Focus: Insolvency – May 2008

Priority of litigation funding in an insolvency

In brief: Partner Anne Ferguson (view CV) and Lawyer Eloise Dias discuss a recent Federal Court decision that considers whether contractual debts to a litigation funder for fees, expenses and a percentage of the proceeds will take priority over the claims of secured creditors.

• Introduction
• The issues
• The decision
• Impact of the decision

How does it affect you? The decision (Meadow Springs Fairway Resort Ltd (In Liq) v Balanced Securities Limited (No 2) [2008] FCA 471) may impact on the ability of liquidators to obtain litigation funding. In this case, the Federal Court held that management fees due to a litigation funder under a litigation funding agreement take priority to the claims of secured creditors. However, a success fee would only be payable to the litigation funder after payment of the debts owed to the secured creditors. This is because the success fee was not an 'expense' incurred in the course of producing the fund and so did not fall within the protection of the liquidator's lien which would have entitled it to priority. Before entering into litigation funding agreements, liquidators should first consider obtaining a specific indemnity or agreement from creditors to postpone or waive their priority to payment from the funds that are realised by the action, until all amounts owed to the litigation funder have been paid.

Introduction

Meadow Springs Fairway Resort Ltd (Meadow Springs) undertook a project to build and sell serviced apartments adjacent to a golf course at Meadow Springs, Western Australia. Before undertaking the project, the company obtained a valuation from Colliers International Consultancy & Valuation Pty Ltd (Colliers). It relied on the valuation in deciding whether to undertake the project, and to raise capital and borrow funds. Upon completion, Meadow Springs was unable to sell the apartments and administrators were appointed and subsequently the company was placed into liquidation.

Following the sale of the resort property, Meadow Springs' only substantial asset was its claim against Colliers arising out of the valuations. Funding was needed to bring the claim for negligence, breach of contract and misleading or deceptive conduct against Colliers. Meadow Springs' unsecured creditors unanimously approved a resolution allowing the company's liquidator to enter into a funding agreement with Insolvency Litigation Fund Pty Ltd (ILF).¹ Subsequently, a second funding agreement (the IMF funding agreement) was entered into with IMF (which was the parent company of ILF) by the liquidator and Meadow Springs. The IMF funding agreement was essentially on the same terms as, and intended to replace, the earlier funding agreement with the ILF.

The IMF funding agreement required that should the liquidator receive any part of the 'resolution sum' (being the sum obtained on the resolution of the litigation), the liquidator would pay to IMF, from the resolution sum, its 'fees'. 'Fees' was defined to mean:

• $10,000 per month plus GST from the date of commencement of [the] agreement up to a maximum of $100,000 plus GST for management services [the management fees]; and
• $15,000 plus GST for assessing the proposal and facilitating [the] agreement [the assessment fees].

Most importantly, the IMF funding agreement also provided for the payment of a percentage share of the resolution sum. The relevant percentage fee in this case was 35 per cent of the resolution sum (the success fee).

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The issues

The key issue before Justice Siopis was the priority of payments from the settlement fund. IMF contended that the amounts due under the IMF funding agreement, comprising the success fee together with the management fees and assessment fees, were required to be met from the fund in priority to the claims of the company's secured creditors. IMF put forward three arguments in support of that contention:

• first, it submitted that the success fee was held on trust by the liquidator for IMF and that IMF had a superior equity for that sum to that of secured creditors;
• second, it relied upon the principle in the case of In re Universal Distributing Company Limited (In Liquidation) (1933) 48 CLR 171 to the effect that there existed an equitable lien in favour of the liquidator which secured the payment of the management, assessment and success fees from the fund in priority to the claims of the secured creditors; and
• third, it contended that the monies claimed by IMF were payable in priority under the principle of salvage.

The secured creditors (Balanced and the Knightsbridge parties) disputed IMF's entitlement to priority. Meadow Springs did not oppose it.

A second issue arose as the liquidator had not obtained approval to enter into the IMF funding agreement, as required by section 477(2B) of the Corporations Act 2001 (Cth) (the Act). That section provides that, except with the approval of the court or the committee of inspection or a resolution of the creditors, a liquidator must not enter into an agreement on the company's behalf which is likely to endure for longer than three months. Although the first funding agreement had received the approval of the company's creditors, the IMF funding agreement had not. The liquidator sought orders approving the IMF funding agreement, to avoid any risk that the IMF funding agreement might be held to be invalid.

A number of incidental issues also arose. These concerned whether Balanced and the Knightsbridge parties had enforceable securities over the monies in the fund and, if so, how much of the amount claimed was subject to those securities.

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The decision

IMF was unsuccessful in seeking payment of the success fee in priority to Balanced and the Knightsbridge parties. Justice Siopis rejected each of the three arguments put forward by IMF.

First, Justice Siopis held that the secured creditors had acquired an equitable interest in the property on the crystallisation of their floating charges. That interest was not merely an assignment of future property (being the fruits from the action against Colliers), but rather an interest in the very action against Colliers, which had existed by the date of the crystallisation of each charge. Accordingly, each of the Balanced and Knightsbridge parties had 'acquired an equitable interest in the Colliers claim and its proceeds, before IMF acquired its equitable interest in the proceeds of the claim.'

His Honour rejected IMF's argument that it had a 'better equity' in the proceeds of the claim than the creditors because it had borne the risk associated with the conduct of the claim. He found that by the time IMF entered into the IMF funding agreement, it had actual knowledge (through its executive director) of the equitable interests of Balanced and the Knightsbridge parties. The equitable rule that a person with notice of an equity takes subject to it therefore applied.

