The Return of Crown Preference and its effect on Floating Charge Holders and Unsecured Creditors

By Paul Nathan and Abtin Yeganeh

Many businesses are struggling as a result of the Covid-19 pandemic and subsequent Government restrictions. The news that HMRC will be restored as a Preferential Creditor from 1 December 2020 will therefore be a cause for concern.

Prior to the Enterprise Act 2002, HMRC had preferential status in insolvencies. When it came to unpaid taxes, HMRC would rank ahead of floating charge holders and (ordinary) Unsecured Creditors. This was known as 'Crown Preference.' The Enterprise Act 2002 removed Crown Preference, and as a result, since that act, creditors ranked as follows:

  1. Secured Creditors - their security is unaffected by the insolvency unless they relinquish their security and choose to vote in the insolvency. If they are only part secured, then they can vote in respect of the balance of the debt due to them.
  2. Insolvency costs
  3. Firstly, The costs of any Petitioning Creditor in a Winding Up
  4. Secondly, the Office Holders costs subject to Creditor's approval
  5. Preferential Creditors (primarily limited to certain employee claims)
  6. Prescribed part - The Prescribed Part is that part of the property of a company that a liquidator, administrator, or receiver must reserve for unsecured creditors, under section 176A of the Insolvency Act 1986, and which would otherwise be available to satisfy claims secured by a floating charge. Where the first ranking floating charge was created on or after 6 April 2020 The Prescribed part is calculated as a percentage of the value of the company's property which is subject to a floating charge; namely, 50% of the first £10,000 of net floating charge realisations plus 20% of anything thereafter, up to a maximum of £800,000 (£600,000 if the floating charge was created before 1 April 2020 ). Lenders with floating charges should note that the increased sum of £800,000 will not apply to floating charges created before 6 April 2020 (a 'grandfathered floating charge') provided no floating charge is created after 6 April 2020, which ranks equally with or in priority to the grandfathered floating charge.
  7. Floating Charge Holders
  8. Unsecured Creditors (including any part of HMRC's claim not covered by the prescribed Part)
  9. Shareholders

Crown Preference will be restored following the Finance Act 2020, which received Royal Assent on 22 July 2020. Under the new rules, which take effect from 1 December 2020, Crown Preference will be restored in respect of insolvencies commencing[1] on or after 1 December 2020.

For insolvencies commencing on or after 1 December 2020, a new 'secondary preferential status' is created in respect of any money owed to HMRC relating to certain types of tax which a company has collected on behalf of others. The relevant types are currently VAT, PAYE, employee national insurance contributions, construction industry scheme deductions, and student loan repayments. Others can be added by regulation. HMRC's claim for these taxes will rank in priority to floating charge holders and unsecured creditors but not to ordinary preferential creditors, which include employees in respect of accrued unpaid wages (up to a cap) and holiday pay. Other tax debts which a company owes to HMRC on its own account, such as corporation tax, will still rank as ordinary unsecured claims.

The application of the legislation depends on the date on which the insolvency proceeding commences. The date that the tax debts were accrued, and the date of the floating charge are not taken into account in determining secondary preference. Therefore, it does not matter whether the floating charge predates the tax debt or vice versa.

There is provision for regulations to be made limiting the amounts afforded preferential status to those referable to a particular period, but no such regulations have yet been made. This means that existing tax debts going back a number of years will be elevated to preferential status, regardless of whether there is a floating charge which pre-dates the debts and/or was entered into before the legislative changes took effect or were even announced. The potential floating charge realisations from existing lending may therefore be affected, as will realisations available for unsecured creditors.

The new order of preference in insolvencies commenced on or after 1 December 2020 is: -

  1. Secured Creditors
  2. Insolvency costs
    1. Firstly, The costs of any Petitioning Creditor in a Winding Up
    2. Secondly, the Office Holders costs subject to Creditor's approval
  3. Preferential Creditors
    1. Ordinary Preferential Creditors (primarily limited to certain employee claims), then
    2. Secondary Preferential Creditors
  4. Prescribed Part (HMRC will no longer share in the Prescribed Part in respect of those debts that rank for Secondary Preference)
  5. Floating Charge Holders
  6. Unsecured Creditors (including HMRC for non-Secondary Preference debts)
  7. Shareholders

COMMENT

The introduction of Crown Preference will undoubtedly impact recoveries for Unsecured Creditors, and it will also impact Secured Creditors with floating charges. It will also be more difficult for companies to achieve acceptance of CVA proposals as HMRC will once again have the power to veto such proposals unless their debt is paid, or they are placed in a preferential position. As a result, many businesses may now find insolvency is inevitable.

In a time where companies need lending to stay afloat, the ability to secure lending after 1 December 2020 will be impacted. This has raised question marks as to why the re-introduction of Crown Preference has not been deferred. Whilst the re-introduction of Crown Preference is likely to raise over £185 million of otherwise unrecovered tax for the public purse, the imposition contradicts those actions taken by the Government to help businesses such as the furlough scheme and grants.

When companies are in financial distress, it is not unusual for them to stretch payment terms with creditors or simply ignore the obligation to make payment. Since the abolition of Crown Preference, HMRC has often been one of the first creditors to suffer (whether informally through missed payments or formally through agreed 'time to pay' arrangements). The stretching of certain HMRC arrears will result in a dilution of lenders' security once the legislation is implemented.

