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Case note: Barrett and Sinclair v. McCormack Appeal Case #9 of 1998, Court of Appeal, Vanuatu, April 21-23 1999, September 27-29, 1999 Dishonest handling of trust moneys - breach of constructive trust - the duty of nominee directors to make enquiries

Barrett and Sinclair v McCormack

Appeal Case No. 9 of 1998
Court of Appeal, Vanuatu
Date of Hearing: April 21-23 1999, September 27-29, 1999
Before: Acting Justice Vincent Lunabek; Justice Bruce Robertson;
Justice John von Doussa; Justice Daniel Fatiaki

The case was an appeal from a decision of the Supreme Court of Vanuatu delivered on 2 October 1998.

The Facts

The Respondent, McCormack operated through a company called Axbridge Pty. Ltd. The Appellants, Sinclair and Barrett, were a firm of accountants. These two parties were brought together through the operations of a man called Kennedy who operated through a number of companies including one called McCullen & Suarez Inc. Kennedy wished to set up a company called McCullen & Suarez Ltd. In Vanuatu. He approached Sinclair and Barratt. Sinclair and Barrett became company directors via nominee companies of McCullen & Suarez Ltd. (Vanuatu) and later a local company called Consolidated Services Ltd. McCormack invested money with McCullen & Suarez Ltd, to purchase shares in a company called Mexigulf Sealand Inc. believing that he would rapidly make a profit on his shares. It turned out that Mexigulf Sealand Inc. was a sham. Money from potential investors disappeared. It came into Vanuatu and was banked with the ANZ. Then it was withdrawn for the benefit of a number of payees including Kennedy. Barrett and Sinclair assisted in the receipt and banking of funds and their transfer as directed by Kennedy.

In 1994 successful criminal prosecutions were brought against certain persons who had acted as salesmen for the Mexigulf Sealand scheme under the Prevention of Frauds (Investment) Act and the Penal Code.

In an effort to recover his money Mr McCormack brought an action against Barrett and Sinclair. The trial judge found that the money paid by McCormack through Axbridge Pty Ltd, for the purchase of shares in Mexigulf Sealand, were held by Barrett and Sinclair on trust for McCormack. This was a constructive trust.

Questions of Law on Appeal

There were four issues raised on appeal:

  1. Was there a trust in respect of the funds paid by the respondent McCormack?
  2. If there was a trust, were the trust funds disbursed in breach of trust?
  3. Did the appellants, Barrett and Sinclair, assist in that breach?
  4. If they did, was their assistance dishonest?

Was there a trust?

Before the trial court it had been argued initially that there was an express or implied trust. The trial judge then allowed the pleadings to be amended to allege that the trust argued was a constructive trust. The Court of Appeal accepted this amendment and therefore had to examine whether there was a trust imposed by law regardless of the parties’ intentions.

The trial judge had held that it did not matter whether McCullen & Suarez Ltd acted as principal or broker. It was accepted in the Court of Appeal that if McCullen & Suarez Ltd was the vendor of the shares and McCormack the purchaser, there could still be a constructive trust imposed on the purchase moneys because the entire transaction was a sham and the purchase money had been obtained by fraud. McCormack would retain a beneficial interest in the trust property because of the total failure by the vendor to meet its contractual obligations. If McCullen & Suarez Ltd acted not as principal but as broker then it owed a fiduciary obligation to McCormack. Money received in breach of this fiduciary relationship could be traced and held on constructive trust . Therefore the Court of Appeal agreed that whether McCullen & Suarez acted as principal or broker it made little difference as the equitable interest in the funds remained McCormack’s under a constructive trust.

Were the funds disbursed in breach of trust?

The Court of Appeal had little difficulty in finding – as had the trial court – that once it had been found that the money paid by McCormack was held on trust there was a disbursement of the funds contrary to the trust. McCormack received share certificates for his money, but these were worthless pieces of paper. This was not a case of a purchaser getting something which turns out to be of less value than originally thought. If McCormack was not going to get what he bargained for – and he could not because the company Mexigulf Sealand Inc was a sham – then the only proper disbursement of funds would have been back to McCormack.

