K/S Lincoln & Ors v CB Richard Ellis Hotels Ltd

This is an application by the claimants pursuant to CPR 3.4 to strike out paragraph 58.2 of the defendant’s defence (which contains an allegation of unlawful tax evasion) or, in the alternative, an order that the defendant provides further information containing full particulars of this allegation.

The claimants are all special purchase vehicles created by a Danish company, Scanplan, to buy eight hotels in England in 2005. They engaged the defendant to carry out valuations of each of those eight hotels. In these proceedings, they claim that the defendant was negligent or in breach of contract in carrying out the valuations, and they maintain that, in consequence, they paid too much for each hotel. They are, to that extent at least, relatively standard claims for professional negligence. The total damages claim is, however, said to exceed £7.5m.

The quantum of the damages claim is calculated in two ways. The primary way in which the damages claim is put is by comparing the defendant’s valuation (which for the eight hotels amounted to a total of £39,470,000), with what the claimants claim is the “non-negligent net valuation” of the hotels, which is in the total sum of £34,350,000. That gives rise to a shortfall of £5,120,000. To that is added a figure of £2,397,805 in respect of “wasted purchase costs”, making a total damages claim, on this calculation, of £7,517,805.

The alternative claim compares the price actually paid for each hotel (said to total £41,039,800) with the non-negligent valuation/true valuation figure of £34,350,000 referred to above. That secondary method of calculation produces a total damages claim of £6,689,800.

This alternative claim highlights – for the first time - the actual purchase price paid by the eight claimants for their hotels. The purchase price is said to be made up of two separate figures. The hotel in Lincoln, the subject of the claim by the first claimant, will serve as an example of this calculation. The total price paid for that hotel is said to have been £5,221,800. That is made up of the sum paid to the seller of the hotel (£4,835,000), and an additional figure, calculated at 8% of the price paid to the seller (in this case £386,800) which was a payment made, not to the seller, but to a property location agent called ESL Properties Limited.

It is this 8% uplift figure, applied to each of the eight hotels, which is at the heart of the present application. The relevant pleadings are as follows:

The Particulars of Claim

Paragraph 105 of the Particulars of Claim provides as follows:

“For reasons of convenience and of tax efficiency in Denmark, the transactions were in each case carried out at a rolled-up price inclusive of a buffer of 8%, which sum was assessed to be sufficient to cover all associated costs. This was accomplished by the sellers entering into a side agreement with ESL under which the sellers agreed to deduct 8% of the nominal sale price on the date of completion and pay this to ESL in consideration of ESL’s introduction of the purchasers.”

There then follows a table in which the two sums (the payment to the sellers and the 8% paid to ESL) are identified in relation to each hotel, thus explaining the total price paid.

The Defence

Paragraph 58.2 of the Defence deals with the 8% in this way:

“The ‘explanation’ for the inclusion of an additional 8% over and above the ‘nominal’ sale price for the hotels is noted. It appears that the claimants have deliberately added 8% to the true purchase price to disguise the nature of the payment and to circumvent the fact that the professional fees were not tax deductible. Prima facie, and subject to the condition that Danish tax law is not more benevolent to the tax payer than English tax law, this was unlawful tax evasion. The defendant will investigate the position and reserves the right to plead further on this point. If the purchase was structured to obtain an unlawful tax saving, the claims fail for illegality.”

