Legal Updates

Directors’ Guarantees

(“just one more signature” back in the day.....now coming home to roost)

Executive and non-executive directors of Irish companies have to be fully aware of the personal exposures which can arise when the company, being in financial trouble, decides to pay off bank loans or finance leases. In the present difficult times all directors need to fully understand the consequences of each course of action available to them when they are dealing with the company’s debt and their own personal exposure to same.

Prior to the Credit Crunch when companies (and more importantly the owners/directors of such companies) were convinced that “getting bigger faster” was the right thing to do bank finance was obtained rather than progressing at a rate that was financeable from the company’s own resources. With such finance it was common practice for all banks and finance houses to require company directors to give personal guarantees in respect of the company’s loans. 

Where a director’s guarantee (or Deed of Guarantee & Indemnity to give them their full formal name) is executed, the director becomes (on an equal footing with the company itself) personally responsible to repay the loan. As such the person or bank in whose favour the guarantee was executed will be entitled to go after the director at the same time as proceeding against the company.

The fact that a trade is carried on through a  “limited liability” company does not as a matter of certainty protect a director in every circumstance from personal liability for the debts of the company where subsequently the company becomes insolvent (in some circumstances even where no written personal guarantees were given).  Where a company goes into insolvent liquidation, the person appointed as liquidator will be compelled to review the conduct of the company’s officers (including directors) and all recent or relevant company transactions prior to the liquidation. Where such events or actions are found to breach company law they will (upon application of the liquidator) be set aside and can very easily lead to sanctions and personal financial liability being imposed on the director(s) involved.

What is Fraudulent Preference?

Fraudulent Preference can be generally understood as a situation where a company pays down its debt to one creditor or group of creditors, at the obvious (or not so obvious) consequential expense of other creditors. Irish company law makes such actions illegal and provides for the ability to unwind such actions upon application to the Courts.

Where an insolvent company has entered into a transaction which is shown to come under the heading of “fraudulent preference” and has been placed into liquidation within six months of such transaction, a liquidator can apply (showing clear and sufficient proof) to the Court to have the transaction unwound for the benefit of the remaining creditors of the company.   Where the transaction is made in favour of a entity “connected” with the relevant company, an application to set aside the transaction can be made if the company goes into liquidation within two years of the alleged fraudulent preference. A connected entity has been interpreted by the courts and defined by the relevant legislation to include;

  • a director or shadow director of the company,
  • a related company (i.e subsidiary, parent or sister),
  • director’s spouse, parent, sibling or child,
  • any trustee of, surety or guarantor for the debt due to any person referred to above.

In addition to the extension of the period of time to two years for connected party transactions, an automatic presumption of a fraudulent preference arises where the transaction concerns a connected person. As such the burden of proof shifts from the liquidator to the company or directors who must demonstrate that the relevant transaction was legitimate and bona fide.

However, notwithstanding the general rule that there can be no preferential treatment of individual creditors, it is not the case that all creditors have to be dealt with in the same manner by the company. This apparent contradiction to the general purpose of the legislative protection exists to take account of the commonly occurring situation where a creditor exercises sufficient pressure on the company and its management so as to cause the company to pay this creditor ( e.g he who shouts loudest often gets dealt with first). Where this set of circumstances is shown to have arisen naturally in the course of business interaction in the time leading up to the liquidation it will not be considered a fraudulent preference.  The fact that the company or its directors/management voluntarily intended (for whatever reason) to prefer one creditor over others must be shown before fraudulent preference will be inferred by the Court.   Importantly notwithstanding that the word “fraudulent” is part of the title “fraudulent preference” there is no requirement for the directors or management to be shown to have been perpetuating an actual fraud on the creditors or the shareholders. The word “fraudulent” is a red herring. It is the word “preference” which indicates what has to be proven.

Fraudulent Preference & Director’s Personal Guarantees

An obvious inclination toward self preservation could arise for a director (or even a shareholder) who has given a personal guarantee to cover the indebtedness of their company when they become aware that the company is heading towards insolvency.  In this situation, which is becoming quite common in the present economic times, where the guarantor in their capacity as director of the company compels the company to make a preferential payment to a creditor (in an obvious example a bank in relation to a company overdraft, invoice discounting facility or loan) who holds a guarantee from that director, this could obviously be held to be a fraudulent preference.  One can easily see that such an action would prefer the bank but also indirectly the director as his guarantee obligations are reduced accordingly.

The courts in analysing a director’s actions will generally look at whether (a) the personal liability of the directors was in fact reduced, (b) the director’s level of knowledge of the condition of the company’s finances at the time the payment to the 3rd party creditor was made and (c) the director’s general level of involvement in the running of the company and in particular his involvement in making the decision to repay the relevant creditor.

The ultimate consequence for a director of fraudulently preferring a creditor who holds the director’s personal guarantee has been illustrated in various court cases.  Firstly, the transaction will be held to be void (i.e it will be looked at as is the transaction had never occurred so that the parties to the transaction will be required to resume the position they held before.  A director should also be aware that he or she can end up being held personally liable for the debts of the company to the amount that his personal exposure was purportedly reduced by the fraudulent preference in the first place.   Furthermore, where the director is shown to have knowingly and without general regard continued in business (incurring various creditor debts etc), transactions which are held to be fraudulent preference can also be held to be fraudulent and reckless trading on the directors behalf. This can, depending on the nature and extent of the directors actions, result in unlimited liability for the debts of the company being imposed on the director together with criminal sanctions.

The above is a very general and simplified summary of the law on the subject matter.  As such you should obtain professional advice before taking any actions as regards you or your company’s  affairs.  Should you wish to make enquiries in relation to any of the areas touched on by this article please contact Adrian Burke & Associates.

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