Tracing and Following Assets — the Location and Identification of Stolen Assets in English Law
This article is a summary overview of the intricate, and frequently overlapping, common law and equitable rules relevant to claimants in complex civil fraud claims for identifying and pursuing claims arising from consequential sophisticated money laundering operations which follow the original act of fraud.
In particular, this article considers how the rules of “following” and “tracing” in
equity in English law can be employed to locate and identify assets that have been misappropriated in breach of trust or fiduciary duty, or property which has been acquired with misappropriated assets. These rules enable the claimant to assert their proprietary interest in those assets and to seek an appropriate remedy to reclaim them and/or seek damages.
The type of cases where one might need to consider such remedies are those where there has been a case of fraud, or a series of frauds, probably over a sustained period in which large sums of money or other assets have been stolen, or where assets have been transferred by mistake. Complex fraud is almost always accompanied by sophisticated money laundering. This habitually involves distancing the stolen assets, both physically and/or in legal terms, from the original owner.
“Tracing” is one method in English law of connecting the fraud with the stolen assets. There is nothing new about tracing, but it is true to say that methods of fraud are constantly evolving as technology develops and society increasingly uses electronic money. That evolution has led more recently to the use of cryptocurrencies in the money laundering process and even to the theft of cryptocurrencies themselves.
There is a fair amount of confusion, and indeed conflation, even in English courts themselves, between the legal concepts of (1) tracing, (2) following, (3) proprietary claims and (4) constructive trusts. We need to separate them out in order to understand better the role tracing plays in proprietary claims.
This article does not allow space for a particularly discursive explanation of how not just practitioners but even English courts have become confused between the various related legal concepts, but it is important to look at tracing separately from claiming in order to understand what types of claims require tracing.
Tracing is not to be confused with “following”
An asset is followed when it passes through the hands of subsequent recipients without substitution and remains in the same form. So there cannot be any change of the product or asset. So a car which is stolen and sold or given to a third party can be followed as it remains the same asset.
Tracing, by direct contrast, involves substitution. The exercise of tracing therefore involves tracing the value of the stolen asset into a substituted product. This means being able to identify the new asset which has been acquired with the old asset. So in the example above, where a car is stolen and then sold, the sale proceeds can be traced, while the car itself can be followed.
In practice, whether the claimant elects to follow or to trace is usually dictated by the circumstances of each particular case.
Why does the distinction matter?
The answer is that it helps us to understand when the court will grant proprietary remedies to a claimant, as opposed to personal remedies.
In the case of following an asset (for example a stolen car) into the hands of
another recipient is that it is clearly a proprietary claim as the claimant can show it was initially his car. The only answer to such a claim is whether the current recipient can show a defence such as he is, for example, a bona fida purchaser for value without notice. A following claim, therefore, relies on the law of property.
By contrast, in a tracing claim, a claimant may decide that he wishes to assert ownership over the new asset which has been acquired with his original asset.
The reason why a court would order ownership over the new asset to the claimant is to prevent the unjust enrichment of the recipient of the new asset.
There has been a long debate in the courts about whether the court’s right to assert a claim in the new asset for the claimant amounts to a proprietary interest in it by operation of law or whether it arises out of the law of unjust enrichment. A 2001 House of Lords’ (the House of Lords is now known, since October 2009, as the Supreme Court) decision (Foskett v. McKeown), in a 3:2 majority, the judges found in favour of the claimants by allowing them a proportion of the insurance policy proceeds where the claimants’ Trust money had been used by a trustee to pay some of the premiums on a life policy on the trustee’s life who then committed suicide. The judges rejected the theory that the claim could be based on unjust enrichment. Lord Millett explained that “[the defendant] may, for example, have paid full value for the property, but he is still required to disgorge it if he received it with notice of the plaintiff’s property”, so in this situation, it could not be unjust enrichment, but the correct approach is to base the claim in property law.
