Consumer prepayments on retailer insolvency - the winds of change?

Establishing a business in a way that provides consumer protection on this basis can often mean substantial additional costs and administrative burdens, and higher working capital requirements. It can also act as a barrier to entry into a market.

Plainly the protection of consumers is desirable, but in highly competitive markets – often involving international competition and differential rules – the cost of providing protection can be significant. For businesses in some sectors (travel agents, deposit banking) this has become a normative requirement, but generally it is not.

Businesses which take the lead and adopt such practices often find this as a way of differentiating themselves from their competitors. For example, some businesses state they hold advance payments in trust accounts.

Repeated business failures in one sector in the past have led to the development of consumer protection through sector-specific arrangements. This has taken the form of trade schemes (Consumer Code Approval Schemes), insurance and bonding arrangements (e.g. ABTA). Many companies have also established ad-hoc consumer pre-payment trust accounts. Bonding levels are not likely to provide sufficient protection without insurance; trust funds, meanwhile, are often difficult to operate and are not always wholly effective.

Some similar schemes may, in fact, be operated without external declaration. These need to be well planned and carefully administered as they can potentially pose risks to directors who maintain they are in place if they are later found not to provide the level of protection promised to customers.

With greater numbers of consumer purchases being made online, it is normal for payments to be made in advance of delivery and such consumers become creditors (pending delivery of goods). As such, it is an enlarged issue, but for most consumers who have paid by credit card, charge card or PayPal, there are formal legal protections and structural practices that protect them (the credit card companies will generally reimburse the consumer and become creditors in their place). These protections do not apply to some newer payments facilities and 'apps payments' yet.

For managers and directors of retailers facing financial difficulties, the absence or ineffectiveness of such protections could lead to further operational challenges when implementing change (and incurring that cost) in the face of risks of insolvency when continuity of trading and cash management will be vital to any recovery or restructuring plan. A change of trading terms may not be easy or even possible to implement without agreement with other stakeholders (e.g. it may be constrained by existing security arrangements with other creditors).

The Law Commission has now reviewed the issue again and made recommendations in its report published in July 2016. The report includes a number of recommendations for practical and legal developments and changes, including:

  • Rules on the transfer of ownership to be amended to favour the consumer;

  • Consumers to 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 or part exchange and the consumer has not received goods or services;

  • The prepayment by the consumer was of £250 or more; and

  • The consumer did not use a payment method which offers a chargeback remedy or is otherwise protected such as a credit card (or through insurance of trust arrangements).

Whether, and if so, when, any of the recommendations will be implemented remains to be seen. However, all consumer-facing businesses should be aware of the recommendations since implementing such changes can, in substantial businesses, require significant financial and structural changes which may involve ring-fencing sizable funds outside existing working capital finance and markedly change their financial modelling.

Such financial and operational changes require significant planning and the remodeling of a business’ working capital requirements. Adopting this approach, and planning for such changes in advance of any compulsory introduction, may enable some businesses to gain a competitive advantage.

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