In an important decision last week, the Court of Appeal considered whether or not a company which had committed fraud could nevertheless claim against its own auditors for failing to detect and report that fraud. The Court of Appeal held that it could not and struck out the alleged US$ 170 million claim against the auditors. This was because in bringing the claim, the company had to rely on its own fraud.
In reaching this decision, the Court of Appeal unanimously overturned the first instance decision of the court below. For our Law Now on that decision, please Click here.
The case concerned a company where an individual, Mr S, was the directing mind and will. It was essentially a "one man" company. The company practiced various frauds on a bank. The bank succeeded in its claim against the company. The company then went into liquidation, and the liquidators claimed against the auditors. So, although the claim was brought by the liquidators, the main beneficiaries of any award would be the bank. There was no question of any duty of care being owed directly to the bank by the auditors.
The court was faced with two key questions. First, was the fraud practiced by Mr S to be attributed to the company? Secondly, if so, did this preclude the company from claiming against the auditors, based on the principle that a claimant cannot rely on its own illegal or immoral act to make a claim (the Illegality Defence).
In a decision which brings welcome clarity to both these areas, the court held that:
- the company was treated as itself having knowledge of the
- there is an established principle that knowledge of a
director's fraud committed against a company of which
he or she is director is not attributed to that company (the
Hampshire Land principle). This is because the company is the
primary victim of the fraud;
- here, the company was not the primary victim of the
fraud. That was the bank. So the fraud of Mr S could be
attributed to the company which was, in reality the
perpetrator of the fraud;
- to bring its claim against the auditors, the company had
to rely on its own illegal act. This precluded it from doing
- it did not matter that "the very thing" the
auditors were engaged to do was to detect whether the company
was engaged in fraud. The Illegality Defence is based on an
unforgiving and uncompromising principle founded in public
policy, rather than something which can be applied at the
court's discretion. The judge at first instance had
been wrong to override the Illegality Defence based on an
attempt to weigh up whether the public conscience would be
offended by finding the auditors liable. The only question
for the court is: is the claimant relying on its own illegal
or immoral act to bring its claim? If so, the claimant is
precluded from doing so.
Auditors and their insurers can be reassured that companies which are, in fact, "villains" rather than "victims" cannot bring claims against their auditors which rely on their own fraud. The confirmation that the court has no option but to put a stop to such claims is to be welcomed. Mummery LJ was forthright in his views in striking out what he described as "an astounding claim" which threatened to turn "the world upside down". He added that auditors owed no duty to take reasonable care to detect the fraud of a fraudster company which was party to, and not a victim of, the fraud.
Further reading: Stone & Rolls Ltd (in liquidation) v Moore Stephens (a firm)  EWCA Civ 644
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 26/06/2008.