Litigation funders get lump of coal for Christmas

This article was written by Moira Saville, Alex Morris and Armen Varvachtian

In a highly anticipated decision, the High Court of Australia has rejected, by a 5:2 majority, the proposition that the Federal Court of Australia and the Supreme Court of New South Wales have power to make common fund orders in class actions.  Allowing the appeals of Westpac and BMW against judgments of the Full Court of the Federal Court and the New South Wales Court of Appeal respectively, the High Court's decision requires litigation funders to re-evaluate their business models and the nature of their involvement in representative proceedings.  While by no means shutting the door to the viability of funding class actions, the decision underscores the fact that litigation funding is an entrepreneurial endeavour and that, to earn returns, funders must expend effort and carefully evaluate risk.

What is a common fund order?

The so-called "common fund order" is one of the mechanisms which evolved, through judicial decisions in recent years, to address the potential for a disparity of outcomes as between funded and unfunded group members in a funded class action.  In circumstances where some, but not all, group members in a class action have signed funding agreements with a third party litigation funder requiring that some of their recoveries in the proceeding be applied to legal costs and a funder's commission, a free rider problem arises to the extent that, if the class action is successful, group members who have not signed such an agreement would receive a greater benefit than those who have entered into a funding agreement.  In other words, there is little economic incentive for a group member to sign a funding agreement if someone else (i.e., the representative applicant) has already done so and the group member could derive a better result without doing so.  It has been held to be:

"uncontentious that unfunded class members in a class action should not receive more in the hand from a settlement or judgment than funded class members, who effectively financed the proceeding by pooling their promises to pay a funding commission to the Funder."

By obliging all group members – whether funded or not – to pay their recoveries into a so-called "common fund", which is to be applied to legal costs and a funder's commission before distribution to group members, a common fund order means that "all class members will pay the same pro rata share of legal costs and funding commission from the common fund of any amounts they receive in settlement or judgment".  In other words, common fund orders impose on group members, who have chosen not to sign funding agreements, the economic consequences they would have borne (in the form of a diminution of their recovery in the proceeding) had they, instead, signed on the dotted line.  This represents a significant commercial benefit for litigation funders, who stand to derive significant commercial returns without having to do the legwork of building a book of interested group members, and undertaking an analysis of the viability of a class action having regard to its risk profile and the balance of costs against potential benefits.

Can the courts do that?

Noting that they impose obligations on group members without their consent, common fund orders are not universally accepted as being desirable, particularly where other mechanisms for bringing about equality of treatment between funded and unfunded class members may be available.  However, the courts have identified that common fund orders have certain benefits and, in a line of authorities in recent years, they have determined that they do have power to make such orders.  The source of their power to do so has been identified as being section 33ZF of the Federal Court of Australia Act 1976 (Cth) ("FCA Act") and its counterparts in comparable State legislation (in New South Wales: section 183 of the Civil Procedure Act 2005 (NSW)).  Section 33ZF(1) provides that:

In any proceeding (including an appeal) conducted under this Part [IVA], the Court may, of its own motion or on application by a party or a group member, make any order the Court thinks appropriate or necessary to ensure that justice is done in the proceeding.

Until Westpac and BMW asked it to do so, the High Court had not passed judgment upon the correctness of the view that this empowers the making of common fund orders.  Today, the nation's highest court spoke the final judicial word on the question.

Background: the Westpac and BMW litigation

In the Westpac litigation, it is alleged that group members were given advice by Westpac, through its financial advisers, on insurance and the premiums payable for it, and purchased insurance policies from Westpac Life by reason of that advice.  It is alleged that, in providing the advice, the relevant financial advisors breached their fiduciary duties, and statutory best interests and no conflict obligations.  It is said that there are over 80,000 group members in the class action, with each claim potentially being worth up to $15,000.

In the BMW case, it is alleged that group members suffered loss as a result of BMW installing faulty airbags in its vehicles.  BMW is said to have contravened provisions of the Trade Practices Act 1974 (Cth) and the Australian Consumer Law by supplying the vehicles to group members, who may number in the order of 200,000 people.

