Tracing Mr Maluf's millions

The recent Privy Council decision in Federal Republic of Brazil and another v Durant International Corporation and another upholding a Jersey Court of Appeal judgment provides guidance on the approach the English Courts may now take to backwards tracing.

Paulo Maluf a former mayor of São Paulo in Brazil, is, according to the Economist magazine, so notorious in his home country that the verb "malufar" meaning "to steal from public funds" has entered the Portuguese language. This recent Privy Council decision involving defendant companies controlled by him (and / or his son), means Mr Maluf's legacy may now be legal as well as linguistic. 

The Privy Council is the highest court of appeal for Jersey, and certain other jurisdictions, and its decisions are persuasive in English law (as well as in some other common law jurisdictions).  In this case it upheld a decision of the Court of Appeal of Jersey (itself upholding a decision of the Royal Court of Jersey), that "backwards tracing" should be allowed, with the result that companies under the control of Mr Maluf (and / or his son) are liable to disgorge US$10.5million paid as bribes to Mr Maluf, rather than only US$7.5million. 

Tracing under English law

Tracing is technically a process rather than a claim or remedy, which can enable a claimant to recover property, provided it can be identified or disentangled where it has been mixed with assets not belonging to the claimant.  If identifiable, property can be recovered if the original asset has been cleanly substituted for another, and even if it has been mixed with other assets.  For example, if a trustee acting in breach of trust applies £200,000 of trust money to purchase a house, the beneficiary may be in a position to trace the £200,000 to the house, even if the house is worth more than £200,000 and the trustee contributed additional funds from another source to the purchase.  If, however, the claimant's asset, or its substitute, is dissipated or disappears, then the tracing process ends. 

"Backwards tracing" refers to tracing the claimant's property to an asset the defendant already holds (even though the claimant's property has not been substituted for another asset in a straightforward chronological order).  For example, if a fraudster has borrowed to pay for an asset and then used trust money to pay off the loan, conventionally, the trust asset would be held to have been dissipated, having been used to extinguish the loan. However, backward tracing would allow the trust beneficiary, nevertheless, to claim the asset acquired at the outset by the fraudster with his loan.    

It has been a matter of debate whether backwards tracing is permitted in English law.    

The underlying facts of the claim

This decision concerned a claim by Brazil as nominal plaintiff on behalf of the Municipality of São Paulo (because the Brazilian constitution requires Brazil to be a party to any action brought outside Brazil by a Brazilian public authority).  The defendants, "Durant" and "Kildare", were companies registered in the British Virgin Islands, which are, or were at the relevant time, under the practical control of Paulo Maluf and / or his son Flavio Maluf (Kildare is a wholly owned subsidiary of Durant).     

At first instance, the Royal Court of Jersey decided that Durant and Kildare were liable to the municipality as constructive trustees of US$10.5 million paid to Mr Maluf senior as bribes in connection with a major public road building contract.  The defence put forward by Durant and Kildare, that the payments represented legitimate brokerage commissions earned in connection with an agreement to acquire a company, for introducing the parties and assisting in their negotiations, was rejected.  This judgment was upheld on appeal to the Court of Appeal of Jersey. 

The key findings of fact at first instance, which were no longer challenged on appeal to the Privy Council, were that:

(i)  in early 1998 Mr Maluf senior, or others on his behalf, received secret payments representing bribes in connection with a major public road building contract;

(ii) that between 26 January and 6 February 1998, funds equivalent to some of these payments, amounting in all to around US$10.5million, were paid in 13 separate instalments into an account at the Safra International Bank of New York in the name of Chanani but under the control of Mr Maluf junior (the "Chanani account");

(iii) between 14 to 23 January 1998, 6 payments, amounting in total to around US$13.1million, were made from the Chanani account to an account held by Durant with Deutsche Bank in Jersey ("the Durant account"); and

(iv) between 22 January and 23 February 1998, 4 payments amounting to US$13.5million were made from the Durant account to an account held by Kildare, also with Deutsche Bank in Jersey.  

