Legal Aid, Sentencing and Punishment of Offenders Bill

Memorandum submitted by R3 (LA 23)

Exempt Insolvency Litigation from Reform of Civil Litigation Costs & Funding

 

Executive Summary

1. The Government’s planned changes to civil litigation costs and funding in the Legal Aid, Sentencing and Punishment of Offenders Bill will severely restrict creditors’ ability to recover money taken by directors who have acted improperly or ‘dodgy directors’, for example, directors that strip value out of a company prior to insolvency leaving creditors with nothing.

2. Creditors owed money are often other well-run businesses that may be put under severe cashflow pressure as a result of delinquent directors’ behaviour. In addition, the Government, in particular HMRC, are also major creditors. As such, the proposed reforms would effectively result in public money being retained by delinquent directors. In these circumstances it is important that creditors should be allowed to recover both their losses and the cost of recovering those losses from the director.

3. Conditional Fee Agreements were introduced by Section 58 of the Court and Legal Services Act 1990. However, it wasn’t until the Conditional Fee Agreements Order 1995 that the first "no win, no fee"-funded cases were made available. In the 1995 order, insolvency was specifically recognised as a category for which "no win, no fee" litigation should be available. The logic behind the introduction is just as robust now.

4. The existing system allows Insolvency Practitioners to pursue directors who have acted improperly and caused damage to a company or financial costs to HMRC. If this were to change, Insolvency Practitioners would be discouraged from undertaking litigation and perpetrators would get away with delinquent behaviour. This would be to the detriment of creditors, Central Government and UK plc’s well-earned reputation as a good place to do business, due to its world-renowned system of law.

5. For this reason R3 is calling for insolvency litigation to be exempt from the Government’s proposed reforms to the recoverability of success fees and After the Event insurance premiums.

What is Insolvency Litigation?

6. Insolvency Practitioners (claimant) undertake litigation on behalf of creditors against company directors or third parties (defendants) whose actions have caused serious harm to a business. This includes taking money out of the business for personal use, concealing assets and committing fraud. In some cases these actions directly contributed to the businesses failure.

7. An Insolvency Practitioner’s overarching legal duty is to maximise returns to creditors. In cases where directors have acted improperly this may involve undertaking litigation to return money rightfully owed to creditors, including the business community and HMRC. Without the use of litigation, directors would get away with dishonest practice and businesses would lose money.

8. In insolvency situations a company by definition has no money. As a consequence there are no funds available to pay the legal costs involved in pursuing litigation. The creditors’ only realistic hope of recouping money owed to them is for the Insolvency Practitioner to engage solicitors on a Conditional Fee Arrangement (CFA). In addition to this, Insolvency Practitioners may be personally liable for costs incurred as a consequence of litigation so must be properly protected with After the Event insurance (ATE). As the system currently exists CFA success fees and ATE insurance premiums are recoverable from the defendant if a judge, on the merits of the case, considers them to be liable.

9. Unlike personal injury cases there are very few insolvency claims against public authorities. In fact Central and Local Government are one of the biggest creditors and beneficiaries of the recoverability of CFA success fees and ATE insurance premiums.

10. In addition, unlike some claimants in personal injury proceedings the Insolvency Practitioner does not pursue frivolous claims. In fact the opposite is true of insolvency litigation; as an officer of the court, the Insolvency Practitioner must avoid bringing unmeritorious claims and the Insolvency Practitioner risks incurring considerable personal costs if the case is unsuccessful. Given the considerable risks involved an Insolvency Practitioner will only commence litigation on advice and once satisfied that it is economically justifiable for the creditors.

How would the Reforms impact on insolvency litigation?

11. Under the Government’s proposals CFA success fees and ATE insurance premiums will no longer be recoverable from the losing party in insolvency litigation. As a result Insolvency Practitioners would be discouraged from undertaking litigation and ‘dodgy directors’ would get away with sharp practice to the detriment of the following parties:

a. The Business community – The current system is particularly helpful in insolvency litigation because it allows Insolvency Practitioners to maximise the assets available for distribution to creditors. If the costs were instead to be borne out by the insolvent estate, it would substantially reduce the amount of money returned to creditors. At a time when businesses are struggling, it would seem counter-productive to implement measures which would reduce their returns.

b. In addition to lost revenue, the business community would also suffer as the Government’s proposals would discourage an Insolvency Practitioner (claimant) from taking action against a delinquent director (defendant). Given the considerable risks involved in insolvency litigation an Insolvency Practitioner will only commence litigation on advice and once satisfied that it is economically justifiable for the creditors. If the payment of CFA success fees and ATE insurance premiums were to be borne out of the estate, the Insolvency Practitioner would be discouraged from taking this course of action, leaving blameworthy directors free to prey on other companies.

c. R3 analysed a sample of 23 case studies where Insolvency Practitioners undertook litigation against a director or third party, using a Conditional Fee Arrangement and After the Event Insurance. If the Government’s proposals were to go ahead, the total impact on creditors (both in terms of cases not going ahead and a reduction in returns) in the 23 cases analysed would be an approximate loss of £3.6 million; a 47% reduction in returns to creditors.

d. HMRC – HMRC is the largest unsecured creditor in formal insolvencies in England and Wales. In recent years HMRC has become the single largest beneficiary of insolvency litigation, which aims to maximise returns to creditors. It has been said that the removal of the recoverability of Conditional Fee Arrangement success fees and After the Event Insurance premiums could cost HMRC a significant amount of money each year. This considerable benefit to the taxpayer is not mentioned anywhere in the Consultation paper/impact assessments and given the current economic situation it would seem counter-productive to implement measures which would remove this revenue.

e. The Courts – The prospect of the losing party paying costs provides a strong incentive for delinquent directors or third parties (defendants) to settle at an early stage, and avoid the costs of litigation altogether. The removal of this incentive could potentially place an additional burden on the courts. With wide ranging cuts to the justice system this is something which the Ministry of Justice is presumably eager to avoid.

Case studies

12. The director of a manufacturing company had used the company’s money to pay off a loan that he had personally guaranteed before liquidating the company and leaving the creditors with nothing. Insolvency Practitioners undertook litigation against the director and approximately £100,000 of additional money was returned to creditors as a result. The success fee and ATE premium amounted to £15,000. In this case the Insolvency Practitioner said:

"We would not have pursued the claim if the CFA and ATE fee were not recoverable. In addition the inability to recover the fees would have affected our negotiating position and the defendant would have dragged the proceedings out for longer rather than settling early, which would have increased costs for all involved."

Impact: A loss to creditors of £100,000

13. An Insolvency Practitioner undertook litigation against the director of a property development company, which had gone into liquidation following the completion of a development of 16 flats. It was found that the director had faked invoices and transferred 13 of the 16 flats to another company he owned, leaving the creditors with nothing. Just over £500,000 was recovered for the creditors as a result of the litigation and the CFA success fee and ATE insurance premium amounted to £150,000.

Impact: A loss to creditors of £150,000 or in the worst case scenario £500,000

Conclusion

14. In insolvency litigation the recoverability of success fees and ATE insurance premiums is a real and tangible benefit to society and the business community. Not only does it ensure that delinquent directors do not get away with sharp practice, but it also increases the returns available to creditors, including HMRC and the business community. If the court determines that a director acted improperly; stripping the value out of a company prior to insolvency, and leaving the creditors with nothing, creditors should be allowed to recover the full cost of funding from the delinquent director.

Background to R3, the insolvency trade body

15. R3 is the trade body representing 97% of Insolvency Practitioners. Our members are lawyers and accountants who help businesses in financial distress on a daily basis and administer formal insolvency procedures.

July 2011