England and Wales High Court (Commercial Court) Decisions

IN THE HIGH COURT OF JUSTICE
QUEENS BENCH DIVISION
COMMERCIAL COURT

		St Dunstan's House
		30th July 1997

This action is by way of sequel to Insurance Corporation of the Channel Islands Ltd. and Another v. McHugh and Royal Hotel Ltd. [1997] Ll.R.L.R. 94, in which I gave judgment on 5th July 1996.

As my previous judgment records, the second defendant ("Royal Hotel") owns the Royal Hotel, a landmark on the water-front at St. Peter Port in Guernsey. The hotel has been closed since June 1992 as a result of a series of fires. Royal Hotel was insured against fire, among other perils, by two annual policies which were renewed in October 1991 with the first plaintiffs ("ICCI") and were effective from 30th November 1991. The first policy No. G0330.ll covered material damage to the buildings. The second No. G0331.ll had four operative sections, of which the business interruption section is most material. The first plaintiff ("Royal Insurance") is the parent company of ICCI. It reinsured ICCI up to £3.7 million in excess of £300,000 each fire loss. In addition, by a document dated 11th July 1986 described as an indemnity, it consented to its name being substituted, if required, in insurances issued by ICCI. Each policy was endorsed with an assignment of the benefit of this indemnity to Royal Hotel. Royal Hotel invoked this benefit in respect of the fires at the hotel.

In the previous action, I considered claims by ICCI and Royal Insurance and counterclaims by Royal Hotel arising out of the fires and the conduct of the potential claims to which they gave rise. I held that Royal Hotel had forfeited all benefit under the business interruption policy and was obliged to repay the £950,000 received under that policy on account of claims arising out of the fires of June 1992. The basis was that, following the fires, Mr McHugh on behalf of Royal Hotel had on a number of occasions used fraudulent means or devices to promote Royal Hotel's position and to obtain benefits under the business interruption policy, and that condition 5 of that policy provided for forfeiture of all such benefit in such circumstances. The counterclaims were for alleged conspiracy and/or breach of contract in relation to both the business interruption and the material damage policies. I dismissed them, with the limited exception that I held that ICCI was as from 31st December 1992 in breach of a contract whereby it had agreed to pay Royal Hotel an interim payment of £1,000,000 in respect of the material damage policy. I ordered damages to be assessed in respect of that breach.

Fundamental to my conclusion that Mr McHugh used fraudulent means or devices following the fires were certain findings which I made (in the report at pages 103-6) regarding the position prior to the fires. The relevant findings can be summarized as follows:

(1) In or about June 1991 Mr McHugh had instructed Mr Anquetil, an accounts clerk with Consolidator Ltd., Royal Hotel's parent company, to create invoices in Royal Hotel's name made out to Consolidator which were to show accommodation (at the hotel) let to Consolidator in July, August and September 1991, in the knowledge (on the part of Mr McHugh and Mr Anquetil) that no such accommodation had in fact been let to Consolidator.

(2) Mr McHugh's purpose and intention in giving the instruction was to manipulate Royal Hotel's monthly and annual occupancy figures, trading turnover and profits for its 1991/1992 financial year so as to create a more favourable picture of its trading performance if and when it became either necessary or desirable to show management or audited annual accounts to one or other of Royal Hotel's bankers, Republic National Bank of New York (Guernsey)("RNB") and TSB Bank (Channel Islands)("TSB") Limited. [The word "audited" follows from my previous judgment.]

(3) In compliance with Mr McHugh's instructions, and as Mr McHugh knew and intended, in or about September 1991 Mr Anquetil produced three invoices in the name of Royal Hotel made out to Consolidator apparently showing accommodation at the hotel let to Consolidator for the months of July, August and September 1991, although, as Mr McHugh and Mr Anquetil each knew, no such accommodation as was shown in the invoices had been let to Consolidator.

(4) The actual effect of these invoices was to increase apparent room turnover and percentage occupancy for the three months affected from £23,488 (32%), £34,503 (35%) and £33,024 (35%) respectively to £74,508 (85%), £80,913 (84%) and 79%) respectively, and to increase total turnover from £91,907, £154,266 and £93,029 respectively to £142,927, £148,769 and £141,344 respectively.

Whilst Mr McHugh could not have known the figures mentioned in (4) in June 1991 and may well not have known the precise effect of the invoices at any presently material time, there can be no doubt, in the light of my previous judgment, that -

(5) Mr McHugh must have known and intended that the invoices would increase, and after their creation that they had increased, apparent turnover and occupancy in a way which would and did paint a significantly more favourable picture of Royal Hotel's performance than would be or had in fact been achieved.

As my previous judgment recounts, a similar course of events repeated itself when Mr McHugh instructed Mr Anquetil in or about March/April 1992 to address further invoices to BCS (another company controlled by Mr Slater whose family trust owns Consolidator) and when such invoices were in June 1992 created for the months March, April and May 1992.

In the present action the focus is on Mr McHugh's creation of the Consolidator invoices with the purpose and intention stated in (2) and (5) above. The Consolidator invoices were both instructed and created prior to the renewal in October 1991 of Royal Hotel's insurances. Following my judgment on 5th July 1996, Herbert Smith by letter dated 12th August 1996 wrote announcing that ICCI and Royal Hotel had decided to avoid the material damage policy and enclosing draft points of claim identifying as the grounds non-disclosure of the matters summarized in paragraphs (1) to (5) above.

The present action raises issues of (A) materiality, (B) inducement, (C) affirmation and (D) cause of action or issue estoppel and/or abuse of process. I take these in turn.

(A) MATERIALITY

It is clear that the knowledge and intentions of Mr McHugh as a director and company secretary of Royal Hotel regarding the matters summarized in (1) to (5) are attributable to the Royal Hotel, and that ICCI and Royal Insurance were unaware of the matters when the material damage insurance was renewed in October 1991. Miss Bucknall Q.C. for Royal Hotel was content to refer to such matters by the shorthand of dishonest conduct. But she emphasized - and I proceed on the basis - that (a) no criminal act had been established (or even suggested until the plaintiff's skeleton) and (b) no actual use of the invoices had been made in relation to any bank before renewal of the insurance. The false invoices were simply prepared for use in relation to banks if and when that should become necessary or desirable.

The issue is whether the matters were material to be known to a prudent insurer in ICCI's position upon the renewal of insurance. The onus of establishing this is on ICCI and Royal Insurance. They adduced evidence from Mr Jack Smith, a former underwriter and later manager with the Commercial Union, who was cross-examined by Miss Bucknall. No expert evidence was adduced by Royal Hotel.

The House of Lords in Pan Atlantic Insurance Co. Ltd. v. Pine Top Insurance Co. Ltd. [1995] 1 A.C. 501 held that a circumstance may be material

"even though a full and accurate disclosure of it would not in itself have had a decisive effect on the prudent underwriter's decision whether to accept the risk and if so at what premium" (per Lord Mustill at p.550C).

As explained by the Court of Appeal in St. Paul Fire & Marine Insurance Co. v. McConnell Powell Constructors Ltd. [1995] 2 Ll. R. 116, Lord Mustill, with Lord Goffs effective endorsement, further defined the duty of materiality as extending to

"all matters which would have been taken into account by the underwriter when assessing the risk (i.e. the "speculation") which he was consenting to assume." (per Lord Mustill at p.538C-D)

In St. Paul at p. 124 the Court of Appeal also interpreted this definition as no different from, and to that extent as expressly approving, part of Steyn LJ's formulation in the Court of Appeal in Pan Atlantic at [1993] 1 Ll.R. 496, 506, viz. that

".... avoidance for non-disclosure is the remedy provided by law because the risk presented is different from the true risk. But for the non-disclosure the prudent underwriter would have appreciated that it was a different .... risk."

It is important to realize what is embraced by "risk". It is not simply the peril or possibility of loss or damage occurring within the scope of the policy. It embraces other matters which would, if known, be likely to influence a prudent underwriter's decision. It includes what is known as "moral hazard", which may merely increase the likelihood of it being made to appear (falsely) that loss or damage has occurred falling within the scope of the policy: see per Lord Mustill in Pan Atlantic at pp. 534D-E and 538E-F.

There is ample authority regarding the potential materiality of "moral hazard". In Locker and Woolf Ltd. v. Western Australian Insurance Co. [1936] 1 K.B. 408, Slesser L.J. said that it was "elementary" that it was one of the matters to be considered by an insurance company, and that in the case before him

".... it is quite impossible to say that the non-disclosure by those proposing to take out a policy against fire risks that they have had an insurance on motors declined on the ground of untrue answers in the proposal form is not the non-disclosure of a fact very material for the insurance company to know - a fact which if known to the company might lead them to take the view that the proposers were undesirable persons with whom to have contractual relations."

May J. referred to this authority in March Cabaret Club & Casino Ltd. v. The London Assurance [1975] 1 Ll.R. 169, 176, He said that there was no objection in law to a conclusion that the duty of disclosure extended to require disclosure of the actual commission of an offence of which the proposer had not yet been convicted or had even been acquitted. At page 177(1) he distinguished between the practical expectations which an underwriter might have about the likelihood of such disclosure being made, and the legal duty to make it. In The "Dora" [1989] 1 Ll.R. 69 Phillips J. concluded on the evidence that (well-founded) pending charges of smuggling and the skipper's criminal record each created a material moral hazard. Finally, in Gate v. Sun Alliance Insurance Ltd. [1995] Ll.R.L.R. 385 (High Court of New Zealand), 407, Fisher J. held that incidents of prior dishonesty by a proposer were capable of being material (in particular, as going to the risk of a false claim), whether or not they had been detected or had led to conviction. It was a question of fact and degree and so of expert evidence whether any particular act of dishonesty was one which a prudent underwriter would take into account when assessing the risk. I respectfully agree with all these statements of legal principle.

The further question whether a proposer is obliged to disclose a still pending charge or allegation, of which he has not been convicted and is in fact innocent, is one on which the authorities differ. May J. in March Cabaret followed by Phillips J. in The "Dora" held that this too depends on the expert evidence. Forbes J. in Reynolds v. Phoenix Assurance Co. Ltd. [1978] 2 Ll.R. 440, 460 and Fisher J. in Gate reached an opposite conclusion. The question does not arise in this case, where the critical conduct is established (and now indeed admitted) to be a matter of fact.

The question is therefore whether ICCI and Royal Insurance have proved that Royal Hotel's conduct through Mr McHugh was material to be known to a prudent underwriter when agreeing to renew the present material damage insurance. The insurance was subject to a long-term (five-year) agreement commencing 30th November 1988. Under this, in return for a 7.5 % discount on premiums, Royal Hotel undertook to offer renewal annually to ICCI. But ICCI was not obliged to accept any such offer. The duty of disclosure thus remained.

Mr Smith was a straightforward witness. His days as an active fire underwriter lie some time in the past. They ended effectively in 1980, when he took up higher managerial responsibilities. But he did not escape from all underwriting involvement thereafter. Underwriters would still come and see him and ask advice and a variety of cases was thus "continually referred" to him. He was qualified to give the relevant expert evidence. In his report he referred to the concern raised by moral hazard at different levels, running from maintenance of management and housekeeping standards to exaggerated claims and on to criminal arson or malicious damage. He identified as particularly significant the fact that

Royal Hotel's conduct in (1) to (5) related to poor trading performance, which could itself give a motive for "extreme action" to insurers' prejudice. Following a comment which I made at the outset of the trial, he supplemented his report with certain literature from the library of the Chartered Insurance Institute, in particular an extract from Hickmott on Interruption Insurance and two prize papers from a 1987 essay competition, Dr R. A. Litton's "Moral Hazard and Insurance Fraud" and A.E.B. Alport's "Risk and Behaviour: some notes towards a definition of moral hazard".

