This Court of Appeal decision in (1) Top Brands Ltd (2) Lemione Services Ltd v (1) Gagen Dulari Sharma (2) Barry John Ward (as former liquidators of Mama Milla Ltd) (2015) is noteworthy as it underlines that the "illegality defence" is still in a state of flux and in need of clarification by the Supreme Court.

In a relatively rare case against an insolvency practitioner who paid away company funds in error, the Court refused to permit her to rely on the defence of illegality to defeat the creditors' claim against her for compensation for breach of duty. This was on the basis that the monies she wrongly paid away were not "criminal property" and given that there was not sufficient nexus between the alleged fraud and the claim brought against her. The fraud in question was merely "collateral" to the creditors' claim. Although this decision turns on its own facts, it nevertheless highlights that the courts will not easily permit insolvency practitioners to escape their duties (as set out in the Insolvency Act 1986) even where the factual background involves evidence of fraud by the company to which they have been appointed.

Prior to this decision, the most recent decision on this front by the Supreme Court was in Jetivia & Another v Bilta (UK) Ltd (in liquidation) (2015) (please click here for our briefing note). In that case, the seven judges differed in their reasoning but collectively concluded that the illegality defence did not apply and could not bar the company's claims against its own directors (for breach of duty). This was because the illegal conduct of the directors could not be attributed to the company. However, the reasoning of the judges leading to this conclusion was not aligned and the proper approach to the illegality test remains unclear. Lord Neuberger indicated that this should be addressed by the Supreme Court in due course.

Top Brands

Mamma Milla Ltd (MML) supplied toiletry products until entering creditors' voluntary liquidation in 2011. The business conducted through the company involved VAT acquisition fraud. The claimant creditors delivered goods to the company but had not been paid. A few weeks before liquidation, MML sent invoices for the goods which had been delivered to its onward purchaser, "SERT". Over GBP 500,000 was paid by SERT into MML's account. The account was frozen and the liquidator (Ms Sharma) appointed. The sum was transferred to her, and she authorised the transfer of the sum to different recipients, wrongly believing that the money was supposed to be returned to SERT as a result of being an advance payment for goods that were never delivered.

The claimant creditors (Top Brands Ltd and Lemione Services Ltd) contended that the Ms Sharma had wrongly paid away monies belonging to MML in breach of duties she owed under sections 107 and 212 of the Insolvency Act 1986 to properly distribute company assets and was negligent and/or in breach of her fiduciary duties and claimed compensation from the company's liquidator, pursuant to section 212 of the Insolvency Act 1986.

The High Court found that Ms Sharma failed to: (1) take adequate steps to ascertain MML's state of affairs at liquidation, (2) give adequate consideration to the material available as to MML's trading assets and liabilities, (3) attempt to obtain important missing information, (4) give adequate instructions to the solicitor, who advised that repayment could be made, (5) give adequate thought to new circumstances and evidence as they presented themselves to her, (6) make adequate enquiries as to the payees of the Sum before payment, and (7) failed to notice, before making payments out, that the indemnity in fact obtained was not in the required form.

The High Court concluded that Ms Sharma did owe a duty of care, had acted in breach of her duties under the Insolvency Act 1986 and was liable in negligence by acting below the standard of care to be expected of an ordinary, skilled practitioner. The Court observed that liquidators' duties are owed to the company but that creditors have an indirect or derived interest in the proper exercise by a liquidator of his/her duties and are authorised to hold a liquidator to account for the benefit of the company. The High Court concluded that Mrs Sharma was in a fiduciary position, stating that, "upon appointment a liquidator becomes an agent of the company; fiduciary duties obviously flow from this....It is difficult to follow how a liquidator, whose task is to gather in the money and property of a company and distribute it to others, is not a fiduciary" and concluded that Mrs Sharma's conduct could be characterised as a "conscious disclaimer or disregard of responsibility for the assets in her charge on a material scale" and crossed the border into the territory of breach of fiduciary duty.

The High Court refused to grant Ms Sharma relief and found that she could not rely on the illegality defence as a bar to the claim. Accordingly, she was ordered to pay GBP 548,074.56 to MML by way of compensation. Mrs Sharma appealed and it fell to the Court of Appeal to decide whether or not she had an illegality defence i.e. whether the claim under section 212 was in reality a claim to recover criminal property and, for that reason, the High Court should have dismissed the application.

