The turbulent economic climate of recent years has heightened the importance to litigants (and their advisers) of establishing the solvency of all parties to proceedings. Where a party looks to be in financial difficulty, the wise litigator will question how and by whom the litigation is being funded. If there is a (solvent) third party involved, parties should consider applying for a non-party costs order (NPCO) under s.51 Senior Courts Act 1981 (“SCA”) and Civil Procedure Rules r.46.2 (“CPR”).
Recent case law demonstrates an increased and pragmatic willingness by the courts to make NPCOs, and to hold directors and/or shareholders liable for the company’s costs. But what happens where the director has also been joined to the proceedings? Two recent cases (Axel Threlfall v ECD Insight Ltd &Anor and Pintorex v Nasser Keyvaner & Ors) provide an interesting insight into how the courts approach this issue.
In the county courts, High Court and Court of Appeal, the jurisdiction to make NPCOs derives from their general discretion to award costs, as contained in sections 51(1) and (3) of the SCA. The first instance of a the court ordering a third party to pay the costs of litigation to which it was not a party was the House of Lords decision in Aiden Shipping v Interbulk Ltd. The CPR now set out the procedure to be followed when the court is considering whether to exercise its discretion to “make a costs order in favour of or against a person who is not a party to proceedings” (para 46.2, previously para 48.2 prior to 1 April 2013).
The general consensus is that NCPOs are only to be awarded in "exceptional" circumstances (Dymocks Franchise Systems (NSW) Pty Ltd v Todd and others, as approved in Arkin v Borchard Lines & Ors). However, “exceptional” has been construed in a fairly broad way, to mean “no more than outside the ordinary run of cases where parties pursue or defend claims for their own benefit and at their own expense” (Dymocks, para 25).
The key, and crucially fact-specific, question is whether in all the circumstances it is just to make an NPCO. As the Court of Appeal observed in Secretary of State v Aurum Marketing Ltd & Anor, 'It is wrong to treat the reported cases as providing a comprehensive checklist of factors which must be present in every case before the discretion can be exercised in a particular case. What may be sufficient to justify the exercise of the discretion in one case should not be treated as a necessary factor for the exercise of the discretion in a different case’.
THE THRELFALL CASE
In Threlfall, Mr Threlfall issued proceedings for breach of his employment contract against his former employer, ECD Insight Ltd (“ECD”). He argued that his contract had been varied by agreement between him and ECD’s sole shareholder and director, Mr Whitney. Mr Threlfall claimed a 20% share in ECD’s equity, share dividends, a termination payment and a bonus. ECD denied the claim and counterclaimed, alleging Mr Threlfall to be in breach of his obligations of fidelity and of restrictive covenants in his contract of employment. Mr Whitney was joined to the action because of his status as sole shareholder: any order in Mr Threlfall’s favour for specific performance of the disputed equity stake would either require Mr Whitney to transfer his own shares or ECD to issue and allot new shares. This would also dilute Mr Whitney’s sole shareholding.
The case went to trial and judgment was handed down on 17 December 2012 (Axel Threlfall v ECD Insight Ltd & Anor  EWHC 3543 (QB)). In summary, Lang J found that the contract of employment had been varied as alleged, and ECD was in breach of contract. Mr Threlfall was therefore entitled to the 20% stake in ECD, or payment in lieu, as well as the dividends. He was not however entitled to the termination payment or bonus. Although Mr Threlfall was not in breach of the restrictive covenants contained in the contract, he was found to be in breach of his obligation of fidelity. Lang J held that ECD had sustained no loss as a result of the breach and awarded ECD only nominal damages.
Finally, Mr Threlfall also applied to Lang J that Mr Whitney should be jointly and severally liable with ECD for the costs of the action. Lang J refused this application, and Mr Threlfall appealed.
Mr Threlfall’s victory was, in the words of Lewison LJ, “a Pyrrhic one” (para 4), because ECD went into insolvent liquidation within a month of the judgment.
COURT OF APPEAL
The Court of Appeal held that Mr Whitney should indeed pay Mr Threlfall’s costs. Lewison LJ gave the (concise) lead judgment, which was approved by Tomlinson LJ with the observation that “this was a very clear and plain case in which the appropriate order was as indicated by my Lord” (para 15). Richards LJ’s judgment stretched to five words of agreement (para 16).
FINDINGS OF FACT
Tomlinson LJ’s starting point was to look at Lang J’s findings of fact. He drew attention to the fact that Mr Whitney was the sole shareholder of ECD, receiving regular and substantial dividends from it. He was also the sole director and actively in control of the business and its foreign subsidiaries. Lang J had found that Mr Whitney exercised “absolute control over ECD” (para 6).
Mr Whitney had also been found lacking as a witness, with the court rejecting his evidence on a number of issues, including the nature of ECD’s business and his plans for it in the future. Importantly, Lang J had also found that Mr Whitney was seeking to resile from the variation to the employment contract he had agreed “because the financial implications of doing so were damaging both to ECD and to himself personally”. The Court of Appeal noted that the discredited evidence was given to further, amongst other things, Mr Whitney’s own personal financial interests (para 7).
VITIATION OF DISCRETION (BLESS YOU!)
At first instance, Mr Threlfall submitted that if Mr Whitney had not been a party to the action, this was the kind of case in which a NPCO would have been made under s51 SCA. It would be wrong for Mr Whitney to be in a better position simply because he had been joined to the action. Mr Whitney argued that any application against him ought to be considered by analogy to an NPCO.
