Who Pays the Piper?

Vernon Dennis on the future of insolvency litigation

Litigation for Whose Benefit?

Immediately post insolvency creditor feelings maybe running high and the wish to see instantaneous action which metes out retribution and not just brings compensation maybe evident. However the commercial imperatives of the IP (are proceedings worthwhile in term of legal merit, recoverability and of proportionate cost vs benefit?) often leads to lengthy investigations and dulls creditor engagement. Conversely creditors may be excluded from decisions regarding litigation, the claim being conceived in the confines of confidentiality and legal privilege, and by using available realised assets, commenced without consultation. Where ultimately the action provides little return or no return to creditors but recovery of costs and expenses, litigation may be perceived as being run for the benefit of the IP and the lawyer. Into this combustible mix comes the question of funding.

It will have escaped no one's attention that on 26 February 2015, the Government granted an eleven hour reprieve to the insolvency profession; announcing that insolvency litigation will continue to remain 'for the time being' outside of the scope of the reforms introduced by the Legal Aid, Sentencing and Punishment of Offenders Act 2012 (LASPO).

No win no fee agreements (conditional fee agreements) (CFAs) and the recoverability from the losing party of CFA success fees and after the event (ATE) insurance premiums have played an important part in the shaping of the litigation practices of both insolvency practitioners and the lawyers acting for them. Removing creditor risk, i.e. limiting or extinguishing diminution in the insolvent estate and allowing a potential recovery where none was otherwise present.

Has the reprieve however stopped the profession from embracing change and developing innovative ways to litigate and provide return to creditors other than by use of the CFA model?

Is The Recovery of CFA Success Fees Here to Stay?

LASPO removed the ability of claimants in commercial litigation cases to recover the CFA success fee and insurance premium from their opponents, a measure driven in part by the growth in personal injury litigation and the consequent response of the insurance industry.

While the funding of commercial litigation is outside the scope of this article, it has been argued that despite the returns to the claimant being potentially reduced, the absence of CFA success fee recovery has not significantly altered litigation volumes. However while a solvent claimant can make an informed decision as whether to provide ongoing funding or alternatively from any reward bear the additional cost of the success fee and premium, for the insolvency practitioner the costs will be borne from a recovery that would otherwise go to creditors.

In support of its campaign to see exemption extended R3 estimated that should the exemption to LASPO be lost there would be a consequent fall in insolvency litigation with a cost to creditors estimated to be at £160m. Why is this?

Firstly in lower value claims, the fact that success fees and premiums would be deducted from the final award would make many uneconomic. Secondly the respective bargaining positions of the parties would alter making litigation less attractive; the defendant tactically employing delay and obfuscation as a means to ‘sweat out’ the claimant. In contrast where the defendant however faces the prospect of increased costs through a success fee and ATE premium, this delaying tactic has significant cost implications and risk.

Despite these compelling arguments it is questionable whether the Governments' announcement marks a permanent change in attitude. As a result the insolvency sector must remain alive to the possibility that the exemption will be removed and will need to consider the alternatives. 

Creditor Funding

As the ultimate beneficiaries of the action should the creditors not fund the same? Indeed it is arguable that the CFA model has allowed major creditors such as financial institutions and Government bodies (who have the ability to fund and maybe advocating that action should be taken) to shirk responsibility and withdraw funding from cases, pushing the risk and capital costs to the insolvency practitioner and legal team.

In many cases however it is the collective nature of the insolvency process and the need to co-ordinate a potential disparate body of creditors provide obstacles, with many creditors taking the not unreasonable view that they have already suffered the economic loss on the insolvency and would have no wish to speculate to accumulate.

In certain limited circumstances creditors may provide funding, and see the return of their ‘investment’ as a costs and expenses, however without an assignment of the causes of action the economic interest in the final award remains with the creditors as a whole, which acts as a potential dis-incentive for individual creditors to provide funding.

Third Party Funding

Over the past decade the litigation funding market has been developing apace offering litigants an alternative to CFA arrangements. The announcement in February is however an indication that the Government does not feel that the insolvency industry has embraced the funding industry and/or that the funding industry has not developed sufficiently to meet the challenges presented by insolvency cases.

While in the months leading up to the potential loss of the exemption some funders developed product lines (often tied to ATE coverage) to deal with lower value claims, a significant take up did not result/was not necessary.

What potential developments might we see should the LASPO exemption be permanently lost?

1. Litigation Funding
   
   The provision of funding by a specialist funder or by potentially a single creditor clearly has its place. A significant advantage being that the funded party does not suffer the perceived lack of fire power that faces those who need to engage a legal team on CFA (particularly where the success fee cannot be recovered from the opponent).
   
