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One of the first questions directors of an insolvent business might ask is can they pay back the local small suppliers before they close the business?

Robbing Peter to pay Paul…

One of the first questions directors of an insolvent business might ask is can they pay back the local small suppliers before the close the business?

You can see why – no one wants to let down someone they have dealt with locally.

There are lots of rules and regulations governing how companies should be run financially - especially if they are facing insolvency.

A major issue for an insolvent business that is still running is deciding whom to pay? Do you pay who shouts the loudest or those local suppliers who have become friends or perhaps let the money get paid into the bank account you have personally guaranteed?

All of these issues could create what is known as a preference. That’s where the directors decide to pay one person over another.

We often find that in addition to loans from the bank the directors may have propped up a company by injecting their own funds to aid with cash flow or will have perhaps gone to a friend or family member and asked to borrow a short term loan.

Ordinarily this isn’t a problem as the loans would normally be repaid by the company if it was continuing in the future.  However a problem may arise if the company is insolvent at the time the loan is repaid and subsequently enters a formal insolvency process such as liquidation or administration.

When we get appointed as liquidator or administrator of a company one of our tasks is to carry out an investigation into the company prior to our involvement and check to see whether any unusual transactions, such as preferences, were carried out that could be overturned.

If there have been preferences we can have these reversed. We will contact the preferred person and ask for the money back so it can go into the company’s funds to distribute to all the creditors equally.

In fact, creditors of a failed business often ask us to pay special attention to these transactions as they are often aware of them.

We can look back at preferences made in the last two years if the person preferred was connected e.g. the directors loan or just six months for anyone else.

The only way that the directors can protect against a claim of a preference arising at a later date is to make sure that the creditors including all suppliers, HM Revenue and Customs, employees, loans and banks are all repaid at the same time and in proportion.

Is there a defence?

If it can be proven that the company had to make the payment to keep going then the court will not make an order asking the preferred money to be paid back to the liquidator. However if the preference was made to a connected party then it is presumed in law that this was a desire to prefer.

The misconceived defence often put to us if the money was repaid to the directors is that the loaned money was for the benefit of the company to stave off insolvency or to help with cash flow.  This does not work as a defence because it is the repayment of the money back to the directors that is the key issue, not the amount, or original purpose of the loan.

David Kirk ACA FABRP

David Kirk

David Kirk is a Chartered Accountant and Licensed Insolvency Practitioner.
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