In Hniazdzilau v Vajgel  EWHC 15 (Ch), the English High Court held that a claim for beneficial ownership in a company was not defeated by a defence of illegality, as the Claimant, Mr Hniazdzilau, had not relied on the alleged illegality in order to establish his claim.
The Claimant, a Belarusian businessman, alleged that he was the beneficial owner of the shares in Benet Invest Limited (BIL), a company incorporated in England in 2006, by Fitton Legal Company Limited (Fitton). The Claimant maintained that he had instructed his Belarusian lawyer, Mr Bronovets, to direct Fitton to establish BIL, and had put him in funds to do so, for the purpose of purchasing and renovating a property in Minsk (the Property). The First Defendant Mr Vajgel, an employee of Fitton, was registered as BIL's only shareholder and the Claimant alleged that Mr Vajgel held the shares on trust for him. The Claimant issued proceedings against the First Defendant asserting his beneficial interest in BIL, after discovering that he had been acting contrary to the terms of the trust. During the course of trial the First Defendant transferred the shares in BIL to a third party, Mr Enriquez, who was joined as Second Defendant to the proceedings.
Mr Bronovets, who was not a defendant, was joined to the proceedings (following his request) as the Third Defendant. He alleged that he was not the Claimant's lawyer and in fact BIL had been set up for his benefit, using his funds, for the purpose of running an electrical business.
The Court found in favour of the Claimant, determining that, on the evidence, the Claimant had clearly given instructions to the Third Defendant to set up BIL for his benefit and provided the funds to do so; the shares in BIL were therefore held by the First Defendant on express trust for the Claimant.
During the course of trial, the Claimant gave evidence that in 2008 BIL had indeed acquired the Property, payment for which was made in ten equal instalments. The funds for these instalments, he alleged, were transferred into BIL from his company accounts as a result of a series of fictitious invoices for the purported sale of equipment. In fact, as the Claimant revealed in cross-examination, the invoices were simply a means of avoiding tax on the payments.
As a result, the Third Defendant applied to amend his Defence and Counterclaim to allege illegality on the Claimant's part. He argued that in order for the Claimant to prove that he had funded the acquisition of the Property, he would be required to rely on his own illegal actions, being the creation of false invoices for the purpose of avoiding tax payments, and that should operate as a bar to any relief he sought in equity.
Illegality was also pleaded in relation to a loan from BIL to another of the Claimant's companies, Kolchugino Reinforced Concrete Products Plant (Kolchugino) in 2006. It emerged in cross-examination that the Claimant had misled a Russian court regarding the purpose of the loan, which was in fact an asset sale, disguised for the purpose of avoiding tax. The Third Defendant alleged that the Claimant had used BIL as a vehicle for fraud and should therefore be prevented from enforcing his beneficial ownership in BIL.
The Claimant submitted that it was not necessary for him to rely on the false invoicing to establish his beneficial ownership in BIL; his legal ownership in the shares had arisen when the Third Defendant set up BIL on the Claimant's instruction, long before the false invoices were created and the Kolchugino transaction took place. Legal title had already passed to the Claimant and the doctrine of illegality would not prevent him from enforcing such rights.
The Court considered whether the Claimant's claim for a beneficial ownership in BIL was defeated by the plea of illegality, noting that there were currently two different approaches to the defence: the public-policy based approached, in Hounga v Allen  1 WLR 2889, and the rules based approach in Tinsley v Milligan  1 A.C. 340.
The Third Defendant argued that the Court should follow the approach in Hounga, and consider whether public policy factors weighed in favour of applying the illegality defence. He submitted that if the Claimant were to succeed, the Court would be allowing him to profit from the fruits of his illegal actions and would encourage others in his position to carry out transactions to defraud the tax authorities. Furthermore, he submitted that it might allow the Claimant to evade a criminal penalty (though it was not clear how).
However, the Court disagreed with this approach and confirmed that, as was clear from the recent case of Davies v O'Kelly  1 WLR 2725, Tinsley was still applicable to cases concerned with establishing equitable interests in property. The Court noted that although there had been some recent debate regarding whether the decision in Tinsley should be followed, the decision had not yet been overruled and the court was still bound to apply it. The principle established under Tinsley was that the claimant's illegal actions would not affect her ability to establish a beneficial interest in a property, provided that she was not required to rely on her illegality to prove her legal title to the property. This was the case even if the title was acquired as a result of an illegal transaction.
Applying Tinsley, the Court held that the Claimant was not required to rely on his own illegality to assert his claim. The Claimant's case, which had been accepted by the Court, was that he had become the legal owner of the shares in BIL on its incorporation, long before he had funded the purchase of the Property. Even if he needed to rely on evidence of the purchase, the Court confirmed this would not have defeated his claim. While the Claimant may have misled the tax authorities regarding the purpose of the transaction, the money that was transferred was his and the transfer of funds was therefore not itself illegal. The Court concluded that the Kolchugino transaction was even further removed from the Claimant's pleaded case and the Claimant had not relied on it in any way to prove his ownership.
The Court distinguished the case from Hounga, which was a claim in tort and therefore, as noted in that judgment, made the application of the defence of illegality highly problematic. The Court held that even if it had applied Hounga, it did not consider that there were any strong public policy considerations in favour of applying the defence; the Claimant could still be pursued under civil or criminal law for tax evasion and the falsification of documents, so the decision would not encourage others to do so. Further, no illegal contract had been entered into, nor illegal payments made, as the funds were the Claimant's. In fact, to apply the illegality defence would only encourage those in the Third Defendant's position to go back on arrangements once payment had been made.
This case highlights that the approach to illegality will differ depending on the nature of the pleaded claim and confirmed that in circumstances where the beneficial ownership of property is in question, the Court will continue to follow Tinsley until there is any decisive judgment ruling otherwise. The Court made clear that the mere existence of illegal activity will not be enough to defeat a claim; there must be a sufficiently close connection between that unlawful activity and the Claimant's pleaded case as to his benefficail ownership. Defendants should therefore be careful about raising such a defence, unless it is clear that the Claimant is required to rely on that specific illegal activity in order to establish legal title to the property.
Hniazdzilau should also give some comfort to beneficiaries that provided the money transferred into trust was the settlor's, they will retain a beneficial interest in those funds. The position is, however, very different if the funds which a party has settled into trust are stolen, or are themselves subject to proprietary claims by others.