February 2009

Funding litigation from secured assets - case raises questions for liquidators and unsecured creditors

Liquidators will now be more readily able to fund litigation and pay for it out of assets the subject of a fixed charge, following a decision of the Full Federal Court earlier this month.  Whilst liquidators will be looking at new opportunities to recover assets, secured creditors need to consider the implications of this decision when dealing with a liquidator appointed to a debtor with valuable legal actions.

Background

In IMF (Australia) Limited v Meadow Springs Fairway Resort Limited (in Liquidation) [2009] FCAFC 9 (6 February 2009), a liquidator sought permission from secured creditors to run litigation in respect of an alleged negligent valuation provided to the company in liquidation.  No consent was forthcoming.  Nevertheless the liquidator entered into a funding agreement with litigation funder IMF to pursue the litigation which was ultimately resolved by settlement.  The settlement included a payment to the liquidator on behalf of the company of an amount of $6,950,000.  The liquidator applied for directions as to how to distribute this sum, and in particular how much of the fees payable to IMF could be paid from the settlement sum, ahead of amounts outstanding to the secured creditors.

Universal Distributing Principle

The liquidator and IMF relied upon the principle in Re Universal Distributing Company Limited (in Liquidation) [1933] 48 CLR 171 (the Universal Distributing principle).  This principle holds that expenses reasonably incurred in the care, preservation and realisation of a fund may be recovered from that fund, even though the fund belongs to a secured creditor.  It does not appear to have been disputed that the liquidator's fees in respect of the litigation were entitled to be paid from the settlement sum (although this was not the subject of the judgment).  It was also agreed that the legal costs which were incurred in the litigation were to be paid from the settlement sum.

The focus of the proceedings was IMF's claim to 35% of the settlement sum, in accordance with its litigation funding agreement, as well as IMF's claim to $115,000 in respect of its management fees and proposal assessment fees for dealing with the litigation funding agreement and supervising the litigation. 

The secured creditors argued that none of these amounts could be deducted from the settlement sum, as they were not expenses incurred in realising the settlement sum.

The trial judge found that the liquidator had acted reasonably in entering into the IMF funding agreement and that the management fees of $115,000 were an expense that was reasonably incurred in establishing the settlement sum.  This was therefore an expense payable in priority to the claims of secured creditors under the Universal Distributing principle.

However the trial judge distinguished the entitlement of IMF to its additional fee of 35% of the settlement sum. His Honour held that this was not a debt covered by the Universal Distributing principle.  His Honour analysed the competing equitable claims against the settlement sum, and found that once the charges had crystallised, the secured creditors acquired an equitable interest in the cause of action, including the settlement proceeds resulting from that action.  Given that IMF had knowledge of the secured creditors\' claims, there was no reason to give IMF's equitable interest any priority over that of the secured creditors.  The normal rule, that the earlier equitable interest has priority, applied.

On appeal

In a unanimous judgment the Full Federal Court considered the Universal Distributing principle, and found that there was no justification to distinguish between the additional 35% share of the settlement sum to which IMF was entitled under its funding agreement, and the management fees which were payable to it under the same agreement.  After looking at the funding agreement, the Court found that the whole of the consideration to be paid to IMF was to come only from the settlement sum. Therefore the Court was satisfied that the whole of that amount was an expense of getting in the settlement sum, within the Universal Distributing principle.  The 35% share of the settlement sum which was claimed by IMF was \"no less part of the consideration to be given to IMF for the performance of its obligations under the IMF Funding Agreement.\" 

Because the trial judge had found that the liquidator was justified in entering into the IMF funding agreement (and this decision had not been the subject of an appeal), the Full Court found no room for the secured creditors\' suggestion that the amounts to be paid to IMF exceeded what would be reasonable expenses of recovering the settlement sum.  The Court also found it irrelevant to consider whether the secured creditors could have funded the action at a cost that was significantly less than the amount payable to IMF for providing funding.

In the end, IMF was entitled to recover the management fees, as well as 35% of the settlement sum, as an expense properly charged against the fund realised by the liquidator from the legal actions.

Conclusions

This judgment raises interesting questions for both liquidators and also perhaps for unsecured creditors, who may wish to consider funding litigation in return for what may amount to priority over secured creditors' claims. It would be wise to proceed carefully, however, remembering decisions such as the Nothintoohard Pty Ltd cases ([2005] NSWSC 357; appeal dismissed [2006] NSWCA 311). In those cases the liquidator was held to be not entitled to be reimbursed for significant expenses incurred in respect of attempts to realise secured assets, which were ultimately realised by the secured creditor.

On the other hand, secured creditors should also consider this judgment carefully as they attempt to protect and realise their security over all assets of the debtor company, including potentially valuable legal actions.

It is not known whether an application for special leave to the High Court will be filed.

This publication is intended as a source of information only. No reader should act on any matter without first obtaining professional advice.

Stephen Mullette