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Legal action in insolvent companies

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This is an interesting article from our friends at Worrells Solvency & Forensic Accountants:

"It is not uncommon for the sole material asset remaining at the end of a company’s life to be a cause of action against a third party (e.g. a claim for breach of contract).  More often than not, at the time a director first approaches an insolvency practitioner, no action has been taken in relation to the claim or the action is in its infancy and where the company is insolvent, a liquidation or voluntary administration, is inevitable. 

The potential value of such litigation, if prosecuted successfully, may be significant.  Although it is usually the case that an insolvency practitioner will be unable to take any action in relation to the claim and realise its value for the following reasons:

(1)    The company is will often be assetless;

(2)    The administrator and/or liquidator will be required to incur significant legal costs to recover on the claim (which may include posting security for costs if legal proceedings become necessary), those costs will typically need to be borne by the practitioner personally;

(3)    The benefit of the claim will be retained solely by the insolvent company to be distributed in accordance with the priorities set out in the Corporations Act and therefore no compensating advantage to the director and/or close associates of the company to fund the costs of the claim (other than the right to apply to Court to recover those costs from the proceeds of the action in priority to creditors); and

(4)    The director is familiar with the material facts and history of the claim and therefore is better positioned than an insolvency practitioner to manage the claim.

On rare occasions the liquidator will negotiate the sale of the cause of action.

In September 2010 Con Kokkinos and Paul Burness, partners of Worrells Melbourne were appointed to two related entities that traded restaurant businesses from leased premises.  Upon appointment, the primary assets of both companies were claims against the owner on the basis of a failure to honour certain representations that their respective tenancies, would be renewed.  As the tenancies were not renewed the companies had no alternative but to cease trading.  The companies then initiated legal proceedings seeking damages for loss of future profits.

The appointments were precipitated by the filing of winding up applications against the companies by the Australian Taxation Office.  The voluntary administration, which typically lasts no more than 35 days, enabled the director to propose a Deed of Company Arrangement to creditors under which he would:

· Contribute a lump sum to be made available for distribution to creditors; and

· Continue to fund the proceedings and, if successful, make 20 percent of the net proceeds of the actions available for distribution to creditors.

The administrators determined that, if the legal actions were successful in a deed scenario, unsecured creditors could expect to receive a dividend of 100 cents in the dollar.  By contrast, it was considered unlikely that the claims would be pursued in a liquidation as no return to creditors could be expected.  Despite this assessment, the Deputy Commissioner proceeded with the winding up application.  The Court received a report from the administrators on the deed proposal, on which the application was adjourned to enable creditors to vote on the proposal.  These were ultimately approved by creditors at the meetings called at the end of the administrations to decide the future of the company.  The Deputy Commissioner not surprisingly voted against the proposals.

The director continued to fund the proceedings in accordance with the terms of the deeds and, in February 2012, judgment was handed down in favour of the companies.  It is our understanding that the legal costs incurred by the director significantly exceeded our preliminary estimates.

The issue of damages has yet to be decided.

This example highlights the fact that a Deed of Company Arrangement may be the most effective form of external administration for an insolvent company where the principal asset of the company is a cause of action."

It also highlights the current attitude of the ATO.

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