Understanding insolvency – a director’s guide
It is important to understand the basic rules of insolvency but please review all the options available; starting with the BusinessSupport.co.uk ‘Business Survival Guide’. By having a grasp of insolvency law a company director will be more able to navigate a path through financial distress that will minimise any potential personal liability.
Which company creditors are paid first?
Insolvency law lays out which of those owed money by the company (company creditors) should be paid first in the event of the insolvent closure of your company.
The order of payment is dependent on which type of creditor that each creditor is.
A secured creditor will have the value of assets on which it has security on to rely upon for repayment of the amount that it is owed. Such as a freehold property for example. This secured creditor status is more often applicable to a finance company such as a bank, invoice factor or asset finance provider.
The second category of creditors are the preferential creditors. This category relates to employee claims for outstanding wages and holiday pay.
Currently HMRC are ranked as an unsecured creditor however, legislation introduced in Finance Bill 2020 (which is due to take effect from 1 December 2020) will reform HMRC’s status to second preferential creditor in relation to outstanding VAT, PAYE Income Tax, employee National Insurance contributions, student loan deductions and Construction Industry Scheme (CIS) deductions.
HMRC will remain as unsecured creditors for corporation tax and employer National Insurance Contributions owed directly by the company.
Next in line are outstanding amounts to trade creditors and HMRC (see above note on HMRC), categorised simply as Unsecured Creditors.
The last in line for payment of any amounts due are shareholders and they can only be paid if all other creditors have been paid in full. An exception to this is the Prescribed Part where some of the assets available to a secured creditor are set aside to go to unsecured creditors.
Insolvency law also requires that an even share of the value of company assets be paid to each individual creditors in the respective category only once the category above them have been paid in full.
For example, if your company owes 10 different trade creditors (unsecured creditors) £1,000 each and you have only £1,000 in asset value in your company then each of the 10 unsecured creditors should get £100 each. This is known as Pari Passu distribution.
Preference to creditors in insolvency law – what is a preference payment?
If the structured treatment of each creditor group is purposely ignored then this can create a problem for the creditor that was paid out of turn. A payment made to a creditor that doesn’t adhere to this structure is known as a Preference Payment. Such a payment can lead to an enforced repayment of the Preference Payment in the event of insolvency. The likelihood of this Preference Payment being reversed is increased if the payment is made to anyone who is connected to the company, for example a company director, company shareholder or their family and business associates.
For a payment to be classed as a Preference Payment the company must be already insolvent or be caused to become insolvent as a result of the payment.
What is wrongful trading?
Wrongful trading is not always easy to describe. An insolvency practitioner has the benefit of hindsight to look back at the transactions of a company. The first aim of this work is to try and identify the point at which a company became insolvent, known as the point of insolvency. This is shown by either a negative company bank account or a company not making payments to creditors on time or at all.
The period of time after the date of insolvency is then reviewed to establish the point at which the company directors knew that their company was insolvent or should have recognised that the company was insolvent.
It is the actions of the directors from the point of insolvency that are under scrutiny.
Imagine a calculation, in money, of how insolvent the company was at the time insolvency was or should have been recognised by the company directors. For example, at the time of insolvency there was £25,000 less value in the assets of the company when compared to what is owed.
If the directors didn’t take (and ideally record) positive steps to try to improve the position of the company and it is then shown that at the time of the insolvent closure of the company that there is, rather than a £25,000 shortfall to creditors, a £125,000 shortfall to creditors. Then that’s wrongful trading to the extent of the extra shortfall to creditors, the £100.000.
The relaxation of the wrongful trading restrictions during the COVID – 19 pandemic are to allow businesses to avoid the need for insolvency at a time when there is great uncertainty over their future. These changes are yet to be tested and where a company can be shown to insolvent before COVID – 19 it is not expected that the changes will protect company directors against wrong trading allegations before COVID 19. The COVID – 19 relaxation of wrongful trading insolvency laws was retrospectively applied from 1 March 2020.
Director’s liability in insolvency – general
A Company Director that has not acted in the best interests of the company’s creditors can find themselves personally liable. There is a scale of rising liability from misfeasance through wrongful trading and culminating with fraudulent trading.
Another more obvious area of Director’s liability is where a company director has given a personal guarantee to a specific creditor. These are most often given to support finance creditors of the company but can also sometimes apply to trade creditors.
Director’s liability – transfer from sole trader or partnership
A rare but potentially expensive director’s liability can arise where a previously unincorporated business has transferred into a limited company. If all creditor accounts (those you pay money to) where not properly transferred across to the new company then, in the event of insolvency, the liabilities may well rest with a company director personally as if the limited liability company had not been formed.