The Sinclair v Versailles1 decision has extinguished any prospect that a victim of a fraud has a proprietary claim to a fraudster’s secret profits. It also offers significant comfort to banks, insolvency practitioners and other potential recipients of trust funds by setting a high bar for whether a recipient person is “on notice” of a proprietary claim to those funds.
- The fraud
The Sinclair decision results from a recovery action following the collapse of a loan kiting scam orchestrated by Carl Cushnie in the late 1990s. Mr Cushnie convinced a number of investors (Traders) that his company Trading Partners Limited (TPL) engaged in trade finance. The Traders invested their funds, and, pursuant to an agreement between TPL and Versailles Trade Finance Limited (VTFL, another Mr Cushnie-controlled company), the Traders’ funds were held on trust for them or TPL by VTFL until such time as they were used for a trade. Profits from TPL’s and VTFL’s business were funnelled into Versailles Group plc (VGP), which was indirectly owned by Mr Cushnie.
In reality, there was only ever one legitimate trade finance transaction, which made a loss. Yet to the outside world, the Versailles Group was extremely successful. In 1999 the group was valued at more than £600 million. By bouncing the Traders’ money between TPL, VTFL, VGP and a host of other companies (known as “cross firing”), the companies were made to appear as though they were profitably engaging in trade finance ventures.
The existence, extent and implications of the fraud appeared by degrees from around November 1999, rather than in a single blinding revelation. In January 2000, VGP’s and VTFL’s lenders appointed PwC to investigate their affairs, and in late January 2000, PwC were appointed as administrative receivers. Through the receivers, the banks managed to salvage something for themselves from the disaster and various distributions were made to them.
- TPL’s claims
One of the defrauded Traders, Sinclair, took an assignment of TPL’s claims against VTFL, and made two proprietary claims. First, it claimed to have a proprietary interest in the proceeds from Mr Cushnie’s sale of some of his shares in VGP (the unauthorised profit claim). Since Mr Cushnie has sold them before the fraud was discovered, the proceeds were substantial. Second, it made a proprietary claim to the Traders’ funds (paid to TPL) which were held on trust by VTFL (the mixed fund claim, arising from VTFL’s trustee-like duties to TPL).
- The issues
There were three key issues:
- whether TPL had a proprietary interest in the proceeds of the sale of VGP’s shares (ie the unauthorised profit claim);
- if so, whether TPL could trace into monies paid by Mr Cushnie to the receivers as part of a settlement of claims by VGP and VTFL, which had been taken by the banks; and
- whether TPL had a proprietary claim to, and could trace into, VTFL’s funds which had also been distributed to the banks (ie the mixed fund claim).2
In relation to the second and third issues, the key element was when the banks became “on notice” of TPL’s claims against VGP and VTFL.
- Unauthorised profit claim
The legal framework
It is well established law that a fiduciary is liable to account to the person to whom he owes such obligations for any gains arising from his position as a fiduciary.3 The question is whether that person can also say that gains are his property and held by the fiduciary for him as such. Typically, this covers situations where a fiduciary establishes a rival business using inside knowledge or takes a bribe. In this situation, the fiduciary is said to hold his gains as “constructive trustee” for the claimant.
There have been two conflicting lines of authority on the issue,4 only one of which (commencing with Reid5)arguably entitled the claimant to bring a proprietary claim against a fiduciary who had made an unauthorised profit. Lewison J identified the two classes of cases. First, those cases where the defendant receives the trust property as a trustee under a transaction which nobody seeks to impugn and secondly, where his receipt of the benefit is itself a cause of complaint. In the first kind of case a proprietary claim arises. In the second it does not. Hence if a trustee misappropriates his beneficiaries’ assets the beneficiaries will have a proprietary claim to them, but if he takes a bribe or makes an unauthorised profit they will not. They do not challenge that he is a trustee, but they do challenge his taking the bribe or making the unauthorised profit.6
Recognising that Reid was not binding upon him, Lewison J rejected the unauthorised profit claim, holding that:
“A claim made in relation to unauthorised profits made by a company director otherwise than by acquiring and subsequently exploiting property formerly owned (or treated as owned) by the company itself falls within the second class of case”.
The Court of Appeal found that Lewison J was right to reject TPL’s claim, although it limited its consideration of this issue to whether Reid should be followed (ie a proprietary claim would arise) in preference to contrary findings in at least five Court of Appeal cases. The Master of the Rolls considered that “[s]ave where there are powerful reasons to the contrary, the Court of Appeal should follow its own previous decisions”. In this instance, the Court of Appeal did not consider that there were powerful reasons to the contrary. The Master of the Rolls recognised that:
“… on the basis that the misuse of the funds by Mr Cushnie in breach of his fiduciary duty was intended to, and did, enable him to make a profit, there is some common sense attraction in the notion that the profit should be beneficially owned by those to whom he owed the duty”,7
but he did not consider the risk that a fiduciary might not be stripped of the profits of his fraud to be a “powerful reason” to follow Reid, stating:
“… there is obvious force in the contention that the mere fact that the breach of duty enabled Mr Cushnie to make a profit should not, of itself, be enough to give TPL a proprietary interest in that profit. Why, it may be asked, should the fact that a fiduciary is able to make a profit as a result of the breach of his duties to a beneficiary, without more, give the beneficiary a proprietary interest in the profit?”.8
The clear implication of this statement was that the courts should be cautious about extending any proprietary rights, which in an insolvency, would be at the expense of the unsecured creditors. The Master of the Rolls considered that any inequity “might well be met by ordering an equitable account”.9
When will someone have notice of a claim?
