Out-Law / Your Daily Need-To-Know

Crown preference: implications for business rescue

Out-Law Analysis | 30 Nov 2020 | 12:25 pm | 5 min. read

The adverse impact of the reintroduction of 'Crown preference' on UK rescue culture is likely to far outweigh any potential benefits to the public purse.

Any change to the order of payments on insolvency inevitably has consequences on the outcomes for creditors, and is therefore likely to drive changes in behaviour. While some of those changes would have been obvious and anticipated by the legislature, others risk undermining some of the stability that has been brought about by initiatives taken by the UK government to support companies through the pandemic – and is arguably contrary to the spirit behind the changes introduced by the 2020 Corporate Insolvency and Governance Act (CIGA).

Changes to the waterfall

On 1 December 2020 HM Revenue and Customs (HMRC), the UK tax authority, will become a second-ranking preferential creditor in respect of certain taxes, most notably uncapped VAT, PAYE and National Insurance (NI) but not corporation tax.

This change in the law will partially reverse the position to that which was in place prior to the 2002 Enterprise Act becoming effective. It is only a partial reversal because HMRC previously ranked equally with all other preference creditors, and for all taxes.

It is worth remembering that the Enterprise Act also introduced the concept of the 'prescribed part' – that part of realisations otherwise available for the holders of floating charges is carved out to be paid to unsecured creditors. At the time the Enterprise Act was introduced, this erosion of a floating charge creditor's realisations was counterbalanced to some degree by HMRC dropping out of the ranks of preferential creditor to rank alongside other unsecured creditors. Crown preference, as reintroduced, comes with no such counterbalance. In fact, the maximum level of the prescribed part was increased by one third from 6 April 2020 to £800,000, a further £200,000 potential erosion of a floating chargeholder's realisations (albeit one that was perhaps overdue, as the first increase since 2003).

When a company is in financial difficulties, there are typically numerous different stakeholder interests that directors need to take into account. How directors consider their duties to competing creditors will often depend to an extent on an assessment as to where the 'value breaks' in the waterfall of competing priorities on an insolvency of the company.

Following the increase in the prescribed part, enactment of CIGA and reintroduction of Crown preference, the order of the waterfall is now:

  1. The holders of fixed charges
  2. The expenses of the administration or liquidation as applicable
  3. First ranking preferential creditors, most notably employees
  4. Second ranking preferential creditors – HMRC for VAT, PAYE and NI
  5. Prescribed part unsecured creditors- increased from a maximum of £600,000 to £800,000 where the floating charge was created post 6 April 2020
  6. Floating charge creditors
  7. Unsecured creditors
  8. Shareholders

In addition, the new moratorium procedure introduced by CIGA has created yet another potential new entrant to the waterfall: certain unpaid pre-moratorium debts when an insolvency process is commenced within 12 weeks. These debts are to be paid after the holders of fixed charges but before the expenses of the administration or liquidation, so in second place in the above list. The details and implications of this are outside the scope of this article.

Access to finance

The most obvious impact of the change to the waterfall is the erosion of floating chargeholders' value. This is likely to mean that lenders and rescue financiers become less willing to advance new loans, or roll over existing debt, unless either the company has assets valued with sufficient headroom over the value of its secured debt or the company has significant uncharged fixed charge assets available - neither of which is common in these circumstances.

UK Finance has estimated that the reintroduction of Crown preference will remove some £1 billion of floating charge finance from the pool of money available to borrowers.

Where lenders are still willing to lend, the increased risk is likely to mean the cost of borrowing will be even higher than the often significant costs of current distressed lending. Those increases, which are often payable as exit fees, may lead directors to think twice about whether it is in the best interests of the relevant stakeholders to borrow the money - for example, if it will absorb any realistic future equity value - or whether it is worth their while doing so.

HMRC veto on CVAs

Preferential creditors cannot be bound by a company voluntary arrangement (CVA) without their consent. Prior to the reintroduction of Crown preference, that was a relative formality because, for most practical purposes, the only preferential creditors of a company were its employees, whose rights are typically unaffected by a CVA.

However, HMRC being reinstated as a preferential creditor will mean that HMRC will either have to be paid in full or, if the economics of the CVA do not allow that, will have an effective veto over approval of the CVA. Paying HMRC in full, particularly in the current environment where companies often owe large sums to HMRC having taken advantage of the ability to defer VAT and PAYE payments due to the Covid-19 pandemic, may significantly change the economics of the outcome for unsecured creditors.

Pre-packs and credit bids

A common rescue technique is a pre-pack administration sale to an entity controlled by the secured creditor, with the consideration being paid by way of a 'credit bid' against amounts due to that creditor, as is common to effect a restructuring process. In these circumstances, it is important to ensure that no creditors are disadvantaged by the sale when compared to an alternative outcome.

Accordingly, where value in a business and its assets has diminished to such an extent that the valuation and marketing evidence makes it clear that value will break in the senior debt in any event – which is not uncommon – common practice has been to fund payment of preferential creditors and the prescribed part to the extent required to replicate the economics of an insolvency process in order to protect creditors' interests. The combined effect of HMRC's elevated status and the increase in the cap on the prescribed part may make that a significantly more expensive exercise for secured lenders, which may of course affect the viability of some rescues.

Cash flow implications

The reintroduction of Crown preference will also be relevant to directors in continuing to trade through difficult circumstances. On the positive side, it may mean that, on a case-by-case basis:

  • HMRC is more willing to agree 'time to pay' arrangements in the knowledge that there is a greater likelihood that they will get paid on an insolvency;
  • HMRC may be less 'trigger happy' in making demands and issuing winding-up petitions for the same reason; and
  • the risk of payments made to HMRC being considered preferences goes away if HMRC would have been paid on an insolvency in any event, so that the payment does not put HMRC in a better position than it would otherwise have been in. This may assist directors in enabling them to pay HMRC without risk of criticism that they were motivated to do so by a desire to minimise their own risk of liability, given the potential personal liability issues for directors for non-payment of taxes pre-insolvency in circumstances where HMRC considers that avoidance or evasion of taxes has taken place, or where it has evidence of 'phoenixism', as introduced by the 2020 Finance Act.

However, lenders are likely to insist on tighter covenant packages around payments to HMRC and, potentially, the control of book debts, particularly if the lender wishes to maintain a claim to a fixed charge over book debts. These restrictions may limit the directors' ability to manage cash flow through short-term difficult trading periods by deferring payments to HMRC; whether through formal time to pay arrangements, trapping cash in fixed charge accounts or otherwise.