Preferential Payments: A Legal Guide For UK Directors
If you or your company are facing serious financial difficulties and can’t pay your debts (or your debts are greater than the value of your assets), you must comply with UK insolvency law.
One key responsibility during such times is to treat all creditors fairly – no preferential payments to friends, family, or favoured suppliers.
Tailored for individuals, business owners, and company directors, this guide explores preferential payments in detail – looking at what they are, why they’re important, and the potential consequences of ignoring insolvency rules.
What is a preferential payment?
A preferential payment occurs when an insolvent individual or business pays one creditor in priority to others, shortly before declaring bankruptcy or entering formal insolvency proceedings.
These payments may give certain creditors an unfair advantage over others. As such, preferential payments can be challenged under insolvency law to ensure fairness.
For a payment to be deemed preferential, it must place the creditor in a better position than they would have been during insolvency proceedings
Preferential payments in insolvency
When it comes to insolvency, suspected preferential payments are scrutinised to ensure the fair treatment of all creditors. If a liquidator or trustee identifies a preferential payment, they may be able to recover the funds for redistribution.
Examples of preferential payments to creditors
Preferential payments to creditors are a common focus during insolvency investigations. These payments can include:
- Settling debts with suppliers to maintain personal relationships: This often happens when a business owner prioritises payments to suppliers or contractors they have a longstanding relationship with. The intent may be to preserve goodwill for future dealings or ensure uninterrupted services during financial instability. However, such payments can disadvantage other creditors.
- Paying off personal guarantees to avoid individual liability: Business owners or directors who have provided personal guarantees on loans or credit facilities may attempt to repay these obligations to protect their personal assets. This prioritises their interests over other creditors and can be challenged under insolvency law.
- Repayment of loans to specific business partners or investors: Repayments made to business partners or investors, especially those with a close relationship with the debtor, may be considered preferential. These payments are often made to satisfy personal obligations or preserve relationships but can lead to inequitable outcomes for other creditors.
The timeframe for preferential payments
The Insolvency Act 1986 outlines the legal framework for dealing with preferential payments in the UK. Under this legislation, payments made within a specified period before the onset of insolvency can be investigated.
These periods include:
- Two years for connected parties (e.g., family members, directors, or related companies).
- Six months for unconnected parties.
Bankruptcy preference payments
In personal bankruptcy cases, trustees are tasked with investigating whether any creditors received payments that unfairly disadvantaged others.
Trustees can seek court orders to recover such payments, ensuring all creditors receive equitable treatment under the law.
Examples of preferential payments during bankruptcy
Preferential payments during bankruptcy happen when individuals deliberately or unintentionally prioritise certain creditors or associates. For example:
- Repayment of loans to friends or family members: For instance, an individual may repay a personal loan to a close relative to maintain goodwill or meet familial obligations, prioritising them over other creditors.
- Prepayment for services or goods to close associates: This could involve advancing payment to a trusted contractor or supplier to ensure continued cooperation, even when other debts remain unpaid.
- Transferring assets to relatives below market value: Commonly known as transactions at an undervalue, this occurs when assets like property or vehicles are sold or gifted to family members for less than their actual worth, reducing the estate available to other creditors.
Who are ‘connected creditors’?
Connected creditors are individuals or entities with a close relationship with the insolvent person or business.
Insolvency law treats payments to these creditors with extra scrutiny because such relationships can increase the risk of preferential treatment.
Examples of connected creditors include:
- Family members: Spouses, children, siblings, or parents of the insolvent individual.
- Company directors or shareholders: Individuals with significant control or ownership of the insolvent business.
- Businesses with shared interests: Entities where the insolvent party has a direct or indirect stake.
- Close associates: Friends or partners with informal arrangements with the insolvent party.
Payments made to connected creditors within two years of the onset of insolvency are automatically subject to investigation, compared to six months for unconnected parties. This extended timeframe reflects the heightened risk that such payments may unfairly disadvantage other creditors.
In some cases, connected creditors may also face additional legal scrutiny if they were aware of the financial difficulties when the payment was made.
Legal consequences of preferential payments
If a payment is deemed preferential, several consequences may follow:
- Reversal of payment
The liquidator or trustee can apply to the court to reverse the payment, bringing the funds back into the insolvent estate. This ensures that all creditors share equitably in the available assets. - Director liability
Company directors making preferential payments may face personal liability claims if the payments occurred after they knew the company was insolvent. They may be required to compensate the estate from personal funds if found liable. - Reputational and professional damage
The court may also impose a ban on acting as a director for up to 15 years, and allegations of misfeasance can harm a director’s professional reputation, making future business opportunities difficult. You can read more about director disqualification here. - Criminal sanctions
In severe cases, making a preferential payment with intent to defraud creditors could lead to criminal proceedings. Penalties may include fines or imprisonment.
How to avoid making preferential payments
- Seek early legal and financial advice: Consulting an insolvency solicitor or insolvency practitioner can help you understand your obligations and rights.
- Know the rules: Familiarise yourself with insolvency laws to ensure you don’t inadvertently breach legal requirements.
- Avoid making ad hoc repayments: Refrain from repaying specific creditors without professional guidance.
- Maintain thorough financial records: Transparent accounting can help demonstrate good faith and compliance with insolvency rules.
