TALK FOR THE LONDON SOLICITORS LITIGATION ASSOCIATION

THE ILLEGALITY DEFENCE: USE AND ABUSE

The Ex Turpi Causa Defence

The general maxim: ex turpi causa non oritur actio. No court will lend its aid to a man who founds his cause of action upon an illegal act.

Holman v Johnson 98 ER 1120 at 1122, Lord Mansfield:

“The objection, that a contract is immoral or illegal as between plaintiff and defendant, sounds at all times very ill in the mouth of the defendant. It is not for his sake, however, that the objection is ever allowed; but it is founded in general principles of policy, which the defendant has the advantage of, contrary to the real justice, as between him and the plaintiff, by accident, if I may so say. The principle of public policy is this; ex dolo malo non oritur actio. No Court will lend its aid to a man who founds his cause of action upon an immoral or an illegal act. If, from the plaintiff's own stating or otherwise, the cause of action appears to arise ex turpi causâ, or the transgression of a positive law of this country, there the Court says he has no right to be assisted. It is upon that ground the Court goes; not for the sake of the defendant, but because they will not lend their aid to such a plaintiff. So if the plaintiff and defendant were to change sides, and the defendant was to bring his action against the plaintiff, the latter would then have the advantage of it”.

The maxim “expresses not so much a principle as a policy. Furthermore, that policy is not based upon a single justification but on a group of reasons, which vary in different cases” (Gray v Thames Trains [2009] 1 AC 1339 at para 30, Lord Hoffmann).

THREE MAIN RULES

Rules that Apply to Enforcement of Contracts

(1) The court will not enforce a contract which is expressly or impliedly prohibited by statute.

A question of statutory interpretation.

Not every contract which involves the breach of a statutory provision will thereby be impliedly prohibited and unenforceable (St John Shipping Corporation v Joseph Rank [1957] 1 QB 267, esp. at 288, Devlin J; see also Shaw v Groom [1970] 2 QB 504 at 523, Sachs LJ).

(2) The court will not enforce a contract entered into with the intention, or object, of committing a legal wrong.

Often applies to contacts entered into with the intention of defrauding the revenue authorities: Alexander v Rayson [1936] 1 KB 169; K/S Lincoln v CB Richard Ellis Hotels Limited [2009] EWHC 2344 (TCC).

Uncertainty as to:

(a) Whether the claimant must have known that his or her purpose was unlawful: compare Waugh v Morris (1872-73) LR 8 QB 202 with JM Allen (Merchandising) Limited v Cloke [1963] 2 QB 340; cf. Anglo-Petroleum Limited v TFB (Mortgages) Limited [2007] EWCA Civ 456.

(b) The closeness of the contract to the unlawful purpose required in order to engage the rule: 21^st Century Logistics Solutions v Madysen [2004] EWHC 231 (QB).

This rule is of potentially wide application because of the principle of ‘taint’: a second contract founded on or consequent upon a first, illegal, contract may also be illegal and unenforceable, even if the second contract is itself innocuous (Spector v Ageda [1973] Ch 30).

Rule of General Application

(3) A person may not recover an indemnity, or compensation, for the consequences of his own deliberate wrongdoing.

The primary rationale for this rule is twofold:

(a) prevent a claimant from profiting from his or her own wrongdoing; and

(b) deter unlawful conduct.

The rule applies to wrongdoing of a serious and deliberate kind. The wrongdoing must involve turpitude (Stone & Rolls v Moore Stephens [2009] 1 AC 1391 at para 24, Lord Phillips).

The rule only applies where the wrongdoing is that of the claimant itself. The wrongdoing must be personal to the claimant (Stone & Rolls v Moore Stephens, ibid). The rule imposes a personal disability upon the claimant preventing him from claiming reparation for his own wilful and culpable wrongdoing (Hardy v Motors Insurers’ Bureau [1964] 2 QB 745).

The rule does not apply where the claimant’s liability is vicarious and not personal: Lancashire County Council v Municipal Mutual Insurance [1997] QB 897 at 908-9, Simon Brown LJ; Stone & Rolls v Moore Stephens.

In order to apply the rule to wrongdoing by a company, it must be shown that the wrongdoing is that of the company itself, as opposed to merely wrongdoing for which the company may be vicariously liable (Lancashire County Council v Municipal Mutual Insurance; Stone & Rolls v Moore Stephens).

The rules of vicarious liability render employers and companies responsible for acts and omissions of their employees and agents, but they do not make the employer or company independently liable for wrongs committed by their employees and agents: see Dubai Aluminium v Salaam [2003] 2 AC 366 at para 155:

“vicarious liability … is … a loss allocation device. The employer is not a wrongdoer; he is not liable in respect of his own conduct. He is answerable for his employee’s wrongdoing, and his liability is co-extensive with that of his employee. He is personally innocent, but he is liable because his employee is guilty.”

