If your company intends to become a party to a debt agreement, either as a borrower or creditor, you should know the order of repayment. This is also called the \u201cwaterfall\u201d. This article will explain the lawful order of priority under insolvency law and provide an overview of some key concepts and their commercial implications. <\/p>\n\n\n\n
When Party A owes Parties B, C, and D money, the law says Party A owes the others a debt obligation. Ideally, Party A repays each creditor according to the terms of their debt agreement, and neither party gives the agreement much thought. However, problems arise when a borrower runs into financial difficulties and cannot honour the debt obligation<\/a>. Furthermore, if a company does not have enough money to repay one creditor, it will not have enough money to repay all the creditors together. <\/p>\n\n\n\n When a company cannot pay its debts (i.e. insolvent) and cannot agree with its creditors on how to restructure the debt, the outcome is liquidation<\/a>. Liquidation is where a court-appointed professional sells off the company\u2019s assets to repay the creditors according to the order of priority. <\/p>\n\n\n\n Insolvency law addresses what happens when there is not enough money to repay each creditor. Specifically, it deals with insolvent liquidation.<\/p>\n\n\n\n One of the most fundamental areas of insolvency law is the order that the law entitles creditors to receive payment in the event of insolvency. This list is known as the order of priority. Overall, the law recognises different classes of creditors depending on the type of interest they have in the company\u2019s property. <\/p>\n\n\n\n In summary, the order of repayment in insolvency is:<\/p>\n \n A secured creditor is a creditor that has a security interest in the debtor company\u2019s property. There are various types of secured creditors, and each type depends on the security interest they have in the company\u2019s property. <\/p>\n\n\n\n For example, secured creditors with fixed charges (fixed charge holders) or mortgages (mortgagees) over the company\u2019s property have the strongest security interest. Accordingly, they have the right to take possession of certain property as set out under the terms of the loan agreement. These rights arise under specified conditions, such as an event of default. The most common secured creditor is a bank that has loaned a company a business loan. Thus, most loan agreements grant the bank a fixed charge over all the company\u2019s property.<\/p>\n\n\n\n The company\u2019s liquidator\/administrator and financial and legal advisors will receive priority before every other creditor other than the secured creditors. <\/p>\n\n\n\n The law protects preferential debts. Some common examples are:<\/p>\n\n\n\n Floating charges provide secured creditors with less protection than fixed charges or mortgages. <\/p>\n\n\n\n However, before paying floating charge holders, a portion of the company\u2019s remaining assets are ring-fenced out of this total amount and held on reserve for the unsecured creditors.\u00a0<\/p>\n\n\n\n Unsecured creditors will receive any remaining amount left over, up to the total value of their debt. Generally, this will often be a very small amount.<\/p>\n\n\n\n Pari Passu <\/em>is the principle that unsecured creditors should be treated equally and receive a portion of the company\u2019s remaining assets corresponding to the value of their debt relative to the other unsecured creditors.<\/p>\n<\/div>\n\n\n\n Common unsecured creditors are trade creditors such as suppliers and customers. <\/p>\n\n\n\n Shareholders receive a portion of the remaining assets. However, this will often be a very small sum of money. <\/p>\n\n\n\n For example, suppose you are a trade supplier to BadCo Ltd, which has recently entered insolvent liquidation.\u00a0BadCo Ltd has no secured debt, and the total value of its assets is \u00a3100 000.\u00a0BadCo\u2019s creditors and the amounts it owes them consist of:<\/p>\n\n\n\n The calculations showing how BadCo\u2019s assets are to be paid out are:<\/p>\n\n\n\n The principle of pari passu <\/em>means that the unsecured creditors will be paid \u00a30.40 per \u00a31 owed (\u00a340,000\/\u00a3100,000). Therefore, if BadCo owes you \u00a310,000 for the cost of goods you supplied it, this means you will receive \u00a34,000 as an unsecured creditor.<\/p>\n\n\n\n Strictly speaking, the order of priority only has a legal effect when a company is in liquidation. In practice, many insolvency proceedings do not reach this final stage because it is not to any party\u2019s advantage. Only secured creditors are guaranteed any sum of money. Even so, depending on the company\u2019s asset value, the amount of money for distribution may be minimal. Instead, the various creditors usually strike a deal amongst themselves and the company, sometimes using the court for help. <\/p>\n\n\n\n Nevertheless, the order of priority exists as the worst-case scenario if the parties cannot agree. For this reason, appreciating your order as a creditor (or the order of your fellow creditors) will help you determine your negotiating position and leverage. For instance, as a trade creditor, you may require your customer to agree to a retention of title clause to avoid being a mere unsecured creditor. <\/p>\n\n\n\n\n\n Continue reading this article below the form\n <\/i>\n<\/a>\nThe Order of Priority<\/h3>\n\n\n\n
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Secured Creditors <\/h3>\n\n\n\n
Wind Up Costs <\/h3>\n\n\n\n
Preferential Creditors <\/h3>\n\n\n\n
Floating Charge Holders<\/h3>\n\n\n\n
Unsecured Creditors and Pari Passu <\/em><\/h3>\n\n\n\n
Shareholders <\/h3>\n\n\n\n
Case Study <\/h3>\n\n\n\n
HMRC<\/td> \u00a340,000<\/td><\/tr> Liqudiation costs <\/td> \u00a310,000<\/td><\/tr> Preferential creditors<\/td> \u00a320,000<\/td><\/tr> Business creditors <\/td> \u00a3100,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n\n\n\n\n\n\n\n\n Amount available to the liquidator<\/td> \u00a3100,000<\/td><\/tr> Less cost of the liquidation (paid in full)<\/td> (\u00a310,000)<\/td><\/tr> Less preferential creditors including HMRC (paid in full) <\/td> (\u00a360,000)<\/td><\/tr> Amount remaining for unsecured creditors<\/td> \u00a340,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n\n\n\n\n Commercial Considerations<\/h2>\n\n\n\n