Finance Act 2020 – Implications for Funders

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With the Finance Act having now gained Royal Assent, the threat of HM Revenue & Customs ranking higher in any insolvency process has now become a reality. The impact is likely to send shockwaves through the lending community, especially for lenders who traditionally rely on either qualifying floating charges or personal guarantees to bolster their security. And for those alternative lenders who rely on personal assets of the directors, will HMRC’s new power to issue Joint Liability Notices to directors personally affect their appetite to lend?

Preferential status for certain HMRC debts

There has been the threat of HMRC obtaining preferential status for quite a while now. Many people in the restructuring and insolvency profession would argue that this change of status hinders recovery and therefore the rescue culture which makes the UK’s insolvency regime so successful. Breathing space had been provided last year when the changes were pushed back to 1 December 2020, but with less than three months to go, it feels like this change may be here to stay. The outcome is that HMRC will rank as a secondary preferential creditor in respect of PAYE arrears, VAT arrears, employees’ National Insurance Contributions (behind employees’ preferential liabilities (arrears of wages up to £800 and holiday pay)). Corporation Tax and employers’ National Insurance Contributions will remain as unsecured creditors.

Is that likely to be an issue?

In short, yes. When businesses fail, the vast majority of Crown debt is usually made up of PAYE and VAT arrears, with the latter often comprising assessments where returns have not been filed on time. If a business has made losses, Corporation Tax does not usually feature prominently in the list of Crown arrears. Whilst there will be the argument that preferential debts are often not repaid in full, the alternative side is that for those which lend in the SME space, employee preferential claims are not significant, especially if the workforce is relatively small, so where there are realisations available, HMRC will have the benefit of additional realisations as a preferential creditor before anything falls to the floating charge creditors.

In addition, to mitigate the potential loss to unsecured creditors, the Prescribed Part is also increasing from £600k to £800k, which may further reduce the pool of assets available to the floating charge-holders should realisations prove to be substantial. Although, it must be said that in order for this to become an issue, realisations would have to be extremely good.

What about unsecured lends and personal guarantees?

The Finance Act has also brought in a change to the landscape in that HMRC now have the power to issue “Joint Liability Notices” to individuals who have been involved in more than two business failures within the previous five years. If HMRC believe that a company is at risk of insolvency, the notice can be issued to directors, shadow directors and participators (those who either have shares or have the rights associated with shares) requiring them to settle the ongoing HMRC liabilities as well as any outstanding liabilities for the old companies. For further information on this topic, please visit our article on the implication for directors which can be accessed here.

If you have personal guarantees and your client has had previous failures, then establishing the potential liability as soon as possible would be a worthwhile exercise, as these personal guarantees may become worthless if the management need to repay HMRC.

Supporting businesses may become challenging

The current situation has meant that lending criteria has had to be reviewed to deal with the number of businesses that have some turnover reduce over the last few months. Those of us who advise business owners are all too aware of the need to support businesses as they try to re-establish themselves in the new normal, however the appetite to lend to businesses may reduce as we head towards 1 December 2020 and the introduction of Crown preference. At a point in time when many businesses are facing distress and challenges in their working capital cycle, lenders are likely to be caught between wanting to assist their clients whilst being all too aware that increasing their exposure at this time could adversely affect their ability to be repaid.

It should also be noted that HMRC will also be issuing notices for those business owners who have been found to have committed fraud with the furlough scheme and that PAYE arrears may be high where businesses have been party to the furlough scheme but have not seen cashflow return to pre-lockdown levels.

What do we expect to see?

It seems likely that lenders will be looking to manage their risk where there is a reliance on the floating charge. We anticipate that this may be in the form of a reduction in overdraft facilities or a reduction in the drawdown possible in the case of an invoice discounting facility. This will of course restrict working capital for these businesses and this will likely require a tighter control of cash going forward. We would also expect to see some movement between now and December as lenders look to de-risk their portfolios, especially in sectors which may be more at risk given the economic climate.

Whilst there will be some lenders with more of a risk appetite than others, using personal guarantees on their own may be less prevalent – whether lenders will want to seek additional security (either in the form of chattel mortgages or charges on director’s personal assets) will likely depend on the lender; ultimately, dealing with personal assets carries a reputational risk and if the worst happens, trying to deal with a sale of a residential home is difficult. Maybe the halfway house is to obtain security over additional assets, but in sectors which aren’t necessarily asset-rich then this will not be the overarching answer.

From the business owner’s perspective, having proper controls in place will no doubt assist with helping the lender to determine whether they can continue to lend at current levels. We often see businesses without an appropriate credit control system in place, resulting in reduced cash collections – if the lender can see cash being collected, they will likely be more comfortable that their risk is being managed. Having appropriate credit insurance in place will also provide comfort, as will updated accurate cashflow forecasts (as much as forecasts can be accurate).

In summary

The changes to HMRC’s status in insolvencies could not have come at a worse time for businesses. Availability is likely to be reduced on working capital facilities as lenders look to manage their exposure especially whilst the economy tries to get back on its feet. Keeping close to the portfolio and dealing with issues in the loan book sooner rather than later will no doubt all assist as we enter yet more uncertain, unknown territory. One thing that is certain however is that businesses will continue to need working capital and that there will be lenders who want to provide that working capital – managing the respective risks will be the way forward.