In July 2016, a nine justice panel of the Supreme Court handed down judgment in Patel v Mirza [2016]. This is an important decision as it creates a wholly new legal test for the "illegality defence" (also known as ex turpi causa - a claimant has no legal remedy allowing it to profit from its own wrongdoing).

It has implications for auditors who might wish to avail themselves of the defence when faced with claims brought by claimant companies alleging the auditor should have reported upon and stopped the companies' own illegal activities.

Facts

The facts in this case are straightforward. Mr Patel loaned £620,000 to Mr Mirza for the purpose of investing in shares in RBS. He hoped to take advantage of advance insider information which Mr Mirza anticipated receiving from his contacts about the timing of an announcement by the government which was likely to affect the price of the shares. It transpired that the announcement was never made and therefore no investment took place.

Mr Mirza failed to repay the money to Mr Patel and, in consequence, proceedings were commenced for its recovery. The claim was for unjust enrichment and, because the agreement between Mr Patel and Mr Mirza amounted to a conspiracy to commit an offence of insider dealing under s.52 of the Criminal Justice Act 1993, Mr Mirza raised the defence of illegality.

At first instance, the court applying the old "reliance test" test held that because Mr Patel had to rely upon his own illegality to establish his claim, the illegality defence succeeded and Mr Mirza could hold on to the £620,000. The Court of Appeal overturned that decision and concluded that Mr Mirza's illegality defence must fail and whilst the reliance test did apply on the facts, because the illegal scheme had not actually been implemented, Mr Patel's claim fell within one of the exceptions to that test.

The Supreme Court Decision

The five justice majority in the Supreme Court found in Mr Patel's favour and disposed of the "reliance" test, introducing a new "range of factors" test. In the leading judgment, Lord Toulson describes these as follows:

"The essential rationale of the illegality doctrine is that it would be contrary to the public interest to enforce a claim if to do so would be harmful to the integrity of the legal system…..In assessing whether the public interest would be harmed in that way, it is necessary to consider:

  • The underlying purpose of the prohibition which has been transgressed [ie. the law which has been breached by the Claimant] and whether that purpose will be enhanced by denial of the claim;

  • Any other relevant public policy on which the denial of the claim may have an impact; and

  • Whether denial of the claim would be a proportionate response to the illegality."

He went on to say "a claimant, such as Mr Patel, who satisfies the ordinary requirements of a claim for unjust enrichment, should not be debarred from enforcing his claim by reason only of the fact that the money which he seeks to recover was paid for an unlawful purpose. There may be rare cases where for some particular reason the enforcement of such a claim might be regarded as undermining the integrity of the justice system, but there are no such circumstances in this case."

In the majority's view, the policy behind the prohibition had not been infringed, because no insider trading took place.

As regards the illegality defence, we think there is merit to the concerns voiced in the minority judgments of Lords Sumption and Mance that the new "range of factors" test has introduced further uncertainty in a complex area of the law. Although the ultimate result for most cases will be the same whether under the new or old test, we anticipate the decision will encourage more appeals in the future due to uncertainty over how the new "range of factors" test should be applied. The law in this area cannot, therefore, be regarded as settled.

How the courts will apply the "range of factors" test is beyond the scope of this article. We would however point out that it is difficult to predict how the third limb of the test (whether denial of the claim would be a proportionate response to the illegality) will be applied to facts of any complexity.

In this context, we think it is interesting to consider the fact that the new range of factors test might well have prompted a different result in the House of Lords in the case of Stone & Rolls [2009].

In that case, the insolvent claimant company was run fraudulently for and by a sole shareholder/director, with no innocent shareholder or director. The House of Lords found the auditors could rely on the defence; the fraudulent conduct was to be treated as the company's conduct. The judicial reasoning underpinning that decision, following Patel, is now overturned but, had their Lordships in Stone & Rolls applied the new "range of factors" test, we consider greater weight would have been given to factors identified by Lord Mance in his dissenting judgment in which he argued against the availability of the defence for the auditors. Lord Mance argued that where the claimant company was insolvent, the rights of the out of pocket creditors should take precedence: those that stood to recover in the name of the company were now the creditors, not any fraudulent shareholder.

Any future decision on the availability of the defence, particularly when applying the third limb of the new test, will be highly fact sensitive, thus our prediction that we shall see more appeals in this area.

As a postscript, we would add that it is difficult to do justice to the importance of this decision in this short article. It possibly represents a move towards a more flexible judicial approach in cases where there are public policy considerations for the court to take into account in the exercise of judicial discretion. In terms of indicating a new approach of the senior courts to such considerations, the decision might therefore have wider implications beyond ex turpi causa.

For accountants and their insurers, there is exposure to novel legal arguments and consequential additional legal costs when faced with litigation where the underlying facts concern illegal conduct on the part of the claimant.