Legal update - professional negligence: A strong defence

Before the high-profile decision of the House of Lords in Stone & Rolls v Moore Stephens (2009), the 'illegality principle' — known in Latin as ex turpi causa non oritur actio — had not significantly featured in the law of professional negligence. But as we enter what many fear may be the second dip of the recession, it is likely that insolvency practitioners will increasingly be engaged in civil claims to recover losses on behalf of creditors. Insurers must use all available defences against this special category of claimant.

The illegality principle applies to any case in which a claimant seeks to base a civil action on their own criminal wrongdoing. In the professional negligence context, the issue is most likely to arise in claims brought by companies against their professional advisers, where a fraud has been committed by the managers of the company that is alleged to have caused the company loss. Typically the allegation will be that the professional has negligently failed in some respect to prevent or curtail the loss, thus giving rise to a claim for damages against that professional.

Causal connection
While the crime is undiscovered, the last thing any criminal will do is bring an action for professional negligence because they will self-evidently not wish to expose their murky dealings to the court. It is only when the crime is unearthed — commonly once the claimant has become insolvent as a result of the fraud in question — that the causal connection with the crime becomes an issue in any subsequent civil proceedings.

Stone & Rolls brought into focus the category of civil claims arising from the fraudulent activities of insolvent companies where liquidators bring an action on behalf of creditors. This case centred around the criminal conduct of one Mr Stojevic. In an earlier action, Mr Stojevic was found to have procured funds for sham commercial transactions by way of bank fraud. The company — by now in liquidation — later sued its auditors for losses caused by the fraud on the basis that the auditors had negligently failed to detect and prevent it. The auditor said that the claim should be barred by reference to the illegality principle. The House of Lords held that, as the fraudulent activities of Mr Stojevic were attributable to the company, the company was a fraudster and the auditors could rely on the illegality defence.

In the wake of the recession the illegality defence has been reported to have been used by several professionals defending claims by the administrators of Lexi Holdings — the former company of the now notorious fraudster, Shaid Luqman. The defendants in Lexi Holdings v DTZ & Ors (2010) applied to the court for permission to amend their defence to include the illegality principle. In allowing their application, Mr Justice Briggs was satisfied that there was "an arguable case" that the ex turpi causa principle applied to the claim.

It was not, in his view, "just shadowy or just barely arguable". It was, on the contrary, "sufficient to give the court real concern" and that, without some investigation, "compensation might be ordered in circumstances which would undermine the integrity of the justice system". Note that this was not a 'whistleblowing case' — that is to say, unlike Stone & Rolls the defendants had not been engaged to detect fraud.

The case of Lexi Holdings v Pannone & Partners (2009) also engaged Mr Justice Briggs on ex turpi where he commented: "In the light of the Stone & Rolls case, it seems to me that the question of whether any particular case is likely to fall within the ex turpi causa principle is inherently likely to be fact-intensive." Hence, we have judicial confirmation that the argument is available where the facts of a case provide an appropriate platform.

An illegality case requires there to be a real connection between the underlying fraud or criminal act and the purported loss relied on. Furthermore, it is likely that the company must be a one-man company — that is to say, there must not be any 'independent', 'non subservient' or 'innocent' shareholders to distract from the controlling influence of the fraudster. The presence of employees and potentially directors is irrelevant. As noted, the company must be a vehicle of fraud in respect of the transaction founding the claim.

Controversial and criticised
Although Stone & Rolls has been controversial and criticised by commentators, it remains good law and the courts have shown a willingness to apply it to other corporate fraud cases in which professionals are sued. Those advising and defending professionals, therefore, should be alert to this line of attack because, if it is boldly and imaginatively applied, it will give claimant liquidators or administrators acting within insolvency constraints very serious pause for thought.

The opportunity to secure an advantageous negotiated settlement — even if the matter is not taken to trial — may be considerable. It is to be borne in mind that ex turpi causa is a complete defence and, in the case of convicted fraudsters, liquidators acting on behalf of claimant creditors are likely to have evidential difficulties.

Perhaps the best summary is as Lord Justice Mummery concluded in the Court of Appeal in Stone & Rolls: "Does common sense matter? Yes. It is contrary to all common sense to uphold a claim that would confer direct or indirect benefits on the corporate vehicle, which was used to commit the fraud and was not the victim of it, and the fraudulent driver of the fraudulent vehicle."

Tony Hill is a consultant, and Kate Thompson a solicitor, in the professional risks group at national commercial law firm Beachcroft