“That’s the effect of living backwards,” the Queen said kindly: “it always makes one a little giddy at first.”
Should ‘backwards tracing’ be permitted? Or will equity sometimes prevent a victim from effecting a complete recovery from a third party recipient of funds fraudulently paid in breach of trust?
In August 2015 the Privy Council grappled with this fundamental question of legal policy in The Federal Republic of Brazil v Durant International Corporation. The Board (comprising Lords Neuberger, Mance, Carnwath, Toulson & Hodge) concluded that backwards tracing should be permitted. It rejected arguments that it is never permissible, or that the court can never trace the value of an asset whose proceeds are paid into an overdrawn account. However, the circumstances in which this will be permitted are likely to be limited in practice.
What is backwards tracing?
This is best illustrated by a short summary of the facts of the case. The proceedings were brought by the Municipality of São Paulo against two BVI registered companies, Durant and Kildare, in the Royal Court of Jersey. The claim concerned the improper conduct of Paulo Maluf, a former Mayor of São Paulo, and his son Flavio. Bribes were paid to Mr Maluf in early 1998 in connection with a major public road building contract. Mr Maluf subsequently deposited some of those payments into a New York account, in the name of Chanani, which was under the control of his son. Payments were made from the New York account into an account in Jersey, held by Durant. Further payments from the Durant account were made to an account held by Kildare, also with the same Jersey bank.
The Municipality sought to trace payments of $10.5 million into the Jersey accounts. The Appellants (Durant and Kildare) argued that their liability should be limited to approximately US$7.7milion.
Appellants’ reasoning
The first difficulty concerned the last three payments into the Chanani account, which occurred after the final payment into the Durant account. How could these payments properly be traced from the Chanani account to the fund in the Durant account? This would be ‘backwards tracing’ for which the appellants argued there was no sound doctrinal basis. It is not possible, they said, to trace funds from account A through account B to account C, if the transfer of funds from account B to account C occurs prior to the transfer of funds from account A to account B.
The second difficulty concerned the fact that the Chanani account was a mixed account. The appellants relied on the ‘lowest intermediate balance’ principle. In other words, where a claimant’s money is mixed with other funds and drawings are made on the account, the bank balance may be reduced to an amount smaller than that of the claimant’s money at any time. This was said to limit the claimant’s recovery to the maximum that can be regarded as representing his money. For instance, assume that an account contains £1000. An amount of £500 of a claimant’s money is paid into the account. A withdrawal of £700 then occurs. In this scenario, there can be no recovery of the remaining £800 by the claimant. This necessarily represents the funds originally in the account.
Explanation
On two occasions payments were made from the Chanani account to the Durant account. The sums exceeded the maximum that could be said to have come from the earlier bribes, having regard to the original balance on the account. This money must therefore have come from other sources. Thus, these sums were said to be irrecoverable.
There is logic to these arguments. They are flip sides of the same coin. The rules of tracing involve determining whether one form of property interest is properly to be regarded as substituted for another. The original property interest cannot metamorphose into a later property interest, if it has ceased to exist. Likewise, a property interest cannot turn into (or provide a substitute for) something which the holder already has; the later acquisition cannot be the source of the earlier. There is considerable support for these arguments from a good deal of authority and academic writings. This was recognised by the Board.
However, it is ultimately a question of policy whether the law ought to allow backwards tracing. The precarious position of unsecured creditors is a particular concern. If backwards tracing were permitted, a claimant with an unsecured claim would be able to reduce the defendant’s assets. This would limit any recovery by other unsecured creditors in the event of an insolvent winding-up.
Why should a claimant in equity be allowed to jump ahead of other creditors and disturb the pari passu principle? Limiting a claimant’s claim to that property which can properly and fairly be said to be his, as opposed to being available to all creditors, is one reason for the restrictive traditional rules of tracing, as a matter of principle. Yet, conversely, why should a beneficiary of a constructive trust be deprived of full recovery from a solvent trustee in circumstances where there is no immediate prospect of the trustee becoming insolvent?
The Board recognised that it is inaccurate to speak of tracing one asset into another. Money may be traced into and out of a bank account but there is no money as such in the account; only a series of debits and credits are causally and transactionally linked. Similarly, it is inaccurate to speak of tracing one asset into another. The original assets still exist in the hands of the new owner or it may have become untraceable. What is traced, therefore, is the value inherent in the asset, as opposed to the physical asset itself. The question of whether value can be properly traced into another asset depends on whether there is a sufficient transactional line.
Determination
The Board determined that the court should concentrate on the substance of the transaction and not the form, in considering whether an equitable remedy should be available. It was crucial for courts to be able to pierce the camouflage of interconnected transactions, in a time of increasingly sophisticated frauds and elaborate methods of money laundering. This was in order to perceive their true overall purpose and effect, rather than being hidebound by the strict chronological order in which associated events occurred.
That said, the Board was (rightly in my view) cautious about permitting backwards tracing in every case. The Board rejected the proposition that money that was used to pay a debt could be traced into whatever had been acquired in return for the debt. Rather, it was emphasised that a claimant must establish a co-ordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim. This would involve looking at the whole series of transactions. It would also depend on what inferences could be drawn from the proved facts, particularly since the testimony of the trustee would, if available, often be of little value. This investigation is necessary to warrant the court attributing the value of the interest acquired to the misuse of the trust fund.
In this case the Board was also influenced by the admission in the pleadings that the various sums received by the Durant and Kildare accounts were linked to those paid out of the Chanani account.
It remains to be seen to what extent the bounds of backwards tracing will be pushed in future cases.