A recipient of trust property will have good title to that property if he acquired it for value, as a bona fide purchaser, without “notice” of the claimants’ equitable proprietary claim at the time he acquired the property. Lewison J held that “notice”:
- is notice of a right rather than a mere claim;
- includes notice of the facts on which the claim is based and of the law applicable to the facts; and
- includes both actual notice and constructive notice. Constructive notice means notice of those things that would have been discovered if “proper steps” had been taken. What are “proper steps” depends upon the context in which the question arises. In a commercial context it must be obvious that the transaction was probably improper.
The Court of Appeal agreed with Lewison J’s findings,10 stating that the issue of notice:
“would be determined by asking what the banks actually knew, and what further enquiries, if any, a reasonable person, with the knowledge and experience of the banks, would have made, and in the light of that, whether it was, or should have been, obvious to the banks that the transaction was obviously improper ...
In this case … the question which the Judge had to determine was whether, on the facts known to the banks … a reasonable person with their attributes (ie those of a responsible large bank, with the benefit of highly experienced insolvency practitioners as their appointed administrative receivers) should either have appreciated that a proprietary claim probably existed or should have made enquiries or sought advice, which would have revealed the probable existence of such a claim”.11
Just how much does a bank have to know to be “on notice”?
What makes Sinclair of tremendous importance to banks, receivers and liquidators is not the legal test to be applied to determine if someone has notice (as outlined above), but the strict manner in which the courts are likely to apply it.
Lewison J and the Court of Appeal considered the banks’ actual and constructive knowledge of TPL’s claims at three points in time.12 None of the following events, which took place before the three relevant points in time, were considered sufficient to put the banks on notice of TPL’s claims:
- PwC produced three reports regarding VGP’s and VTFL’s affairs within a month of their appointment as investigators. The reports identified Traders’ debts of £22.6m. The first report concluded that the persons who funded VTFL through TPL “were also the victims of the fraud and had lost substantial funds”.
- The banks had been advised that there might be claims against Mr Cushnie and in a bank memo it was concluded that “it is highly likely that other parties (shareholders, Versailles Traders) who have also suffered would look to join in any claim thereby reducing our eventual recoveries from [Mr Cushnie]”.13
- TPL’s liquidators met with PwC on various occasions. At one meeting the liquidators said they were interested in a tracing process. At another, PwC’s notes recorded that the Traders considered they had a proprietary claim to trump the banks, two Traders were intent on pursuing Mr Cushnie, and monies were all put into the same pot.14
In agreeing with Lewison J’s findings, the Court of Appeal held that:
- “although there was plenty of evidence to support the contention that TPL had a [personal] claim in relation to the monies that it had paid over to VTFL, it never occurred to [PwC] or the banks that TPL had a proprietary claim in respect of these monies”15 until shortly before the third date in question;16 and
- it was not clear at any point before the third date that there would be a claim against Mr Cushnie in respect of the unauthorised profits or that there was a proprietary interest in the mixed fund. Accordingly, Lewison J concluded, and the Court of Appeal agreed, that the banks had not been on notice of TPL’s proprietary claims at any point prior to the three dates in question.
What does “notice” mean in practice?
Where a bank or experienced insolvency firm discovers that an entity has been part of a fraud, it seems likely that one of the first matters they will consider is whether there is a risk of a proprietary claim. This is particularly the case for secured creditors: whilst personal claims do not directly impact upon their prospects of recovery, proprietary claims do. However, Sinclair suggests that the issue of notice will not be of concern unless:
- the person who has received trust monies can identify the equitable owner of the monies (ie can identify the potential claimant);
- the potential claimant has asserted a proprietary right to the monies (rather than a mere personal claim);
- the subject matter of the claim is identified; and
- the person who has received trust monies is aware of the potential defendant (ie the fiduciary who has breached his duties).
The decision seems hard to square with other areas of law which put a bank at hazard when it suspects something unwelcome about funds it receives. For example, if a bank suspects that the funds it receives are criminal property, it is unlikely to avoid liability under the Proceeds of Crime Act 2002 merely because it did not know the identity of the victim or that a claim had been made by him to the money.17 Similarly, on a knowing receipt claim, one would expect there may be circumstances where the court would find that it would be unconscionable for the bank to retain the benefit of the receipt notwithstanding that the bank was not aware of the same two matters. Yet one would expect the both tests to require more culpability on the part of the bank. Indeed, in Sinclair, the defendants tried to argue that the test in relation to what the banks knew was that applicable to knowing receipt of trust property,18 presumably on the basis that this would result in a more stringent test.
There are real grounds to expect the courts to row back from the notice requirements that were apparently applied in Sinclair. In the interim, the clear message to interested parties is to keep any such thoughts off the books and to wait for, rather than to anticipate, a proprietary claim.
The significance of proprietary claims
The fact that TPL asserted proprietary claims, as opposed to personal claims, is critical. Where a fraud has been committed and/or a party seeks to recover funds in an insolvency context, a proprietary claim can mean the difference between recovering everything or virtually nothing, especially if the victim’s property has been passed to a third party or there are secured creditors. Ordinarily, a proprietary claim enables a claimant to:
- capture any uplift in the value of the asset received, before or after receipt;
- obtain income generated by the asset in question since receipt;
- by means of tracing, assert equivalent rights to substitute assets;
- make prima facie claims (both personal and proprietary) against others who receive the property or its proceeds; and
- take priority in insolvency over general creditors.