ABC, Sanctions and illegality – beware of illegal contracts
Banks today are justifiably concerned about protecting themselves through their client KYC, relationship management and documentation against claims that they have breached, anti-money laundering anti-bribery and anti-corruption legislation (sometimes referred to as “ABC” provisions) and applicable sanctions legislation. Recent stringent financial penalties, restrictions on business activities and the wider PR impacts of transgressions have been well publicised. Banks are also mindful that their clients should also be ABC and sanctions compliant, not just in their relationship with the bank but more widely in their business behaviour. Failure by a bank customer to comply with its covenants and representations requiring compliance with such measures are intended to give the bank a right to terminate a credit facility, seek repayment and avoid potentially damaging affiliation with non-compliant clients. The protections are largely there to both demonstrate it adopts prudent measures in its dealings with its counterparts, and to give a bank options in order to protect its position from a regulatory and compliance perspective by exiting a relationship.
In a trade and receivables finance context, there is also an added question which the bank should consider. What happens if the contract between the customer and its counterparty supplier or purchaser is itself illegal due to, for example, sanctions or ABC breaches (or any other form of illegality, such as illegal tax avoidance)? If the bank is relying on acquiring title to, or security interests in, the rights of its customer to receivables or inventory, the contract may present more than a regulatory problem for the bank should it be forced to seek enforcement of such rights derived from what could amount to an “illegal” contract.
If the counterpart is able to successfully claim the “illegality defence” when the bank demands payment or performance, the bank may be at risk of losing its right to make any recovery from the asset it was financing. If the bank’s customer has illegally entered into, for example, a contract which is subject to sanctions applicable to the customer, the bank relying on an assignment of its customer’s rights to payment may be exposed to the counterpart seeking to claim that it should not have to pay because the bank had stepped into the shoes of the original offending party.
The illegality defence has received recent reconsideration by the Supreme Court in the case of Patel v Mirza (2016). Prior to Patel, it had long been a principle in English law that “[n]o court will lend its aid to a man who founds his case upon an immoral or illegal act” (Lord Mansfield in Holman v Johnson (1775) as reconfirmed by the House of Lords in Tinsley v Milligan (1994). Successfully arguing the illegality defence will lead to the contract in question being void. Whilst this tenet of case law holds true following the Patel case, the exact degree and nature of illegality required to defeat such a case has not been so easily determinable. Patel marked a change of direction as the Supreme Court rejected the so-called “rules based” approach adopted previously in Tinsley in favour of looking at a range of factors to determine that the defence of illegality could be used only where enforcing the claim would be harmful to the legal system and contrary to the public interest. The guideline questions set down by the Supreme Court to assess whether allowing a claim would harm the public interest were:
- whether the underlying purpose of the law which has been broken will be enhanced by denying the claim;
- whether there were any other relevant public policies which might be made ineffective or less effective by denying the claim; and
- whether denying the claim would be a proportionate response to the illegality.
In the Patel case, Mr. Patel transferred £620,000 to Mr. Mirza. Using this money Mr. Mirza was to place a bet on the movement of a company’s listed share price with the benefit of insider information that he was to obtain. The insider information failed to materialize, with the result that Mr. Mirza did not place the bet. Mr. Patel then asked for his money back; Mr. Mirza refused relying on the defence of illegality. Under the new approach, Mr. Patel was found to be entitled to restitution of his money.
The facts of the case may not in themselves be a cause for concern for lenders (although the illegal insider information related to a bank’s shares), but the case and its outcome in the Supreme Court should remind banks that due diligence on their customer contracts is not just for their own regulatory compliance requirements. There could be credit consequences as well. If a customer’s debtor refuses to pay on grounds of illegality applying to the contract the bank is seeking to enforce as assignee, how will a court, applying the new “range of factors approach”, decide whether the use of the defence is proportionate to the “illegal” claim of the bank?