Just reward for creditors that indemnify liquidator’s pursuit of third-party claims

Section 564 of the Corporations Act can give creditors of a company in liquidation which has third party claims an opportunity to improve their prospects of recovery and match the risk of funding the pursuit of those claims with the potential reward.  Keep it in mind.

As insolvencies increase in the current economic environment, companies and sole traders may find themselves as significant creditors of a company in liquidation and frustrated at the prospect of their return out of the winding up.

Often the most valuable assets of the company in liquidation will be claims it has against third parties.  

Equally as often, the liquidator has no, or insufficient, funds to pursue these claims and generate a return to creditors.

One option we have discussed in other posts and videos is third party funding, where a litigation funder funds the liquidator’s claim in return for a fee (typically the return of their costs and a % of the recoveries).

Another option is for a creditor to fund the liquidator to pursue the claim.  

But without any direct incentive to do so, why would a creditor take the risk of funding the liquidator if any amounts recovered are simply distributed between all creditors, and according to s 556 Corporations Act 2001 priority payments.

Section 564 of the Corporations Act 2001 provides an option which can deliver a direct incentive to creditors.

I recently discussed the operation of section 564 with Stewart Peters, who has an office in the same building as Mackay Chapman, and who has written about this section in the past.

Under s 564, the Court can make orders in favour of a creditor that takes the risk in providing a liquidator with an indemnity, for the purpose of pursuing claims to recover property.  

Importantly, the Court may order that any property recovered is distributed in a way that favours the creditor providing the indemnity, despite what otherwise would be required under the s 556 priority categories. 

Such orders are made on the basis of what the Court deems ‘just’ in consideration of the risk assumed, providing a broad discretion.

The policy objectives of s 564 are to encourage creditors to indemnify liquidators to pursue recoveries and to discourage corporate misconduct (through increasing the prospect of recovery action against wrongdoers).

Depending on the circumstances, a creditor that takes some risk, may apply under section 564 for the lion’s share of any recoveries and in priority to other creditors.  In rare circumstances, creditors have been awarded 100% of the net recovery proceeds, or at least subject to liquidator costs to complete the winding up.

An application under section 564 is a real option for a creditor of a company in liquidation that has a claim against a third party with good prospects where the liquidator is unfunded.  It provides creditors, in the right circumstances, with a way of matching their return with the risk they take in indemnifying the liquidator.  

An unfunded liquidator may be willing to ‘spec’ the litigation, but in our experience, in particular in third party insolvency claims, running litigation on ‘spec’ rarely leads to as good an outcome as properly funded litigation.  And of course, the liquidator will recover any costs expended, the normal priorities will apply under 556 and any remaining recoveries will go into the general pool.

In these increasing turbulent times as counterparty risk rises or crystallises with liquidation, creditors would do well to remember that:

• third party funding (and the associated fee) is not the only available option in pursuing those claims that have a strong chance of delivering a return in the winding up; and
• a section 564 court application gives them an option to increase their recovery prospects and priority, and match the efforts or risk undertaken by the creditor themselves to the potential return (rather than just being for the benefit of others).

If you are exposed to a liquidation, or think you might be, get expert advice early.  It doesn’t have to cost a lot but can contribute much more to your understanding of the options and therefore strategy and response.

If a liquidation does arise, speak to the Liquidator to find out what claims there are, review the Liquidator’s reports closely to see if there are third party claims and keep section 564 in mind.

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The contents of this article do not constitute legal advice and it is not intended to be a substitute for legal advice and should not be relied upon as such.  It is designed and intended as general information in summary form, current at the time of publication, for general informational purposes only.  You should seek legal advice or other professional advice in relation to any particular legal matters you or your organisation may have.

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