Did Barrett and Sinclair assist in the breach?

The Court needed to be satisfied that there was a relevant and sufficient nexus between the conduct of the appellants and the breach of trust. The authority of Selangor United Rubber Estates Ltd v Craddock (1968) 2 All ER 1073, relying on an earlier case of Gray v Johnston (1868) LR3 HL1, indicated that such assistance must be conduct undertaken with knowledge or notice of a breach of trust.

Applied to the facts this meant that it would have to be established that the appellants assisted in the breach of trust. The breach being the appropriation of funds which were obtained by a fraud and in respect of which the respondent received nothing. The Court of Appeal was satisfied that Barrett and Sinclair did assist in the breach of trust. Their assistance took the following forms: the incorporation of McCullen & Suarez Ltd. as an international company; the incorporation of Consolidated Services Ltd. as a local company to carry on the business of McCullen & Suarez in Vanuatu; the opening of bank accounts for the companies, becoming signatories thereto and undertaking banking transactions; their appointment, via nominee companies, as directors of McCullen & Suarez Ltd and Consolidated Services Ltd.; leaving the management of the affairs of the companies of which they were directors to Kennedy despite there being no company resolution to this effect; preparing fund summaries; undertaking administration tasks such as telephone installation and appointment of office staff.

Was such assistance dishonest?

To be satisfied on this point the Court of Appeal had to find that the appellants knew they were participating in a fraudulent breach of trust. The trial judge had relied on six aspects of the appellants’ conduct to arrive at a finding that the appellants did know they were participating in a fraudulent breach of trust. The Court of Appeal did not accept all of these, and was not persuaded that the remaining evidence, if viewed in isolation, was of great significance. However the Appeal Court acting under the power conferred on it by s. 26(2) of the Court Act [CAP 122] went on to consider other evidence. In particular it considered the evidence of Sinclair, which had been rejected by the trial judge, and the lack of evidence of an employee, Ms. Thomson, who had not been called as a witness. This evidence, the Court held, contained clear indicators of possible fraud of some sort, which called for an inquiry, and none was made. Following the reasoning of Millett J in the case of Agip (Africa) Ltd. v Jackson [1991] Ch 265, it was not necessary for the appellants, either directly or vicariously through Ms Thomson, to have been aware of the precise nature of the fraud or the identity of its victim. The failure of the appellants to make inquiries had to be assessed in the light of their role as directors – through nominee companies – of McCullen & Suarez Ltd. By law – s. 48 International Companies Act and s381 Companies Act – they were required to act in good faith, with the care, diligence and skill of a reasonably prudent person in comparable circumstances. In accordance with these standards the directors should have satisfied themselves that the disbursement of funds to an unknown person in Australia, to Kennedy himself and to an unknown company in the Isle of Man, were not payments that misapplied the property of McCullen & Suarez Ltd.

The Court of Appeal found that the facts were sufficient to infer that the appellants did not make inquiries in case they learned something which they would rather not know. In such circumstances adverse inferences could be drawn from the failure of the appellants to call as witnesses either Barrett, or Ms Thomson or any other relevant employee.

The Court inferred that the decision not to call these witnesses was because their evidence would have been detrimental to the appellants’ case.

The Court held further that there was sufficient evidence taken together which gave rise to a strong inference that the dealings of McCullen & Suarez were not above board. In order to establish that a reasonable honest person in the appellants’ position would not have suspected this, the court had to consider whether there was any information known to the appellants which could explain away any such suspicions. The Court did not find any evidence which could reasonably justify a belief in the legitimacy of the enterprise in Sinclair’s testimony. No innocent explanations had been provided.

The only reasonable inference open to the court on the whole of the evidence was that the appellants did not act as honest people would in the circumstances. It could reasonably be inferred that the appellants deliberately closed their eyes to the indicators of suspicion, and continued to provide assistance which allowed the scheme to continue and the moneys received to be misappropriated.

