Crown Preference 2.0: Steps to safeguard lender recoveries

From 1 December 2020 new changes to the priority rules in insolvency will have a real impact on the recoveries achieved by secured creditors on the insolvency of a debtor. These new rules give HMRC priority above floating charge holders and ordinary unsecured creditors in relation to tax collected by an insolvent company from third parties, such as VAT, PAYE income tax and NICs.

Both of these proposals will potentially eat into the proceeds recovered by an administrator or liquidator from a sale of a company’s assets which would otherwise be distributed to the company's secured lender.

In particular, the second of these reforms has the potential to have a significant impact, as HMRC is often one of the biggest, if not the biggest, creditor of an insolvent company. The proposal will partially reverse the 2003 abolition of the Crown preference under the Enterprise Act 2002, which relegated claims by HMRC from a preferential position to rank alongside ordinary unsecured creditors. It is expected to amount to approximately £185m in unpaid tax per year, the majority of which would have otherwise been paid to secured creditors.

In this note we examine how HMRC will be given priority and discuss ways in which lenders can take steps to protect themselves against a possible erosion of their recoveries from insolvent companies in the future.

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What is changing?

Currently, employees and the Financial Services Compensation Scheme (FSCS) are the only preferential creditors in an insolvency.

However, in insolvencies that commence on or after 1 December 2020 HMRC will join the FSCS as a secondary preferential creditor in relation to outstanding taxes paid by employees and customers that are, in effect, collected and held by a business on HMRC behalf. These taxes are PAYE, VAT, employee NICs and Construction Industry Scheme (CIS) deductions. Note, however, that HMRC will remain an unsecured creditor for other amounts owed directly by a company, i.e. corporation tax and any other taxes.

Crucially, the legislation does not include a cap the on the age of tax debts that can have preferential status. Therefore, any unpaid liabilities (regardless of when they were incurred) at the time of any insolvency proceedings which start on or after 1 December will have priority.

Priorities

Protective steps

What can lenders to protect themselves against the effect of these reforms? Lenders should consider ways in which they may:

encourage borrowers to ensure they are paying their tax liabilities as they fall due; and
maximise fixed charge recoveries by ensuring that as many as possible of a borrower's assets are characterised as fixed charge assets.

Encourage borrowers to pay tax when due

Lenders may consider including additional representations, warranties and undertakings about obligors' payment of taxes in their loan documentation. In addition to the current standard LMA provisions, lenders could require borrowers to warrant on an ongoing basis that its tax liabilities have been paid when due, and to undertake to provide them with any demands received from HMRC. Cure periods could be shortened (or removed) in relation to breaches of these types of covenants.

Fixed charge assets

Security documentation

Lenders should ensure that, as much as possible, an obligor’s assets fall within the scope of the fixed charge granted in favour of the lender, rather than the floating charge. The standard approach is generally to take (or at least purport to take) a fixed charge over as many of a borrower's assets as possible. A standard form debenture will generally include a shopping list of generic types of assets that a company can be expected to have, which are subject to the fixed charge. However, this list is not exhaustive, and lenders should consider on a case by case basis the business and assets of the borrower and whether this list can be supplemented with other types of assets. This will of course be a matter for negotiation with the borrower, because the security document will prevent the borrower from disposing of fixed charge assets without the lender's consent.

Perfection and control

The drafting of the fixed charge clause of a security document is only part of the picture. In order for a fixed charge to be effective, the lender must also ensure that the fixed charge is "perfected" and exercise the requisite level of control over the assets that are intended to be subject to the fixed charge. If the security is not perfected and control is not actually exercised, the fixed charge is likely to be characterised as a floating charge (and the proceeds from the sale of the relevant assets will be subject to erosion by the Crown preference).

Requirements for perfection and control depend on the nature of the assets. In order to ensure their charge is characterised as a fixed charge, lenders should:

ensure the security is registered at the relevant registry and all notices of assignment are sent to third parties;
enforce their right to consent to the disposal of the relevant assets. If, despite the restriction on disposals in the security document, a lender in fact allows fixed charge assets to be disposed of in the ordinary course of the borrower's business, then the control requirement will not be met;
in the case of bank accounts held with the lender, ensuring the account is in fact operated as a blocked account and avoiding blanket consents to withdrawals; and
in the case of book debts and other receivables, ensuring that the proceeds are paid into a blocked/charged account.

Please get in touch if you would like further information or advice.