The Reply

Paragraph 21 of the Reply deals in detail with this allegation in the following terms:

“a)

The fact that the price paid was a “rolled-up” price inclusive of some 8% transaction costs was not disguised. It was openly stated in the prospectuses for all 8 claimants. The prospectuses were reviewed by Deloitte, who issued an auditor’s declaration in respect of each.

b)

The annual financial reports of the claimants, which have been audited by Deloitte, contain a cost price. These annual reports are filed with the Danish Commerce and Companies Agency, and are public documents.

c)

There would be no tax advantage to be gained from misleading the Danish tax authorities into believing that the transaction prices (for instance, £5,221,800 in the case of Lincoln hotel) did not include the topping up with transaction costs, since the Danish tax laws permit lawyers fees, surveyors fees, land tax and so on to be included in the capital acquisition sum for the purposes of depreciation. Each year up to a specified percentage of such capital may be set against current income, for the purpose of calculating taxable profit. In 2005 this percentage was 5%; today it is 4%. (In the case of a hotel the value of land acquired, as opposed to buildings, machinery and installation, may not be depreciated.)

d)

What has been an issue in Denmark is whether the fee of the promoter of a K/S (in this case Scanplan’s fee) may be included in the capital costs thus depreciated. The Danish courts have recently held that this is not permissible. The prospectus highlighted this issue and included a sensitivity analysis of its tax impact.

e)

The persons who are responsible for submitting a tax return in respect of such annual profits are the individual limited partners of the K/S. The K/S itself is a “tax transparent” entity in Denmark.

f)

The payment of a rolled-up price (covering a whole series of different outgoings and disbursements in respect of transaction costs) contributed to simplicity of presentation, and to administrative convenience and efficiency. But, save in that sense, it did not create any tax advantage.

g)

It is denied that the nature of the additional 8% payment was disguised.

h)

It is denied, if it should ever be alleged, that the claimants were engaged in unlawful tax evasion.

i)

Without prejudice to the above, the last sentence of paragraph 58.2 is, as a matter of law, denied.”

For the purposes of this application to strike out (but emphatically not for any other purpose) Mr Speaight QC, on behalf of the claimants, accepts that I should assume that the transaction was structured in order to facilitate unlawful tax evasion. However, he says that, even making such an assumption, there would be no ground in law for the claims against the defendant to fail for illegality. Thus he submits that, since paragraph 58.2 only exists in order to allow the defendant to assert illegality and thus the failure of the professional negligence claims against them, the paragraph should be struck out.

On behalf of the defendant, Mr Lawrence QC takes three points. First he asserts that illegality has not actually been pleaded, and that the offending paragraph merely warns the claimant that an illegality point may be taken if, following disclosure, it appears from the tax returns that unlawful tax evasion has occurred. Secondly he submits that, contrary to Mr Speaight’s submissions, if there had been unlawful tax evasion then it would be at the very least arguable that the professional negligence claims would indeed fail for illegality. Allied to this submission is his third point, to the effect that, prior to disclosure of the relevant tax returns and their proper consideration, it would be premature to strike out this part of the defence.

I deal first with the suggestion that paragraph 58.2 does not, in reality, amount to a positive averment of tax evasion and/or an assertion that the claim against the defendant must fail for illegality. In my judgment, such a submission is unsustainable.

Pleadings in civil proceedings are intended to set out a clear summary of each party’s case, so that the particular issues between them can be identified at the outset and form the necessary agenda for the witness statements, the experts’ reports and the subsequent trial. Following the introduction of the CPR, a defendant is not entitled blankly to deny (or fail to admit) specific matters relied on by the claimant; wherever possible a defendant is obliged to plead a positive case.

By the same token, neither a defendant, nor for that matter a claimant, can use the pleadings as a means of (as it is sometimes put) ‘firing warning shots’ to the other side, or ‘putting down markers’ as to arguments which, at present, have not been fully thought through. Such an approach to pleadings makes for uncertainty and confusion. A positive averment is either made or it is not, and there can be no sensible half-way house.

In my view, when considered in the round, paragraph 58.2 of the defendant’s defence is raising, albeit in rather languid terms, an allegation of fraud and illegality giving rise to a complete defence to the claimants’ claim. I also agree with Mr Speaight that, were there any doubt about that, the witness statement from Mr Wright, the defendant’s own solicitor, expressly accepts that this is “clearly an allegation of unlawful tax evasion”. In addition, the defendant’s solicitors have sought disclosure of tax returns and/or reports to the Danish tax authorities, a request reiterated by Mr Lawrence in his oral submissions. Such documents can only be disclosable under standard disclosure if the allegations of tax evasion and illegality are raised expressly on the face of the pleadings. Disclosure could not be appropriate in respect of an issue that was merely a ‘warning shot’ or a ‘marker’.