Outcome

The appeal was dismissed. A cross appeal against the order of the trial court not to award interest was upheld and simple interest as an ancillary relief to the equitable remedy of a constructive trust was allowed.

The original sum awarded by the trial judge was reduced to take into account moneys recovered from one of the persons convicted of fraud under the criminal trial.

Comment

At first sight, this case appears to illustrate one of the historical applications of the constructive trust as distinct from the "New Model Constructive Trust" which was developed by Lord Denning, in particular, during the 1970s. That is the imposition of a constructive trust on property in the hands of third parties who know that the property has been transferred in breach of trust. In this case, however, the use of the constructive trust seems to go a little further. This decision appears to support the use of the constructive trust as a contractual remedy where a bad bargain has been made. Namely, where a plaintiff has been induced to enter a contract through fraudulent misrepresentation, and the other contracting party has no intention of carrying out his part of the bargain or the subject matter of the contract does not exist, the plaintiff’s remedy lies in trust not contract, and therefore will not be defeated even if the property of the plaintiff – here moneys paid – has passed into the hands of a third party (unless the third party is a bona fide purchaser for value without notice).

The least clear part of the judgment is the finding of a constructive trust. This is partly because there is some confusion between the imposition of a constructive trust as a result of tracing, and the requirement to find a fiduciary relationship which has been breached to commence tracing (Agip (Africa) Ltd. V Jackson (1991) Ch 547).

The difficulty is noted by Lord Brown-Wilkinson in Westdeutsche Bank v Islington London Borough Council [1996] AC 699 at 716, and referred to in the Court of Appeal’s decision. Where moneys are traceable in equity the proprietary interest arises under a constructive trust. When property is obtained by fraud equity imposes a constructive trust on the fraudulent recipient. The property is then recoverable and traceable in equity – Bankers Trust Co v Shapira [1980] 1 WLR 1274, and Black v S Freedman (1910) 12 CLR 105. But, as Lord Browne-Wilkinson states: it is difficult to find clear authority for the (latter) proposition. Part of the problem is that a number of the cases on which this proposition rests are cases involving the fraudulent conduct of infants, who have misrepresented their age – for example, Stocks v Wilson [1913] 2 KB 235, and R Leslie v Shiell [1914] 3 KB. Both cases decided, incidentally, before the Minors Contracts Act (U.K.) 1987.

It has long been established that a constructive trust may be imposed on a third party who has received trust property knowing there has been a breach of trust. The recipient need not himself be fraudulent, nor need there be an existing fiduciary relationship for finding a constructive trust. Property knowingly received in breach of trust can be traced and recovered in equity (Westdeutsche Landebank Girozentrale v Islington London Borough Council [1996] AC 699), either by imposing a lien on it or bringing it within a constructive trust.

In determining whether Barrett and Sinclair assisted in the breach of trust to an extent that was sufficient to impose a constructive trust on property in their hands, the Court of Appeal divided the issues into two inquiries: was there assistance; and was it dishonest assistance? It is possible, as was recognised in the case of Gray v Johnston (1868) for conduct by a third party to be entirely consistent with there being no breach of trust. The third party is fixed with notice or knowledge of the breach when there is proof that the third party is privy to the intent to make (the) misapplication of the trust funds per Sir Jon Leach Keane v Robarts (1819) 4 NADD at 357. The intention of the original trustee of the funds to breach the trust will generally be tinged with dishonesty if not downright fraudulent. To be privy to the same intention it will have to be established that the third party handling the trust funds was also dishonest or fraudulent. The quality and test of this form of intention is not the subjective test of mens rea in criminal law, but an objective test. This leads to the question of knowledge or notice.

Does the third party actually have to know, or is it sufficient that the third party is fixed with constructive notice?

Actual knowledge requires the court to establish that the third party subjectively knew, or had notice of, the breach of trust. Constructive knowledge may be inferred where a third party fails to act as an honest person would act in the circumstances. There is however, a hybrid test.

This hybrid test appears to have been applied by both the trial judge and the Court of Appeal. This is the "Nelsonian" test, named after the famous English one-eyed Admiral who held a telescope to his blind eye in order not to see.

