A key principle in insolvency law is that of pari passu – that all creditors in a class have a right to be treated equally in the distribution of the remaining assets of a business.
Section 239 of the Insolvency Act 1986 prohibits paying any creditor in preference to any other in order to safeguard this principle.
When a company is trading normally, creditors have a right to enforce repayment of a debt on a 'first claim, first repayment' basis. However, when a company becomes insolvent, for the sake of good order and fairness, this principle is changed to one where each creditor has a general right to a proportionate share of the net proceeds pari passu.
In other words, losses in insolvency are borne by the creditors equally, with each creditor receiving the same number of pence for each pound of debt.
The change in principle to pari passu leaves some creditors at a comparative disadvantage to their outcome had they enforced the repayment only slightly earlier. It can be tempting for a director, knowing that the business certainly faces closure or restructure, to attempt to rescue his or her own interests as best as possible.
What is a preferential payment?
A payment (or a transfer of assets) is said to be given preference when it benefits one creditor to the detriment of others who have equal rights to be repaid. The preference might be given to the timing of the payment as well as to the value.
For example, a director who suspects that the company may shortly become insolvent might:
- repay a loan to a person connected to the company, such as another director, or his or her wife (a possible shadow director)
- pay a supplier in order to maintain or to create goodwill in a personal or business relationship that might continue post-insolvency
- repay a debt (such as the company’s overdraft facility) that is secured with a personal guarantee by the director
- sell back at the purchase price surplus stock to a supplier to whom payment is owed
- return goods that have been delivered but not paid for
- release a guarantee, or have a debt secured
The payment also has to be 'influenced by a desire'. In other words, there must be a motivation.
The issue here is that desire is subjective and difficult to prove. While the circumstances may suggest desire, sometimes it is necessary to choose the better of two undesirable choices. If there are proper commercial considerations to justify the payment then it is not said to be influenced by a desire.
It is useful at this point to be reminded about the responsibilities of a director when a company becomes insolvent.
Director responsibilities during insolvency
A company becomes insolvent either when it becomes unable to repay debts as they fall due, or if the liabilities on the balance sheet outweigh the assets.
A business is said to be cash-flow insolvent if it has sufficient assets to repay debts, but not an appropriate form of payment. For example, an agricultural machines dealer might hold stock of equipment that in value exceeds a loan it has taken out from a bank. However, if trading slows, it might not hold sufficient cash to repay the loan payments.
A business is said to be balance sheet insolvent if the value of debts exceeds the value of assets. It may be able to pay some debt repayments in the short-term, but if all debts were called in at the same time, some could not be repaid.
Focus of interests change
It is important to recognise that not all directors in title are company directors in law.
The title director can be given to any employee. It is a term that usually denotes the status of a senior manager. It is common to add an adjective to describe the area of the business that the person manages, for example 'Sales Director'.
In law, a company director is someone who has specific legal responsibilities for the management of the company: to the shareholders, but also to the company as a legal person, and to other stakeholders. Read more about the role and responsibilities of directors.
A company can continue to trade while it is insolvent. However, when a company becomes insolvent, the stakeholders to whom the directors are responsible in law change, from being the shareholders to being the creditors and possibly others.
Time considerations when judging whether a payment is preferential
In Court decisions, whether a director has acted wrongfully or unlawfully in making a preferential payment depends on when the payment was made.
Payments within two years of the date of insolvency could be preferential if made to a connected party; otherwise, the time limit is six months.
For this test, the date of insolvency could be the date of presentation of a petition for an administration order, the filing date of the Notice of Intent to Appoint, or the date on which the winding-up of the company starts.
While such rules can remove subjectivity in Court judgments as to whether a payment was made with preference, in practice, there are issues about which directors should be aware.
Particularly in situations of cash-flow insolvency, the date at which the company becomes insolvent can be difficult to establish. It is entirely possible that a director may authorise or make a repayment in good faith, knowing that while cash flow is tight, reasonably expecting that an event will happen shortly that will allow all debt obligations to be met on time.
Similarly, a director might have private information about the longer-term cash flow of the business. For example, he or she might be told by a reliable source that a key customer is unlikely to be able to make payments due after six months. In such a situation, while a payment to a favoured supplier would not be judged as a preferential payment in litigation, in the spirit of the law, it clearly would be.
In other words, it is possible for a business to hobble along with cash flow difficulties without technically becoming insolvent. Payments in this period may not be preferential.
Consequences for directors of making preferential payments
An insolvency practitioner can apply to the Court for preferential payments to be set aside, i.e. for their effects to be undone.
Should this happen, the company directors could become personally liable for those debts set aside. That leaves the creditors able to pursue the directors as individuals for the company’s debts.
An additional consequence is that a director could be disqualified for a period of up to 15 years. This isn’t a direct consequence of having made the payment, but rather one of failing in his or her duties as a director, notably exercising reasonable care, skill and diligence, and acting in an unconflicted way with personal interests.