It is clear from Mr Smith's evidence and these two papers that, although the existence of moral hazard as a relevant concept is beyond doubt, its scope and facets have been the subject of very limited discussion and examination. Mr Smith made a pertinent comment, when he observed that textbook authors preferred to restrict themselves to cases which had come to trial. Leaving aside straightforward situations (such as motoring offences or prior losses covered by questions in a proposal form), it seems likely that there is a high percentage of cases where proposers do not reveal, and insurers never know about, matters creating a moral hazard. It is only after a loss, if at all, that the matters come to light. However, to ask an insurer whether he would expect a proposer to disclose such matters is, as May J. clearly saw, not the right question. Materiality does not depend on what the ordinary insured would or would not be expected to disclose in the practical world. It depends upon what a prudent underwriter would, if he knew it, take into account when assessing the risk. It is probably fair comment both (a) that because of the human propensity not to disclose embarrassing or prejudicial material, expert underwriters may be unable to speak on the materiality of matters of potential moral hazard with as much direct experience as they can apply to other familiar features of a risk (e.g. the materiality of a working sprinkler system) and (b) that the limited occasions on which matters of moral hazard come to light and the fact that they commonly do so only during investigation of a claim, tend to make moral hazard appear both rarer and more significant than it would be if a complete picture could be obtained of all undisclosed moral hazard in insurance risks. These are points which ought, it seems to me, to be taken into account when evaluating expert evidence in the present area.

Ms Bucknall cross-examined Mr Smith and Mr Walpole of ICCI by reference to the combined insurance proposal form disclosed by ICG, which could embrace hotel insurance and was itself based on a Royal Insurance form, as well as by reference to various standard forms of proposal which she put to him as being used by the Royal Insurance and other leading companies. No proposal form was actually required by ICCI in respect of the insurance of the Royal Hotel. Mr Walpole explained that the proposal disclosed was designed for small risks. The Royal Hotel was a large risk, the insurance of which was placed through a broker, who would be expected to advise Royal Hotel as to the range of matters material to be disclosed. In any event the proposal forms examined do not appear to me of any real assistance. They contain specific questions about convictions. It does not follow that there may not be other aspects of moral hazard which would be material for disclosure. Many of the proposal forms produced (including ICCI's own form) contain a question reminding the proposer of the general duty to disclose any other material information.

Taking account of all these matters, I conclude without hesitation that Royal Hotel's conduct in preparing the false Consolidator invoices for use if and when necessary or desirable in relation to bankers would have been a matter which any prudent underwriter would have taken into account, if it had been known to him, when assessing whether to renew the Royal Hotel's fire insurance risk. Good faith between the parties is, as Mr Smith indicated, at the heart of such an insurance. I accept, as Mr Smith said, that a propensity to dishonesty towards bankers, involving the careful preparation of false invoices to distort the hotel's trading figures, would be "plainly material" to any prudent insurer. It would suggest both a risk of distortion of any figures which might be presented in the context of a material damage claim as well as the possibility of other still more serious types of dishonesty m relation to the property and claims.

(B) INDUCEMENT

To justify avoidance, it is not only necessary to establish materiality in the sense just considered; the actual underwriter must also show that he himself was actually induced by ignorance of the material matters not disclosed to enter into the insurance on the terms on which he in fact did. In Pan Atlantic, which establishes this second requirement, Lord Mustill mentioned without exploring in any detail the presumption of inducement that may arise once materiality is shown. In principle, however, the two concepts are distinct. The one does not necessarily involve the other although the two overlap. That is the very essence of the decision itself in Pan Atlantic. It cannot, necessarily, be assumed that a matter which a prudent underwriter would take into account would lead any or every prudent underwriter, still less the actual underwriter to any different underwriting decision. In obvious cases it may be so, in others it may not. The following statement of the position was thus approved as correct by the Court of Appeal in St. Paul:

"The existence of such a presumption is recognized in the authorities: see Halsbury's Laws of England vol. 31 par. 1067 where the law is stated as follows:

"Inducement cannot be inferred in law from proved materiality, although there may be cases where the materiality is so obvious as to justify an inference of fact that the representee was actually induced, but, even in such exceptional cases, the inference is only a prima facie one and may rebutted by counter evidence."

In Marc Rich & Co. A.G. v. Portman [1996] 1 Ll.R. 430, decided before St. Paul. Longmore J. pointed out that in most cases in which the actual underwriter is called to give evidence the court will be able to make up its own mind on inducement, and in cases where he is called and the court cannot decide the underwriter will ex hypothesi have been unable to satisfy the legal burden resting on him. The presumption, he suggested, will only come into play in those cases in which the underwriter cannot (for good reason) be called to give evidence and there is no reason to suppose that the actual underwriter acted other than prudently in writing the risk. Even this appears to pre-suppose that any prudent underwriter would not only have wanted to take the matter into account, but would, in probability, have declined in its light to write the risk on the terms in fact accepted.

In the present case the relevant hierarchy within ICCI consisted in 1991 of Mr Bray as commercial underwriting assistant, working in a team headed by the commercial controller Mrs Butler, above whom in seniority was Mr Peter Morris, the business manager, and then Mr Peter Walpole, the managing director. Mr Bray also acted as part-time executive assistant to Mr Walpole. In a small company, relations were informal and all these individuals had ready access to each other. Mr Bray and Mr Walpole gave oral evidence.

Hearsay statements were adduced from Mrs Butler and Mr Morris on the grounds that they could not be called as a witness at the trial because they were "beyond the seas". Mr Morris has since May 1992 been managing director of Rossboroughs, brokers who acted for Royal Hotel in the placing of the present insurances and the presentation of claims under them. His statement records that he met and discussed the matter with both Mr McHugh and Mr Walpole and Mr Bray in or after October 1996. No evidence was adduced that Mr Morris or Mr Butler would not in fact have been willing to attend court or to give oral evidence by video-link.

Mr Bray actually dealt with the 1991 renewal of the material damage insurance. In this context he reviewed and annotated a claims record "pre-list" dated 4th September 1991. Since that showed more than three claims (albeit none significant) since inception, the renewal would have required special review. Since Mr Bray only had authority up to only £2 million he would anyway have reported on the renewal to Mrs Butler or to Mr Morris direct. Since her authority was limited to £3.5 million, Mrs Butler referred the renewal to Mr Morris, though it appears that he would not ordinarily do more than verify the adequacy of the reinsurance arrangements made. Mr Morris's underwriting authority was strictly limited to £5 million, but in practice Mr Walpole allowed him flexibility and leeway.

What would have happened had ICCI known of Royal Hotel's conduct set out in paragraphs (1) to (5) above? I think it right to formulate the question in this way. If one asks what would have happened if Royal Hotel itself had disclosed such conduct, the very question introduces an element of frankness which was not present. Even the question I have formulated involves an opposite problem, on which I have touched above. The occasions when insurers will on placing or renewal know of an insured's dishonest conduct must be fewer than the occasions when there has in fact been such conduct. For this reason, to ask particular insurers about their attitude if they had known of particular dishonest conduct in the context of a specific insurance may risk putting a question which is somewhat loaded against the insured. In reality however most insurers will be aware that moral hazard must be a much more frequent occurrence than the occasions on which it is disclosed or detected. This still leaves the difficulty that questions of moral hazard appear commonly to arise after the event of a loss, when it is easy and insurers have every incentive to adopt a strict attitude. This difficulty is particularly acute in a case such as the present where it can be seen with hindsight that the moral hazard has in fact materialized. It is one which the court should recognize and take into account when seeking to identify what, realistically, would have been the actual insurers' reaction to the relevant conduct at the time of placing or renewal.

Mr Bray had in April 1991 successfully taken the final set of Chartered Insurance Institute examinations for Associateship and was able to produce before me his copy of the CII textbook "Property Insurance Risk Assessment and Control". His copy contains throughout the signs of his study in the form of marginal annotations and summaries. On the page dealing with moral hazard he noted amongst other points that the range of insureds extended from "perpetrators of fraud to utmost meticulousness" and that consequences of moral hazard were "avariousness in claims negotiations" and "insurance companies fair game - a tendency to exaggerate". He also underlined the single passage emphasizing the need for insurers "in all cases [to] exercise care when selecting policyholders to ensure that they are honest and straightforward, careful for the safety of their property and not in financial difficulties". I accept Mr Bray's oral evidence that, if he had known of Royal Hotel's conduct, he would immediately have referred it to one or other of his superiors. Although she did not attend for cross-examination, I also accept Mrs Butler's written statement that she would have referred the matter on to Mr Morris, or to Mr Walpole in his absence. Since there is no reason to believe that Mr Morris would have been absent, the matter would therefore have been referred to him.

In his statement Mr Morris says that knowledge that inter-company transactions such as those represented by the Consolidator invoices existed and were fraudulent "would have had a considerable impact on my attitude towards underwriting the policy", that it "would have raised the question of moral hazard and, as a matter of policy, it would have caused me to discuss the matter with Mr Peter Walpole with a view to agreeing an appropriate course of action". Reading his statement, including the note to it, as a whole, I do not think that he meant more by "fraudulent" inter-company transactions than that they were brought into existence with dishonest intent. I bear in mind that he was not tendered for cross-examination. Mr Walpole considered however that

"... the seriousness of the situation was such that he would have referred it to me eventually, before making a decision, unless it was urgent and I was away from the island, but I think he would have tried to get hold of me".

An earlier passage in Mr Walpole's evidence indicates that Mr Walpole was under the misapprehension that "the deliberate impression was being given to the bankers that the hotel was doing rather well". In fact the position at renewal was simply that the Consolidator invoices had been brought into existence and the hotel's trading figures manipulated so as to create a more favourable picture if and when it became either necessary or desirable to show management or annual accounts to one or other of the bankers. It was only in March 1992 that this purpose was implemented by supplying RNB with the February 1992 management accounts distorted by the Consolidator invoices. But I do not consider that Mr Walpole or Mr Morris would at the time have drawn any distinction between an unfulfilled but continuing intention to use dishonestly created accounting figures as and when necessary or desirable in relation to bankers and a situation where they had actually been so used.

Mr Walpole's evidence was that, if he had known of Royal Hotel's conduct, he would have declined to allow renewal, on the ground of moral hazard.

In assessing this evidence and the extent to which ICCI has made out its case, certain other background factors require mention. Firstly, the long-term insurance agreement appears in practice to have had some impact on ICCI's attitude to the extent to which it could or should seek more stringent terms, but it was not suggested that this would have been of any real significance to its reaction to moral hazard. Secondly, no proposal was used for the present renewal. For reasons already indicated, neither this nor the other forms of proposal put to Mr Smith have however any real weight in the present context. Thirdly, Mr Walpole gave oral evidence that the population of the Channel Islands is essentially very genuine, sincere and honest. He also said that the economy had also been fairly buoyant for many years and that it was rare for an organization to be trading at a loss. This evidence contrasts somewhat with his witness statement, where he said that any inference that Royal Hotel was doing so badly that Mr McHugh had caused false documents to be created to misrepresent the truth would have been a considerable concern to him "particularly in a recession (October 1991), when there was already growing concern about arson". Mr Walpole went on however to say that he had never knowingly insured a person whom he believed to be dishonest, as to do so would diminish the quality of ICCI's risk portfolio. Fourthly, the two Royal Hotel insurances represented among the larger risks in ICCI's portfolio, though the largest risk was about four or five times as large. They generated over £30,000 per annum in premium income, somewhat less than three per cent of ICCI's total premium income at the time. ICCI had built up its portfolio of business, consisting mainly of Channel Island risks and entirely of risks with some Channel Island connection, by "underpricing of our products in a selective and sensitive way, best suited to the characteristics of the market". This meant that it used its local presence and appreciation of local conditions, particularly in areas such as weather, to offer lower premiums than United Kingdom companies which tended to treat the Channel Islands as another English county. Because of its size ICCI remained dependant on reinsurance, but that would not have encouraged it to regard itself as unexposed, for the obvious reason that such an attitude would have imperilled the availability of reinsurance at economic rates. Fifthly, in December 1992, during the course of events following the fires, insurers became aware of adverse comments in a DTI report affecting Mr Slater, the individual ultimately behind Royal Hotel and its group, but took no steps to avoid any of the insurances on that ground. Apparently, the report recorded the inspectors' view that the conduct of Mr Slater and another in and about the prosecution of their bid for Norwest Hoist "was deplorable and showed scant respect for the responsibilities of directors of public companies and the interests of shareholders" and the inspectors recommended prosecution of Mr Slater under the Companies Act 1967 ss. 27 and 33. No prosecution took place. The events in question went back, I was told, to shareholdings acquired in 1972 and a takeover in the mid-1970s; the appointment of inspectors took place in March 1977 and their report was dated 24th April 1981. Insurers' attitude when they learnt of these old events in December 1992 does not in my view furnish any guide to their likely attitude, had they known before renewal of the insurances in October 1991 of Royal Hotel's dishonest conduct involving the creation of, and the intention if and when necessary or desirable to use the Consolidator invoices relating directly to the insured hotel.