Rules of Attribution

A company is an abstraction. Although it has an independent legal personality, it “has no mind of its own any more than it has a body of its own” (Lennards Carrying Co v Asiatic Petroleum Company [1915] AC 705 at 713. It is a legal person, but not a natural person. It can only act, and conduct business, through individuals. The extent to which the acts and omissions of these individuals constitute acts and omissions ‘of the company’ are determined by rules of attribution. As Lord Hoffmann explained in Meridian Global Funds Management Asia Limited v Securities Commission [1995] 2 AC 500, at 506:

“Any proposition about a company necessarily involves a reference to a set of rules. A company exists because there is a rule (usually in a statute) which says that a persona ficta shall be deemed to exist and to have certain of the powers, rights and duties of a natural person. But there would be little sense in deeming such a persona ficta to exist unless there were also rules to tell one what acts were to count as acts of the company. It is therefore a necessary part of corporate personality that there should be rules by which acts are attributed to the company. These may be called ‘the rules of attribution’.”

A company’s primary rules of attribution are normally found in its constitution, typically its Articles of Association, as supplemented by general principles of company law. The primary rules usually include rules to the effect that decisions made by the shareholders acting in general meeting, or the board of directors acting in accordance with the powers of management granted to them by the Articles of Association, constitute the acts of the company and are binding upon it.

These primary rules will not normally be sufficient to enable a company to conduct its business: not every corporate decision, or act, can be the subject of a board resolution or shareholders’ vote. The primary rules are therefore supplemented by general rules of attribution that apply also to individuals, such as the principles of agency and vicarious liability. On this basis, the company is able to act through, and be bound by, individual directors, employees or agents.

These general rules of attribution, however, cannot be applied to determine whose acts count as acts of the company for the purposes of the rule of public policy denying recovery of an indemnity or compensation for loss caused by the claimant’s own deliberate wrongdoing. As explained above, the wrong of an employee or agent for which the company is vicariously liable is not, for these purposes, the wrong ‘of the company’.

It is therefore necessary to apply a special rule of attribution to determine whose conduct is, for these purposes, to count as conduct of the company. As Lord Hoffman said in Meridian at p507:

“The company's primary rules of attribution together with the general principles of agency, vicarious liability and so forth are usually sufficient to enable one to determine its rights and obligations. In exceptional cases, however, they will not provide an answer. This will be the case when a rule of law, either expressly or by implication, excludes attribution on the basis of the general principles of agency or vicarious liability. For example, a rule may be stated in language primarily applicable to a natural person and require some act or state of mind on the part of that person "himself," as opposed to his servants or agents. … In such a case, the court must fashion a special rule of attribution for the particular substantive rule.”

The special rule of attribution to which English courts have usually resorted when rules of vicarious liability are not apt is the ‘identification principle’, whereby the acts and state of mind of the natural person who is the “directing mind and will” of the company for the purposes of the transaction in question are attributed to the company so as to make that person’s acts and state of mind the acts and state of mind of the company (Lennard’s Carrying; Tesco v Nattras [1972] AC 153). This person, sometimes described as the company’s alter ego, is treated in law as the “embodiment of the company … and his mind is the mind of the company” (Tesco v Nattras at 170, Lord Reid).

In order to identify who is a company’s directing mind and will, it is “necessary to look closely at the organisation of the company in order to see of what individual it can fairly be said that his act or omission is that of the company itself” (The Lady Gwendolen [1965] P 294 at 343, Wilmer LJ). The enquiry is not as to which individual or individuals have overall, or general, control and management of the company, but as to which individuals, in relation to the specific matters in issue, had management and control. As Nourse LJ said in El Ajou v Dollar Land Holdings [1994] 2 All ER 685 at 695-6 (emphasis added):

“It is important to emphasise that management and control is not something to be considered generally or in the round. It is necessary to identify the natural person or persons having management and control in relation to the act or omission in point. … It is necessary to establish whether the natural person or persons in question have the status and authority which in law makes their acts in the matter under consideration the acts of the company so that the natural person is to be treated as the company itself.”

No Discretion

Where the rules of illegality apply, the courts do not have a discretion to disapply them.

The ‘affront to public conscience’ test has been disapproved and rejected by the House of Lords: Tinsley v Milligan [1994] 1 AC 340.

But it is still necessary to determine whether application of an illegality defence is, in any particular case, in accordance with the “general principles of policy” underlying the ex turpi cause doctrine (cf. Holman v Johnson at 1122, Lord Mansfield).

THE CASE LAW

Three cases concerning application of the rule denying recovery for the consequences of the claimant’s own deliberate wrongdoing:

· Arab Bank v Zurich Insurance [1999] 1 Lloyd’s Rep 262

“There remains the question ... whether the Hampshire Land doctrine is confined to cases of fraud where the principal is himself the victim of the fraud, or whether, as Mr. Justice Vaughan Williams put it in Hampshire Land itself, the doctrine extends to other breaches of duty where common sense would destroy the inference of transfer of knowledge. ... In the present case, ... the primary victim of the fraud has been the lending institution which has relied on the valuation. I would accept, however, the plaintiffs' submission that JDW was also a victim, even if only a secondary victim, of the assumed fraud. One consequence of that assumed fraud has been JDW's liability to the plaintiffs. ... In my judgment, Mr. Browne's fault comes within the concept of an agent's fraud on his principal. ... It follows that the Hampshire Land doctrine would in any event prevent Mr. Browne's knowledge being attributed to JDW.” (at 282-3, Rix J)

· KR v Royal & Sun Alliance [2006] 1 Lloyd’s Rep IR 327 (Simon J); [2007] 1 Lloyd’s Rep IR 368 (C.A.)

