty of Mr Stojevic was attributed to the Company. The Company is reported to have appealed to the House of Lords.

Auditors and their insurers may also gain some reassurance from the recent changes to the Companies Act 2006 which means auditors are now allowed to cap their liability for statutory audits (although this is subject to approval of shareholders). Until 6 April 2008 such practices were prohibited.6

On a more general note, this case perhaps allays the fears of those who earlier raised general concerns about litigation funding, and its propensity to increase litigation and unmeritorious claims. Here, the claim funded by the unrelated third party funder, IM Litigation Funding, who raised money from hedge funds and other investors, failed. This may make third party funders more cautious about such claims going forward.

Footnotes

1 CA [2008] EWCA Civ 644.

2 Holman v Johnson (1775) 1 Cowp. 341, at 343.

3 Komercni Banka AS v Stone & Rolls Limited and Another [2002] EWHC 2263 (Comm).

4 [1986] 2 CH 743.

5 [1994] AC 340 at 355B.

6 See: Sections 523-538 Companies Act 2006.

This article first appeared in the Edwards Angell Palmer & Dodge publication 'Commercial Litigation Review' in December 2008.

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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