Looking at all the material before me, I am satisfied that all the underwriting personnel within ICCI and Mr Walpole as its managing director would have taken a serious view of Royal Hotel's conduct, and that ICCI would have been unlikely to offer renewal if it had known of such conduct before renewal. I accept that the matter would have been likely to reach Mr Walpole's attention. He was and is clearly the dominant character within ICCI. Although he has an insurance background in fire surveying and risk assessment, broking (for a short time) and in setting up and in the early days underwriting for two direct writing and broker-fed insurance companies in the Channel Islands, his primary role over the last 14 years has been in management and administration. In that role he would naturally be concerned about the quality of the ICCI's portfolio. Although there could be minor exceptions, I consider that Mr Walpole was and is someone who would, if he had known of conduct such as the Royal Hotel's conduct set out in paragraphs (1) to (5) above, have adopted and applied the general attitude which he mentioned in his statement, that is of not knowingly insuring a person whom he believed to be dishonest and of refusing renewal accordingly. I also consider that this is the attitude which any reputable and experienced insurer (like the present insurers) would have been likely to adopt in the face of dishonest conduct such as Royal Hotel's here.

I therefore find that ICCI was induced to underwrite the renewal of the material damage policy in October 1991 by non-disclosure of Royal Hotel's conduct set out in paragraphs (1) to (5) above.

(C) AFFIRMATION

Royal Hotel's pleaded case on affirmation involves consideration of the period from January 1993 up to my previous judgment dated 5th July 1996. During her final speech Miss Bucknall sought leave to add a further particular of affirmation referring to a consent order dated 24th July 1996. I heard submissions on this de bene esse and reserved my decision whether to grant leave. In the event I refuse leave for reasons which will appear.

Law

The principles governing affirmation (or election) were considered in my previous judgment at p. 126. My conclusions in the context of that action appear at pp. 132-3. In summary, the type of affirmation here in issue involves an informed choice (to treat the contract as continuing) made with knowledge of the facts giving rise to the right to avoid it. Provided that the party knows sufficient of the facts to know that he has that right, it is unnecessary that he should know all aspects or incidents of those facts. Although this point was left open in The Kanchenjunga [1990] 1 Ll.R. 391, there is Court of Appeal authority in Peyman v. Lanjani [1985] 1 Ch. 457 that the party must generally also know that he has that right. The making of his choice must be communicated unequivocally to the other party before there can be a binding affirmation.

What is required for affirmation is knowledge, not any form of constructive knowledge. Miss Bucknall submitted to the contrary, suggesting that the correct principle was reflected in a sentence from Chitty on Contracts (27th Ed.) Vol. l paragraph 24-006 to the effect that "[in] case of waiver by election the party who has to make the choice must either know or have obvious means of knowledge of the facts giving rise to the right ....". The cases cited, Bremer Handelsges, mbH v. C. Mackprang Jr. [1979] 1 Ll.R. 221 and Avimex S.A. v. Dewulf & Cie [1979] 2 Ll.R. 53 as well as Cerealmangimi S.p.A. v. Toepfer (The Eurometal) [1981] 1 Ll.R. 337 all ante-date both Peyman v. Lanjani and The Kanchenjunga and are anyway explicable as cases on estoppel, rather than election. The sentence in Chitty is in my judgment wrong in suggesting that means of knowledge without knowledge itself could suffice. Even so, a special problem may arise where a person has deliberately and knowingly decided not to investigate or confirm a matter about which he knows that he could acquire definite knowledge. Similar problems have arisen in other areas of the law - see e.g. the first three categories of knowledge suggested in Baden v. Societe Generate [1983] 1 W.L.R. 509, 575, in the areas to which it continues to be relevant following Royal Brunei Airlines v. Tan [1995] 1 A.C. 378, 392G.

Whether a person has knowledge is for lawyers essentially a jury question. The meaning of knowledge has perplexed philosophers from Plato (and no doubt before) to after A.J. Ayer, and been said by some to be ultimately unanswerable. But as a matter of law and everyday understanding some points are reasonably clear. First of all, I reject Miss Bucknall's submission that a party must be taken to know whatever he could properly plead. The submission cannot be accepted, even if attention is confined to dishonest conduct which, under the Code of Conduct of the Bar of England and Wales, requires a pleader to have "before him reasonably credible material which as it stands establishes a prima facie case". At the other extreme, knowledge is not to be equated with absolute certainty, itself an ultimately elusive concept. The impossibility of doubt which Descartes found only in the maxim "I think, therefore I exist" is not the criterion of legal knowledge. For practical purposes, knowledge pre-supposes the truth of the matters known, and a firm belief in their truth, as well as sufficient justification for that belief in terms of experience, information and/or reasoning. The element of regression or circularity involved in this description indicates why knowledge is a jury question.

The other aspect to affirmation is that it requires an unequivocal communication to the other party of the making of the choice. In Scarf v, Jardine (1882) 7 App. Cas. 345, 360-1, cited by Slade L.J. in Peyman v. Lanjani. Lord Blackburn said at pp.360-1:

"The principle, I take it, running through all the cases as to what is an election is this, that where a party in his own mind has thought that he would choose one of two remedies, even though he has written it down on a memorandum or has indicated it in some other way, that alone will not bind him; but so soon as he has not only determined to follow one of his remedies but has communicated it to the other side in such a way as to lead the opposite party to believe that he has made that choice, he has completed his election and can go no further; and whether he intended it or not, if he has done an unequivocal act - I mean an act which would be justifiable if he had elected one way and would not be justifiable if he had elected the other way -the fact of his having done that unequivocal act to the knowledge of the persons concerned is an election."

Although dicta in Kammins Ballrooms Co. Ltd. v. Zenith Investments (Torquay) Ltd. [10971] A.C. 850 were not followed in Payman v. Lanjani on the question whether knowledge of the right to choose was itself also necessary, Lord Diplock's reference at pp.882-3 to a party with alternative rights acting "in a manner which is only consistent with his having chosen to rely on one of them" remains relevant.

Where the circumstances justify an avoidance and the choice is to avoid, the requirement of an unequivocal communication creates no problem. The claim to avoid demonstrates of itself at one and the same time awareness of the choice and its making. Where it is said that there has been an election to affirm rather than to avoid, the position is more problematic. Is it sufficient for affirmation that there is knowledge and a communication (by words or conduct) which, assuming such knowledge, demonstrates an unequivocal choice? Or must the communication itself or the surrounding circumstances demonstrate such knowledge to the other party? In principle, it seems to me that the latter approach is correct in the context of affirmation. The communication itself or the circumstances must demonstrate objectively or unequivocally that the party affirming is making an informed choice. In the context of estoppel, where knowledge is not a pre-requisite (though reliance is), it is in contrast the appearance of choice with which the law is concerned. Authority on these points is not easy to find, and dicta of Herring C.J. in Coastal Estates Pty. Ltd. v. Melevende [1965] V.R. 433 quoted with approval by Stephenson L.J. in Peyman v. Lanjani at p.489D-E may be said to point towards the former approach. Slade L. J's judgment in Payman v. Lanjani at pp.502-3 does however offer clear support for the latter approach. Whether there was an unequivocal communication of a choice depended, in his view, on whether the other party had reason to believe that the party allegedly affirming was aware of the facts and of his right to object or affirm. In my previous judgment at pp. 132-3, I also held that whether there had been an unequivocal representation had to be considered in the context of Royal Hotel's knowledge about what insurers knew or did not know.

Whether conduct amounts to an unequivocal communication of a choice to affirm requires therefore, an objective assessment of the impact of the relevant conduct on a reasonable person in the position of the other party to the contract. A reasonable person in that position must, it seems to me, be treated as having a general understanding of the possibility of choice between affirmation and objection. In affirmation (as distinct from estoppel), the actual state of mind of the other party is not the test. Affirmation depends on the objective manifestation of a choice. I do not read Lord Blackburn's reference to communication to the other side in such a way as to lead the other party to believe that he had make a choice as intended to suggest the contrary. Where, as here, the potential choice is whether or not to avoid on the ground of non-disclosure of matters material to be known to a prudent insurer which induced the actual insurer to enter into the insurance on the terms on which he did. it might be asked how far a reasonable person in the insured's position would be aware what matters were material to a prudent insurer or what matters had induced the actual insurer, and, how, short of such awareness, the reasonable person could regard any conduct of insurers as unequivocal. In insurance law and practice, the reasonable insured and the prudent insurer are somewhat different concepts. The authorities do not, I think, address this potential conundrum. In the present case, Royal Hotel's undisclosed conduct can be regarded as so obviously material and so obviously likely to have induced insurers to enter into any insurance that a reasonable person would proceed on that basis, unless otherwise instructed. The conundrum, if it exists, does not require resolution here.

Facts

In the light of these principles, I return to the facts. I heard evidence from Mr Martin Bakes of Herbert Smith, Mr Carter of Royal Insurance and Mr Walpole of ICO. My previous judgment dealt at some length on pages 128-9 and 130-3 with insurers' state of knowledge between the end of 1992 and the date in November 1993 when insurers concluded that they had a proper basis to assert fraud to obtain benefit under the business interruption insurance. I held that up to and including this date insurers did not have full knowledge of the relevant circumstances; that had been withheld from them by Royal Hotel; the only representations that insurers could be treated as having made up to that stage were that they did not have full information or a full understanding of the position, that they were anxious to achieve this, that they had wanted to cross-examine Mrs Farnon and Mr McHugh in the arbitration for that reason and that, once it became clear that those witnesses were not to be called, insurers were very likely to assert that there had been fraud to obtain benefit, in the absence of any satisfactory last minute explanation. Herbert Smith's letters dated 12th and 19th October 1993 gave Royal Hotel a last chance to put forward such an explanation. Royal Hotel's rejection of their requests led to insurers' avoidance for fraud to obtain benefit by letter dated 23rd November 1993.

The existence of the BCS and Consolidator invoices came to light during the course of discovery in the arbitrations around the middle of 1993. In mid-1993 Royal Hotel announced that its directors had concluded that its 1993 accounts should include a prior year adjustment reversing the transactions with BCS, which Royal Hotel's expert accountant in the business interruption arbitration (Mr Haberman) told insurers' expert (Mr Lee) on 6th October 1993 that he suspected had been included in Royal Hotel's accounts to "massage" the figures, though neither he nor Mrs Farnon knew why. Mr Haberman's report dated 5th October 1993 said that he had "ascertained" by discussion with Mrs Farnon and Mr McHugh that the rooms charged to Consolidator were occupied by related company employees and "represent actual occupancy", but determined to leave them out of consideration on the basis that "they do not represent a source of repeat or recommended business as would conventional occupants". A distinction was thus being drawn between the BCS and Consolidator invoices.

