How will insolvency be dealt with during the second national lockdown and what do company directors need to be aware of?

With the second lockdown about to start, and its ensuing effects on business, it is at least a little comforting to know that a number (but not all) of the Covid-related restrictions set out in the Corporate Insolvency and Governance Act 2020 (“CIGA 2020”) on creditors using statutory demands and winding up petitions remain in place.

The current approach to insolvency

The Covid-related restrictions in CIGA 2020 mean that:

  • Statutory demands served between 1st March 2020 and 31st December 2020 cannot be used to support a winding up petition (unless the petition was presented before 28th April 2020); and
  • Any winding up petition presented between 27th April 2020 and 31st December 2020 will first require the creditor to set out reasonable grounds for believing the company was insolvent even if Coronavirus had not had a financial effect on it (the “Covid Criteria”). Furthermore, the Court will need to be satisfied of the Covid Criteria before making a winding up order.

This is a sensible and pragmatic move to seek to prevent floods of petitions, particularly because restrictions on landlords forfeiting leases for non-payment of rent have also been extended.

However, that does not mean that company directors can be complacent by thinking that CIGA 2020 gives them a blanket protection against insolvency risks.

What company directors need to be aware of

Not all the restrictions have been continued. Here’s what directors need to know:

  • The so called ‘suspension’ of liability for wrongful trading has not been extended. Therefore, under section 214 of the Insolvency Act 1986 directors could find that they are liable for a worsening in the company’s financial position for periods after 1st October 2020; and
  • Unless the date is put back for a second time, for insolvencies that commence on or after 1st December 2020, HMRC regain some of the preferential status that tax debts enjoyed prior to 15th September 2003 (known as “Crown Preference”). This will apply to amounts owed for VAT and also for sums which the company has deducted from employees (but not paid to HMRC) for PAYE income tax, national insurance contributions, student loan deductions and sums under the construction industry scheme (the “Relevant Debts”).

These changes suggest Government policy is moving from protecting all companies from the effects of Covid irrespective of their viability, to protecting those which have a viable future.

How does Crown Preference apply to insolvency procedure?

Crown Preference is perhaps not an obvious issue, but here is why:

In the event of insolvency a company’s assets are distributed in a certain priority, known as the “waterfall”; so money “flows” to each step on the waterfall until it runs out.

The first step on the waterfall is payments to holders of fixed security; then to the costs and expenses of the insolvency procedure; then to preferential creditors. Currently this will be for certain claims made by employees and it is at this point that Crown Preference will apply behind those existing employee preferential claims.

After this, the next step on the waterfall is holders of floating security; then unsecured creditors (where debts to HMRC currently rank); and then, if interest is paid to creditors, any balance will flow to the company’s shareholders.

The holders of floating charge security are often banks and other lenders and they currently enjoy priority over tax debts. With the reintroduction of Crown Preference, the Relevant Debts will have priority over what the lender would otherwise recover under its floating charge, which creates a greater risk for the lender. This might mean that lenders are reluctant to lend, or lend less, for fear that any unpaid Relevant Debts of the company will erode the value of their security.

It can be common for directors to give personal guarantees to lenders who also hold floating charge security. In that situation, any reduction in the sum paid to the lender because of Relevant Debts will increase the amount claimed by the lender under the personal guarantee from the director. To put it another way, directors who cause a company to run up unpaid Relevant Debts will, in effect, be paying for those debts through their personal guarantee to any lender with floating charge security.

Beware! This is a very subtle way to police irresponsible action by directors that would otherwise leave HMRC out of pocket and another reason for directors to fully consider the decisions they take when their company is in financial difficulty.

Concerned that one of your suppliers may be at risk of insolvency? Read our article here for the signs to look out for.