Backwards tracing added to the arsenal of civil recovery weaponry in fraud and breach of trust case
On 3 August 2015 the Privy Council handed down its judgment in The Federal Republic of Brazil and another v Durant International Corporation and another  (UKPC 35) in which Lord Toulson confirmed that backward tracing, the process of tracing an asset acquired before trust funds are received, can be used by beneficiaries of misappropriated trust funds. This is subject to the requirement that there is “evidence of an overall transaction embracing the coordinated outwards and inwards movements of assets” (Ibid paragraph 41).
The decision is going to be of particular interest to insolvency practitioners and litigators involved in fraud and breach of trust claims where the availability of proprietary remedies are often the difference between whether a claimant makes a recovery or not. It also has the effect of potentially reducing the assets available in insolvent estates for the general body of unsecured creditors, if those assets are the subject of a successful backwards tracing action.
Brazil brought tracing claims against Durant and its subsidiary in respect of the alleged proceeds of bribes paid to Mr Paulo Maluf, the former mayor of Sao Paulo, for a major road building project. The Royal Court of Jersey, whose decision had been upheld by the Jersey Court of Appeal, held that some 15 bribes had been paid over the period of a month, and 13 of these payments totalling $10.5m, were traced through an account with the Safra International Bank of New York into two accounts held by Durant with Deutsche Bank in Jersey. The funds in Jersey were transmitted through 10 payments totalling over $26m although there was no claim made for the excess over the $10.5m.
Of the 10 payments Durant accepted, for the appeal, that it was liable as constructive trustee for $7.7m, but it claimed that as the last three payments into the Safra account were made after the transfer to the Deutsche Bank account they couldn’t be traced as there was no doctrinal basis for “backwards tracing”. The second limb of its appeal was that the “lowest intermediate balance rule” applied and that on two occasions payments were made to the Deutsche Bank account from the Safra account which exceeded the maximum that could be said to have come from the bribes.
Lord Toulson, who delivered the judgment, considered that both limbs of Durant’s appeal had a “simple logical parentage” (Ibid paragraph 17) and derived from the maxim “Ex nihilo nihil fit: nothing comes from nothing.” His judgment, therefore, dispensed with both of Durant’s arguments by applying the same principles.
Having taken judicial note of Professor Matthew Conaglen’s article “Difficulties with tracing backwards”  (127 LQR 432) he recognised that the authorities on backwards tracing were inconclusive and that public policy was necessarily going to inform the board’s judgment. Applying that purposive approach he concluded:
“The development of increasingly sophisticated and elaborate methods of money laundering, often involving a web of credits and debits between intermediaries, makes it particularly important that a court should not allow a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect. If the court is satisfied that the various steps are part of a coordinated scheme, it should not matter that, either as a deliberate part of the choreography or possibly because of the incidents of the banking system, a debit appears in the bank account of an intermediary before a reciprocal credit entry. The Board agrees with Sir Richard Scott V-C’s observation in Foskett v McKeown that the availability of equitable remedies ought to depend on the substance of the transaction in question and not upon the strict order in which associated events occur.”
Whilst this decision will be welcome to the victims of fraud and breach of trust, the extension of proprietary remedies necessarily balances the interests of the beneficiaries under a trust with those of unsecured creditors. This purposive approach appears to be a common theme in recent jurisprudence, most notably FHR European Ventures LLP and others v Cedar Capital Partners LLC  (UKSC 45) (a Supreme Court decision on the existence of proprietary remedies in respect of the proceeds of bribes) and JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev  (EWCA Civ 139) (a Court of Appeal decision on the appointment of a receiver with power to revoke trusts). These authorities do not, however, involve intervening unsecured creditors albeit the courts do appear to have unsecured creditors’ interests in mind.
Lord Toulson, in particular, notes Professor Conaglen’s conclusions on the issue:
“When the already precarious position of unsecured creditors is weighed against the concomitantly far better protected position of trust beneficiaries, it is suggested that the law ought not to recognise the possibility of tracing backwards. The unsecured creditors should not have their position worsened further by effectively making them insurers for the beneficiaries against trustee defalcations. Trust beneficiaries whose money has been wrongly applied in satisfaction of a debt can stand in the position of the satisfied creditor (by subrogation), but it is a step too far, in policy terms, to allow them to stand in the position of the debtor and act as owners of property that the trustee acquired before the debt was paid.
Alternatively, if backward tracing is to be allowed, then the policy concerns that have been highlighted above suggest that the extent to which payment of the debt is considered attributable to acquisition of the asset should perhaps be limited in some way, such as by reference to whether the trustee intended at the time the asset was acquired to (mis)use trust funds to pay for it… That would be consistent with equity’s traditional concern for substance – meaning intention – over form. However, the evidential difficulties inherent in a test that is focused on the defalcating trustee’s intentions provide yet further reasoning for concluding that the balance is appropriately struck by refusing to recognise backward tracing.”
The balancing act between the interests of unsecured creditors and trust beneficiaries was, in the board’s view, capable of being resolved by taking a “helicopter view” of the transaction as a whole. If there is sufficient evidence of an intention to connect the transactions, then backwards tracing is likely to be allowed.
“The claimant has to establish a coordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim, looking at the whole transaction, such as to warrant the court attributing the value of the interest acquired to the misuse of the trust fund. This is likely to depend on inference from the proved facts, particularly since in many cases the testimony of the trustee, if available, will be of little value” (Durant ibid paragraph 40).
Durant had claimed that all of the payments said to have been bribes were legitimate brokerage commissions. As such, on its own pleaded case (which failed on the facts) Durant accepted the connection between all of the payments made into the Safra account and their relationship with those made into the Deutsche Bank account.
The future battle ground in backwards tracing actions is likely to focus on the intention behind transactions. This can often be difficult to prove, particularly when claims are brought by office holders. Thankfully, in yet another purposive judgment the Court of Appeal in the recent case of Relfo Ltd (in liq) v Varsani  (EWCA Civ 360 per Lady Justice Arden paragraph 56) accepted that the court will readily make such a finding on the basis of inference from the proven factual matrix. This will be necessary in most if not all fraud and breach of trust claims where navigating through a sea of lies to get at the truth is often the greatest challenge.
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