For present purposes it is insurers' state of mind regarding the Consolidator transactions which is critical. Herbert Smith's letter dated 19th October 1993 recorded that insurers were deeply troubled about both the BCS and Consolidator transactions. It said that prima facie the BCS invoices appeared to be dishonest documents, that Price Waterhouse (in the person of Mr Lee) had been unable to think of any other explanation for them and that, although Royal Hotel had sought to distinguish the Consolidator invoices, "they are very similar, and your clients have declined to provide any details to support their suggestion that Consolidator received significant consideration for the charges made to it". It went on to assert that the failure to call either Mrs Farnon or Mr McHugh

"raises the inevitable inference that you are unwilling to make them available for cross-examination because they are unable to give a proper explanation to show (a) that the Consolidator and BCS documentation was prepared honestly and (b) that the statements made in relation to it, i.e. that our clients could rely upon it and that it supported a trend of materially increased business as stated by Mr McHugh were made honestly."

The letter dated 23rd November 1993 recorded that the inference which insurers drew from Royal Hotel's failure to respond in any meaningful sense to the points raised was that Royal was unable to do so, and that

"Our clients conclude therefore that there is no honest explanation for the BCS documentation. It may well be that the same considerations arise in respect of the Consolidator documentation in that whilst your clients have sought to distinguish between the two, they have refused to answer our questions which have been directed towards a proper understanding of that distinction."

The previous action ("the 1994 action") was begun on 24th January 1994. The "statement of claim" endorsed on the writ asserted that the statistics supplied to Cunningham Hart by Royal Hotel's letter dated 19th August 1992

"were knowingly false and misleading in that they included figures relating to the BCS and Consolidator transactions. The Consolidator invoices are similar in all material respects to the BCS documentation and represent fictitious transactions."

Royal Hotel's points of defence and counterclaim served 24th March 1994 pleaded (in what was then paragraph 18.17) that Mr McHugh had in mid-June 1991 instructed Mr Anquetil to raise invoices to Consolidator in the sum of £150,000 at the rate of £50,000 per month for the following three months, that during January to August 1991 the hotel had provided accommodation for contractors' staff working on Havilland Hall and the hotel on behalf of Royal Hotel and other group companies and that

"The sum of £150,000 was a reasonable sum for this accommodation".

On 25th March 1994 Sir Patrick Neill Q.C. issued his first interim award in the material damage arbitration. Insurers' application for leave to appeal was dismissed by Longmore J. on 10th June 1994. Insurers then made a payment to Royal Hotel in respect of the material damage award on 21st June 1994, obtaining an order on 28th July 1994 that involved payment of £950,000 into a joint account pending trial of the 1994 action. Royal Hotel's solicitors sought from Sir Patrick a second interim award for costs of the material damage arbitration, which they submitted should follow the event. After letters from them and Sir Patrick, Herbert Smith responded on 12th October 1994:

"Material Damage Award

We are content that this should be dealt with in the manner proposed."

Sir Patrick thought it ambiguous whether they were concurring simply in a second interim award or also in its being in Royal Hotel's favour, but Herbert Smith did not respond to his request of 18th October 1994 seeking this clarification.

In the 1994 action, points of reply and defence to counterclaim were served on 29th April 1994 and a request was made on 14th June 1994 for particulars of the allegations in the points of defence regarding contractors and accommodation and as to how the £150,000 was calculated to support the allegation that it was a reasonable sum for such accommodation.

They were ordered by Waller J. on 7th October. When supplied on 25th November 1994, they stated that staff were accommodated not at the hotel but "in premises known as Ypres Guest House, Kingslynn and Fermoygave". They explained the basis of the £150,000 as being:

"The estimated income requirements of the Hotel in the light of the delay in the works being carried out at the Hotel."

During a meeting to discuss these particulars within Herbert Smith, Mr Bakes noted on his copy of this page of the particulars the words "Moral hazard" and "Rel'ship with Banks". On about 22nd May 1995 witness statements by Mr McHugh and Mr Anquetil were served in the 1994 action. Mr McHugh's statement confirmed that the contractors' workmen had been housed in staff accommodation (Ypres Guest House, Kingslynn and Fermoy) and other guest houses, and not therefore in the rooms shown in the Consolidator invoices. The statement recounted that in mid-1991 the hotel had cash flow difficulties and was supported by Consolidator in a variety of ways, and went on:

"20. I then had to decide how this financial support should be shown in RHL's accounts. I did not want to account for the payment as loans, as they would simply have increased RHL's liabilities to the group and weakened the balance sheet. I therefore decided to treat the payments as income, by including charges from RHL to Consolidator, Our banks knew that RHL was being supported by the group until the new business was established and were pleased that we had improved the Hotel and upgraded the business.

21. In or around June 1991 I therefore instructed Stephen Anquetil, an accounts clerk with responsibility for the preparation of the Hotel's management accounts, to raise charges to Consolidator in the sum of £150,000: £50,000 for each of the following three months. This was my estimate of the income which would be required to support the Hotel in the light of the delays."

On 13th April 1995 Sir Patrick Neill issued a second interim award awarding Royal Hotel its costs of the material damage arbitration. He recorded that, since Herbert Smith had been given more than one opportunity to resist such an order, he had to conclude that there was no submission that they wished to make in opposition.

On 7th November 1995 Royal Hotel's solicitors sent Herbert Smith a detailed summary of costs and disbursements in the material damage arbitration seeking to reach agreement without need for taxation. On 22nd November 1995 Herbert Smith requested copy invoices relating to experts' and counsels' fees and other matters to enable them to consider the disbursements claimed in more detail, and these were then sent. After further pressure from Royal Hotel's solicitors to agree costs with a 10% discount against the sums claimed (failing which such solicitors threatened an application to vary the order relating to the £950,000), Herbert Smith wrote on 22nd December 1995 that they were seeking instructions and that Royal Hotel's time limit of 29th December 1995 was unreasonable, and again on 22nd December, after taking instructions, that Royal Hotel's offer was unacceptable. A letter from Herbert Smith to Royal Insurance of the same date recorded that the thinking behind this was, first, that insurers had good prospects of a better discount on taxation, secondly, that agreement on costs might simply provide Royal Hotel with a fighting fund for the impending trial of the "fraud" (i.e. 1994) action and, thirdly, that

"(c) Consideration is to be given to the possible impact of the outcome of the fraud action on the material damage award. It is safe to assume that any money paid over to Royal Hotel will be extremely difficult to recover."

In November/December 1995 Mr Bakes with assistance from counsel prepared a draft amended statement of claim, which was served in January 1996 pursuant to leave granted on 13th December 1995. It added to the existing allegations, that the BCS and Consolidator transactions represented fictitious transactions, further allegations that they were

"(a) .... entered into, as Mr McHugh and, by him, Royal Hotel knew at the time of the transactions, to mislead Royal Hotel's bankers as to the state of its balance sheer and/or

(b) they included figures relating to the BCS and Consolidator transactions, which in whole or in part did not represent any or any real occupancy of the hotel and/or did not represent occupancy of the hotel in the ordinary course of its business as a hotel. The Plaintiffs will say that such occupancy as there may have been by workmen employed for the benefit of the Defendants or either of them (as to which no admissions are made) was not occupancy of the hotel in the ordinary course of its business as a hotel."

At the end of January 1996 Royal Hotel served supplementary statements from Mr McHugh and Mr Anquetil in the 1994 action. Mr McHugh insisted that his instructions to Mr Anquetil to raise the BCS and Consolidator "charges" were given pre-fire in mid-June 1991 and March/April 1992 and were nothing more than a straightforward way of providing internal support, which it was Mr Anquetil's job to process. Mr Anquetil sought to say that reference in his previous statement to his being instructed by Mr McHugh to raise some invoices to Consolidator had not been significant, that he could not remember Mr McHugh's actual words and that it was he who drafted the invoices and by them allocated charges within existing room categories. He suggested that this was because charges had to be allocated for management account and general ledger purposes and

"the only way I could think of to deal with this was to split the charges between rooms that had been unlet during the relevant months. It did not occur to me at the time to create a special category in the management accounts to which these charges could be attributed. I split the charges within the existing room categories on my own initiative."

Mr McHugh and Mr Anquetil persisted in this explanation of events throughout the trial before me, at the end of which I disbelieved their evidence on the point, and concluded that the invoices were deliberately created by Mr Anquetil on Mr McHugh's instructions in order to manipulate the management and annual accounts to create a more favourable picture if and when it became necessary or desirable to show these to Royal Hotel's bankers.

The trial of the 1994 action began on 7th February 1996. Judgment on claim and counterclaim were given on 5th July 1996 to the effect summarized at the start of this judgment. In the light of my judgment, insurers and Herbert Smith took independent expert advice on materiality, discussed materiality, inducement and the prospects of Royal Hotel establishing affirmation, decided to avoid the material damage insurance and on 12th August 1996 wrote accordingly.

Oral evidence

The oral evidence of Mr Bakes and Mr Carter filled in and dealt with the state of mind of those representing insurers¹ interests during the period from 1993 to 1996. On the evidence,

Herbert Smith have for several decades been regularly engaged by Royal Insurance to handle most of their large and high profile claims, as well as policy interpretation and litigious matters. The relationship is one of closeness and considerable confidence, in which Royal Hotel looked to Herbert Smith when they wanted the highest quality of legal assistance. Royal Insurance, which instructed Herbert Smith on behalf of both itself and ICCI, thus relied upon Herbert Smith to look after the interests of insurers during the arbitrations and the preparation for the 1994 trial and, as Mr Carter confirmed, to make judgments that required to be made during their course. Before me, Herbert Smith's state of mind and handling of both the arbitrations and the 1994 action have been treated for all purposes as synonymous with insurers'. No suggestion has been made that any knowledge which may have been possessed or decision which may have been taken by Herbert Smith was not or should not be attributed for any relevant purposes to both ICCI and Royal Insurance. This is relevant, since Herbert Smith at some points conducted matters without specific reference back to insurers.

Mr Carter's evidence was that, since fraud is a very serious allegation, he would in general only advance such a case where there was clear evidence and no satisfactory explanation. Herbert Smith's letters dated 19th October and 23rd November 1993 were drafted by Herbert Smith, who "had a much more detailed understanding of the facts than me" but he saw and approved them before they were sent. His statement said that he remembered being of the view that it remained possible that Royal Hotel would come up with an explanation for the BCS and Consolidator invoices. He saw the statement of claim and points of defence in the 1994 action in January and March 1994, but did not analyse them, leaving the running of the action to Herbert Smith. Herbert Smith had drawn his attention to paragraph 18.17 of the points of defence, which indicated that the invoices were created around the time when they were dated; it was also "surprising" in so far as it indicated that they related to staff accommodation. When payment was made in respect of the material damage award in June 1994, he was not aware of any case against Royal Hotel which would permit insurers to avoid the material damage policy and withhold such payment. During the trial of the 1994 action, he believed that insurers' case would be upheld, but "we were, however, by no means sure of how the facts would emerge and remained fully reserved for our line at, I believe, £10m until we received the judgment ....".

Royal Insurance's initial and principal contact within Herbert Smith was the senior partner in the insurance litigation group, Mr D. Higgins. He in turn involved Mr Bakes, by then a very experienced insurance litigator who had qualified as a solicitor in 1980 and became a partner in 1987. Mr Bakes was assisted by Ms H. Kydd, a senior assistant solicitor and a partner from 1st May 1994, who had been away from the London office since 1992 but had some experience of insurance cases between 1988 and 1991. The only one of these three who gave evidence before me was Mr Bakes, who had the day to day handling of the matter. He was in daily contact with Mr Higgins, so that there was opportunity for discussion whenever appropriate. Documents such as the points of defence would normally reach Mr Higgins first, because of his reference on incoming post, and he in fact drew Mr Bakes's attention to paragraph 18.17 in the points of defence. Mr Higgins would have had the final decision on major matters.

