How Does the ATO Fund Liquidation Claims?

In article:

Liquidations are often assetless. The Australian Small Business and Family Enterprise Ombudsman’s (ASBFEO) Insolvency Inquiry Report July 2020 reported that for liquidations in the 2018-2019 year: 

• 37 percent had zero assets; and
• 58 percent had assets of $10,000 or less. 

Often, an effective liquidation means a liquidator needs to recover funds that are not held by the debtor company itself, but can be recovered as ‘voidable transactions’. With so few liquidations having available assets, how is the liquidator to pay for litigation? In short, to pursue litigation with respect to a voidable transaction, the liquidator either needs to self-fund or find a funder. 

Liquidations and funding

By default, the appointed liquidator is required to pay for all costs that they incur in the liquidation. While the liquidator is, of course, entitled to charge fees and recover expenses, these need to be approved by the creditors themselves (see Ultimate Guide to Liquidation Part 3: Responding to Liquidation). 

This risk of non-payment in the case of an assetless (or low asset) liquidation is mitigated somewhat by the priority rules in the Corporations Act 2001 (Cth). Under section 556 of that Act, the liquidator has ‘first dibs’ on the proceeds of liquidation, ahead of other unsecured creditors, to cover their own fees and disbursements. 

Arguably, the need to fund liquidations themselves is a disincentive for liquidators to ‘probe too deep’ and/or litigate voidable transactions — it requires them to risk their firm’s working capital to chase a claim. Indeed, it is often difficult to assess whether a claim would be worth litigating until evidence is obtained and potential witnesses questioned (which presents a significant upfront cost in billable liquidator hours). 

As well as pursuing transactions where the liquidator has given unfair preference to one or more creditors over others, other voidable transactions that the liquidator might wish to investigate or pursue include: 

• Uncommercial transactions: where the company has engaged in ‘under-valued’ transactions. 
• Unreasonable director-related transactions: transactions that were to the benefit of a director (or their associates), but to the detriment of the company as a whole.
• Unfair loans: where the debtor company previously entered into loans with ‘extortionate’ interest rates, charges (eg. mortgages) or other terms.
• Breaches of director’s duties: claims against former directors for not acting in the best interests of the liquidated company and usually diverting opportunities to themselves or causing the company to incur a loss.
• Insolvent trading: claims against directors for continuing to trade whilst the company is actually insolvent and thereby causing loss to the creditors.

Private party litigation funders do exist, in principle, to fund these types of litigation. But in reality, they are not interested in most liquidations in Australia (because most liquidations in Australia are for small businesses with few assets, the potential for a return is relatively small). Most of the above claims that a liquidator can pursue are in the hundreds of thousands, not millions. 

Litigation funds each have their own set of criteria for accepting claims to fund. Examples of such criteria includes:

• Not funding claims of less than $5 million
• Not funding claims where the estimated legal fees are more than 1/8 of the total expected return
• Not funding claims where an independent counsel has not issued an advice that the prospects of success are >50%
• Avoiding one off claims and preferring to fund (through draw-downs) a portfolio of claims that a liquidator may have 

The takeaway is that it is very unlikely that a liquidator will be able to obtain private litigation funding for a one off claim against a company director in the order of hundreds of thousands of dollars. Why would they when they are really looking for multiple claims in the millions against large corporates? 

The ATO has an interest in funding liquidators as they are (very commonly) a major creditor in liquidations. Although this isn’t written into policy, the ATO sees itself as a backstop to help liquidators going after ‘repeat offenders’ and their primary objective is not to obtain a return on investment but to protect systemic integrity. 

Note also, that there is the possibility of the Australian Securities and Investments Commission (ASIC) funding aspects of a liquidation. Where the liquidator believes that there could be grounds for director banning, where the liquidator believes offences may have occurred or other misconduct in relation to the Corporations Act 2001 (Cth), the liquidator may apply to the Assetless Administration Fund (AAF). 

The third government player is the Fair Entitlements Guarantee (FEG), administrated by the Federal Attorney Generals Department. FEG takes an active role in funding liquidators that make claims that would ultimately be distributed to the scheme fund for unpaid worker’s entitlements. 

How does ATO funding work?

The short answer is no one really knows (unless you are the ATO) so it is not possible to guess what liquidator actions will be funded.

The ATO has an extensive list of pre-requisites before it will fund litigation. It is worth noting that: 

1. The ATO is primarily interested where it is itself a major creditor;
2. The funding must be sought in advance (not after action is initiated);
3. The ATO expects input into the decision to pursue litigation; and
4. The ATO explicitly rules out covering certain costs (such as costs incurred in carrying out the liquidator’s duties). 

But the real ‘x factor’ in the ATO’s decision on whether or not to fund is their focus on the public interest. As custodians of the public purse they would, of course, like to recoup their costs, but they are not solely focused on a commercial return (as a private sector litigation funder would be). 

Once the ATO has decided to fund litigation, it will enter into a ‘deed of indemnification’ with the liquidator to legally protect their position. 

What does the deed of indemnification usually include?

The terms of the deed of indemnification are up to the ATO to decide for individual cases. However, typically, the deed of indemnification will include: 

• A provision stating that if the liquidator recovers any property to pay their own fees and expenses, the ATO needs to be informed and paid first under the terms of the indemnity; 
• Onerous, ongoing, reporting obligations to the ATO on the progression of any litigation; and 
• A requirement that, before making any settlement, the liquidator needs to clear it with the ATO first.

If you’re a company director, what should you do?

Company directors in an assetless (or very low asset) liquidation might feel a sense of security in the thought that a liquidator has little commercial incentive to pursue litigation. However, the ability of the ATO to fund action should give directors pause for thought. 

While the ATO is obviously not in a position to fund litigation for every liquidation, where there are prima facie significant voidable transactions in place, and especially where the ATO is a creditor, there is a risk for directors. The usual warning for a director that this may be occurring is that the liquidator will need to call a creditors’ meeting to approve the ATO funding agreement. 

In the writer’s experience the matters that are funded by the ATO are where the director is perceived by the ATO to be a ‘repeat offender’ and that it is good policy to run the claim. An example of this is phoenix activity, where the director has used labour hire arrangements and the liquidator process to avoid remitting PAYG tax. This is an example of a situation where a liquidator may be funded by the ATO because the ATO wants to stop the company director (or their backers) from a regular phoenix process.