Liquidators and litigation funding

07 December 2007

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On 23 November 2007 Justice Palmer handed down his decision in Hall v Poolman in the NSW Supreme Court. The decision sends a clear warning to those who seek to profit from “churn and burn” litigation, confirming that the courts will readily inquire into the conduct of liquidators.

Background

The liquidators of a failed wine venture entered into a litigation funding agreement and brought proceedings against the company’s directors for insolvent trading. The liquidators knew that the maximum potential recovery was only a fraction of the value of creditor claims. Even if the litigation was successful, creditors would receive minimal or no return.

The key issue was whether the court could take into account the fact that the litigation would result in negligible benefit to creditors when exercising its discretion to allow the director a defence under s 1317S of the Corporations Act 2001 (the Act).

The decision

First, Palmer J was concerned about why the proceedings were prosecuted given that even a favourable judgment would result in negligible compensation for creditors. He condemned so-called “churn and burn” litigation, stating clearly that liquidators are not justified in commencing proceedings and incurring costs for the benefit of themselves or a litigation funder if those proceedings will not produce a worthwhile benefit for creditors.

Secondly, Palmer J was concerned that the extent, duration and cost of the litigation were not proportional to the complexity of the issues in the proceedings. The enormous cost of the litigation was particularly relevant given the minimal returns anticipated even if the case was won. This mismatch raised concerns about whether the liquidators had improperly permitted expenditure to expand to fulfil the budget available under the funding agreement.

Finally, Palmer J was concerned that the liquidators did not seek direction from the court on whether to proceed with the litigation, even though they knew that the costs would be high and the return to creditors minimal. He stated that a liquidator who is considering entering into a litigation funding agreement should always apply to the court for directions. He emphasised that liquidators, as officers of the court, act in the public interest and that the court has a duty to ensure that they perform their duties properly.

Palmer J indicated that he would exercise the court’s supervisory power under s 536(1)(a) of the Act to inquire into the conduct of the liquidators in:

• entering into the funding agreement and conducting proceedings when they knew that there was a substantial risk that the creditors would receive little or no return;
• permitting costs to amount to approximately $2 million when the litigation could have been conducted at much lower cost; and
• failing to seek directions from the court before proceeding.

Lessons to learn

Liquidators considering entering into a litigation funding agreement should apply to the court for directions as to whether they are justified in commencing litigation in light of the impact of the funding agreement on potential returns to creditors. Generally, liquidators can apply to the court for directions regarding any matter in the winding up of a company (eg whether or not to enter a litigation funding agreement in the first place).

The court and ASIC have supervisory powers to inquire into the actions of liquidators and are prepared to exercise those powers to ensure proper conduct.

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