Mr Bakes's statement, which was adduced as his evidence in chief, described how a question-mark arose over the "honesty" of the BCS transactions as a result of their reversal in Royal Hotel's accounts in late June 1993, Mr Lee's advice that he could not think of an honest explanation and a comment by counsel for Royal Hotel in the arbitration that they had taken place "in order to boost the revenue of the Royal Hotel". But, Mr Bakes said, as best as he could recall he was waiting to hear what Mr McHugh and Mrs Farnon said in cross-examination. The Consolidator invoices looked very similar, and Royal Hotel's solicitors had not explained any difference, but they had not been reversed. Mr Haberman's report maintained that the distinction lay in actual occupancy, although he withdrew reliance upon the Consolidator invoices. Only after the refusal to call Mr McHugh and Mrs Farnon in arbitration, did Mr Bakes carry out a full factual analysis, when preparing the letter dated 19th October 1993. That letter was seeking to ensure that they had as much information as possible, including any explanations from the insured, before advising their clients on the question of fraud. As to the letter dated 23rd November 1993 written after Royal Hotel's refusal to give any further explanation, Mr Bakes recalled that he probably did speculate whether it would make any difference to insurers' case on fraud in the claims context, if the BCS and Consolidator invoices had been prepared initially not to defraud insurers, but to mislead others such as Royal Hotel's bankers, and concluded that it would not, if the invoices had subsequently been used dishonestly to present the claim. He said that his state of mind regarding the Consolidator invoices, both then and later when drafting proceedings, was that

"there was (just) a sufficient basis to allege that they might be dishonest documents alongside the BCS invoices (in respect of which I felt on firmer ground - although I was always conscious that Royal Hotel might ultimately have some explanation even for those)."

A non-disclosure point did not then occur to him. Paragraph 18.17 of Royal Hotel's points of defence appeared to be trying to offer an innocent explanation for the Consolidator invoices, but he "found it opaque and it did not ring true". The particulars of the points of defence served in November 1994 "seemed to me to indicate that the Consolidator invoices appeared to be on all fours with the BCS invoices", and made him "more confident that there was not an innocent explanation for the Consolidator invoices". It then occurred to him that it might be open to insurers to avoid. The "moral hazard" which he noted on his copy of the particulars in November 1994 was dishonesty in relation to bankers. It brought to his mind the possibility of avoidance of the material damage insurance, as well as - he confirmed in oral evidence - the business interruption insurance. In three lengthy paragraphs (Nos. 47-49) Mr Bakes sought to describe the attitude adopted then and thereafter in discussion which took place, though not he said of any great length, between Mr Higgins, Ms Kydd and himself about this potential non-disclosure point and about whether there were any steps that should be taken in its light.

The gist of Mr Bakes' account in paragraphs 47-48 was that Herbert Smith were troubled that the factual position remained unclear; a distinction was still drawn between the BCS invoices and supported by KPMG; they had formed the view that they were dealing with untrustworthy people at Royal Hotel, but they recognized a danger that they might be allowing essentially personal and instinctive reactions to get in the way of providing objective and dispassionate advice; all the relevant evidence was in Royal Hotel's hands and they knew that the burden of proving fraud was a heavy one. In these circumstances, according to paragraph 48:

"We decided that the prudent course was to see how the facts emerged at trial and in particular what findings of fact were made by the judge at trial before giving further consideration to a possible non-disclosure case. I was concerned, for example, that Royal Hotel might call evidence from its bankers saying that they had been fully informed of the circumstances which lay behind the invoices. I was also concerned that Royal Hotel (as had been contended in the letter of 11th June 1993) had allocated the rooms shown in the Consolidator invoices to Consolidator and that whilst these rooms had not been occupied, the allocation might be sufficient to justify the invoices. I recognized that this was not a case that Royal Hotel had yet advanced in the action and that if it was raised it would of itself raise a number of questions about the availability of rooms for occupation, but given that it had successfully changed its case in the arbitration at the last minute I felt that it might do something similar in this action as well. We felt that because of these uncertainties the correct course was to await the outcome of the fraud action."

Mr Bakes went on in paragraph 49 to say that this approach was not materially affected by Mr McHugh's and Mr Anquetil's witness or supplementary witness statements in February 1996.

This account of the thinking in and after November 1994 was not recorded in any contemporaneous document. The only documents, privileged or unprivileged, which bear on the present issues in the whole period from November 1994 to the date of my judgment in the 1994 action, are Mr Bakes' copy of the particulars annotated "Moral hazard" and the letter dated 22nd December 1995. Further, the reference to providing objective and dispassionate advice does not mean that any advice was in fact given to insurers following the discussion of November 1994. On the evidence, the consequence of whatever view was then taken was that no mention was made to insurers of any possible avoidance point. Any communication with Royal Insurance on such a point would in practice have been by Mr Higgins. Mr Bakes did not speak to Royal Insurance on the point until early 1996. He had a very vague recollection of Mr Higgins telling him at some point that he had mentioned the point to Mr Carter, but could give no time or detail. In the light of Mr Carter's evidence, I find that this mention did not occur until late 1995, shortly before Ms Kydd's letter dated 22nd December 1995.

Although the discussion within Herbert Smith in November 1994 was short, Mr Bakes's account of his thinking in the paragraphs which I have summarized was detailed. It does however face the problem that insurers were already alleging fraud, involving reliance on both the BCS and the Consolidator transactions as fictitious. The concerns and scruples emphasized by Mr Bakes's statement had not prevented Herbert Smith as experienced litigators from pleading fraud. According to Mr Bakes's oral evidence, the adverse view of the honesty of those behind Royal Hotel which he had formed had in fact been a factor encouraging him in his plea of fraud in the January 1994 statement of claim. It is clear that nothing since then can have done anything to diminish that view. Further, in November 1995, Herbert Smith with counsel's assistance actually amended their pleadings in the 1994 action to allege expressly that both the BCS and the Consolidator invoices had been prepared to mislead bankers. The considerations expressed in paragraphs 47 and 48 of Mr Bakes's statement could not explain why, as suggested in paragraph 49, Herbert Smith's approach was not materially affected even in later 1995 and early 1996 or why no claim to avoid any of the insurances was then made.

In fact, it emerged during Mr Bakes's evidence that his witness statement had been prepared without reference to significant documentation on Herbert Smith's files coming into existence in the period immediately after my previous judgment. This privileged material was made available during the present trial as a result of an application by Royal Hotel on the basis that there had been a waiver of privilege by insurers in adducing Mr Bakes's evidence. Among other passages, a letter from Mr Bakes to Mr Carter dated 31st July 1996 contained this;

"In short our case on affirmation and/or estoppel is that both these matters depend upon the party alleged to have affirmed or be estopped having full knowledge of the facts. Until service of the further and better particulars in late 1994 we did not have the requisite knowledge. From that time as you know, it has been recognized that the point might be available to be taken. The judgment that was rightly exercised at that stage was that to take the point at that time might have a disastrous impact on the allegations of fraud and would put that case in jeopardy. In any event it did not appear that any steps were to be taken (and were in fact taken) before the trial and determination of the fraud action which would amount to an act of affirmation of the material damage policy. In summary therefore I do not consider that any affirmation/estoppel case advanced by the insured should succeed."

The phrase "from that time as you know" was explained by Mr Bakes as referring to his discussion with Mr Carter in early 1996 about Herbert Smith's thinking in November 1994. Mr Bakes could not at first help, without a great deal of speculation, as to "whose judgment rightly exercised by whom" was meant in the next sentence, but he later accepted that it was the judgment of the three partners of Herbert Smith in November 1994. So read, and I do not doubt that it is so to be read, the sentence strikes an oddly emphatic note of justification. The sentiment that it expresses, that it could have had "a disastrous effect" and put the fraud case "in jeopardy" also strikes one as an odd and very extreme view of insurers' or any litigant's prospects of obtaining an objective resolution of plainly arguable disputes before a judge of this court.

The discrepancy between paragraphs 47-49 of the statement and the letter dated 31st July 1996 led Miss Bucknall to put to Mr Bakes that neither explanation was correct. She suggested that the reality was that the three Herbert Smith partners had been motivated not to carry any avoidance defence further in November 1994 by embarrassment at not spotting it before the payment made in respect of the material damage policy in June 1994; the letter dated 31st July 1996 was to attempt to justify that step as a positive tactical decision; the witness statement was an inaccurate attempt to meet the defence of affirmation on a different basis, namely that Herbert Smith's state of knowledge had not been sufficient to require any choice. In final submissions, Ms Bucknall did not pursue the first suggestion, and submitted that the right conclusion on the material before the court was simply that there had been a tactical decision as indicated in the letter.

Mr Bakes denied the first suggestion, and denied that his witness statement and letter were inconsistent. He said that it was just an oversight or pure omission that he had not mentioned the tactical aspect in his witness statement. What had happened, he said, was that, very much towards the end of a short discussion along the lines of paragraphs 47-48, someone had said words to the effect:

"Besides which tactically the right thing to do is to await the outcome of the fraud action",

and that

"there was a sense that actually as a matter of efficiently conducting this matter we should dispose of the fraud action because otherwise there would be a sense of wasting the court's time with lots of pleading and so on and lengthening the original trial".

That itself is, however, in my view a rather different "case management" point to the suggestions of "disastrous impact" and "jeopardy" made in the letter.

The explanations given in Mr Bakes's witness statement dated 17th January 1997 and in his letter dated 31st July 1996 are, in my judgment, inconsistent. The former could not and would not have been formulated as it was, had Mr Bakes had any recollection of what he had written so emphatically and recently less than six months before.

The difference is the more striking, when one looks back at the affidavit of Mr Bakes sworn 27th September 1996 in relation to an application by insurers for summary judgment in the present action. To that affidavit Mr Bakes first produced his copy of the particulars annotated "Moral hazard". He recalled the discussion with Mr Higgins and Ms Kydd in November 1994, and said that they had been concerned about the reliability of the information produced by Royal Hotel and had concluded (a) that they would only have all the relevant facts after judgment in the 1994 action and (b) that the right course would be to wait until then before deciding whether or not to assert non-disclosure in respect of the material damage policy, The affidavit continued:

"We decided that we were not in a position to amend the pleadings in the 1994 action, in relation to the business interruption policy."

In relation to the amendment in late 1995/early 1996 of the statement of claim in the 1994 action, the affidavit said that the dishonest creation of the charges to Consolidator was pleaded simply as a particular from which fraud in the presentation of the business interruption claim could be inferred, the date of the fraud on bankers was not pleaded and Herbert Smith and insurers remained "perplexed as to what precisely was RHL's case in respect of the Consolidator invoices, and for what services they had been raised". It said that from the commencement of the trial of the 1994 action "it seemed sensible to wait until [the Judge] had decided one way or the other as to the true facts before the insurers decided to allege material non-disclosure in respect of the material damage policy". Again, no doubt, this affidavit was prepared without reference to and without having in mind the documents and account on Herbert Smith's file dating from July 1996.

In my judgment, awareness of the issues which were bound to arise and have indeed arisen in this litigation has had a strong sub-conscious effect in shaping this evidence. In the light of the documentation, the oral evidence and cross-examination and the inherent probabilities, I find myself unable to place any real reliance on what is said in the witness statement in relation to the thought processes which determined the attitude adopted in and after November 1994. I also consider it probable that the descriptions given of the state of mind of those directing the litigation at previous dates portray a greater incomprehension and uncertainty that is likely to have been the case. Putting aside hindsight, it seems to me that on any objective view every successive development during the course of 1993 and 1994 reinforced the cause, first for suspicion, then for belief and finally for assurance that the Consolidator charges were both fictitious and dishonestly prepared, despite Royal Hotel's denials.