Critics of this House of Lords’ decision consider that (1) it fails to give any relevance to the distinction between following and tracing and (2) the House of Lords’ decision does not give reasons to explain the ownership in another asset, and that this is an assertion of a new proprietary right, and not simply the original proprietary right.
In any event, whatever the academic criticisms of this judgment over the past 16 years or so, this House of Lords case is the law as it stands.
Although “tracing of assets” is a phrase in common parlance amongst lawyers, in reality, as the law stands, tracing is about locating assets which contain the value of the stolen asset, and not about tracing specific assets themselves. Contrast this with following which is about identifying the original asset. In Foskett v. McKeown Lord Millett explained: “Where one asset is exchanged for another, a claimant can elect whether to follow the original asset into the hands of the new owner or to trace its value into the new asset in the hands of the same owner…what the claimant traces is not the physical asset itself but the value inherent in it.”
Tracing is therefore about finding out where the value of the stolen asset is at any time. Once that has been established, the claimant needs to work out what type of claim he can bring. Tracing is merely a process by which a claimant finds out what has happened to his property. That process may include (i) identifying the persons who have handled or received his property and (ii) justifying his claim that the money which they handled or received can properly be regarded as representing his property. Tracing does not itself determine the existence or nature of any claim. The completion of a tracing exercise may lead to several differing claims. It may be a proprietary claim or it may be enforcing legal or equitable rights.
Without tracing, proprietary claims in substitute assets would not be possible.
In OJSC Oil Co Yugraneft v Abramovich  EWHC 2613 (Comm), Mr. Justice Christopher Clarke commented “In order to be able successfully to trace property it is necessary for the claimant firstly to identify property of his which has been unlawfully taken from him (“a proprietary base”); secondly, that the property has been used toacquire some other new identifiable property.
The new property may then have been used to acquire another identifiable asset
(“a series of transactional links”). Thirdly, the chain of substitutes must be unbroken.”
In personam claims in equity
These claims may be made for “knowing receipt” i.e. a claim against a person who has received or handled stolen trust assets, whether or not he retained them.
In this example, tracing does not establish the defendant’s liability; this will be governed by the requirements of the law on knowing receipt and not by the law on tracing.
In personam claims in common law
Again, in order to advance a claim, tracing is essential to be able to gather together the evidence required to provide the link between the asset originally owned by the claimant to the value transferred to a third party.
Common law tracing
If a claimant seeks a common law remedy i.e. an in personam claim or a proprietary claim, he needs to show that the monies or assets belonged to him. However common law rules on tracing have limitations. It is often necessary to show that the defendant in fact received property belonging in law to the claimant.
So the claimant needs to follow the rules of tracing again.
Often the defendant has not received stolen monies directly from the claimant but via a third party. In such cases tracing is essential to provide the link between the asset originally owned by the claimant to the value transferred to the defendant. The issue as to who now has legal title to the asset so transferred is determined by other rules, however, and not by reference to rules on tracing.
Common law tracing rules permit tracing of the same asset that originally belonged to the claimant and/or a so-called “clean substitute” for the original asset and/or profits obtained from the original asset or clean substitute asset. Common law tracing is unable to trace through any of (i) mixed funds, (ii) banks clearing systems or (iii) electronic bank payments. The courts still lay emphasis on the physical aspect of a tracing exercise. However, there are different, conflicting, court of appeal decisions which are not all in accordance with each other on the rules of common law tracing. This is, to say the least, an unsatisfactory position, not least because, based on one court of appeal authority, common law does not allow tracing of electronic payments. The case law on common law tracing is out of kilter with the House of Lords’ decision in Foskett v. McKeown, referred to above, which places an emphasis on tracing the value inherent in a relevant substitute asset.
To the lay observer (known in English law as “the man on the Clapham omnibus”) this situation might seem like a very restrictive approach by the courts, not to say rather a mess in terms of rule-making, but, with the habitual pragmatism of the English legal system, the rules of equity come to the rescue of claimants for claims made in equity, in this situation. In my view, the common law rules do need to be thoroughly reviewed, rationalised and updated by the courts, particularly as all large payments are made electronically nowadays. Doubts as to how the rules operate lead to uncertainty and increased legal costs.
