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Understanding Section 239 Preference Payments in Liquidation: Your duties as a director
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What happens if you make a preference payment when your company is insolvent?
A preference payment is made when an insolvent company pays a particular creditor ahead of others, putting that creditor into a more favourable financial position than they otherwise would have been. This is a breach of your duties as a company director and these transactions could be challenged when the company enters liquidation.
A preference payment is a transaction which is made by an insolvent company to a particular creditor with the intention putting that creditor into a more favourable financial position than they otherwise would have been.
Once you become aware that your company is insolvent, or there are warning signs that it is heading this way, it is your responsibility as director to ensure that you do all you can to maximise the financial return to your creditors as a whole. This means you should not engage in any activity which threatens to worsen their position and you should ensure all creditors are treated the same.
This means you are not allowed to use company funds to pay off one debt if you are unable to satisfy all your outstanding creditors; doing this is known as making a preference payment and is a serious breach of your duties as a company director.
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If your company is insolvent, making a preference payment will not improve your own company’s fortunes, however, you may be tempted to make such a payment out of a sense of loyalty to a particular creditor, or to ensure friends and family who are owed money by your company are repaid. You may also be tempted to prioritise paying off any borrowings which are secured with a personal guarantee in order to protect your own personal finances once your company enters liquidation. Although you may be able to justify these reasons to yourself, these types of transactions are in breach of the Insolvency Act 1986 as per section 239.
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An unfair preference is sometimes created if the creditor is a family member or friend of a board member, for example. Creditors who are family members are known as ‘connected creditors.’
There may also be a vested interest or commercial benefits in ensuring that particular creditors are paid prior to entering liquidation, perhaps if the directors intend to continue to use certain suppliers in a new business venture.
During the liquidation process, it is part of the insolvency practitioner’s role to thoroughly scrutinise all dealings of the bankrupt company, ensuring that other creditors have not suffered financially because of any preference payments made while the company was insolvent.
In instances involving a connected party, intention to prefer is presumed, and these transactions can be challenged up to two years after they were made. In other cases, however, the reasons why a particular creditor may have been paid unfairly will require detailed investigation by the insolvency practitioner who must be able to prove that an intention to prefer was the driving force behind the transaction.
A principle exists within insolvency law called ‘pari passu.’ This means that the distribution of the assets and 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 formal insolvency proceedings, 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.
Directors have a duty to know and understand their company’s financial position at all times. If they can’t pay their bills as and when they fall due, or their liabilities total more than their assets, then the business is deemed to be 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 once they know - or ought to know - that the company is insolvent. Continuing to trade on when the company is knowingly insolvent can be seen as wrongful trading.
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 itself, directors are likely to face investigation and run the risk of further action when the company enters liquidation.
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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.
It is the liquidator’s duty to prove that a deliberate preference has been created, unless the transaction in question was to a connected party. 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 was already insolvent.
During the liquidation procedure, the appointed insolvency practitioner is bound to investigate the conduct of the company’s directors in the period leading up to it becoming insolvent and its subsequent entry into liquidation.
As part of this process all transactions in and out of the business will be scrutinised and should a preference payment be suspected then the director will be questioned about this as a first step. If it is judged that the director deliberately aimed to create a preference by favouring particular creditors, then the courts may order that the recipient of the preference payment returns this money to the insolvent company to restore it to the position it was in before the preference payment was made.
If you believe your company has reached, or is approaching, insolvency, you should enlist the help of a licensed insolvency practitioner. Do not be tempted to sort the situation out on your own or hope the problems will solve themselves.
Although preference payments are illegal, there are occasions where you are permitted to pay certain creditors even when insolvent, so long as these payments are for the greater benefit of the company and its outstanding creditors. An example of this would be paying the electricity bill in order to allow the office to remain open which would facilitate the collection of debtor payments. However, the rules surrounding this are complex and you should always seek professional advice before making any payment if you are unsure whether it would be considered a preference.
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Further Reading on Preference Payments in Liquidation: Understanding Section 239
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