The Scope And Development Of The Illegality Defence – Key Issues For Auditors And Directors

Liquidators of companies may have breathed a sigh of relief in April of this year when the UK Supreme Court held that the dishonest directors of a company could not rely upon the "illegality defence" to defeat a claim by the company against them. Patrick Perry considers the impact of this far reaching decision for auditors and company management.

Auditors are appointed by the client company to provide audit reports, which contain their opinion on the truth and fairness of the company's annual accounts. In performing the audit tasks, auditors have essentially undertaken the duty to act as gate-keeper and watchdog of the company and its shareholders.

During the course of an audit, should an auditor fail to detect unlawful acts that ultimately cause loss to his client company, he can face the risk of being held liable to the client company for breach of his professional duties.

However, what if the unlawful acts were committed by one or several members of the management of the client company, and the company claims against the auditors for loss suffered as a result of the illegal conduct? Are there any limitations on the potential professional accountability of auditors? If the company is effectively itself guilty of dishonest conduct, is it right that it can bring a claim against its auditors?

This article will provide a brief overview on the illegality defence and its application in a corporate context for directors and auditors, in view of the recent UK Supreme Court judgment in the case of Jetivia SA and another v Bilta (UK) Ltd and others [2015] UKSC23.

The illegality defence for auditors - Stone & Rolls

The Latin maxim ex turpi causa non oritur actio, also known as the illegality defence, prohibits a party that has engaged in unlawful conduct from seeking compensation from another party for the loss suffered owing to his own illegal action. Put simply, where a claimant has to rely on his own illegal act to make out a claim, that claim must fail.

In Moore Stephens v Stone & Rolls Limited [2009] 1 AC 1391, the auditors involved, Moore Stephens, successfully relied on the illegality defence to bar a claim from their client company, Stone & Rolls Limited.

In that case, the controlling shareholder of Stone & Rolls, Mr. Stojevic, used Stone & Rolls to deliberately carry out a scheme to defraud banks, and then pay away monies to himself or other of his companies. As a result, the company became heavily insolvent and entered into liquidation. Stone & Rolls brought a claim against Moore Stephens for failing to detect that Stone & Rolls' transactions were fraudulent and bogus and for delay in stopping the continuing fraud.

The House of Lords, by a 3:2 majority, held that Moore Stephens were entitled to rely on the illegality defence to strike out the claim by Stone & Rolls. In summary, the House of Lords was of the view that Mr. Stojevic was the only shareholder, the sole director and controlling mind of the company, and hence Stone & Rolls was vested with the knowledge of the fraudulent scheme. Although Moore Stephens owed a duty of care to their client company and its shareholders, Stone & Rolls was precluded from suing its auditors in order to take advantage of and obtain benefit from its own fraud.

Applicability of the decision in Stone & Rolls

A company, as a persona ficta, is a separate legal entity but in reality, it can only act through individuals. The House of Lords in Stone & Rolls attributed the fraud or dishonesty of the company's "directing mind and will" to the company. By attributing the unlawful conduct of Mr. Stojevic to the company itself, the fraud was treated as the conduct of the company. The auditors could then rely on the illegality defence to prevent the company from pursuing a claim against them.

Nonetheless, one should not forget the unique facts underlying Stone & Rolls:

Stone & Rolls was formed and run for the exclusive purpose of fraud, and was all along used as a vehicle of fraud; Stone & Rolls was a one-man company acting through...