If you cannot view this email correctly, please click here to view it online.

Auditors' liability for failure to 'blow whistle' on fraud

In an important decision, the Commercial Court considered whether or not a company which had perpetrated a fraud could claim against its auditors for failing to detect and report that fraud.  Even though this involved the company relying on its own fraud, the Court nevertheless held that it could continue with its claim against the auditors.  This was, according to the Court, because the fraud was “the very thing” that the auditors were under a duty to identify, and the “ordinary citizen” would not find anything repugnant in allowing the company to make a recovery in such circumstances.

The facts

In this case, an individual, S was the directing mind and will of the claimant company which was used throughout as a “vehicle for fraud”.  The company’s fraud consisted of collusion with a third party to create artificial commodity sales and the generation of documents relating to those artificial sales, for the purpose of obtaining funds under letters of credit issued by a bank for the company’s benefit.  The money received by the company was then passed on to the third party or to companies connected with the third party.

The bank had succeeded in a prior claim against both the company and S.  The company  went into liquidation and the judgment was unsatisfied.  The liquidator, through the company, then claimed against the company’s auditors, although the principal beneficiary of any award would be the bank.  The company alleged that the auditors were in breach of duty in failing to detect the fraud.  They further alleged that had the fraud been detected the auditors would have “blown the whistle” and it would not have continued.  The Court acknowledged that the company was not alleging that the accountants were under a duty to prevent the fraud, and nor could the company do so.

The strike out application

The defendant auditors sought to strike out the company’s claim.  It was an established principle (Ex Turpi Causa) that an individual could not rely on his own criminal conduct to make a claim.  The issue that fell to be decided here was whether the company would similarly be prevented from making a claim as a result of the fraudulent conduct of S, the company’s directing mind and will.  For the purposes of the application, the Court was obliged to assume that the allegations made by the company against the auditors were true.

The decision

The Court refused to grant the auditors’ application and made the following points.

•  For the Ex Turpi Causa principle to apply, the claim had to be founded on an illegal act by the claimant and not merely be collateral to it.
  
• S’s knowledge and fraudulent conduct could be attributed to the company.  This was because S was the directing mind and will of the company.  The company was therefore fixed with actual knowledge of S’s fraud, so that it was the fraud of the company.
• Although this was not a straightforward issue, the company was not a victim of the fraud.  It could not, therefore, rely on the exception to the attribution rule that a company is not to have attributed to it knowledge of a fraud where it is either a primary, or possibly a secondary, victim of the fraud.  The company lost nothing to which it was entitled by passing funds on to the third parties, since it was never entitled to the money from the bank in the first place.  It was “in a real sense the perpetrator of the fraud” rather than the victim.
• Had S brought the claim personally, it would have been defeated by the principle that S could not rely on his own fraud to bring the claim.
•  Expressly acknowledging difficulty in researching the various authorities which are “relatively few and far between” the Court decided that where discharge of the “very duty” alleged against the auditors would have resulted in the fraud being detected and stopped it would not offend the “conscience of the ordinary citizen” if the company, as perpetrator of the fraud, was allowed to pursue its claim provided that S did not benefit from any recovery.

A number of important issues are raised by this judgment and permission for the auditors to appeal to the Court of Appeal has been granted.  As matters stand, by allowing the company to continue to claim damages from the auditors, the appearance is that the company’s fraud has been rewarded, the very consequence that the rule in question is intended to prevent; moreover the “public conscience” test had been previously rejected by the House of Lords in another case.  This is certainly an area of the law which is ripe for judicial review with a view to giving some clear guidelines as to the future application of the Ex Turpi Causa principle; the Court in this case decided that strict application of the maxim would be unforgiving.

Case Stone & Rolls Limited (in liquidation) v. Moore Stephens (a firm) and Another [2007] EWHC 1826 (Comm).

For further information, please contact: