Preferences and Undue Preferences in Insolvent Companies

In the context of company insolvency in England and Wales, preferences and undue preferences are important legal concepts under insolvency law that enable appointed insolvency practitioners - such as liquidators and administrators - to challenge and unwind certain transactions entered into before insolvency. These provisions are designed to ensure that creditors are treated fairly and that no creditor is put in a better position than others shortly before a company's insolvency. They are found primarily in Sections 239–240 of the Insolvency Act 1986, which allow the court to set aside or reverse preferential transactions made within specified time limits and in defined circumstances.

This article explains what preferences and undue preferences are, how they are identified and challenged, time limits that apply, legal tests and defences, the role of connected persons, and practical examples to illustrate the principles.

What Is a Preference?

A preference is a type of antecedent transaction that may be challenged in insolvency. Under Section 239(4) of the Insolvency Act 1986, a company gives a preference to a person if:

1. That person is a creditor of the company, or a surety/guarantor for any of the company's debts; and
2. The company does anything, or allows anything to be done, which has the effect of placing that person in a better position in the event of the company's insolvent liquidation than they would otherwise have been.

In essence, a preference improves one creditor's position relative to others before insolvency. Common examples include paying one supplier in full while other creditors are left unpaid, or repaying a director's loan ahead of general creditor claims.

Relevant Time and Connected Persons

For a preference to be actionable, it must fall within a statutory “relevant time” before the onset of insolvency:

• Six months prior to the formal insolvency event for ordinary (unconnected) creditors;
• Two years for connected persons, such as directors, their relatives or companies under common control.

The extended period for connected persons reflects the higher risk that transactions involving related parties may be intended to advantage those parties before insolvency.

A connected person is defined in the Insolvency Act 1986 and generally includes directors, shadow directors, associated companies, relatives of directors, and certain other close associates. For connected persons, the law presumes insolvency and a desire to prefer, unless the contrary is shown.

Legal Test for Undue Preference

To establish that a transaction is an undue preference (voidable under Section 239), the insolvency office‑holder must prove three core elements:

1. Relevant time - the transaction took place within six months (or two years for connected persons) of the formal insolvency process beginning.
2. Insolvency at the time - the company must have been insolvent at the time of the transaction, or become insolvent as a consequence. For connected persons, insolvency is presumed unless evidence shows otherwise.
3. Desire to prefer - the company must have been influenced by a desire to put the creditor in a better position than if the preference had not been given. This requirement is subjective and focuses on the company's state of mind at the time of the transaction.

The “desire to prefer” means that the person deciding the transaction acted with an intention to improve that particular creditor's position. It is not enough that the creditor simply benefited; the transaction must have been influenced by that desire.

Case Example: Re MC Bacon Ltd

In Re MC Bacon Ltd (No 1), the court clarified that a transaction is not necessarily a preference simply because it benefits a creditor; there must be evidence of intention to prefer. In that case, a charge granted to a bank under commercial pressure was not held to be a preference because the company's motive was to continue trading rather than to place the bank in a better position.

Effects of Undue Preferences

If the court finds that a transaction amounts to an undue preference, it has broad powers under Section 239 to make “such order as it thinks fit” to restore the company's position. Typical outcomes include:

• Order to repay amounts received by the creditor;
• Unwinding transactions that put the creditor in a better position;
• Restoring value to the company's insolvency estate for distribution among creditors.

These remedies ensure fair and equal treatment of creditors and prevent the depletion of assets through preferential dealings.

Defences and Limitations

Good Faith and Value

A creditor may defend against a preference claim by showing that they received the payment or benefit in good faith and for value, without notice of the company's insolvency or the director's intentions. However, this defence is more limited in preference cases compared to other antecedent transaction categories. Good faith alone may not be enough if the liquidator can establish an intent to prefer.

Commercial Justification

Sometimes a transaction that improves a creditor's position is not a preference if it can be justified on commercial grounds rather than a desire to prefer. For example, securing continued supply of essential goods or maintaining critical banking facilities can be accepted if the primary purpose was business preservation, not preferential treatment.

Related Concepts: Transactions at an Undervalue

Preferences are often discussed alongside transactions at an undervalue, which are distinct but similar statutory remedies (Section 238 IA 1986). Transactions at an undervalue involve the disposal of assets for significantly less than market value, or as a gift, and are challenged to restore value to the estate. They have their own time limits, typically two years before insolvency, with certain presumptions for connected persons.

Practical Examples

• A company repays a loan owed to a director's relative shortly before insolvency while leaving external suppliers unpaid. This is likely a preference if the repayment was influenced by a desire to benefit the relative.
• A company pays off a guarantee given by a director to a bank to avoid personal liability, improving the bank's position relatively to other creditors. This may be treated as a preference.
• A supplier receives payment because the director believed the supplier's continued support was necessary to try to save the business. A court may consider the evidence of intention to prefer before setting aside such payments.

Key Takeaways

Preferences and undue preferences are statutory mechanisms under the Insolvency Act 1986 that allow an insolvency office‑holder to challenge transactions entered into before a company's insolvency that have advantaged particular creditors. For a transaction to be treated as an undue preference:

• It must occur within six months of insolvency (or two years for connected persons);
• The company must have been insolvent at the time or become insolvent due to the transaction;
• The decision to make the transaction must have been influenced by a desire to prefer that creditor.

If successfully challenged, such transactions can be set aside by the court, and value can be restored to the company's estate for the benefit of creditors generally. Understanding these provisions helps directors and creditors recognise when pre‑insolvency conduct may be challenged and informs prudent decision‑making when a company is under financial distress.

James William Steven Parker

James is the founder of UKLegalGuides.com and a former agent at the Ministry of Justice (UK). With a background in processing legal claims, he launched this platform to make the laws of England and Wales accessible to everyone.