Understanding the Difference Between Preferential and Non-Preferential Creditors

When a company enters liquidation or another form of insolvency, its creditors are paid based on a strict hierarchy. At the top of this list are preferential creditors, while non-preferential creditors rank lower. Understanding the difference between the two can help businesses and creditors alike navigate the complex process of insolvency.

This article will explain the key distinctions between preferential and non-preferential creditors, outlining what each category entails, the priority in which they are paid, and how it impacts the liquidation process.

Who are Preferential Creditors?

Preferential creditors are those who are given priority when a company’s assets are distributed during insolvency. Their claims are addressed before those of non-preferential creditors, ensuring they are more likely to recover a portion of what they are owed.

Examples of preferential creditors include:

• Employees: Staff members with unpaid wages, holiday pay, or redundancy entitlements are considered preferential creditors. There is a limit on the amount that qualifies as preferential, but employees have a higher chance of being repaid before other creditors.
• Contributions to Pension Schemes: Unpaid contributions to an employee pension scheme also fall under preferential claims.
• Some Taxes: In recent years, HM Revenue and Customs (HMRC) has regained its preferential status for certain unpaid taxes, including VAT, PAYE, and National Insurance contributions (NICs).

In an insolvency situation, these creditors are given priority in receiving payments from the sale of the company’s assets before the claims of other, lower-ranking creditors.

Who are Non-Preferential Creditors?

Non-preferential creditors, also known as unsecured creditors, are those who do not have priority in the repayment order. These creditors are often left with a smaller recovery or, in some cases, nothing at all, as their claims are dealt with only after the preferential creditors have been paid.

Examples of non-preferential creditors include:

• Trade Creditors: Suppliers or vendors who have provided goods or services to the company but are yet to be paid.
• Unsecured Loans: Creditors who have lent money to the business without securing it against company assets.
• Customers with Deposits or Payments: If a customer has paid for goods or services that have not been delivered, they may be considered a non-preferential creditor.

Non-preferential creditors are paid only after preferential creditors and, in some cases, secured creditors (those with security over company assets) have received their share.

How Are Creditors Paid in Liquidation?

When a company enters liquidation, its assets are sold off, and the proceeds are distributed according to a strict order of priority:

1. Secured Creditors: These creditors hold a fixed or floating charge over company assets, giving them the right to be repaid first. Secured creditors are not preferential, but they are often paid before other creditors due to the nature of their secured claims.
2. Insolvency Practitioner Fees: Before any creditors are paid, the fees and expenses of the Insolvency Practitioner overseeing the process must be settled.
3. Preferential Creditors: After secured creditors and practitioner fees are paid, the remaining funds are used to pay preferential creditors, such as employees (first preferential) and HMRC (second preferential).
4. Non-Preferential Creditors: Once preferential creditors have been paid, any remaining funds are distributed among non-preferential creditors. Unfortunately, non-preferential creditors often receive only a small fraction of what they are owed, if anything at all.
5. Shareholders: If there are any funds left after paying all creditors, shareholders may receive a distribution. However, this is rare in most insolvency cases.

Key Differences Between Preferential and Non-Preferential Creditors

• Priority of Payment:
Preferential creditors are paid before non-preferential creditors during the insolvency process. This gives them a higher likelihood of recovering some or all of their debts.
• Types of Claims:
Preferential creditors typically include employees (for unpaid wages and pensions) and HMRC (for specific unpaid taxes), while non-preferential creditors include trade suppliers, unsecured lenders, and customers.
• Likelihood of Repayment:
Because preferential creditors are higher on the repayment hierarchy, they are more likely to receive payment. Non-preferential creditors, by contrast, often face much lower recovery rates, especially in cases where the insolvent company’s assets are limited.

The Impact of the Preferential Creditor Status

The reintroduction of HMRC as a preferential creditor in 2020 under the Finance Act has had a significant impact on other creditors. Previously, HMRC was treated as an unsecured, non-preferential creditor for most tax debts. This change means that trade creditors, suppliers, and others further down the payment chain may receive even less than they would have in the past, as HMRC takes priority in the repayment order.

For business owners and directors, understanding how creditors are ranked can provide valuable insight into the likely outcomes of insolvency. Knowing whether a debt is preferential or non-preferential can help creditors manage their expectations and make more informed decisions about working with companies facing financial difficulties.

Conclusion

Preferential and non-preferential creditors differ primarily in the order of repayment during an insolvency process. Preferential creditors, such as employees and HMRC, are paid before non-preferential creditors, like suppliers and unsecured lenders. This distinction greatly affects how much, if any, of the owed amount each creditor can recover.

If you're concerned about the status of your business or debts, seeking advice from an Insolvency Practitioner such as Molly Monks of Parker Walsh can help clarify your position and provide guidance on the next steps to take.

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