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The Illegality Defence in Civil Proceedings: Corporate Attribution, Ex Turpi Causa, and In Pari Delicto

7 minute read

One significant aspect of the Supreme Court of Canada decision in Livent (Receiver of) v Deloitte & Touche LLP, [2017] 2 S.C.R. that gets little attention is its analysis of the illegality defence and the applicability of the corporate attribution doctrine in cases of corporate fraud.

The doctrine provides that because a corporation can only act through its agents, the knowledge and actions of corporate officers and directors, when acting within the scope of their authority (whether actual or apparent), are presumptively attributable to the corporation.  Therefore, fraudulent conduct of the corporation’s directing minds, or their knowledge of a fraud, may be attributed to the corporation itself.

Should the corporation seek relief from a third party to recover its losses arising out of the fraud, the corporation would be relying upon its own illegal conduct and, therefore, the claim should be barred.

There is a distinction between fraud committed on behalf of the corporation and fraud committed against it.  In the latter circumstances, the corporate fraudster has acted against the interests of the corporation and those actions are not attributable to the corporation. This concept is articulated in Canadian Dredge & Dock Co. v. The Queen, [1985] 1 SCR 662.

In Livent, the corporation (through its Receiver) sued its auditors for having failed to detect the pervasive fraud that had been perpetrated by management.  The Court (at para. 98) referred to “the defence of illegality”, which will apply if the fraudulent conduct of management is attributable to the corporation:

The defence of illegality bars an otherwise valid action in tort on the basis that the plaintiff has engaged in illegal or immoral conduct and therefore should not recover (Hall v Hebert, [1993] 2 S.C.R. 159 at p. 169…)… Grounded in public policy it is available in very “limited” circumstances, only when it is necessary to preserve “the integrity of the justice system”.  And the integrity of the justice system will only be compromised “where a damage award in a civil suit would, in effect, allow a person to profit from illegal or wrongful conduct…”

The Court emphasized that policy considerations should drive the analysis and that they may be different in civil cases than in criminal cases, such as Canadian Dredge & Dock:

…the policy factors which would weigh in favour of imputing a corporation with the illegality or wrongdoing of its directing mind flow from the ‘social purpose’ of holding a corporation responsible for the criminal acts of its employees where those acts are designed and carried out, at least in part, to benefit the corporation.

However, in civil cases, because the doctrine is one of “judicial necessity”, the rationale for its application “fades away” where “it would not provide protection for any interest in the community” or “would not advantage society by advancing law and order”.  Therefore, courts retain the discretion to refrain from applying the doctrine when it would not be “in the public interest to do so”.

In Livent, the Court found that there was no public policy purpose to attributing the wrongful conduct of management to the corporation to provide a defence to the auditors because the very purpose of the statutory audit was to provide a means by which fraud and wrongdoing may be discovered.

This was determinative of the outcome. In fact, this conclusion remains a matter of debate because an audit expressly provides no more than “reasonable” assurance that a corporation’s financial statements are free from material misstatement, but does not provide a guarantee.

The Ontario Court of Appeal recently applied these principles in Caja Paraguaya de Jubilaciones y Pensiones del Personal de Itaipu Binacional v Garcia, 2020 ONCA 124.  The Plaintiff (Cajubi) was a Paraguayan pension fund that was defrauded by the Defendants, who worked in concert with insiders, the fund’s president, vice president, and treasurer.  Cajubi invested over $34 million in Canadian investments and, unbeknownst to investors, both the Defendants and the insiders received commissions and kick backs of 10% of the investments. False investment statements were prepared which did not disclose the kick-backs and also showed non-existent monthly returns.

When the financial crisis intervened, one of the investments was liquidated and reinvested in a sham investment which was diverted to a bankrupt and fraudulent colleague and the funds were dissipated.  Once the schemes became apparent, the insiders were removed from office and jailed in Paraguay. New management of Cajubi brought this action in Ontario to recover its losses. The trial judge found that the Defendants were responsible for Cajubi’s losses as the investments would not have been made but for their fraudulent misrepresentations.

On appeal, the Defendants argued that the trial judge had failed to consider their defence based upon the corporate identification doctrine.  Although it is not expressly stated in the decision, presumably the Defendants argued that the wrongful conduct of the insiders should be attributed to Cajubi and thereby bar its claim against the Defendants.  Relying upon the Livent case, the Ontario Court of Appeal stated:

The corporate identification doctrine is not a free-standing rule; rather it is used for the purpose of applying the ex turpi causa doctrine which is also relied upon by the appellants. The overriding concern is whether recovery by the respondent would damage the integrity of the legal system……

Although the Court of Appeal noted that the trial judge did not refer to either corporate attribution or ex turpi causa, it found that he had considered and rejected their application when he made the following findings:

  • The fraud committed with the knowledge of insiders did not lose its character of fraud; the appellants knew that the insiders were acting  corruptly and worked with them to prevent Cajubi from discovering that fact so the appellants’ fraud should not be excused; and
  • Recovery by Cajubi would not damage the integrity of the justice system, a conclusion with which the Court of Appeal agreed because applying the doctrine would deprive the company, vulnerable to fraud, of any civil remedy to the detriment of its shareholders and creditors and would permit the fraudsters to pocket their ill gotten gains with impunity.

In both cases, the doctrine of corporate attribution was rejected.  However, the public policy reasons supporting this outcome in the Cajubi case are much stronger than in the Livent case:

  • In Livent, the Court considered who should bear the loss in circumstances in which the  corporation derived some benefit from the fraud (because it would otherwise have been insolvent much earlier) and both the corporation and the defendant auditors were innocent – the former having been defrauded by its management and the latter having failed to detect the fraud.  (The Court left open the possibility of a different outcome in a case of a one-person corporation in which there are no innocent stakeholders.)
  • In the Cajubi case, the Court had to allocate the loss between the corporation, which derived no benefit from the fraud and whose investors and creditors were harmed, and the fraudsters.   The public policy choice is clear where the defendants are not innocent.

Neither Livent nor the Cajubi case considered the defence of in pari delicto, which is another approach to the doctrine of corporate attribution that is well-developed in the United States. It requires a relative weighing of the fault of the parties and may bar a claim where the plaintiff corporation is equally or more culpable than the defendant.  It is easy to see that the result in Livent could have been different had in pari delicto been applied.

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Lisa C. Munro, Q.Arb

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