Mr Bakes's witness statement made no reference at all to any significance which moral hazard might have had in terms of the business interruption policy, under which insurers were already seeking to forfeit all benefit on the grounds of fraudulent claim, or to any discussion in that regard. On any objective view, any moral hazard represented by dishonest preparation of invoices to mislead bankers about the hotel's trading would have been more directly material to the business interruption policy than to a material damage policy. Mr Bakes's affidavit sworn in the Order 14 application is of interest in confirming what one would expect, namely that avoidance of the business interruption policy on this ground was considered in November 1994. But its suggestion that the partners in Herbert Smith then "decided that we were not in a position to amend the pleadings in the 1994 action, in relation to the business interruption policy" cannot be correct. Mr Bakes, when recalled to give evidence about the thinking in November 1994 with regard to the business interruption policy, suggested that they "did not focus on [that] policy because we were already engaged in the fraud proceedings which related to that policy". But an additional way of justifying an existing avoidance of liability would be something on which one would have expected them to focus, rather than not to focus. The key to Herbert Smith's thinking is in my view probably to be found in later answers by Mr Bakes, in which he accepted that part of the thinking was that they really had good enough defences - a "good, clear argument" - to be happy to go to trial on the business interruption policy, without developing a variant. In theory, a case based on non-disclosure would have offered a more direct route to avoidance of all liability. But it would obviously have lacked the compelling forensic attraction of the existing defence based on fraud in the presentation of the very insurance claim which Royal Hotel was pursuing. It is the sort of alternative defence which legal advisers might prefer not to be seeking to introduce by way of amendment because it would complicate matters and/or possibly also for fear of giving a wrong signal.

There can be no real doubt but that the primary commercial and legal concern in November 1994 must have been the current litigation to forfeit benefit under the business interruption policy. The material damage award had left insurers dissatisfied, but it had been paid. This was certainly Mr Carter's attitude when, a year later, the possibility of avoidance of the material damage policy was first discussed with him by Mr Higgins. He was "very cool" towards the suggestion, because they had already paid. Further, the material damage policy was until February 1996 only mentioned in the points of counterclaim in the 1994 action in the context of the counterclaim for conspiracy; all the same, it would hardly have been practicable to have sought to supplement the existing forfeiture by avoidance of the business interruption policy for moral hazard, without at the same time either avoiding the material damage policy or, if there was no such avoidance, gravely prejudicing any future attempt to avoid it. Mr Bakes did not think that the matter was thought through in quite that way; the focus, he said, was very much on the material damage policy "so I do not recall consciously going through that thought process". It seems to me that it would be surprising if it did not play a part, consciously or instinctively, in the thinking of the highly experienced litigators handling and discussing this matter in November 1994 and subsequently.

The decision in November 1994

However that may be, I am satisfied that an essentially tactical decision was taken and maintained in and after November 1994, to concentrate on the existing litigation and issues, and not to expand them by a claim to avoid either policy on grounds of moral hazard. I think it unlikely that Mr Bakes's letter dated 31st July 1996 correctly explains the thinking behind this tactical decision. It is more likely that it was a litigators' decision to concentrate on the claim in hand, and on the central and solid issues which it raised about which Herbert Smith were already confident. Insurers were not looking to Herbert Smith to do more than win that case. Once it was won, the material damage policy could be revisited without diversion of energy to matters which Herbert Smith and their clients did not then regard as being of primary concern, and without any risk of giving any sign of weakness to anyone. If, after a successful outcome of the business interruption action, steps could be taken which offered the prospect by litigation or compromise of some recoupment of monies in relation to the material damage policy, that would be pure benefit without any real downside. This thinking was it appears encouraged by the belief, reflected in Mr Bakes's letter dated 31st July 1996, that it would be possible to avoid any step which could be taken as an unequivocal affirmation by insurers.

Knowledge

I do not accept that the decision not to raise moral hazard in relation to the material damage policy in and after November 1994 was because of any scruples or uncertainties about the facts or about the basis for avoidance on this ground. In my judgment, if Herbert Smith had considered that it was in their clients' interests to raise moral hazard then or at any time thereafter, they would have raised it without hesitation and their clients would have accepted their advice and have acted accordingly. Further, not only could and would the point have been pleaded, but Herbert Smith in my judgment had, for the purposes of affirmation, the requisite knowledge that there had been dishonesty in the preparation of invoices to mislead bankers at all material times in and after November 1994. Mr Bakes himself came close to admitting as much when he wrote his letter dated 31st July 1996, though I would reach the same conclusions about knowledge independently of that letter. I find not only that Herbert Smith believed and on strong grounds that there had been such dishonesty, but that they did for present purposes "know" the real position, however much Royal Hotel continued to brazen it out with implausible denials or evasions. The particulars served in November 1994 represented in fact the final demolition of any idea that the Consolidator invoices could have been honestly prepared. Their devastating precision in identifying and billing particular hotel room usage was wholly and obviously undermined by the confirmation that the only accommodation which it could be suggested that workmen had actually utilized was staff accommodation in guest houses, etc. elsewhere, and that the £150,000 was based on nothing more than the hotel's income requirements. Mr Bakes was referred in re-examination to KPMG's apparent continuing support of the Consolidator invoices and to Mrs Farnon's statement dated 18th May 1995 basing this on representations from Mr McHugh, recorded, as Mr Bakes understood, in and on Consolidator's letter dated 11th February 1993. On the very face of these documents, Mr McHugh had deceived Mrs Farnon (in particular by telling her in February 1993 that the invoices related to rooms at the hotel allocated to associated companies for workers mainly doing up Havilland Hall and advisers on other projects), which is what I also ultimately held despite subsequent attempts by Mr McHugh to explain away the obvious. Mr Bakes said that Mr McHugh's explanations in paragraphs 18-19 of his witness statement of 22nd May 1995 left him "in a genuine state of not understanding what had been going on here". This contrasts not only with a submission by Lord Irvine during the proceedings for summary judgment that paragraph 19 of Mr McHugh's statement was a "giveaway" which caused Herbert Smith to put two and two together and led to the November 1995 pleading, but also with Mr Bakes's subsequent statement in his witness statement that paragraph 19 "reinforced my feeling that any deception might well have been intended to affect Royal Hotel's bankers". In reality, I consider, once the particulars had been reviewed in November 1994, Herbert Smith was aware and for present purposes knew that the only purpose of the elaborate and palpably false invoices to Consolidator must have been to mislead and, in particular, to mislead persons such as bankers reviewing the hotel's trading and that Mr McHugh on behalf of Royal Hotel must have caused them to be brought them into existence for that dishonest purpose. The unusual feature of the present case is the conclusion that insurers had, for the purpose of affirmation, knowledge of dishonest conduct by their insured, which their insured was in continuing litigation denying. That denial, although an important factor to be taken into account, does not preclude a conclusion that insurers had the relevant knowledge and knew that Royal Hotel's denial was in truth unsustainable.

For insurers to have had a choice whether or not to affirm the material damage insurance, Royal Hotel's dishonest conduct must have been material and have induced insurers' renewal of the insurance and they or their legal advisers must have known this and that it gave them the right to avoid. Fan Atlantic was decided on 25th July 1994 and its effect was no doubt well known to insurance specialists like Herbert Smith. In their submissions before me, insurers did not at any point suggest that any of these requirements represented any obstacle to Royal Hotel. It is true that Herbert Smith did not go into the position with their clients in any detail until after my judgment in July 1996. That was due to their tactical decision not to advance any case of avoidance based on moral hazard in any context until the 1994 action had been brought to a satisfactory conclusion. It also corresponded with Mr Carter's instinctive reaction in late 1995 not to become involved in any avoidance of the material damage policy at that stage. I have no real doubt, however, that Herbert Smith considered the dishonest conduct to be, on the face of it, material and knowledge of it to be, on the face of it, something that would have precluded insurers from renewing the risk in October 1991 on the same or any terms. Is it fatal to affirmation that Herbert Smith decided for tactical reasons not to pursue any moral hazard point at that stage and so did not actually address these points with their insurer clients? Or that, once it was drawn to Mr Carter's attention in late 1995 that the moral hazard point was there to pursue, he accepted that it should be left until after judgment in the 1994 action? I do not consider that it is. A person who deliberately and for tactical reasons decides not to acquire definite knowledge of a matter which he believes it likely that he could confirm must be treated as having knowledge of that matter. This is not to introduce any conception of constructive knowledge or negligence into the present situation. It reflects Herbert Smith's awareness of the point and the deliberate nature of the tactical decision which they took for better or worse not to raise or pursue it at that stage, however good it was in fact and law. They were in effect prepared to take the risk of the position being whatever it was, and it should be treated as within their knowledge accordingly. Mr Carter was, it appears, ready to adopt a similar attitude, although the way in which the matter was put to him and the extent to which he focused on it are unclear. It seems likely that it was for these reasons that insurers did not in their evidence or submissions before me focus on the fact that materiality and inducement were not considered or confirmed with insurers or any expert until after my judgment.

Unequivocal act

Royal Hotel's case is that there were unequivocal acts by insurers as follows: (1) payment of sums under the material damage policy in June 1994; (2) conduct in treating the policy and/or awards under it as valid and enforceable, consisting in particular of (i) the prosecution of the 1994 action and defence to the counterclaim in it, (ii) the sequence of events leading to the second interim award under the material damage policy and (iii) the subsequent correspondence between parties with a view to agreeing the costs due under that award. Royal Hotel now seeks to add (iv) "the consent order dated 24th July 1996 in the 1994 action, pursuant to which the balance of the material damage award was paid by [insurers]".

As to (1), payment in June 1994, it was not until November 1994, when the particulars confirmed the dishonesty of the Consolidator invoices, that moral hazard occurred to Herbert Smith as a basis for avoidance. It is irrelevant to consider whether the point could - or should - have occurred to Herbert Smith earlier, since it did not and constructive knowledge has no part in affirmation.

As to (2), the original counterclaim in the 1994 action was for conspiracy in respect of both policies, with breach of the agreement to pay £1 million under the material damage policy appearing as a particular of conspiracy. The damage alleged consisted of loss suffered by delay due to the conspiracy in expeditious payment of claims under both policies. It would have been an answer to a claim for such damages (although, it may well be, not to the allegation of conspiracy itself) that the material damage policy had been avoided. The defence to counterclaim served 29th April 1994 pleaded:

"7. It is denied that Royal Hotel suffered any loss and damage by reason of the matters pleaded in the Counterclaim. The dispute between the Royal Hotel and Royal and/or ICCI as to the extent of the liability of Royal and/or ICCI under the policies was referred to arbitration and Royal Hotel will be compensated in respect of any loss suffered by an award of interest in that arbitration."

The course of arbitration in respect of the business interruption claim had been halted by the claimed (and effective) forfeiture of all benefit under that policy. Paragraph 7 of the defence to counterclaim remained unaltered at all times. Further, Herbert Smith's letter dated 12th October 1994 involved a recognition of the validity of Sir Patrick Neill's first award under the material damage policy, of his continuing jurisdiction and so by necessary implication of the continuing validity of the material damage award, since his jurisdiction was predicated on liability being admitted (as insurers themselves had successfully persuaded him in February 1994, with the result that no actual business interruption award was ever issued). It seems unlikely (although Mr Bakes was not asked by either side about this) that it was simply coincidence that after the November 1994 particulars Herbert Smith failed to respond to Sir Patrick's requests for clarification of their position on a second interim award on costs. Mr Bakes acknowledged that a year later he was seeking to "string [Royal Hotel] along" in correspondence on costs in the hope of avoiding any step which might be construed as an affirmation. However, in the context of a continuing arbitration, silence is not necessarily equivocal. In the present case, it led to Sir Patrick issuing his second interim award dated 13th April 1995. A party to an arbitration who, with knowledge that he has a right to avoid, allows further performance by the arbitrator of the tri-partite arbitration contract between the parties and the arbitrator, whose decision will give rise to enforceable rights and duties between the parties, may in my view be taken to recognize unequivocally by his conduct the continuing applicability of the arbitration agreement and, in the present context, the continuing validity of the insurance policy upon which its applicability was predicated. He owes a duty to speak and to prevent or at least dissent from further performance, if his conduct is not to be so construed.

