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

Stone & Rolls Ltd, a one-man company used as a vehicle for large letter-of-credit frauds, sued its auditors Moore Stephens for negligent audits in failing to uncover and stop the fraud. The court held the illegality defence did not bar the claim, but struck out a compound interest head.

Facts

Stone & Rolls Ltd (“S&R”) was an English company owned through an Isle of Man company by Mr Stojevic, who was its controlling mind. It had no employees and was effectively a one-man company. From about 1997, S&R was used by Mr Stojevic as a vehicle for a substantial letter of credit fraud on banks, principally Komercni Banka (“KB”). The fraud involved S&R presenting sham documents purporting to evidence non-existent commodity trades, receiving funds under letters of credit and promptly paying those funds away to an Austrian company, BCL Trading GmbH (“BCL”), and related entities.

In Komercni Banka AS v Stone & Rolls Ltd and Another [2002] EWHC 2263 (Comm), Toulson J held that the documents presented by S&R to KB were false to the knowledge of both S&R and Mr Stojevic, and gave judgment in deceit for KB for about USD 94.5 million. Following that judgment S&R went into provisional liquidation, and liquidators were appointed.

Moore Stephens were S&R’s auditors for the financial years 1996–1998 (and beyond). They signed unqualified audit reports. The liquidators, on behalf of S&R, alleged that Moore Stephens conducted the audits negligently (and, as regards certain individuals, dishonestly for 1998), failing to detect patterns of fraudulent and irregular payments and Mr Stojevic’s dishonesty. S&R claimed that any competent auditor would have detected the fraud and “blown the whistle” by resigning and/or reporting to authorities, thereby bringing the scheme to an end.

The pleaded loss was the net amount of funds said to have been “dissipated fraudulently and/or not in usual course of business”, almost entirely derived from monies fraudulently obtained from banks and paid on to BCL and related parties. S&R also claimed substantial compound interest as special damages on the basis that, had funds not been dissipated, they would have been used to reduce indebtedness or earn interest.

Issues

The illegality (ex turpi causa) defence

Moore Stephens applied to strike out the claim and/or for summary judgment, arguing that it was barred by the maxim ex turpi causa non oritur actio. Their core contentions were:

• Mr Stojevic was the controlling mind and will of S&R; S&R was a one-man band and a vehicle of fraud.
• S&R itself was guilty of the letter-of-credit fraud; it had no legitimate assets, only funds obtained by deceit. It was therefore seeking to recover a loss caused by its own fraud, essentially its liability to repay the defrauded banks.
• On ordinary principles of attribution, Mr Stojevic’s knowledge and acts should be treated as those of the company. On that basis, if an individual could not recover loss caused by his own criminal conduct, the same must apply to S&R.

S&R resisted the application, contending that:

• The claim was for its own loss represented by fraudulent and irregular payments out, not for the loss of the banks.
• Moore Stephens owed S&R contractual and co-extensive tortious duties, including a duty to plan and perform audits with a reasonable expectation of detecting material misstatements, including those resulting from fraud, and to react appropriately when indications of fraud arose.
• On the authority of Reeves v Commissioner of Police for the Metropolis [1999] QB 169, the illegality defence does not apply where the plaintiff’s wrongful act is “the very thing” the defendant had a duty to prevent or detect.
• Mr Stojevic’s dishonesty should not be attributed to S&R for the purpose of defeating its claim; the company should be treated as a victim (at least secondarily) of his wrongdoing.

Compound interest

Moore Stephens also sought to strike out the separate head of claim for compound interest as special damage, arguing that it was unsustainable on the pleaded facts.

Judgment

Legal principles on ex turpi causa

Langley J reviewed the authorities on illegality. He endorsed a “reliance test” drawn from Holman v Johnson, Tinsley v Milligan, Clunis v Camden and Islington Health Authority, Cross v Kirkby and related cases. The ex turpi maxim bars a claim where:

• the cause of action is “founded on” or “arises from” the claimant’s own illegal act; or
• the claimant must necessarily plead or rely on that illegality to put forward and sustain the claim; or
• the facts giving rise to the claim are “inextricably linked” with the illegality, as opposed to the illegality being merely collateral or incidental.

He accepted that only part of a claim may be defeated by the maxim, and that the principle is one of policy rather than justice, capable of producing harsh results.

Application to corporations and attribution

On attribution, the judge considered El Ajou v Dollar Land Holdings plc and the “directing mind and will” test. He held that in many contexts Mr Stojevic’s knowledge and wrongdoing would plainly be attributed to S&R, given his complete control of the company.

However, he then turned to the so-called “Belmont rule” (from Re Hampshire Land, J.C. Houghton, and Belmont Finance v Williams Furniture): where an officer or employee is committing a fraud on the company, the fraudster’s knowledge is not attributed to the company, which is treated as the victim of the fraud. He also noted that in some cases there may be both primary and secondary victims of the same fraud, as suggested in Arab Bank v Zurich Insurance.