For all these reasons, I have concluded that the defendant has clearly alleged tax evasion and raised the illegality point. The next question is whether, assuming tax evasion, it could even be argued that the claims against the defendant must fail for illegality.

The underlying principle, of course, is the court will not lend its aid to someone who founds his cause of action upon an immoral or illegal act: see the words of Lord Mansfield in Holman v Johnson [1775] 1 Cowp.341 at 343. Although a large number of cases were cited to me during the course of argument, outlined below are those more recent cases which I consider to be of particular importance to the issues raised by this application to strike out.

In Tinsley v Milligan [1994] 1 AC 340, the claimant and the defendant had entered into an arrangement to perpetrate a fraud on the Department of Social Security, part of which involved the vesting of a property in the sole name of the claimant. When the parties fell out, the claimant sought a declaration that she was the sole owner of the property. The defendant counterclaimed for a declaration in respect of her beneficial interest in the property. The House of Lords concluded that the defendant was entitled to that beneficial interest, despite the fact that the title on which she relied was acquired in the course of carrying through an illegal transaction. They decided that it was not appropriate any longer to ask whether the public conscience would be affronted by recognising rights created by illegal transactions. Lord Brown-Wilkinson said:

“In my judgment the time has come to decide clearly that the rule is the same whether a plaintiff founds himself on a legal or equitable title: he is entitled to recover if he is not forced to plead or rely on illegality, even if it emerges that the title on which he relied was acquired in the course of carrying through an illegal transaction… In my judgment the court is only entitled and bound to dismiss a claim on the basis that it is founded on an illegality in those cases where the illegality is of a kind which would have provided a good defence if raised by the defendants. In a case where the plaintiff is not seeking to enforce an unlawful contract but founds his case on collateral rights acquired under the contract (such as a right of property) the court is neither bound nor entitled to reject the claim unless illegality of necessity forms part of the plaintiff’s case.”

In Taylor v Bhail (1995) 50 Con LR 70, which was a building case, a contractor who agreed to inflate his price by £1,000, in order that the uplift could be paid to the employer’s representative personally, was not entitled to recover the balance due under the contract, because it was tainted by illegality. In his judgment, Millett LJ referred to the earlier case of Miller v Karlinski (1945) 62 TLR 85 (a case concerned with employees who connive with their employers to defraud the Inland Revenue) and said that such employees:

“… have been unable to recover compensation for unfair or wrongful dismissal or to enforce their contracts of employment in any way. In such cases the contract of employment is tainted by fraud by the illegal use for which it was intended to be put.”

The decision of the Court of Appeal in Hewison v Meridian Shipping PTE [2003] P.I.Q.R. P252 concerned a claimant who was entitled to recover various heads of loss against his employers following an accident at work. However his claim for loss of earnings was dismissed because his continued employment would have required him to continue to deceive his employers by fraudulently representing that he did not suffer from epilepsy. The case is an example of a situation where, although the claimant’s underlying claim may succeed, a particular head of loss may fail for illegality.

In 21^st Century Logistic Solution Limited v Madysen Limited [2004] 2 Lloyd’s Lloyd’s Rep 92, Field J was considering a situation where the claimant, 21^st Century, was involved in a missing trader VAT fraud. The claimant agreed to sell to Madysen various CPUs as part of this fraud (about which Madysen knew nothing). The equipment was delivered to Madysen, who then refused to make payment to 21^st Century, claiming that, since the contract had been entered into for the purpose of defrauding Customs and Excise, it was illegal. Field J said that there had to come a point when the connection between the claimant’s intention and the underlying contract was too remote for the contract to be held to be unenforceable. He held that not every contract entered into with the intention of committing an illegal act was illegal and unenforceable. In that case he allowed 21^st Century to recover the sums due under the contract for the equipment that had been delivered to Madysen.