Second, Justice Siopis dismissed the contention of IMF founded on the Universal Distributing case. Universal Distributing involved the fixing of the remuneration of an official liquidator. The liquidator had realised the assets of the company and had created a fund over which a debenture-holder had security. The debenture-holder contended that the liquidator's remuneration and certain disbursements contained in the accounts ought not be paid out of the fund in priority to the amount the subject of the debenture-holder's security. Justice Dixon held (at 174):

If a creditor whose debt is secured over the assets of the company come in and have his rights decided in the winding up, he is entitled to be paid principal and interest out of the fund produced by the assets encumbered by his debt after the deduction of the costs, charges and expenses incidental to the realization of such assets (In re Marine Mansions Co). The security is paramount to the general costs and expenses of the liquidation, but the expenses attendant upon the realization of the fund affected by the security must be borne by it (In re Oriental Hotels Co; Perry v Oriental Hotels Co). ... In applying this principle, only those expenses appear to have been thrown against the fund belonging to the debenture-holders which have been reasonably incurred in the care, preservation and realization of the property.

IMF contended that the assessment, management and success fees were expenses 'reasonably incurred' by the liquidator in producing the resolution sum and were, therefore, payable in priority.

Justice Siopis found that while the assessment and management fees comprised 'expenses' incurred in producing the fund, the liability for the success fee did not. He held that the principle in Universal Distributing was concerned with liabilities creating 'mere debts', whereas the liquidator's obligation to account for a portion of the proceeds from the settlement was an obligation 'to account as trustee to his or her beneficiary'. His Honour stated:

In my view, the obligation which arose under the IMF Funding Agreement on the liquidator on receipt of the proceeds from the settlement of the Colliers claim, was to account as trustee to IMF for such amount of the fund as IMF was beneficially entitled pursuant to the disposal under cl 4.3 ...

It was not, therefore, a liability that comprised an 'expense' of the nature contemplated by Justice Dixon in Universal Distributing. As the liability did not fall within the protection of the liquidator's lien by reason of being incurred in the production of the fund, it did not have priority for payment out of the fund over claims of the secured creditors.

Justice Siopis went on to consider the liquidator's application for approval of the IMF funding agreement, as this overlapped with the issue of whether the assessment and management fees were 'reasonably incurred' by the liquidator. His Honour found that the liquidator had acted reasonably in entering into the IMF funding agreement and granted retrospective approval. The following factors persuaded his Honour to grant the relief sought:

• there was a reasonable prospect that there would be extraneous benefits, particularly to creditors, from the liquidator entering into the funding agreement and the subsequent pursuit of the claim against Colliers;
• the claim against Colliers was Meadow Springs' only substantial asset;
• it was not unreasonable for the liquidator not to have first approached other litigation funders, given IMF was well-known and a public company with the financial resources to fulfil its obligations;
• the terms of the IMF funding agreement were usual in the marketplace at the time; and
• it was an honest and understandable mistake for the liquidator to take the view that the novated agreement on essentially the same terms and with a party that is the parent of the existing party to the agreement would not require a renewed approval by the creditors.

Justice Siopis held that the management and assessment fees (unlike the success fee) were reasonably incurred expenses in producing the fund and were to be paid in priority to the debts owed to the secured creditors.

Finally, Justice Siopis rejected IMF's argument based on salvage. Briefly, salvage is a maritime principle that rewards (and not merely compensates) services rendered to assist in salvaging another's property.² Justice Siopis found that this principle did not form a separate basis for IMF's claim but rather was a rationale for the principle in Universal Distributing.³ As such, it ran into the same difficulty as did the Universal Distributing argument.

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Impact of the decision

It is not yet known whether there will be an appeal of the decision of Justice Siopis to the Full Court.⁴ However, the decision is potentially problematic for liquidators who enter into litigation funding agreements, as it appears to erode their ability to pay success fees from the fruits of the litigation. This is despite the court's finding that the liquidator had acted reasonably and honestly in entering into what was a fairly standard, commercial litigation funding agreement.

To address this, liquidators and other insolvency practitioners should consider seeking a specific indemnity or written agreement from the relevant creditors under which they agree to postpone or waive their priority to recover from the fund. If such an agreement is not forthcoming (as was the case in Meadow Springs) then, in the unlikely event that the litigation funder is prepared to proceed, the agreement should be modified to cater for the priority of payment to secured creditors.

Footnotes

1. The liquidator had first invited creditors and/or shareholders to participate in a 'fighting fund' to pursue litigation against a number of potential defendants. No creditors or shareholders indicated any willingness to fund the potential litigation.
2. Lord Goff of Chieveley and Gareth Jones, Goff and Jones: The Law of Restitution (2007) 469-470.
3. At pars 155-157, citing Dean-Willcocks v Nothintoohard Pty Ltd (in liq) [2006] NSWCA 311.
4. Justice Siopis adjourned the matter to a date to be fixed to permit the parties to produce a minute of orders giving effect to his reasons, and also, for the making of directions as to the further conduct of the outstanding matters, including certain cross claims.

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For further information, please contact:

Anne Ferguson Partner, Melbourne Ph: +61 3 9613 8890 Anne.Ferguson@aar.com.au		Clint Hinchen Partner, Melbourne Ph: +61 3 9613 8924 Clint.Hinchen@aar.com.au
Michael Quinlan Partner, Sydney Ph: +61 2 9230 4411 Michael.Quinlan@aar.com.au		Geoff Rankin Partner, Brisbane Ph: +61 7 3334 3235 Geoff.Rankin@aar.com.au
Kim Reid Partner, Perth Ph: +61 8 9488 3727 Kim.Reid@aar.com.au		Simon McConnell International Partner, Hong Kong Ph: +852 2840 1202 Simon.McConnell@aar.com.au

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