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Focus: Litigation funding decision impacts on insolvency practitioners

2 May 2011

In brief: The New South Wales Court of Appeal recently held, with significant implications for insolvency practitioners, that a litigation funding agreement constituted a 'financial product' and could be rescinded because the funder was not licensed to deal in 'financial products'. This follows the Full Federal Court's 2009 decision that litigation funding arrangements for class actions constitute 'managed investment schemes' (a particular type of 'financial product'). Partners Ross Drinnan (view CV) and Michael Quinlan and Senior Associate Jenny Campbell report.

How does it affect you?

  • The decision1 has potentially wide-ranging implications for insolvency practitioners, as they are some of the more frequent users of litigation funding. These include:
    • If an insolvency practitioner has entered into a funding agreement, they may have grounds to rescind if the litigation funder does not hold an Australian Financial Services Licence (AFSL). This may be helpful if the practitioner has entered into such an agreement and they no longer consider it to be beneficial or there are now better deals on the table. The rescission of such agreements may also have implications for the security for costs position of other parties to that litigation.
    • Insolvency practices that have an associated business that offers funding should consider whether they now require an AFSL.
    • A number of insolvency-related funding arrangements have been shielded from the implications of the decision by way of the Australian Securities and Investments Commission's (ASIC) class order relief. Among other things, ASIC Class Order [CO 10/333] exempts funders involved in representative proceedings and claims lodged with liquidators to prove in the winding up of insolvent companies from the requirement to hold an AFSL.2
    • The decision continues to apply with full force to funded litigation falling outside the scope of the class order relief.

Background

In October 2008, Chameleon Mining NL (Chameleon) entered into a litigation funding agreement with International Litigation Partners Pte Ltd (ILP) to fund Chameleon's litigation in the Federal Court against Murchison Metals Limited (the funding agreement). ILP is a litigation funder based in Singapore that has been actively involved in funding litigation in Australia. ILP has never held an AFSL.

Chameleon purported to rescind the funding agreement under section 925A of the Corporations Act (all references to statute in this Focus are to that Act) on the grounds that it constituted or related to the provision of a 'financial service' by a person who did not hold an AFSL and was not exempt from being licensed.

One of the key issues in the proceedings was whether ILP's entry into the funding agreement constituted the provision of a 'financial service'. That, in turn, depended on whether the provision of funding by ILP amounted to dealing in a 'financial product'.

The funding agreement as a 'financial product'

The key question was whether the funding agreement was a facility through which, or through the acquisition of which, Chameleon 'manages a financial risk', being one element of the definition of 'financial product' in s763A.

Section 763C provides that a person manages financial risk if they (among other things) 'manage the financial consequences to them of particular circumstances happening'. Also relevant to the court's analysis was s763E, which essentially excludes a facility from the definition of 'financial product' if managing financial risk is only an incidental component (and not the main purpose) of the facility.

The Court of Appeal (in a majority decision) held that the funding agreement was a facility for managing financial risk and was therefore a 'financial product'. In general terms, Appeal Justices Giles and Young found that the funding agreement managed Chameleon's financial risk by passing to ILP the risks to Chameleon associated with the financial consequences of maintaining expensive litigation and the possibility of an adverse costs order in that litigation. This was a main purpose of the funding agreement and could not be considered incidental.

Appeal Justice Hodgson (in dissent) held that, while managing financial risk was one purpose of the funding agreement, it was not the main purpose. The main purpose was to provide finance for, and therefore to facilitate, the pursuit of the Federal Court proceedings. On that basis, his Honour held that the components of the funding agreement that did manage risk were incidental and that the effect of s763E was that the agreement was not a 'financial product'.

Other issues – the funding agreement as a 'derivative' or 'credit facility'

Chameleon also argued that the funding agreement was a 'financial product' because it was a 'derivative' under s761D. Justices Young and Hodgson held that the funding agreement was not a derivative (for different reasons), whereas Justice Giles held that it was. Incidentally, in issuing an AFSL to IMF (Australia) Limited (Australia's biggest and most high-profile litigation funder) in 2005, ASIC described the litigation funding agreements in respect of which the licence was issued as 'derivatives'. 3

ILP argued that, under s765A, the funding agreement could not be a 'financial product' because it was a 'credit facility'. Justices Young and Giles (with Justice Hodgson dissenting) rejected that argument on the basis that the funding agreement was an agreement to pay costs and did not involve a loan or advance of money.

The outcome

It followed from the finding that the funding agreement was a 'financial product' that ILP had dealt in a 'financial product' and therefore provided a 'financial service'. As ILP did not hold an AFSL, the court held that Chameleon was entitled to rescind the funding agreement.

It remains to be seen whether ILP will seek special leave to appeal to the High Court. It will need to make any such application within 28 days of final orders being made by the Court of Appeal.

The broader implications of the decision

The decision has implications for both funded litigants and other parties to litigation in which funding is provided by an unlicensed funder. It may also have implications for insolvency practices that offer funding arrangements.

For funded litigants

Insolvency practitioners are some of the more frequent users of litigation funding. Like Chameleon, an insolvency practitioner who is a funded litigant may be entitled to rescind its funding agreement if its funder is unlicensed, but only within a 'reasonable period' after becoming aware of the facts giving rise to its entitlement to do so. It may not, however, do so if the funder informed it that it was unlicensed before the agreement was entered into.

This may be helpful if the practitioner has entered into such an agreement and they no longer consider it to be beneficial or a better funding deal is available elsewhere. If a funding agreement is rescinded on the basis that the funder is unlicensed, the funder will not be able to enforce or rely upon it, including in respect of the recovery of any commission or fees due to it. This would include, for example, the commission the funder would ordinarily receive upon a settlement or judgment in the funded party's favour (ss 925E and 925F).

Even if the funding agreement is not rescinded, s925H provides that the funded party may recover from the funder as a debt the amount of any commission or fees paid to the funder under the funding agreement.

For other parties to funded litigation

The rights of a funded party described above may also have implications for the costs position of other parties to the funded litigation. In particular, those parties may need to reassess the need for an order (or the appropriateness of an existing order) for security for costs against the funded party if the relevant funder is unlicensed. The particular issues to be considered will depend on the circumstances of each case.

For insolvency practices

Insolvency practices that have an associated business that offers funding should consider whether, having regard to the Court of Appeal's decision, they now require an AFSL.

Legislative response

In May 2010, following the Full Federal Court's decision that funded class actions constitute a 'managed investment scheme',4 the Federal Government announced an intention to legislate to exclude funded class actions and proof of debt arrangements from the definition of 'managed investment scheme'. Pending enactment of that legislation, ASIC has granted interim class order relief to funders involved in representative proceedings and claims lodged with liquidators to prove in the winding up of an insolvent company commenced after 4 November 2009, which, among other things, exempts them from the requirement to hold an AFSL.

We are not aware of any proposals at this stage for a similar response to the Court of Appeal's decision. In our view, the most likely outcome is that an AFSL will be required for all forms of litigation funding in Australia.

Footnotes
  1. International Litigation Partners Pte Ltd v Chameleon Mining NL [2011] NSWCA 50.
  2. ASIC Class Order [CO 10/333]: Funded representative proceedings and funded proof of debt arrangements.
  3. Announcement by IMF to ASX on 16 March 2011 entitled 'Judgment in Chameleon Mining NL'.
  4. Brookfield Multiplex Ltd v International Litigation Partners Pte Ltd [2009] FCAFC 147.

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