The first of two very recent cases decided by the House of Lords in this area of law is Gray v Thames Trains Limited [2009] 3 WLR 167. That was a claim by a man who suffered post-traumatic stress disorder as a result of the Ladbroke Grove crash and, as a consequence of his mental condition, killed a man. The claimant’s negligence claim against Thames Trains was upheld in relation to the claim for general damages, but the claim for loss of earnings (following his detention in a mental hospital) failed, because that part of the claim relied on his criminal conduct. Lord Hoffmann held that the maxim ex turpi causa expressed not so much a principle as a policy which was based not upon a single justification but a group of reasons which varied in different situations. He referred to the decision in Tinsley as a case about rights of property which he did not consider to be of direct application to the facts of Gray.

In the most recent case, Stone & Rolls Limited (in liquidation) v Moore Stephens [2009] 3 WLR 455, the claimant company had been involved in a fraud which was not spotted by their auditors and ultimately gave rise to their liquidation. The liquidator sought to pursue the auditors for negligence in failing to spot the fraud. The House of Lords refused, by a majority of three to two, to allow the claim to continue. Lord Phillips said:

“21.

The House in Tinsley v Milligan did not lay down a universal test of ex turpi causa. It was dealing with the effect of illegality on title to property. It established the general principle that, once title has passed, it cannot be attacked on the basis that it passed pursuant to an illegal transaction. If the title can be asserted without reliance on the illegality, the defendant cannot rely on the illegality to defeat the title…. The House held that it also applied in the case of both legal and equitable title to realty. The House did not hold that illegality will never bar a claim if the claim can be advanced without reliance on it. On the contrary, the House made it plain that where the claim is to enforce a contract the claim will be defeated if the defendant shows that the contract was for an illegal purpose, even though the claimant does not assert illegal purpose in making the claim; see Alexander v Rayson [1936] 1KB 169, approved by Lord Brown-Wilkinson at page 370.”

In a later passage in his judgment, Lord Phillips said:

“26…. The policy can be sub-divided into two principles in relation to contractual obligations.

1)

The court will not enforce a contract which is expressly or impliedly forbidden by statute or that is entered into with the intention of committing an illegal act.

2)

The court will not assist a claimant to recover a benefit from his own wrong doing. This extends to claims for compensation or an indemnity aspect of the adverse consequences of the wrong doing: see Beresford v Royal Insurance Co Limited [1938] AC 586.”

Unfortunately, it does not appear that 21^st Century was identified to their Lordships, a case that appears, on its face, to be rather more relevant to the issues than many of those authorities which were cited in argument.

From these various authorities I have derived the following general principles:

Contracts which are entered into with the intention of committing an illegal act will not generally be enforced (Stone & Rolls) although, in exceptional circumstances, the intended illegality may be so remote to the subject matter of the claim as to make the contract enforceable (21^st Century).

In a case where the claimant is not seeking to enforce an unlawful contract but founds his case on collateral rights acquired under that contract, and where illegality does not, of necessity, form part of the claimant’s case, the claim may well succeed (Tinsley v Milligan) although the comments by Lord Phillips in Stone & Rolls and by Lord Hoffmann in Gray may indicate that this more generous approach may be confined to property cases.

The court will not generally assist a claimant to recover the benefit of his own wrongdoing, whether or not the claimant has pleaded or expressly relied on the illegality on making the claim (Stone & Rolls).

Although the test is no longer to ask if the public conscience is affronted by the allowance of such a claim (Tinsley v Milligan), it seems clear that the underlying principle or policy is one of deterrence; that the courts will not encourage illegal acts by allowing claims based upon them.