- Document all agreements: Ensure all negotiations and agreements are documented in writing to avoid misunderstandings or disputes later.
- Act in the best interests of all creditors: Prioritise collective fairness over individual relationships.
Managing creditor relationships during insolvency
Transparent communication and strategic negotiation with creditors during times of financial distress can help mitigate conflicts and reduce the risk of preferential treatment claims.
Be proactive and transparent
Reach out to creditors as soon as financial difficulties arise. Delaying contact can erode trust and limit the options for resolving issues. Keep creditors informed of progress and any changes to your financial situation.
Show a commitment to fairness
Emphasise your intent to treat all creditors fairly. Avoid any appearance of favouring specific creditors, as this could raise suspicions of preferential payments. Avoid any arrangement that prioritises one creditor over others when negotiating payment terms unless it’s legally justified.
Leverage goodwill
Build on existing goodwill and highlight your past reliability and the mutual benefits of maintaining a positive relationship. Request adjustments such as extended payment terms, reduced interest rates, or temporary payment holidays to ease immediate financial pressures.
Defending against preferential payment claims
To defend against a preferential payment claim, directors must demonstrate they acted in good faith and took reasonable steps to manage the company’s financial situation.
Bankrupt individuals must also demonstrate payments were not made with the intent to unfairly favour one creditor over others, or that they fell outside the scope of what the law defines as preferential.
Key defences include:
- Proving there was no ‘intention’ to prefer
Directors can argue the payment was made in the ordinary course of business or was necessary for the company’s survival rather than with the intent to prefer one creditor over others.For example, payments to secure essential supplies or services might not constitute preferential treatment. Individuals in bankruptcy can show the payment was part of regular financial dealings and not intended to favour one creditor.
- Showing that the payment happened outside the relevant timeframe
Payments made outside the statutory periods – six months for unconnected parties and two years for connected parties – cannot usually be challenged as preferential.Directors and bankrupt individuals must provide clear evidence of when the payment occurred to counter claims.
- Demonstrating the payment was made in exchange for value
If the payment was part of a transaction that provided equal or greater value to the company, such as settling debts to secure vital goods or services, it might not qualify as preferential.In bankruptcy cases, payments that helped reduce overall liabilities or prevented the loss of critical assets may also be defensible.
- Establishing that the company/individual was solvent at the time
Preferential payment claims often rely on proving the company/individual was insolvent at the time of the payment.Directors and bankrupt individuals can defend themselves by providing financial records showing they / the company was still solvent when the payment was made.
A successful defence against a preferential payment claim often relies on clear documentation and professional advice. Anyone facing a claim should act proactively to ensure compliance with insolvency laws and seek legal assistance at the earliest signs of financial trouble.
How can directors avoid personal liability?
- Fulfilling their fiduciary duties: Directors must act in the company’s and its creditors’ best interests, especially when insolvency is imminent.
- Monitoring financial health closely: Directors must remain informed about the company’s financial position to avoid allegations of preferential payments.
- Seek professional advice early: Consult legal professionals at the first signs of financial distress. They can provide tailored advice on legal obligations and compliance.
- Avoid preferential payments: Refrain from prioritising specific creditors, such as family members, friends, or connected parties, over others.
- Maintain accurate and transparent records: Ensure all financial transactions, board decisions, and communications are well-documented and accessible.
Preferential Payments Insolvency - FAQs
Payments made shortly before insolvency that give one creditor an unfair advantage may be preferential payments.
Recovery depends on the timing, recipient, and circumstances of the payment.
Liquidators, trustees, or courts evaluate payments within the framework of insolvency law.
Pari passu is a Latin term meaning “equal footing” or “equal rank.” In the context of insolvency, it refers to the principle that creditors of the same class should be treated equally and share assets or payments proportionally.
However, certain creditors still have statutory or contractual priority:
- Secured creditors: Paid first from the proceeds of secured assets.
- Preferential creditors: Such as employees’ wages or certain tax liabilities.
- Subordinated creditors: Paid only after all higher-ranking creditors have been satisfied.
If you suspect another creditor is getting preferential, take prompt and strategic steps to protect your rights and ensure fairness.
This includes:
- Gathering evidence: To challenge preferential payments, you’ll need clear and credible evidence.
- Reporting concerns: Once insolvency proceedings begin, an insolvency practitioner (IP) or liquidator is appointed to oversee the debtor’s estate. Share your suspicions and evidence with them.
- Formally object: If the IP does not address your concerns, you can escalate the issue by filing a formal objection or requesting an investigation.
- Consider legal action: If your rights have been seriously undermined, consult a solicitor with insolvency expertise to advise you on challenging the preferential treatment.
Contact our director defence lawyers today
Understanding the concept of preferential payments is essential for anyone navigating insolvency or bankruptcy proceedings. Not least because such payments can have significant legal and financial implications.
Professional legal advice is vital if you suspect a payment to another creditor may be preferential, or if you are a director facing a preferential payment claim. With over 30 years experience, we regularly assist clients facing all types of liquidator claims, including preferential payments, overdrawn directors loan accounts, wrongful trading, misfeasance, and transactions at undervalue.
For your free consultation, contact our director defence solicitors today on 020 7467 3980 or complete the enquiry form on this page.