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18 February 2020
A director who extracted money from a company by way of sham invoices may have a defence to an equitable compensation claim for misappropriation of the company's funds if the director could have lawfully transferred the funds to the same recipients for no value. The Court of Appeal explored this possibility in Auden McKenzie (Pharma Division) Ltd v Patel.(1)
Mr Patel, the first defendant, and his sister, the second defendant, were the sole directors of Auden McKenzie (Pharma Division) Ltd and owned all of the shares therein. Between 2009 and 2014, in order to evade corporation and income tax, Mr Patel paid out £13.8 million against sham invoices purportedly raised for research and development, for which Auden received no value.
Following investigations by Her Majesty's Revenue and Customs (HMRC), which resulted in a settlement, Mr Patel paid £14.6 million to HMRC in respect of income tax, national insurance contributions and corporation tax, together with interest and penalties.
Meanwhile, the Patels sold Auden, which pursued them for "damages and/or equitable compensation for breach of fiduciary duties". There was also a claim, among others, for all "such further orders, accounts, inquiries and declarations as shall be necessary or appropriate in order to fully compensate the Claimants for the Defendants' wrongs".
Auden applied for summary judgment in the sum of £13.1 million (the aggregate amount paid against the sham invoices, less agreed credit for corporation tax paid by Mr Patel as part of his settlement with HMRC) plus interest on its claim "for damages and/or equitable compensation for breach of statutory fiduciary duties".
While Mr Patel accepted that he had acted in breach of his fiduciary duties as a director, he argued that Auden had suffered no loss, claiming that if the payments had not been made unlawfully, the shareholders would have caused the company to make equivalent payments to them as dividends or in another lawful manner.
The High Court gave summary judgment on Auden's application, holding that Mr Patel could not rely on hypothetical payments when he had taken no steps to make those payments. Mr Patel appealed.
The Court of Appeal's starting point on the question of equitable compensation was "the basic rule… that a trustee in breach of trust must restore or pay to the trust estate either the assets which have been lost to the estate by reason of the breach or compensation for such loss".(2) This rule extends to company directors.(3) Any compensation figure should be reduced by reference to the loss that flowed directly from the breach of trust.(4)
As regards Mr Patel's misappropriation of Auden's funds, the Court of Appeal held that a defence might be open to him if, in the absence of the misappropriation, the funds would have been lawfully transferred to the Patels for no value. The court stressed that it was "far from saying that Mr Patel has a defence that will succeed if he establishes the facts on which he relies", but nor was it "prepared to say that it is unsustainable in law".
The court accordingly allowed the appeal and set aside the summary judgment.
As this was a summary judgment application, the issues were not fully examined. However, the decision reveals a tension between an impetus to punish Mr Patel for his breach of fiduciary duty and the fact that the real loss to Auden might have been nil. The Court of Appeal described claims for equitable compensation as a developing area of the law. The facts in this case, described by the court as "striking" and "stark", may test the willingness of the trial court (due to hear the matter later in 2020) to develop the equitable remedies for breach of fiduciary duty.
For further information on this topic please contact Davina Given or Benedict Coxon at RPC by telephone (+44 20 3060 6000) or email (firstname.lastname@example.org or email@example.com). The RPC website can be accessed at www.rpc.co.uk.
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