Preferential Creditors: a Worked Example

An insolvency pays people in an order set by statute. Creditors with no security share what is left at the bottom. A short list is lifted above them. The secured lender's interest lies in a further step: the same list also outranks security over assets that turn over in trade. A mortgage over a factory is not affected in the same way. A general security agreement over stock and debtors is.

In New Zealand, Schedule 7 of the Companies Act 1993 sets it: after the liquidator's costs come employees' wages for the four months before liquidation with holiday and redundancy pay, up to a maximum per person, then Inland Revenue's preferential claims, including GST and PAYE. Those claims reach accounts receivable and inventory ahead of a general security interest, though not ahead of a purchase money security interest or a factor registered in time.

In Australia, section 556 of the Corporations Act 2001 ranks employee wages and superannuation, leave and retrenchment pay, and section 561 puts those claims ahead of a circulating security interest where the free assets fall short. The tax office lost its general priority in 1993 and mostly ranks as an unsecured creditor. In the United Kingdom, employees' capped arrears are ordinary preferential debts. Since 1 December 2020, VAT and tax deducted from pay, including PAYE and employee National Insurance, have been secondary preferential debts, ranking after employees and ahead of the floating charge. Corporation tax and employer contributions are not on that list.

Each line moves against the lender as a business declines. Realised value is usually well below book, because stock sold in a closure fetches less and customers dispute invoices once supply stops. Costs are paid first. The claims line is the one a balance sheet shows least well. Accrued holiday pay may be there; redundancy usually is not, because it arises only when staff are let go. Tax arrears appear as a creditor, but rarely with the detail a lender needs, and they tend to build in the months before failure, when a company stretches whichever creditor is slowest to act.

What counts as a working asset depends on the market's wording. New Zealand uses the personal property definitions of accounts receivable and inventory, and in [2013] NZCA 357 the Court of Appeal treated money in a bank account as an account receivable. Australia speaks of circulating assets. The United Kingdom asks what a floating charge covers.

A maker of commercial catering ovens in New Zealand, constructed for this page like every figure in it, owes its bank US$6.0m under a general security agreement and a mortgage over its factory. Its last management accounts show receivables of US$2.4m and stock of US$1.6m. The bank's security schedule carried them at a lending value of 60%, or US$2.4m. That percentage belongs to the example and is not offered as a market norm. A large customer fails, the bank appoints a receiver, and every employee claim falls within the statutory maximum.

The bank's lending value of US$2.4m turned out to be a fair estimate of what the assets would fetch. It was wrong about who would be paid. Priority claims of US$1.6m took two-thirds of the proceeds, and the bank received about a fifth of what its schedule showed. The factory sells for a net US$3.2m, so the bank recovers US$3.7m of US$6.0m and claims the US$2.3m shortfall as an unsecured creditor.

On the same figures in Australia, the tax line would not rank on these assets and the bank would take US$1.2m from them. In the United Kingdom the tax line would stay, assuming the receivables were caught by a floating charge, but the employee line would be smaller, since capped wage arrears and holiday pay rank and statutory redundancy pay generally does not. A further slice of what remained would be set aside for unsecured creditors as the prescribed part.

The two names sound alike and do opposite jobs. A preferential creditor is ranked highly by statute on the day of insolvency. A voidable preference is a payment made to one creditor shortly before insolvency that left it better off than the others, which a liquidator may recover. One is a place in the queue, and the other is a payment taken back for jumping it.

Nor is a preferential creditor a secured creditor. It holds no interest in any asset. Its priority is a rule about the order of payment, and on a mortgaged factory it generally gives way. A supplier relying on retention of title is different again: if the clause holds, which in New Zealand and Australia depends on registering it as a security interest, the goods come out of the pool or rank first on it, before any of these sums begins.

DEFINED IN ONE PARAGRAPH → · TAX ARREARS, READ BY A LENDER → · WHAT YOUR BANK HOLDS AS SECURITY →

A desk puts a figure on what a borrower's staff and tax arrears would take from its security, and carries that figure into the credit paper. For a wage-heavy business with little property, the claim on working assets can be most of what those assets would fetch. An asset-based lender often turns this into a reserve against the borrowing base. A cash-flow lender more often asks for evidence: tax statements, payroll summaries, and any payment arrangement agreed with the revenue authority.

The sum also changes the reading of a deteriorating file. Arrears to the tax authority do two things at once: they signal stress and they move a creditor above the bank on the assets it thought were its own. Paying down the bank from receivables while tax accrues can leave the lender no better placed than the balance reduction suggests. A lender watching a weakening borrower therefore wants the tax position in the monitoring pack, and reruns the recovery waterfall when it changes.

THE RECOVERY WATERFALL → · THE FLOATING CHARGE → · PROBLEM LOANS AND WORKOUT →