Recent changes in the Australian regulation of third-party funders will have a dramatic effect on the funding of certain disputes. Although these changes were accompanied by Government and industry commentary that they would not affect litigation funding for insolvency-related claims, this may not be the case for all insolvency funding arrangements. The below discussion focuses on the effect of the regulatory changes on the funding of claims pursued by external administrators, with a view to highlighting issues that insolvency practitioners and their advisors may need to be mindful of in structuring all future funding arrangements.
- No change in the regulation of:
- Creditors or shareholders funding a company or its external administrator to conduct investigations, seek remedies, or defend certain proceedings; and
- Litigation funders funding a single claimant to seek remedies or prove claims in an external administration.
- An unrelated litigation funder providing funding to more than one claimant (e.g. both a company and its liquidator) may be required to hold an AFSL and comply with financial product regulations in certain circumstances. It may be prudent to apply to ASIC for relief from these requirements and/or to seek Court declarations that they do not apply.
The regulatory change
Prior to 22 August 2020, the Corporations Regulations 2001 (Cth) (“the Regulations”) exempted litigation funders from the obligation to hold an Australian Financial Services Licence (“AFSL”) and from the obligation to comply with the Managed Investment Scheme (“MIS”) regime (collectively “the Exemptions”).
When originally enacting the Exemptions, the Government did so noting that it supports litigation funders as they provide access to justice, and that the registration, licensing, conduct and disclosure requirements associated with MIS schemes were “not appropriate” for litigation funding arrangements.
Earlier this year, however, the Treasurer Josh Frydenberg MP issued an unexpected announcement that by 22 August 2020 the Exemptions would be repealed.
The Corporations Amendment (Litigation Funding) Regulations 2020 (Cth) (“Amending Regulations”) have since been enacted to give effect to the Government’s announcement, such that litigation funders are now required to hold an AFSL and comply with the MIS regime for certain funding arrangements.
Anticipated effect on insolvency matters – business as usual?
In the insolvency context, the Treasurer’s announcement was met with some apprehension, including a submission from the Australian Restructuring Insolvency & Turnaround Association (“ARITA”) that reiterated the importance of litigation funding in the insolvency context and expressed concern over the effect of the proposed changes. ARITA noted that “when used appropriately, insolvency practitioners and key stakeholders obtain considerable benefits from the use of litigation funding”.
Happily, when the Amending Regulations were enacted, their Explanatory Memorandum explicitly stated that they “do not remove the effect of … exemptions that currently apply to certain litigation funding schemes in the insolvency context and litigation funding arrangements (which are used in actions involving a single plaintiff).” Consistent with this, on 23 July 2020 ARITA announced that the Amending Regulations “keep insolvency related litigation funding arrangements outside of the additional compliance measures for litigation funding.”
Nevertheless, as is often the case with legislative interpretation, the devil is in the detail (or perhaps, as discussed below, in the definition). The Explanatory Memorandum refers to the status quo being maintained for “certain” litigation funding schemes in the insolvency context. What are those “certain” schemes, and what do the Amending Regulations mean for other funding arrangements in the insolvency context? This is discussed in further detail below.
The Amending Regulations
The structural changes
Prior to the implementation of the Amending Regulations, the Exemptions applied to what were defined as “litigation funding schemes” and “litigation funding arrangements”, so long as the providers of such exempt products complied with the requirement to maintain and document adequate practices for managing conflicts of interest that may arise.
The effect of the Amending Regulations was to remove the Exemptions for “litigation funding schemes”, while maintaining the same Exemptions for “litigation funding arrangements” and for the newly coined “insolvency litigation funding schemes”.
The devil in the definition
Importantly, the Amending Regulations did not only change the number of arrangements that enjoy the Exemptions, but also changed the definition of those exempt arrangements.
The superseded Regulations defined (broadly speaking):
- “Litigation funding schemes”, as being both:
- Schemes in which, with the assistance of a funder (i.e. funding, indemnities) under a funding agreement a number of parties sought remedies arising out of similar or related circumstances (for ease of reference, referred to below as “Multi-Claimant Funding”); and also
- Schemes in which creditors or shareholders provided assistance to a company or its external administrator in order to conduct investigations, seek remedies, or defend certain proceedings (referred to here as “Creditor Funding”).
- “Litigation funding arrangements”, as being arrangements in which, with the assistance of a funder under a funding agreement a party sought remedies to which it was entitled, or proved claims in an external administration (referred to here as “Single-Claimant Funding”).
The Amending Regulations reshuffled the definitions of these key terms to now define (again, broadly speaking):
- “Litigation funding schemes” as Multi-Claimant Funding only, thereby removing Creditor Funding from this umbrella;
- “Litigation funding arrangements” as Single-Claimant Funding, broadly leaving this category the same; and
- Importantly, “insolvency litigation funding schemes” as Creditor Funding only. To recap, this means schemes in which creditors or shareholders provide assistance to a company or its external administrator in order to conduct investigations, seek remedies, or defend certain proceedings. It does not include funding by an unrelated litigation funder.
Actual effect on insolvency matters – business as usual for some, not for all
Under the superseded Regulations, a litigation funding arrangement between an unrelated litigation funder (i.e. one that is not a creditor or a shareholder) with a company in external administration and any number of its appointed external administrators (“Commercial Insolvency Funding”), enjoyed the Exemptions either by reason of it meeting the criteria for Single-Claimant Funding or, if relevant, Multi-Claimant Funding.
