When a company becomes insolvent, one of the main directors’ responsibilities is to act in the best interests of all of the company creditors.
Essentially, under the ‘pari passu’ principle, directors must ensure that all creditors are treated equally in terms of repayments/losses. To do otherwise is considered unlawful, which is why directors are closely investigated to find out whether or not they have acted wrongfully.
One type of transaction that comes under scrutiny is preferential payments. According to the Preference Insolvency Act 1968, an equitable distribution of funds is required to ensure that no unsecured creditors are given preferential treatment at the expense of others.
It’s really important that company directors understand this area of legislation, because if preferential payments have been made, the repercussions can be severe.
Read on to find out all about the Preference Insolvency Act 1986, from what preference payments are to what the ramifications are, and how you can avoid making preferential payments…
Everything you need to know about preference payments in insolvency:
What is a preference payment?
A potential ‘preference’ occurs when a company pays a specific creditor(s), making them better off than the majority of other creditors, before entering into formal insolvency.
The law around preference in the Insolvency Act 1986 is set out in section 239, and as such, if a company enters insolvency, the appointed insolvency practitioner will scrutinise all transactions (including cash payments and the transfer of assets) up to two years prior to the insolvency.
If the directors are found to have created a preference, they could face penalties including personal liability for company debts. The liquidator also has the right to request repayment from the beneficiary as well.
Why unfair preference is created
More often than not, preferential payments are made by directors who believe that doing so will somehow improve the company’s fortunes, or such payments are sometimes made out of a misguided sense of loyalty, especially if the payment is made to someone who is closely connected to the company.
For example, this could be a director choosing to repay a family member who had lent them money above other creditors, or you could feel an obligation to pay off creditors who you have built up a good relationship with over the years.
Other reasons preference payments often occur include because the company director wants to encourage an ongoing business relationship with a particular creditor post insolvency, or if a director has provided a specific lender with a personal guarantee, they might be tempted to repay this loan first to protect their personal finances.
However, although you may be able to justify these reasons to yourself, an insolvency practitioner won’t have the same view.
What happens if an unfair preference is suspected?
When a company formally enters insolvency, the IP will look at all payments made within the last six months. In the case of payments to a connected creditor, the time limit increases to two years prior to the onset of insolvency.
If a preferential payment is identified, the IP will apply to the court for an order to recover the monies, and if it is decided that you deliberately created a preference by favouring particular creditors, the recipient will be ordered to return the money.
So, what are the ramifications for directors?
If a preference is found to have been made, the directors could face personal liability for some or all of the company’s debts. Further still, if a preferential payment was found to be made when the company was already insolvent, it could lead to you being disqualified as a director for up to 15 years.
How to avoid making preference payments
In the day-to-day running of a business, the best way to protect yourself from preference payments is by using your common sense. Basically, if the decision to pay someone seems off for some reason, it’s usually because it is.
Without a doubt, the safest way to ensure that you don’t make preference payments is by treating all your creditors equally.
You should also regularly consider your company’s solvency, keep a close eye on company cash flow to ensure you don’t run out of money and be aware of the warning signs of insolvency.
Finally, it goes without saying that if you believe your company is facing financial difficulty, you should seek expert advice as soon as possible.
How McAlister & Co can help
At McAlister & Co, we are experts in business insolvency. So, if you are currently facing financial difficulty, don’t suffer in silence – contact us today for free, confidential advice.
From guidance on the Preference Insolvency Act 1986 to business rescue solutions or even options should you wish to close things down and make a fresh start, our team is here to help.