This brings me to insurers' conduct in late 1995 in seeking documentation to enable them to consider Royal Hotel's suggestion that the costs awarded under the second interim award be agreed without taxation. Taken in conjunction with the earlier conduct which I have identified, this underlines my conclusion that insurers by their conduct recognized unequivocally the validity of that award and of the material damage policy. If it had stood alone, however, I would doubt whether it was a sufficiently unequivocal recognition of such validity; for example, although consistent with such a recognition, it might alternatively have been attributable to a desire to have full information about the financial position, before deciding whether or not to avoid the material damage policy.

In January and February 1996 amended and re-amended points of counterclaim in the 1994 action first introduced and then developed Royal Hotel's assertions of breaches of the two policies as independent claims: see paragraph 38. The reamendment for which I gave leave at the outset of the trial added a specific claim for bank charges and interest as damages for breach of the agreement to pay £1 million under the material damage policy. The action was fought on that basis, and I held that insurers were in breach of a contract made by their loss adjusters on their behalf whereby it had been agreed to make an interim payment of £1,000,000 to Royal Hotel in respect of the material damage policy. I ordered damages to be assessed in respect of that breach. In practice, this assessment has not been pursued, quite possibly because the award of interest in the material damage arbitration covered the same period. Nonetheless, the trial was fought before me in terms which recognized the existence of the material damage policy. If that policy had been avoided, the agreement by the loss adjusters to make the interim payment would have been vulnerable. Its underlying assumption was the existence and validity of the material damage insurance. Whether avoidance of the material damage policy would have made the agreement to make the interim payment under the material damage policy void or voidable may be a nice point, which was not addressed by submissions before me. An agreement to make an interim payment under a policy appears, if anything, even more obviously dependant on the validity of that policy than the agreement to compromise a claim in ignorance of right to avoid considered in Magee v. Pennine Insurance Co. Ltd. [1969] 2 Q.B. 507, (where it did not matter whether the agreement was void or voidable and the majority judgments are open to different interpretations). I am inclined to think that the agreement to make the interim payment would have fallen away automatically with avoidance of the material damage policy. On this limited basis and more generally because the 1994 action was, to outward appearances, conducted throughout in terms which assumed the existence and validity of the material damage policy, it seems to me that, whatever was intended, insurers' conduct of the 1994 action is also capable of constituting an unequivocal representation as to the validity of the material damage policy.

The unusual feature that Royal Hotel was itself denying any dishonest conduct in the course of the 1994 action makes it necessary to focus more closely on the requirement that the conduct relied on as affirmation constituted a sufficiently unequivocal representation of choice. Insurers themselves had, I have concluded, the requisite knowledge from November 1994. Royal Hotel was throughout denying any dishonesty, but it must have known that its denial was untruthful and may very well have had a shrewd appreciation that the denial was not making any impact on insurers. But Royal Hotel's own state of mind is not the test. The test is whether a reasonable person, in Royal Hotel's position and with its knowledge, would have regarded insurers as making an unequivocal representation or choice. That depends upon what a reasonable person could and would infer about insurers' knowledge. Insurers' own actual knowledge derived from a common sense consideration of documents and information which Royal Hotel had supplied. Although Royal Hotel continued to brazen it out, it seems to me that a reasonable person would have reached exactly the same conclusion that Herbert Smith reached, namely that these were dishonest and fictitious invoices deliberately created by Mr McHugh to distort the hotel's trading in the eyes of persons such as bankers. In these circumstances, I consider that the conduct which I have identified did constitute affirmation, in particular (a) insurers' and their advisers' conduct in late 1994 and early 1995 in relation to the second interim award on costs and (b) their conduct of the 1994 action, especially after the amendment and reamendment of the points of counterclaim to claim damages directly for breach of the agreement made under the material damage policy.

I need say relatively little about the further step which Miss Bucknall sought to plead as affirmation, the consent order dated 24th July 1996. Mr Veeder resisted its admission into the action on the grounds that it was far too late, incomprehensible and, so far as it could be understood, hopeless. The order dated 24th July 1996 discharged paragraph 4 of a previous order dated 28th July 1994. That order dated 28th July 1994 had by paragraph 3 restrained Royal Hotel from enforcing the material damage award as to £950,000 (of its total of nearly £5 million) until trial of the 1994 action or further order. By paragraph 4 it had ordered insurers to pay £950,000 into an account in the parties' solicitors' joint names. The conceptual basis of this order is not, I think, free from doubt. The general idea was that since Royal Hotel had received £950,000 on account under the business interruption policy, they should not receive the full amount of the material damage award pending the outcome of the 1994 action. What in law was the basis for or effect of paragraphs 3 and 4 is less clear. It was apparently accepted that the £950,000 (allegedly) paid and recoverable in respect of the business interruption policy could not be set off in extinction of the undisputed debt on the material damage award. But, if the full amount of the material damage award had had to be paid over, insurers might have obtained Mareva relief in relation to the £950,000 being reclaimed on the business interruption policy. The order, on whatever basis, short-circuited matters. In early 1996, by way of variation of the order, £475,000 was allowed to be paid out of the joint bank account. Paragraph 4 was discharged by the order dated 24th July 1996, which ordered the balance remaining in the joint account (some £571,000 by that date) to be paid out to insurers in part satisfaction of my judgment in favour of insurers for return of the £950,000 paid to Royal Hotel on account under the business interruption policy.

If this summary is right, insurers were simply recovering monies which they were due from one source or another under the business interruption policy. It was as if the monies had been paid over to Royal Hotel, maraeva-ed in their hands and were now the subject of execution to satisfy the business interruption judgment. The variation said nothing about the legitimacy of Royal Hotel continuing to hold the £950,000 originally paid under the business interruption policy. It said nothing to suggest or confirm that those monies could now be applied to meet the balance of the material damage award. The variation cannot have constituted an act of affirmation. Accordingly, assuming that I have understood the position correctly (and Miss Bucknall did not, I think, suggest the contrary), the amendment sought is bound to fail and should not be granted. If it is suggested that my understanding of the position is not correct, then it seems to me that it would be necessary to clarify the position by proper pleading, proof and explanation of the various orders. It is too late to undertake this by an amendment suggested for the first time in counsel's final submissions, and I would have refused leave on this ground. As it, however, Royal Hotel do not in any event need to rely on it.

Conclusion

It follows that insurers' action fails on the ground that insurers affirmed the material damage policy, despite their and legal advisers' unannounced internal intention not to do so.

(D) CAUSE OF ACTION OR ISSUE ESTOPPEL AND/OR ABUSE OF PROCESS Miss Bucknall's short point is that insurers should have raised any case based on avoidance of the material damage policy, or for that matter the business interruption policy, in the 1994 action, if they wanted to do so at all. They are, she submitted precluded on grounds of estoppel or abuse of process from doing so subsequently. This point was argued before me on the basis that, if it was otherwise well founded, it would be open to me to give effect to it as a defence in so far as it involves a defence or as a ground for striking out the action if and in so far as that is the appropriate remedy in a case of abuse of process.

The primary basis for Miss Bucknall's submission is the statement of principle by Wigram V-C in Henderson v. Henderson (1843) 3 Hare 100, 114:

"... where a given matter becomes the subject of litigation in, and of adjudication by, a court of competent jurisdiction, the court requires the parties to that litigation to bring forward their whole case, and will not (except under special circumstances) permit the same parties to open the same subject of litigation in respect of matter which might have been brought forward as part of the subject in contest, but which was not brought forward, only because they have, from negligence, inadvertence, or even accident, omitted part of their case. The plea of res judicata applies, except in special cases, not only to points upon which the court was actually required by the parties to form an opinion and pronounce a judgment, but to every point which properly belonged to the subject of litigation, and which the parties, exercising reasonable diligence, might have brought forward at the time."

This was examined and explained in the Privy Council in Yat Tung Co. v. Dao Heng Bank [1975] AC 581, 590-1, where Lord Kilbrandon said:

"The shutting out of a "subject of litigation" - a power which no court should exercise but after a scrupulous examination of all the circumstances - is limited to cases where reasonable diligence would have caused a matter to be earlier raised; moreover, although negligence, inadvertence, or even accident will not suffice to excuse, nevertheless "special circumstances" are reserved in case justice should be found to require the non-application of the rule. For example, if it had been suggested that when the counterclaim in no. 969 came to be answered Mr. Lai was unaware, and could not reasonably have been expected to be aware, of the circumstances attending the sale to Choi Kee, it may be that the present plea against him would not have been maintainable. But no such averment has been made.

The Vice-Chancellor's phrase "every point which properly belonged to the subject of litigation" was expanded in Greenhalgh v. Mallard [1947] 2 All E.R. 255, 257, by Somervell L.J.:

"... res judicata for this purpose is not confined to the issues which the court is actually asked to decide, but... it covers issues or facts which are so clearly part of the subject matter of the litigation and so clearly could have been raised that it would be an abuse of the process of the court to allow a new proceeding to be started in respect of them.""

The terminology used is not entirely consistent. For the most part, the entire topic is dealt with under the general rubic of res judicata or issue estoppel. In some cases, however, emphasis is laid on the different conceptual basis of abuse of process on which rests, as stated in Yat Tung at p.590A-B, "the wider sense in which the doctrine can be appealed to". In Brisbane C.C. v. A-G for Queensland [1979] AC 411, 425G, this was again identified as the true basis for the wider jurisdiction, which the Privy Council there said "ought only to be applied where the facts are such as to constitute an abuse: otherwise there is a danger of a party being shut out from bringing forward a genuine subject of litigation". Chitty on Contracts (27th Ed.) Vol. 1, paragraph 25-011 adopts a different approach, treating both aspects of Henderson v. Henderson under the rubric of cause of action or issue estoppel, but identifying with reference to this and other authorities a third head of jurisdiction under the rules of court and inherent jurisdiction, to stay or dismiss an action by which a plaintiff seeks to raise matters which were or should have been litigated in earlier proceedings. It seems to me, in the light of Yat Tung and Brisbane C.C. v. A-G for Queensland that it is more correct to analyse the matter under only two heads. Valuable discussions of the nature and scope of the jurisdiction under both heads are found in other authorities cited in Chitty, such as Dallal v. Bank Mellat [1986] 1 Q.B. 441 (Hobhouse J.) and Talbot v. Berkshire C.C. [1994] 1 Q.B. 290 (C.A.), 296, 301.

There is a considerable overlap in the facts relevant to this point and to affirmation. The legal tests are different. Estoppel or abuse does not depend on either knowledge or a manifested election, but upon the existence of a point "properly belonging to the subject of litigation" which might "with reasonable diligence" have been brought forward in it. The test is also subject to "special circumstances".

The relevant parties before me were parties to the 1994 litigation. The judgment in that action is final and conclusive on the merits of the matters decided. But the validity of the material damage policy was not in issue in the 1994 action. The first head of jurisdiction identified in the authorities, res judicata or issue estoppel in the narrow sense, is not available. The wider head of jurisdiction requires consideration whether insurers could and should have put the voidability of the material damage policy in issue in the 1994 action, and should be held precluded from doing so in the present fresh action.

Insurers could without doubt have claimed to avoid the material damage policy, and have resisted liability for the damages claimed for conspiracy and for the alleged breaches of (inter alia) the material damage policy on that basis. They could have avoided the material damage policy by defence or amended defence to the original (or amended or reamended) points of counterclaim. Irrespective whether they had sufficient knowledge for the purposes of affirmation, they certainly had sufficient knowledge for the present purpose in and from November 1994. Their decision not to do so was, as I have found, a tactical decision. This is exactly the sort of context in which the wider principle in Henderson v. Henderson may apply.

