Making creditor payments in financial distress
This series of articles has, so far, focussed on the duties of directors when a company is in financial distress – and how they stay the right side of ‘the line’. The next logical question is – can we still pay creditors? There’s not simple answer to that, but this article aims to provide some guidance.
When their company is in financial difficulty, the directors will be juggling competing interests and demands. Even if they’re confident the company can trade out, they’re likely to face the prospect of key suppliers restricting credit lines and insisting debts be paid before supply resumes. It’s against this backdrop I’m often asked about preferences (also called preferential payments) and when they should, and should not, pay creditors.
As discussed in a previous article, the first to remember is the rule that once you know (or ought to know) the company has no reasonable prospect of avoiding insolvent liquidation, your duty is to act in the best interests of the company’s creditors as a whole (as opposed to members). Failing this you may incur personal liability. Once that view is formed, it’s sensible for to consider ceasing all payments and taking steps to place the company into an insolvency process.
But what if a director reasonably considers that the company will be able to trade out: How do they navigate the preference issue when paying key creditors, bearing in mind the risks if liquidation or administration follows?
There are 4 key elements for a “preference” to exist:
- the company must do something that puts a creditor or a guarantor of its debts (“X”) in a better position than otherwise on liquidation. This can include providing security and transferring assets, as well as making payments;
- the company (i.e. its board of directors) must be influenced by a desire to put X in a better position than they would otherwise be on liquidation;
- the company must have been unable to pay its debts when due at the time of the alleged preference, or become so as a result; and
- the alleged preference must have be made at a relevant time, which is 6 months before liquidation / administration if X not connected with the company (2 years if X is connected).
This key is the need for a desire to put X in a better position. If that does not exist, there is no preference. Broadly speaking, the fact a company has no choice but to make a payment to preserve continued supplies (or keep staff working) would extinguish that desire. However, if the payment was not strictly required, then it will not.
To protect themselves if the trade out doesn’t work, I’d suggest directors clearly document their decisions and reasons for believing that a trade out will work; ceasing all but essential payments out; not providing security to any existing creditors unless essential to preserve trade; and not doing anything designed to eliminate personal guarantee liabilities (commonly seen in this scenario). They should also consider approaching a formal insolvency process as soon as it becomes clear the company cannot reasonably avoid liquidation / administration.
It goes without saying that advice should be sought, and (before you ask) payment for that advice up front isn’t a preference – it’s an essential supply!
If you’d like more information on this update, please contact Frank Bouette or give us a call on 0345 070 6000.