In each case, costs are being funded by a third-party litigation funder.  In each case, a relatively small number of group members has entered into a funding agreement with the relevant funder.  In these circumstances, the funders sought common fund orders.  The Federal Court made a common fund order in the Westpac case, rendering all group members in that proceeding liable for a proportionate share of the legal costs of the proceedings as well as a commission for the funder.  Westpac appealed to the Full Court.  In the BMW case, the Supreme Court removed the question whether it has the power to make the common fund order to the Court of Appeal. 

The two appeals were heard at the same time and in the same courtroom, during a historic concurrent sitting of the Full Court of the Federal Court and New South Wales Court of Appeal.  Each Court, in separate decisions, held that they had power to make common fund orders.

Westpac and BMW appealed to the High Court.

High Court finds the courts had no power to make common fund orders

A majority of five judges of the High Court found that, properly construed, section 33ZF of the FCA Act (and its New South Wales equivalent) did not empower the courts to make common fund orders.  The plurality – Kiefel CJ, Bell and Keane JJ – said that, although the power conferred by those sections is wide, they:

"empower the making of orders as to how an action should proceed in order to do justice.  They are not concerned with the radically different question as to whether an action can proceed at all."

That "radically different question" stems from the assertion that common fund orders are necessary to do justice by addressing the free rider problem.  But their Honours found that:

"It is not appropriate or necessary to ensure that justice is done in a representative proceeding for a court to promote the prosecution of the proceeding in order to enable it to be heard and determined by that court.  The making of an order at the outset of a representative proceeding, in order to assure a potential funder of the litigation of a sufficient level of return upon its investment to secure its support for the proceeding, is beyond the purpose of the legislation."

The words of the statutes authorise orders that would advance the effective determination of the dispute the subject of a class action and "[w]hether or not a potential funder of the claimants may be given sufficient financial inducement to support the proceeding is outside the concern to which the text is addressed."  So too is the question whether a proceeding "is viable at all as a vehicle for the doing of justice between the parties to the proceeding".

As to the question of whether a proceeding should or should not be commenced,  or should or should not proceed as a class action, the majority judgments make two key observations.  On the former, Gordon J (in a concurring judgment) notes that a class action can be commenced if it satisfies the threshold criteria provided for in the statute (namely, the existence of at least seven people with claims against the same person, arising in respect of or out of the same, similar or related circumstances, and giving rise to substantial common issues of law or fact).  Her Honour observed that a class action "cannot be commenced on the possibility that the Court might be persuaded to make a common fund order to overcome the fact that the class action might otherwise be uneconomic or risky for a litigation funder."        

On the latter, the plurality observed that the legislative schemes governing class actions as a whole "make specific provision for the role of the court in determining whether representative proceedings should or should not proceed and for the circumstances in which that intervention by the court may occur".  Those circumstances include a recognition that a class action may not withstand scrutiny on a cost/benefit basis, in which case the legislation provides that the court may stay a proceeding or direct that it no longer continue as a class action.  Such provisions recognise that the cost of pursuing a class action may be too high, or identifying group members too difficult, in comparison to the value of their claims.  In that case, the legislation contemplates that the litigation should cease – not that a common fund order should be made because it would be too hard or expensive for litigation funders to excite sufficient interest among potential group members.

As to issues of access to justice, the plurality observed that legislative means adopted by parliaments to address such concerns are as set out in the words of the statutes.  Sections 33ZF and section 183 "do not empower the courts to rewrite" the broader legislative scheme.  The report of the Australian Law Reform Commission which preceded the enactment of Part IVA of the FCA Act "simply did not include the absence of sufficient incentive for litigation funders to fund litigation" – the plurality thought this significant given that the Commission "was alive to the possibility that a representative proceeding might be funded by third parties."  This is echoed by Nettle J, who, in a concurring judgment, said that although litigation funding is no longer invariably considered to be an abuse of process that is contrary to public policy, "[i]t is, however, quite another thing to accept that the commercial interests of those funders formed part of the mischief that the introduction of Pt IVA was intended to confront.  Plainly, the legislative purpose of the enactment of Pt IVA did not extend to addressing uncertainties on the part of litigation funders as to the financial viability of funding such proceedings."  The "harnessing" of claims "for the primary purpose of generating profits for entrepreneurial litigation funders", and "the making of orders to facilitate entrepreneurial litigation funders to generate profits by fomenting disputes which, but for the making of such orders, might never flare into controversy", were not within the foresight of the legislature.

