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Recovery of Secret Profit from Directors Under Constructive Trust

1. Introduction

Managing directors and officers of a company misappropriate a corporate opportunity and indulge in a form of appropriation of corporate assets. Thus, they have breached their fiduciary duty and are liable to the company and must disgorge the secret profit, either by way of a personal remedy or by way of a constructive trust.[1] But suppose that the directors earned the secret profit as part of a criminal scheme to defraud the national revenue, and that they were charged and convicted. whereas the company was not charged. The state seeks to recover the directors’ ill-got gains under proceeds of crime legislation. The company was placed in administration, the administrator assigned the company’s claims against the directors to another company, and subsequently it went into liquidation. The second company seeks to recover the secret profit from the directors. Can it do so, or does the state have priority because of the fraudulent scheme? Those are the basic facts and issues in the recent UK Supreme Court case, Crown Prosecution Service v Aquila Advisory Ltd.[2]

2. Facts

VTL was incorporated in Jersey in 2003 to offer tax planning services to clients. The Vantis Group of companies, of which VTL formed part, recruited Mr Faichney and Mr Perrin,[3] who were both former Inland Revenue Officers, in 2003. They became directors of VTL and it appointed Faichney as Managing Director and Perrrin as Deputy Managing Director. They had a software product developed that would allow financial advisers to identify high net worth individuals that might benefit from tax planning. The intellectual property (‘IP’) in the software vested in VTL.

The directors devised and promoted a tax avoidance scheme that took advantage of section 587B of the Income and Corporation Taxes Act 1988.[4] The section provides that if a taxpayer purchased shares in a company listed on a recognized stock exchange and those shares increased in value, and if the taxpayer then transferred them to a charity, the taxpayer could claim tax relief at the higher value.

The directors’ scheme first time round involved the creation of a tax avoidance company in which taxpayers (clients of VTL) could subscribe for shares for a small price per share. The company then purported to acquire assets that would increase the share price, after which the taxpayers could give the shares to a charity and claim relief that was much higher than their original outlay for the shares. The property acquired by the company was ostensibly the IP. The directors arranged for the ‘purchase’ of the IP rights by the company by way of a purported written assignment of the IP from a fictious trust, the ‘Richardson Trust’ of which Mrs Perrin (using her maiden name of Barnes) was the purported trustee for £500,000. The company then issued a cheque in that amount to Mrs Perrin, supposedly for the IP. The money was used for the benefit of the directors and their wives. VTL then informed their clients to claim the higher share price on their tax returns, but of course the valuation was false, since the company did not own the IP. The VTL clients also had to pay subscription fees of 12% of the amount sheltered under the scheme

The directors replicated this scheme on three other occasions, using different tax avoidance companies each time and issued further cheques to Mrs Perrin in her maiden name. The total amount paid by the companies to the Richardson Trust was £4.55m, all of which was transferred to the directors and their wives. The source of that amount was the subscription fees paid by the clients.

Thus, the scheme was fraudulent in its entirety and the money paid to VTL by the clients was obtained as a result of or in connection with the offence of cheating the public revenue. Further, the scheme breached the directors’ fiduciary duty in that they exploited the corporate opportunity they had access to when they pretended to sell VTL’s IP rights for their own benefit.

Her Majesty’s Revenue Commissioners learnt of the flagitious scheme and the directors were charged for cheating the Revenue. They were convicted and in due course confiscation orders were made against them under s. 6 of the Proceeds of Crime Act 2002.[5] The directors then resigned their positions. VTL was later placed in administration. Through its administrator, it assigned its claims against the directors to Aquila. VTL then went into liquidation.

Aquila, as assignee of the choses in action and property rights of VTL brought these proceedings to recover the secret profit from the directors and their wives. CPS intervened in the proceedings. There were other parties to the action, but they dropped out after they reached settlements, so that in the end the only parties were Aquila and CPS.

3. Discussion and Decision

COPA does not interfere with existing third-party property rights. It is of interest that CPS only brought criminal charges against the directors. It did not bring criminal charges against VTL. Thus, no confiscation order could be made against it in respect of its proprietary rights under a constructive trust. Nor did CPS obtain a restraining order against VTL to prevent it from dissipating its proprietary rights. Further, CPS was unable to bring civil proceedings to recover the property, since COPA prevents such proceedings if the property has been taken into account for the making of a confiscation order. However, CPS argued that since the directors were the directing mind and will of VTL, their fraudulent actions should be attributed to VTL.

The Trial Judge dismissed CPS’s claims. It appealed to the Court of Appeal. The Court of Appeal dismissed the appeal and applied two Supreme Court cases, FHR European Ventures LLP v Mankarious[6] and Bilta (UK) Ltd v Nazir,[7] both of which the Trial Judge had also considered.

