Disputes - What to look out for in 2020: Insolvency disputes

In brief

• insolvency litigation is increasing and this will accelerate further in 2020. A key issue for office holders will be how to fund actions to recover assets, or whether to monetise claims by selling them to litigation funders.
• office holders are increasingly interested in exploring the funding of claims through third party funders or using their own capital, but this comes with risks.
• there are likely to be further compensation orders against directors using the Secretary of State’s new powers, while more officeholder claims against auditors are likely to be seen against the backdrop of a heavily scrutinised audit industry.

Approaching downturn

Most commentators are in agreement that there is set to be a global downturn. The likely effect of such a downturn is a wave of insolvencies across a range of sectors. In many cases, litigation may be the only means available for attempting to recoup losses for creditors.

Such a global downturn is, however, predicted to come at a time when the legal landscape for insolvencies is itself uncertain. Brexit may affect the recognition and enforcement of insolvency processes across Europe, which may in turn trigger parallel proceedings to preserve and recover assets in the UK and EU Member states. The UK Government published proposals in August 2018 for the reform of insolvency law and corporate governance rules, which may gain impetus if the European framework no longer applies.

What is clear to us is that, if there is to be a wave of litigation arising from insolvencies, the only way for many of those claims to be progressed will be with the assistance of third party funders. The litigation funding industry has continued to grow this year and what we see going into 2020 is an increasingly creative industry, responding to changes in the market and attracting new players with different business models, including accountancy firms.

The Litigation Funding landscape

The original model for litigation funding was a straight injection of capital to be used to fund a case in exchange for a return of that capital, plus success fee, in the event of a win. At the time that this model was introduced, insolvency practitioners were still able to rely on the recoverability of Conditional Fee Agreement success fees from losing parties and that continued to be the preferred way of funding an insolvency claim until such success fees were abolished in April 2016.

However, the straight funding option is an excruciatingly expensive model and the market has adapted to that with the development of a range of products which combine both funding and insurance. There is an appetite amongst law firms to share and manage risk, to deliver an overall cheaper method of monetising a claim. Such models can be more palatable to insolvency practitioners and the creditors in whose interests they act.

We have also seen new funders enter the market with different business models which can ensure that good cases with a value as low as 5 figures can be entertained.

Selling claims

Schedules 1, 4 and 6 of the Insolvency Act 1986 give administrators, liquidators and trustees in bankruptcy the power to sell the property of the company or bankrupt, including claims. Following the Small Business Enterprise and Employment Act 2015 (which created a new Section 246ZD to the IA 1986 in respect of liquidations after 1 October 2015), a liquidator or administrator can assign officeholder claims which give them the power to challenge antecedent transactions such as preferences, transactions at an undervalue, wrongful trading etc.

The benefits for both officeholders and funders are clear. Funders can take control of the litigation without becoming concerned about the rules against champerty and maintenance. Officeholders can, quite quickly, sell a claim with good prospects for an upfront sum that provides capital to pursue other actions or to give a return that can be used in running the business in an administration.

We expect to see the use of these alternative ways of monetising claims increase in 2020 and to see more activity from accountancy firms and law firms to share some of the risk of the claims.

The dangers of funding

Care needs to be taken, however, by new parties beginning to explore the funding market as Griffins, the accountancy firm, found out in November 2019 in the case of Burnden Holdings (UK) Limited (in Liquidation) v. Gary John Fielding.

The liquidators of Burnden brought a claim against its directors for payment of unlawful dividends. The liquidators lost a strike out application by the directors at first instance. The liquidators wanted to appeal but could not get funding from a commercial third party funder. Griffins, the firm of accountants where the liquidators were based, therefore advanced funding to Burnden for the costs of the appeal and the payment of certain adverse costs orders. The appeal was successful. At this stage a commercial third party funder provided funding for the full trial, but the liquidators went on to lose.

The directors then sought costs orders against the commercial third party funder and Griffins.

The Judge found that Griffins was not a “pure funder” but had an interest in the outcome of the litigation because the liquidators had agreed to be remunerated in the sum of 50% of the net proceeds, in the event of a win. On that basis, the question then arose as to whether Griffins’ liability should be for all of the directors’ costs or limited to the amount of the funding it had provided (approximately £500,000), by the application the so-called Arkin cap. Zacaroli J. found in favour of the latter approach because Griffins’ rate of return on the funding (repayment of capital invested plus 1x the amount of funding) was a fair reflection of risk. The intention of Griffins could therefore properly be said to have been to find a way of monetising the claim rather than maximising its own financial gain.

It should be noted that in the case of Davey v. Money in April 2019, the Arkin cap was held to be discretionary and can be disapplied in appropriate cases. More on that case can be found here. The Davey decision is subject to appeal in 2020.

Other developments to watch

In November 2019 the first compensation order requiring a disqualified director to compensate creditors upon the application of the Secretary of State was made in the Noble Vintners case. In 2020, expect case law on how such claims interplay with officeholder claims. It also remains to be seen how the Secretary of State’s powers will be used, eg what is the scope for settlement?

Officeholder claims against auditors for negligence are also likely to increase, against a backdrop of ongoing reviews of the audit industry and the transition between regulators from the Financial Reporting Council (FRC) to the Audit, Reporting and Governance Authority (ARGA).

What this means for you

• the legal landscape for future insolvency cases, particularly in a post-Brexit world, is somewhat uncertain.
• all parties should be thinking creatively about how insolvency cases can best be monetised in order to manage risk and ensure that creditors are reimbursed for losses to the fullest extent possible.
• legal advisors need properly to understand and consider the whole range of funding and financing options to give their clients the best possible range of options.
• as parties and advisors start to think creatively and look for new opportunities to finance claims other than via the traditionally expensive straight funding model, they must be wary of developments in case law. The courts are beginning to require further responsibility on the part of funders as to the size of their return, and to control the legal spend on both sides of a case where they have the oversight to do so. Proceeding to fund a case in the absence of adequate adverse costs cover has proven, for some, to have been a risk too far.