Castle caper condoned? Court of Appeal rules on dishonest condonation and aggregation under solicitors policy in Discovery Land v AXIS
On 15 January 2024 the Court of Appeal handed down judgment in Discovery Land Company LLC and others v Axis Specialty Europe SE [2024] EWCA Civ 7.
The case concerns the ability of a solicitors’ insurer to decline cover for a claim on grounds of dishonesty and, in particular, the meaning of “condonation” of dishonesty. It also concerns how the aggregation clause operates in a solicitors’ professional indemnity insurance policy.
The decision is of some importance for solicitors and their PI insurers. To understand that significance, it is necessary to look quite closely at the facts, as follows.
1. Relevant background
Discovery Land Company LLC (Discovery Land) is a property development company based in Arizona which specialises in the development of exclusive "private residential club communities". In early 2018, Discovery Land became interested in acquiring and developing Taymouth Castle, a 180-year-old neo-gothic castle on a 450-acre estate in the Scottish Highlands.
In April 2018, Discovery Land instructed tax lawyer Mr Stephen Jones, who practised with Mr Vieoence Prentice through entities called Jirehouse (Jirehouse Partners LLP, Jirehouse, and Jirehouse Trustees Limited), to advise on the most tax-efficient approach to their purchase of the castle for $14m. Jirehouse was based in Northern Ireland but was regulated by the Solicitors Regulation Authority (SRA). Apparently on the basis that the ultimate intended purchasers of the castle wished to remain anonymous, Mr Jones proposed that an SPV (Esquiline Asset Managers Ltd) be used; but he failed to disclose his personal interest in that company.
One of the claimant companies transferred $14,050,000 to Jirehouse's client account in April 2018. These purchase monies should have remained in Jirehouse's client account until completion. However, they were immediately used by Mr Jones, purportedly as a loan from the SPV to another company in that group, and then as further loans to two further borrowers. Of the misappropriated money, £1.9m had been intended to be retained by Jirehouse as a retention. In addition, Jirehouse mortgaged the castle to Dragonfly Finance Sarl and drew down almost £5m, using £1.9m to replenish Jirehouse's client account and restoring the retention. At the point of completion, Jirehouse requested, and the claimants paid, a further $9.3m (the Surplus Funds), which Jirehouse undertook to return as soon as it had completed (fictitious) compliance checks.
The balloon went up in March 2019, when the claimants discovered the Dragonfly loan. They applied for a freezing injunction against the SPV and for an order that Jirehouse give disclosure concerning the Surplus Funds and the Dragonfly loan. Mr Jones undertook to pay the Surplus Funds into court; however, he failed to do so and was committed to prison for contempt of court. The SRA intervened into Jirehouse's practice on 3 May 2020.
2. The insurance problem
Unsurprisingly, the claimants sought the return of the misappropriated funds from Jirehouse, obtaining default judgment for the Surplus Funds and the balance of the Dragonfly loan. However, Jirehouse became insolvent without satisfying the judgments. The claimants then brought a claim against Jirehouse's professional indemnity insurer, AXIS Specialty Europe SE (Insurers), relying on the Third Parties (Rights Against Insurers) Act 2010. The Act entitles claimants against an insolvent insured to step into the shoes of the insured for the purpose of seeking an indemnity from insurers. While Jirehouse's liability to the claimants was relatively clear, Insurers' liability to its insured, and therefore to Jirehouse, was less so. Insurers declined to indemnify Jirehouse on the basis that Jirehouse's dishonesty and/or fraud gave rise to the claim.
Since Jirehouse was SRA-regulated, the policy of professional indemnity insurance written by Insurers had to comply with the SRA Minimum Terms and Conditions (MTC). Under the MTC, Insurers can only decline cover for claims arising from dishonesty and/or fraud if all directors, members or partners of the insured committed or condoned the dishonest or fraudulent act or omission. In the case of Jirehouse, the focus therefore shifted to the role of Mr Jones's ostensible partner (co-director and co-member of the Jirehouse entities), Mr Prentice.
Insurers alleged that Mr Prentice was not a true director or member of Jirehouse, and therefore his knowledge was irrelevant for the purpose of the fraud/dishonesty exclusion. Alternatively, Insurers contended that Mr Prentice had resigned as a director or member prior to the applicable events. In the further alternative, Insurers argued that Mr Prentice condoned Mr Jones' dishonesty. By the time the case reached trial, the latter point was Insurers' primary argument on dishonesty and declinature.
