Alex Jay provides a review of the funding options and tactics available for insolvency litigators, including a look at methods of dealing with hard costs incurred in an investigation. This article was originally published in CRI.

Key points

  • The indefinite extension of the insolvency exemption to sections 44 and 46 of the Legal Aid, Sentencing and Punishment of Offenders Act 2012 is good news for the industry and creditors alike.
  • Provided they are used reasonably, a combination of third party funding, CFAs and ATE policies are a pragmatic way of addressing the litigation funding deficit in many insolvencies and ensuring that any sums owed to the insolvent estates (often a significant asset in the estate) can be recovered through the courts.
  • New funding products and models continue to develop, including the recent trend of the Insolvency Practitioner's firm providing up front funding for 'hard' costs, which is then recovered from future recoveries (together with an additional payment to reflect the fact that monies have been risked in pursuit of the litigation).

Introduction

Lord Faulks QC's announcement in late February of this year that insolvency proceedings' exemption from sections 44 and 46 of the Legal Aid, Sentencing and Punishment of Offenders Act 2012 ("LASPO") would be continued indefinitely was widely regarded as a triumph for the insolvency sector. The provisions from which insolvency proceedings are currently exempt prohibit the recovery of success fees charged under conditional fee agreements ("CFAs") and after the event ("ATE") insurance premiums in ordinary litigation proceedings.

According to a 2014 research paper commissioned by R3, one of the most vocal opponents to the proposal to end the exemption, an end to the exemption would result in more than £160 million being lost to fraudulent or negligent directors. Although an estimate, this figure demonstrates the continued importance of alternative litigation funding in the context of insolvency proceedings, and highlights the role that such proceedings play in UK corporate governance.

This article shall look at the available streams of funding currently available to insolvency practitioners ("IPs"), including options and potential issues IPs should bear in mind when deciding which option to use.

Available streams

Set out below are the funding options available to IPs contemplating litigation. The most appropriate option (or options) will depend upon a range of circumstances, including liquidity and the likelihood of a successful claim being brought.

Funding out of the insolvent company's estate

The most straightforward and, if successful, almost certainly the cheapest option is for the litigation to be funded out of the assets of the insolvent company. However, often there are insufficient assets to pay litigation costs (in whole or even in part). In addition, even where there are sufficient funds available in the insolvent estate, given the uncertainty that litigation can create as to the total costs that will be incurred pursuing a claim to trial, in some cases having finance available from third parties can still be a benefit.

Conditional Fee Agreements

A CFA is a funding arrangement whereby the legal fees and expenses (or any part of them) incurred on a matter will only be payable if the claim succeeds (section 58(2)(a) of the Courts and Legal Services Act 1990). There are some clear benefits to using a CFA: they allow IPs to commence litigation proceedings without up-front costs and eliminate the risk of an unsuccessful claim still having to be funded out of the assets of the insolvent estate. However, in order to off-set the risk of not recovering their fees, lawyers will typically only agree to a CFA on the basis that, if successful, they receive a higher than normal payment. Under regulation 4 of the Conditional Fee Agreements Order 2000 the maximum uplift chargeable is 100% of the relevant fee-earner(s') hourly fees).

IPs considering a CFA should bear in mind the following points:

How is 'success' defined?

(a) CFAs used in general commercial litigation typically define success as 'obtaining judgment', placing the risk of recovering any judgment debt with the client. In the context of insolvency, office-holders should be very cautious about accepting this risk, preferring instead to link success to the actual recovery of assets. Of course, where a legal advisor is willing to agree to shoulder the risk of non-recovery they will inevitably insist upon a greater uplift in the event of "success".

Who is liable for costs?

(b) The High Court has recently clarified that where litigation proceedings are brought in the name of the IP, any liability to pay fees arising by virtue of a CFA will not be impliedly confined to the debts in the insolvent company's estate (Stevensdrake Ltd v Hunt and others [2015] EWHC 1527 (Ch). IPs seeking to restrict personal liability should therefore ensure that the wording of the CFA expressly provides that they are personally excluded from any liability for sums due under the agreement, and that it is the estate assets/recoveries from which the CFA costs should be paid.

What costs are outside the scope of the CFA?

(c) Legal advisors will typically seek to exclude certain disbursements, such as court and expert witness fees, from the scope of the CFA. This should be borne in mind in cases where liquidity is an issue, and it may be that funding of these "hard" costs might be required.

Funding from creditors and third parties

An alternative option, and the principal method employed by IPs prior to the advent of CFAs, is for a creditor (less usual) or professional funder (increasingly common) to fund all (or part) of the litigation costs.

