The illegality defence and misfeasance claims against IPs—Top Brands v Sharma

In what circumstances can an insolvency practitioner (IP) against whom a misfeasance claim is made rely on the company’s involvement in an illegal act as a defence to the claim? Ali Tabari, a barrister at St Philips Chambers, discusses the Court of Appeal’s decision in Top Brands v Sharma and its implications for practitioners.

Original news

Top Brands Ltd and another v Sharma (as former Liquidator of Mama Milla Ltd) and another [2015] EWCA Civ 1140, [2015] All ER (D) 77 (Nov)

The Court of Appeal, Civil Division dismissed the defendant former liquidator's appeal against an order that she contribute £548,074.56 to the assets of a company in creditors' voluntary liquidation (CVL) by way of compensation for her breaches of duty. The illegality defence could not apply, as there had been no inextricable link between the claim and the fraudulent conduct, and the policy of requiring liquidators properly to collect and distribute the assets of the company that had to prevail.

What was the background to the appeal?

Mrs Sharma was appointed as liquidator of a company, Mama Milla Ltd, which, it transpired, was used as vehicle for VAT fraud. As the company entered CVL, it received a sum of over £500,000 from a wholesaler with whom it dealt (Sert), that sum representing the only substantial asset of the company.

Contrary to the assertions of two creditors, who eventually brought this action, that sum was paid away by Mrs Sharma, on the seemingly-fraudulent instructions of Sert, to various bank accounts with no ostensible links to Sert or to the company itself. The instructions appeared to have been given on the false basis that Sert had made an advance payment for goods which were never delivered by the company, and that it was entitled to be repaid.

At trial, the performance by Mrs Sharma of her duties as office-holder was strongly criticised by HHJ Barker QC, sitting as a High Court Judge, and the paying away of that sum was found to amount to misfeasance under section 212 of the Insolvency Act 1986 (IA 1986) by reason of her negligence and breaches of fiduciary duty. Specifically, she made no proper enquiries about the recipients of the monies she was paying away, or the circumstances surrounding Sert’s initial payments and the subsequent instructions that she ought to pay those sums away. She was ordered to repay the sum, plus additional sums, to the company.

For further reading on the first instance decision, see blog post: How will the court approach misfeasance cases against office-holders?

What were the legal issues the Court of Appeal had to decide?

In her skeleton argument for trial, Mrs Sharma—for the first time—pleaded a defence of illegality. She claimed that the misfeasance claim was, in reality, a claim by the creditors to obtain compensation for the loss of criminal property, because the company had been involved in VAT fraud—notably, she did not rely on the illegality of the fraudulent instructions she had received from Sert. She pleaded that, accordingly, the claim should be barred, as otherwise it would run contrary to the public policy of preserving the integrity of the legal system—in other words, allowing the claim would condone, or allow the company to profit from, being involved in criminal activity.

Judge Barker found that any illegality was peripheral to Mrs Sharma’s breaches of duty, and that the defence did not assist her. She was granted permission to appeal on this point.

What were the main legal arguments put forward?

Mrs Sharma submitted on appeal that the company was a fraudulent enterprise from the outset, and that its only business was that of VAT fraud. She submitted that the test for the Court of Appeal was whether the claim was inextricably linked to the illegality, and attempted to distance the Court of Appeal from the test in Tinsley v Milligan [1993] 3 All ER 65, which said that the defence of illegality arose where the claimant needed to rely on the illegality itself to found a claim (the reliance test). Mrs Sharma submitted that the claim was so closely connected with the company’s involvement in VAT fraud that, if the Court of Appeal permitted recovery in the claim, it would appear to condone the illegality—regardless of the fact that this action was brought by creditors, the real beneficiary was the company which had carried out the illegality.

Mrs Sharma also submitted that the sum in question was criminal property for the purposes of section 340 of the Proceeds of Crime Act 2002 (POCA 2002), which meant that any recovery would—effectively—be paying compensation for the loss of criminal property. That, it was submitted, had two effects:

  • firstly, the court cannot be seen to award compensation for such loss
  • secondly, in fact, there was no loss to the company, because any sums gained by the company in the first place were tainted by criminality

Finally, Mrs Sharma submitted that the illegal conduct should be attributed to the company, not its directors, and attempted to distinguish Bilta (UK) Ltd v Nazir [2015] UKSC 23, [2015] All ER (D) 149 (Apr) which found against such a proposition.

What did the Court of Appeal decide, and why?

The Court of Appeal agreed almost entirely with the submissions of the respondents and dismissed the appeal.

The Court of Appeal found that it was bound by the reliance test in Tinsley, albeit doubted the clarity of the legal position when considering other authorities which suggested that an ‘inextricable link’ test might also be appropriate. Much like the judgment in Bilta, the Court of Appeal volubly highlighted the need for clarification of the illegality defence by the Supreme Court as soon as possible.

