Illegality and the Enforcement of Contract
02 Nov 2015
Regulation is a fact of life for every financial service provider ("FSP"). FSPs face an ever-increasing volume of regulation. Regulatory requirements range from those which go to the root of the FSP's business (solvency, fitness and probity, proper governance) to more technical requirements (such as financial reporting and record keeping). What is the effect of a breach of a regulatory provision on an FSP's rights to enforce a contract with its customer or counterparty? If the FSP breaches a regulatory provision associated with a transaction is the underlying contract unenforceable by it? If this is a loan does it mean that the FSP lender cannot compel repayment, or enforce security? If it is a trade in securities or derivatives does it mean that the FSP cannot compel its counterparty to complete? It is clear that the answer will often have significant commercial implications.
The question is simple but the answer is complicated. The key difficulty facing the FSP is that it has (in legal terms) put a foot wrong and yet it is looking to the law (and ultimately a court of law) to assist it to compel the customer or counterparty to perform obligations it has signed up to. Like many complex legal doctrines there is an elegant Latin phrase to summarise it – ex turpi causa non oritur actio. A related doctrine is that where each party is in breach of the law, the defendant is always in a better position – the pari delictu doctrine. The main policy will be referred to in this article as the "ex turpi policy".
The ex turpi policy can cause injustice. (The case law makes it clear that this policy is not about doing justice between the parties.) A regulatory breach may cause no loss or prejudice to the FSP's customer or counterparty. The FSP's regulator may well impose sanctions on the FSP for the breach. However to allow the customer or counterparty to exploit the breach so as to resile from its contractual obligations is unfair. This unfairness is exacerbated where the FSP has been subject to a fine or other penalty for in that case the FSP suffers a "double whammy" – the regulatory sanction, and the inability to recover what is otherwise contractually due from the customer or counterparty.
The law dealing with these issues has never been clear. A contract can be affected by illegality in many different factual circumstances. Therefore it is difficult to find a common thread in all of the relevant case law.
Irish Supreme Court decision - overview
However a recent decision of the Irish Supreme Court helps in understanding how a court should resolve such dilemmas. In brief, there are two key messages:
- the ex turpi policy has to be tempered in the light of the sheer volume of regulation prevalent in modern commercial life; and
- in many cases justice is achieved by upholding the contract rather than declaring it to be unenforceable by reason of the regulatory breach.
In more detail
In Quinn v Irish Bank Resolution Corporation Limited  IESC 29 guarantors of loans made by Anglo Irish Bank ("Anglo") sought to repudiate their liability because they claimed that the loans which they had guaranteed had an illegal purpose – namely a scheme by Anglo (then a listed company) to prop up its share price. It was alleged that the Anglo loans were used by the borrowers to purchase shares in Anglo thereby creating a false market. The borrowers were companies in the Quinn group. The guarantors were the spouse and children of the controller of the Quinn Group, Sean Quinn. (By the time the litigation was commenced Anglo had been nationalised and changed its name, and eventually went into special liquidation and was acting through its joint liquidators.)
If a listed company lent money to third parties to enable them to buy shares in the company so as to prop up its price on the stock exchange this would be illegal on a number of fronts. First, it would amount to
market manipulation. Secondly, it would amount to unlawful financial assistance by a company in connection with/for the purpose of the purchase of its own shares. Market manipulation and unlawful financial assistance are criminal offences.
Anglo sought trial of a preliminary issue – namely whether the Quinns could rely on Anglo's alleged illegal conduct to support their claim that their guarantees were invalid. The High Court held that they could. Anglo appealed to the Supreme Court. The Supreme Court held that even if it was proved that the underlying loans had an illegal purpose, it did not follow that the Quinns' liability as guarantors would be unenforceable.
The Supreme Court held that the effect of any breach of law is determined primarily by reference to the intention of the legislature in outlawing the particular act or omission. In this regard, a key question is whether the legislature intended that contracts sufficiently connected with the illegality must be regarded as unenforceable.
The Supreme Court described the outcome in each case as "statute specific but … not case specific". Accordingly, the outcome will depend on analysis of the particular statute which has been breached. The ex turpi policy is not an absolute rule: much will depend on the nature of the wrongdoing concerned. The court will be mindful that commercial entities operate in a highly regulated environment.
Where the statute spells out the statutory consequences of a breach, then the result is predictable. However, many (if not most) statutes do not do so. The court will then have to see if the legislature implied that certain consequences were to follow. The court will also bear in mind that public policy, understood in the widest sense, may at times be better served by upholding a contract rather than declaring it to be unenforceable. The court will also consider how closely connected the transaction is to the relevant illegality. Further the absence of a provision stipulating that a contract entered into in breach of the statute is to be rendered void or unenforceable could itself suggest that a court should not treat it to be so.
In conclusion, the Quinn judgment cautions against the automatic application of the ex turpi policy. The court's role should be more nuanced: unlike the ex turpi policy, it should engage with the legislative intent and the justice of the case. The primary role of the court is to give effect to the legislation in question. If the legislation does not provide a clear answer then the court will balance the ex turpi policy with the risk of an injustice should the contract be declared unenforceable.
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