UK: Changing Attitudes On The Illegality Defence

Last Updated: 8 November 2016
Article by Sedgwick Chudleigh

Two recent decisions of UK appellate courts — one concerning a misfeasance claim against a liquidator and another involving an attempt to recover monies intended for insider trading — illustrate a new, more flexible approach to the "illegality defence". While common sense has prevailed, the new approach will make it harder for legal advisors to predict outcomes when an illegality defence is asserted.

At the heart of the illegality defence in civil claims lies the maxim: no court will lend its aid to a person whose cause of action relies on an illegal act. This principle is based upon public policy that no person should benefit from wrongdoing and that the law should not condone illegal activity. However, while it is clear that no court will give effect to an illegal agreement, this is where the certainty ends and it remains unclear as to where parties to such agreements are left when the agreement unravels.

The traditional test for determining whether illegality can successfully be pleaded as a defence is the 'reliance test' set out in Tinsley v Milligan [1994] 1 AC 340. The reliance test will bar a claim if the claimant relies on the illegality in order to bring a claim. Two recent cases, however, have reduced the scope of the defence, broadened the courts' discretion and abolished the reliance test altogether.

Sharma v Top Brands

In Sharma (as former Liquidator of Mama Milla Ltd) v Top Brands Ltd & Anor [2015] EWCA Civ 1140, the English Court of Appeal refused to allow a liquidator of a fraudulent company to rely on illegality in defending a claim for breach of duty under the Insolvency Act 1986 (UK) (Act).

Background

Mama Milla Ltd (MML) was a UK company that imported toiletry products and sold them within the UK without accounting for VAT, essentially committing VAT fraud. Top Brands and Lemione Services Ltd (LSL) supplied products to MML, and also agreed with MML to deliver goods directly to one of MML's customers, SERT Plc (SERT). SERT would typically pay MML for these deliveries and MML would then compensate

Top Brands and LSL. On the relevant occasion, however, MML was paid £548,074 from SERT but failed to make an onward payment to Top Brands and LSL before entering into a creditors' voluntary liquidation. Mrs Gagen Sharma was appointed as MML's liquidator. The liquidator incorrectly believed that SERT had not received the relevant goods from Top Brands and LSL and, accordingly, she instituted a number of refunds from MML to SERT, on what she thought were SERT's instructions. In fact, SERT had fraudulently claimed that it had not received the goods and instructed MML to make a number of payments into various bank accounts unrelated to SERT.

Top Brands and LSL were unable to recover their loss from MML's assets and together instituted recovery proceedings against the liquidator under Section 212 of the Act for misfeasance. At trial, the liquidator was found to have breached the Act by her negligence and breach of fiduciary duty. She pleaded MML's illegal VAT fraud as a defence to the misfeasance claim. (Interestingly, Mrs Sharma did not attempt to rely upon SERT's illegality). Specifically, the liquidator argued that it would be contrary to public policy to allow the creditors to recover the proceeds from a fraudulent business. The trial judge found against the liquidator on the basis that MML's illegality was not relevant to Sharma's misfeasance.

The decision on appeal

Mrs Sharma appealed and argued that MML's primary business was essentially that of committing VAT fraud. She argued that the test for illegality was whether the claim was 'inextricably linked' to the illegality. In this case, MML's conduct was so closely linked with its VAT fraud that granting the respondent's claim would amount to condoning MML's illegality. The liquidator argued that the 'reliance test' should not be applied.

The Court of Appeal rejected the liquidator's submissions, regardless of which test was applied. She failed the 'reliance test' because MML's VAT fraud was irrelevant to her misfeasance and the respondents had no need to rely upon the illegality in making their claim. She failed the 'inextricable link' test because she could establish no causal link between the loss and the illegality. The court found that the illegality was simply a part of the factual background of the creditors' claim, but played no causal role in the loss itself.

