Conceptualizing Backwards Tracing: a paradigm for vindicating the property rights of another

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The case of Durant (2015) involved a payment of bribes totalling US$10.5 million into a bank account; while at about the same time a total of US$13.5 million had been paid out of that account to the defendants.

Yet, the the Privy Council held that all the bribes could be traced to the defendant.

The material facts of Brazil v Durant International Corp [2015] UKPC 35

The defendant companies Durant and Kildare registered in the British Virgin Islands were found previously by the Court of Appeal in Jersey to be liable to the Brazil municipality as constructive trustees of US$10,500,055.35 representing bribes to Mr Maluf mayor of the municipality in relation to a major public road building contract ( [2015] UKPC 35)

Over the period from 22 January to 23 February 1998 there were four payments from the Durant account to an account held by Kildare also with Deutsche Bank in Jersey (the Kildare account). These payments totalled US$13,500,000.

The municipality claimed to trace the amount of the payments (US$10,500,055.35) to the Durant account and thence to the Kildare account. It asserted that the full amount of those bribes was paid
from the Chanani account to the Durant account
([2015] UKPC 35)

Part of the Defendants’ claim included the argument that the final three payments into the Chanani account identified as proceeds of bribery between 26 January and 6 February 1998, were paid after the final payment from the Chanani account to the Durant account and, therefore, could not be traced to the defendants because the doctrine of backwards tracing lacked ‘sound doctrinal basis’. (para.10,[2015] UKPC 35).

Does the doctrine of tracing extend to following value into a previously acquired asset?

A seminal case relied upon by the Privy Council in Durant was Foskett v McKeown [1998] Ch 265, in which the claimants, purchasers of a property development scheme whose monies were held on trust, were permitted to trace their money into the proceeds of a life insurance policy purchased by a trustee for his children.

Lord Millet, speaking in the House of Lords recognized the seemingly artificial way in which money paid into or paid out of a back account is often conceived. His Lordship opined:

We speak of tracing money into and out of the account, but there is no money in the account. There is merely a single debt of an amount equal to the final balance standing to the credit of the account holder.

We also speak of tracing one asset into another, but this too is inaccurate. The original asset still exists in the hands of the new owner, or it may have become untraceable.

The claimant claims the new asset because it was acquired in whole or in part with the original asset. What he traces, therefore, is not the physical asset itself but the value inherent in it (Per Lord Millet, para .26 [2015] UKPC 35)

Drawing from Lord Millet’s analysis in McKeown, when one traces into the bank account of another, it is not actual dollars or cents that form the subject matter of the equitable tracing claim. Since money credited in a bank account is merely a convenient way of describing a much more complex underlying legal concept:

a chose in action or a personal right to be paid a debt owed to a customer by her bank, which remains the legal beneficial owner of whatever sums of monies paid by a customer funding her account.

In this context, the extinguishment of a debt owed by a bank or debtor bank account holder to another is argued by Prof. Conaglen to be distinguished from the acquisition of an asset; although a debt may be conceived as ‘an asset in the hands of the creditor’, it is a liability which lacks any asset value and ‘ceases to exist when it is paid.‘ ( Lord Toulson, para. 29, [2015] UKPC 35).

It is, therefore, not entirely accurate to say that a person is tracing one asset into another since, as Lord Millet reasons, ”the original asset still exists in the hands of the new owner, or it may have become untraceable’‘ (Per Lord Millet, para. 26 [2015] UKPC 35). ‘

Instead, what is sometimes described as a transfer of money from one bank to another is ”simply a series of debits and credits which are causally and transactionally linked…..What he traces, therefore, is not the physical asset itself but the value inherent in it” (Lord Millet quoted by Lord Toulson, para.26 [2015] UKPC 35).

The claimant, therefore, instead of suing the bank, would sue the account holder so as to claim the proceeds of the money in her hands (para .26 [2015] UKPC 35, having traced ”trust funds through the payment of a debt into assets that the trustee has acquired.” (Lord Millet quoted by Lord Toulson, para. 30, [2015] UKPC 35). Prof. Conaglen recognizes that such an approach would not be ‘conceptually impossible’, but would be contingent upon legal policy accepting it.

Such a policy approach was arguably evident in a Canadian case which the Privy Council in Durant considered: Agricultural Credit Corpn of Saskatchewan v Pettyjohn [1991] 3 WWR 689, 79 DLR (4th) 22, 90 Sask R 206 (Sask CA);

The Pettyjohns in that case had succesfully applied to a credit corporation for loans to purchase cattle before they went on to use a credit line with their bank as their initial source of funds to complete the purchase.

