Certain provisions of the Enterprise Act 2002 (the act) came into force on 15 September 2003. As its name suggests, the act attempts to foster a spirit of enterprise by seeking to boost productivity and promote prosperity for all.
The reforms are designed to make the existing insolvency regime more supportive of enterprise by promoting competition and creating open, dynamic markets that will deliver a better deal for consumers.
On receiving Royal Assent, Trade and Industry Secretary Patricia Hewitt said: “The Enterprise Act is good news for business, consumers and the economy. It will open up markets, increasing competitive pressures. It will improve consumer protection. It will give those entrepreneurs who have failed honestly a second chance and help ensure that companies in difficulty do not go under unnecessarily. Together, these measures will help promote an enterprise culture and drive up productivity.”
The act introduced many changes to the previous insolvency legislation, and this article will touch on a small but significant and novel part of the amendments: the abolition of ‘Crown preference’ and ‘top slicing’.
Before the act came into force, liquidators were bound by statute to give preferential status to debts due to the Inland Revenue and HM Customs & Excise before any payment was made to floating charge-holders and unsecured creditors. This ‘Crown preference’ was justified on two bases. First, it was argued that the Crown was an involuntary creditor without any choice over whom it engages in business. Second, Crown debts are public debts, and it is in the public interest that they are collected for the benefit of the community as a whole.
The Crown’s preferential treatment often resulted in unsecured creditors receiving very little or nothing in satisfaction of their outstanding debts. This in turn often led to hardship for unsecured commercial creditors and, in extreme cases, resulted in their insolvency.
Safe in the knowledge that they could rely on this preferential treatment, the Crown departments were often slow to take action to recover unpaid VAT or arrears of PAYE. Such delay would give struggling companies false confidence and they would attempt to continue trading out of trouble. This often resulted in rising unsecured trade creditors and a significant increase in Crown debt.
When the company was ultimately wound up, the Crown would take an even larger part of the available pot and the unsecured creditors would be left with even less.
Dissatisfaction with Crown preference
Not surprisingly, there was much dissatisfaction and criticism of the Crown’s preferential status and the historical justifications for
the existence of Crown preference were repeatedly questioned. In 1982, the Cork Report described the ancient prerogative of Crown preference as unsupportable by principle or expediency and considered that it could no longer be justified in view of the calls for fairness and reform. Although the scope of the Crown’s preferential status had been reduced as part of the 1986 Insolvency Act reforms, it was thought that further reductions were needed.
In December 1998, the Government published a white paper entitled ‘Our Competitive Future: Building the Knowledge Driven Economy’.
This heralded the Government’s intention to review arrangements for business rescues and re-evaluate the differing rights of creditors, including possible changes to the Crown’s preferential status.
In September 1999, a joint Department of Trade and Industry (DTI) and Treasury working party was set up, which issued a consultation document entitled ‘A Review of Company Rescue and Business Reconstruction Mechanisms’. The review was principally concerned with whether the UK insolvency regime should remain ‘creditor-friendly’ or whether, like a significant number of other industrialised countries, notably the US, it should adopt a more ‘debtor-friendly’ regime.
In November 2000, the working party published a report recommending, among other things, an improvement in the approach of the Inland Revenue and Customs towards business rescue.
Following consultation, in July 2001, the Government set out its proposals in a white paper entitled ‘Productivity and Enterprise, Insolvency – A Second Chance’. It recognised the trend in other jurisdictions, such as Australia and Germany, towards restricting or abolishing Crown or state preference and led to the introduction of the Enterprise Bill in March 2002. The bill received Royal Assent in November 2002, and the act was born.
Abolition of Crown preference
The act abolishes Crown preference in all types of insolvency procedures with retrospective effect, in the sense that there will be no Crown preference in any corporate insolvencies commenced after 15 September 2003. With its preferential status removed, the Crown departments are now forced to wait in line with the other unsecured creditors for any distributions. In this way, the removal of Crown preference has the potential effect of putting previously unsecured creditors in a far more secure position.
The abolition of Crown preference, however, has not removed the category of preferential creditors in its entirety, but has reduced the number of categories. Employees are still the principal category of remaining creditors and are entitled to be treated as preferential creditors for unpaid wages and occupational pensions scheme contributions.
In addition to the abolition of Crown preference, a specified proportion of the proceeds of sale of assets subject to floating charges, created after 15 September 2003, will have to be set aside for the benefit of the unsecured creditors. This has been called ‘top slicing’, and the amount to be set aside will be called ‘the prescribed part’. The prescribed part is calculated as part of a company’s net property. Net property is the part of the company’s property that remains after taking account of liabilities owing to fixed charge-holders, preferential creditors and the cost of realising the company’s property. The prescribed part is calculated at 50 per cent of the first £10,000 of the net property and 20 per cent of any net property in excess of this amount, subject to a cap of £600,000.
The introduction of top slicing will not affect holders of floating charges created before 15 September 2003. This means that these floating charge-holders will be in an improved position, as they will have the benefit of the abolition of Crown preference without giving up part of the proceeds to unsecured creditors under top slicing.
A recent survey of insolvency practitioners would suggest that the majority believe the act will fail in its aims to create a more dynamic entrepreneurial culture or lead to more companies being saved. One of the main concerns stems from the fact that the act fails to tackle key issues of company rescue, such as the funding of businesses and the loss of director management control during a rescue process. Although the abolition of Crown preference appears to have been universally welcomed, there are real concerns that the Crown is now likely to be far more proactive in collecting its debts, which in turn could lead to more corporate insolvency.
The Institute of Chartered Accountants in England & Wales (ICAWE) supports the abolition of Crown preference and the concept of top slicing but points out that in some cases the ringfencing of the funds generated will result in complex calculations and procedures. It warns that “unless a significant return to unsecured creditors is likely, there is a strong danger of a disproportionate amount of the proceeds being absorbed by costs”. The ICAWE, like the British Bankers’ Association, has also warned that a further unintentional effect of Crown preference removal is that the Crown departments could well be motivated to enforce methods of recovering their debt at an earlier stage than they have been accustomed to in the past.
This, in turn, could have the effect of causing more insolvencies.
The Association of Business Recovery Professionals (R3) has supported enthusiastically the removal of Crown preference. It makes the point that, although the change will cost the taxpayer money, this will not be much, and in return unsecured creditors should receive higher returns and the Crown departments should take a more positive attitude to business rescues.
The Federation of Small Businesses also welcomed the abolition of the Crown’s preferential right to recover unpaid taxes ahead of unsecured small businesses. Although it accepted that this move might well cost the treasury £90m, it said it saw the small firm sector benefiting by the same amount, thereby giving small businesses a greater chance of surviving and prospering.
The ramifications of abolishing Crown preference have yet to be seen in practice. However, with its removal, it is likely that the Crown departments will become more proactive in taking steps to recover unpaid arrears at a far earlier stage.
Partner Philip May and assistant solicitor Robert Foote are members of TLT Solicitors’ insolvency and turnaround team