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Understanding preference in insolvency and why you should avoid making preferential payments

When a company enters administration or is liquidated, the conduct of directors leading up to insolvency will be investigated to find out if they have acted wrongfully or unlawfully. One type of transaction that comes under scrutiny in this situation is preferential payments.

It is incumbent upon directors to maximise returns for all creditors once insolvency is threatened - to do otherwise could be viewed as acting unlawfully. Directors must set aside their own interests and those of the company, and under the ‘pari passu’ principle, ensure that creditors within each class are treated equally as far as repayment/losses are concerned.

What constitutes a preferential payment?

‘Preference’ occurs when a particular creditor is placed in a more beneficial position, to the detriment of the remaining creditors in that group. For example, repaying a loan from someone connected to the company, such as a director’s relative, or making sure that a creditor is paid simply to encourage an ongoing business relationship post-insolvency.

If a director has provided a specific lender with a personal guarantee, they might be inclined to repay this loan first to protect their personal finances. This too could be seen as a preference in insolvency. Preferences include the transfer of assets in addition to cash payments.

Parameters for judging whether a payment is preferential

When deciding whether payments should be treated as preferential, consideration is given to the length of time between the transaction and the onset of insolvency. There are two aspects to this:

  • If the transaction involved a ‘connected party’ such as a relative of the director, the timescale is two years before the onset of insolvency
  • For non-connected recipients, the time limit is six months

The date of insolvency could be when the petition for an administration order is presented, the filing date of Notice of Intent to Appoint, or the date on which winding-up begins. If a company has struggled on for a period of time without actually becoming insolvent, a payment that was indeed preferential, could be overlooked simply because of the timescale.

What are the ramifications of making a preferential payment?

Directors could face personal liability for some or all of the company’s debts if a preference is found to have been made. The insolvency practitioner will apply to the court for the transaction(s) to be set aside, and action may be taken against you.

If the preferential payment was made when the company was insolvent, or caused it to become insolvent, it could lead to disqualification as a director for a period of up to 15 years.

To find out more about preferences in insolvency, and to ensure you are acting accordingly as a company director, call our expert Begbies Traynor team. We can advise on whether your actions might be investigated, and discuss the options available. With a nationwide office network, we can also offer a same-day consultation in complete confidence, free of charge.

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Insolvency Practitioners Association Institute of Chartered Accountants in England and Wales R3: Association of Business Recovery Professionals ICAEW Business Advice Service Turnaround Management Association ACCA (the Association of Chartered Certified Accountants) ICAS | The Institute of Chartered Accountants of Scotland
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