Stone & Rolls Ltd (in liq) v Moore Stephens (a firm) [2007] EWHC 1826 (Comm)

A 'one-man' company, used entirely as a vehicle for a massive fraud by its sole director, sued its auditors for negligently failing to detect the fraud. The court held that the fraud was attributed to the company, barring its claim based on the illegality principle (ex turpi causa).

Facts

Stone & Rolls Ltd (S&R), acting through its liquidators, brought a claim for over US$94 million against its auditors, Moore Stephens (MS). The claim was for negligence, alleging that MS had failed in its duty to detect and report a massive, fraudulent scheme perpetrated by S&R’s sole director and shareholder, Mr Zvonko Stojevic. S&R was a ‘one-man company’ which Mr Stojevic used as a vehicle to defraud various banks, principally Komercni Banka a.s. (‘KB’), by using letters of credit based on fictitious commodity trades. The moneys obtained were extracted by Mr Stojevic for his own benefit. After the fraud collapsed, S&R was placed into liquidation. The liquidators sought to recover the company’s liability to the defrauded banks from the allegedly negligent auditors, for the benefit of the company’s creditors (the defrauded banks themselves).

Issues

Moore Stephens applied to have the claim struck out, relying on the defence of illegality, specifically the principle of ex turpi causa non oritur actio (no action can arise from a disreputable cause). The central legal questions for the court were:

Attribution

Could the fraudulent acts and state of mind of Mr Stojevic, the company’s sole directing mind and will, be attributed to the company, S&R, itself?

Ex Turpi Causa Defence

If Mr Stojevic’s fraud was attributed to S&R, did the ex turpi causa principle prevent S&R (acting through its liquidators) from suing its auditors for failing to uncover the very fraud the company was created to perpetrate?

Judgment

Mr Justice Langley, in the High Court, granted the auditors’ application and struck out the claim. The judgment rested on a two-stage analysis concerning attribution and the application of the illegality defence.

Attribution of Knowledge

The judge held that the knowledge and fraudulent acts of Mr Stojevic were to be attributed to S&R. He reasoned that S&R was a ‘one-man company’ completely under the control of Mr Stojevic. It was not a case where a director was defrauding the company; rather, the company was the instrument of a fraud against a third party. The judge distinguished the case from the ‘Hampshire Land principle’, where a director’s knowledge of his own fraud against the company is not attributed to it. In this case, S&R itself was the fraudster.

In my judgment the answer to the question of attribution in this case is plain. S&R was a one-man company. It was Mr Stojevic. S&R was, as the Particulars of Claim rightly state, used by Mr Stojevic as a vehicle for the fraud on KB. In such circumstances the acts and knowledge of Mr Stojevic are the acts and knowledge of S&R.

Application of the Illegality Defence

Having established that S&R was legally considered to be a party to the fraud, Langley J concluded that the ex turpi causa principle provided a complete defence. To allow the company to sue its auditors for losses that stemmed directly from its own fraudulent activities would be contrary to public policy. The company, even in liquidation, could not be allowed to rely on its own illegality to found a cause of action. The very loss for which S&R sought compensation was its liability for its own fraud.

My conclusion on the ex turpi causa issue is that MS have a complete defence to this claim. The claim is made by the company and the company was the corporate vehicle for, or, as Lord Hoffmann would put it, ‘is to be identified with’ Mr Stojevic by whose fraud the (only direct) victims were KB and the other banks. It would in my judgment be a failure to have regard to public policy to permit the claim to proceed in those circumstances. It is a claim which consists of the consequences of the fraud which the company itself committed.

Implications

This High Court decision strongly affirmed the traditional scope of the ex turpi causa defence in the corporate context. It established that where a company is essentially the alter ego of a fraudster and is used as the vehicle for a fraud against third parties, the company cannot then sue its own auditors for failing to prevent the fraud. The judgment prioritised the public policy of preventing a claimant from profiting from its own wrong over the objective of holding potentially negligent auditors to account. This left the defrauded creditors without a remedy against the auditors, a point of significant contention that led to subsequent appeals to the Court of Appeal and the House of Lords.

Verdict: The auditors’ application to strike out the claim succeeded and the claim was dismissed.

Source: Stone & Rolls Ltd (in liq) v Moore Stephens (a firm) [2007] EWHC 1826 (Comm)