The issue on Appeal

In their appeal to the Privy Council, Durant and Kildare argued that their liability as constructive trustees was (in round figures) for only US$7.5million rather than US$10.5million, on the basis that the last 3 payments into the Chanani account identified as proceeds of bribery had been madeafter the final payment from the Chanani account to the Durant account, with the result that the balance was less than the amount which could said to be the claimant's money.    

The claimant argued that tracing the payments backwards should be allowed, with the result that payments from the Chanani account into the Durant account could be traced up to the value of US$10.5million, even though the last 3 relevant payments into the Chanani account were made after the final relevant payment out of the Chanani account into the Durant account. 

The defendants argued that there was no sound doctrinal basis for "backwards tracing".

The first instance decision by the Royal Court of Jersey concluded on this point of dispute that the law was uncertain and that at a level of policy the point was unlikely to be settled under English law below the Supreme Court.  However, the Royal Court nevertheless allowed backward tracing of the disputed payments. This was on the basis that, at least when the relevant bank account remained in credit during the relevant period (ensuring no risk of possible insolvency and risk to unsecured creditors), and where there was no suggestion of an intervening bone fide purchaser for value, the question should be whether there was sufficient evidence to establish a clear link between credits and debits to the account.  The court considered that, as a matter of judicial policy, this approach would accord most closely with considerations of justice and practicality.  As the court observed, otherwise, any sophisticated fraudster would be able to defeat an otherwise effective tracing claim simply by manipulating the sequence in which credits and debits were made to his account. 

This decision at first instance was upheld on the defendants' appeal to the Court of Appeal of Jersey but was again appealed by the defendants to the Privy Council.     

The decision of the Privy Council

The Privy Council noted that the defendants' argument was conceptually coherent and supported by a good deal of authority and academic commentary.  The Privy Council went on emphasise that caution should be exercised before expanding equitable proprietary remedies in a way which might have an adverse effect on other innocent parties (for example unsecured creditors of a bankrupt trustee).  Therefore the Privy Council rejected as a statement of general application the claimant's submission that money used to pay a debt can in principle be traced into whatever was acquired in return for the debt and stated this was a very broad proposition which would take the doctrine of tracing far beyond its limits in case law to date. 

Ultimately, however, the Privy Council rejected the argument that there can never be backwards tracing and dismissed the appeal. 

The Privy Council agreed with Sir Richard Scott V-C's obiter observations in Foskett v McKeown [1998] Ch 265, 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. It therefore concluded that in order to successfully backwards trace, a claimant would have to establish 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 (noting this would likely depend on inference from proved facts).  In this case, the Royal Court of Jersey and the Jersey Court of Appeal were justified in concluding that the necessary connection was proved between the bribes and the payments made. 

The decisions in James Roscoe (Bolton) Ltd v Winder [1915] 1 Ch 62 and In re Goldcorp Exchange Ltd [1995] 1 AC 74 were distinguished as in neither case was there evidence of an overall transaction embracing the coordinated outward and inward movement of assets.

Comment

As Privy Council decisions are persuasive (albeit not binding) in English Law, and the members of the Privy Council who arrived at the decision in this case, Lords Neuberger, Mance, Carnwath, Toulson (who wrote the decision), and Hodge, are all current members of the UK Supreme Court, this judgment provides a useful insight into the likely approach the English courts may now take to backwards tracing.    

In arriving at its decision the Privy Council sought to strike a balance between protecting the interests of other innocent parties, with the interest of a claimant attempting to trace funds which often may have been misappropriated through fraud.  Nevertheless, its decision goes further than English caselaw by confirming that in certain circumstances backwards tracing is permissible.  The test it sets for backwards tracing to be allowed is a flexible one, focusing on the substance of the overall transaction rather than the strict sequence of events.  As such it will be welcomed by victims of fraud and others seeking to use backwards tracing to recover misappropriated property.  As noted in the decision, given the development of increasingly sophisticated and elaborate methods of money laundering, often involving a web of credits and debits between intermediaries, it is particularly important that a court should not allow a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect.