When a business fails, it’s often because it can’t pay its debts.
Those that it owes money to are called creditors - but when dealing with creditors during business liquidation, it’s vital to remember the order of priority. According to the Insolvency Act, there is a strict hierarchy of creditors, and each must be paid in full before moving on to the next.
However, if a company is insolvent it will be unable to pay its debts in full - which means that some creditors will not receive the full amount owed to them, if anything at all. But what is the order of priority? Who ranks above whom? And where do employees fall in this list? Read on to find out…
The hierarchy of creditors
A preferential creditor is a creditor who is granted preferential status by receiving the right to first payment.
Once the preferential creditors are paid in full, funds will then be allocated to the next in the following order: secured creditors with a fixed charge, preferential creditors, secured creditors with a floating charge, unsecured creditors, connected unsecured creditors and then shareholders.
The difference between fixed and floating charges
At the top of the creditor priority list during business liquidation will be secured creditors which hold either a fixed or floating charge over a business asset.
These creditors have a legal right or ‘charge’ over company property, which can include anything from buildings to machinery or even intellectual property.
If a loan or debt is subject to a fixed charge, it means that the borrowing is secured against a substantial and physical asset such as land, property, vehicles or machinery. When a lender has a fixed charge, it pretty much has full control over the asset.
This means that if the business wants to sell, transfer or dispose of the asset, they need to get the permission of the lender first or pay off the remaining debt. As such, those with a fixed charge will be paid first once the insolvency practitioner has received their fee.
A floating charge relates to other assets such as stock, raw material, fixtures, fittings and movable machinery. As the name suggests, this type of charges ‘floats’ over the assets, but the company is free to use them in the course of their trading.
Floating charge holders are placed further down the payment hierarchy than fixed charge holders. Confused? For more information on the difference between fixed and floating charges, be sure to read this blog.
Secured creditors with a fixed charge
At the top of the creditor hierarchy, then, are secured creditors with a fixed charge. This creditor group includes banks and other large financial institutions that have provided borrowing to the company by taking security on one or more business assets.
If the company has borrowed money in order to purchase land or property, for example, this will be a fixed charge and they will be allowed to sell the asset in default or liquidation in order to get their money back.
Assets typically covered by a fixed charge include property, machinery and vehicles and these types of assets are often fundamental to a business and unlikely to be sold in the normal course of events.
Next on the list are preferential creditors, who are members of staff that are entitled to certain statutory payments, such as arrears of wages up to a maximum of £800, holiday pay, redundancy and unpaid pension contributions.
Employees are next in line after fixed charge creditors to receive payment from realised assets.
Secured creditors with a floating charge
Next in the ranking of creditors are secured creditors holding a floating charge. As explained above, these creditors will have security over a particular asset, such as stock, raw materials, fixtures and fittings or work-in-progress.
Basically, floating charges refer to any asset not subject to a fixed charge that can be traded in the normal course of business. When a company enters liquidation, these floating charges ‘crystallise’ and become fixed charges.
Floating charge creditors will be paid after preferential creditors, and at this point a sum of money will also be set aside for unsecured creditors.
This is known as the ‘prescribed part’ and is used to provide unsecured creditors with a greater chance of recovering some of their debt.
50% of the first £10,000 realised from the sale of floating charge assets will be set aside as the prescribed part, followed by 20% of any further realisations up to £600,000.
Following secured creditors with a floating charge are unsecured creditors, which typically consist of customers, suppliers, contractors, certain employee claims and HMRC.
Prior to 2002, HMRC was ranked as a preferential creditor, but the introduction of the Enterprise Act reduced their status to an unsecured creditor for all forms of tax.
If all unsecured creditors have received an equal dividend and there are further funds available, interest will also be paid on their debt.
Connected unsecured creditors
The technical term for connected unsecured creditors is ‘associate creditors’, which means that the creditor is in some way associated with the company.
An associate creditor is usually a director or employee who has provided money to the company on an unsecured basis, family members or directors’ spouses.
Non-payment of expenses can also fall into this area. Connected creditors do not generally receive a dividend in a CVA, but would be eligible for a dividend in liquidation. However, usually the dividend for unsecured/connected creditors is nil in business liquidation.
Finally, at the bottom of the creditor hierarchy are shareholders. Shareholders are people who have provided money to the business on a risk basis and therefore are not entitled to remuneration, dividend or repayment until all of the other creditors are satisfied.
How McAlister & Co can help
When it comes to administration, liquidation and the sale of assets, the hierarchy of creditors can be complicated, and fixed and floating charges is a particularly tricky area to understand.
What’s more, if a business enters insolvency, it’s important to maximise the interest of the creditors in order to avoid accusations of wrongful or unlawful trading, which could lead to 15 years of disqualification.
Luckily, McAlister & Co are expert insolvency practitioners with years of experience, so we can help to clarify a company’s financial position and determine who takes priority when it comes to payment.
In addition, we will also ensure that you meet all of your legal obligations as a director, reducing the risk of wrongful trading allegations.
If your or your client’s business is facing financial difficulty, the sooner you act the better, so don’t hesitate to contact McAlister & Co today for expert advice.
You don’t have to face financial difficulty alone - our friendly, dedicated team will be more than happy to help. Alternatively, why not download our guidance notes for directors for more help and advice.