   The most significant problem in funding insolvency litigation is that the costs of proceedings can often be high; even in cases of low value complex issues of law and fact often arise. This can mean that after deduction of the costs the funder’s percentage recovery from the award is often limited. As a result funders will seek to ensure that there is a high ratio of potential damages as against costs; meaning in practice they are looking at high value claims. Potentially where costs are recoverable from the losing party this poses less of a problem, although clearly an insolvency practitioner will only take on a case where the funding costs and the irrecoverable costs (e.g. the office holders fees) will still result in a significant return to creditors. As a result litigation funding fails to provide a solution in many cases.
    
2. Portfolio Funding
   
   Due to the difficulties in pursuing low value insolvency cases funders may increasingly look at a model which sees a portfolio of cases being funded. The portfolio may consist of cases linked by the same the insolvency practitioner and lawyer, or consist of claims of a similar type. For the funder this provides a different type risk assessment; requiring a close analysis of the team working on the cases, their competence in the type of litigation being pursued and overall success rates as opposed to the merits of the individual cases.
    
3. Work in progress Funding
   
   A short leap from portfolio funding is work in progress funding. Here the funder would simply provide an advance against the lawyers work in progress secured against recoveries. For the law firm this overcomes the significant cash flow problems that arise in taking on CFA work, providing certain working capital and de-risking taking on work of this type. The cost of finance however will eat into the profitability of the work being undertaken and for some practices the loss of control over certain recoveries will be difficult to integrate into their practice model.
    
4. Hybrid CFA/DBA
   
   Since LASPO and following the US inspired model, damages based agreements (DBAs) have been available; anecdotally however they do not appear to have been significantly taken up. A DBA can see a legal team rewarded with up to 25% of the damages and in high value cases this could see significant return. The concept of a DBA does not however sit comfortably with UK legal system which sees the recoverability of the legal costs from the losing party, underpinned by the indemnity principal. In contrast a CFA retains a link to the value of the work actually being carried out, with the uplift/success fee compensating for the risk being taken.
   
   If any success fee was to be payable from the potential damages one might see a move to tie the legal team into a percentage recovery from the damages. A hybrid CFA and DBA could arise with minimum and maximum recovery levels being calculated based on the eventual award. The need to define levels of success would require a great degree of sophistication at the outset of the arrangement, but may have application in some cases.
    
5. Assignment of Claims
   
   While the assignment of claims to parties potentially interested/involved in the litigation has been an option often utilised by an office holder, the presences of specialist funds seeking to obtain a profit on investment has provided for a different dynamic. However significant development of this form of asset realisation is currently hindered as claims deriving from the office holders appointment and brought by the office holder (e.g. Insolvency Act 1986 Sections 213,214,238 and 239) are not capable of assignment (see Oasis Merchandising Services Limited [1997] 2 WLR 764).
   
   The Government is however proposing to allow the assignment of such office holder claims, a move that is currently due to be introduced with a raft of Insolvency Rule changes in April 2016. This move could well be the key to opening up new opportunities for funders and providing an alternative to the CFA/ATE model.
   
   Firstly insolvency practitioners whose practices are more aligned to debtor led liquidations may find it beneficial to treat causes of action as any other company asset and simply seek to realise value by assignment. While some investigation and valuation (i.e. assessment of the merits) will be necessary, these practices may prefer to provide an increasingly commoditised cost effective service and not tie up staff in longer term (and possibly more specialist) litigation/recovery work.
   
   Where specialist funds take on a larger number of cases economies of scale will result; with the fund, possibly employing its own specialist in-house team of insolvency practitioners and lawyers to run its acquired actions, as opposed to relying on external advisors.
   
   Alternatively rather than the fund running the actions one might see joint ventures between a fund and insolvency practitioners. The funder providing working capital to the increasingly specialist insolvency practitioners who would take forward the assigned claims. This would have attraction to practices that have grown on reliance of creditor services and/or are reliant on the legal team’s engagement on a CFA. Of course there is nothing to stop the fund and the insolvency practitioner insisting that the legal team continue to work under a CFA.
   
   Most radically the alignment of interests between the fund, the insolvency practitioner and legal teams could be met by the development of alternative business structures, providing a special purpose vehicle possibly created by a fund or in which a fund has a stake.

Conclusion

The Government has provided for the continuation of the insolvency exclusion to LASPO for ‘the time being’. With pressures on the insolvency industry over costs and remuneration, there is an inference that creditors do not receive adequate return. Perhaps allowing the assignment of office holder claim is in reality a means of promoting the market/the private sector to find a solution to this problem. However while this is a solution that may see directors of failed companies being pursued more regularly, this will not necessarily lead to any better return to creditors.

As a result despite the eleventh hour reprieve, this is no time for the insolvency profession to rest on its laurels. The profession must remain alive to the reputational damage suffered if it does not pursue active engagement with creditors and evidence that litigation is conducted on their behalf. Furthermore irrespective of whether the CFA/ATE exemption remains, potential significant change will arise with the entry of new funders/products into the insolvency litigation market. These changes should be embraced and the innovation that the industry has consistent shown must be at the fore to ensure that this important form of asset recovery is not lost for creditors.