Tracing in equity
The rules on tracing in equity do not suffer the same problems as in common law of tracing through mixed funds or clearing systems, and tracing in equity does not require some form of physical substitution. However, the rules do require a fiduciary relationship. The claimant’s right to trace in equity is based on his equitable interest in the asset which can arise under an express trust, resulting trust or constructive trust. There are many legal authorities in this area which have, for example, allowed claimants to demand a rateable share of real estate which has been purchased by the tortfeasor using mixed funds, and not just a lien over the property for the amount which was stolen. In this way, the courts have allowed claimants to share in the profits made in an appreciating asset.
There is a court of appeal authority (Re Diplock  Ch 465) which holds that for a claimant to be able to trace in equity, he must show that the assets have passed through the hands of a fiduciary. Problems arise in cases where there is no pre-existing fiduciary relationship, although it is fair to say that courts have been quite flexible or even creative in their approach to this rule, so as to prevent victims of theft being left with fewer remedies than victims who have been defrauded by someone in whom there was a pre-existing relationship of trust and confidence i.e. a fiduciary relationship. The problem with this typically pragmatic approach is that courts have had to essentially ignore other well-established legal principles relating to fraud and legal title. Therefore, the courts have had to “discover” new circumstances in which a “constructive trust” may be recognised by the court. A constructive trust arises by operation of law. It is not imposed by the court, but it will be recognised by the court when the circumstances of the case demand it, even where it was not intended by the court. The extent of a trustee’s duties may vary, depending on the circumstances in which the constructive trust arose: a constructive trust which arises where there was no pre-existing fiduciary duty is probably going to be a bare trust. A bare trust is a simple trust, where the beneficiary (or beneficiaries) has an immediate and absolute right to both the capital and income of the trust. The property is held in the name of the trustee (or trustees), but the trustee has no discretion over the assets held in trust. The trustee of a bare trust is a mere nominee, in whose name the property is held.
Constructive trusts can arise in many situations but can give effect to the common intention of the parties in relation to the beneficial ownership of property; they can deprive the defendant of the profits of fraud or other wrongdoings; they can be used to reverse the effects of a voidable transaction, for example payments made by mistake.
Although one approach by the court has been to hold that a fraudulent trustee who mixes trust funds with his own funds to the degree that it is not possible to identify what belongs to whom, the entire fund should belong to the beneficiary, another court has held that where it is possible to determine the amount of each party’s contribution, the court would make a finding that the parties would hold the funds as “tenants in common” in rateable proportions.
Where there are mixed funds containing monies from two or more innocent parties, the court’s approach will differ depending on whether the account holding mixed funds is a current or deposit account. For deposit accounts, the court will allow the parties to share rateably in proportion to their contributions. When it comes to current accounts however the usual rule in “Clayton’s Case” applies: this rule is a “first in, first out” rule. However, this general rule may be displaced if, on the facts of the case, there is a reason to displace the rule — for example, if there was a class of investors. Broadly speaking, the courts aim for the greatest level of fairness, which is often regarded to be a pari passu distribution.
English jurisprudence has developed a number of other rules relating to the distribution of mixed funds. These rules are too numerous to set all of them out in this article, but one of them is known as the rule in Re Hallet’s Case. This rule was designed by the court to prevent a claimant who had been defrauded from being prejudiced because the trustee has spent the claimant’s funds before spending his own, meaning that the remaining funds must all belong to the trustee. This rule amounts to a presumption that the trustee has spent his own funds first. That presumption is reversed in circumstances where the asset purchased appreciates in value, such that the court will hold that the monies used for the purchase were the claimant’s.
The court’s approach in the many examples of case law is very pragmatic and is clearly designed to ensure that the innocent claimant always comes out on top. However, this has definitely led to some anomalies between various legal rules in this practice area, as well as a series of very case-specific legal authorities, in an attempt by the courts to cover a myriad of types of fraud.