Contemporaneously with the purchase or just after it took place, the credit corporation obtained security over the cattle when the loan agreements were executed, and money was transferred to reimburse the bank. In due course, the Pettyjohns became insolvent having sold the cattle and purchased replacement cattle.

The legal issues before the Sask CA comprised of two questions:

whether the lender had a right to security over cattle which were purchased after the loan
application had been approved but before the loan moneys had been advanced: and, if so, whether the lender was entitled to trace the value of its original security into the replacement cattle.
” (para. 35 [2015] UKPC 35).

The Sask CA, faced with a seemingly intractable problem, considered the following question:

How can it be said that the moneys advanced were used to acquire rights when the purchase had already taken place and the rights already acquired?

Yet, in a cogent analysis which the Privy Council in Durant agreed with, the Sask CA recognised that its would not be reasonable from a commercial perspective to divide the various transactions in such a detailed way, according to the strict timeline in which they took place.

Instead they reasoned that the PettyJohns had used the value given to them by the credit corporation to pay off the interim financing provided by the bank; These transactions to acquire rights in the cattle were carried out by them with the objective that the bank be repaid by the credit corporation.

As the Sask CA stated:

The fact that the use of the value given was, due to the nature of the transaction, after the acquisition of rights does not alter the conclusion that the value given was used to acquire those rights.”(para. 36 [2015] UKPC 35).

The nexus evident on the facts justifying the CA’s decision was the finding that value had been given by the credit corporation so as to enable the initial financing provided by the bank for the purchase of the cattle to be paid off.

The Sask CA was not deterred by the fact that the payment was made by the corporation subsequent to the bank advancing the loan for the acquisition of rights in the cattle. The precise sequence in which payments were made, first by the bank in purchasing the cattle , and then by the credit corporation towards discharging the debt owed by the PettyJohns to the bank was not as significant as the finding that value had indeed been given by the corporation for the acquisition of rights in the cattle.

Conceptualizing a model of Backward Tracing acceptable to legal Policy

Consider Lionel D. Smith’s conception of backward tracing:

Suppose that D buys a car from C …….on credit; he takes ownership of the car, but he is C’s debtor in respect of the purchase price. A day later, D pays the debt with the money being traced. Can we trace from the money into the car as before? It is difficult to see why notwhen money is used to pay a debt, it is traceable into what was acquired for the incurring of the debt.…….”

instead of tracing through substitution in D’ hands, we could trace the substitution in C’s hands. When the car is bought for cash, the car is the traceeable proceeds of the money, that is the substitution in D’s hands.” (LD Smith (1977, at 146) quoted in Penner, The Law of Trusts, p.338).

Smith’s analysis underscores the idea that the Claimant’s property rights are perceived to endure even when his or her money has been fully used by the defendant to pay a debt, if indeed the debt was incurred in order to acquire an asset.

The acquisition of such an asset is rightly termed a substitution in D’s hands, since it represents the traceable proceeds of the claimant’s money. (Smith, 1977, at 146).

Kayleigh Bloomfield argues that such a situation involves ”tracing through payment of a debt as opposed to tracing into payment of a debt”since the debt is merely an ‘intermediate step’ enabling the defendant to acquire an asset. (Trusts & Trustees, Vol. 23, No. 2, March 2017, pp. 227–241).

if, as Lord Millet argues, what the claimant traces is not the physical asset itself ,but the value inherent in it” (Lord Millet quoted by Lord Toulson, para.26 [2015] UKPC 35), the tracing process does not end with claimant’s funds being used to discharge the debt incurred by the defendant, but continues through the debt into the asset acquired ‘by means of incurring the debt.’ (Kayleigh Bloomfield, Trusts & Trustees, Vol. 23, No. 2, March 2017, pp. 227–241).

Conceiving such a model of backward tracing that seeks to identify substitutes in the hands of the defendant acquired in the process of, but not necessarily contemporaneously with, the incurring of a debt is not without juridical basis.

Arden LJ speaking in Relfo Ltd (in liquidation) v Varsani [2014] EWCA Civ 360 argued:

Agip is authority for the proposition that monies held on trust can be traced into other assets even if those other assets are passed on before the trust monies are paid to the person transferring them, provided that that person acted on the basis that he would receive reimbursement for the monies he transferred out of the trust funds.” Relfo Ltd (in liquidation) v Varsani, [2014] EWCA Civ 360, (Transcript: Wordwave International Ltd (A Merrill Communications Company)

The receipt of such a ‘reimbursement’ or a traceable substitute of the claimant’s property, if intended by a defendant to enable his prior acquisition of an asset, arguably provides a juridical basis for backward tracing.

