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Directors' duties in a third party fraud

Mary Erb
29/10/2014

Locations

United Kingdom

The High Court has recently held that two directors, who were taken in by a substantial fraud, were in breach of duty to the company.

Good Company October 2014 edition


The High Court has recently held that two directors, who were taken in by a substantial fraud, were in breach of duty to the company.  This throws some interesting light on directors' duties, and is a reminder to directors of their potential personal liabilities where the company is defrauded by a third party (Group Seven Limited v Allied Investment Corporation Limited and others [2014] EWHC 2046 (Ch)).

Background

The case involved a claim by Group Seven Limited for fraud in relation to a fantasy investment of €100 million.  One of the defendants alleged that the company's directors had breached their duties in falling for the scam, and should be in part liable for the company's loss.

Although this case was decided under Maltese law, the High Court's conclusion that two directors were in breach of duty is worthy of note.  Directors in this situation could face personal liability to the company for losses caused by fraud perpetrated by third parties.

Factual circumstances

In each case concerning an alleged failure to comply with directors' duties codified in the Companies Act 2006, the particular facts will be paramount.  In this case, a number of factors were relevant including:

  • the patent absurdity of the fraud perpetrated on the company (amongst other things, it promised returns of €1.3 billion on an investment of €100 million over a period of 13 months, and it was made out by the fraudsters to involve the Federal Reserve in Washington releasing Medium Term Notes at a discount of up to 20% from face value to special, 'selected' projects of which the Federal Reserve approved, thereby allowing the recipients to make an almost immediate profit (to be split with the Federal Reserve);

  • the level of secrecy that the fraudsters had encouraged, thereby closing off investigation into the preposterous nature of the 'investment' or the shadowy group of people who would be involved in the 'investment' – an unknown and credential-free "Tier 1" authorised trader of the Federal Reserve; an unknown and unheard of group called the 786 Group in Washington; the Committee of 300; the Illuminati; and finally a trading 'platform' operated by the Vatican and the Royal House of Aragon;

  • the credit of €100 million of the company's money to an account over which the company surrendered control and had no security, the purposes of which were deliberately concealed from the bank where the account was held and operated; and

  • the side-lining of the company's Chief Financial Officer from the decision making process, who reviewed initial proposals relating to the scheme and was extremely sceptical from the outset.

Directors' conduct

The court found that two directors, one of whom was also Group Legal Counsel, were in particular responsible for the company's entering into the fraudulent scheme.  Their conduct was heavily criticised, and the comments below give a flavour of the criticisms made by the judge:

"It is impossible to overstate the level of incompetence demonstrated by [the Group Legal Counsel's] evidence at this trial.  He did no checks on the background of these people trying to sell this transaction to him…He discovered nothing about the details of the transactions…He accepted without challenge anything they said.  Finally in October 2011 he signed away control of €100 million, despite being required never to agree anything like that…He took comfort from documents that were meaningless…If he were uncertain as to the law, he should have obtained advice from somebody else.  That is what one would expect of a senior in-house legal counsel who might have knowledge of generalities, but would not necessarily have knowledge of specifics.  It is plain that he had no idea what the investments were, but was content to accept the vague descriptions provided by the defendants and fell into the trap of believing in the secrecy of everything."

The two directors were, in the judge's view, "thoroughly taken in" rather than "dishonestly complicit" in the fraudulent scheme, and committed the Company's funds in a "ridiculous and reckless" way.  He concluded it was clear that they had been in breach of their duty as directors to exercise reasonable skill and care, but he did not think they had been in breach of their fiduciary duty.

Potential consequences for directors

Where a director has breached a fiduciary duty, he must restore the dissipated assets even if it is possible that the company would have suffered the same loss without the breach.  In contrast, as in this case, where a director has breached his duty to exercise reasonable care and skill, but not his fiduciary duties, the court will consider what may have happened without the director's breach, and whether the loss would still have occurred in any event.  The director may still be liable to compensate the company, to the extent that the loss suffered can be shown to have been caused by his breach.

In the case of a fraud perpetrated on the company by a third party, directors who have been shown to be in breach of their duty to exercise reasonable care and skill may still be liable for the whole amount of loss suffered by the company as a result of the fraud, despite the malevolent involvement of the fraudster.  In 2009, the Court of Appeal held in Lexi Holdings plc v Luqman that two non-executive directors who knew of another director's previous dishonest conduct, and did nothing about it, were liable to the company for the third director's fraud.  The reasoning was that the fraud could not have taken place but for the non-executive directors' failure to exercise reasonable care and skill. 

Closing considerations

The courts have acknowledged, in cases concerning directors' duties, that business activity undertaken by company directors necessarily involves a certain amount of risk and that too hard an attitude on the part of the courts to directors' conduct may reduce the appetite of directors for appointments, or 'chill' that risk taking business activity beyond a point which is healthy for a company.

It is therefore worth noting that a director may be protected from liability in the case of breach of duty by seeking relief from the court on the grounds that he acted honestly, reasonably and that it is fair in all circumstances of the case to relieve him of liability (in full or in part).  Another possible avenue to protect a director is the ratification by the company of his conduct, or the company may have in place a policy of D&O insurance which may cover the relevant liability.

This case illustrates that directors must be vigilant against the possibility of the company becoming a victim of fraud.  They may be in breach of duty (and risk personal liability to compensate the company) if the company is victim to fraud and they failed to spot a scam which a reasonably diligent person, with the general knowledge, skill and experience that would be expected of a director in their position (and the general knowledge, skill and experience that they actually have), would have spotted. 

Mary Erb is a Partner in Fieldfisher's Corporate Group in Manchester.

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