Following the implementation of the Amending Regulations, in order for an insolvency funding arrangement to enjoy the benefit of the Exemptions, it would need to meet the criteria for a Creditor Funding arrangement or that for a Single-Claimant Funding arrangement. Therefore, in order for Commercial Insolvency Funding (i.e. not Creditor Funding) to be exempt, it would on the face of the Regulation need to have the dominant purpose of allowing its singular funded party (presumably, the company or the external administrator) to seek remedies to which it may be legally entitled.
The particular difficulty with applying these criteria to Commercial Insolvency Funding is that the claims available for an insolvent company may include claims of that company, claims that vest in its administrator, or both. Recoveries from such claims would in any event flow through to the company. Consequently, third-party litigation funders routinely enter into litigation funding agreements which have both the company and its external administrator(s) as parties. With more than one party being included in the arrangement, this very common funding structure would arguably fall outside of the definition of Single-Claimant Funding under the amended Regulations and would, thereby, fall outside of the arrangements that enjoy the Exemptions.
This result would appear to be an unintended consequence of the Amending Regulations; it would seem clear that these regulations were not drafted with any specific objective relating to Commercial Insolvency Funding for two or more claimants. Nevertheless, although there are arguments that may be available to assert that these structures are in fact Single-Claimant matters (for example, that this structure is an “arrangement” rather than a “scheme”; that the claims that vest in the external administrator are nevertheless claims for remedies to which only the (singular) company “is legally entitled”; that a liquidator and an insolvent company are together one “party” (or ‘general member’ for the Regulations); or that the Single-Claimant definition ought to be interpreted to include the plural of ‘general member’ as well as the singular), this regulatory change is one that may need to be front of mind when structuring future funding arrangements.
What if the funding is not Exempt?
The focus of the above discussion is on the status of the Exemptions for third-party insolvency funding arrangements.
But what does it mean if a Commercial Insolvency Funding arrangement is not exempt?
- Is it a Managed Investment Scheme?
The exemption from the operation of the MIS regime (under Regulation 5C.11.01) only becomes relevant if the scheme or arrangement otherwise falls under the MIS definition under the Corporations Act 2001 (Cth) (“the Act”). If the funding arrangement does not meet that definition, it does not need to rely on an exemption – it is simply not an MIS on the face of the statute.
Without working through all aspects of an MIS under the Act, for present purposes it is noted that a common Commercial Insolvency Funding arrangement is unlikely to satisfy the criteria for an MIS at least because the definition requires that the scheme’s “members do not have day-to-day control over the operation of the scheme”. Although it is far from settled precisely what the “operation of the scheme” will mean in a litigation funding context, it is difficult to justify an argument that an external administrator is not exercising control in their legal actions and funding arrangements. As summarised by ARITA in its recent Submission, “litigation funding arrangements in an insolvency context entail control of proceedings remaining firmly with the insolvency practitioner (who owes statutory and fiduciary duties)”.
- Does the funder require an Australian Financial Services Licence?
Consequently, unless an exemption applies (under Regulation 7.6.01), a funder wishing to issue or otherwise deal in a litigation funding arrangement or provide advice in relation to it, will be providing financial services and will be required to hold an AFSL (or be authorised to provide the services on behalf of another licensee).
As a result, in arrangements that are other than Creditor Funding or Single-Claimant Funding it may be prudent to engage a funder that holds an AFSL. If the relevant funder does not hold an AFSL, consideration ought to be given to applying to the Australian Securities and Investments Commission (“ASIC”) for relief from compliance with this requirement and/or to seeking Court declarations (for example, as part of an application for Court approval of a funding agreement under section 477(2B) of the Act) that the relevant Commercial Insolvency Funding arrangement is an exempt “litigation funding arrangement” for the purposes of the Regulations.
- Other considerations:
In addition to the obligation to hold an AFSL, by reason of litigation funding arrangements and schemes being financial products, Part 7.9 of the Act dealing with financial product disclosure and their issue, sale and purchase, may also apply to a funding arrangement that is not covered by the Exemptions. Subject to the funded party meeting the criteria for a ‘wholesale client’, this may include a requirement to provide proscribed product disclosure. Therefore, depending on the circumstances of the arrangement, it may also be prudent to apply to ASIC for relief from compliance with some of these additional regulatory requirements and/or to seek Court declarations that the arrangement is an exempt “litigation funding arrangement”.
Litigation funders, insolvency practitioners and their advisors need to consider structuring future Commercial Insolvency Funding arrangements in a way that meets the criteria for Single-Claimant Funding if they wish to avoid an argument that they do not have the benefit of the Regulations’ Exemptions and must comply with the Act’s financial product requirements, including the need for the funder to hold an AFSL.
If it is not possible to structure an arrangement in a clearly exempt way, it may be prudent to engage a funder that holds an AFSL. Otherwise, it may be prudent to apply to ASIC for relief from compliance with the relevant provisions and/or to seek Court declarations that the arrangement is an exempt “litigation funding arrangement”.
In any event, a funder’s capability to meet the requirements of the Act and Regulations is a relevant factor when selecting an appropriate funding partner. By way of illustration, Litigation Capital Management Ltd (“LCM”) has long championed the funding industry’s compliance with a licensing regime as an added means of ensuring continued transparency and integrity within the industry. LCM already held an AFSL before the Treasurer’s announcement, and presently believes it is the only funder to be licensed in Australia.
On 26 August 2020, New South Wales Senator Deborah O’Neill gave Parliament notice of a motion to disallow the Amending Regulations. If this motion succeeds, the Amending Regulations will be repealed, reversing all of the changes that they introduced into the Regulations. An instrument of ‘the same substance’ as the Amending Regulations would not then be able to be made again without the approval of both Houses of Parliament.
The motion is presently postponed to 6 October 2020, and an update will be provided to this article following the motion’s resolution.