In FHR, the agent of a purchaser had entered into an agreement with the sellers of a hotel to be paid a secret commission of €10m. The purchaser sued to recover that amount from its agent when it learnt of it after the transaction closed. The issue was whether a bribe or secret commission received by an agent is held by the agent on constructive trust for the principal, or whether the principal has only a personal remedy for an account of the bribe or secret commission. It is a long-standing principle that secret profits made by an agent in breach of fiduciary duty to the principal are held on constructive trust. The question was whether the same rule applied to a bribe or secret commission. Lord Neuberger, who delivered the judgment of the court, held (at para 30) that a constructive trust is justified in both cases because equity does not allow an agent to rely on his own wrong to justify retaining the benefit. On the contrary, as agent, he acquired the benefit for his principal, and he must give it up to the principal under a constructive trust and should not be allowed simply to pay compensation. His Lordship acknowledged that the authorities differed on whether a constructive trust is appropriate in the case of a bribe or secret commission, But he went on to hold (in para 35) that, in the interests of promoting simplicity and clarity in the law, ‘any benefit acquired as a result of his agency and in breach of his fiduciary duty is held in trust for the principal’, whether the benefit consist of a secret profit or a bribe or commission.

FHR did not have to consider whether the agent’s fraud should be attributed to the principal so as to prevent the principal from relying on the constructive trust when the benefit was gained through illegality. That question did arise in Bilta. In that case directors of the company had used it as a vehicle to commit a VAT carousel fraud. In consequence, the company went into liquidation. The liquidator alleged that other parties dishonestly assisted the directors’ breaches of fiduciary duty. Thus, since the claim was based on knowing assistance, the remedy is not proprietary but personal for equitable compensation. The other parties applied to strike out the claim against them, because the directors’ wrongful activity should be attributed to the company. The Supreme Court held that their activity should not be attributed to the company. Lord Neuberger said (at para 7) that when a company is the victim of wrongdoing by the directors, the wrongdoing cannot be attributed to the company as a defence to a claim brought against the directors. Lord Mance stated (at para 42) that when the matter concerns the duties owed by an officer or director of a company, ‘the acts, knowledge and state of mind of the company must necessarily be separated from those of its officer. Therefore, as Lord Stephens noted in the current case (at para 60) ‘the company [i.e., VTL] is not acting illegally and its claim is not barred by the defence of illegality’.

CPS appealed to the Supreme Court on a number of grounds. Among other grounds, it argued that the decision in Bilta on illegality was effectively altered by the subsequent case, Patel v Mirza.[8] However as Lord Stephens stated (in para 61), ‘the reasoning in Bilta, built as it is on the policy of avoiding illegality undermining the purpose of the rule in question, is entirely consistent with Patel and has not been undermined by it’. Thus, Bilta remains good law. His Lordship also indicated (at para 81) that although  Bilta was concerned with loss-based claims rather than claims to strip profits, it applies equally to the breach of fiduciary duty that led to a claim to strip profits. ‘Bilta is authority for the proposition that the unlawful acts or dishonest state of mind of a director cannot be attributed to the company so as to afford the director an illegality defence to the company’s claim against him for breach of fiduciary duty. The principles of illegality in Patel simply do not arise’.

CPS also argued that the Court of Appeal’s decision was inconsistent with the POCA regime, which it argued is intended to protect only innocent third-party purchasers, who have paid market value for criminal property. However, the Supreme Court held (in para 83) that POCA protects the property rights of others regardless of how they arise. Besides, POCA allows the state to override property rights, but, as discussed above, CPS did not avail itself of those provisions.

4. Conclusion

Lord Stephens makes the point (in para 88) that English cases have not adopted the Canadian view that constructive trusts can be either institutional or remedial. The English view is that they are always institutional.[9] That is, a constructive trust can be imposed only on existing property rights. Despite this difference in approach, the principles upheld and refined in Aquila will undoubtedly be found persuasive in Canada.

[1]    The leading Canadian case on point is Canadian Aero Services Ltd v O’Malley, [1974] SCR 592, 40 DLR 3d 371.

[2]    [2021] UKSC 40, judgment given on 3 November 2021, affirming an appeal from the Court of Appeal, [2019] EWCA Civ 588, which affirmed the decision of Mann J, [2018] EWHC 565 (Ch). For economy’s sake and ease of reference, I shall refer to the Crown Prosecution Service as ‘CPS’, Aquila Advisory Ltd as ‘Aquila’, the first corporation, Vantis Tax Ltd, as ‘VTL’, and the case as ‘Aquila’. Lord Stephens delivered the reasons of the High Court, with which the other members of the court agreed. I am indebted to Joel Nitikman for drawing the case to my attention.

[3]    I shall usually refer to the two as ‘the directors’.

[4]    1988, c. 1.

[5]    2002, c 29 (‘POCA’).

[6]    [2014] UKSC 45, [2015] AC 250 (‘FHR’). For a leading Canadian case with somewhat similar facts, see Soulos v Korkontzilas, [1997] 2 SCR 217, 146 DLR 4th 214. In it the court also imposed a constructive trust.

[7]    [2015] UKSC 23, [2016] AC 1 (‘Bilta’)

[8]    [2016] UKSC 42, [2017] AC 467 (‘Patel’)

[9]    See, e.g., FHR at para 47.

This paper is intended for the purposes of providing information only and is to be used only for the purposes of guidance. This paper is not intended to be relied upon as the giving of legal advice and does not purport to be exhaustive.

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