E and Another v A [2003] CKCA 3; CA 8.2002 (6 January 2003)

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Procedure - Cook Islands - Legal professional privilege - Fraud exception - Whether documents covered by privilege or subject to fraud exception - Nature of "fraud" for purposes of rule - Standard of proof required

E and B had guaranteed payment of a $US17million promissory note and when they defaulted the A bank commenced arbitration proceedings. Soon thereafter, E settled property on a Cook Islands Trust registered under the International Trusts Act 1984. A US Court subsequently entered judgment against E and B for the amount claimed. The A bank then set out to prove that the trust had been settled with the principal intent of defrauding it as creditor. If it were able to prove this beyond reasonable doubt then, under s 13B(1) of the International Trusts Act the trust would be liable to satisfy the creditor's claims. The bank applied for discovery of documents and E and B claimed that certain documents were covered by legal privilege. The High Court ordered production of the documents under the fraud exception and E and B appealed to the Court of Appeal.

(1) While s 13B(5) (d) provided that a settlement was not to be taken to be fraudulent solely by reason that the settlement took place when proceedings in respect of that creditor's cause of action had already been commenced, that matter could be taken into account in determining whether a sufficient prima facie case had been made out if there was other evidence from which fraud could be inferred (see para [11] post).

(2) The Court would always be most reluctant to interfere with legal privilege but would exercise its discretion as to the terms in which the allegation of fraud was made and as to the surrounding circumstances, for the purpose of seeing whether the charge was made honestly and with sufficient probability of its truth to make it right to disallow the privilege of professional communications. Fraud went beyond deceit or fraud simpliciter and caught any commercial practice or business dealing that could readily be described as dishonest to the point of fraud by a reasonable businessman. The evidence established that there was a strong prima facie case of fraud and the appeal would be dismissed (see paras [8], [9], [13] post).

515 South Orange Grove Owners Association v Orange Grove Partners (6 November 1995, unreported), CA Cook Is.

A F Grant (NZ Bar) and H McKee for the appellants.
J R F Fardell QC (NZ Bar) and C Morris for the respondent.

[1] This is an appeal against an interlocutory judgment of Williams J delivered on 10 October 2002 in the High Court at Rarotonga. He ordered disclosure by the appellants to the respondent of discoverable documents for which legal privilege had been claimed in an action commenced by the respondent in the High Court claiming some $US 17m from the appellants (resident in the United States), alleging fraudulent disposal of their assets to avoid payment of a judgment in its favour by an American court.

[2] The respondent is an American bank and the first appellant E settled property on her husband (B) and their children under a trust to which B also transferred property. That trust, established on 12 July 2000, is a registered Cook Island international trust pursuant to the International Trusts Act 1984. The appellants had guaranteed payment to the respondent bank of a $US 17m promissory note and on default the bank commenced arbitration proceedings, and claims that, while these were pending, the appellants transferred assets to the trust in the Cook Islands for no consideration, rendering themselves unable to pay the bank. On 31 October 2000 they consented to arbitration awards for the amounts due under the guarantees and on 28 September 2000 the Circuit Court in Maryland entered judgment against them for the amount now claimed.

[3] The present proceedings are brought pursuant to s 13B(1) of the International Trusts Act 1984 which reads:

'Where it is proven beyond reasonable doubt by a creditor that an international trust settled or established or property disposed to an international trust

(a) was so settled, established or disposed by or on behalf of the settlor with principal intent to defraud that creditor of the settlor; and

(b) did at the time such settlement, establishment or disposition took place render the settlor, insolvent or without property by which that creditor's claim (if successful) could have been satisfied.

then such settlement, establishment or disposition shall not be void or voidable and the international trust shall be liable to satisfy the creditor's claim out of the property which, but for the settlement establishment or disposition, would have been available to satisfy the creditor's claim and such liability shall only be to the extent of the interest that the settlor had in the property prior to settlement, establishment or disposition and any accumulation to the property (if any) subsequent thereto.'