The limit of indemnity under the policy was £3m any one claim, which meant that, on the claimants' case, only £3m could be sought from Insurers in connection with the claim for return of the Surplus Funds, and only a further £3m could be sought in connection with the claim for the balance of the Dragonfly loan. The MTC allow insurers to aggregate similar claims; ie to treat any number of claims as though they are one claim, provided certain conditions are satisfied. In response to the claim under the Act, Insurers contended that the claimants' claims aggregated, so that, even if the claimants were successful in securing a declaration that the policy responded, they would only recover a maximum of £3m in connection with these claims.
3. The dishonesty exclusion
Clause 2.8 of the Policy (the Dishonesty Exclusion) provided that Insurers would have no liability under the policy for:
"Any claims directly or indirectly arising out of or in any way involving dishonest or fraudulent acts, errors or omissions committed or condoned by the insured, provided that:
(a) the policy shall nonetheless cover the civil liability of any innocent insured; and
(b) no dishonest or fraudulent act, error or omission shall be imputed to a body corporate unless it was committed or condoned by, in the case of a company, all directors of that company or, in the case of a Limited Liability Partnership, all members of that Limited Liability Partnership."
To rely on the Dishonesty Exclusion, Jirehouse had to have committed or condoned the dishonest or fraudulent conduct giving rise to the claim. Dishonest and fraudulent conduct involves a dishonest state of mind and Jirehouse – being a corporate entity – did not have a mind of its own. One must therefore look to the minds of its directors and/or members, Mr Jones and Mr Prentice. Mr Jones's dishonesty was common ground in the claim, but only if Mr Prentice condoned Mr Jones's dishonesty could the dishonesty be imputed to Jirehouse.
4. Condonation and blind eye knowledge
The test for dishonesty is an objective one, albeit based on what the individual subjectively knew or believed at the time, with the court having described a dishonest state of mind as including "suspicion combined with a conscious decision not to make inquiries which might result in knowledge". This is often called "blind eye knowledge" or "Nelsonian blindness". It is a question of fact whether the condoner was suspicious and consciously decided not to investigate their suspicions.
4.1 The first instance decision
At first instance, the judge adopted a nuanced approach to interpreting Mr Prentice's evidence, finding that he was truthful on some points but not on others. Crucially, the judge found that, despite Mr Prentice having acted dishonestly himself in the past, and despite opportunities having arisen for Mr Prentice to discover that Mr Jones had misappropriated client money, Mr Prentice had not realised that that had been happening, nor should he have realised. It was not until after the event, when Mr Jones came clean, triggering Mr Prentice's resignation from Jirehouse, that Mr Prentice acquired knowledge of the misuse of client money.
A more competent or professional solicitor would have become suspicious earlier, but Mr Prentice did not make enquiries because he lacked the necessary sense of professional responsibility and appreciation of the SRA's regulatory requirements. In other words, it simply did not occur to Mr Prentice that he should have been asking questions. Even if he had been suspicious about misuse of client money "to address temporary exigencies and pressures", he would not have been suspicious of a fraud of the nature and scale of the underlying events. His shock when he discovered the fraud and his immediate resignation, indicating a tendency to protect his own interests, supported this.
Accordingly, the decision at first instance was that Mr Prentice did not condone Mr Jones's dishonesty and, as such, Insurers were not entitled to rely on the dishonesty exclusion.
4.2 The Court of Appeal decision
Andrews LJ neatly summed up the knowledge required for condonation in paragraph 47:
"One cannot condone dishonest behaviour without having some knowledge or awareness of it. That does not necessarily mean that the condoner must know of the fraud or other dishonest act before or at the time it was committed. If he does, and fails to do anything about it, he might be more appositely described as an accessory to the other person’s dishonesty, and thus as a party rather than a condoner. A person might condone another’s dishonest behaviour after the event, by doing or saying something (such as assisting to cover it up, or lying about it to others) or by not taking the type of action that one would expect an honest person in their position to take. If a person has a duty to act on becoming aware of the behaviour in question, and fails to do so, they are more likely to be found to have condoned it than someone who has no such duty".
In another important passage in the decision at 43, Andrews LJ said,
In my judgment the Judge was right when he held at [23] that the language of Clause 2.8 is wide enough to embrace a situation in which someone condones a pattern of dishonest behaviour which is of the same type as the dishonest behaviour that directly gives rise to the claim, and of which the latter forms part (for example, if one member/director condoned the regular use by the other member/director of client funds for their own purposes). The question in each case would be whether or not knowledge and acceptance or approval of other acts in the same pattern amounted to condonation of the act or acts which gave rise to the claim.
