UK Supreme Court: Does the FSA Need to Give a Cross-Undertaking as to Damages in Favour of Third Parties?

8 12 2012

FSA On 12 and 13 December 2012, the UK Supreme Court will be hearing an extremely interesting appeal. The case of The Financial Services Authority (a company limited by guarantee) (Respondent) v Sinaloa Gold plc and others (Respondents) and Barclays Bank plc (Appellant) UKSC 2011/0244 concerns cross-undertakings, damages, freezing injunctions and third parties. The issue thrown up by the appeal is whether the Financial Services Authority (FSA) should generally be required to give a cross-undertaking in damages to third parties affected by a freezing injunction obtained pursuant to its statutory regulatory functions over and above the costs incurred in complying with the order. See Supreme Court’s judgment here

I. Background

The FSA regulates financial services and markets under the powers and duties conferred upon it by the Financial Services and Markets Act 2000 (FSMA). In December 2010, the FSA commenced proceedings in the Chancery Division against the three named defendants, Sinaloa Gold (S), PH Capital Invest (PH) and Mr Glen Hoover (GH), whom it alleged were involved in what is commonly referred to as a “boiler-room fraud” involving the sale of S’s shares.

The FSA obtained a freezing (or Mareva) injunction in relation to assets owned by S. The injunction contained an undertaking to compensate third parties for loss suffered as a result of it, extending beyond merely the costs of complying with the order. The FSA then applied to have that undertaking removed and S, having been notified of the injunction, sought to be joined as an intervenor to oppose the application. At first instance, the High Court refused the application.

The affected third party, Barclays Bank plc (B), intervened and contended that the order should contain a cross-undertaking in favour of third parties in the standard form, which would cover both costs and losses. The High Court held that, in obtaining injunctive relief, the FSA was not required to give a cross-undertaking in damages to defendants but it was required to give the usual third party cross-undertaking. The High Court took the view that a third party should be protected from any loss suffered should it later transpire that the injunction had been wrongly granted and that the court’s discretion in enforcing any undertaking would provide sufficient protection for the FSA.

S is a UK registered company and GH is one of its directors and is said to control the company. In association with an individual or individuals trading as PH, GH had arranged for shares in S to be offered for sale to third party investors at prices ranging from 62 pence to 91.5 pence per share. The value of the company was based on various gold and mineral concessions which it claimed to have with parties in Mexico and the United States.

For the FSA, the share sale scheme was a fraud because (a) the concessions either do not exist or are worthless and (b) the proceeds of sale obtained from the disposal of the shares had been dissipated to parties unconnected with the company. Moreover, S did not have an approved prospectus for the sale of its shares as required by section 85 (Prohibition of dealing etc. in transferable securities without approved prospectus) of FSMA. So the offer of the shares for sale was therefore unlawful and a criminal offence. GH and those behind PH had allegedly committed breaches of sections 19 (The general prohibition) and 21 (Restrictions on financial promotion) of FSMA by inviting third parties to invest in the shares.

On 17 December 2010 the FSA made a without notice application for a freezing order against the defendants. The form of order sought and granted by the judge (Mr Kevin Prosser QC) prohibited any further sales of S shares and restrained all three defendants from disposing of or dealing with their assets worldwide up to a value of £858,266.97.

Appendix B of the order stated in paragraph (1) that the FSA did not offer a cross-undertaking in damages but included in paragraph (5) the standard form of undertaking to third parties that:

The Applicant will pay the reasonable costs of anyone other than the Respondents which have been incurred as a result of this order including the costs of finding out whether that person holds any of the Respondents’ assets and if the court later finds that this order has caused such person loss, and decides that such person should be compensated for that loss, the Applicant will comply with any order the court may make.

The claim form was issued following the without notice hearing. The FSA sought declaratory relief that the defendants have committed breaches of sections 85, 19 and 21 of FSMA; an injunction restraining them from committing any further such breaches and orders under sections 380(2) (Injunctions) and 382(2) (restitution orders) for the repayment of the investors’ monies or the payment of a just sum to compensate them for their loss.