Many legal observers consider that there is a need for a thorough review and overhaul of the many complex rules governing tracing, and that this review is long overdue, and I agree with this view. Even in Foskett v McKeown, a 2001 decision, Lord Millett recognised that there is no real justification for maintaining different rules for tracing at law and in equity, not least because tracing is not a claim itself but a legal process. However, this anomaly was not dealt with by the House of Lords in that case, but remains to be considered again and will, we hope, be subjected to a complete reform in the Supreme Court when a suitable case comes before it.
Claims which can be made after equitable tracing
Once a claimant has been able to establish what has happened to his stolen assets using the rules pertaining to equitable tracing and following, he must then identify what claims in (i) common law and (ii) in equity he can bring against (a) the party or parties who control the asset or (b) those people who have been instrumental in the money laundering process.
The claimant can pursue one or more of the following remedies at the same time (although he will be obliged to elect between alternative, but inconsistent, remedies by the time of judgment, in order to prevent a double recovery):
— A proprietary remedy, by which he seeks to enforce his property rights in the asset itself.
— A personal remedy for breach of trust or breach of fiduciary duty.
— Personal claims against third parties in “knowing receipt” or “dishonest assistance”.
Which claims a claimant chooses to pursue will require a careful consideration of the facts of each case, including the defendant’s financial circumstances and the state of the market for each asset, so for example:
If a defendant is insolvent or there is a risk of insolvency, a personal remedy will not be of use as the claimant’s judgment debt would only rank alongside other unsecured creditors, and he may receive nothing. On the other hand, pursuing a proprietary or security claim will often give him priority over other unsecured creditors and possibly over some secured creditors, depending on the ranking (in insolvency law) of his equitable proprietary interest.
A proprietary claim is potentially more valuable if the price of assets is rising, as the asset may be worth more than originally, but on the other hand if asset prices are falling, the claimant may decide to pursue a personal claim (if the defendant is solvent) rather than re-acquire the asset which has lost some of its original value. It is possible that the claimant could still pursue a claim for the balance of his losses if the equitable lien over the property recovered did not cover his judgment debt.
It is easier in proprietary claims to obtain a freezing injunction to prevent the disposal of property where the disposal is intended to defeat a proprietary claim.
In cases where the causes of action arose a long time ago, there may be a risk of a limitation defence but it should be noted that there is no limitation period for breach of trust claims where dishonesty is involved.
If the claimant decides to pursue a proprietary remedy, he can opt to assert an equitable interest in the property, or claim a lien over the asset, in order to secure the personal liability of the trustee relating to the trustee’s breach of fiduciary duty.
In cases where the asset has become mixed with other assets, he can elect either to claim a proportionate share of the asset, or he can claim a lien over the asset in order to secure his personal claim against the trustee — the lien will be over the whole asset and not just a proportionate part of it.
Where the court imposes a constructive trust on any unauthorised profits acquired by a fiduciary in breach of the “no profit” or “no conflict” rules, the claimant can also pursue the profits made by the fiduciary and not just an equitable interest in the original asset or its traceable proceeds.
By way of summary, the rules relating to tracing assets and making claims for those stolen assets are fairly complex and they need to be considered carefully before a claimant embarks on issuing legal proceedings. Such claims are inevitably very time intensive and, therefore, expensive, and the work needed to pursue such cases is only really proportionate in high value claims. That said, the English courts have been very creative over the years in their development of common law rules in an attempt to prevent fraudsters getting away with the proceeds of their fraudulent actions. The concept of the constructive trust itself is very frequently employed by claimants in order to recover the value of their stolen assets. By way of contrast, the trust concept is simply non-existent in civil law jurisdictions. This may explain why claimants often come “forum shopping” in London, particularly when combined with the English court’s jurisdiction to issue worldwide freezing injunctions.
Adam Greaves, partner in the London commercial disputes team at CMS Cameron McKenna Nabarro Olswang LLP