Two objections to this conclusion arise. The first is that the wider principle in Henderson v. Henderson can only apply when there has been a decision in the prior proceedings adverse to the party now seeking to pursue further litigation: see The Doctrine of Res Judicata by Spencer Bower (2nd Ed., 1969) paragraphs 197 and 203. This qualification inter-relates with the rule, mentioned in Chitty paragraph 25-010, that cause of action and issue estoppel only apply to issues which it was "necessary to determine" for the purpose of resolving the previous proceedings. Issues which a court may in passing have decided or assumed against a party but in respect of which he could not ex hypothesi appeal (either because he succeeded in the action on other grounds or because he would have lost anyway on other grounds) are likely on this basis to fall outside Henderson v, Henderson, The requirement of an adverse decision, on the particular issue and on the action as a whole, cannot however be absolute. For example, under the narrower principle in Henderson v. Henderson, a party who sued on a contract and recovered judgment in his favour for damages could be precluded from later asserting that the contract was void. The principle was so stated by Lord Denning M.R. in Fidelitas Shipping Co. Ltd. v. V/O Exportchleb [1966] 1 Q.B. 630, 640. Under the wider principle, based on abuse of process, it is also not clear to me why there should be the completely rigid restriction on the court's jurisdiction indicated in Spencer Bower and in the older authorities there cited. I note that in re State of Norway's Application [1990] 1 A.C. 723, 752, Balcombe L.J. expressed the view that appealability on the particular issue was no more than a test to decide whether a particular issue was fundamental to the court's substantive decision. These points were not argued before me, and I do no more than draw attention to them. For present purposes, it is sufficient to note that my judgment in the 1994 action was adverse to insurers on the issue whether ICCI was in breach of the contract to pay £1 million under the material damage policy and in adjudicating that ICCI was liable to pay damages to be assessed for that breach. That conclusion could not have been reached unless the material damage policy continued in force.

The other objection is that it is erroneous to treat an issue about avoidance which could only arise as and when insurers chose to avoid, as a "defence" or as an issue which could or should have been raised in the 1994 action at all. No such issue arose (it is submitted) until insurers elected to avoid on 12th August 1996. Unless before that date they had affirmed (or had precluded themselves from avoiding by promissory estoppel, which has not been suggested), it remained open to them on 12th August 1996 to avoid. Accordingly, it is said, insurers must in this case either succeed on affirmation or not at all. In short, the principles in Henderson v. Henderson do not extend to, and should not be interpreted to restrict, a party's contractual or equitable rights, particularly to avoid. They apply simply to the timely bringing forward, as a matter of procedure, of claims or defences based on existing rights, immunities and facts.

This second objection raises another point of general interest. Miss Bucknall helpfully located, and Mr Veeder relied upon, a decision of the Court of Appeal in Duchess Theatre Company Ltd. v. Lord (9th December 1993. In that case Minories Finance Ltd. (formerly Johnson Mathey Bankers Ltd. - "JMB") claimed by writ issued in October 1991 in respect of monies of which they had on 25th February 1996 demanded payment from various companies in the Gomba group as guarantors of Gomba Exim Ltd. Previously, in mid-1995, JMB had demanded payment from the same companies of various other monies due from them as principal debtors or as guarantors of companies other than Gomba Exim Ltd., and judgments were given against such companies in respect of those monies on 16th January 1996. It was argued in the 1991 action that JMB was precluded under the wider principle in Henderson v. Henderson from pursuing the claims made in the 1991 action, since they could with reasonable diligence have been made in the 1985-86 proceedings. The argument failed. Under the terms of the Gomba Exim guarantees, no cause of action arose against the companies unless and until a demand was made, and no demand was made until 25th February 1986 - that is, after the previous judgments. Balcombe L.J., with whom the other members of the court agreed, held that, even if the demand had preceded the proceedings which led to the judgments of 16th January 1996, still the causes of action thereby created would not have been so clearly part of the subject matter of those actions that it would be an abuse of the process of the court to allow a new action to be started in respect of them. He went on that the fact that there were no causes of action at all until 25th February 1986 made the matter even clearer, since:

"It would in my judgment be an unwarranted extension of the doctrine of Henderson v. Henderson, even if it were otherwise applicable, to apply it to a case where no cause of action existed at the relevant date but which might then have existed had JMB made the necessary demands on the plaintiffs."

This reasoning lends obvious support to insurers' submission before me that Henderson v, Henderson has no application to a situation where there was no avoidance and no right to reclaim sums paid under the material damage policy until 12th August 1996. It was however delivered in a case where there was no real connection between the subject-matters of the different proceedings. Further, the position of a person who may, if and when he chooses to make a demand, acquire a cause of action in debt or for damages is not necessarily analogous for present purposes to that of a party to a voidable contract with a right to avoid. The former may make such a demand at any time. The latter is anyway subject to certain restrictions, arising from the possibility of affirmation as well as promissory estoppel.

The Privy Council decision in Yat Tung presents an instructive contrast. In the first action (no.969), the appellant, Yat Tung, had claimed that an apparent mortgage to secure a loan to it was a sham and that it held the property as trustee for the bank, Dao Heng. Dao Heng counterclaimed for loss suffered by it on exercise by it of a power of sale contained in the mortgage, by virtue of which it sold the property to Choi Kee. In response to the counterclaim Yat Tung admitted the sale to Choi Kee, but denied that it owed any sum or that the bank had suffered any loss. Yat Tung lost both the claim and the counterclaim. In the second action (no.534), Yat Tung claimed against both the bank and Choi Kee that the sale was void or voidable as fraudulent in that both had, in effect, been conspiring to obtain the property at a gross undervalue. The issue was "whether the allegation of fraud and voidability of the sale to Choi Kee were matters available for litigation in [action no.] 969": see page 5S8D. I observe, in parenthesis, that this formulation reflects what I would perceive to have been the position in law, namely that, if Yat Tung's allegations were well founded, they would have made the sale voidable, not void. The rules would have enabled such an issue to be raised by counterclaim to the counterclaim. That being so, the Privy Council applied Henderson v. Henderson in its wider aspect. Following passages which I have already quoted, its advice went on:

"Again a phrase used by Lord Shaw of Dumferline in delivering the opinion of the Board in Hoystead v. Commissioner of Taxation [1926] AC 155, 171, "the present point was one which, if taken, went to the root of the matter on the prior occasion", appears precisely apposite to the failure, in answer to the counterclaim in No. 969, to raise the matters founded on in no. 534 which, if then substantiated, would have been then decisive."

This authority appears therefore to favour the view that there may be circumstances, in which a party who fails to take advantage of a right to avoid (of which he knew or ought to have known) in order to defeat a claim under or by reference to a contract, may be precluded from later doing so. Such an avoidance may be effected in and by the same pleading that raises it as an issue in the action. Although in a strict sense, a party has no defence unless and until he avoids, there is an element of unreality about this view of the matter. As responses to a claim, avoidance, breach of warranty, failure to perform a condition precedent to liability or a suggestion of fraudulent claim are in the ordinary course all probably considered and, where arguable, either deployed or rejected in litigation, without attention to whether they depend on some formal act which has effect in contract or equity outside insurers' pleading. Avoidance for non-disclosure does depend on such an act. Avoidance for breach of warranty now, on House of Lords authority, Hellenic Mutual War Risks Association v. Bank of Nova Scotia [1992] 2 A.C.233 (and contrary to what some commentators had previously suggested to be the law) does not. Denial of liability for breach of condition precedent does not. Forfeiture of benefit for fraud in the claims context under a specific policy provision does not. But avoidance of liability at common law for fraud in the claims context may operate on a different legal basis, although the position is not clear: see my previous judgment, pages 133-4.

Insurers' insistence before me that avoidance for non-disclosure is a course which they can reserve for subsequent use without risk of application of the wider principle in Henderson v, Henderson does not appear to me to fit easily with the day-to-day realities of claims handling and litigation or with the basis of the wider principle in that case, namely to avoid abuse of the process of the court. The Privy Council advice in Yat Tung appears to me to recognize that there are some situations where a party should be expected to make any case which he has on avoidance at the time when reliance is placed on the contract which he later suggests is voidable, and that failure to do so at that time may preclude him asserting avoidance in later proceedings. I acknowledge that this involves a slight extension of the scope of Henderson v. Henderson into the field of exercise of substantive rights. Such an extension in the particular context of voidability of insurance contracts appears to me to reflect the commercial and practical realities which apply between parties to litigation such as the 1994 action, where the insurance contracts had no continuing significance save in respect of claims already paid or being pursued under them. I note, in passing, that in Magee v. Pennine Insurance Co. Ltd.. Lord Denning, who regarded the compromise agreement as voidable not void, nonetheless spoke of Mr Magee as having no "no valid claim on the insurance policy" (page 515A). That usage reflects the same reality. Apart from the claims which had been paid or were being pursued in respect of the material damage insurance policy, that policy had by the time of the 1994 action no significance for either party.

In my judgment, the principle extended in this way in potentially applicable in the present context. Reliance was placed on the material damage policy in the counterclaims made by Royal Hotel against insurers in the 1994 action. Insurers met that reliance by accepting the existence of the material damage policy, but by denying any liability, whether for conspiracy or for breach, in respect of it. In one area, albeit minor, insurers lost on the case made against them of breach. The effect of their present case would be to undermine that conclusion, as well as to enable them to recover the sums paid under the material damage policy, which they could on the face of it also have counterclaimed to the counterclaim in the 1994 action. How the 1994 action would then have proceeded is a matter which cannot of course now be known for certain; but it would probably have been considered on the application for a split trial with which I in fact dealt with on 9th December 1994, as outlined on page 98 of my previous judgment, or at a later stage if the issue had been raised later.

There would in practice probably also have been a claim to avoid the business interruption policy. The strong likelihood is that the issue of avoidance for non-disclosure, being relatively short and linked factually with the background issues in the 1994 action as well as the counterclaim, would have been tried and determined with all the other issues which I decided on 5th July 1996.

There is in the circumstances no doubt that the issue of non-disclosure and avoidance could with reasonable diligence have been brought forward in the 1994 action. Was it one which "properly belonged" to the previous action? And, if it did, are there special circumstances which should lead to the non-application of the wider rule in Henderson v. Henderson? The arguments on these two points overlap. Mr Veeder submits that his clients were justified in viewing the counterclaim as substantially misconceived. Any issues under the material damage policy were, he suggested, subsidiary, or, at all events, the only issue on which insurers lost was very subsidiary. In these circumstances, any claim to avoid the material damage policy did not properly belong to the 1994 action, or there were special circumstances why the court should not hold insurers precluded from pursuing it, even though it would undermine a minor part of the previous judgment. In my judgment, despite the tactical considerations which led Herbert Smith to the course which they and insurers took, any issue regarding the voidability of the material damage policy was so closely connected with the subject matter of the counterclaim that it did properly belong in the 1994 action. It could and would have been accommodated there and, in all likelihood, tried together with the other issues which I determined in the 1994 action. That the only issue depending upon the validity of the material damage policy upon which insurers lost was a subsidiary issue could be more directly important if insurers had sought to avoid that policy but had, after judgment, decided not to appeal on the issue because of its insignificance. Here, however, there was a tactical decision not to take any point about the validity of the material damage policy in an action in which the defendants were counterclaiming on a relatively broad basis which assumed and depended in one way or another upon the validity of the material damage policy. Although I have in mind the underlying basis of the wider principle in Henderson v. Henderson and the words of the Privy Council in Brisbane C.C. v. A-G for Queensland. I do not see this as a case where special circumstances exist taking the matter outside the scope of that principle. The court need not be too sympathetic to a tactical decision to postpone avoidance, in circumstances where, to all outward appearances and so far as the court was aware, the validity of the material damage policy was and remained throughout the course of the 1994 action unchallenged - as Mr Bakes, on the basis of his attendance note dated 23rd July 1996, also believed that Royal Hotel itself thought was the case.

In these circumstances, although it may be rare that a decision not to avoid will fall within the wider principle of Henderson v. Henderson. I consider that this is such a case. The claim therefore fails on this ground also.

There will be judgment dismissing the claim against Royal Hotel.

29 July 1997