When dealing with creditors in insolvency situations, it is vital to remember the order of priority. Who ranks above whom? Where do the bank and HMRC rank? If the bank has security, do employees rank ahead of them? These are all common questions we get asked.
The simplest way to answer these questions is to imagine creditor ranking as a ladder. Further down the page, we have a written explanation but if you prefer a pictorial format, we have produced an infographic that shows the situation.
Author: Keith Steven
At the top are secured, creditors. Secured creditors have a legal right or charge over the property (property meaning anything from bricks and mortar to plant and equipment, motor vehicles, fixtures and fittings, particular pieces of machinery or things such as patents or intellectual property).
Fixed and floating charges:
The fixed and floating charge is given under a debenture and this must be considered carefully. It is essential to take expert and independent legal advice before signing. However, we would assume that if the reader is looking at this page that a debenture already exists.
Fixed charge creditors:
The easiest way to understand a fixed charge creditor's rights is to think of their position as holding title to or ownership of the property in question. Whilst this isn't strictly legally correct, it is a simple way to understand their position. This means that the person (company) who has given the fixed charge to a bank or other lender (there must be a consideration for fixed and floating charges) has relinquished permission to trade or sell the property in question, without the explicit permission of the charge holders. Usually, a fixed charge exists over, for example, a piece of machinery. Because this machinery is used to develop the economic activity of the business in question, it is unusual or abnormal for the business to want to sell or trade this piece of equipment. If the machinery in question was redundant or no longer sufficiently efficient, then the company may seek to sell this equipment (but would have to seek permission from the fixed charge holder first). Usually, this is not withheld as the proceeds for the sale would probably be used to pay down borrowings.
Floating charge creditors:
An altogether more complicated situation exists under the floating charge. Essentially the way to remember how floating charge works is as follows: all items that the company uses, or sells or trades in the normal course of business where it isn't possible to refer to a fixed charge holder for permission are covered by floating charges. This can be complicated to apply, for example, a fixed charge may exist on a piece of machinery which is sold in liquidation, the proceeds of which would go to the fixed charge holder. If the machinery was sold for say £10,000 more than the fixed charge, then this amount is covered under the floating charge collection. Under any floating charge created before 15th September 2003, any floating charge collections are payable to preferential creditors first. Under any new floating charges created from September 15th 2003, all collections are first subject to a prescribed PART which must be set aside for the unsecured creditors. This is calculated as follows 50% of first realisation up to £10k and 20% of £10k to £600k is paid to unsecured creditors with the balance going to the floating charge.
This is a very complex area and advice should be taken as soon as possible if you do not understand the position. We have produced a new page on fixed and floating charges that will help to explain them.
From September 2003 the Inland Revenue and VAT's preferential status was abolished under the Enterprise Act 2002. This will lead to a lower dividend than the Crown creditors use to enjoy BUT a higher dividend in insolvency should be received by trade creditors (for example) than previously. However this is likely to change in December 2020 as HMRC is to get back its preferential status. Employees retain the status of preferential creditors for their Arrears of Pay and for Holiday Pay claims in insolvency situations.
Unsecured creditors now include HMRC for deductions for employees through a PAYE Scheme and for VAT, trade creditors, suppliers, unsecured portion of fixed charge debts, national non-domestic rates and some employees' claims for example.
Connected unsecured creditors:
Usually, this is where a director or employee has provided money to the company on an unsecured basis, non-payment of expenses can fall into this area. The technical term is "associate creditors" this means that the creditor is in some way associated with the company. Associate or connected creditors can include family members of staff or director's spouses etc. Connected creditors will not generally receive a dividend in a CVA but would be eligible for a dividend in liquidation. Usually, however, the dividend for unsecured/connected creditors is nil in liquidation.
This is a complex area and advice should be taken as soon as possible if you do not understand the position.
Unfortunately, at the bottom of the pile comes members. otherwise known as shareholders. Shareholders are people (or companies) who have provided the money to the business on a risk basis and are therefore not entitled to remuneration, dividend or repayment of their exposure until all of the above creditors are satisfied. Hence the name risk capital! Shareholders are at the biggest risk of losing their money.
There are, of course, many different classes of shareholders and there are many complex issues appertaining equity - it is not the purpose of this guide to go into these areas but should the reader require advice they are encouraged to discuss this matter with their professional advisors, call 0800 970 0539 or use our contact form on the website. It is quite common for shareholders to covert some of the equity into secured debt, to ensure that they are paid in the event of a collapse.
Above all, the reader should remember this key point...
If the company is insolvent then the directors have a duty of care to act to maximise the body of creditor's interests. This means acting in the best interests of all creditors, by assessing the situation, collating as much information as possible, looking at their objectives, studying the options available and making a decision to ACT. The message is clear: if the business is insolvent (see Is our company insolvent?) think very carefully about payment to creditors. If after reading this page you are unsure what the order of priority should be, please call our support team on 0800 970 0539.
Worried about poor cashflow? Covid-19?, How to pay wages on pay day? For expert advice on a range of issues download our free Ultimate Guide For Worried Directors today. Or just call us on 0800 9700539
Please note that the guide was mostly written pre Covid-19 and there have been some changes to insolvency legislation that limits creditors actions and relaxes rules regarding wrongful trading. A new 20 day moratorium for distressed businesses has also been introduced.