Hired guns best kept at arm's length

Once upon a time in the west, there was a town of plain, hard-working folks.

One day a wild gang rode through on shiny palominos, spinning yarns of gold in the hills and riches for the taking, at least a percentage point above bank rates, if only they could get some seed money.

The folks handed over their savings and the wild gang rode off, never to return.

Years passed. Tumbleweed blew. Then a gunslinger strode into the sheriff's office. I've got a deal for you, he drawled. I get your money back and split it 70-30. That's 70 for you, 30 for me.

Hooray, cheered the folks, and promised to engrave the gunslinger's name upon every spittoon in every bar in town.

So the gunslinger sued the sheriff, who was insured against failing to gather a posse to hunt down the gang, but not the deputy, who wasn't.

Years later these events inspired Bob Marley to write a song.

Chalkie reckons they also inspired Pyne Gould Corporation's announcement late last month of investment in litigation funding - the legal gunslingers who bankroll court action to extract damages from wherever they can.

PGC said it had created Torchlight Fund No 2 to work with litigation funders on both sides of the Tasman.

"Clearly, this is first a business opportunity," it said. "However, we believe it is important that investors, small and large, who lost by depositing with finance companies, access justice."

Amen. With billions up in smoke, little hope of recovery remains for most finance company investors save legal action against directors, auditors or trustees.

But it's now the fourth quarter of 2012, four years since the last big finance company blew up.

Why has no legal action begun?

Let's think. Could it be because trustees, who are well-placed to initiate litigation, are themselves potential targets?

For example, Perpetual Trust - a subsidiary of litigation fund investor PGC - was trustee for numerous failed finance companies including St Laurence, OPI Pacific, Dominion, Strategic, Nathans and Capital + Merchant.

The last, which collapsed in 2007, had enough assets to recover nearly $24 million for preferred creditor Fortress, but receivers appointed by the trustee, Perpetual, had no assets left to sell. So debenture holders owed $167m got nothing.

Legal action against directors might have been an option - companies usually take out directors' and officers' liability insurance, known as D&O cover, for their top people.

Companies issuing prospectuses may take out extra cover, because standard D&O policies exclude all risks related to issuing stock to the public.

Unfortunately policies also typically void cover for dishonest or criminal acts by directors, which probably rules out claims against Capital + Merchant's board because three of its directors are now behind bars after criminal convictions.

Meanwhile several insurers are involved in lawsuits as directors try to tap their cover for defence costs. Hanover Group, for example, is suing insurers Chartis and QBE, the latter because it is refusing to pay out, alleging Hanover failed to disclose its financial difficulties.

But if some non-criminal directors end up in lawyers' sights, it is a comfort to know real money is available if a lawsuit goes investors' way.

In the fallout from Skellerup's implosion in the late 1990s, for example, liquidators sued directors and won a multimillion settlement. One report on Skellerup subsidiary DML Resources showed $7.8m gained from legal action against directors, while some say the overall deal cost insurers the thick end of $15m.

That payout lifted distributions to creditors substantially.

What about suing the auditors?

We probably don't even get to the issue of whether Capital + Merchant's auditors stuffed up, because there is the tricky matter of whether auditors have any responsibility to creditors at all.

Chalkie reckons this is far from clear. Technically auditors have responsibility to shareholders, but usually disclaim responsibility to lenders. Even a Scottish High Court ruling in 2002, which found an auditor was legally responsible to a bank lender, has failed to dent their sense of impunity.

Suing auditors, therefore, is like jumping double-decker buses on a Vespa - maybe it can be done, but you need balls of steel.

That leaves trustees, which for receivers usually means suing their own bosses and is therefore out of the question.

This, sources say, is a major source of delay in mounting litigation, because trustees are the gatekeepers to legal action and won't lift the latch.

Chalkie reckons the source could be right, but fortunately for Capital + Merchant's investors a solution has been found involving Perpetual passing the pistol to Public Trust, walking 20 paces and baring its chest.

This isn't as selfless as it seems, because if Perpetual ends up liable for a payout the cash will come from its insurers.

And if the insurers pay out, 25 per cent to 30 per cent of the money will go to the litigation funders who bankroll the case - whoever they may be.

This is where complications emerge for PGC's litigation funding strategy.

Chalkie understands interests associated with PGC's major shareholder George Kerr began investing in litigation funding around Christmas 2009, initially as a hedge against the potential impact on Perpetual. Those funds are said to include New Zealand outfit LPF Group, whose shareholders include Singaporean outfit International Litigation Partners, whose shareholder is Penz Investment Inc of the British Virgin Islands. And there we have to leave it because BVI company shareholdings are not open to public scrutiny.

Ordinarily we might not care too much about whose money is behind litigation funding - why worry where the money comes from if it gets the job done?

Chalkie offers a couple of reasons.

One, if Perpetual pulls the trigger on behalf of investors it would effectively be involved in appointing a litigation funder to finance the legal action. If it appointed a litigation fund partly owned by its parent company, it would face a conflict over how big a cut to offer.

Legally, its interest would be to get the best deal for investors; financially, its interest would be to get the best deal for the litigation fund.

It would be difficult to satisfy finance company investors such a conflict could be managed.

Two, Perpetual could be seen as controlling a lawsuit against itself, risking invalidating its insurance. This could happen if, say, Perpetual brought legal action against directors, who then argued Perpetual was also culpable and pulled it into the suit - a process apparently known in litigation land as "blowback theory".

If Perpetual's parent company was potentially making money from the suit through litigation funding, Perpetual's insurers could have a strong challenge against liability. As one insurer told Chalkie: "They'd be screwed, and rightly so".

Chalkie reckons neither of the above scenarios would look attractive to investors looked after by Perpetual.

These issues are rendered more immediate by the pending expiry of Perpetual's licence to operate as a trustee. Under a new regime run by the Financial Markets Authority, existing trustees had to apply for a licence by July this year and the deadline for FMA approval is the end of this month.

Sources say PGC is keen to keep Perpetual's licence, even though it wants to sell the underlying business, in order to have control over the handling of finance company lawsuits.

With PGC counting the government as an investor - through Crown Asset Management and ACC's holdings in the Torchlight distressed assets funds - Chalkie understands official persons have been asked to put in a good word for it with the FMA (although ask may not mean get).

However, whether or not the FMA grants Perpetual's request, Chalkie can't help thinking investors would be better off if someone else took over its trusteeships and any associated litigation. It would surely be a simpler, cleaner process.

Hired guns are best kept at arm's length.

- Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.