Which creditors get paid first in insolvency and why?
When a company becomes insolvent, it invariably means that it cannot repay all of the third parties that it owes money to. These are called the company’s creditors. Creditors commonly include HMRC, suppliers, landlords, banks, employees and customers.
When the company enters a formal insolvency procedure, an insolvency practitioner will be appointed. One of their key roles is to distribute the available funds to the company’s creditors. These funds must be distributed in a prescribed order, with some creditors higher up the hierarchy than others.
In this guide, we’ll explain which creditors get paid first in insolvency procedures and look at the various classes of creditors and what they mean in real terms.
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When is a Company Insolvent?
Broadly speaking, a company is insolvent when it does not have sufficient assets to pay its debts and liabilities. Several different tests are used to determine whether a company is insolvent:
- The cash-flow test – Can the company pay its debts on time? If there’s evidence that the company is not paying its debts, for example, if it has unpaid tax bills, it could be insolvent.
- The balance sheet test – Is there a shortfall in the value of the company’s assets versus its liabilities, including its future liabilities? If there is, it could be insolvent.
- The legal action test – Has a creditor served a statutory demand or attempted to enforce a judgement against the company and the debt remains unpaid? If so, the business is considered to be insolvent.
How do the Director’s Responsibilities Shift When a Company is Insolvent?
When a company becomes insolvent, there’s a shift in the directors’ responsibilities. Their duty to promote the success of the company is replaced by a duty to act in the best interests of the company’s creditors. An important part of this rule is to act in the best interests of all the creditors and not just a select few.
Once the company becomes insolvent, there are strict rules that govern which creditors get paid first. Ignoring those rules and choosing to repay certain creditors over others is an offence under section 239 of the Insolvency Act 1986. This is called showing a ‘preference’. If the company enters administration or liquidation and a preference can be proven, company directors can be made personally liable for the debts of the company and even be disqualified from acting as a director for up to 15 years.
Which Creditors Get Paid First When a Company Becomes Insolvent?
It’s not the case that a company must repay all of its creditors as soon as it becomes insolvent. In some instances, if the company is viable and can be saved, there may be funding options that can be explored and procedures such as a company voluntary arrangement (CVA) that will allow the company’s debts to be repaid over time.
Who Gets Paid First in Administration and Liquidation?
In the administration and liquidation procedures, a licensed insolvency practitioner is appointed to collect and sell the assets of the insolvent company for the benefit of its creditors. Those funds are distributed to the creditors in a hierarchy established by the Insolvency Act 1986. You can think of this as a ladder. Each class of creditors must be paid in full before funds are allocated to creditors on the next rung down the ladder.
How are Creditors Ranked in Insolvency?
- The fees and costs of the administrator/liquidator
- Secured creditors with a fixed charge
- Preferential creditors
- Secured creditors
- Unsecured creditors
- The fees and costs of the administrator or liquidator
The first payment that must be made from the sale of the company’s assets or any remaining cash is the liquidator’s or the administrator’s fee. These fees cover the costs of advising the directors, settling legal disputes, processing creditor claims and valuing and realising the assets.
The overall return that’s available to the company’s creditors is dependent on the cost of the administration or liquidation process. If creditors are unhappy with the fees being applied, there are mechanisms they can use to challenge them.
- Secured creditors with a fixed charge
Secured creditors are those that have a legal charge over a company asset such as a building, equipment, vehicles, etc. If the business cannot repay the creditor, the asset the debt is secured against is sold for the benefit of that creditor.
Secured creditors are split into those with a fixed charge and a floating charge. The first creditors to be repaid in administration or liquidation are secured creditors with a fixed charge. They are typically banks or other lenders that hold a title over a specific business asset. When a fixed charge is given to a lender, the company loses the right to sell or trade that asset. If the company becomes insolvent and goes into administration or liquidation, the asset with the fixed charge over it can be sold for the benefit of the charge-holder.