There are some important qualifications. Under sub-s (2), regard must be had to the fair market value of the settlor's other property immediately after settlement in determining whether it had rendered him or her insolvent, and if it exceeded the value of the creditor's claim, the disposition to the trust is deemed not to have been with intent to defraud the creditor. Of particular relevance to these proceedings is sub-s (5):

'A settlor shall not have imputed to him an intent to defraud a creditor, solely by reason that the settlor-

(a) has settled or established a trust or has disposed of property to such trust within two years from the date of that creditor's cause of action accruing;

(b) has retained, possesses or acquires any of the powers or benefits referred to in paragraphs (a) to (f) of section 13C;

(d) has settled or established a trust, or has disposed of property to such trust, at a time when proceedings in respect of that creditor's cause of action against that settlor have already been commenced in a court of competent jurisdiction.'

The onus of proof of the settlor's intent to defraud the creditor lies on that creditor (see sub-s (7)).

[4] The purpose of s 13B, accepted by this court in 515 South Orange Grove Owners Association v Orange Grove Partners (6 November 1995, unreported) is to provide funds to satisfy a creditor's claim out of properties settled on or disposed of to an international trust which, but for the settlement or disposition, would have been available to satisfy that claim. It does not render the trust or disposition void or voidable, but achieves a balancing action, preserving the integrity of the trust while granting access to the assets fraudulently settled or disposed of earlier (p 19). The court, in discussing the purpose of the 1984 Act (at p 27), was loathe to interpret it as a statute 'which was intended to give succour to cheats and fraudsters by totally excluding the legitimate claims of overseas creditors.'

[5] There is no doubt about the fundamental importance of privilege from disclosure of communications passing between a client and legal adviser, whether for the purpose of seeking advice generally, or of litigation. Mr Grant cited the justification for the rule given to the European Court of Justice by Advocate General Slynn of England-namely that every person 'should be able to know what they can do under the law, what is forbidden, where they must tread circumspectly, where they run risks.' However, privilege will not attach to communications made with intent on the client's part to facilitate crime or fraud, and this exception has been consistently recognised in civil and criminal proceedings since R v Cox (1884) 14 QBD 153, [1881-5] All ER Rep 68. We hardly need add that this exception does not apply to communications made for the dominant purpose of being used in pending or contemplated proceedings.

[6] Williams J discussed at some length the meaning of fraud in relation to privilege in civil litigation, and we quote the following forthright comments of Kekewich J in Williams v Quebrada Railway Land and Copper Co [1895] UKLawRpCh 145; [1895] 2 Ch 751 at 755:

'... where there is anything of an underhand nature or approaching to fraud, especially in commercial matters, where there should be the veriest good faith, the whole transaction should be ripped up and disclosed in all its nakedness to the light of the Court ... it is alleged that the company was insolvent, and that they found it useless for them to continue to carry on business and they had to stop, but that in order to prevent for a time this inevitable result they gave a charge in favour of their agents, and, as the plaintiff alleges, they did it in such a way as to defeat the holders of first debentures. That is what I understand the plaintiff's case to be, and it is said that is not a charge of fraud. It is difficult to say it is not commercial dishonesty. It is, in my opinion, commercial dishonesty of the very worst type; and that is fraud.'

[7] This dictum was referred to by Vinelott J in Derby & Co Ltd v Weldon (No 7) [1990] 3 All ER 161, [1990] 1 WLR 1156 and by Goff J in Crescent Farm (Sidcup) Sports Ltd v Sterling Offices Ltd [1972] Ch 553, [1971] 3 All ER 1192 and Gamlen Chemical Co (UK) Ltd v Rochem Ltd (No 2) (1979) 124 SJ 276. In the former case, Goff J held that a conspiracy and inducement of a breach of contract did not come within the ambit of fraud, while in the Gamlen Chemical Co case he thought commercial men and lawyers alike would say that it is fraud for servants to secretly use a master's time and money to take his customers and employees and profit from them in their own business. He added:

'Where you draw the line in the infinite gradation of good and evil between Williams's case (Kekewich J) and the Crescent Farm Sports case ... I do not attempt to say, but I have no doubt the present case is on the same side as Williams's case and that discovery ought to be given ... I wish only to add two further observations. First the court must in every case, of course, be satisfied that what is prima facie proved really is dishonest, and not merely disreputable or a failure to maintain good ethical standards and must bear in mind that legal professional privilege is very necessary thing and is not lightly to be overthrown, but on the other hand the interests of victims of fraud must not be overlooked. Each case depends on its own facts.'

