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The Supreme Court unanimously ruled in that the ex turpi causa principle (the defence of illegality) cannot be raised against a company when the wrongful activities of the company’s directors and shareholders cannot be attributed to the company, in a decision that provided immediate and welcome relief to insolvency practitioners and creditors. Those hoping for more certainty as to the Supreme Court’s more general position on the proper approach of the illegality defence were however left to wait for a future judgment.

The court also held that the Insolvency Act 1986, s 213 has extra-territorial effect.

Background

Bilta (UK) Ltd was compulsorily wound up in November 2009 pursuant to a petition presented by HMRC. Bilta’s liquidators, Mr Hellard and Mr Ingram, then bought proceedings against its two directors (one of whom was also its sole shareholder) and Jetivia SA, a Swiss company, and its CEO, Mr Brunschweiler.

The pleaded claim alleges that the four defendants were parties to an unlawful means conspiracy to injure Bilta by a fraudulent scheme whereby Bilta’s two directors caused the company to enter into a series of transactions relating to European Emissions Trading Scheme Allowances (“EUAs”), commonly known as carbon credits, with various parties, including Jetivia. Bilta claimed that all parties participated in fraudulent trading under section 213 and, in doing so:

  1. its directors breached their fiduciary duties;
  2. Jetivia and Mr Brunschweiler were liable as parties to the conspiracy and accountable as constructive trustees on the footing of knowing assistance in the dishonest diversion of book debts due to Bilta; and
  3. Jetivia was liable to account on the footing of knowing receipt of the proceedings of those book debts.

The series of transactions worked as follows. Bilta purchased large numbers of EUAs from sources outside the UK, including Jetivia, free of VAT and sold them to UK companies with VAT added on. The price for which Bilta sold the EUAs was lower before VAT than the price at which it had bought them. The transactions generated an obligation on Bilta to account to HMRC for output VAT; however Bilta was never going to be in a position to meet its liabilities to HMRC. The proceeds of Bilta’s sales, together with the VAT thereon, were paid either to Bilta and then on to Jetivia, or directly by the UK buyers to Jetivia or to an offshore account, and Bilta had no other business and no other assets. Bilta was insolvent throughout the period of its trading in EUAs and was unable to pay the output VAT (amounts in excess of £38m in total) to HMRC.

The application

The appellants applied to strike out Bilta’s claim against them on two principle grounds:

  1. Bilta could not maintain the proceedings in view of the ex turpi principle. The appellants were able to defeat the allegations on the basis of an illegality defence by reason of the criminal nature of Bilta’s conduct under its directors control (the function of Bilta was to serve as a vehicle for defrauding HMRC); and
  2. section 213 could not be invoked against the appellants as it does not have extra-territorial effect.

The application was dismissed at first instance by Sir Andrew Morritt C, whose decision was upheld by the Court of Appeal.

Judgment

The Supreme Court unanimously dismissed the appeal on both grounds.

Illegality defence

The Supreme Court held that the illegality defence cannot bar Bilta’s claims against the appellants on the basis that the conduct of the directors cannot be attributed to the company in the context of a claim against the directors for a breach of their duties.

Where a company has been a victim of wrong-doing perpetrated by or its directors (or with their knowledge), then the wrong-doing or knowledge of the directors cannot be attributed to the company as a defence to a claim brought against the directors by the company’s liquidator for the loss suffered by the company as a result of the wrong-doing. This applies even where the directors were the only directors and shareholders of the company, and even though the wrong-doing or knowledge of the directors may be attributed to the company in many other types of proceedings.

There was however some disagreement between the Justices as to the scope and the purpose of the illegality defence. As Lord Neuberger noted: “[the illegality defence] is a difficult and important topic on which, as the two main judgments in this case show, there can be strongly held differing views, and it is probably accurate to describe the debate on the topics as involving something of a spectrum of views” (para 13).

The proper approach to the illegality defence

Whilst all of the Justices emphasised the need for a review of the law of illegality by the Supreme Court in an appropriate case, Lord Neuberger (Lord Clarke and Lord Carnwath agreeing) and Lord Mance all considered that this was not the case in which it should be decided. This case was concerned with attribution and the outcome was the same irrespective of the correct approach to the illegality defence: “It would, in my view, be unwise to seek to decide such a difficult and controversial question in a case where it is not determinative of the outcome and where there has been little if any argument on the topic” (Lord Neuberger at para. 16). The Supreme Court would only be able to address this issue having heard and read full argument on the topic.

The role of statutory policy in this case

Lord Toulson and Lord Hodge would also have dismissed the appeal on the illegality issue on the ground of statutory policy. In particular, they suggested that it would make a nonsense of the statutory duty in the Companies Act 2006, s 172(3) if directors against whom a claim was brought under that provision could rely on ex turpi causa or the illegality defence (see para 129).

Lord Neuberger and Lord Mance both considered that the present case was not an appropriate case for the court to decide the issue conclusively as it was not relevant to the points at issue in the case.

Lord Sumption on the other hand expressly disagreed that the appeal could also be decided on the grounds of statutory policy: “The fact that the illegality defence is based on policy does not entitle a court to reassess the value or relevance of that policy on a case-by-case basis. In a broad sense, any rule of law which imposes civil liability in respect of a wrong may be described as a reflection of legal policy. It does not follow that the courts may apply the illegality defence or not according to the relative importance which they attach to the policy underlying it by comparison with desirability of allowing an otherwise sound claim to succeed” (para 99). In any event, Lord Sumption stressed that the current case was one about attribution and the policy argument focused too narrowly on the status of the directors and on the insolvency of Bilta given the way the directors caused it to carry on business, when the illegality would have failed even if these particular features of the facts were not present.

 

For Part 2 of this article, click here.