Company Loans To Connected Parties: Who Goes A Borrowing Goes A Sorrowing!

Company directors enjoy a privileged position as the guardians of a company's assets. Accordingly, company law seeks to curb the directors' ability to exploit their special position for their own benefit which would thereby adversely affect the interests of the company's shareholders and creditors.

What’s in the news?

Under the Company Law Enforcement Act, 2001, the Director of Corporate Enforcement is legally responsible for encouraging compliance with company law and investigating and enforcing suspected breaches of the legislation.

The “Interim Review of ODCE Activity in 2006” published by the Office of the Director of Corporate Enforcement (the ODCE) in January 2007 has confirmed that the issue of directors’ loans continues to be a major focus of the ODCE’s attention as a result of the continuing use by company directors and connected persons of company assets contrary to law. In 2006, 237 cases were reported to the ODCE involving directors’ loan amounts to an aggregate value of €73 million.

This is a complicated area of law which sets out various prohibitions on directors and people connected with them from dealing with the company. An example of a prohibited transaction would be where a director/shareholder makes a loan of company money to his son or daughter in order to help them buy an apartment. Another example would be where a director uses company money or lets the company guarantee the purchase of property by another company which the director owns (and it is not a group company). However, there are also a number of reliefs which diminish the blanket prohibitions contained in section 31 of the Companies Act 1990 (the “Act”). The ODCE remains vigilant in this area and it is important for companies and their directors to stay compliant with the law.

What is the law?

Section 31 prohibits companies from entering into certain types of transactions, which would otherwise be lawful, for the benefit of a director or a party connected with a director. The legislation was introduced to prevent the controllers of companies abusing their position of power by diverting company assets to themselves, whether directly or indirectly and provides generally that the company may not:

• make a loan or a quasi-loan to a director of a company or of its holding company or to a person connected with such a director;

• enter into a credit transaction as creditor for such a director or a person so connected; or

• enter into a guarantee or grant security in connection with a loan, quasi-loan or credit transaction to any other person for such a director or a person so connected.

The prohibition applies only in circumstances where such a transaction or arrangement is made to or for the benefit of the directors of the company and other relevant people. It is useful to list out those persons for whom a company is prohibited by section 31 from entering into a prohibited transaction.

Directors and other “relevant persons”

Directors of the company;

Shadow directors of the company;

Directors of the holding company;

Shadow directors of the holding company ;

The partner of the director of the company or its holding company;

Trustees where the principal beneficiaries of the trust are a director of the company or holding company, his spouse, any of his children or any body corporate he controls;

A body corporate controlled by a director of the company or of its holding company;

A body corporate controlled by another body corporate that is itself controlled by a director of the company or of its holding company;

There is a presumption that the sole member of a single-member private limited company is a person connected with a director.

What are the exceptions?

The provisions of section 31 appear quite restrictive, but there are five exceptions which may be availed of. However, each exception does not apply to each type of prohibited transaction.

1. Less than 10%

Section 31 will not be breached if the aggregate value of such transaction is less than 10% of the net assets of the company as per the last financial accounts (or called up share capital if the company is newly incorporated and there are no such accounts). To rely on this exemption, the last financial accounts must have been filed on time. It should be noted that guarantees, indemnities and securities given by a company in favour of a director are not covered by this exemption.

Moreover, if the aggregate value at some time in the future exceeds the 10% limit, then the company, the directors and any person with whom the arrangements were made must within two months amend the arrangement so that the value is brought down below the threshold.

2. Validation procedure

Section 34 of the Act exempts companies from the prohibition on entering into guarantees and providing security in connection with such loans made by any person in favour of a director of the company, where the interests of creditors and shareholders are protected. There is a validation procedure which, if followed, allows companies to enter into such transactions. The validation procedure, which must occur before the implementation of the relevant transaction, involves:

(a) the passing of a special resolution (75% majority) by the company approving of the giving of the guarantee and/or security;

(b) the swearing of a statutory declaration by at least a majority of the directors of the company stating what benefit will accrue to the company and that they have made a full inquiry into the affairs of the company and are of the opinion that having entered into the transaction, the company will be able to pay its debts in full as they fall due; and

(c) the preparation, in support of the statutory declaration, of an independent person’s report. This report must be made by an independent person qualified to be an auditor of the company whereby the independent person states that in his opinion the statutory declaration is reasonable. In practice, it can be difficult to obtain such a report as there are concerns amongst the accounting profession that the prescribed form of the report is too wide and open-ended and might expose the auditor to civil liability.

3. Group relief

The most commonly availed of exception is contained in section 35 of the Act and provides that any member of a group of companies can, in favour of another member of that group, make or enter into any of the transactions or arrangements that are otherwise prohibited by section 31. It is a fundamental part of this exception that the companies (or bodies corporate) are part of the same group within the meaning of Companies Act, 1963, section 155, which defines what constitutes a ‘holding company’ and a ‘subsidiary company’.

4. Directors’ expenses or ordinary course of business

Finally, an exemption to the prohibitions contained in section 31 is if the payments made were a reimbursement of directors’ vouched and properly incurred expenses or were transactions entered into in the ordinary course of its business.

For this latter exemption to be maintained, it is a requirement that such a transaction be made or entered into on terms which are no more favourable and for a value no greater than those which the company would both reasonably and ordinarily offer to others. However, the use of this exemption is limited as there are few companies whose main business is making loans or entering into guarantees or credit transactions, which is the standard required to fulfil the ‘ordinary course of its business’ criteria.

What are the consequences of a breach?

If Section 31 is breached the transaction is voidable at the instance of the company, which means that the company (via its directors) can decide if it wants to cancel or reverse the transaction.

Any director, shadow director or connected person who authorised the transaction is liable to account to the company for any gain made by them as a result of the prohibited transaction and is liable to indemnify the company for any loss suffered as a result.

If the company is wound up and it is believed that the breach of Section 31 contributed materially to the insolvency, then the person who benefited by the provision of the security may be made personally liable for the debts of the company, with or without limitation.

A company officer who authorises or permits the company to enter into a prohibited transaction is guilty of a criminal offence if he knew, or had reason to believe, that the company was contravening Section 31.

Conclusion

Directors of companies need to carefully consider the prohibitions contained in section 31 before entering into or authorizing the company to enter into any loan, quasi-loan or credit transaction involving the company, a director of the company or any person connected with that director.

The ODCE has reported that 556 cases of questionable loans totaling €244 million were examined in detail in 2006. In the absence of evidence of willful default, the ODCE has encouraged administrative rectification of the defaults and is aware of the repayment of over €160 million.

---

The content of this article is provided for information purposes only and does not constitute legal or other advice.