The House of Lords on Thursday dismissed this appeal, brought by the liquidators of a company (Stone & Rolls Limited) against the company’s former auditors (the firm Moore Stephens) for contractual and tortious negligence. Their Lordships ruled (by a 3-2 majority) that the Court will not assist a company to recover losses which have been brought about by its own fraud.
The sole director and shareholder of Stone & Rolls Limited (“S&R”), a Mr. Zvonko Stojevic, had used his company to defraud banks of tens of millions of dollars, following which a European bank sued and was awarded substantial damages. Unable to pay, the company was placed into liquidation. In bringing the claim on behalf of its creditors (for losses in excess of $94 million), the liquidators argued that Mr Stojevic’s actions were distinct from those of the company, that S&R was itself a victim of the fraud, and that it should not be prevented from bringing a claim for breach of duty (in contract and tort) by the auditors, who had failed to spot the fraud and admitted breach.
The majority consisted of Lord Phillips, Lord Walker and Lord Brown, with Lord Phillips delivering the leading judgment. The majority noted that while fraud may be an example of a “very thing” auditors are engaged to detect, this does not supersede the principle that a company cannot bring a claim that relies on its own illegal conduct (applying the principle of ex turpi causa non oritur action – often summarised as “no Court will lend its aid to a man whose cause of action is founded upon an illegal or immoral act”). In applying ex turpi causa the Court had to consider whose interests the relevant duty is intended to protect. Following Caparo Industries plc v Dickman  2 AC 603, it was clear that the duty of care owed by auditors to a company extended to the company’s shareholders, but not to its creditors (or liquidators). In this case, Mr Stojevic was the shareholder, and as he was responsible for the company’s illegal conduct, the fraud was properly attributable to the company. S&R was therefore not entitled to rely on the fraud to claim a breach of duty. Accordingly, ex turpi causa was a complete defence for the auditors and the liquidators’ claim was struck out.
What are the implications for commercial parties and practitioners? Whilst the result is on the face of it good news for auditors, it will in fact be unlikely to assist unless the fraudulent company is a ‘one man band’. Their Lordships appeared to agree that since S&R was a one man company (with Mr Stojevic as shareholder), the fraud was attributable to the company, the defence applied and there was no right to claim from a third party. If S&R had not been a one man company and had had, for example, innocent independent shareholders, then the fraud would not have been attributable, the defence would not have applied and there would be a right to claim. In the majority of commercial frauds, where innocent shareholders are deceived by an individual director or group of directors acting in unison, the fraud will not be attributable to the company and third party auditors who failed to spot it may still be liable.
The dissenting judgments also raise the possibility of an incremental extension of the Caparo duty of case owed by auditors beyond its current boundary, shareholders, to a company’s creditors in the event of insolvency. Both Lord Scott and Lord Mance found that ex turpi causa should not be a defence, and that the liquidators should be able to claim from the auditors for their breach of duty, on the basis that S&R had gone into insolvency and so it would in fact be the innocent creditors and not the fraudulent shareholder who would be the beneficiary of the claim. Lord Mance concluded that “the world has sufficient experience of Ponzi schemes operated by individuals owning “one man” companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies’ activities”.
The case was also bad news for third party funding – the liquidators’ were backed by IM Litigation Funding in one of the largest claims to be funded by a third party in the UK so far.