Consumers could be set to jump up the insolvency hierarchy if Parliament backs the latest Law Commission recommendations.

The Law Commission’s report, Consumer Prepayments on Retailer Insolvency, recommends, among other things, that consumers who prepay for goods or services over £250 in the six months prior to a formal insolvency process should be paid out as preferential creditors instead of unsecured creditors.

The report was commissioned by the Department for Business, Innovation and Skills (recently renamed the Department for Business, Energy and Industrial Strategy) and laid before Parliament on 13 July 2016.

The recommendations have been welcomed by consumer rights groups, however questions remain over their wider impact.

Recommendations

The Law Commission recommends that consumers move up the insolvency distribution hierarchy to become preferential creditors if they meet the following criteria:

  • The person is a consumer under section 2(3) of the Consumer Rights Act 2015;
  • There is a prepayment by the consumer i.e. money been paid to an insolvent business and goods or services not received;
  • The prepayment by the consumer amounted to £250 or more in the six months prior to the insolvency; and
  • The consumer did not use a payment method which offers a chargeback remedy, such as a credit card.

The Law Commission initially suggested that the threshold amount be £100 in the three months prior to the insolvency. However following the consultation process, the final report recommended that a larger amount over a longer period would provide a fairer level of protection for consumers.

Rationale

Under current insolvency legislation consumers are generally unsecured creditors. This means they are last in the queue for any distribution of the insolvent estate. Despite the introduction of the prescribed part concept, in which an amount of floating charge realisations are ring-fenced to provide some distribution to unsecured creditors, in most situations consumers lose out heavily.

By way of example, in the liquidation of Zavvi, unsecured creditors received 25.9 pence in the pound. This was a positive result when compared to the liquidation of Blockbuster which paid out 14 pence in the pound and JJB Sport where the number of unsecured creditors and the cost of distribution meant that unsecured creditors received just 0.34 pence in the pound.

The Law Commission explained that change is required because consumers are often vulnerable, may not understand risk in the same way as corporate or trade creditors and may suffer hardship as a result. They also suggest that there is a “perverse incentive” for struggling retailers to trade their way out of difficulty by taking more prepayments from consumers with little incentive from secured creditors to prevent this. This “perverse incentive” can lead to consumers effectively funding a last-ditch attempt to rescue the business with little prospect of recovering their money should the rescue attempt fail. In such cases the consumer carries 100% of the risk while secured and preferential creditors take the benefit.

Further questions

Protecting consumers in an insolvency is clearly important, however changing the insolvency hierarchy raises a number of questions:

  1. How will this effect the position of other creditor groups? For example, floating charge holders would subsequently rank below prepaying consumers in an insolvency. This may increase the price of lending or reduce the willingness of lenders of provide finance. The cost of more expensive lending may ultimately be passed onto the very consumers which the change is trying to protect.
  2. Will this change directors’ behaviour in the twilight zone? The period during which a company transitions from being in financial distress to being definitively unable to avoid insolvency creates significant problems for directors who can find themselves personally liable for the debts of a company if they are found to have deliberately or negligently worsened the position for creditors of the company during that transitional period. A new class of consumer creditor would add a further layer of complexity to a director’s assessment of the company’s ability to continue to trade. This may cause inexperienced directors to take unnecessary action ahead of time, creating potentially avoidable insolvencies.
  3. Will it add more delays and costs to the insolvency process? In their response to the consultation paper R3 note that “the need to scrutinise a large number of small claims” would add cost and delay to the process. The Law Commission respond that this scrutiny would happen in any case and a liquidator or administrator would simply have to carry out this assessment at an earlier stage. However the delays and costs will be felt by secured creditors who often finance the business. Again this may lead to an increase the cost of borrowing for the retailer.
  4. How many consumers will actually benefit? While liquidators and administrators will have to scrutinise a large number of claims, it is unclear how many consumers will actually benefit from the changes. The credit card chargeback remedy will cover a large number of consumers and many may not meet the £250 threshold (such as holders of gift cards and vouchers). It is unclear that additional legislation and complexity in the insolvency process will make a significant difference to consumers.

The changes to the Insolvency Act 1986 brought in by the Enterprise Act 2002 helped to create a better outcome for unsecured creditors than had previously been available. However the number of large scale retail insolvencies in recent years, where many consumers have been affected, has raised the question as to whether those changes went far enough. Whilst this suggested change provides a perceived positive message to consumers, changing the pari passu principle of all unsecured creditors ranking equally could have a negative impact. If the amount available to other non-consumer unsecured creditors is to be reduced further, those creditors may adjust their own business practises by reducing credit terms or insisting on cash on delivery before supplying to a company which could weaken the ability to trade. It could also see HM Revenue and Customs become even more aggressive as they see their chances of financial recovery weaken further. It will be interesting to see how Parliament balances the desire to provide some comfort to consumers against the potential consequences of providing that comfort to businesses suffering distress.