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Corporate Insolvency and Distribution of Funds

Corporate insolvency is governed by the Insolvency Act 1986 and the Insolvency Rules 1986. A new set of rules will come into force on 6 April 2017, with the aim of modernising existing practices and procedures. All statutory sections mentioned throughout this article refer to the Insolvency Act 1986.

A company is insolvent if it is deemed unable to pay its debts and solicitors are often expected to advise the company, its creditors or an insolvency practitioner. One of the options of an insolvent company is liquidation, whereby proceedings are commenced and a liquidator is appointed. The liquidator is responsible for collecting the company’s assets and in doing so also scrutinises past transactions. The liquidator will then distribute the assets to the company’s creditors in the statutory order and the company will be subsequently dissolved, ceasing to exist.

Schedule 4 sets out the powers and duties of a liquidator, which include the collection and distribution of funds, the conduct of litigation on the company’s behalf and carrying on the business of the company. A liquidator also has the power to review the actions of directors. For example, a director may have transferred property after the winding up procedure was initiated or in anticipation of it and may therefore be liable for fraud under s. 206.

Maximising the Company’s ASSETS

When a company is in financial difficulty, directors and other interested parties may try to move assets away from the company in anticipation of liquidation. There are provisions in the IA 1986 allowing liquidators and administrators to look into the affairs of the company and its directors before liquidation, which are referred to as antecedent transactions.

One category of such transactions are those at an undervalue, in respect of which a liquidator or administrator may apply to court to set aside pursuant to s. 238 (1) and (2) if certain criteria are satisfied. Under s. 238(4) an undervalue is either a gift or transaction where the company received consideration significantly lower in value than the company provided. S. 240(1) provides that the relevant time before insolvency during which transactions may be reviewed is 2 years ending with the onset of insolvency as provided by s. 240(3). Depending on the circumstances under which the liquidation or administration came about, this may be the date a petition was put forward for example. It is also a requirement that the company must have been insolvent at the time of the transaction, i.e. unable to pay its debts, or become insolvent as a result (s. 240(2)). However, if the transaction was entered into with a connected person, which is defined under s. 249, such as a director, his/her spouse or a shadow director among others, then the inability to pay debts is presumed. The insolvent company may have a defence if it can prove that the transaction was entered into in good faith to benefit the company (s. 238(5)). A transaction at an undervalue is voidable if proved and the court can make a number of orders which may be found in s. 241(1) such as returning property to the company, releasing any security given by the company and others.

Another category in relation to which only a liquidator or administrator can apply under s. 239(1) and (2) is referred to as ‘preferences’. A preference is a transaction that puts a company’s creditor, surety or guarantor in a better position on liquidation and than he would have been had the transaction not occurred, and the company had desired to prefer this party (s. 239(4) and (5)). However, if the transaction was entered into with a connected person then the desire to prefer is presumed under s. 239(6). Some examples of such transactions include making an unsecured creditor secured, giving priority to an unsecured creditor before other unsecured creditors, submitting to a claim against that creditor even if the company has a good Defence and others. The relevant time before insolvency for this type of transactions is 6 months ending with the onset of insolvency (s. 240(1)(b)) unless it is with a connected person in which case it will be 2 years (s. 240(1)(a)).  As previously, the company must have been insolvent at the time or as a result (s. 240(2)). There is no defence and if proved the transaction is voidable. The court can make the same orders as with transactions at an undervalue, as listed in s. 241(1).

Invalid floating charges are automatically deemed to be void so there is no need for an application to court to be made (s. 245(2)) and there is no defence. For a floating charge to be invalid, it must have been created without any fresh consideration as s. 245(2) provides. The relevant time before insolvency is 12 months ending with the onset of insolvency (s. 245(3)(b)) unless it is with a connected person where the relevant period is 2 years. As s. 245(4) provides, the company must have been insolvent at the time or as a result but there is no need to prove this if the transaction is with a connected person.

  1. 423 refers to transactions defrauding creditors and provides that any victim of such transaction may also apply to court to set it aside, as well as an administrator or liquidator. The transaction must be at an undervalue (s. 238) and the purpose must have been to put the assets beyond the reach of a person that may make claim or the aim must have been to prejudice the interests of such person in relation to any such claim (s. 423(3)). S. 425 lists the orders a court can make which are similar to those mentioned above. There is no time limit for such transactions to be set aside however proving intention to defraud is not easy and this category is mostly used when the time limit for transactions at an undervalue has expired.

A liquidator or administrator can apply to open extortionate credit transactions made within 3 years of a company going into liquidation under s. 244(2). An application can only be made if the transaction is extortionate under s. 244(3), which provides that payments must be grossly extortionate, or the transaction must contravene the ordinary principles of fair dealing. Such transactions are rarely encountered in practice as they very difficult to prove and there is minimal case law.

Conduct of DIRECTORS

A liquidator may look at the conduct of directors and obtain financial contribution from the directors personally in certain situations. Wrongful trading is set out in s. 214 and provides that a director may be liable if he knew or ought to have known that the company could not avoid liquidation but continued to trade. Fraudulent trading as set out in s. 213 is established when directors continue to operate the business with the purpose of defrauding creditors. S. 212 refers to misfeasance, which involves any breach of fiduciary or other duty of directors. Directors who are liable in respect of the above may be disqualified from being a director by the court.

Distributing the Company’s Assets

Once a liquidator realises the insolvent company’s assets, they are distributed in the following order under ss. 175, 176A and 176ZA:

  1. Fixed Charges

Fixed charge holders will usually have been paid out already when the asset they had security over was sold, subject to any receiver fees. If there is a surplus after the sale, it will go to the liquidator to be distributed among the remaining creditors and if there is a shortfall the fixed charge holder can try to recover the balance under their floating charge, if any, or as an unsecured creditor.

  1. Liquidator’s and advisers’ fees and expenses
  2. Preferential debts

The main categories under ss. 175, 386 and Schedule 6 are wages and salary of employees for work done in the 4 months before insolvency subject to a cap of £800 per person and holiday pay due to any employee whose contract has been terminated before or after the insolvency date. Such debts rank and abate equally, which means that all creditors in a particular category will share the money that is available. There may not be enough money for them to be paid in full but each will get the same percentage of their original debt.

  1. Monies secured by floating charges by order of priority (subject to ring-fencing)

In relation to floating charges created on or after 15 September 2003, the liquidator must ring-fence a prescribed part for unsecured creditors as s. 176A stipulates. This is calculated as a percentage of the value of the company’s property subject to floating charges. 50% is allocated for the first £10,000 and 20% thereafter with a maximum cap at £600,000. However, secured creditors do not have access to the ring-fenced fund for any unsecured portion of their debts.

  1. Unsecured creditors, which rank and abate equally
  2. Shareholders, if there is any surplus

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ELS Legal is an international law firm based in London with more than 50 partner offices across the world. As part of the Cathay Associates global legal network, we are the first choice law firm for a number of British businesses and overseas clients.


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