Actual knowledge is different from Nelsonian notice. The latter may be inferred where the indicators of a possible breach of trust are so extensive that the disregard of these warrants the conclusion that the third party deliberately or willfully closed their eyes and ears, or deliberately did not ask questions in case they learned something they would rather not know.

However, there is also some indication that the Court of Appeal considered the question of actual knowledge. In considering the rejection by the trial judge of Sinclair’s evidence, the Court of Appeal held:

The rejection of his denial cannot prove actual knowledge by the appellants or either of them in participating in a fraudulent scheme. Such a finding can only be upheld if there is other evidence that can reasonably lead to that conclusion.

The Court of Appeal did not think the evidence supported a finding of actual knowledge of Kennedy’s fraudulent scheme. The Court, however, did not appear to consider that actual knowledge was required for the imposition of accessory liability for the breaches of trust.

The Court of Appeal also seems to have applied the concept of constructive knowledge, or, in this case what was termed constructive dishonesty. This notion seems to have been derived from that of objective dishonesty discussed in the recent case of Royal Brunei Airlines SDN BHD v Philip Tan Kok Ming [1995] 2 AC 378. In this case the Privy Council indicated that accessory liability for breach of trust could only be imposed in the case of dishonesty. Carelessness, imprudence, negligence and unconscionability were all held to be insufficient. What appears to be required is, according to Lord Nicholls of Birkenhead lack of probity …conscious impropriety. Like the Nelsonian test, this is a hybrid of subjective and objective elements. Honesty …is a description of a type of conduct assessed in the light of what a person actually knew at the time … However,… The standard of what constitutes honest conduct is not subjective.

Although in the Vanuatu Court of Appeal it was held that: It is unhelpful to seek to provide exhaustive check lists in an area such as this and unnecessary where the evidence before the primary Judge disclosed such a carefully contrived and sophisticated issue of deception and fraudulent conduct, it is regrettable that the Court, bearing in mind its role in developing a body of local jurisprudence, did not indicate a little more clearly the rules it was minded to adopt.

If the Royal Brunei test is adopted, there are both disadvantages and advantages. The test is stricter than that of constructive knowledge because it requires dishonesty. This means that the remedy of the constructive trust will not be imposed on a third party who receives trust property in breach of trust as a result of carelessness, imprudence, negligence or unconscionability. Presumably in these cases the victim would have to rely on contractual remedies. However, dishonesty, may be something less than fraud. Yet it is fraud and theft, which is cited in the examples used by Lord Browne-Wilkinson in the Westdeutsche Bank v Islington Borough Council case to justify the imposition of the constructive trust. Indeed the Court of Appeal in Barrett & Sinclair v McCormack held at one point that: "we are left in no doubt that the funds which were forwarded by Axbridge Pty Ltd at the direction of Mr McCormack were stolen". This choice of words may have been used to bring the facts within those covered by the Australian decision of Black v Freeman (1910) 12 CLR 105, in which O’Connor J said at 110:

Where money has been stolen, it is trust money in the hands of the thief, and he cannot divest it of that character. If he pays it over to another person, then it may be followed into that other person’s hands

The facts of the case however, do not amount to theft. McCormack intentionally and voluntarily transferred money to McCullen & Suarez Ltd. While to the lay person the end result may not look very different, the distinction is important legally. Had criminal charges on the basis of theft been brought successfully this could have had a bearing on the onus of proof in the civil proceedings. Moreover there is no indication that a civil action in the tort of conversion was contemplated at any time.

The advantage of the Brunei approach is that, according to Lord Nicholls: (H)onesty is not an optional scale, with higher or lower values according to the moral standards of each individual.

Mr Sinclair in his evidence had argued that the business environment that prevails in Vanuatu was one in which people such as the appellants do not make the searching inquiries of their clients that may be made in other places. The inference being that different standards of probity prevailed in Vanuatu.

