A director has been found liable in the High Court for fraudulent trading as a result of failing to carry out proper due diligence in a series of transactions which were found to be part of a VAT fraud scheme.

The claim was brought against the director by the Liquidator of JD Group Limited (the “Company”).

Background

Mr Deepak Bhatia was the sole director of the Company and between August 2005 and 2006 it entered into a series of transactions for the purchase and sale of mobile phones. These transactions would become the subject of a tax dispute with HMRC and were considered to be a type of VAT fraud.

HMRC disallowed certain input tax credits claimed by the Company on the basis that the Company knew, or had the means to know those credits were related to the VAT fraud. As a result, the Company was left with a net VAT liability of £1,246,736.17.

The Liquidator appointed to the Company relied on the substantial evidence that was produced as part of the tax dispute to bring a claim against the director for breach of fiduciary duty and for fraudulent trading, pursuant to s.212 and s.213 of the Insolvency Act 1986.

The Liquidator sought an order that the director contribute to the Companies assets for the penalty imposed by HMRC (£285,897), the total input tax paid to suppliers (£2,117,762 less profits of £692,500), plus interest.

The Decision

The director denied knowledge that the transactions were part of a VAT fraud or that he had acted dishonestly. Further, the director did not accept that the chains of transactions were necessarily a VAT fraud.

The Judge was satisfied that features of the transactions “clearly…operated for the purposes of fraud”.

The Judge then considered the 2 stage test for dishonesty (applying NatWest v Bilta ) that the court must ascertain the defendant’s actual state of knowledge and belief as to the facts and whether, in light of that state of mind, the conduct was honest or dishonest, applying the objective standards of ordinary decent people. Satisfied that the test for dishonesty was met, the Judge rejected the evidence that the director was unaware of the fraud, that he honestly believed that the transactions were commercial transactions, and that he believed that there was no link to the fraud. Fraudulent breach of duty under s.212 of the Insolvency Act 1986 was also established.

The Judge was satisfied that the fraudulent conduct caused a loss to the Company and awarded £1,785,892 to the Liquidator (i.e. the sum of £2,117,762 less profits but including the penalty), with interest.

What are the implications for Directors and Officers and their insurers?

The decision highlights the importance for directors to carry out due diligence in transactions or otherwise risk being implicated in fraud committed by other parties. A key factor that influenced the Judge was the director’s failure to heed the advice provided by HMRC in implementing fraud-prevention measures along with keeping contemporaneous records of checks being made.

D&O policies invariably include exclusion clauses which would apply for any liability which occurs as a result of fraudulent trading. However, until a final determination or admission (depending on the wording) there may be cover for the legal costs of defending fraudulent trading claims and where they involve complex fraudulent transactions, this can be expensive.