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Brief Counsel

Substance over form in equitable tracing – Privy Council

28 September 2015

A recent Privy Council judgment may make it easier for victims of fraud to trace property through complex money laundering schemes and enforce against constructive trustees. 

The decision is persuasive rather than binding but, if followed in New Zealand, has the potential also to affect third parties – in ways which may or may not be beneficial.

Tracing – the evidentiary process

Tracing is an evidentiary process that allows a beneficiary of a trust (including victims of fraud seeking the remedy of a constructive trust) to recover property that is an identifiable substitute for other property. 
Because it is subject to strict rules of equity, including the need to demonstrate the property’s continued existence, it is not possible to continue to trace an asset once it has ceased to exist and there is no longer any identifiable substitute property.  Neither is it possible to trace into a pre-existing asset.
This has meant that:
  • funds cannot be traced into an overdrawn bank account, even if the account is subsequently put in credit, and
  • ‘backward tracing’ – tracing property to an asset the defendant has previously acquired, rather than a substitute for the beneficiary’s property – has not been permitted.

A road to nowhere?

In Federal Republic of Brazil v Durant International Corporation (Jersey) [2015] UKPC 35, the former mayor of Sao Paulo had received US$10.5 million in bribes in connection with a major road building contract in Brazil.  He sought to launder this money through a series of transfers through bank accounts held by BVI companies.  The bribe proceeds were first paid into an account in New York and then on to an account in Jersey. 

The issue arose due to the timing of the payments.  The final US$2.8 million of bribe proceeds were paid into the New York account shortly after the final payment from New York to the Jersey account.  The BVI companies, liable under a constructive trust, argued that only US$7.7 million could be traced from New York to Jersey.  The BVI companies claimed that, under the ‘no backward tracing’ principle, the balance of the final US$2.8 million could not be traced into the existing funds in the Jersey account.

It’s not the journey, it’s the destination

The Board held that backward tracing could be permissible in certain situations.  It recognised that this was a matter of policy:

the development of increasingly sophisticated and elaborate methods of money laundering, often involving a web of credits and debits between intermediaries, makes it particularly important that a court should not allow a camouflage of interconnected transactions to obscure its vision of their true overall purpose and effect.

The Board also held that, where there is a sufficiently close causal connection, it could be possible to trace the value of an asset the proceeds of which are paid into an overdrawn account.

Chapman Tripp comments

Fraudsters can often exploit discrepancies in the regulatory regimes between jurisdictions to transform assets and place them out of reach.  The decision is a further signal of the courts’ willingness to adapt in order to deal with such complex schemes.

The New Zealand High Court has previously been willing to exercise its discretion in favour of a plaintiff by impressing a defendant’s property with a remedial constructive trust.  However the Court of Appeal confirmed in Fortex v MacIntosh that this discretion is limited by considerations of third parties and statutory insolvency regimes. 

A more flexible interpretation of the rules of tracing will not, on the face of it, include any such consideration of any effect on other creditors.  If a plaintiff is more easily able to assert a proprietary claim then this would give them priority over unsecured creditors if the defendant is insolvent.

It is not clear what the test of a ‘close causal connection’ will entail and this will potentially lead to uncertainty.  However it seems apparent that any claim for backward tracing will come with a high evidentiary threshold: the claimant must establish clear coordination between the depletion of the trust fund and the acquisition of the asset which is the subject of the tracing claim. 

This may be difficult to demonstrate.  For example, the Board considered the case of Re Goldcorp Exchange Ltd, previously heard by the Privy Council from the New Zealand Court of Appeal.  In that case, an equitable lien over stocks of mixed bullion was limited to the lowest balance of bullion held at any time, as stock had been depleted with no identifiable substitute and there was no evidence to link later purchases of bullion with earlier depletion of stock.  The Board did not doubt the correctness of that decision: in that case there was no evidence of an overall transaction embracing the coordinated outward and inward movement of assets.

While this high threshold may not necessarily protect creditors’ interests, it will restrict proprietary claims to cases where a corrupt transaction is self-evident on the facts.

Our thanks to Sarah Quilliam-Mayne for writing this Brief Counsel.  For further information please contact the lawyers featured.

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