In many cases, such funding will be accompanied by the legal team operating under a form of CFA, often on terms that part of their fees are payable as the litigation progresses while a proportion remains conditional on "success". In addition, aside from the professional team's fees, there will be certain "hard" costs that will be incurred in the course of most litigation. This includes Court fees, but can extend in larger cases to expert witnesses, document management/disclosure operators, foreign counsel and others who may not be prepared (or unable under the regulations that apply to them) to operate on a CFA basis.

Third party funding will typically be provided in either the form of a loan or in return for an assignment of a share of any recoveries. The possibility of spreading the risk of an unsuccessful claim which results in the professional team going unpaid may make the latter option an attractive possibility even where sufficient funds to fund the litigation are available from the insolvent's company's estate.

The market for third party litigation funding has grown considerably since the Court of Appeal's 2005 decision in Arkin v Borchard Lines Ltd and others. The decision established that, unless a funding agreement is champertous, third party funders' liability will be limited to the amount of their investment. This effectively kick-started the litigation funding sector. There is now significant appetite from investors seeking returns in this sector. By way of demonstration, in May of this year, a third party funder announced that it had raised funds of £200 million to invest in litigation. There have been similar stories from a number of funders in the market in England, and this increased competition does mean that funding is perhaps getting less expensive now than it was. The traditional cost of funding model of 3 or 4 times the funding provided, or 30% of recoveries, has changed in recent time. Different funders will also operate different models, some of which can be quite innovative and are worth considering dependent on the type of case and its funding needs. We advise clients to discuss these options with us if funding is being considered, in order to identify which funders might be best suited to the case in question.

In evaluating a claim, third party funders will typically consider:

  1. the claim's prospects of success. Although assessing a claim's chances of success is, to a large extent, subjective, litigation funders will generally require at least a 60% likelihood of success;
  2. issues which may impede or delay enforcement, such as the creditworthiness of the opponent and the assets they hold within the jurisdiction;
  3. the size of the damages claim relative to the level of funding required;
  4. the litigation proceedings' likely timescale;
  5. whether there would be an alignment of risk between the funders and the claimant (and potentially the claimant's legal representatives). Funders prefer to share the risk with clients as it ensures their continued co-operation throughout proceedings;

Litigation funders will, of course, need to be given access to relevant documents in order to reach a decision about whether or not to invest. This may give rise to some difficulty in circumstances where privileged documents are provided to the prospective funder. It is arguable that privilege in relation to those documents could be waived if the funder subsequently decided not to proceed with the investment. However, this risk must be balanced against the possibility that if relevant documents are not provided to the funder they may have legitimate grounds for terminating the funding agreement at a later date. Where the balance should be struck will depend on the particular circumstances of each case. However, the risk of inadvertently waiving privilege can be reduced by requiring the prospective funder to enter into a common interest agreement which makes clear that the documents are being disclosed on a confidential basis and that the parties intend to have a common interest in the litigation and are therefore covered by the common interest privilege.

Careful thought should also be given to the costs the third party's funding is intended to cover. Claimants covered by ATE insurance may find that it is cheaper to self-fund those costs covered by their insurance policy rather than rely on third party funding. Equally, care should be had to ensure that 'success' is defined as the successful recovery of damages, rather than obtaining judgment in order to avoid a position in which the claimant is liable to pay sums they have not received.

After the Event Insurance

ATE is a useful resource for office-holders wishing to restrict the risks of pursuing a claim, providing cover for the other side's costs and disbursements in the event that a claim is unsuccessful and an adverse costs award is made. The premium payable under the policy will depend upon the strength of the case and the level of cover required. However, provided it is 'reasonable', the successful litigating party will generally be able to recover this cost from the other side. Moreover, although the premiums for ATE insurance cover tend to be relatively expensive, it is possible to obtain a contingent policy whereby the premium will only be payable if the claim is successful. In Callery v Gray [2001] EWCA Civ 1246, for example, it was held that he costs of insuring the premium and the insurance premium tax where both, in principle, recoverable.

Picking up on the costs of ATE, our recent experience is that while the costs to secure outright funding of a piece of litigation have reduced in recent years, ATE cover has not. If ATE is obtained as part of an overall funding package, then its costs can be reduced. However a standalone ATE policy often attracts a premium of around 30% of the insured risk, and sometimes up to 60%. Insurers also provide better (i.e. cheaper) quotes for larger cases where they are being asked to insure the entire claim - asking for cover up to certain stages of a claim has, in our experience, been less attractive to them.

