March 2008

Litigation funding in insolvency administrations

The boundaries and limitations of access to commercial litigation funding in insolvency administrations are continually developing. A recent decision of Justice Palmer in the Supreme Court of NSW in which he criticised the practice commonly referred to as "churning and burning", contains some interesting observations of which all liquidators should be aware.

The case

The Judge observed that "the true beneficiaries of this huge piece of litigation are the litigation funder, the Liquidators and their lawyers, not the creditors", and described this as a "disquieting aspect of the litigation". Part of the action involved a claim by liquidators against directors of the company in liquidation for insolvent trading. The defendants sought to have the Court exercise its discretionary powers under the Corporations Act to relieve them from any liability which they might otherwise have, relying on the circumstances in which the litigation had been brought and conducted, being the "disquieting aspect of the litigation" referred to above.

During the course of the hearing, one of the liquidators was cross examined about the costs of the proceedings and the terms of a litigation funding agreement. The Judge observed that even if the liquidators recovered the full amount of their claims (a maximum of $6m) including costs and interest, the unsecured creditors would receive no more than a fraction of a cent in the dollar of their claims after payment of the litigation funder's costs and "success fee" and the costs of the liquidators and their solicitors (in the order of $2m).

The Judge reviewed the development of the law in respect of commercial litigation funding and specifically in respect of insolvency litigation and distilled from the cases the following factors that the Court may take into account in determining whether the liquidator is justified in proceeding:

  • the liquidator's prospects of success;

  • the amount of costs likely to be incurred in the conduct of the liquidator's case and the extent to which the litigation funder is to contribute to them;

  • the extent to which the funder is to contribute to the costs of the defendant if the liquidator's action is not successful;

  • the extent to which the liquidator has canvassed other funding options;

  • the level of the funder's "premium";

  • the risks involved in the claim;

  • the wishes of the creditors.

Implications of the case

According to Justice Palmer, the element of the developing law that comes out of this case is that a liquidator proposing to enter into a litigation funding agreement should apply to the Court for directions as a matter of course as to whether he or she is justified in commencing litigation in view of the terms of the proposed funding agreement, the costs of the proceedings and the likely return to creditors.

That the liquidators in this case had not sought directions prior to initiating the action had resulted in their conduct of the proceedings being called into question.

Having determined that the "disquieting aspect of the litigation" did not relieve the directors from liability, the Judge went on to further consider the circumstances of the proceedings and determined that he would conduct an inquiry pursuant to section 536(1)(a) (instituted when it appears to the Court that a liquidator has not faithfully performed his or her duties) into the conduct of the liquidators in:

  • entering into a funding agreement and commencing these proceedings when they were aware that there was a substantial risk that the creditors would receive no, or very little, dividend;

  • permitting costs to amount to approximately $2m;

  • failing to obtain the directions of the Court before proceeding.

The Judge reserved the question of the costs of the proceedings until his inquiry into the liquidator's conduct was concluded. The Judge observed that the broad discretion given to the Court under the Civil Procedure Act to award costs of proceedings enables the Court to make an order so that the costs to the parties is in proportion to the importance and complexity of the matter in dispute, and indicated that he was considering making a limited costs order noting "it is the cost/benefit to the parties themselves which the Court must promote, not the cost/benefit to the parties' litigation funder".

In practice

What does this all mean for a liquidator who considers that he or she has a cause of action available for recovery but is without funds?

  1. Pack up the file and invite a commercial litigation funder to bankroll the case (to assist in resisting a security for costs application).

  2. If the terms offered by the litigation funder are considered to justify initiating an action, go to Court and seek a direction that the liquidator is justified in commencing and pursuing the claim (to avoid the outcome for the liquidators described above).

Author - Philip Brand