Arden LJ’s analysis was based on the facts of AGIP (Africa) Limited v Jackson & Others (1990) 1 Ch. 265, a case which involved an accountancy firm that used a number of shell companies to launder money traceable to the Claimant’s company ; In doing so, Ardern LJ pointed out that Agip is also an authority for the idea that tracing of money into substitutes is not contingent upon the payments occuring in a chronological order. (para. 63, per Arden LJ, [2014] EWCA Civ 360).

Such a model of backward tracing that traces throught a debt and into substitutes in the hands of the defendant may be perceived to conflict with the lowest intermediate balance rule stated in another case, James Roscoe (Bolton) Ltd v Winder[1915] 1 Ch 62, 8).

The rule in Roscoe recognizes that the tracing mechanism is limited in its application to only tracing into the lowest sum of the account balance representing the Trust monies. This means that if trust monies deposited into an account are depleted, to the point that the account goes into overdraft, the tracing process ceases.

Sargant J in Roscoe held that the vendor of the company concerned was only entitled to trace £25
‘representing the lowest sum to which the balance on the account had fallen between the payment of the £455 into the account and the purchaser’s death.” ( Lord Toulson, para. 19 [2015] UKPC 35_

The alternative to such a strict causal approach to equitable tracing posited by the lowest intermediate balance rule might be to adopt a form of backward tracing posited by Lord Toulson in Durant;

a judicial approach informed by the ‘substance of the transaction in question and not upon the strict order in which associated events occur.’ ( Lord Toulson concurring with Sir Richard Scott V-C’s observation in Foskett v McKeown) , para:38, [2015] UKPC 35);

One which does not focus primarily on the sequence or the order in which bank accounts are credited or debited, or whether ‘a debit appears in the bank account of an intermediary before a reciprocal credit entry.’ ( Lord Toulson, para:38, [2015] UKPC 35), but on the entirety of the transaction in question.

As Lord Toulson argues in Durant, this would depend on the Claimant establishing:

a coordination between the depletion of the trust fund and the acquisition of the asset which is
the subject of the tracing claim, looking at the whole transaction, such as to warrant the court attributing the value of the interest acquired to the misuse of the trust fund
.’ ( Lord Toulson, para: 40, [2015] UKPC 35),

How might the court discern such a coordination between the use of a trust fund and the acquisition of an asset?

A crucial factor would be to ascertain if a loan taken out by the defendant had been done with the purpose of discharging it with the claimant’s money. (Virgo, Principles of Equity and Trusts, p.604).

Matters may be become further complicated, as Prof. Graham Virgo notes, where money has been borrowed from a third- party such as a bank in order to purchase the vendor’s property as in the case of Boscawen v Bajwa [1996] 1 WLR 328. (Virgo, Principles of Equity and Trusts, p.604).

Should it matter as a question of legal policy ‘whether the money was borrowed from third party or the vendor , which will turn on how wide the notion of ‘the same transaction’ is. (Virgo, p. 604). As Prof. Virgo argues, ” it is surely possible to attribute value from the original asset to the substitute asset if the claimant’s money had been used to discharge a debt incurred in respect of the substitute asset.’

A more principled approach may be for the Courts to shift their focus away from the causal and arithmetic limitations of what might be traced into, in cases involving the misapplication of proprietary rights of a Claimant, and be ‘concerned with the attribution of value‘ derived from the Claimant’s money as traceable into a substitute asset, if such an asset had indeed been acquired by a debt incurred that was discharged with the Claimant’s money.

In this respect, the use of the Claimant’s money to discharge such a debt would, as Smith argues, be ‘just delayed payment’. (Tracing into a payment of a debt” (1995) 54 CLJ 209, 292 in Virgo, The Principles of Equity and Trusts, p.602).

The Privy Council in Durant undoubtedly provides us with an eloquent approach to conceptualizing backwards tracing; one that examines the entire context in which the interconnectedness of various credits and debits of bank account funds are effected between intermediaries in the banking world and beyond; Such transactions may be perceived as ‘part of a coordinated scheme’ by individuals such as money launderers to defraud beneficial owners of their funds. The merit of such an approach is that it provides the Courts with an unobscured vision of the ‘true overall purpose and effect’ of the transaction in question. (Lord Toulson, para:38, [2015] UKPC 35).

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