Key Point
- Considering that creditors usually have assessed the merits of litigation funding, and the cost of going to court, making court approval a mandatory step does not appear justified.
Should all litigation funding agreements involving liquidators be screened by courts?
That was the proposal put forward by Justice Palmer in his now-famous attack on litigation funding in Hall v Poolman [2007] NSWSC 1330. However, an analysis of the current state of litigation funding and its brief history in Australia calls into question the practicality of his suggestion.
Background
In Campbell's Cash & Carry Pty Ltd v Fostif Pty Ltd (2006) 80 ALJR 1441, the High Court held that litigation funding is a reality of commercial life and that courts would look favourably on litigation funding arrangements that offered access to justice, provided that any tendency to abuse of process is controlled.
Notwithstanding this, Hall v Poolman shows that the litigation funding story "on the ground" may not be as clear cut as might be hoped.
Litigation funding agreements usually provide the litigation funder with a significant "success fee". On occasions, this success fee and the costs of litigation combine with the liquidator's bill to swallow most of the payout from successful litigation.
Such an outcome faced Justice Palmer in Hall v Poolman.
The collapsed Reynolds group of companies could not pay unsecured creditors or even the costs of the winding up. The only potential assets were voidable preference claims against the Australian Tax Office and insolvent trading claims against former directors. Having no funds to pursue these claims, the liquidators entered into a funding agreement with a litigation funder.
The amounts sought to be recovered totalled approximately $9.6 million (compared with unpaid creditors' claims of more than $130 million). When the trial began, the Court was informed that most of the $9.6 million would be eaten up by:
- the litigation funder's costs and "success fee"; and
- the costs of the liquidators and their solicitors.
The litigation against the directors and the ATO was largely successful. Nevertheless, by the conclusion of the trial, it was estimated that creditors would receive between $0.004 and $0.0285 in the dollar. Justice Palmer was clearly disturbed by this outcome. He suggested that the "true beneficiaries of this huge piece of litigation are the litigation funder, the liquidators and their lawyers, not the creditors". He said that the facts of the case demonstrated how:
"...a mammoth piece of litigation can be instigated, perhaps to the ruin of the defendant, with negligible `access to justice' for those who have suffered a wrong but with lucrative reward for those who make a business of investing in law suits."
Accordingly, although allowing the liquidators' claims, he ordered an inquiry into their conduct (under section 536(1)(a)) that would address the liquidators':
- entering into a funding agreement and commencing 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 $2 million; and
- failing to obtain directions of the Court before proceeding.
This last point is particularly interesting.
Is obtaining court approval of each funding agreement a practical measure for liquidators?
According to Justice Palmer, a liquidator, before entering into a funding agreement, should ask the court for directions under section 511(1)(a). This provision, along with section 479(3) (for compulsory liquidations), allows liquidators to obtain guidance from the Court and thereby secure a "degree of protection against subsequent claims of a breach of duty".
Justice Palmer suggested that applications by liquidators for directions as to whether funded litigation should be commenced are "frequent"; however, this is not borne out by a consideration of the existing authorities.
In particular, it appears that. liquidators nowadays tend to apply to the court for approval of litigation funding agreements to ensure compliance with the section 477(2B) requirement that long-term (>three months) agreements be approved by creditors or by the court. Most, if not all, litigation funding agreements will be for more than three months. As a consequence, liquidators will need to have such agreements approved in accordance with section 477(2B) of the Act.
Importantly, such approval can be obtained from the court, the creditors or the committee of inspection. As considered in more detail below, there are a number of reasons for a liquidator's seeking the necessary approval from creditors or from the committee of inspection (rather than via an application to court). Indeed, a number of applications for court approval have followed an unsuccessful attempt to obtain creditor approval.
In short, the authorities suggest that previous applications to court by liquidators for approval of litigation funding agreements generally fall into two categories:
- applications made in the mid to late 1990s when the scope of the insolvency exception to champerty and maintenance was still actively being judicially considered; or
- applications to obtain approval under section 477(2B), often in circumstances where approval by creditors was initially sought by the liquidator but was not obtained.
(It is instructive that in Leigh re King Bros [2006] NSWSC 315, an application under both sections 477 and 479, the Court was prepared to give approval under section 477 but declined to give a direction under section 479, on the grounds that the section 477 order would make it otiose.)
Notwithstanding the use of section 477, Justice Palmer concluded that liquidators intent on entering a litigation funding agreement should seek and obtain court approval on each occasion, for two main reasons:
- "the application enables the Court to control, so far as it can, the use of litigation funding so that it does not destroy the very system of justice upon which it feeds";
- "In such applications ASIC may be given notice so that it may make its own submissions."
On the ASIC point, he said that the Court did not know whether ASIC might have regarded the alleged insolvent trading as warranting prosecution for a civil penalty order. Conversely, if ASIC thought that the alleged contraventions were not so serious as to warrant prosecution, then the liquidators would not be justified in commencing proceedings.
Justice Palmer's observations may leave liquidators thinking that a failure to obtain court approval will leave them open to criticism. However, a number of considerations tell against a strict requirement that liquidators must seek court approval in every instance of proposed litigation funding.