Given that lenders will be at higher risk, they will no doubt be less willing to lend to companies. In situations where they are willing to lend, the security and costs will be increased. Companies may also be less inclined to borrow where the directors are required to give personal guarantees.

What can lenders do?

Providing HMRC with priority ahead of floating charge holders will require all lenders to reconsider and amend their lending procedures and structures to ensure that as many assets as possible are subject to a fixed charge or a trust arrangement, thereby elevating the lender above HMRC in the statutory order of priority.

Where a significant amount of lender assets consist of stock or other types of assets usually only subject to a floating charge, the lender could consider asking the borrower to create a subsidiary company that collects no VAT and has no employees to hold those floating charge assets. Advice should be taken from accountants and tax lawyers in this regard. We do not provide such advice

Lenders should also exercise control over assets purportedly subject to a fixed charge to mitigate the risk of such security being re-characterized as floating security and therefore diluted by the Crown Preference. In the past, lenders have taken a Fixed and Floating charge over land. In the future, land should be subject to a Fixed Charge only

Lenders should consider on-going diligence to ensure their borrowers are complying with their tax obligations. To do this, they should consider adding requirements/obligations to their standard facility terms. For example:

  1. a warranty that at the time of the loan, the borrower's tax is paid up to date;
    1. an obligation to regularly report the paid/unpaid tax position;
  2. to comply with monitoring information requests.

Lenders could consider holding back a reserve for tax and/or making it compulsory for borrowers to hold tax reserves if, for example, the borrower's business has an irregular tax profile. This will be a 'hot potato' in present circumstances, given the combination of widespread financial distress together with significant tax arrears, which are likely to have built up as a result of the various payment deferrals granted by the Government.

Lenders should seek Personal Guarantees from the Directors, ensuring that these are not 'bare' guarantees. The guarantees should contain restrictions upon the directors charging or otherwise dealing with assets that would need to be realised to meet the guarantee.

Lenders should seek Collateral Guarantees from other group members if the borrower is part of a group.

Upon learning of any financial distress affecting a borrower, lenders should consider whether they can take measures to improve their position. These might include:

  • perfecting, supplementing or taking/retaking fixed charge security[2]; and/or
  • exploring whether existing working capital facilities consisting of overdrafts, cashflow loans, or revolving credit facilities, which are wholly or partially secured by floating charge security, can be refinanced through the provision of invoice discounting facilities which shift floating charge assets from being charged in favour of the lender to being owned by the lender.

Any changes to a lender's practices need to be considered carefully in terms of the potential inconvenience and cost to both the lender and their borrowers in implementing these structures and any associated risk that a lender will be perceived as uncompetitive in the market.

In making an assessment, lenders will need to calculate the worst-case scenario position in respect of losing assets/value to HMRC upon insolvency. They should calculate this based on the maximum amount of unpaid VAT, PAYE, and NICs, a company, might liable for at any given time in its cash flow cycle. For a company that collects significant amounts of VAT but seeks to account to HMRC as infrequently as possible, the liability could be a significant sum. Likewise, a company with a large number of employees could also have very material peaks in its PAYE collection liability.

Lastly, lenders might consider how the re-introduction of Crown Preference and the recent increase of the prescribed part to GBP800,000 should affect the pricing (arrangement fees and interest rates) of their facilities, based on their increased risk exposure.

Stop Press!!

We have seen the news regarding the failure of the Arcadia Group. Why did Phillip Green refuse Mike Ashley's offer of a £50,000,000 loan, given that the immediate amount required was £30,000,000? To the man on the street, the refusal of the offer makes little sense, and it could be said to show a lack of regard for the employees of the group, many of whom will lose their jobs. We speculate that the refusal of the offer and the placing of the group into Administration on 30 November 2020 may have been a decision to avoid Crown Preference from biting had the Administration been affected on or after 1 December 2020.

Also, notably, the Government has once again suspended the Wrongful Trading provisions under Section 214 of the Insolvency Act 1986. This is likely to mean that in the event that the Administrators/Liquidators find evidence of this in respect of the running of the businesses in the group, Philip Green and any other directors will not face any liability for Wrongful Trading. For the avoidance of doubt, we do not offer an opinion as to whether there has been Wrongful Trading.

 

[1] The date of commencement of a Bankruptcy or Winding Up is the date of presentation of the Petition and not the later date of the Bankruptcy Order or Winding Up Order.

[2] it is not sufficient to simply serve a Notice of Crystallisation of a Floating Charge as such notice will post date the renewal of Crown Preference and does not backdate the Floating Charge into a Fixed Charge. The danger with relinquishing the floating charge and taking a new fixed charge is that the new fixed charge will sit behind any earlier Fixed charge.

 

The authors of this article are Paul Nathan (Partner) and Abtin Yeganeh (Associate), who are part of the commercial dispute resolution and insolvency teams at Fletcher Day. If your company is currently facing uncertainly or you require more information about the contents of this article, please feel free to send us an enquiry to find out how we can assist.

1 December, 2020
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