“It does not seem to us to make any difference that the victims in the present case are third parties rather than, in the example we have given, the insured itself. Suppose, in contra-distinction to the present case, the company was solvent. Most right thinking people would regard it as abhorrent for the company to be indemnified by the insurer against liability created by the criminal acts of John Allen when he, as the majority shareholder, stood to benefit. In the days before incorporation there could have been no question of Allen himself being indemnified by the insurer.” (at para 66, Scott Baker LJ)

· Stone & Rolls v Moore Stephens [2009] 1 AC 1391

“It is no secret that the profession have found it very difficult to understand what the precise ratio of the decision in the Stone & Rolls case is” (Lexi Holdings v Pannone & Partners [2009] EWHC 3507 (Ch)).

Two main issues:

(1) Attribution: did the rule in Re Hampshire Land [1896] 2 Ch 743 apply?

(2) The ‘very thing’: did the rule in Reeves v Commissioner of Police [1999] QB 169 (CA); [2000] 1 AC 360 (HL) apply?

The ratio is to be found in the speech of Lord Walker. Lord Brown essentially agreed with Lord Walker. Lord Phillips’ reasoning was different but on analysis the substance of what he said was a justification for the conclusion reached by Lord Walker.

Lords Scott and Mance dissented (for differing reasons).

Lord Walker on attribution:

“157. The “sole actor” exception was applied (although not by that name) by the Privy Council (on appeal from Brunei) in Royal Brunei Airlines Sdn Bhd v Tan [1995] 2 AC 378. ...

159. In situations like those in Royal Brunei ... denial of attribution on “ adverse interest” grounds would not serve the ends of justice. It would on the contrary operate as a reversion to the views of Lord Bramwell in Abrath v North Eastern Railway Co 11 App Cas 247, reducing a one-man company to a mindless creature in the eyes of the law. Instead it has the mind of its human embodiment ...

161. ... In this context I would treat the expression [one-man company] as covering cases where there is one single dominant director and shareholder (such as Mr Tan in Royal Brunei, ... or Mr Stojevic in the present case) even if there are other directors or shareholders who are subservient to the dominant personality (such as Mr Tan's wife in Royal Brunei ... or S & R's nominee directors). I would also treat it as covering cases where there are two or more individual directors and shareholders acting closely in concert ... . It may be simplest to propose a test in negative terms, ... that is a company which has no individual concerned in its management and ownership other than those who are, or must (because of their reckless indifference) be taken to be, aware of the fraud or breach of duty with which the court is concerned.

162. The principle of the “sole actor” is more fully developed in United States case law. ... I find the general reasoning in these cases persuasive and in line with the English authorities ... .

167. ... In the case of a one-man company (in the sense indicated above) which has deliberately engaged in serious fraud, I would follow Royal Brunei (and the strong line of United States and Canadian authority) in imputing awareness of the fraud to the company, applying what is referred to in the United States as the “sole actor” exception to the “ adverse interest” principle.

168. In particular I would apply the “sole actor” principle to a claim made against its former auditors by a company in liquidation, where the company was a one-man company engaged in fraud, and the auditors are accused of negligence in failing to call a halt to that fraud. ...

174. I would therefore limit my ground of decision in this appeal to the proposition that one or more individuals who for fraudulent purposes run a one-man company (in the sense described above) cannot obtain an advantage by claiming that the company is not a fraudster, but a secondary victim.”

Lord Scott’s dissent:

“121. In a case, such as the present, where the company is insolvent and will stay so whatever damages are recoverable from the auditors, the need to ensure that the delinquent director does not benefit from the damages does not present a problem. There is no possibility of Mr Stojevic benefiting from any damages recoverable from Moore Stephens. So, I repeat, why should the ex turpi causa rule, a rule based on public policy, bar an action against the auditors based on their breach of duty?

“122. The wielding of a rule of public policy in circumstances where public policy is not engaged constitutes, in my respectful opinion, bad jurisprudence.”

THE LAW COMMISSION

Report on the Illegality Defence (10.2.2010)

“1.2 This area of law purports to be governed by strict rules, which often appear arbitrary. Very early on, the case law established that the illegality doctrine is not there to find a just resolution to the dispute between the claimant and the defendant; rather it is based on ‘general principles of policy’ that might arbitrarily apply to the advantage of the defendant. As the Chancery Bar Association noted in its response to our 2009 consultative report, ‘the result is a forensic lottery depending on the accidents of litigation or the manoeuvrings of the parties’.

“1.6 We think that in most areas of law, legislative intervention is not required to solve these problems. It is open to the courts to make the law more transparent and less apparently arbitrary by doing more to articulate the policy rationales that underlie their decisions.”

CRAIG ORR Q.C.

Fountain Court,

Temple,

London EC4Y 9DH

10 May 2010