In applying these principles to the pleaded dispute raised by paragraph 58.2 of the defence, I have reached the following conclusions.

This is not a case in which the claimant is seeking to rely upon or enforce a contract based on an illegal or fraudulent intention. The claim against the defendant is founded upon the alleged duty of care owed by the defendant as surveyors and valuers, and a further allegation that there were direct contracts for the provision of such services between the parties. Neither the duty nor the alleged contracts are, on the face of it, tainted by any illegality at all. Conversely, the contracts which are the subject of the fraud allegation are the contracts for sale of the hotels, to which the defendant was not a party and and in respect of which the defendant had no direct involvement at all.

Thus, the only way in which the alleged fraud would give rise to a complete defence to this claim would be if the court concluded that, notwithstanding the defendant’s lack of involvement in the contracts for the sale of the eight hotels, the court’s desire to deter such conduct should lead to the dismissal of the professional negligence claim. That is broadly how Mr Lawrence put it during the course of his submissions. He emphasised that this was a complex area of law and that it would be wrong to strike out the claim prior to the proper examination of the facts and the relevant documents.

I find myself struggling to accept that broad submission. Prima facie, it seems to me that the alleged fraud (which is relevant to the 8% uplift only) is, subject to one point with which I deal below, too remote from the alleged negligence and breaches of contracts on the part of the defendant which lie at the heart of this case. There is very little in any of the authorities which I have summarised above which would lead me to conclude that, on the assumption that the fraud allegation was well-founded, the inevitable (or even arguable) consequence would be the dismissal of the professional negligence claim on grounds of illegality. Indeed, the claimants are here in a stronger position than the successful claimant in 21^st Century, because the fraud in the present case does not taint the underlying contract which forms the basis of the claim. Putting the point another way, the claimants’ argument as to remoteness appears to be a strong one. Accordingly, on the face of it, I consider that the plea raised at paragraph 58.2 of the defence is very likely to fail.

That preliminary conclusion is subject to one important qualification. As I pointed out to Mr Speaight, the odd thing about this whole issue is that the 8%, which gives rise to the fraud allegation in the first place, is only relevant to the claimant’s alternative calculation of damages. It does not arise out of their primary way of putting their damages claim. But if the alternative way of putting the damages claim was the right way in law of assessing the loss, then I can well see that the defendant would have a strong argument to say that, whilst the comparator should, as a matter of law, be the price paid to the seller for each of the hotels, the 8% cannot be added on top (thereby increasing the damages claim) in circumstances where the 8% is based on a fraudulent arrangement. Thus it might well be the case that the claim for the 8% would fail for illegality, even if the rest of the claim was unaffected by the alleged fraud.

That seems to me to be a much more powerful argument. Indeed, assuming (as I must do for the present purposes) that the allegation of fraud is made out, it seems to me that it would be impossible for the claimants successfully to persuade the court that their damages claim should be uplifted by the tainted 8%. If the fraud is established at trial, but the secondary way of putting the damages claim is found to be the right one, then the obvious solution would be for the court to ignore the 8% uplift, and use as the comparator the price actually paid to the sellers, without the uplift. In that way, the court would not be assisting a claimant to recover a benefit from his own wrongdoing (see paragraph 22 (c) above and Lord Phillips in Stone & Rolls).

Thus, on this analysis, the question of fraud/illegality would be relevant to the claims made. It would not lead to the dismissal of the entire claim, but it would lead to a reduction in the amount of the claim by striking out that particular element of the damages calculation. In that regard, it seems to me that it is no different to the approach taken by the courts in Hewison, and Gray, where the head of claim based on the illegality failed, but the other untainted heads of loss succeeded.

