Creditor funding where the liquidator has limited means to recover or preserve company assets

31 March 2015

In this issue:

Creditors willing to financially assist the liquidator in recovery or preservation of company property.
Relevance of section 564, Corporations Act, its operation and objective.
Common uses of section 564, Corporations Act.
Court assessment of risk assumed by indemnifying creditors under their indemnities.

Introduction

Des Munro, Director, BRI Ferrier, Adelaide in a conference paper observes:

“In many administrations the assets available to a liquidator are minimal. During the course of an administration it may be discovered that there are payments made by the company or a disposition of assets which may be set aside. The recipient of this advantage, realizing the strength of their position because of the lack of funds in the administration, often refuse to disgorge the funds hoping that the liquidator will eventually abandon the claim.

In these circumstances the procedure that the liquidator should follow is to call a meeting of creditors and submit a report setting out the facts as determined stressing the impossibility of taking proceedings unless creditors are prepared to indemnify the liquidator against costs should the proceedings be unsuccessful.”

Here, as Des Munro points out, the liquidator is encouraging creditors to become actively involved in the recovery or protection of company assets which may well result in a better financial return at the end of the administration.

Similarly, the Corporations Act under section 564 seeks to encourage creditors to become actively involved in the administration by offering incentives to those creditors who are willing to financially assist the liquidator in the pursuit or protection of company assets.

At this stage it will be useful to consider the purpose and operation of this key provision.

The operation and objectives of section 564, Corporations Act

The operation of section 564, Corporations Act

In general terms, section 564 provides that where in any winding up property has been recovered or been preserved under an indemnity by creditors, the court may make such orders as it deems just with respect to the distribution of property so recovered or preserved with a view to giving the indemnifying creditors an advantage over others in consideration of the risk assumed by them under their indemnities.

Section 564, in allowing for an advantage to be granted in these terms, has created an exception to the usual rule of equality of treatment of unsecured creditors in the winding up. Such exceptions are rare and need to be justified by strong policy objectives.

The policy objectives of section 564, Corporations Act

The courts have consistently acknowledged that section 564 is not intended to support litigation for the sake of litigation; nor is its principal objective to provide private benefit to those creditors who have provided an indemnity or funds to the liquidator. In State Bank of NSW v Brown (2001) NSWCA 223, 10/7/2001, the Court of Appeal described the objectives of the section in the following terms:

“…..there are two public purposes involved in the encouragement of pursuit of claims by liquidators, namely to benefit creditors and shareholders generally, and to recover property from wrongdoers and thus discourage misconduct in relation to corporations.” (para91)

These objectives reflect the public interest dimension in proceedings by liquidators. However, although section 564 is driven by public interest considerations, such objectives are achieved by granting an advantage out of recovered property to those creditors who have assisted the liquidator.

The uses of section 564, Corporations Act

Litigation funding

Most commonly, creditors will be invited to assist the liquidator by either funding actions to recover assets for distribution among creditors or funding the defence of claims which would otherwise diminish the value of assets available for distribution.

Accordingly, we may encounter cases where creditor funding was provided to support the liquidator in pursuing insolvent trading claims against directors (see Jarbin Pty Ltd v Clutha Ltd (in liq) (2004) NSWSC 28); or recovery of company funds used to discharge director’s personal debt (see In the matter of Proficient Building Company Pty Ltd (2011) NSWSC 1540).

In other cases creditors have financed successful preference recovery litigation (see Re Ken Godfrey Pty Ltd (1994) 12 ACLC 1071, SC (Vic); ANZ Banking Group Ltd v Tjf Ebc Pty Ltd (2006) NSWSC 25).

With respect to creditor funding with a view to preserving company assets, a liquidator may be in a position to resist claims against the company that would otherwise reduce the assets available to creditors (see Robinson, in the matter of ACN 069 895 585 Pty Ltd (formerly known as Waterman Collections Pty Ltd) (in liq) (2013) FCA 706).

Funding of public examination

A liquidator may seek funding from creditors with a view to meeting the costs and expenses associated with conducting public examinations and other investigations into the affairs of the company. In such cases creditor funding may enable the liquidator to determine whether the company had viable claims to pursue (see Lombe, in the matter of Babcock & Brown Limited (in liq) (2012) FCA 107, where information gained from a public examination enabled the liquidator to formulate causes of action against certain directors and the former auditor).

Also, where a public examination funded by creditors achieves a clear formulation of causes of action, the liquidator may be in a better position to negotiate a favourable litigation funding agreement with an external litigation funder to pursue those actions (see Lombe (above) at para 27; In the matter of Shepherds Producers Co-Operative Ltd (in liq) (2012) NSWSC 390).

Advantage to indemnifying creditors

Section 564, Corporations Act seeks to reward creditors who have borne the burden and assumed the risks of litigation instituted by a liquidator to recover or protect company assets. Importantly, as one Court observed, if creditors are “deterred from funding because the risk assumed is not adequately recompensed, then the clear public purpose behind section 564 will be defeated.” (Parkston Pty Ltd (in liq), Application of (2000) NSWSC 764 at para 66).

Accordingly a crucial aspect of section 564 relates to the approach adopted by the courts in determining the advantage to be granted in favour of indemnifying creditors. In this respect the courts have sought to achieve a just result which offers sufficient incentive to funding creditors, while not being punitive to non-funding creditors.

On occasions the court may conclude that the risk assumed by the indemnifying creditor was modest. For example, in Re Home Projects (2002) NSWSC 879 the amount contributed by the indemnifying creditor ($4,850) constituted some 10% of the costs incurred by the liquidator in the recovery action. The action was eventually settled in the sum of $90,000. The court determined that after reimbursement of the amount contributed, the liquidator would be justified in paying the funding creditor some $6,500 from the recovered moneys, being 10% of the funding creditor’s debt, with the remaining 90% of the debt ranking for dividend with the debts of other unsecured creditors.

On the other hand, where funding creditors have expended large sums with all the attendant risks that go with complex factual and legal disputes, it is becoming increasingly common for courts to award 100% of the net recovery proceeds to funding creditors on a proportionate basis based on their debt size (see, for example, State Bank of NSW v Brown (2001) NSWCA 223).

Summing up

Often the whole amount available in a winding up has been sourced from recoveries made possible by reason of the contribution made by funding creditors. Such creditors, taking advantage of the financial incentives offered under section 564, have made a commercial decision to become actively involved in the winding up process by investing time and money assisting the liquidator to recover or preserve company property. At the same time the public interest has been served in ensuring that assets of the company in winding up will be maximized, and misconduct with respect to companies in financial difficulties will be discouraged.