New guidance on whether guarantees and loans are distributions

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The accountants sent the lawyers into somewhat of a panic last year when the Institute of Chartered Accountants in England and Wales (ICAEW) together with their Scottish counterparts published a Technical Release suggesting that companies which guarantee the debt of a parent company or fellow subsidiary without receiving an appropriate fee might, as a matter of law, be making a distribution.

The original ICAEW Guidance can be found by clicking on this link: Tech 02/17BL (PDF, the relevant paragraphs are at 9.45 to 9.69).

Fortunately in June the Law Society and the City of London Law Society (CLLS) (and yes, that is two separate societies) came to the rescue by publishing two joint notes on whether certain transactions do in fact qualify as “distributions” under English company law.

Here Matthew Padian and Caroline Carmichael summarise the conclusions reached by the Law Society and CLLS in these welcome developments.

Do cross- or upstream guarantees constitute distributions?

The first note considers whether a subsidiary makes a distribution when it guarantees its parent’s or sister company’s obligations to a third party (such as bank).

We can report with relief that the note concludes that, in the opinion of the authors, where such a guarantee is given as part of a normal financing transaction, then the guarantee will not amount to a distribution. This is good news and should allay concerns that guarantors should start charging a fee to the relevant parent or sister company, or obtain some other appropriate consideration, whenever providing such guarantees.

We note by way of completeness that a “normal financing transaction” was deemed by the authors to be a transaction where, at the time when the guarantee is given, the board of directors of the guarantor properly consider the financial position of the member of the group to whom the credit is provided and conclude, in good faith and on reasonable grounds, that it is likely to be able to repay or refinance the credit when due such that a demand upon the guarantee is unlikely to be made by the creditor.

The implication here is that if the directors should have reached a different conclusion so that, in other words, it is inevitable (or likely) that the guarantee will be called, then there is a risk that the guarantee does amount to a distribution. In those circumstances the subsidiary which acts as guarantor should receive full value for doing so, otherwise the guarantee will amount to a distribution.

Do intra-group loans constitute distributions?

The second note published by the Law Society and CLLS looks at whether a normal on-demand intra-group loan from a subsidiary to its parent or sister company is a distribution.

By “normal on demand intra-group loan”, the authors mean a loan made by a subsidiary to its parent company or to a fellow subsidiary (whether or not interest-bearing) that is repayable immediately on demand by the lender and where, at the time when the loan is advanced, the board of directors of the subsidiary properly consider the borrower’s financial position and conclude, in good faith and on reasonable grounds, that it is likely to be able to repay the loan when the creditor makes demand for repayment.

Fortunately it is a good outcome here too, for the authors conclude that a normal on-demand intra-group loan of the kind described above will not amount to a distribution. In reaching their conclusions, the authors acknowledge that whilst the making of such a loan involves the transfer of cash from lender to borrower, in their view it does not amount to a distribution since the creditor can demand repayment of the loan at any time. The loan will only constitute a distribution where, objectively, it is likely that the borrower will not be able to repay the loan when demanded, and the subsidiary does not receive appropriate value for assuming such risk. Equally, if there is no expectation that the borrower will ever repay the loan, then in those circumstances too the loan will also amount to a distribution.

Summary

Distributions generally cause lawyers a great deal of anxiety because, unless made from available distributable profits sufficient to cover the amount of the distribution in question, the amount of the distribution which exceeds those profits is “unlawful”. Unlawful distributions can trigger several adverse consequences, including personal liability for the company’s directors where they are in breach of their duties, a requirement for the recipient of the distribution to hold it on trust and return it, and a risk that the distribution may be vulnerable to challenge (and clawback) where the company making the distribution subsequently enters liquidation or administration.

The conclusions of the CLLS and Law Society have therefore been warmly received, as there had been much concern since the original ICAEW Guidance note that all cross- or upstream guarantees, as well as intra-group loans, fell into the same distribution bucket. Those concerns have now been largely addressed, although directors will still need to look at each transaction carefully and consider whether the guarantee is in fact required in the context of a “normal financing transaction” (as described above), or whether an intra-group loan properly represents a “normal on demand intra-group loan” (as described above). It is inevitable that some guarantees and loans will not fall within these “normal” parameters, in which case company directors and their advisors need to proceed very carefully before going ahead with the relevant transaction.

Contact our experts for further advice

View profile for Matthew PadianMatthew Padian, View profile for Caroline CarmichaelCaroline Carmichael

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