Understanding Preferential Creditors Under Section 327 of the Companies Act, 2013

When a company faces financial distress and ultimately goes into administration or liquidation, its financial affairs are closely scrutinized to determine whether any wrongful or illegal actions were undertaken by the directors prior to insolvency. One critical aspect of this process is examining whether preferential payments were made to certain creditors over others. The role of the liquidator in such cases is to ensure the fair and lawful distribution of the company’s assets while maximizing returns for all creditors.

One of the key provisions governing the distribution of assets in liquidation is Section 327 of the Companies Act, 2013, which lays down the framework for preferential payments. It outlines which creditors are entitled to receive priority payments before settling the claims of other unsecured creditors. This provision applies to all cases of winding up except where liquidation occurs under the Insolvency and Bankruptcy Code, 2016 (IBC), in which case the IBC rules prevail.

Who Are Preferential Creditors?

Preferential creditors are those individuals or entities that are legally entitled to be paid before other unsecured creditors when a company is liquidated. Section 327 establishes a priority order for such payments to ensure that certain obligations, especially those owed to employees and government agencies, are settled first. The following categories of creditors are included under preferential payments:

1. Government Dues: Any revenue, taxes, cesses, or rates payable to the central, state, or local government that became due within one year before the winding-up order must be settled on priority.
2. Employee Wages and Salaries: Employees’ wages and salaries for up to four months, provided they were earned within the 12 months preceding the winding-up order, are considered preferential.
3. Accrued Holiday Remuneration: Any unpaid holiday wages due to an employee or their legal heirs must be paid. Unlike wages, there is no time limitation on holiday remuneration claims.
4. Contributions to Employee State Insurance (ESI): Any outstanding amounts due for contributions under the Employee State Insurance Act, 1948, in the last 12 months are also given preferential treatment.
5. Compensation for Workmen: Compensation owed under the Workmen’s Compensation Act, 1923, for injuries, disablement, or death of an employee must be paid on priority.
6. Provident Fund, Pension Fund, and Gratuity Dues: Any contributions due to employees’ provident fund, pension fund, or gratuity fund maintained by the company are protected under this section.
7. Expenses of Investigation: If any investigation was conducted under Section 213 or 216 of the Companies Act, 2013, and the company is liable for the investigation costs, those expenses are also considered preferential payments.

Key Highlights of Section 327 towards Preferential Creditors

• Preferential creditors have the first right to repayment when a company goes bankrupt.
• Section 327 operates in conjunction with Section 326, which means that if all assets are exhausted under Section 326 (which protects the rights of workmen), then no distribution occurs under Section 327.
• The provisions of Section 327 do not apply to companies undergoing liquidation under the Insolvency and Bankruptcy Code, 2016.
• Unpaid wages and tax obligations are of the highest priority for the liquidator.
• Unsecured creditors face the highest risk of non-repayment, as they are paid only after all secured and preferential creditors have been satisfied.

Implications for Directors and Creditors

From a director’s perspective, ensuring compliance with these provisions is essential to avoid potential legal consequences. If it is found that directors intentionally prioritized certain creditors over others outside the prescribed legal framework, they may be held personally liable for misconduct. Moreover, any fraudulent preference given to a creditor could be challenged and reversed by the court.

For creditors, understanding their position in the liquidation hierarchy is crucial. While secured creditors have the first right to claim proceeds from asset sales, preferential creditors come next, followed by unsecured creditors. This structure significantly impacts the ability of unsecured creditors to recover debts owed to them, often leaving them with little to no reimbursement after the liquidation process is complete.

Conclusion

The liquidation of a company is a complex and highly regulated process where every creditor’s claim must be carefully evaluated. Section 327 of the Companies Act, 2013, provides a well-defined structure for prioritizing payments, ensuring that government dues, employee wages, and essential financial contributions are settled first. However, it is crucial to remember that this section does not apply when a company is liquidated under the Insolvency and Bankruptcy Code, 2016.

For business owners, ensuring compliance with these regulations is vital to avoid allegations of wrongful trading. Employees and government bodies benefit from these provisions as they are given higher priority in recovering their dues. Meanwhile, unsecured creditors, including suppliers and contractors, must be aware that they stand at the end of the repayment hierarchy, often resulting in minimal recovery of outstanding debts.

Understanding the nuances of preferential payments and the legal framework governing them can help stakeholders navigate the liquidation process more effectively. Whether you are a creditor, an employee, or a company director, knowing your rights and obligations under Section 327 can make a significant difference in the event of insolvency.

Related Resources

• Section 327, The Companies Act, 2013

This article is presented by CA B K Goyal & Co LLP Chartered Accountants, your trusted partner in audit and compliance solutions. For expert assistance, feel free to contact us.