When a company gets into financial difficulties and can’t pay its debts as they fall due or has debts greater than the value of its assets, it becomes insolvent. When the company becomes insolvent, the directors must shift their focus from the shareholders of the company to the company’s creditors. During this time between becoming insolvent or experiencing financial difficulties and entering into a formal insolvency process directors are at a risk of being held personally liable for certain actions (or lack of action) if the company then goes into insolvent liquidation or administration.
It is vital that directors are fully aware of their responsibilities and duties at times of insolvency to avoid falling foul of the law, as the personal financial consequences can be very severe if found guilty.
A common issue is when a company director is accused of making a ‘preference’ payment to a creditor, at a time when other creditors are waiting for payment. In this article, Eleanor Stephens, Insolvency Solicitor at Harper James explores how this might happen, and ways to avoid this.
Jump to:
- What is an example of a preference payment?
- Why might a preference payment be made?
- What is a preference claim against a director?
- Who can make a preference claim against a director?
- Who is at risk?
- What is required in order to bring a successful claim?
- Who is considered to be a connected person?
- Is there a limitation period for preference payment claims?
- What defences are available against preference payment claims?
- What does it mean if the court finds there was a preference payment?
- Directors’ disqualification for making a preference payment
- What should I do as a director or as a creditor to avoid liability?
- Summary
What is an example of a preference payment?
A preference payment could be the repayment of a loan to a director or to a connected party of the company, for example, an employee or family member. It could be the repayment of an overdraft, where the overdraft is covered by a personal guarantee by one or more of the directors. It could be a payment to a key supplier which is made to secure favourable relations with the directors’ post-insolvency. It is not always a cash payment and it could include the surrender of an asset to a creditor instead or even the granting of security to a creditor to give them priority over other unsecured creditors in an insolvency event.
Why might a preference payment be made?
The motivation behind making a preference payment is to extract cash or assets out of the business before it can be claimed by other creditors. Payments are generally made for either personal gain or with the intention of creating and improving relations with certain creditors who may be useful or necessary to your business or personal interests after the company has entered into an insolvency process.
What is a preference claim against a director?
A preference claim can be brought against a director of a company (or a limited liability partnership) which has gone into insolvent liquidation or administration if it can be shown that the company has made a preference payment.
Who can make a preference claim against a director?
Either a liquidator or an administrator will usually bring a claim, but they can also assign a claim to a third party, such as a creditor.
Who is at risk?
A claim may be made against a company director. This category can extend further than those directors registered at Companies House to include de facto directors (those who act as directors) as well as shadow directors (those with a significant controlling interest in the decision making of the company). It also includes non-executive directors as well as executive directors. Depending on the circumstances, the recipient of the payment may also be at risk of having to repay what they have received.
What is required in order to bring a successful claim?
If the payment is made to a person or entity that is not connected with the company, then it has to have been made within six months of the date of administration or liquidation.
If the payment is made to a person or entity that is connected with the company, it can be any payment made up to two years before the date of administration or liquidation.
The company must have been classed as insolvent at the time of the payment – this means that it either was unable to pay its debts as and when they fell due, or it was balance sheet insolvent – so it had more liabilities than assets.
There must also have been a ‘desire to prefer’ when making the payment. If the payment or security is given to a connected person, then this desire is presumed, and the burden is on the directors to show there was no desire to prefer the payee. So, if you have made a payment to yourself, it will be hard to convince the court that it was not a preference.
Who is considered to be a connected person?
The definition in legislation is that a person will be connected to the company if they are a director or shadow director, or are an associate of the company.
The term ‘associate’ has a very wide definition and includes almost any link you can imagine to a director or the company, including all family links (including extended family and civil partners, former spouses, illegitimate children etc) and most business links.
Is there a limitation period for preference payment claims?
The limitation period for a preference claim is:
- six years, if the aim of the claim is to recover money; and
- twelve years, if the aim of the claim is to recover property.
The limitation period only starts to run when the company goes into liquidation or administration which could extend the life of certain claims if subsequently characterised as a preference claim.
What defences are available against preference payment claims?
A director can successfully defend a claim depending on the facts of the case and the burden is on the liquidator or administrator to set out the effect of any preference on the interests of other creditors.
General defences could include:
- the claim is not eligible because the preference was made outside of the relevant time periods or the company was not insolvent at the time of the preference and didn’t become insolvent as a result of the preference
- there was no desire to prefer - in the case of a connected person this desire is presumed, although this can be rebutted
- the preference was made to a party who was not a creditor of the company
- the creditor is not in a more favourable position than they would have been on a liquidation of the company, as a result of the preference
What does it mean if the court finds there was a preference payment?
The court has a wide discretion to make any order it thinks necessary to restore the company to the position it would have been in had the preference payment not been made. For example, it might order that the payment be transferred back to the company, or if that is not possible then it may order one or more directors to pay a compensatory amount back into the company.
If a person received a preference payment in good faith for value, then they are unlikely to be asked to repay this, however, if it is clear the payee knew this was a preference, then they may be asked to repay the amount received.
Any money ordered to be paid will go back to the company for the benefit of all creditors, not just the creditor who took the claim.
Directors’ disqualification for making a preference payment
Making a preference payment can also be considered as wrongdoing for the purposes of directors disqualification proceedings. Depending on what other wrongdoing may be found, a director can be disqualified from being a company director for anywhere between 2 and 15 years.
What should I do as a director or as a creditor to avoid liability?
Sometimes it is necessary for a company to pay one creditor over another even while insolvent, particularly if that creditor is a key supplier and it would be impossible to continue to trade without their continued supply. Some creditors are fully aware of this and insist on being paid before supplying a company when they are concerned about a company’s precarious financial position. These are sometimes called ‘ransom’ creditors, and in this situation, it is possible for a director to argue that they had no choice in preferring that creditor over others when it is for the greater good of the company as a whole.
Obviously, if the ransom creditor also happens to be connected to the company or directors, then this argument is seriously weakened!
If such a payment is made, it is advisable that the company records the reason behind the payment in the company’s books, so that there is clear evidence of the decision making behind the payment at the time, for any liquidator or administrator looking at the transaction later on.
Any creditor who is aware of the company’s insolvent position and accepts what they realise could amount to a preference payment should accept the risk that this payment might be ordered to be repaid in the event of the company’s formal insolvency if it meets the time criteria above. This includes any bank that seeks additional security in light of a company’s financial difficulties.
If your company is facing difficulties, it is important to always keep on top of the financial position of the company at all times, so that you have an accurate view of the finances and can assess what payments need to be made, and what payments it may be inappropriate to make at certain times.
Regular board meetings should be held to discuss decision making, and these meetings should be recorded in detail in order to clearly explain the reasoning behind decisions made at the time.
Don’t repay personal loans or any loans that may personally benefit you or anyone connected with you. For example, repaying an overdraft which you have personally guaranteed. This can all be clawed back.
Summary
Preference payments and preference claims are a complex area of insolvency law and the liability for directors could be serious. It is crucial that if you are facing a preference claim or you are worried about making a payment or taking any action which could be deemed to be a preferential payment. You should seek legal advice as soon as possible to make sure you are protecting your interests and those of the company.