During the course of the arguments there was a good deal of debate as to the likely difficulties, trouble and expense that would be caused if the claimants were obliged to obtain the tax returns lying at the heart of the fraud allegations. This is partly because the relevant returns would be those of the individual investors, not the company vehicles themselves. Once those tax returns had been provided, there would then have to be an analysis of the information which they contained and possibly the exchange of experts’ reports. The whole exercise might well become extremely expensive.

It is unattractive for a party in the position of the defendant here to acknowledge that their assertion may look rather thin now but that, following disclosure and the exchange of witness statements and the like, it might have become much more persuasive, particularly when, at the same time, it is plain that it will cost a good deal of time and effort to reach such a stage. It is contrary to the overriding objective in two ways: it encourages a party to wait for something to turn up, whilst putting the other side to a good deal of trouble and expense whilst they do so.

I have already expressed the view that (aside from the effect on one aspect of the secondary damages claim) I consider that the allegation of fraud is most unlikely to give rise to a conclusion that this professional negligence claim should fail for illegality. I have also expressed concern about the costs if the allegation remains. Both of those things said, I am still a little reluctant to strike out such a claim at this stage, prior to disclosure and any evidence, given the acknowledged complexities in this area of the law. What then is a proportionate response to this application and the issues that it raises?

In the light of my analysis, and questions of proportionality, I have reached the following case management decisions in respect of this application.

On any view, the fraud/illegality allegations raised by defendant cannot be struck out whilst the 8% uplift, which lies at the heart of those allegations, forms an express element of the (secondary) damages claim. It seems to me, therefore, that I ought to give the claimants a choice. If the claimants wish to pursue that element of their claims then they should confirm to the defendant and to the court within 14 days of this judgment that they will do so. In that event, paragraph 58.2 of the defence will not be stuck out and I would rule that the tax returns and the like must form part of standard disclosure (Footnote: ¹).

If in that 14 day period the claimants inform the court and the defendant that they wish to amend to delete their reliance on the 8% discount, then such an amendment would (subject to any matters not previously raised) probably be allowed. If the amendment is allowed, so that the 8% no longer forms a live element of the dispute between the parties, then (for the reasons noted above) the claimants’ position in respect of the striking out becomes much stronger.

In that event, so thin is the illegality argument in the present case, whatever the potential complexities of this area of the law, I would conclude that, if it is not struck out, it must be for the defendant to decide whether it wishes to pursue that allegation to the next stage, namely disclosure, and to understand now the consequences of such a decision. If the defendant decides to pursue the allegation, notwithstanding the fact that the 8% will no longer form part of the claimant’s pleaded case, I would direct that the claimants keep a separate note of the costs that they incur in dealing with that aspect of standard disclosure and that, following the disclosure process, the claimants can make an application for payment of those costs on an interim basis. I would then assess those costs at that stage and order their payment within 14 days.

If at that time, or shortly thereafter, the fraud/illegality argument is abandoned by the defendant, or if it is pursued and fails, then that would only confirm the reasonableness of requiring them to pay the costs of the disclosure exercise in advance of any trial. If, on the other hand, the fraud allegation and the illegality argument are pursued and are ultimately successful, then it would of course be appropriate to make an order at the end of the trial requiring the claimants to repay those disclosure costs.

Although slightly unusual, I consider that this solution is in accordance with the overriding objective, because it requires the defendant to be aware of the costs risks that it will run if, assuming the deletion by the claimants of any reliance upon the 8%, the defendant chooses to maintain the illegality point, an argument which does not seem to me to be at all strong, for the reasons noted above.

For completeness, I should note that Mr Speaight had an alternative argument, to the effect that, because the alleged illegality was not illegality under English law, the claim could not fail in any event. Mr Lawrence disputed that and both parties made reference to the lengthy judgment in Libyan Arab Foreign Bank v Bankers Trust [1989] QB 728. It seemed to me that it was impossible to decide this (potentially very complex) point summarily, and that, in any event, in view of my proposed order, it was unnecessary to reach even a preliminary view on the foreign law issue at this stage.