We are in agreement with this commonsense assessment of the approach to be taken by the courts.

[8] Williams J saw the theme of dishonest purpose in the cases he cited, leading him to conclude that the scope of the fraud exception-

'goes beyond deceit or fraud simpliciter and catches any commercial practice or business dealing that would readily be described as dishonest to the point of fraud by a reasonable businessman. Beyond this, further generalities are probably not helpful.'

He saw no reason for a more restrictive definition in the light of the asset protection regime of the legislation, and the requirement of proof beyond reasonable doubt by the creditor, and we agree. Mr Grant criticised the judge's reference to the 'reasonable businessman', but this is no more than a conventional recognition by the courts of an objective test of 'dishonesty to the point of fraud' in the commercial environment of the questioned transaction. Mr Grant also referred to a passage of the judgment citing the New Zealand Law Commission's statement in its Evidence Code of 1999, that a strong prima facie case of fraud or dishonest purpose should be established to justify the exception. We do not think this reference to 'dishonest purpose' indicates that the judge was accepting mere dishonesty as sufficient. He was dealing with the quite different question of the standard of proof; focussing on what the Commission said about that aspect in the passage. Read as a whole, the judgment makes it quite clear that Williams J understood that the test was fraudulent purpose and applied it.

[9] The judge then went on to consider the standard of proof of fraud required to justify disclosure. After considering a range of cases (many of which were summarised by Vinelott J in Derby & Co Ltd v Weldon [1990] 3 All ER 161, [1990] 1 WLR 1156), and bearing in mind that s 13B required the creditor to prove fraud beyond reasonable doubt, he held that a strong prima facie case of fraud had to be established. This test was accepted by Mr Fardell QC for the respondent, but Mr Grant submitted that it should have been more stringent by requiring a strong prima facie case that the plaintiff will be able to establish beyond reasonable doubt at trial that the dispositions were made by the appellants with the principal intent of defrauding the bank. It must be borne in mind, of course, that in civil proceedings where fraud is alleged the courts will always scrutinise the evidence with a degree of care reflecting the gravity of the charge requiring to be satisfied in Mr Fardell's submission at the higher end of the spectrum of probabilities, effectively leaving little distinction between proof on balance of probability and proof beyond reasonable doubt. Like those in many of the reported cases, these attempts to define the strength of the prima facie case required often lead to semantic arguments tending to obscure the court's basic approach to the exercise of its discretion. This approach was stated by Viscount Finlay in O'Rourke v Darbishire [1920] AC 581 at 604, [1920] All ER Rep 1 at 6 in the following passage, also cited by Cardozo J in the United States Supreme Court in Clark v United States [1933] USSC 52; (1933) 289 US 1 at 15:

'The court will exercise its discretion, not merely as to the terms in which the allegation [of fraud] is made, but also as to the surrounding circumstances, for the purpose of seeing whether the charge is made honestly and with sufficient probability of its truth to make it right to disallow the privilege of professional communication.'

This approach was also adopted by the New Zealand Court of Appeal in Matua Finance Ltd v Equiticorp Industries Group Ltd [1993] 3 NZLR 650 at 653.

