The Cost of Fraud (updated)

Readers who saw my valedictory to the law lords in last week’s Law Society Gazette will no doubt be anxious to discover whether the accounting firm Moore Stephens were found to have been negligent by failing to stop a fraud in Stone & Rolls, a company that they were auditing.

On Thursday, the law lords rejected, by a majority of three to two, a claim brought by the commodity trading company’s liquidators. The House of Lords held that Moore Stephens were not liable for failing to spot an extensive letter-of-credit fraud by the company and the man who owned and controlled it, Zvonko Stojevic.

The claim – originally for £89m – was one of the largest so far to be funded commercially.  One can only imagine the efforts that Lord Scott and Lord Mance, the minority judges, made to try to win over either Lord Phillips, Lord Walker or Lord Brown, who made up the majority.

The three upheld an earlier ruling by the Court of Appeal striking out the claim on the basis that the conduct of Mr Stojevic was to be treated as that of the company, and so the loss Stone & Rolls claimed arose directly from its own fraudulent activities.

Moore Stephens argued that such a claim should be barred by the principle of public policy that a court will not assist a claimant to recover compensation for the consequences of its own illegal conduct. The fact that the company was insolvent and any winnings would go to the creditors did not change the position.

In a 130-page judgment, the House of Lords also affirmed the long-established principles that auditors’ duties are owed to the company in the interests of its shareholders and that ordinarily no duty is owed to creditors.

Moore Stephens was represented by Barlow Lyde & Gilbert while the liquidators of Stone & Rolls were represented by Norton Rose. The claim was funded partly by IM Litigation Funding and partly by Norton Rose.

Welcoming the ruling, Julian Randall of Barlow Lyde & Gilbert said it confirmed that auditors were not there simply to pick up the creditors’ losses when a company collapsed.

“As the law lords noted, the application of the illegality defence to a claim by a company against its auditors is novel,” Mr Randall addded. “We always felt strongly, however, that in this case the company was pursuing Moore Stephens for losses caused by its own fraudulent behaviour and that the claim should therefore fail.”

But it was touch and go. Take these initial comments from Lord Phillips, for example:

My initial reaction to Stone & Rolls’s claim was that, as a matter of common sense, it could not succeed. There were three reasons for this reaction. The first was that Stone & Rolls are seeking to put themselves forward as the victims of fraud when they were, in fact, the perpetrators of the fraud. The true victims of the fraud were the banks…

The second reason why common sense led me, initially, to consider that Stone & Rolls’s claim should not succeed was that Moore Stephens were also the victims of Stone & Rolls’s fraud. They were induced to agree to act as Stone & Rolls’s auditors by a fictitious and fraudulent account of Stone & Rolls’s business, given to them on behalf of the company by Mr Stojevic, and they were deceived in carrying out their audits by accounts fraudulently prepared on behalf of the company, albeit that it is for present purposes to be assumed that they were negligent in not detecting the fraud.

It does not seem just that, in these circumstances, Stone & Rolls should be able to bring a claim in respect of the very conduct that Stone & Rolls had set about inducing.

The final reason of common sense that predisposed me against this claim was one which would not, unlike the other two, occur to the man in the street but might occur to a student with knowledge of the principles of the law of negligence.

Looking at the realities, this claim is brought for the benefit of banks defrauded by Stone & Rolls on the ground that Moore Stephens should have prevented Stone & Rolls from perpetrating the frauds. Why, if this is a legitimate objective, should the banks not have a direct cause of action in negligence against Moore Stephens? One answer, I would suggest, is that a duty of care in negligence will only arise where this is fair, just and reasonable. It would not be considered fair, just and reasonable for auditors of a company to owe a duty of care to an indeterminate class of potential victims in respect of unlimited losses that they might sustain as a result of the fraud of the company.

If it would not be fair, just and reasonable for the banks to have a direct claim, then it would not seem fair just and reasonable that they should achieve the same result through a claim brought by the company’s liquidators for their benefit.

But compare them with what Lord Mance had to say:

The world has sufficient experience of Ponzi schemes operated by individuals owning “one man” companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies’ activities. The speeches of my noble and learned friends in the majority have that effect. In my opinion, English law does not require it.

and, later:

The company’s ability to recover its own loss in such circumstances is in my view not only also right in principle, but also desirable. It means that recovery does not depend on the happenstance of whether or not all the company’s shareholders were involved in the fraud. Whether a company is a one-person company or not may itself also be unclear, until one has penetrated a web of nominee or trust shareholdings.

The result I reach reflects the various categories of person interested in the company, with whom in mind the auditors ought to plan and conduct their work. The contrary result espoused by the majority of your Lordships will weaken the value of an audit and diminish auditors’ exposure in relation to precisely those companies most vulnerable to management fraud.

The (too topical) lesson for creditors or depositors might be said to be that they should not expose themselves to one-person companies, at least without extensive due diligence.

That is neither attractive nor realistic as an answer, when one-person companies can be large financial enterprises offering banking facilities to or inviting deposits or investments from many ordinary members of the public.

It is in relation to exactly such companies that auditors ought to be encouraged to exercise the skill and care anyway due, rather than to feel that the risks of incurring liability to the company for a negligent audit are reduced.

Update (August 4):

Barlow Lyde and Gilbert have now published a briefing on the case. It concludes:

As a final note, this case was trumpeted as the first case in the UK of any substance to be backed by commercial third-party funders. Those third-party funders will now be facing a large costs bill.

We will see in due course whether this impacts on funders’ willingness to get behind large commercial cases. But one thing that is clear is that the mere fact a funder has  evaluated a claim and decided to back it is no guarantee that the claim has merits.

Thiugh true, this strikes me as a little harsh. Two of the law lords thought the claim had merits. Only three did not.

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