Proceed with Caution - NSW Court of Appeal overturns inquiry into liquidators' conduct

In Hall v Poolman [2009] NSWCA 64 the NSW Court of Appeal has upheld an appeal by a liquidator against orders that an inquiry be conducted into his conduct in entering a litigation funding agreement.  However the judgment still provides a warning to liquidators to proceed with caution in this area.

The facts

In this case liquidators entered into a funding arrangement to conduct insolvent trading and other proceedings relating to a winding up.  Committee of Inspection approval was obtained but not approval from the Court.  The proceedings were ultimately successful in obtaining a judgment against the former directors however the judge criticised the liquidators in commencing expensive litigation which produced only a nominal return to creditors, and where the majority of any recoveries would be paid to the funder, the liquidators, and the lawyers.  The trial judge also criticised the failure to obtain approval from the Court to enter into the funding agreement.  The trial judge ordered an inquiry into the conduct of the liquidators pursuant to section 536 Corporations Act.  

The liquidators appealed against the orders for an inquiry.

On Appeal

One difficulty for the Court of Appeal was that since the inquiry had been ordered by the trial judge of his own motion, there was no proper contradictor to oppose the liquidators' appeal.  ASIC, the most natural contender for the task, declined to become involved.

Interestingly for all those concerned, the Court of Appeal was quite clear that the only matters which were the subject of the inquiry were the legal costs incurred. Notwithstanding that the inquiry was into the liquidator's conduct, the only contemplated outcomes, according to the Court, were whether or not the liquidators' costs of the proceedings should be limited, having regard to any findings from the inquiry. That is, the liquidators' own fees were not in issue.

The Court found that although there were sufficient grounds for the trial judge to consider whether an inquiry should be ordered, the trial judge's discretion to make such an order miscarried in two principal areas:

• The trial judge failed to take sufficient account of the public interest in the prosecution of recovery proceedings;
• The trial judge took into account an extraneous consideration, namely the suggestion that liquidators need to approach the court for directions as a matter of course, before entering into litigation funding agreements.

As it turned out, the Court of Appeal found that the discretion to order an inquiry had miscarried. However, because the proceedings had settled, including the costs orders, there was no longer any point in considering whether an inquiry should be conducted. As a result, the Court simply set aside the orders for an inquiry.

First, the Good News

There are a number of pieces of good news from the case.

• First, the Court clarified that the size of the potential return to creditors, compared with the size of the creditor pool, is not a relevant consideration for a liquidator when deciding to commence proceedings. Rather, it may be proper to pursue recovery of a \"significant\" amount, even if the return to creditors will be low because of the total value of creditor claims (at [117]);
• Second, the Court acknowledged \"that there is a public interest in liquidators bringing recovery proceedings, such as proceedings against directors for breach of duty or insolvent trading and proceedings for recovery of unfair preferences.\" (at [128]);
• Thirdly, the court reaffirmed the ability of liquidators to commence recovery proceedings where it is possible or even likely that creditors will not benefit from such proceedings. This is because:

\"there is a public interest in liquidators making preliminary investigations into matters that appear to them to warrant investigation, even where there are no assets available to fund their doing so. Liquidators may be discouraged if it were held to be improper per se for liquidators to try to recover the costs of their investigations by legal proceedings that would not directly benefit creditors\" (at [152]).

In certain circumstances (considered further below) then,

\"the liquidators may legitimately and in accordance with their duties pursue litigation with the aid of a litigation funder, and they may do so even if there is little or no likelihood of recovery going beyond their own costs and expenses and the funder's fees.\" (at [150])

• Fourthly, the Court made it clear that there is no mandatory obligation to approach the court for directions to enter into a litigation funding agreement (at [176]). However the court also said that in some cases the \"proper discharge of the liquidators' duty may involve an application to the court for directions.\" This is likely to be prudent where, if the court's approval under 477(2B)/506(1A) were required, there is uncertainty as to whether it would be granted.

The Warnings

Notwithstanding the great result for the liquidators, there are still some cautionary lessons from this case:

• First, one only needs to think for a moment about the costs and distraction that the appeal proceedings would have caused to know that if orders for an inquiry can be avoided, this would be preferable;
• Second, the Court emphasised the importance of the court's supervisory role over liquidators (both court-appointed and voluntary) as evidence of the \"central significance of corporate conduct for the economic and social life of the nation\" (!)(at [53])
• Third, the Court made it clear that in ordering an inquiry, what is required is something less formal than a prima facie case ? that is, there need only be \"something which required inquiry\", relating \"to the liquidator's faithful performance of duties or observance of requirements\" (at [59]). In the present matter, the Court of Appeal was satisfied that the following were sufficient grounds:
• The extent and costs of litigation;
• The lack of balance or proportionality between the liquidators' costs of $2 million and a possible maximum recovery of $6 million;
• The fact that the proceedings would at best produce only a token return to creditors; and that the proceedings may possibly have been conducted for the benefit of the liquidator and litigation funder;
• The evidence of one of the liquidators expressing discomfort about the amount of costs

These matters were enough to satisfy the threshold test and enliven the court's discretion as to whether or not to order an inquiry. In the end, it was the exercise of that discretion that miscarried. It can be seen that the matters taken into account were not particularly unusual concerns and appear commonly in many insolvency proceedings.

• Fourthly, in terms of enquiry under section 536(1)(b) the Court of Appeal held that no formal complaint was required. It was enough that the matters the subject of the complaint appeared in the submissions to the court critical of the liquidator's conduct of the liquidators. This was so even though those submissions were directed at excusing the Director from liability for insolvent trading, rather than for advancing any request that the liquidators' conduct be investigated. Such submissions are likely to be common enough in most insolvent trading proceedings.
• Fifthly the court pointed out that creditor approval is only one of a number of relevant factors. However the court considered that the \"weight to be given to that factor depends on the circumstances and in many cases it will not be a significant factor\" (at 140]). Getting creditor approval is therefore not a panacea for an otherwise dubious litigation arrangement.
• Sixthly it is important to note the limits on the Court's imprimatur on the commencement of proceedings to recover the liquidator's own costs and expenses. The court's approval was only in circumstances where (at 150]):
• Liquidators had incurred costs in preliminary investigations and in creditors' meetings; and
• They consider that the prospective benefits to creditors justify further investigation in which they will incur more costs and expenses; and
• There are then no assets, in the absence of litigation, to pay the costs already incurred.

The court also put further provisos on the approval of fee recovery proceedings (at [151]):

• The pre-litigation costs must have been either necessary or reasonably considered to be necessary to be justified because of the prospective benefits to creditors;
• The litigation costs themselves must have been reasonably incurred and proportionate to the prospective benefits (including not only possible direct benefits to creditors but also the benefits derived through the reimbursement of the liquidator's fees and expenses); and
• The litigation funding agreement must not be on manifestly unreasonable terms.

There are still a number of unclear and difficulty aspects of applying these tests. \"Reasonable\", is a loaded word, as is \"necessary\". What might be thought to missing from this consideration, are the liquidator's statutory requirements and obligations to investigate and report to creditors and ASIC on possible breaches of the Corporations Act. These may not of themselves be connected directly to a (prospective) benefit to creditors. It would seem odd if it would not be reasonable for a liquidator who had incurred such expenses, who later identified a possible action, to bring proceedings to recover the earlier fees.

The Conclusion

This judgment will do much to restore confidence in liquidators' ability to fearlessly pursue proceedings, including litigation funded proceedings. However they should only do so after giving this judgment, and their own claims, proper and careful consideration.

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

Stephen Mullette