The key element of the judgment was the Court of Appeal’s finding that the company’s involvement in the VAT fraud was irrelevant to the misfeasance claim being brought against Mrs Sharma. In order to make out their claim, the respondents did not need to rely on any facts disclosing illegality by the company, and in fact some transactions by the company were genuine and unrelated to any fraud. Accordingly, there was no reliance by the respondents on illegality, nor was the basis of the claim inextricably linked to the illegality. There was no causative relationship between the illegality and the loss complained of, and the VAT fraud was described as a ‘legally irrelevant aside’.

The argument relating to POCA 2002, s 340 was also rejected, as it would firstly have required a finding that the company or its directors were complicit in any fraud that Sert intended to carry out. That was not an argument which was advanced at trial, nor one on which Judge Barker made any findings. In any event, POCA 2002 constituted a scheme of its own, and did not affect the principles of the illegality defence in the context of tort and contract law.

In relation to the argument about public policy, the Court of Appeal found that an equally important public policy was that enshrined in IA 1986, ss 107 and 212, which required a liquidator to comply with his statutory duties for the benefit of the creditors, particularly in circumstances where any illegality was peripheral to the office-holder’s dereliction of duty. It would be illogical and impractical if HMRC, one of the creditors in this liquidation, were deprived of a share of the company’s main asset as a result of the company perpetrating the fraud which caused HMRC to suffer loss in the first place.

Finally, there was no public policy reason for attributing to the company the dishonest intentions of the directors for the purpose of defeating the creditors’ claims.

To what extent is the judgment helpful in clarifying the law in this area?

There are three main elements to the illegality defence which may be affected by this judgment:

  • firstly, albeit temporarily, this judgment is helpful in determining that the balance between the ‘reliance test’ and the ‘inextricable link’ tests lie in favour of the former. It draws on the speech of Lord Sumption in Les Laboratoires Servier v Apotex Inc [2014] UKSC 55, [2014] All ER (D) 328 (Oct), in which he explained that the logic of the test is to exclude the consequences of any illegal act which is merely collateral to the claim
  • secondly, on the attribution point, the Court of Appeal appeared to find that the dishonest conduct of the directors should not attach to the company, particularly when no dishonesty was alleged against Mrs Sharma and dishonesty was not the basis of the claim against her. It followed the approach encouraged by Patten LJ in Bilta, which was for a more nuanced approach to attribution, rather than the mechanistic application of a rule regardless of the circumstances and nature of the claim. Had the illegality been attributed to the company, arguably it could have given Mrs Sharma immunity if she acted in breach of her statutory duties, to the obvious detriment of the creditors
  • thirdly, the importance of the statutory scheme governing the conduct of office-holders was explicitly given substantial weight, which will make future appellant arguments about contrary public policy difficult to sustain, save in exceptional circumstances

As an aside, the Court of Appeal appeared to be of the view that the law on this topic has been muddled by parties’ over-reliance on what are presented as principles of general application derived from Stone & Rolls Ltd v Moore Stephens [2009] UKHL 39, [2009] All ER (D) 330 (Jul)—the Court of Appeal reaffirmed that no such general principles can be derived from a case which turned very much on its own facts.

What practical lessons can those advising take away from this case?

The key lesson, unfortunately, is that reliance on an illegality defence will be a risky option until the Supreme Court clarifies the law. Instead of setting hard-and-fast rules, this judgment appears to affirm the importance of determining each case on its own facts.

At present, it seems clear that no respondent to a claim can rely on an illegality defence unless the claim itself has to rely on the illegality in order to succeed, following the reliance test in Tinsley.

When it comes to attribution, the courts will seek to apply a flexible and pragmatic approach which will, inevitably, be fact-specific. It is important to note that there is increasingly little use for the decision in Stone & Rolls unless the case is on all-fours with the factual background to that matter.

It is clear from this judgment, and others recently, that this topic urgently requires a review and clarification, so the message to practitioners at this stage must be: watch this space.

Ali Tabari is a barrister at St Philips Chambers, specialising in insolvency. He is rated as a leading junior in the 2015 edition of Legal 500, and has previously been ‘Highly Commended’ in Legal Week’s ‘Stars of the Bar’. He is regularly instructed in claims involving misfeasance and other Insolvency Act offences, together with urgent applications for injunctive relief and is currently instructed in a dispute concerning illegal dividends under the Companies Act 2006 which has been granted permission to appeal to the Court of Appeal.

Interviewed by Stephen Leslie.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Further Reading

If you are a LexisPSL subscriber, click the link below for further information:

A summary procedure under section 212 of the Insolvency Act 1986 and the process for bringing a misfeasance claim

Webcast: Challenging an office holder

Role, powers, functions and duties of a liquidator

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First published on LexisPSL Restructuring and Insolvency

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