At the return date for the continuation of the freezing order, David Richards J drew attention to a possible inconsistency between paragraphs (1) and (5) of the order of 10th December but decided to continue the injunction in substantially the same form until a later return date. The undertaking in favour of third parties is a standard form provision in the form of freezing order contained in the Commercial Court Guide and the judge expressed the view that it operated as a cross-undertaking in damages in favour of third parties who suffered loss as a result of the making of the order. It was not therefore limited simply to the expenses incurred in complying with the order.

S maintained three bank accounts at the Churchill Place branch of B (or Barclays Bank plc): GH was the authorised signatory. Some of the monies raised from investors were channelled through these accounts to various individuals and entities such as Seagull Enterprises Inc, a Seychellois company with a bank account in Cyprus. As part of the original freezing order, S and H were each ordered to provide information about these transfers including the identity of the recipients. B was served with the order and would therefore have had the benefit of the undertaking contained in paragraph (5) of Appendix B.

The FSA considered its position in relation to the paragraph (5) undertaking and decided that it would not offer to continue the undertaking at the adjourned hearing of its freezing order application. It wrote to B and Mr Jonathan Phelan, the head of the FSA’s Unauthorised Business Division, made an affidavit explaining the reason for the change. He said that it had always been the practice of the FSA not to offer a cross-undertaking in damages and that the undertaking in favour of third parties had been included in orders sought in order to cover the costs incurred (e.g. by banks) in complying with the order. If the wording of the undertaking extended beyond that to include other losses then the FSA would seek to vary the undertaking so as to limit it to the costs of compliance.

The position of the FSA was that it could only be liable in damages in the discharge of its functions as regulator in very limited circumstances. It was not therefore willing to expose itself to a voluntary liability in damages which Parliament by the FSMA has expressly exempted it from in order to facilitate the pursuance of its duties. The existence of the indemnity in paragraph was sufficient to establish and underline the rule of public policy that public authorities acting in the public interest should not be exposed to the same liabilities as private individuals acting in their own commercial interests.

II. What is a Cross-Undertaking?

A cross-undertaking is a critical feature of a freezing injunctions. Usually, applicants must give a cross-undertaking in damages to the court. This is to compensate respondents and any affected third parties if the court decides that the applicant was not entitled to injunctive relief (which is discretionary). Where no cross-undertaking is given, the courts will refuse to grant an injunction. But in situations where freezing injunctions are procured by public bodies pursuing law enforcement functions, the courts usually do not require such bodies to proffer a cross-undertaking in damages to safeguard the respondent’s position.

III. High Court: Financial Services Authority v Sinaloa Gold Plc & Ors [2011] EWHC 144 (Ch) (25 January 2011)

The effective hearing of the application to continue the freezing orders took place before His Honour Judge Hodge QC (sitting as deputy as judge, read judgment) who held that in the event that a public authority and law enforcement body such as the FSA sought to enforce the law using the civil courts by means of a freezing injunction (with potential adverse financial implications for innocent third parties), then, the customary third party cross-undertaking as to damages should be given.

Judge Hodge QC rejected S and H’s arguments regarding non-disclosure by the FSA and there being no risk of dissipation and continued the freezing orders against them in the form of the undertakings which were offered. The injunction and other orders against PH were also continued. But B intervened at the hearing and contended that the order should retain the cross-undertaking in favour of third parties in the standard form in which it had originally been framed. The court declined to vary the undertaking in the manner sought by the FSA but granted permission to appeal on this point.

The court accepted that the usual practice when dealing with an application for an injunction by the Crown or some other public authority in exercise of its statutory duties was not to insist upon a cross-undertaking in damages in favour of the defendants. Moreover, the court rejected the FSA’s submissions that there was no logical difference between the position of a defendant and that of a third party on the basis that, in order to obtain the injunction, the authority must have established at least a good arguable case of wrongdoing on the part of the defendants which of itself justified the intervention of the claimant.

