It is all too common for receivers to find that the directors of a company have made personal profits from the company's dealings in the run up to its collapse. The English courts have often been willing to apply equitable principles to require company officers to account to the company for the proceeds of fraudulent transactions.
On 30 June 2010 Mr Justice Lewison gave judgment in one part of the long running Versailles Trade Finance litigation (Sinclair Investments (UK) Ltd v Versailles Trade Finance Ltd (in administrative receivership) and others [2010 EWHC 1614] (Ch)). This judgment clarifies certain important aspects of the law relating to the equitable duty to account for the proceeds of fraud. In short, unless the company can show that the director made the unauthorised profit by the use of company property (as opposed to simply through his position as a director) the company will only have a personal claim against the director. The uncertainty as to whether the company can trace into assets which represent the proceeds of fraud has been resolved: unless those proceeds represent the profits of dealing with company property, no proprietary right to trace will exist.
The background to VTL’s collapse is very complicated. In overview, VTL was engaged in a Ponzi type fraud in which it raised money from banks and investors for use in a largely fictitious trade finance business. The investors provided money to VTL through a subsidiary company “TPL”. TPL’s terms of business with those investors provided that it would hold their money on trust pending its application by VTL in trade finance transactions.
TPL in fact lent the money to VTL to fund VTL’s returns on its fictitious trading activity. One of the directors of VTL and TPL, Mr Cushnie, was primarily responsible for the operation of this scheme. Shortly before VTL collapsed, Mr Cushnie sold part of his shareholding in VTL’s ultimate parent company for around £29 million. He used this money in part to repay VTL’s bank lenders, and in part to repay a mortgage debt of £9 million which he owed to one of those banks in relation to one of his personal properties. TPL brought a claim against the banks in which it alleged that Mr Cushnie held the sale proceeds as a constructive trustee for TPL (in that it represented the proceeds of Mr Cushnie’s fraudulent breach of trust as against the TPL investors), that TPL therefore had a proprietary interest in that money, and that the banks should repay to TPL the part of TPL’s money which Mr Cushnie paid to them.
The two key questions in the case were therefore (a) whether TPL could establish a proprietary interest in the share sale proceeds as opposed to a mere personal claim against Mr Cushnie, and (b) if so whether the banks could defeat that claim on the basis that they received that money in good faith and without notice of TPL’s interest in the money.
The first question is particularly significant, since unless a proprietary interest could be shown, TPL could not trace the proceeds of the share sale into assets. TPL, even if it could establish a breach of trust or fiduciary duty, would only have an unsecured claim against Mr Cushnie. In answer to this question Mr Justice Lewison identified two strands in the pre-existing case law. The first strand deals with unauthorised profits made by a director resulting from his dealings with an asset which, prior to that dealing, was trust or company property. In those cases the original owner of the property has a proprietary right to recover the unauthorised profit, and the director/fiduciary holds that unauthorised profit as a true constructive trustee. The second strand deals with cases where a director has, by fraud, made an unauthorised profit otherwise than by acquiring or exploiting property previously owned by the company. In those cases, although the director has frequently been referred
to as a constructive trustee, the company does not have any proprietary interest in the unauthorised profit.
“Constructive trustee” in these cases is no more than shorthand for a person under an equitable duty to account.
Applying that test to this case, the court held that when Mr Cushnie sold his shares he was not dealing with an asset in which TPL could establish any proprietary rights. The shares were Mr Cushnie’s property, notwithstanding that part of their inflated value was as a result of misapplication of TPL’s funds, and the sale proceeds in Mr Cushnie’s hands originated from the pockets of the duped purchasers of shares, rather than from TPL. TPL could establish that some part of the increase in the share price was as a result of Mr Cushnie’s fraud, but that could only result in their having an unsecured claim against Mr Cushnie for that part of the value he extracted from the companies. While this part of the judgement was sufficient to dispose of the proprietary claim, there was still the possibility that TPL could succeed against the banks if it could show that they received the proceeds of the fraud in circumstances where they had notice of the fraud. This claim failed on the facts. There was simply not sufficient evidence to show that the banks received money from Mr Cushnie otherwise than in good faith and without notice of the fraud.
There may yet be appeals in the Versailles litigation, but it is tempting to see this decision as something of a high water mark in the court’s willingness to apply constructive trust principles to claims against directors. There is no doubt that it will be harder in the future to establish a proprietary remedy where there is doubt as to whether the asset in question truly represents a company asset. Good news at least for banks. So long as the bank is not on notice of the fraud, the risk of having to disgorge debt repayments made by directors before the company’s collapse is now much reduced.