There are some further issues to consider with ATE insurance. Before agreeing to a particular policy IPs should consider:

  1. whether the level of cover is sufficient. In the event that a claim is unsuccessful, the claimant will be liable for any costs not covered by the insurance policy. Obviously, the higher the level of cover, the higher the premium will be so it is important that the correct balance is struck;
  2. what costs are to be excluded from the cover. This will generally be a heavily negotiated area. Standard exclusions include: misrepresentation or fraud (from the claimant). Persimmon Homes Ltd and another v Great Lakes Reinsurances (UK) plc [2010] EWHC 1705 (Comm) is an example of ATE insurers successfully avoiding an insurance policy due to misrepresentation from the policy holder; insolvency of the opponent; negligence from the IP's legal representatives; discontinuance due to lack of funds; failure to beat a Part 36 offer; and the costs of defending a counterclaim; and
  3. the insurer's potential involvement in settlement discussions. In order to ensure that their interests are adequately protected, ATE insurers will generally insist upon being made a party to any settlement talks. The inclusion of a third party inevitably complicates matters and may delay settlement.

IP funding

A practice which we have seen emerge in recent times is for certain of the hard costs of litigation to be funded by the IP firms. In other words, where costs have to be incurred to pursue a claim (eg foreign counsel's fees), the IP's firm will provide the funding and repay its costs of doing so from recoveries, together with an additional payment to reflect the fact that monies have been "risked" in pursuit of the litigation. There are some clear advantages to self-funding these hard litigation costs rather than relying upon a third party. Significantly it removes the need for the IP to 'go to market' seeking funding from a third party, on terms which will be expensive (on any level) and thus reduce the ultimate returns to creditors. This also saves the time and cost of engaging a prospective funder to carry out its own (often costly) assessment of the merits of the case is eliminated. The possibility of inadvertently waiving privileged documents is also excluded.

SIP 9 does not seem to preclude this as an option, if it is agreed with creditors. However, this is a relatively untried area and it remains to be seen how this practice to develop. While we can see some good arguments in favour of allowing this practice to continue, an IP considering this source of funding should be alive to the following risks:

Could it give rise to a conflict of interest?

(a) IP funding could potentially give rise to a variety of conflicts of interest, for example when negotiating what payment, if any, should be due to the IP's firm for providing funding or, further down the line, when looking to settle a claim. IPs intending to pursue this option should therefore ensure that due consideration is given to any conflicts that may arise and that this is properly documented. In particular, the IP should consult the company's creditors and set out all of the options available. Although it does not deal with IP-funded litigation, the Interim Statement of Insolvency Practice 9 does consider third-party funding more generally. With reference to creditor funding, paragraph 11.6 provides that "[a]ny arrangements of this nature will be a matter for agreement between the trustee and the creditors concerned and will not be subject to the statutory rules relating to remuneration." By extension, the IP's rate of return will be a matter to be agreed with the creditors.

IP's potential liability

(b) By funding the hard costs of any litigation, IP firms potentially expose themselves to a higher risk of being ordered to pay adverse costs as, in this regard, they are more akin to non-party funding proceedings for their own financial benefit than a party acting in the interests of the company and its creditors.

Third party costs orders were considered at length by the Privy Council in Dymocks Franchise Systems (NSW) Pty Ltd Todd and others. At paragraph 29 the Council concluded:

"generally speaking, where a non-party promotes and funds proceedings by an insolvent company solely or substantially for his own financial benefit, he should be liable for the costs if his claim or defence or appeal fails. […] that is not to say that orders will invariably be made in such cases, particularly, say, where the non-party is himself a director or liquidator who can realistically be regarded as acting rather in the interests of the company (and more especially its shareholders and creditors) than in his own interests."

Other challenges - FCA issues?

(c) While outside the scope of this note, it is also worth considering whether the provision of funding would carry any FCA implications. It is not immediately obvious that it would, but we can see scope for FCA issues to be raised depending upon how the arrangements are structured. IP firms should consider this with their legal advisors.

Conclusion

Potential claims often represent a significant asset in insolvent estates. However, the very nature of insolvency litigation means that funding litigation costs (potentially including adverse costs orders) out of the insolvent company's assets will not always be possible. Provided they are used reasonably, a combination of third party funding, CFAs and ATE policies are a pragmatic way of dealing with this issue and ensuring that any sums owed to the insolvent estates can be recovered through the courts. It is also very positive that the recent regulation exempting insolvency proceedings from the Jackson reforms on success fee recoverability has been adopted.

The funding market is also continuing to develop; costs are coming down and more interestingly there are now different models being operated by the different funding providers to provide a range of options to fund your case. Although ATE as a standalone product remains relatively expensive in some circumstances, it remains a useful product.

In the shadow of the booming third party funding market, it is perhaps unsurprising that a trend towards IP firms funding hard costs has emerged. This trend will need to be considered and monitored as it develops.