With respect to the liquidator's public policy argument, the court found that there was a competing public policy requiring liquidators to collect and distribute the company's property among the creditors, especially where illegality had occurred.

However, the Court of Appeal was careful to note that there was actually no clear test elucidated in the authorities. It urged the Supreme Court to address the issue, but ultimately seemed to prefer the reliance test.

Patel v Mirza

In the July 2016 UK Supreme Court decision of Patel v Mirza [2016] UKSC 42, the Court revisited the illegality defence, this time in the context of contract for illegal insider trading.

Background

Patel gave Mirza £620,000 to purchase shares in a bank about which Mirza had insider knowledge. Mirza's contacts failed to deliver and the deal collapsed, but Mirza kept Patel's money anyway. Patel brought restitution proceedings and Mirza pleaded the pair's illegal agreement of insider trading as a defence. Patel argued causes of action in trust, contract and restitution. At first instance, Patel's trust claim was unsuccessful and his contractual and restitutionary claims were barred because they relied upon an illegal agreement. The Court of Appeal unanimously overturned the trial judge's decision on the basis that the illegality (i.e. insider trading) had not occurred. Patel was accordingly entitled to restitution. However, as in Sharma v Top Brands, the Court of Appeal reiterated that there remained uncertainties with respect to the application of the illegality defence.

The Supreme Court's decision

The full bench of the Supreme Court unanimously upheld the Court of Appeal's decision that the illegality defence did not apply. In so doing, the court also rejected outright the reliance test in Tinsley v Milligan.

Writing for the majority, Lord Toulson held that a claimant who satisfies the ordinary requirements of a claim for unjust enrichment should not be barred from enforcing his claim simply because the money was paid for an unlawful purpose. The court held that a variety of factors must be taken into account when determining whether the illegality defence applied and whether it would be disproportionate to refuse relief. Such factors include (but are not limited to) the severity of the conduct, its connection to the contract, whether it was intentional and whether there was disparity between the parties' culpability. The court reiterated that punishment for wrongdoing is the responsibility of criminal courts. Patel in this case was seeking to unwind the agreement, not profit from it, and there was no reason why public policy would require Patel to forfeit the money.

Similarly, Lord Neuberger found that a claimant should be entitled to recoup money paid pursuant to a contract to carry out an illegal activity as a general rule.

Lord Sumption, however, dissented with respect to Lord Toulson's 'range of factors' test, arguing that it would lead to arbitrariness, confusion and an overly broad discretion, and that such a 'revolutionary change' was unnecessary to achieve justice in the majority of cases. The illegality defence should prevent Patel's contractual claim because the contract itself contained illegal terms. Having said that, his Honour nevertheless found that Patel was entitled to restitution because this would not be giving effect to an illegal contract. Rather, it would simply return the parties to the status quo.

Analysis

Traditionally, the illegality defence has been a muddy area of the law and that remains the case notwithstanding the recent decisions. While the test has undoubtedly become more flexible, it has also raised new uncertainties. In the absence of similar factual scenarios, parties may be hard pressed to draw any meaningful principles from recent case law. Among other issues, differences remain between:

  • Cases where the illegality arises at contract inception and cases in which the illegality only occurs upon performance.
  • Cases where illegality is 'inextricably linked' to the agreement and cases in which it is simply incidental (e.g. Sharma v Top Brands).
  • Cases where both parties are culpable and cases where culpability is asymmetric.
  • Cases where the illegality arises under statute (e.g. Patel v Mirza) and cases where illegality is a moral matter.
  • Cases involving property rights, contractual rights, insolvency and restitution.

However, a clear consequence of these recent decisions is that the circumstances in which the illegality defence will succeed have narrowed. Accordingly, defendants should not place knee-jerk reliance on the illegality defence, nor can claimants simply expect to recover monies paid pursuant to a dubious contract. The courts have retained a high degree of discretion and have implemented a more policy- (as opposed to a principled-) based approach, and this is sure to influence the application of the illegality defence in cases in the offshore world.

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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