The illegality defence, or ex turpi causa, cites the principle that a person should not be able to profit from his or her own wrong.
In a recent case the Supreme Court considered the illegality defence when it was raised by two former directors of a wound-up company called Bilta, another company called Jetivia and Jetivia's chief executive.
A liquidator, acting on behalf of Bilta, claimed that the directors, Jetivia and its chief executive conspired in a fraud by which VAT was added to the value of transactions between Jetivia and Bilta in Jetivia's favour and which involved Bilta being deliberately run into insolvency to avoid paying the VAT to HM Revenue and Customs (HMRC). According to the judgment, Bilta's debt to HMRC is more than £38 million.
The liquidator has tried to recover compensation from the former Bilta directors, Jetivia and its chief executive over the alleged fraud.
Under the Insolvency Act, liquidators that find that companies they are winding up were being operated in a way which had the intention of defrauding creditors or for any fraudulent purpose can seek a court order forcing people who were "knowingly parties" to that activity to "make such contributions (if any) to the company’s assets as the court thinks proper".
The former Bilta directors, Jetivia and its chief executive raised the illegality defence against the liquidator's action by claiming that Bilta could not obtain compensation from others for wrongdoing where the company itself was involved in that wrongdoing. Their claim was founded on the basis that the two former directors being pursued by the liquidator were the sole directors and shareholders of Bilta and that their illegal actions must be attributable to Bilta as a result.
However, the seven Supreme Court judges dismissed the appeal. They did so because they said that the wrongdoing of the former Bilta directors could not be attributed to Bilta itself. The company, through the liquidator, was therefore not precluded from pursuing its case, they ruled.
Summarising the conclusions reached, Lord Neuberger said: "Where a company has been the victim of wrong-doing by its directors, or of which its directors had notice, then the wrong-doing, or knowledge, of the directors cannot be attributed to the company as a defence to a claim brought against the directors by the company's liquidator, in the name of the company and/or on behalf of its creditors, for the loss suffered by the company as a result of the wrong-doing, even where the directors were the only directors and shareholders of the company, and even though the wrong-doing or knowledge of the directors may be attributed to the company in many other types of proceedings."
Some of the judges said that the appeal raised by the former Bilta directors, Jetivia and its chief executive could also be rejected on the basis that the illegality defence they raised runs contrary to statutory policy. The Companies Act imposes fiduciary duties on company directors, which among others require them "to consider or act in the interests of creditors of the company".
However, Lord Sumption disagreed with the views of Lord Toulson and Lord Hodge. He said that the Companies Act and common law principles cannot be interpreted as imposing a "civil liability on directors notwithstanding the illegality defence". He said it was also "unnecessary and undesirable" to dismiss the illegality defence in the way Lords Toulson and Hodge suggested in this case.
Lords Toulson and Hodge said their disagreement with Lord Sumption on the issue showed the need for a review of how the illegality defence should be applied. They said the Supreme Court should consider a Law Commission report on the issue and look at how the issue is addressed in other jurisdictions.
Lord Neuberger agreed. He said "the proper approach to the defence of illegality needs to be addressed by this court (certainly with a panel of seven and conceivably with a panel of nine Justices) as soon as appropriately possible".