Our dedicated insolvency litigation team bring you their monthly update on the cases and issues affecting the insolvency and fraud investigation industry.
In our update covering April, Ian Weatherall, Alex Jay and Kanika Kitchlu-Connolly focus on the decision handed down by the Supreme Court in Jetivia SA & another v Bilta (UK) limited and others.
Directors cannot rely on defence of illegality to avoid liability for breach of fiduciary duty
In its long-awaited decision, the Supreme Court has confirmed that directors (and third parties who assist them) who carry out illegal acts in the name of the company cannot then rely on the company having committed those acts to avoid liability. The defence of illegality - which prevents a claimant from bringing a claim that arises out of its own illegal acts - cannot be used where the company is claiming against its directors.
This decision will be welcomed by insolvency practitioners (and creditors) who need to seek redress from dishonest directors who, in breach of their fiduciary duties, have caused the company to commit illegal acts from which it, and others, have suffered.
Bilta (UK) Limited (Bilta) was compulsorily wound up in November 2009, following a petition presented by HMRC. Bilta's liquidators then brought proceedings against its two former directors (the directors) and Jetivia SA (a Swiss company) (Jetivia) and its chief executive (the appellants in the appeal) - collectively the defendants.
The liquidators alleged that the defendants were parties to an unlawful means conspiracy to injure Bilta by a fraudulent scheme. The scheme involved the directors breaching their fiduciary duties as well as Jetivia and its chief executive dishonestly assisting them in doing so. It was alleged that the directors caused Bilta to engage in fraudulent trading in carbon credits with various parties, including Jetivia, and those transactions constituted carousel frauds.
The transactions generated an obligation on Bilta to account to HMRC for output VAT and an obligation on HMRC to pay a slightly lower sum by way of input VAT to another company. HMRC paid the input VAT, however, the nature of the fraud was such that Bilta was always insolvent and never in a position to pay the output VAT to HMRC. As a consequence, on its insolvency, Bilta was liable to HMRC for output VAT in excess of £38 million.
Through Bilta, the liquidators claimed damages in tort against all of the defendants and sought compensation based on a constructive trust argument from appellants. They also sought a contribution under section 213 of the Insolvency Act 1986 (s213) from each of the defendants directly.
The appellants applied to strike out the claims made against them on the basis that:
- they were bound to defeat the claims against them on the basis of an illegality defence; and
- s213 does not have extra-territorial effect.
The application was dismissed at first instance and that decision was upheld by the Court of Appeal. The appellants appealed to the Supreme Court.
The appellants argued that Bilta was, through its directors and shareholder, party to the illegality. Bilta was fixed with the knowledge of the directors who were complicit in the fraud. They argued that the directors could defend the claims against them using the illegality defence. If the claims against the directors failed, the claims against the appellants must also fail as a consequence - since the breach of fiduciary duty constitutes the unlawful means on which Bilta relied in making its claim against the appellants.
The appellants also argued that claims under s213 could only be brought against defendants resident in the UK. As Jetivia was a Swiss company and its chief executive was a Swiss national living in France, it was argued that claims under s213 could not be made against them.
The Supreme Court decision
The Supreme Court unanimously dismissed the appeal. The court held that the illegality defence could not bar Bilta's claims against the appellants on the basis that the conduct of directors cannot be attributed to the company in the context of a claim against the directors for breach of their duties. The court also held that s213 does have extra-territorial effect and can therefore be invoked against the appellants.
All seven Supreme Court judges agreed that the defence of illegality could not succeed in this case. Lord Neuberger summarised the conclusion reached by the court as follows:-
"Where a company has been the victim of wrong-doing by its directors, or of which its directors had notice, 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, in the name of the company and/or on behalf of its creditors, for the loss suffered by the company as a result of the wrong-doing, 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."
While the outcome of the appeal was unanimous, there was some disagreement on the proper approach to the illegality defence. Lord Neuberger acknowledged that the approach did need to be addressed by the court but this was not the case in which to do that. No real argument had been advanced as to the proper approach and in this case the outcome would be the same irrespective of the correct approach to the illegality defence.
Lord Toulson and Lord Hodge were of the view that the defence of illegality is a rule of public policy that depends on the nature of the particular claim brought by the claimant and the relationship between the parties. The fiduciary duties of a director of a company which is insolvent or bordering on insolvency differ from the duties where the company is able to meet its liabilities. Where a company is insolvent (or is bordering on insolvency) the director's duties require him to have proper regard for the interests of its creditors. If that protection could not be enforced, it would be worthless.
In this case the action was brought by the liquidators in the name of the company, to recover, for the benefit of the creditors, the loss caused to the company by the directors' breach of their fiduciary duties.
Lord Toulson and Lord Hodge went on to say that the doctrine of illegality has been developed by the courts on the grounds of public policy. In the circumstances of this case, to allow the directors to escape liability for breach of their fiduciary duty on the ground that they were in control of the company would undermine the duty in the very circumstances in which it is required.
Creditors' interests are included within the scope of the fiduciary duty of the directors of an insolvent company towards the company so that the directors cannot avoid liability if they act in disregard of the creditors' interests. It would be contradictory and contrary to the public interest if, in such circumstances, their control of the company should provide a means for them to avoid liability on the ground that their illegality tainted the liquidators' claim.
Lord Sumption said he regarded the defence of illegality as a rule of law on which the court is required to act. It is not a discretionary power on which the court is merely entitled to act and it is not dependent upon a judicial value judgment about the balance of the equities in each case, although it will be subject to a 'breach of duty exception' in order to avoid 'injustice and absurdity' - which covered the present case.
Extra-territorial effect of s213
The Supreme Court unanimously dismissed the appellants' argument that s213 does not have extra-territorial effect.
S213 provides a remedy against any person who knowingly became a party to the carrying on of an insolvent company's business with a fraudulent purpose. Its context is the winding up of a company registered in Great Britain and, in theory at least, the effect of such a winding up order is worldwide. It would seriously handicap the efficient winding up of a British company in an increasingly globalised economy if the jurisdiction of the court responsible for the winding up of an insolvent company did not extend to people and corporate bodies resident overseas who had been involved in the carrying on of the company's business.
The Supreme Court also acknowledged that s213 is one of a number of discretionary powers conferred by statute to require persons to contribute to the deficiency of a company now in liquidation - where those persons dealt with the company in a manner which depleted its assets. Another such power - contained within section 238 of the Insolvency Act - has previously been held by the Court of Appeal to apply without territorial limitations ('any persons' means 'any persons' wherever they reside). The reasoning for that decision was equally applicable to s213.
Things to consider
While the decision is not surprising - as why should directors be able to attribute their own dishonesty/misconduct to the insolvent company to escape liability - it will come as a relief to insolvency practitioners who can take comfort from the decision and use it to support claims against directors for breach of duty, as a consequence of which the insolvent company has suffered loss.
The appellants had sought to rely on the earlier House of Lords decision in Stone & Rolls . The Supreme Court accepted that Stone & Rolls was rightly decided by the Court of Appeal on its facts - where the illegality defence was used by auditors defending a claim against them for negligently failing to detect the fraudulent activity of the company - but considered here that it should not be widened further than that. Lord Neuberger even went as far as suggesting that the decision should be put to one side and marked "not to be looked at again".
On this basis, insolvency practitioners can be confident when bringing claims against directors for breach of fiduciary duty that those directors will not be able to avoid liability by relying on the defence of illegality.
Insolvency practitioners will also be relieved with the confirmation provided by the Supreme Court that s213 does have extra-territorial effect. S213 has historically been used to seek contribution from those outside the territory and this decision confirms it can continue to be used to such effect.