What is a Creditor?

There are three types of creditor in the UK – secured, preferential and unsecured – and their priority in terms of payment when a business is liquidated is laid down in the Insolvency Act 1986.

In this article, we’ll define the role of a creditor in depth. I’ll also cover what happens if creditors aren’t repaid.

>>Read our full article on How to Communicate Effectively with Creditors

What is a Creditor?

In simple terms, a creditor is a person or a business to whom money is owed. Whether it is a large bank or an individual, creditors have a number of powers that are defined in law and by which they can seek to secure payment.

In the context of business, creditors can take various forms, such as suppliers, banks, or bondholders, depending on the nature of the credit extended. Creditors may be secured, having a claim on specific assets of the debtor as collateral for the debt, or unsecured, without such rights to specific assets. Their rights and priorities in case of a debtor’s default vary based on the terms of the credit agreement and relevant laws.

What’s the Difference Between Secured, Preferential and Unsecured Creditors?

It’s important that business owners understand the differences between the three main types, since there is always a priority of creditors denoting which should be paid first.

Secured Creditors

A secured creditor will usually be a large financial institution such as a bank, building society or invoice factoring company. They hold a ‘charge’ over the company they are seeking payment from, such as property. The charge needs to be registered with Companies House and this ensures the asset cannot be disposed of unless this is permitted by the secured creditor.

Secured debt usually comes with better terms compared to unsecured debt because, for the lender, the risks are lower. Secured creditors are paid first in liquidation, and they have the most authority. In some cases, they are able to appoint an administrator if there are serious concerns about viability.

Preferred Creditors

Next in line in terms of their priority are preferred preferential creditors and they are typically employees. It should be noted that HM Revenue and Customs is also classed as a preferential creditor, as are tort victims, namely those who have taken legal action against the business owing money for wrongful action. 

A change in the law, via the Banks and Building Societies Order 2014, means that depositors protected by the Financial Services Compensation Scheme are also now categorised as preferred creditors. 

Unsecured Creditors

Unsecured creditors are last in terms of priority in the event of insolvency and if they do gain a payout, it will often be smaller than secured and preferential creditors. Unsecured creditors cover a wide remit of contractors, suppliers and customers.

Because they have less security of payment, unsecured creditors are in a more precarious position.

Where do Shareholders Stand as Creditors?

Company shareholders are the final grouping and are not classified as secured, preferential or unsecured creditors.  Shareholders will only receive proceeds if there are any funds available after other creditors have been paid. 

What Happens if Creditors Don’t Get Paid?

When a limited company fails to repay its creditors, several outcomes can occur, affecting the company’s operations, legal status, and its directors’ responsibilities:

1. Payment Demands and Legal Action: Creditors may initially issue formal payment demands. If these are ignored, they can pursue legal action to recover the debt, leading to court judgments against the company.
2. Statutory Demand: A creditor can issue a statutory demand for debts over a certain threshold. Failure to respond to this demand within the stipulated period allows the creditor to initiate insolvency proceedings against the company.
3. Winding-Up Petition: If the debt remains unpaid, creditors can file a winding-up petition. If the court approves this petition, it can lead to the forced liquidation of the company, where its assets are sold off to pay debts.
4. Administration: The company might enter administration, where an appointed administrator restructures the company or sells the business and assets to repay creditors.
5. Impact on Credit Rating: Non-payment to creditors can severely damage the company’s credit rating, making it difficult and more expensive to borrow in the future.
6. Director’s Liability: In certain circumstances, if wrongful trading is proven (continuing to trade when insolvent without regard for creditors), directors can be held personally liable for company debts.
7. Insolvency: Ultimately, non-repayment can lead to insolvency proceedings, affecting the company’s ability to continue operating. Insolvency professionals are called in to manage the company’s remaining assets and distribute them among creditors, according to legal priorities.

For limited companies, the separation between the company as a legal entity and its directors/shareholders typically protects the latter from personal liability for the company’s debts, unless personal guarantees have been given or there’s evidence of wrongful or fraudulent trading.