Langley J considered whether S&R should be regarded as victim or perpetrator. The primary victims were the defrauded banks. S&R incurred liabilities to those banks that it could not pay once the funds were channelled away. But it never lost money to which it was entitled; everything it received was fraudulently obtained, held under a liability to repay. In that sense, he concluded that S&R was in a real way the perpetrator rather than a victim.

Interaction with Reeves and the “very thing” test

The judge examined Reeves, where the police owed a duty to take reasonable care to prevent a prisoner’s suicide and where the prisoner’s act (suicide) was described as the “very thing” the defendant had a duty to prevent. The House of Lords ultimately held that the suicide did not break causation, though contributory negligence applied.

Moore Stephens argued that Reeves was a special case involving an express duty to prevent a particular act, and that there was tension between Reeves and Clunis, where a mentally disordered manslaughterer was barred from recovering detention-related loss because his claim arose from his own serious crime.

Langley J preferred the reasoning in Reeves but distinguished Clunis on the basis that there the loss flowed directly from the killing, and the duty could not fairly be expressed as one specifically to prevent that killing. In contrast, in the present case the auditors’ duties included planning and performing audits with a reasonable expectation of detecting material misstatements, including those resulting from fraud, and taking action that would expose and terminate the fraudulent scheme.

He noted that, although an auditor does not have a free-standing duty to prevent fraud, the proper performance of the audit duty here would (on the assumed facts for the application) have uncovered Mr Stojevic’s activities and brought them to an end. This was analogous, in effect, to the Reeves situation where the defendant owed a duty to guard against the very harmful conduct in question.

Application of the ex turpi defence to S&R’s claim

Langley J accepted that if Mr Stojevic personally had sued the auditors, his claim would plainly be barred by ex turpi causa. He also considered that his trustee in bankruptcy would be in no better position. He then asked whether there was any compelling reason why a corporation, whose wrongdoing is attributable to it, should be treated differently in principle.

He held that, but for the Belmont-type considerations, attribution principles would indeed fix S&R with the knowledge and wrongdoing of Mr Stojevic: his role was “as clear an example of the “directing mind and will” as is perhaps likely to exist”. Nonetheless, he ultimately concluded that the illegality rule should not operate to defeat the liquidators’ claim in the circumstances.

Central to this conclusion were policy and fairness considerations, including:

• While S&R was the corporate vehicle of the fraud, the practical beneficiaries of any recovery would be the defrauded creditors, principally KB, who could not sue the auditors directly because no duty of care was owed to them.
• The court could and should ensure that no recovery enured to the benefit of Mr Stojevic himself. Any such benefit would be barred by the ex turpi maxim.
• Defrauded creditors should not be in a worse position than ordinary creditors when a company’s claim against negligent auditors is pursued through liquidation.
• The harsh and “unforgiving” nature of the illegality rule cautioned against an application which would prevent any redress in circumstances where the defendant’s very breach permitted the fraud to continue unchecked.

Langley J expressly referred to the “conscience of the ordinary citizen” and considered that it would not be affronted by permitting S&R’s claim (for the benefit of creditors) to proceed, provided that the individual fraudster did not benefit.

Accordingly, he held that the ex turpi causa defence did not justify striking out or giving summary judgment on S&R’s claim against Moore Stephens.

Compound interest claim

As to the separate head of claim for compound interest as special damage, Langley J held it was unsustainable. The claim assumed that the fraudulently obtained funds would have been used legitimately to pay down debts or to earn interest. This was squarely inconsistent with the evidence that the whole purpose of the scheme was to pay away incoming funds so that S&R did not retain them.

He also found that the pleaded case did not allege any actual interest liability incurred by S&R, nor any knowledge on the part of Moore Stephens that would have put such a loss within their contemplation, which would have been necessary to sustain a claim of that nature.

He therefore characterised the compound interest claim as “hopepless” and ordered that the relevant paragraph of the Particulars of Claim and the supporting schedule be struck out.

Implications

This decision is a significant authority on the interaction between the illegality defence and corporate claims in professional negligence, particularly auditor negligence where the company has been used as a vehicle of fraud by its controlling mind.

Langley J affirms a reliance-based approach to ex turpi causa while signalling that its application must take account of complex corporate realities, attribution principles and the position of innocent creditors. The judgment suggests that, even where a company is deeply implicated in fraud through its directing mind, claims against auditors for failing to detect and report fraud may in appropriate circumstances proceed, especially in insolvency where recovery will benefit defrauded creditors rather than the fraudster.

At the same time, the decision provides a clear warning that speculative heads of damage, such as hypothetical compound interest on fraudulently obtained funds, will be rigorously scrutinised and struck out where not properly pleaded or grounded in evidence.

Overall, the case illustrates a nuanced, policy-sensitive application of illegality principles to corporate tort claims, foreshadowing later appellate consideration of similar issues in the same litigation.

Verdict: The High Court refused Moore Stephens’ applications to strike out or obtain summary judgment on S&R’s negligence claim, allowing the action against the auditors to proceed. However, it struck out the claim for compound interest as special damages (paragraph 398 and Schedule 3 of the Particulars of Claim).

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