It is worth noting that the Court of Appeal (please see more below) agreed with the High Court that the FSA was not required to give a cross-undertaking in damages in favour of the respondents. Note: this point was not the subject of appeal in the Court of Appeal which could not see any justification to depart from its usual practice of not requiring a cross-undertaking in damages to be given to a defendant in proceedings brought by a public authority to secure enforcement of the law. In the instant case, the courts agreed that the FSA’s application for a freezing order was regarded as part of its law enforcement functions because it supported claims made for restitution orders under section 382 of FSMA.

In the case of third parties, however, there was no allegation of wrongdoing. The issue was whether they should be protected from any loss suffered in the event that the injunction turned out to have been wrongly granted.

Judge Hodge QC accepted that the exemption from liability in damages was a strong pointer towards dispensing with a cross-undertaking in damages but was not in itself conclusive. The balance of authority indicated, he said, that the court retained a discretion in the matter which required to be exercised by balancing the interests of the public in the efficient enforcement of the regulatory framework against those of the innocent third party who may suffer loss as a consequence of the orders made. The balance, he held, came down in favour of protecting third parties:

65. It seems to me that an important consideration, in evaluating the effect and consequences of the dispensation principle, is that before an injunction will issue at the instance of an enforcement authority, the court must have been satisfied that the enforcement authority has raised an arguable case of wrongdoing on the part of the respondent. That is of no concern to, and does not affect the position of, an innocent third party. The real issue seems to me to be whether the potential costs which may fall upon a third party of a statutory body exercising its law enforcement functions should, in the general run of cases, and admitting that there may be particular exceptions in individual cases, fall on a wholly innocent third party or whether they should fall on the public purse from which the enforcement authority receives its costs and resources. In other words, the real issue seems to me to be one of the allocation of costs and resources.

66. In my judgment, the submissions of Miss Oppenheimer for the bank are to be preferred to those of the FSA. Whilst I acknowledge the force of certain of Mr Vineall’s submissions, in my judgment they are not sufficient to override the considerations identified by Miss Oppenheimer. It does seem to me that when a law enforcement body is seeking, through the civil courts, to enforce the law by way of a freezing injunction, which may have adverse financial implications for third parties who are innocent, then, as a matter of course, the usual third party undertaking as to damages should be given. I can see no logical reason for distinguishing between third party expenses and third party loss and damage.

IV. Court of Appeal: The Financial Services Authority v Sinaloa Gold Plc (t/a PH Capital Invest Glen & Ors) [2011] EWCA Civ 1158 (18 October 2011)

Appealing the decision the FSA submitted in the Court of Appeal that, apart from the costs of compliance with the order as a public authority, it should not be required to give cross-undertakings for losses because its application for a freezing injunction was part of its law enforcement functions. The FSA mounted the argument that no distinction should be made between defendants and third parties.

Moreover, the FSA also argued that it should not be obliged to compensate defendants or third parties because it enjoys statutory immunity in relation to damages under paragraph 19 of schedule 1 – providing that neither the FSA, nor any of its officers, can be liable in damages for anything done or omitted to be done in performance of its functions unless the act or omission is shown to have been done in bad faith or is unlawful under the Human Rights Act 1998 – of FSMA. This argument was not raised in the High Court and the Court of Appeal thought it to be flimsy because the defendant has no cause of action for loss and enforcement and is reliant upon the court’s discretion to make an order for compensation, not liability in damages. So the Court of Appeal held that the statutory indemnity in paragraph 19, schedule 1 did not operate to annul the effect of any cross-undertaking.

On the issue of whether the principles on which cross-undertakings in favour of respondents are generally not required equally apply to third parties, the Court of Appeal ruled that the principles applicable to respondents also applied to innocent third parties. The adverse effect on third parties of freezing orders (and other injunctions) did not outweigh the general rule that, in law enforcement proceedings, no cross-undertaking should be required. The Court viewed the FSA’s statutory immunity in FSMA as pointing to its entitlement to seek injunctive relief to assist its law enforcement function without being required to compensate third parties for the effect of its actions.

Thus, allowing the appeal in part, the Court of Appeal removed the undertaking. Mummery and Patten LJJ, Hedley J (read judgment; see especially paras 47 – 55) held that in exercising its law enforcement in getting a freezing order (or other injunction) with potentially adverse financial implications for innocent third parties the FSA, a public authority, was not obliged to give the expected third party cross-undertaking as to damages.

