An equitable distribution of funds during insolvency is required by legislation laid down in the Insolvency Act, 1986. This is to ensure that no unsecured creditors are given preferential treatment at the expense of any others.
It is important that company directors understand this potentially complex area of legislation, as the repercussions can be severe if preferential payments have been made.
If your company becomes insolvent and enters an administration process or is liquidated, the appointed insolvency practitioner will scrutinise all transactions up to two years prior to the insolvency.
Any payments to creditors made in this backdated timescale will be investigated for preferential treatment. If the directors are found to have created a preference, they may face penalties including personal liability for company debts.
This unfair preference rule includes transactions such as the transfer of company assets, as well as payments of cash. A liquidator has the right to request repayment from the beneficiary if they suspect that a preference has been created to the detriment of other unsecured creditors.
An unfair preference is sometimes created if the creditor is a family member or friend of a board member, for example. There may also be a vested interest or commercial benefits in ensuring that particular creditors are paid prior to declaring insolvency. Creditors who are family members are known as ‘connected creditors.’
In these instances it will probably not be difficult to identify and assert that a preference has been intentionally made by the director(s). In other cases, however, the reasons why a particular creditor may have been paid unfairly will require detailed investigation by the insolvency practitioner.
This is part of the IP’s role – to thoroughly scrutinise all dealings of the bankrupt company, ensuring that other creditors have not suffered financially because of any specific payments.
A principle exists within insolvency law called ‘pari passu.’ This means that the distribution of the assets and cash funds of an insolvent company must be equitable, with no unsecured creditor receiving favourable treatment.
The company liquidator will look at payments made within six months of entering insolvency, and if an unfair preference transaction is suspected, they may take action to recover it. In the case of payments to a ‘connected creditor,’ the time limit is backdated two years prior to the start of winding-up proceedings.
In addition to family members, other connected parties could include an employer or employee, a business partner or another director of the company.
A solvent company has the ability to pay all of its liabilities as they fall due. Therefore, directors have a duty to know and understand their company’s financial position at all times. If they can’t pay their bills when required, or their liabilities total more than their assets, then the business is deemed insolvent.
Directors are required to seek the professional input of an insolvency practitioner, and to put the interests of all creditors ahead of their own, and those of the company.
In terms of preferential payments, if the transaction is found to have been made when the company was in an insolvent position, or it became insolvent because of the payment, directors are likely to face investigation and penalties as a consequence.
If a preferential payment has been identified during the liquidator’s investigations, they have the power to apply to the court for an order to recover the monies. Where the burden of proof lies depends on whether the creditor was a connected party – a family member, for example.
In this instance, the connected creditor is obliged to prove that there was no intentional preference created, and that they had no knowledge that the company was approaching or had entered insolvency. Otherwise, it is the liquidator’s duty to prove that a deliberate preference has been created.
One would think that these types of payments would be obvious simply by checking through a company’s bank accounts, but this is not always the case. Transactions like these can take many forms, including the transfer of company property – essentially, any type of transaction that benefits the creditor more than if they had received funds in the same way as other unsecured creditors.
If you need more detailed advice and guidance on how to avoid accusations of unfair preference payments, call our expert team to arrange a same day consultation free of charge. Real Business Rescue provide director advice online, over the phone, or in-person at one of our 75 UK offices or a place of your convenience.