A key dispute on appeal was whether the Court of Appeal should interfere with the trial judge's findings of fact since it could only do so if they were "plainly wrong".
It was significant that the trial judge had heard two and a half days' oral evidence and cross examination from Mr Prentice. Insurers nonetheless argued that the judge's reasoning was flawed, as his conclusions as to Mr Prentice's state of mind were inconsistent with his findings that Mr Prentice was dishonest, deeply unprofessional and lacking in integrity. However, the Court of Appeal pointed to the judge's lengthy, nuanced and painstakingly detailed analysis of the evidence in concluding that the trial judge's reasoning was rational, not plainly wrong, and thus could not be disturbed on appeal. Ultimately, there was insufficient evidence that Mr Prentice had been "closing his eyes to the obvious" as Mr Jones's thefts were simply not clear enough at the relevant time.
5. Sham partnership
In the alternative, Insurers argued that Mr Prentice was not a true director or member of Jirehouse. As such, his knowledge could be disregarded for the purpose of the dishonesty exclusion. The trial judge dealt with this briefly: this was a serious allegation for which there was no compelling evidence. There was some business justification for Mr Prentice becoming a partner (he wanted to progress in his career and Mr Jones wanted to keep him); whilst the partnership was unequal and Mr Prentice did not assume significant additional responsibilities as a result of his promotion, that did not mean that the arrangement was a sham. This finding was not appealed.
6. Aggregation
In accordance with the MTC, clause 5.2 of the policy provided that:
“All claims against one or more insured arising from…
(a) one act or omission;
(b) one matter or transaction;
(c) one series of related acts or omissions;
(d) the same act or omission in a series of related matters or transactions;
(e) similar acts or omissions in a series of related matters or transactions;
will be regarded as one claim for the purposes of this policy and the payment of any excess.”
Limbs (c) and (e) were the relevant ones for this dispute.
The trial judge concluded that the Surplus Funds claim and the Dragonfly loan claims did not aggregate, applying Baines v Dixon Coles & Gill (find our analysis of this decision here) and AIG Europe Ltd v Woodman. In Baines, Nugee LJ had quoted Lord Hoffman's analysis requiring the series of acts to cause both claims:
"In other words, if there is a series of acts, A, B and C, it is not enough that act A causes claim A, act B causes claim B, and act C causes claim C. What is required is that claim A is caused by the same series of acts A, B and C; claim B is also caused by the same series of acts; and claim C is too.”
The same series of acts did not cause the two claims in this case as the thefts were brought about separately. Similarly, applying Woodman, while a purchase and lending transaction might ordinarily fit together, the matters (Mr Jones' last-minute request for a further £9.3m on account and his 9-month later secret mortgaging of the castle) did not fit together, although they of course had factors in common when considered in the round at a high level. AIG Europe Ltd v OC320301 required the matters to have a "real or substantial degree of similarity as opposed to a fanciful or insubstantial degree of similarity". The Court of Appeal agreed with the trial judge that Insurers' case on aggregation took too high level a view, and that the two claims were substantively different in ways which were not just questions of fine detail. One involved a straightforward misappropriation of client funds held on trust; the other involved the wrongful arrangement of a mortgage, drawdown of the facility and then misappropriation of the funds. In any event, they did not fit together.
7. Conclusions
The Discovery Land decision on appeal shows the importance of winning on the facts at first instance where there are allegations of dishonesty. This may not be news, but it is a useful reminder of the point.
More significantly, the decision appears to provide welcome clarification of the scope of the concept of “condonation” of someone else’s dishonesty for the purposes of a solicitors’ PI policy. The Court of Appeal has made clear that it is possible to condone dishonesty after the event of its occurrence. That accords with a natural language interpretation of the word “condone”. The Court of Appeal also held that it is possible to establish condonation of a specific dishonest act without demonstrating that the condoner necessarily knew of that specific act and its dishonest nature – an awareness of similar instances of dishonesty, and/or a pattern of similar dishonesty, may be enough. That proposition emerged some years ago in Zurich Professional Ltd v Karim [2006] EWHC 3355 (QB), and the Court of Appeal has now made clear that it is the correct approach to adopt under the MTC too.
That leaves the potential significance of the decision on the aggregation wording. The case does not appear to introduce a new legal principle concerning the aggregation language in the MTC, but it certainly provides grist for the argument that applying the aggregation clause to a given set of facts will be a detailed exercise, one where short-cuts and ‘high level’ views will not work.