The Judicial Committee of the Privy Council has handed down a landmark judgment (1) concerning the doctrine of tracing, which confirms the approach taken by the Royal Court and the Jersey Court of Appeal regarding the previously unsettled question of whether so-called ‘backwards tracing’ is permissible under Jersey law.

Facts

1. The Federal Republic of Brazil and the Municipality of Sao Paolo claimed against approximately $10.5 million that had been paid into the defendant’s bank accounts in Jersey.
2. The funds were alleged to be the traceable proceeds of bribes received by the former mayor of Sao Paolo, Paulo Maluf, and his son Flavio during the mayor’s time in office.
3. The plaintiffs claimed that the funds had made their way to Jersey via
   1. unidentified black-market currency dealers in Brazil and
   2. an account beneficially owned and controlled by the Malufs in New York.
4. The claim was not for damages, but rather for the recovery of the funds on the grounds that the defendants were constructive trustees of the funds received by them with knowledge of their tainted origin, or alternatively on grounds of unjust enrichment or a proprietary claim to the funds.

Issues

1. The first issue was that the last three payments made into the New York account – identified as the proceeds of the bribes – were made after the final payment from the New York account into the Jersey accounts. It was submitted that those three payments could not be traced, as to do so would be backwards tracing – a process for which there was no sound doctrinal basis.
2. The second issue was that the New York account was a mixed account. Where a plaintiff’s money is mixed with other money, and the account’s balance is reduced to less than the amount that represents the plaintiff’s money, the plaintiff can recover only what can be considered its money. This is known as the lowest intermediate balance principle.

Decision

1. The Privy Council considered the substance of the transactions in question, rather than the strict order in which the associated events occurred, and held that the payments in question could be traced. Lord Toulson, who delivered the judgment, stated as follows:
   1. “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 overall purpose and effect.
   2. If the court is satisfied that the various steps are part of a coordinated scheme, it should not matter that, either as a deliberate part of the choreography or possibly because of the incidents of the banking system, a debit appears in the bank account of an intermediary before a reciprocal credit entry.“
2. In doing so, the Privy Council rejected the argument that backwards tracing cannot be used.
3. It also rejected the argument that the court cannot trace the value of an asset whose proceeds are paid into an overdrawn account.
4. Rather, the court stated that the claimant must establish a link between the depletion of the trust fund and the acquisition of the asset that is the subject of the tracing claim, taking into account the whole transaction in order to prove to the court that the interest has been acquired through misuse of the trust fund.

Comment

1. The Privy Council’s approach is consistent with equity’s traditional concern for substance over form and allows the court the flexibility to review a scheme when presented with clear evidence of a coordinated scheme to misuse trust funds.
2. However, the wider implications of this approach remain to be seen. In particular, it is unclear what will happen if there are questions regarding insolvency, prejudice to unsecured creditors, the involvement of third parties acquiring assets for value or multiple victims of fraud. Moreover, it will be interesting to see how the courts will deal with the evidential difficulties inherent in a test that is essentially focused on the alleged money launderer’s intentions.
3. For those holding assets for others – whether as a banker, trustee, custodian or fund manager – this judgment underlines the importance of understanding the ultimate source of funds received.
4. Without such an understanding, any financial institution is at risk of finding itself drawn into complex legal and regulatory claims, including claims for paying away assets that might be found to belong to third parties.

Endnotes

(1) The Federal Republic of Brazil v Durant International Corporation. http://bit.ly/1VYlWbE

http://bit.ly/1h6mQSZ