[10] Williams J held there was a strong prima facie case of the fraud in his conclusions summarised in para 85 of his judgment:

'The plaintiff contends in essence that the timing of the establishment of the trust and the transfers to it, occurring immediately after demand for payment by the bank and commencement of arbitration proceedings to recover the debt, gives rise to a strong inference that actions were undertaken to defraud E and B's creditors. The first defendants, on the other hand, say that the trust was established and funded for the legitimate purpose of future asset protection for themselves and their children. They say that they believed that the assets they had left after funding the trust would be sufficient to satisfy their outstanding creditors. In my view the plaintiff has satisfied the strong prima facie test by reference to the establishment of the trust in the shadow of an impending arbitration and judgment (eventually by consent) for a very substantial sum. Although E and B profess legitimate reasons for the establishment of the trust, a careful reading of B's explanation reveals no persuasive reason for its timing or the rapid transfer of assets to it thereafter. If, in fact, E and B were establishing a trust for legitimate reasons, it is perhaps odd that they had not done so before. They are clearly wealthy and sophisticated business people who had been taking business risks involving substantial borrowings since the establishment of the first store in 1995. Full evidence at trial may lead to the prima facie case falling away and the plaintiff failing to satisfy the beyond reasonable doubt test contained in s13B but as mattes stand a strong prima facie case has been established, especially since the requirement under s13B (1) is to demonstrate that the "principal intent", not the sole intent, was to defraud.'

[11] Mr Grant submitted that, in reaching this conclusion, the judge relied effectively on the disposal of the assets while the arbitration was pending, and that this ignores the provision in s 13B(5)(d) as set out earlier in this judgment, to the effect that a settlor shall not have imputed to him an intent to defraud a creditor, solely by reason that the settlor has disposed of property to the trust, at a time when proceedings in respect of that creditor's cause of action had already been commenced in a court of competent jurisdiction. (Mr Fardell accepted that for the purpose of these proceedings, this provision in subs (5)(d) applied, and he also conceded that the settlement fell within subs (5)(a) as a disposal within two years from the date of the creditor's cause of action accruing.) However, if there is other evidence from which fraud can be inferred, then the matters referred to in subs (5) can be taken into account in determining whether a sufficient prima facie case has been made out. In the extract just cited, Williams J referred to other matters from which such an inference can be drawn. In order to understand the factual situation more clearly and the opposing arguments thereon advanced by counsel, it is convenient to set out the relevant parts of the chronology prepared by the judge:

April 1995 - Sept 1999	E and B's company, P Inc, opened four bookstores.

24 March 1988	The plaintiff bank made a line of credit available to P in total and not to exceed $ US 17m.

31 May 1999	E and B guaranteed payment to the plaintiff of all indebtedness under a promissory note given by P to the bank.

31 May 2000	The promissory note matured. As a result, all indebtedness to the bank under the promissory note and the guarantee signed by E and B became immediately due and payable.

5 June 2000	The plaintiff demanded payment from P and E and B on 12 June 2000. The demand was not met.

Circa April - June 2000	E and B decided to sell the stores.

Circa June 2000	Efforts to sell the stores commenced. The initial asking price was $US 15m.

June 2000 - circa Dec 2000	Efforts to sell the stores continued. Initial interest was shown by retail chain stores Q and R. Negotiations began with R.

23 June 2000	E and B were served with a notice of claim by the bank and demand for arbitration.

12 July 2000	A notice was issued by the arbitrator S notifying the parties that arbitration proceedings had been initiated.

12 July 2000	E and B formed the trust.

18 July 2000	The bank served its complaint in the arbitration proceedings.

26 July 2000	E and B served their answer to the bank's complaint.

1 August - circa Oct 2000	E and B transferred assets to the trust for minimal consideration. The transferred assets include E and B's residence in Maryland, a second property in Georgia, the furnishings and artwork contained in the Maryland residence and cash, shares and interests in partnerships worth over $US 16m. All appear to have been transferred prior to the end of October 2000.

7 August 2000	A Pricewaterhouse Coopers valuation report on P was issued. The report valued P (the bookstore company) at $US 12.7m.

31 October 2000	E and B consented to two arbitration awards against them in favour of the bank totalling over $US 17m.

28 December 2000	The Circuit Court entered judgment against E and B for an amount over $US 17m including interest and costs.

End of 2000	[Retain chain store] R indicated that it was not in a position to proceed with the purchase of the stores.

Late December 2000	Approximately $US 14m in cash and $US 729,000 in stocks and other investments were transferred by the trust to a Swiss bank. There was no explanation in the first defendant's affidavits as to the purpose of this transfer.