The illegality defence

In summary, Ms Sharma submitted that, as MML's only business was VAT fraud, the sum that she had paid away was criminal property and hence that MML had suffered no loss because the sum was never legitimately acquired in the first place and was tainted from the moment it was received. The Court discussed the alternative approaches adopted in previous case-law to the illegality defence which are mentioned briefly below:

  • The "reliance test", the effect of which is that the claim is barred only if the claimant needs to rely on (i.e. to assert, whether by way of pleading or evidence) facts which disclose the illegality. This approach was favoured by three judges in Tinsley v Milligan (1994). In Bilta, doubt was expressed over whether this test was still the law and whether or not the Supreme court ought to determine this point
  • The "sufficiently close connection" test such that the claim is barred if there is a sufficiently close connection between the illegality and the claim made (favoured by two judges in Tinsley v Milligan and Lords Carnwath and Hughes in Hounga v Allen (2014))
    NB: In Les Laboratoires Servier v Apotex Inc (2014), Lord Sumption said that both of the above tests are intended to exclude those consequences of an illegal act which is merely collateral to the claim
  • The "inextricable link" test to the effect that the claim is barred if there is an inextricable link between the relief claimed and the illegal conduct (endorsed in several cases)
  • Causative criterion i.e. to the effect that the illegality defence will only be made out if the illegality in question has a causative relationship to the loss claimed
  • Public policy approach i.e. the policy in favour of disallowing claims where that would give the appearance of condoning illegal conduct

Deciding that (whichever test was applied) the illegality defence could not succeed, and distinguishing the facts of this case from other cases relied on by Ms Sharma (including Stone v Rolls (in liquidation) Ltd v Moore Stephens (2009), the Court of Appeal stated, "In the present case... the illegality has no causative relationship to the loss claimed. It is.. no more than collateral to the Respondents' claim." Further, "I reject Mr Soole's argument that there was a close connection, or inextricable link, between the relief claimed ... and the illegal conduct of MML and its directors on the ground that the Sum was criminal property."

The judge observed that the lack of the "inextricable link" between, on the one hand, the loss claimed, and on the other hand, the fraudulent conduct of MML and its directors, was reflected in the fact that it was not necessary for the respondents to rely on anything illegal in order to found their claim against Ms Sharma, since, by the time of her involvement, MML's business had entirely ceased and the monies paid into MML (and paid away by Ms Sharma) could never have actually been employed in a VAT fraud.

Moreover, no actual finding had been made by the High Court to the effect that there was a criminal conspiracy by the company and its directors to commit VAT fraud. Accordingly, it had to be assumed that the sum paid was pursuant to genuine and lawful contracts of sale. Even if the sum could be deemed "criminal property" pursuant to the Proceeds of Crime Act 2002 (the Act), the Court stated that it was not clear that this would necessarily enable the successful deployment of the illegality defence since the Act provides, "no clear steer for the scope and application of the common law principle ex turpi causa non oritur actio in a civil action for negligence and breach of duty".

The Court emphasised that public policy considerations had to adapt to the circumstances and one policy could be outweighed by another. It did not consider that the policy of avoiding giving the appearance of condoning illegal conduct, was persuasive here since the company's fraudulent business was carried on prior to its winding up and had no close connection to the loss claimed. Moreover, it was superseded by the other important public policy that sections 107 and 212 of Insolvency Act 1986, requiring a liquidator properly to collect in and distribute the company's property among the creditors in accordance with the statutory scheme, should be upheld and given effect.

It is notable that the decisions reached by the courts in cases requiring consideration of the illegality defence, are highly fact specific. The courts will, in general, attempt to consider the defence in a sensible manner which achieves a just and fair result. In Bilta, it would clearly have been inequitable to allow the defence to succeed as it would have effectively prevented the company from claiming against its own directors for their wrongdoing. In Stone & Rolls, the auditors who were not privy to fraud by the company, successfully raised the illegality defence to prevent themselves being sued by the company for failing to prevent it from committing the fraud. In Bilta, Lord Neuberger emphasised that that Stone & Rolls very much turned on its own specific facts which involved the company being managed by a sole (fraudulent) director who was the company's directing mind and will. In this case, the liquidator was not permitted to use the illegality defence to prevent funds being returned to the company, which would then be available to pay down the debts owed to (non fraudulent) creditors, including the claimants and HMRC. In all these cases, it is possible to discern the courts ensuring an outcome which is the most equitable given the differing factual circumstances presented to them.

That said, there can be no doubt that it is currently very difficult to clearly define the parameters of the illegality defence. The Court of Appeal concluded that the illegality defence was ripe for consideration by the Supreme Court, stating that, "it is apparent from the differences in view in Bilta, about the current state of the law, that the proper approach to the defence of illegality needs to be addressed by the Supreme Court, (conceivably with a panel of nine judges) as soon as appropriately possible." We look forward to and anticipate any such clarification from the Supreme Court and will report in due course.

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.