In circumstances where a person operates a fraud through the medium of a company of which he is the controlling mind and ultimate beneficial shareholder, that company cannot hide behind the corporate veil and bring a claim against auditors who negligently fail to discover the fraud in breach of its duty to the company. This was the finding of the House of Lords in the case of Stone and Rolls Ltd (in liquidation) v Moore Stephens. But it was a tight call.
The company, Stone and Rolls Limited, was entirely managed and controlled by a Mr Stojevic. For a number of years Mr Stojevic used the front of Stone and Rolls to further his own fraudulent ambitions, deceiving banks into handing over large sums of money. Moore Stephens were engaged by Stone and Rolls as auditors during the period when this fraudulent activity was taking place. Eventually the fraud was discovered by one of the banks and the victims of the fraud successfully sued both the fraudster and his company for a sum exceeding $94 million. Neither Mr Stojevic nor Stone and Rolls could settle the judgment debt and the company went into liquidation. Stone and Rolls, then under the control of liquidators, sued Moore Stephens in negligence for failing to notice the fraudulent behaviour and prevent its occurrence. Moore Stephens denied liability.
If this claim had been successful, the auditors would have been left with a massive bill in the order of US$174 million, being forced to pay out any losses suffered by the company as a result of having to pay compensation to the victims of Mr Stojevic’s fraud. As it was, Moore Stephens managed to avoid this by relying on the principle of ex turpi causa non oritur action, which prevents someone relying on their own illegal conduct in order to claim compensation against another person for loss arising from the consequences of that illegal conduct.
However, resolution of this case was far from simple. Stone and Rolls, relying on the established notion that a company has its own legal identity from its human actors, argued that Mr Stojevic, and not the company, had committed the fraud and that therefore the ex turpi causa doctrine did not apply to them.
The Lords, after a lot of argument, ruled by a majority that Stone and Rolls were primarily liable for the actions of Mr Stojevic and so were hit by the ex turpi causa doctrine. They reasoned that the company was solely managed and controlled by Mr Stojevic, that he was its single directing mind and that the company therefore had sufficient knowledge of the frauds to be primarily (as opposed to just vicariously) liable for them. The company was not a victim of the fraudster but a co-perpetrator of the fraud and, in order to win the case against Moore Stephens, Stone and Rolls would have to rely on their own illegal conduct – which they could not do.
However, it was a close shave for Moore Stephens. Stone and Rolls argued that, even if the principle of ex turpi causa could apply to them, the “very thing” doctrine trumped it. The “very thing” doctrine states that if a person is under a duty to prevent a particular harm (for example fraud) then that person will be liable if it in fact fails to prevent that particular harm. Moore Stephens, they said, were under a duty to protect the company from fraud. It had failed to uncover the fraud, had therefore breached that duty and should be liable for any loss arising. The majority of the Lords did not accept the Stone and Rolls submission. They held that ex turpi causa trumped the “very thing” doctrine and Moore Stephens could still shelter behind the principle even though they were employed to prevent the “very thing” that happened – i.e. the harm caused by the company’s fraud.
The application by Moore Stephens to strike out the claim was therefore allowed and there was no need to get into the specific argument of whether in fact they had been negligent in the fulfilment of their duties.
Part of the reason Moore Stephens could rely on the ex turpi causa doctrine was the decision that Stone and Rolls was not a victim of Mr Stojevic’s fraud on the grounds that, as Mr Stojevic was the absolute beneficial owner of the company (in effect the ultimate “shareholder”), there were no innocent individuals within the company to be considered victims.
This begs the question what would have happened if such an innocent person did exist (and the two dissenting judges argued that the creditors of the insolvent company should fall into a category to whom the auditors owed a duty). From the judgment, it appears that the existence of an innocent beneficial owner or other innocent participator could have resulted in the opposite conclusion being reached. The dissenting Lord Scott argued that it was not possible to conclude that Stone and Rolls was not a victim of the fraud until a detailed assessment of the set-up of the company had been done to ensure no innocent beneficial owners of the company existed. If a detailed assessment had been done and an innocent shareholder discovered, Stone and Rolls may indeed have been considered a victim of the fraud. This, in turn, would have meant the fraud may not have been attributed to the company and therefore that Moore Stephens could not rely on the ex turpi causa defence.
Lord Mance, dissenting, remarked at the end of his judgment that the critical issue dividing the Court was whether auditors, who should in the performance of their contractual and tortious duties towards a company have detected and reported a scheme of fraud by top management, owe any enforceable duty towards the company to detect and report that fraud thereby avoiding further loss to the company . He thought so and, put like that, it is not easy to challenge.
We may look back and see this case as heralding a time of greater scrutiny of auditors’ duties and perhaps even a widening of those duties.