The rationale behind the decision was that the line of authority that began with F Hoffmann La Roche & Co AG v Secretary of State for Trade and Industry [1975] A.C. 295 and culminated in United States Securities & Exchange Commission v Masterfield [2009] EWCA Civ 27 made clear that the general practice of the court was not to require a cross-undertaking in favour of a defendant from a public authority when it sought an injunction as part of its law enforcement functions: in doing so the court followed the former case and applied the latter. (See interesting article in the Solicitors Journal here.)

While the possibility of exceptional cases did arise, the instant case was not exceptional. So Masterfield established the right approach to a freezing order application as part of the law enforcement process. Moreover, a cross-undertaking in favour of S would not have been imposed – however in a private action it would have been routine – and the central question was whether the position of third parties required or justified a different approach. Furthermore, given the practice of the court in law enforcement cases since Hoffman-La Roche, Parliament’s failure to make express provision about cross-undertakings in FSMA remained unsurprising.

Equally, the court’s retention of discretion was not accompanied by an implied direction by Parliament about the proper treatment of third parties in law enforcement cases. To require the FSA to provide a cross-undertaking in damages which was only likely to be enforced if the action turned out to be ill-founded was to create a potential liability which would not be achieved by an action brought by a defendant or third party whose rights were affected by the order. In a similar vein, the existence of the FSA immunity under paragraph 19 of schedule 1 of FSMA pointed strongly in favour of the FSA being permitted to seek injunctive relief in exercise of its law enforcement function without being required to compensate third parties for the effect of their actions.

The rules governing the imposition of cross-undertakings for the benefit of third parties particularly in relation to freezing orders were not formulated with those considerations in mind and cases such as Z Ltd v A-Z [1982] Q.B. 558, which were distinguishable, were not authority governing the situation in the present case (para 54). It was obvious that any form of law enforcement action was likely to have unfavourbale consequences for some third parties. The grant of a pre-judgment freezing order was no different in that respect from a final judgment for a restitution order or the exercise of the FSA’s statutory powers to shut down or impose asset requirements on authorised entities under FSMA.

th-34Moreover, the court explained that, once it had been recognised that the grant of the injunctions in the present case was part of a law enforcement process, the rule that no cross-undertaking should be required ought to apply was axiomatic.

Thus, Judge Hodge QC was in error to rule that the usual practice should be for the FSA to give a cross-undertaking in favour of third parties covering both the costs of compliance and other losses.

Patten LJ explained it as such:

55. For these reasons the judge was wrong in my view to say that the usual practice should be for the FSA to give a cross-undertaking in favour of third parties covering both the costs of compliance and other losses. The FSA is willing to cover the costs and expenses of compliance and that is not therefore an issue on this appeal. As a general rule public authorities should be prepared to meet such expenditure. But I do not agree with the judge that no distinction can sensibly be drawn between those costs and other losses. There seems to me to be a world of difference between the limited costs of identifying assets in compliance with the order and the kind of blank cheque referred to by Neuberger J in Miller Brewing Company v Mersey Docks & Harbour Company which would be the consequence of imposing the form of cross-undertaking required by the judge.

Ultimately, the undertaking contained in the freezing order was set aside and substituted for an undertaking in respect of costs in line with the FSA’s proposed variation.

Lady Hale and Lords Neuberger, Clarke, Wilson and Sumption JJSC will hear this case. Most UK Supreme Court cases are watchable on the internet (unfortunately for some reason VTB v Nutritek was not!). Since, this is the only case being heard on 12 and 13 December 2012 (interestingly Digital Satellite Warranty Cover Limited and another (Appellants) v Financial Services Authority (Respondent) UKSC 2012/0003 is also being heard on 10 and 11 December) the Supreme Court’s registry said that these proceedings should be available on Sky live.



4 responses

12 12 2012

Case by case basis. Lord Neuberger and Mance not happy at the outset …

12 12 2012

Lord Sumption getting things pacified …

12 12 2012

Lady Hale is coughing a lot …. !

12 12 2012

This is a private law matter

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: