Guarantee Tightrope

Directors of companies in financial trouble have to beware of paying off loans that have personal guarantees, writes solicitor Barry Heslin

During the recent years of economic expansion, when companies were eager to exploit the buoyant market conditions, it was a frequent occurrence for company directors to give personal guarantees to banks in respect of the company's loans. The most basic effect of giving a personal guarantee is that a company director becomes personally responsible to repay the loan if the company fails to do so. As the current economic climate becomes tighter, it is important that directors tread carefully between protecting themselves personally and ensuring that they do not contravene the law.

It is a common misconception that setting up a limited liability company shields a director in all cases from personal liability for the debts of the company in the event that the company becomes insolvent and has to be wound up. If an insolvent company goes into liquidation, a liquidator will examine the conduct of the company's officers (including directors) and all transactions carried out by the company prior to the liquidation. This investigation may reveal instances and actions that can be set aside and lead to sanctions being imposed on the directors.

Fraudulent Preference

The concept of fraudulent preference was introduced into Irish company law to combat a scenario where a company would pay some or all of its debts to one creditor, at the expense of other creditors. Where an insolvent company enters into any transaction with the intention of favouring one creditor and then goes into liquidation within six months, a liquidator can apply to the High Court to set the transaction aside on the basis that it constitutes a fraudulent preference.

A transaction to favour a particular creditor to the detriment of others is the basis of fraudulent preference. If such a transaction is made in favour of a person "connected" with the company, an application to set aside the payment can be made if the company goes into liquidation within two years of the alleged fraudulent preference. A connected person is defined as;

• a director or shadow director of the company,
• a director's spouse, parent, sibling or child,
• a related company,
• any trustee of, surety or guarantor for the debt due to any person referred to above.

A transaction in favour of a "connected" person is automatically presumed to have been a fraudulent preference unless the contrary is shown. So the burden of proof is on the company or directors to establish that the repayment of the debt to the connected person or entity was completely legitimate. If a liquidator is attempting to set aside a transaction with an "unconnected" person or entity the liquidator has to demonstrate an intention to prefer for the transaction to be set aside.

This does not mean that every creditor has to be treated in the same manner by the company. The courts have established that if a creditor exercises sufficient pressure on the company to force it to pay, then this will not be considered an intention to prefer and the transaction will not be set aside. A payment to a creditor will only be classified as fraudulent if there is a degree of voluntary preference.

Personal Guarantees

There is a particular danger for a company director who has given a personal guarantee to cover the indebtedness of their company. As outlined above, if the guarantee is called upon - usually a bank or major supplier - the director may eventually have to satisfy the demand from his/her own private resources. So where a director, in anticipation of the company going into liquidation, arranges for a company to make a payment to a creditor who holds a guarantee from that director, this can be held to be a fraudulent preference in certain circumstances.

The hazards of preferring the personal guarantors was illustrated in a case where the directors of a company had given personal guarantees over the company's debts. The directors decided to put the company into voluntary liquidation but prior to this they reduced the company's overdraft and therefore their personal liability under their guarantees. The court ruled that this action was fraudulent preference on the basis that it had the direct effect of preferring the bank and the indirect effect of preferring the directors. The court based its decision on three factors:

1. the personal liability of the directors was reduced
2. the directors were fully aware of the state of companies finances at the time they reduced the overdraft
3. only the cheques presented to the bank to pay off the overdraft were honoured

Where a fraudulent preference is found to have occurred, the transaction is held to be void. It can also lead to the director being held personally liable for the debts of the company and possibly being restricted from acting as a company director. In certain cases the conduct which gave rise to the fraudulent preference could be found to amount to fraudulent or reckless trading, which can result in unlimited liability for the debts of the company being imposed on the director. In addition fraudulent trading can result in the imposition of criminal sanctions.

Professional advice should be sought if there any concerns that a payment may give rise to a fraudulent preference.

Barry Heslin is a solicitor with Brian O'Donnell & Partners.