Lang J concluded that there was no basis for making Mr Whitney personally liable for ECD’s breach of contract. She could see no other basis of claim against him and held that it was not necessary for any order to be made against him. In respect of costs, she held that ECD had accepted its liability for costs. She did not accept Mr Threlfall’s submission that Mr Whitney should be made liable for the costs “for the reasons given above”.
The Court of Appeal took issue with this approach, holding that Lang J’s reasons all related to the question of substantive liability. She had not given any consideration to the principles on which a claim for an NPCO are made, despite it being common ground that the application should be considered to be analogous. Lewison LJ held that it was this omission which vitiated her exercise of discretion, which left it open to the Court of Appeal to exercise the discretion afresh (para 10).
The Court of Appeal held that an NPCO against a company director should not be characterised as piercing the corporate veil, or as treating the company and director as one and the same. The principle of separate legal personality was intended to deal with legal rights and obligations. By contrast, “the very fact that the making of [an NPCO] is discretionary demonstrates that the question is not one of rights and obligations of a non-party, for no obligations exist unless and until the court exercises its discretion (para 13)”.
Lewison LJ held that it was not enough merely to say that Mr Whitney was a director of ECD, but in deciding whether or not to make an NCPO, the court was “not fettered by the legal realities. It is entitled to look at the economic realities (para 13).” In other words, the key question is whether the non-party is “the real party” in the litigation. The cumulative effect of the facts of this case, together with the fact that Mr Whitney gave evidence in bad faith and caused ECD to advance a defence which he must have known to be false, was that the Court of Appeal found it would be just for Mr Whitney to pay Mr Threlfall’s costs. Lewison LJ also noted that Mr Whitney was in fact a party and therefore entitled to participate in the trial to the fullest extent possible.
It is not yet clear how widely the ripples from Threlfall will spread. Early indications are that it will remain very much case sensitive and justice driven in its application.
In Pintorex, the First Defendant had taken with him a complete copy of the claimant’s SAGE accounts package when he left the claimant and joined the second defendant. Mr Recorder Alistair Wilson QC found the first and second defendants guilty of misuse of confidential information but the third defendant (a director of the second defendant) was found not guilty. The claimant argued that the third defendant should be ordered to pay the costs which the second defendant had been held liable to pay.
The court declined to make an NPCO against the third defendant director, noting both its “superficial resemblance” to Threlfall, and the fact that the circumstances were very different (footnote to para 19). The court also cited Lewison LJ’s warning against relying too much on decided cases, and his conclusion that “the ultimate question is whether it is just to make what is an exceptional order” (para 11).
In the Recorder’s view, this required a two step analysis: firstly, to ask whether there are exceptional circumstances giving rise to the discretion, and secondly to ask whether in all the circumstances of the case, it is just to exercise the discretion in favour of making an NPCO (para 22). The special circumstance relied on here was whether the third defendant had made himself the “real party” to proceedings.
The court could see that, where a third party has funded the bringing of an action, it is easier to see how he can be viewed as the real party to proceedings, particularly if he gives untruthful evidence to suit his case. However, where the third party is the director and owner of a company which finds itself (through no fault of his) defending an IP claim, the position is not so clear. If the director/owner believes the company to have a defence, he should be entitled to allow the company to defend the claim without being personally liable for its costs, even if he will inevitably be controlling and funding the litigation (either directly or indirectly via a diminution of the company’s funds).
The fact that the third defendant was also a personal defendant in the action was also not enough to invoke the jurisdiction, particularly since he was not found liable. The Claimant needed to establish that he was also a “real party” “in the sense, in some way, of standing in the shoes of the second defendant” (para 24). From considering the Threlfall judgment, the recorder concluded that “factors that may decisively tip the balance against the owner/director would be that he had known what was going on in his company, or that he was using the company as a vehicle for wrongful transactions…. Another factor which might affect the issue is the manner in which the owner/director has caused his company to conduct the litigation (paras 26/27)”. The fact that the third defendant had not given false evidence or encouraged the second defendant to consistently take bad points meant that he should not be held liable for the claimant’s costs.
The court also noted that the second defendant had ceased trading at an early stage in proceedings and the claimant had pursued the action in an attempt to fix the third defendant with personal liability. There were therefore no exceptional circumstances which would trigger the discretion to make an NPCO. If the court were wrong on this point, Recorder Wilson was still of the view that it would not be just to make an NPCO against the third defendant. Even if the third defendant had instructed the second defendant to concede at an earlier stage, the claimant would most likely have continued the action in order to try and fix the third defendant with personal liability.
These two cases demonstrate the pragmatic and flexible approach the courts will take in ensuring that justice is done in the individual case. In a sense, they illustrate both sides of the coin: Threlfall shows the courts ensuring that the wronged party was not left out of pocket as a result of the director being made a party for a technical rather than substantive reason; Pintorex shows the courts preventing a successful claimant from recovering costs from an owner/director they had joined to the action in an attempt to boost their chances of recovery.
Irrespective of whether they are joined to proceedings or not, directors of companies in financial difficulties should heed the words of Rix LJ at paragraph 59 of Goodwood Recoveries Ltd v Breen, as cited in both these more recent cases: “Where a non-party director can be described as the real party, seeking his own benefit, controlling and/or funding the litigation, then even where he has acted in good faith or without any impropriety, justice may well demand that he be liable in costs on a fact-sensitive and objective assessment of the circumstances”.
This article was published in Commercial Litigation Journal in March 2014.