Making Creditor payments in financial stress
When a company is in financial difficulty, the directors will be juggling a number of competing interests and demands.
If they are confident that the company can trade its way out of difficulty they may face the prospect of key suppliers restricting credit lines, insisting on debts and future supplies being paid up front. In this scenario many directors (and creditors) ask about preferences (also commonly called preferential payments) and when they should, and should not, pay creditors.
The first thing the director must remember is that when they form the view that the company is (or may be) insolvent, their duty is to act in the best interests of the company’s creditors as a whole (as opposed to members). If they allow it to continue trading when they know, or ought to know, that there is no reasonable prospect of it avoiding liquidation / administration, they may incur personal liability for “wrongful trading”. I address this in a separate article. Once that view is formed, it would be sensible for them to consider ceasing all payments and immediately take steps to place the company into an insolvency process
If a director reasonably considers that the company will be able to trade out: How do they navigate the “preference” issue when paying creditors (just in case the trade out fails and it ends in liquidation / administration)? This is bearing in mind that if liquidation / administration does ensue, and if the court considers a preference exists, not only can the recipient be ordered to repay it, but the directors can (in theory at least) be ordered to contribute too (as well as arguably being in breach of duty).
- There are 3 key elements for a “preference” to exist:
- The company must do something that puts a creditor or guarantor of its debts (Recipient) in a better position than they would otherwise be upon its liquidation. This can include providing security and transferring assets, as well as making payment.
- The company (i.e. its board of directors) must be influenced by a desire to put the Recipient in a better position than they would otherwise be upon liquidation.
- The company must have been unable to pay its debts as when due at the time of the alleged preference, or become so as a result.
The preference must also be made at a relevant time, which is 6 months prior to liquidation / administration for a Recipient not connected with the company; which is extended to 2 years if they are connected.
The key here is the need for the requisite desire. If it does not exist, then there is no preference. Broadly speaking, the fact a company has no choice but to make the payment to preserve continued supplies (or keep staff working) would mean that desire does not exist. However, if the payment was not strictly required, then that desire may exist.
To protect themselves in case the trade out strategy does not work, we would suggest that the directors:
- clearly document their decisions and reasons for believing that a trade out started will work (to protect against a wrongful trading allegation).
- easing all but absolutely essential payments out.
- not providing security to any existing creditors unless it is absolutely essential to preserve trade.
- not doing anything that is designed purely to eliminate personal guarantees provided by the directors (an all too commonly seen in this scenario).
They should also cease trade and consider an insolvency process as soon as it becomes apparent that the company cannot reasonably avoid liquidation / administration.
Finally, it goes without saying that advice should be sought. For further information, please contact Frank Bouette or give us a call on 0345 070 6000.