Updated: 3rd January 2021
A preferential creditor is a creditor who is granted preferential status during an insolvent liquidation by receiving the right to first payment, a hierarchy established by the Insolvency Act 1986.
An official ‘hierarchy’ laid down by the Insolvency Act, 1986, determines which group of creditors is paid first during an insolvent liquidation. When a company enters liquidation, each class of creditors must be paid in full (the exception being ‘prescribed part’ secured creditors) before funds are allocated to the next.
Creditors are ranked as follows:
Fixed charge holders are often banks and other asset-based lenders who hold title over a business asset. When a fixed charge is provided to the lender your company loses the right to sell or trade the item. Assets typically covered by a fixed charge include property, plant, machinery, and vehicles.
Assets used in this way are often fundamental to a business, and unlikely to be sold in the normal course of events. Depending on the original agreement, however, in liquidation the asset can be sold by the charge-holder or liquidator to realise funds.
Preferential creditors include employees entitled to arrears of wages up to a maximum of £800, and holiday pay.
Assets subject to a floating charge often include stock, raw materials, work-in-progress, fixtures and fittings – basically any other assets not subject to a fixed charge. Assets of this type can be traded in the normal course of business. Floating charge creditors are entitled to receive a distribution from the net property of the company (the amount remaining after the application of costs) subject to the dilution of the prescribed part.
The ‘prescribed part’ refers to an amount set aside from the sale of floating charge assets net of costs of the liquidation and applies to charges taken out after 15th September 2003. This sum is used to provide unsecured creditors with a greater chance of recovering some of their debt.
Fifty percent of the first £10,000 realised from the sale of floating charge assets is set aside in this way, and then 20% of any further realisations up to £600,000. Terms and conditions relating to fixed and floating charges are laid out in a debenture - a document which is signed by the directors and registered by the lender at Companies House.
These include trade creditors, suppliers, customers, contractors, some staff claims, plus HM Revenue and Customs. Prior to 2002, HMRC was ranked as a preferential creditor, but the introduction of the Enterprise Act reduced their status to that of unsecured creditor for all forms of tax.
Shareholders are the final group to be paid. Because they have taken a business risk in providing money to the company, they are not entitled to a distribution until all other creditor groups have been paid.
Each class of creditor must be paid in full before the liquidator can distribute funds to the next group. It’s important to maximise the interests of creditors once you enter insolvency, otherwise you may be open to accusations of wrongful or unlawful trading.
Fixed and floating charges are a complex area to understand, particularly if more than one charge has been taken on an asset. Begbies Traynor can clarify your company’s financial position, and identify who takes priority in cases where more than one charge-holder is in place.
We’ll also ensure you meet your legal obligations as a director of an insolvent company, and help to reduce your risk of allegations of misfeasance and wrongful trading.