Auditors can sleep a little more, but not too soundly, thanks to the UK House of Lords

The UK House of Lords issued a lengthy opinion in July 2009 in the Moore Stephens v. Stone Rolls Limited case [2009] UKHL 39.  In summary, the court upheld the decision of the Court of Appeal and, applying the ex turpi causa non oritur actio (ex turpi causa in brief) principle, struck out summarily the claim against the auditors Moore Stephens of the company Stone Rolls brought by Stone Rolls’ liquidator.The UK House of Lords issued a lengthy opinion in July 2009 in the Moore Stephens v. Stone Rolls Limited case [2009] UKHL 39. In summary, the court upheld the decision of the Court of Appeal and, applying the ex turpi causa non oritur actio (ex turpi causa in brief) principle, struck out summarily the claim against the auditors Moore Stephens of the company Stone Rolls brought by Stone Rolls’ liquidator. The reason: the loss claimed arose from the fraud committed by the company itself.

The facts were simple in the extreme. Stone Rolls was used as a front by a single individual, who controlled, directed and effectively owned the company, i.e. a classic ‘one-man’ company to perpetrate significant frauds on a commercial bank using letters of credit. Moore Stephens was the auditor of Stone Rolls. The liquidator of Stone Rolls filed suit against the auditor claiming it should have uncovered and deterred the fraud and thus prevented or reduced the loss. The beneficiaries of any recovery against the auditors would principally have been the bank creditors, the victims of the fraud, who were themselves delinquent in their own due diligence. The auditor applied to have the claim struck out on the basis of ex turpi causa.

The ex turpi causa legal principle is long established and prevents a claimant recovering compensation for the consequences of his own illegal conduct. The case in point presents the interesting issue of how this principle applies to a claim by a company against those whose breach of duty – in this case the auditors – has caused or permitted the company to commit the fraud that has in turn damaged that company.

The decision helpfully summarises the duties of auditors under English law. These duties are essentially founded in contract and are to exercise reasonable care in carrying out the audit of the company’s accounts. These duties are owed to the company itself and not directly to the shareholders or creditors.

The court also addresses the issue of attributing to the company the fraudulent behaviour of the individual who owned, controlled and directed that same company.

There is some divergence of opinion amongst the Law Lords, but the majority agreed that, in the particular circumstances of the case, the sole will, mind and beneficial owner of the company was the perpetrator of the illegal activity that formed the basis of the company’s claim. Thus, all the possible interests, i.e. the sole mover and shaker, to whom the auditors might owe a duty of care, were complicit in the fraud. The company was, therefore, in exactly the same position as the individual behind it. It was noted that had the individual simply carried out the fraud himself and not via the company, neither he nor his trustee in bankruptcy could have succeeded against the auditors. And the liquidator was in no better position than the company. So in this case, the ex turpi causa principle could equally and properly be applied to prevent the company, effectively his alter ego, from bringing its claim.

The reasoning of the five Law Lords (two dissented) is extensive and provides a valuable and expansive review of the relevant principles and the authorities including Australia, Canada and the US. Although the decision was reached under English law, the principles would likely be applied in the same way in offshore financial centres that share a similar common law heritage. But it is interesting to note that the decision leaves open for future consideration a number of important and complex issues – for instance, what would be the situation where there is not simply a ‘one-man’ company and there are innocent shareholders or other relevant interests who are not party to the fraud? These should ensure that auditors do not sleep too soundly, as yet.

 

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Timothy Ridley

Timothy Ridley qualified as a solicitor in England and is an attorney-at-law in the Cayman Islands. He provides legal consulting and advisory services and acts as an expert witness in Cayman Islands legal and regulatory matters. He holds directorships in various private companies engaged in a broad range of activities, including fund administration. Prior thereto, he was for many years a senior partner of the leading Cayman Islands law firm and from 1995 until 2000 led the Asia practice in Hong Kong. He specialized in a broad range of international financial transactions.

Tim has wide regulatory and governance experience. Currently he is a member of the Disciplinary Tribunal Committee of the Cayman Islands Society of Professional Accountants (CISPA) and a member of the Board of Advisors of the Foundation for Fund Governance. He served on the Boards of the Cayman Islands Health Services Authority (2002-2005) and the Cayman Islands Monetary Authority (2002-2008, Chairman 2004-2008). He has also served on various consultative committees that advise the Cayman Islands Government on matters relating to the financial services and local industries.

Tim has taught law at the University of Southampton and at Trinity College, Cambridge and writes and speaks widely on Cayman Islands legal, financial and regulatory issues. He is a member of numerous international professional associations and has served on the editorial boards of leading publications, including the Harvard International Law Journal. Most recently he was chairman of the editorial advisory board of the Cayman Financial Review.

He is a graduate of Cambridge University (BA, Senior Scholar, Trinity College) and Harvard Law School (LL.M, Kennedy Memorial Scholar).

In recognition of his services to the financial services industry and the local community in the Cayman Islands, he was appointed an Officer of the British Empire (OBE) in 1996.

Timothy Ridley
Attorney-at-Law
E. timrid100@gmail.com