When a company gets into financial difficulties and moves towards insolvency, the duty of the directors of that company shifts from a primary duty to the company, to a primary duty to the creditors of that company. During this time (known as the twilight zone) 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. For more information on all of these duties see: Directors duties: what are they on insolvency, and how can a director avoid personal liability for breach?
It is vital that directors are fully aware of their responsibilities and duties at times of insolvency to avoid falling foul of these provisions, as the personal financial consequences can be very severe if found guilty.
One of the most common issues, and therefore one of the most common later claims against a director that can arise in these circumstances is when a company director is accused of making a ‘preference’ payment to a creditor, at a time when other creditors may go unpaid. Here, we explore how this might happen, and ways to avoid this.
- What is a preference claim against a director?
- Who can take a preference claim against a director?
- Who is at risk?
- What does it mean if the court finds there was a preference payment?
- What is required in order to bring a successful claim?
- Who is considered to be a connected person?
- Directors’ disqualification
- What should I do as a director or as a creditor to avoid liability?
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 an insolvent liquidation or administration if the company has done something, such as make a payment, which has the effect of putting one or more creditors into a better position than other creditors. For example, by repaying a loan made by a director or a family member, or by ensuring an overdraft is repaid in priority to suppliers, if the overdraft is covered by a personal guarantee by one or more of the directors. The granting of new security to a lender can also be considered preferential in certain circumstances.
Who can take 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 taken against a company director, which covers not only directors registered at Companies House, but also de facto directors (these are directors that may not be registered but act as directors), as well as shadow directors (someone with a significantly controlling interest in the decision making of the company). This includes non-executive directors as well as executive. Depending on the circumstances, the recipient of the payment may also be at risk of having to repay what they have received.
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 had 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 that took the claim.
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 6 months of the date of administration or liquidation.
If the payment is made to a person or entity that is connected with the company, this it can be any payment made up to 2 years before the 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. However, 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, a payment to yourself 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.
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. For more information see: Directors’ duties: being disqualified from acting as a company director, and obtaining leave to act despite disqualification.
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 (if continued trading is appropriate see: What is wrongful trading?). 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 accurate 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 that time.
Hold regular board meetings to discuss decision making, and make sure these are minuted in detail in order to clearly explain the thinking 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.
Take professional advice from an insolvency solicitor if you have any doubts and are concerned that you are making a preference payment.