Hindsight
Justice Palmer had the advantage of knowing the legal costs that had been incurred in pursuing the matter to trial. This information is not available to liquidators when they are determining whether or not it is in the interests of the creditors to commence funded litigation. As a matter of commercial reality, costs estimates are routinely exceeded, not least because it is difficult to predict with certainty how long the litigation process will take.
Justice Palmer was apparently concerned by the extent, duration and cost of the litigation, particularly when the potential return to creditors was minimal. It is not clear however whether the extent of costs incurred in the proceeding to that point could have reasonably been anticipated before the proceeding. Approaching the court before entry into the funding agreement, therefore, may not necessarily have averted the situation in which the liquidators found themselves.
Is nothing better than anything?
As noted above, Justice Palmer found that the relevant companies had no potential assets, other than the preference and insolvent trading claims. In those circumstances, it is perhaps unsurprising that the committee of inspection approved the liquidators' entry into the litigation funding agreements.
On the most optimistic scenario, the largest creditor would receive $545,992 (on a debt of $19 million) and a creditor owed $100,000 would receive just over $2,800. Although comparatively small, this is a better return than creditors would have received if the litigation had not been commenced at all, especially since they would not face any litigation costs. If prior court approval of the funding agreement had been sought, would the court have denied creditors an opportunity to recover even such a small amount in respect of their claims against a company in liquidation?
The approach of Justice Fryberg in Re Imobridge Pty Ltd (in Liq) (No. 2) [2000] 2 Qd R 280 is instructive. A liquidator had indicated that one reason for seeking leave to enter a funding agreement was that the litigation would, if successful, pay for the liquidator's fees. Despite this, Justice Fryberg approved entry into the funding agreement. In doing so, he appeared to believe that even a small benefit for creditors was better than nothing:
"...the fact that the most likely outcome of the litigation will benefit only the professionals involved in the winding up is not necessarily a reason to stifle the litigation. If costs had been properly incurred in the winding up and a preference is available to be recovered, it is not unreasonable that proceedings should be brought to recover it and so fund those costs. That there is also some chance of benefit for the unsecured creditors without any detriment to them to some degree reinforces the case for bringing the proceedings."
This approach was equally evident in Carob Industries v Simto [1999] WASC 258:
"although it is very obvious that the members and creditors will not be any better off if the agreement is approved, I cannot see that they can be any worse off".
The Court in Carob also took the view that such a litigation funding arrangement was commercially moral:
"it is in the company's interests and also in the interests of the community that the liquidator should be paid his proper fees and the winding-up concluded in an orderly manner".
This approach is arguably at odds with Justice Palmer's view that a liquidator should not proceed with a funding arrangement that offers "no more than a token benefit to the creditors."
A commercial decision like any other
Entry into a litigation funding agreement is ultimately a commercial decision to be assessed like any other commercial decision.
In cases approving entry into a litigation funding agreement, Courts have given the liquidator "considerable latitude in exercising commercial judgment." ((2000) 42 ACSR 296, at 300). In Anstella Nominees Pty Ltd v. St George Motor Finance Ltd (2003) 21 ACLC 1347, Justice Finkelstein noted that a liquidator will usually be "in a far better position than a judge" to evaluate whether the terms of a proposed litigation funding agreement are acceptable. This appears particularly true in an environment where there are a number of providers competing to offer litigation funding.
To some extent, also, the litigation funding market enables liquidators to "outsource" the analysis of the prospects of potential claims. As Justice Austin noted in ACN 076 673 875 Ltd: (2000) 42 ACSR 296
"...there is the commercial reality that IMF [the litigation funder in that case] would not, acting rationally, prosecute litigation at its expense unless there were a reasonable prospect of a verdict or settlement..."
It is notable that, despite expressing some concerns, courts have tended to approve funding agreements. This suggests that the prospect of a court not approving a litigation funding agreement (particularly where it already has creditor approval) is somewhat remote. Courts have also acknowledged that creditors are "better judges than Courts of their own commercial interests." (Re Imobridge Pty Ltd (in Liq). (No. 2) [2000] 2 Qd R 280, at 297).
Given those facts – and the additional legal costs – is there much point in requiring court approval for a litigation funding agreement that has already been approved by creditors (assuming, of course, that there has been full disclosure)?
Conclusion
There is no statutory requirement that every funding agreement be approved in advance by the court. Nor does this occur in practice. Liquidators will generally seek, and be satisfied with, creditor approval (whether via resolution at a meeting of creditors or from the committee of inspection).
The Reynolds Group Case highlighted the extent to which funding agreements can sometimes result in creditors' receiving proportionally less than the liquidator or litigation funder. Against that backdrop Justice Palmer advocated that liquidators always obtain Court approval of litigation funding, a step that liquidators may now see as providing additional protection against subsequent claims of breach of duty.
On the other hand, there are compelling policy reasons against seeking court approval for every litigation funding agreement. As courts have acknowledged, liquidators and creditors are in the best position to assess the merits of a proposed litigation funding agreement and to determine whether it is in creditors' interests. In the vast majority of cases, it will be sufficient that the creditors have made that assessment. Having their judgment "second guessed" by a court will rarely yield a different outcome. On that basis and having regard to the attendant cost for creditors and burden on court resources, making court approval a mandatory step does not appear justified.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.