What next for extant common fund orders?

To the extent that common fund orders remain on foot in ongoing class actions, those orders have been shown by the High Court to be beyond power – at least in the Federal Court and the Supreme Court of New South Wales.  Those orders can be of no effect and should, as a formality, be set aside without disputation by representative applicants.

Does the High Court's decision spell the demise of funded class actions? 

Not if litigation funders are prepared to work for their return. 

All five of the judges in the majority adverted to the fact that litigation funding is a business – an entrepreneurial undertaking – which seeks to derive a return for funders but which also entails risks.  Kiefel CJ, Bell and Keane JJ noted that the practice of making common fund orders at an early stage of proceedings:

"may provide some assurance, even if only provisional, to a litigation funder of a particular level of return on its investment and so relieve the litigation funder of the expense and effort of canvassing the level of public interest in the proposed proceeding and making its assessment of the commercial viability of the proceeding in light of the likely balance of risk and reward…

To the extent that a CFO may allow a litigation funder to avoid the burden of the process of book building by enlisting the court's aid, there is no warrant to supplement the legislative scheme by judicial involvement to ease the commercial anxieties of litigation funders or to relieve them of the need to make their decisions as to whether a class action should be supported based on their own analysis of risk and reward."

A similar rationale may be discerned in Gordon J's judgment:

"[T]o ask whether a funder will withdraw funding if a common fund order is not made is to ask the wrong question.  A funder assesses whether to fund litigation.  Once commenced, it is not appropriate or necessary to improve the economic position of the funder against the possibility that it will carry out a threat to proceed no further.  The action as framed and instituted proceeds, or it does not."

The remedy for funders' concerns about not obtaining a large enough return for funding proceedings is for them to test the market for interest among potential group members and to set about entering into funding agreements with those who wish to participate.  Suggestions that this process is too hard or too costly found little favour with their Honours.  For example, Gordon J observed that one of the reasons for the failure by funders to take active steps to build a book was the relatively high costs of doing so.  Her Honour did not think that this appeared "at all convincing", saying:

"the unchallenged evidence of the solicitor acting for the representative applicant based on his past experience of the cost of book building activities in other proceedings was that it 'would likely exceed $1 million' and that '[a]ll or part of such costs may ultimately be deducted from the possible recoveries of Group Members' (emphasis added).  A person seeking to build a business usually incurs expenditure in seeking to establish that business.  Given the size of the potential return to the litigation funder in these proceedings is not insignificant, it is difficult to accept that the cost to build the book is prohibitively expensive.  Whether the litigation funder then seeks to recover that cost from the group members is a separate issue…"

Her Honour also suggested that there appeared no reason why book building could not occur by contacting group members "in a variety of ways without incurring significant costs" as had been proposed for the purpose of giving them notice of an application for a common fund order.

Are free riders a problem again?

No.  The plurality noted that the legislative schemes recognise that a representative party should not necessarily have to bear the entire cost of a class action.  However:

"[T]he equitable sharing of the expense of the proceeding may be achieved by the making of a FEO [funding equalisation order] that reduces unfunded group members' awards by an amount equivalent to that paid by funded group members to the litigation funder.  The cost of litigation is thus borne equitably between all group members."

Their Honours saw no reason for amounts so taken from unfunded group members to be given to litigation funders – "[t]he funder has no right to that money under contract or under equitable principles" – nor, further, that such an order be made early in a proceeding rather than towards the end.  The plurality held that a common fund order is "not the obvious solution" to the free rider problem.  This is not least because, under a funding equalisation order, the starting point for the equitable sharing of costs is the actual cost incurred in funding the litigation.  By contrast, a common fund order would impose an additional cost on unfunded group members by way of a funding commission.  Gordon J also observed that funding equalisation orders represent an already existing and "accepted solution to the problems which the common fund order supposedly seeks to address".

Conclusion

The High Court has changed the landscape for class actions in Australia's most popular jurisdictions for bringing such proceedings.  While a number of immediate effects will be observed in representative proceedings that are currently on foot, longer term changes in funder behaviour may slow the growth of such litigation.  That said, a path remains open for litigation funding to continue – albeit requiring funders to revive their previous practice of book building and to undertake their own detailed risk and cost/benefit analyses with a view to earning their returns.