Preferences in Insolvency: What they are and why Directors must avoid them.
This is the second article in our series looking at how Insolvency Practitioners work and the legal framework behind financial distress. In the first, we looked at why asset valuations sit at the heart of every insolvency process. This time we turn to a different area: the duties placed on directors of a company that is insolvent or heading that way. There are four things directors must avoid at this stage, set out in our Directors’ Duties guide as the “four sins”: wrongful trading, fraudulent trading, preferences, and transactions at undervalue. Over the coming weeks we will look at each in turn, starting here with preferences in insolvency, one of the least understood but most commonly encountered of the four.
What is a preference in insolvency?
A preference happens when a company, while insolvent or about to become insolvent, does something that puts one creditor in a better position than they would otherwise have been in, compared with the position other creditors are left in. This is set out in section 239 of the Insolvency Act 1986.
It is rarely a single dramatic act. A preference can arise from repaying a director’s loan ahead of trade creditors, releasing security held by one lender while others remain unpaid, or settling one supplier’s invoice in full while others are left waiting.
For a payment or transaction to count as a preference, it must fall within a defined window before formal insolvency proceedings begin, known as the relevant time: six months where the recipient is an unconnected creditor, extended to two years where they are connected to the company, such as a director or a close family member. The company must also have been insolvent at the time or have become insolvent as a result of the transaction.
Crucially, there must be evidence that the company was influenced by a desire to put that creditor in a better position. Where the recipient is a connected person, the law presumes that desire was present unless the contrary can be shown.
Preferences are, however, a complex area, as Jeff Brenner, a Licensed Insolvency Practitioner at our London office points out:
“Under Section 239 of the Insolvency Act 1986, a payment can be justified if it lacks the subjective “desire to prefer” the creditor. Key justifications include yielding to threats of legal action, securing essential supplies for continued trading and adhering to established, routine payment terms.”
Why are preferences taken so seriously?
Insolvency law works on the principle that creditors should rank fairly together, known as pari passu distribution. When one creditor is quietly moved up the queue ahead of formal insolvency, whether deliberately or simply because they pushed hardest, every other creditor loses out by the same amount. Preferences exist to put that right, restoring the position so the available assets are shared as they should have been.
Does an Insolvency Practitioner have to report it?
Yes. Once appointed, an Insolvency Practitioner has a duty to look back over the period leading up to insolvency at the company’s significant transactions and decisions. These are generally known as antecedent transactions, and a preference is one of the specific things this review is designed to catch.
Where a preference is identified, the liquidator or administrator can apply to court under section 239 for an order restoring the position, usually meaning repayment of the sum received.
Every officeholder also has a duty under section 7A of the Company Directors Disqualification Act 1986 to report on directors’ conduct to the Insolvency Service, within three months of appointment. Evidence of a preference is one of the matters that can be flagged within that report, as we explained in our earlier article on directors’ conduct reports.
None of this is optional, and none of it exists to catch anyone out. It is simply part of how the system protects the wider body of creditors.
What are the consequences of a preference?
If the court finds that a preference was given, it can make whatever order it thinks fit to restore the position, which in practice usually means the recipient repaying the value of what they received. A director who arranged or approved the preference can be held personally liable for that sum. Where the conduct is serious enough, it can also contribute to a director disqualification action of up to 15 years, and in some cases a compensation order on top.
A single payment made under pressure, in good faith, with no thought of gaining any personal advantage, is a very different matter from a deliberate pattern of favouring connected parties. The facts of each case, and the director’s state of mind at the time – not least because of the stress that financial difficulties can cause – are what the law looks at.
How can directors avoid giving a preference?
Treat creditors consistently once financial difficulty sets in, rather than paying whoever is shouting loudest. Avoid repaying director loans, family loans, or other connected party debts ahead of trade creditors, HMRC, or staff. Keep clear board minutes recording the genuine commercial reasoning behind any payment made during a difficult period. Take advice before releasing security or repaying any loan from a director or shareholder.
Elaine Wilkins, a director at our Bournemouth office, who is usually the first point of contact in the area for directors worried about their company’s position, sees this concern come up often.
“By the time a director picks up the phone to us, they’ve usually been carrying their worries on their shoulders for a while,” she says.
“Preferences sound frightening when you read about them, but in my experience the directors who come to us early, before any decision has been made about who gets paid, are almost always fine. We’re not here to catch anyone out. We’re here to help directors get it right, and the earlier that conversation happens, the more options everyone has.”
Talk to Antony Batty & Company about directors’ duties at insolvency
Antony Batty & Company are Licensed Insolvency Practitioners with offices in London, Bournemouth, Brentwood, Mill Hill, Salisbury and Thames Valley. If you are concerned about a payment you have made, or about the financial position of your company more generally, contact us for a free, no commitment confidential initial discussion.
Frequently asked questions about preferences in insolvency
What is the difference between a preference and a transaction at undervalue?
A preference is about treating one creditor better than others. A transaction at undervalue is about the company receiving significantly less than something is worth or giving an asset away. We will look at transactions at undervalue elsewhere in this series.
Can a preference be unwound years later?
Where the recipient is connected to the company, the relevant time extends to two years before insolvency, so a transaction completed sometime earlier can still come under scrutiny.
Is paying a supplier to keep them on side a preference?
Not necessarily. The law looks for a desire to prefer, not simply an improved position. Paying a supplier to maintain continuity of trade is a different motivation to repaying a director’s loan ahead of other creditors, though every case depends on its own facts.
What should I do if I think a payment I made might be considered a preference?
Speak to a licensed Insolvency Practitioner as soon as possible. Early advice gives directors the best chance of explaining the commercial reasoning behind a decision, before it is looked at in hindsight.