Circa 2001	P filed for bankruptcy protection.

January 2001	The plaintiff bank learned of the existence of the trust.

[12] The judge added that E and B and their children continue to live in their residence in Baltimore and enjoy the furnishings and artwork; that most of their assets remaining in the United States apart form their shares in P cannot be reached by creditors; that the bank has recovered approximately $US 3.4m from the sale of P's assets. He also set out the reason given by B for the establishment of the trust. He said it was done on the advice of senior and experienced lawyers as part of estate planning to preserve the value of assets by placing them in the trust for their children's benefit. In effect he claimed they were simply setting up a 'spendthrift trust' to save them from potentially ill-advised business ventures which they and eventually their children might otherwise undertake. B concluded that he was confident they could satisfy their then creditors from assets not placed in the trust. As the judge observed, whether this was so depended largely on the successful sale of the bookstores at a good price and that this was by no means guaranteed at the time the trust was set up on 12 July 2000. The asking price was $15m set in conjunction with the lawyer, who obtained a valuation from PricewaterhouseCoopers which arrived on 7 August 2000, by which date transfers to the trust had already begun.

[13] In this court Mr Fardell emphasised as highly significant the timing of the transfer of property and assets to the trust in the face of the appellants' consent to the award and eventual confession of judgment; the lack of consideration; their continued enjoyment of the residence and chattels; the transfer to the Swiss bank account by the trust, the choice of assets transferred to the trust as against those of relatively little value left behind; the inaccessibility of other assets held in trust for E; the discrepancy between the valuation of the business and the actual realised value; and the lack of candour in the appellants' dealing with the bank. One of Mr Fardell's main criticisms was the PricewaterhouseCoopers valuation, which was hedged around with disclaimers and was based on discounted future earning capacity from information supplied by the company and without any independent check. On the other hand, Mr Grant relied heavily on the appellants' claim of good faith in going ahead to make their dispositions to the trust in reliance on this valuation and their expectation of a sale price sufficient to satisfy their liabilities. Most of the other matters raised by Mr Fardell were dismissed by him as occurrences normally incidental to protective trusts from which no fraudulent inferences should be drawn.

[14] It seems clear that the P corporation was not profitable and when the sale negotiations collapsed it sought bankruptcy protection in February 2001. Against this background there are obvious reservations about the genuineness of the appellants' belief that the stores would sell for sufficient to clear the bank. It could be strongly urged that they were not prepared to take this risk and bundled all their disposable assets into the trust. There seems no satisfactory answer to the obvious question that if they were honestly motivated, why did they not arrange to pay the bank out of the substantial assets apparently readily at their disposal before setting up the trust for the future protection of themselves and their children, as they now maintain. There is a starling difference between the PricewaterhouseCoopers valuation and the amount actually realised for the bookstores, and the basis of that valuation may be open to question. We see an obvious need for disclosure of the advice the appellants received from their legal experts experienced in the intricacies of protective trusts in order to ascertain whether it is being advanced as mere widow-dressing to conceal their alleged purpose of defrauding the bank.

[15] The court is always most reluctant to interfere with the operation of legal privilege, and in this case must also bear in mind the special protection afforded by s 13B. But in the end it has to stand back and form a judgment based on the whole of the relevant circumstances in deciding whether it is 'right to disallow the privilege of professional communications': see O'Rourke v Darbishire per Viscount Finlay above. From the circumstances of the formation of the trust and the disposal of assets to it in the face of the pending arbitration and judgment, which are highly relevant circumstances along with the other factors mentioned above, we are satisfied that a strong prima facie case of fraud has been established; indeed it satisfies Mr Grant's test of a case of fraud able to be proved at trial beyond reasonable doubt. We therefore uphold the conclusions reached by Williams J.

[16] The appeal is dismissed with costs of $5,000 to the respondent together with disbursements to be fixed by the Registrar if the parties cannot agree.

Court of Appeal of the Cook Islands

E and Another v A [2003] CKCA 3; CA 8.2002 (6 January 2003)