- Preferential creditors
Next in line to receive the money they’re owed are the company’s preferential creditors. Typically, preferential creditors are any employees of the company who are owed wages or holiday pay. Employees claiming payment in lieu of notice and redundancy payments are not classified as preferential creditors. Instead, they are classed alongside the unsecured creditors of the business. If there are insufficient funds from the sale of assets to pay the employees’ claims, the shortfall will be covered by the Government’s Redundancy Payments Fund up to certain limits.
HMRC used to be a preferential creditor in insolvency, but changes to the Enterprise Act in 2002 reclassified HMRC as an unsecured creditor. That results in lower returns for the Crown but increases the money available to trade creditors.
- Secured creditors with a floating charge
A floating charge is a security held over current assets, such as stock and raw materials, which can be openly traded by a business. Unlike a fixed charge, which applies to a specified asset, the assets subject to a floating charge can change in quantity and value. It’s not until the company becomes insolvent that the floating charge is said to ‘crystallise’. At that point, it becomes a fixed charge and the assets can no longer be traded by the business without permission from the lender.
For any floating charge created after 2003, all collections are subject to what is called a ‘prescribed part’. That means some of the money realised by the sale of assets for the repayment of floating charge holders is set aside for the benefit of unsecured creditors. 50% of the sale of assets up to £10k and 20% from £10k to £600K is ringfenced for unsecured creditors, with the balance being paid to the floating charge holders.
- Unsecured creditors
Next on the list to be paid are unsecured creditors. They include suppliers, customers, contractors, HMRC (all forms of tax) and employee claims that do not have preferential status. In practice, it’s often the case that by this stage, there’s very little money remaining from the sale of assets to pay the unsecured creditors, who could receive just a few pence in the pound.
Another group of unsecured creditors are known as ‘associated’ or ‘connected’ creditors. They are directors or employees of the company who are owed expenses or have lent the company money that has not been repaid. Family of the staff and directors’ spouses can also fall into this category. Although they are entitled to receive funds from a liquidation, usually there is very little or no money left for the connected creditors on liquidation.
At the bottom of the pile are the company’s shareholders. They are the individuals or organisations that have invested in the company. As they have taken a business risk in providing capital to the company, they are only entitled to repayment after all other classes of creditors have been repaid. That means they face the biggest risk of losing their money, and in all likelihood, they will not be repaid any of their original investment unless they had some form of security.
How are Unsecured Creditors Paid?
Unsecured creditors will be notified by the administrator or liquidator of their appointment and asked to submit a claim for the money they are owed. If the original contract allows it, unsecured creditors have the right to claim interest on their debt up to the liquidation date. However, any interest that is claimed will only be paid if unsecured creditors receive full repayment from the sale of the company’s assets.
If the insolvent company is holding goods that belong to the creditor, they can claim ownership via the insolvency practitioner. Proof of ownership will have to be submitted along with their claim. If the insolvency practitioner accepts the claim, the goods may be returned or the creditor will be reimbursed.
The reality is that many unsecured creditors have to write off some or all of the money they are owed by an insolvent company. In that case, the creditor will be eligible to use VAT bad debt relief to claim back the VAT on the proportion of the debt that remains unpaid.
Do Employees get Paid When a Company Goes into Liquidation?
Yes. If an employer is insolvent and goes into administration or liquidation and there is no continuing business, employees will be able to claim all or some of the money they are owed, depending on the circumstances.
In an administration, the administrator has 14 days after their appointment to decide whether to dismiss the employees. If they do, those employees will become unsecured creditors of the company. If the administrator decides to retain the employees beyond the initial 14 days, the employees will become preferential creditors of the business. That will increase their likelihood of recovering outstanding salary or redundancy payments.
If the company enters liquidation, the employees will be immediately out of a job. They will become a preferential creditor for outstanding salary and accrued holiday payments, as well as some occupational pension payments. They will rank alongside the company’s unsecured creditors for any other money they’re owed.
Although the prospect of receiving payment as an unsecured creditor is not particularly good, all is not lost. You can still make a claim to the Redundancy Payments Office for outstanding payments subject to certain limits. Your employer must be insolvent and your employment must have been terminated.
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