Why shareholders come behind creditors in the insolvency queue
March 23, 2023
Fortunately, few people have any direct experience of a company failure. When they do, the priority ‘waterfall’ for distribution of what’s left in the pot after a business has gone through Administration or Liquidation comes as a mystery.
In an ideal world, there would be enough money to go round, but, in reality, it is rarely that straight forward. Due to this, insolvency legislation sets out very clearly who ranks where in the pecking order of distribution. According to these laws, shareholders are always last on this list. Here, we look at why that is.
Reward and risk
Shareholders stand to get the biggest return in terms of dividends and increased capital value for their shares. At the same time, they take the greatest risk in any business, because they are the least likely to get anything back if things go wrong.
If, as so often in SMEs, they are also directors and any of a wide range of rules against bad behaviour have been broken (such as Wrongful Trading), they face all sorts of negative consequences including disqualification and even personal liability for some or all of their company’s debts.
This is a real life Faustian pact that most entrepreneurs are happy to make. Directors get all the upside, but in return they can have the greatest downside too. That said, few business owners think about insolvency outcomes very often and certainly not at the outset.
Fairness to creditors
A company’s suppliers trade on what they hope are profitable terms, but they don’t stand to get the same rewards as the owners. How would they feel if they knew that they would be jostling with the owners for an equal slice of the diminished insolvency pie? Ordinary unsecured creditors get little enough back in most failures.
Moderating excessive commercial exuberance
The theory is that awareness of the near-certainty of losing their investment will prevent the most extreme risk taking by owners, although that will inevitably depend on the scale of their equity commitment. Unfortunately, the argument for a mandatory and meaningful lower limit on the value of the equity in private companies was lost many years ago, so that many owners have little skin in the game.
You may also be interested in: Why does insolvency reduce business value?
Increasingly, owners invest in their businesses more through loans than equity. The rationale is that loan capital is easier to extract and its withdrawal may have little or no tax implications, compared to equity. Some creditors of insolvent companies are surprised to discover that such loans rank alongside their exposure and that they can provide a means to influence or even control the appointment, for example, of a Liquidator. On the other hand, loans by owners will always be subject to scrutiny by the insolvency practitioner handling a failure, especially where they have arisen from something other than a cash injection.
Different classes of shareholders
It is not unusual even in smaller companies for there to be different types of shares in issue, carrying varying voting rights and participation entitlements in the event of a distribution to shareholders. There may be ‘preferred’ or ‘preference’ shares and ‘ordinary’ shares. All that these distinctions do is to govern how any money for shareholders will be shared out in an insolvency. It does not improve the overall position of the shareholder group in the queue.
Minority or public shareholders
As businesses mature and grow, small parcels of shares may be allocated to employees or to private investors, especially now that more companies raise their growth finance through crowd funding. With publicly-quoted entities there could be legions of shareholders, with large or small holdings and who are not involved in any meaningful way in the management or running of the company. These shareholders are in the most invidious position of all, often with little detailed knowledge of problems as they develop and no realistic chance of selling their shares before an insolvency filing.
Acting promptly and taking advice
The high probability of losing their investment if their company fails should be a prime incentive for business owners to act at the first sign of trouble, when there will be a greater number of options available. Achieving a positive outcome will be far more likely with an experienced restructuring and rescue professional at your side, helping and supporting you.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.