The Court held that the various confidentiality laws relating to companies and commercial transactions were not intended to lower the standard of honesty expected of company officers. Although it may be difficult to arrive at universal standards of honesty, this decision must be reassuring for current and potential investors. There is moreover the well-established equitable maxim that a statute should not be used as a cloak for fraud. Hiding shady dealings behind the secrecy provisions of the International Companies Act or those of the Companies Act may of course, be attractive to some categories of investors and businesses, but once this equitable maxim is jettisoned with respect to one area of legislation, why not others?

The advantage of using the trust rather than contractual remedies is clear from the judgment. A remedial constructive trust is a proprietary remedy, conferring a right in rem rather than one in personam, and therefore gives the beneficiary of the trust a preferred claim over other creditors.

The judgment does, however, touch on a number of contractual issues and it is not always clear how these fit together. In particular counsel for the appellants argued that the relationship between the parties was one of vendor and purchaser of shares. McCormack had made a bad bargain, he had acquired share certificates in a company which turned out to be a scam. If the contractual argument was accepted then this would have been a case of fraudulent misrepresentation giving rise to remedies in common law, equity or under the Misrepresentation Act (UK) 1967, which has effect in Vanuatu. It was not on this ground however, that the contractual argument was disposed of. The Court found that there was a total failure of consideration, because although McCormack had paid money he had acquired nothing in return – other than some worthless share certificates. Normally, where there is total failure of consideration then the remedy is restitution. The Court of Appeal, however chose to follow the approach in Nest Oy v Lloyd’s Bank Plc [1983] 2 Lloyd’s Rep 658, in which the court had held that a proprietary interest can arise when consideration for the purchase price has totally failed. Restitution as a quasi-contractual remedy does, of course, entail the recovery of money or property in order to prevent unjust enrichment. To that extent it is both equitable and proprietary. It is not usually categorised as a constructive trust.

The weakness with the contractual route to the imposition of a constructive trust where there has been a total failure of consideration lies – as indicated above – in the authorities relied on. The cases of Cowern v Nield [1912] 2 KB 49 and Stocks v Wilson [1913] 2 KB 235, where the contracts in any case were unenforceable owing to the lack of capacity – regardless of any failure of consideration - can be clearly distinguished from the situation in Barrett & Sinclair.

A final comment relates to the use of case authorities cited. The fact that cases of other jurisdictions decided after 1969 are only persuasive in Vanuatu and not binding, is not referred to once in the judgment. The point is relevant in as much as the binding law relating to the imposition of a constructive trust on a third party is that found in Carl Zeiss Stifung v Herbert Smith No.2) [1969] 2 Ch 276 and Selangor United Rubber Estates Ltd. V Craddock [1968] 2 All ER 1073, both of which adopt the approach taken in the earlier case of Barnes v Addy. (1874) LR 9 Ch. App. 244. This was that in order to establish that the defendant was liable as if he were a trustee it was necessary to show "assistance by the stranger with knowledge in a dishonest and fraudulent (i.e. morally reprehensible) design on the part of the trustees". Since 1969 the law on constructive trusts has been unsettled, with a number of different approaches taken to knowing receipt – requiring notice of the breach of trust – and knowing assistance – requiring knowledge or later, dishonesty. The Privy Council decision in Royal Brunei Airlines marks a further departure because it appears to do away entirely with the criteria "knowingly" and hold that dishonesty is both a necessary and sufficient criteria for imposing accessory liability on a third party, even if the original trustee is not dishonest. It should be noted that not only did the Privy Council not categorize the accessory liability in Brunei as a form of constructive trusteeship, but that the Privy Council’s reasoning has itself been subject to criticism, see for example, Gardner (1996) LQR 56, Berg A (1996) MLR 443, and Birks A (1996) LMCLQ 1.

There is no reference to constructive trust decisions from the South Pacific region, and only very limited reference to Australian or New Zealand cases, despite the fact that a number are referred to in the Royal Brunei case, and indicate that in these common law jurisdictions the law is by no means settled in this area.. There is no reference at all to French law, although the concept of unjust enrichment is well established in French law and the underlying failure of consideration could have been dealt with under the contractual notion of cause.

Sue. Farran.


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