Oleg de Lousanoff June 9 1999 Cash Pooling - Problems and New Trends Hengeler Mueller | Corporate Finance/M&A - Germany Oleg de Lousanoff Corporate Finance/M&A Introduction Description of a Typical Cash Pool Structure Financial and Legal Concerns Raised by Cash PoolingSolutions New Pooling Concepts for Reduction of Risk IntroductionCentralized cash management systems, and cash pooling in particular, have become indispensable tools for corporate finance on a group level. Cash pooling is generally understood as a centralized concentration and redistribution of liquidity that is performed in cooperation with banks by channeling liquidity through the accounts of the companies participating in the cash pool. Description of a typical cash pool structureCash pools are typically structured to create a daily, automatic transfer of debit and credit balances from the accounts of group subsidiaries (referred to as 'source accounts') to a specified account of the group's parent company (referred to as a 'target account'). The funds received in the target account are used to redistribute liquidity in the amounts needed by the respective subsidiaries. In order to allow this liquidity transfer, each of the subsidiaries agrees to the transfer of credit balances from its own source account to the target account of the parent company. Conversely, the parent company opens 'overdraft facilities' in favor of its subsidiaries. The subsidiaries draw on these overdraft facilities by debiting their respective source accounts. The parent company undertakes towards each participating subsidiary and the bank maintaining the participating accounts to settle the debit balances created by the use of the overdraft facilities. Thus, only the parent company borrows from the bank. The typical structure described above is varied and customized as necessary for the particular needs of individual corporate groups. However, the primary reasons for establishing a cash pool are nearly always the same, and can be summarized as follows:Cash pooling significantly reduces administration costs, as well as the costs of payment flows and financing. It also serves to optimize the group's investment income by pooling available funds. Further, cash pooling can be used to reduce interest and exchange rate risks.Financial and Legal Concerns Raised by Cash PoolingTogether with the aforementioned advantages, cash pooling systems also raise a number of financial and legal concerns that must be carefully addressed. A major financial concern is the possibility that cash pooling can dangerously deplete the financial resources of group member companies. Cases in which corporate groups have suffered spectacular collapses teach us that careless cash pooling can cause enough financial difficulties for some group companies to pull an entire corporate group into bankruptcy. In this way, sound companies can be weakened and broken down by having their funds regularly swept away through cash pooling to other group companies. Because the parent company disposes of the sound company's funds through pooling transfer to other group companies, situations can occur in which further liquidity becomes unavailable at the level of the parent, and cannot be retrieved by the relevant subsidiary when needed.Major legal concerns raised by cash pooling are capital maintenance requirements, treatment as shareholder loans, the risk of the parent company being held liable for the debts of its subsidiaries, and the characterization of pooling transfers as 'hidden profit distributions' for tax purposes, as well as the possibility of managing directors being found personally liable for funds swept away.In particular: (a) 'Downstream' loans to a subsidiary may, under certain circumstances, be treated as substituting equity capital if the subsidiary is in possession of the funds upon entering a financial collapse. If the subsidiary enters insolvency proceedings, the lender (parent) would not be able to enforce its repayment claims. Moreover, in such case the lending parent could be forced to reimburse any amounts that the subsidiary has already repaid on the loan. (b) The sweeping of credit balances from subsidiary source accounts to a parent target account could conflict with the subsidiary's legal obligations to preserve its share capital. Any payments made from assets required to preserve share capital would have to be reimbursed to the subsidiary. Further, the managing directors of the subsidiary would be personally liable to compensate the subsidiary for any such depletion of company assets. (c) If the parent company fails adequately to consider the interests of the subsidiaries when managing the cash pool, especially by insufficiently documenting payment flows, it could become liable for the debts of the subsidiaries. Such liability could be imposed pursuant to the 'qualified de facto group of companies' principles established by a number of decisions of the Bundesgerichtshof (German Federal Supreme Court). This risk in particular exists when, as a part of the cash pooling concept, one subsidiary assumes the liabilities of other group companies. (d) Finally, the liquidity swept from a subsidiary source account to the parent target account could be treated as 'hidden profit distribution' for tax purposes. Such distributions are often deemed to exist when benefits in an amount affecting the company's income are granted to a shareholder or another person or entity closely connected to a shareholder because of such shareholding, but without approval through a duly adopted shareholders' resolution. Thus, even if upstream transfers of liquidity constitute payments under loans granted by the subsidiary to the parent, they must be made under at least arm's length conditions in order to avoid characterization as hidden profit distributions. A characterization of a liquidity transfer as a hidden profit distribution would result in the funds transferred by the subsidiary to the parent being taxed as if they were profits of the subsidiary. SolutionsCertain criteria have been developed to address and resolve the legal concerns raised by cash pooling: Payment flows between the participating companies must be documented in detail. The group must establish an adequate, group finance surveillance system, with control and an early warning system that allows financial difficulties in individual group companies to be discovered, addressed and resolved as soon as possible. Termination rights must ensure that participating companies may be excluded from the cash pool if they enter into financial difficulties, and that each participating company may terminate its participation in the cash pool. The cash pool agreements among the group companies must ensure that the upstream and downstream liquidity transfers are made at arm's length. New Pooling Concepts for Reduction of RiskBecause the risks described above can be minimized, but not fully excluded, by complying with the aforementioned criteria, alternative concepts have been developed to further reduce risk. One of these new pooling concepts is 'notional pooling'. In notional pooling, funds on source accounts are not physically transferred. Rather, the positive and negative balances on source accounts are placed in relation to each other to determine the overall net debit and credit position of the group of participating companies. On the basis of this overall credit/debit position of the group, the credit and debit interest rates applicable for each participating account are calculated. Notional pooling can be performed independently from classic cash pooling or used to pool target accounts of 'classic' cash pools denominated in different currencies (to avoid foreign exchange costs incurred by the actual conversion into the currency of the target account).There are two forms of notional pooling: (a) In the first, referred to as 'interest compensation', all debit and credit balances are (notionally) set off for calculation purposes. Only the resulting (credit or debit) balance is subjected to (credit or debit) interest. Accounts in different currencies are (notionally) converted to one reference currency to render the notional set off calculation possible. However, current banking supervisory rules allow banks to offer interest compensation to their customers on favourable conditions only under very limited circumstances. (b) Therefore, in most cases, notional pooling takes the second form of 'interest optimization'. In this form, a preferred interest rate is applied to both credit and debit balances. The respective interest rates are calculated by subtracting a specified percentage from the spread normally subtracted from or added to the mean interest rate to calculate the respective debit or credit interest rate. The specified percentage is calculated on the basis of the ratio of aggregate credit and debit balances. In other words, all the companies participating in the interest optimization are offered the preferred interest rates. The advantage of notional pooling over classic cash pooling is that although no physical transfer of funds is necessary, the participating companies are treated as a group and thus may receive more favorable conditions than they would on a stand-alone basis. The transaction costs created by the regular upstream and downstream transfer of funds in classic cash pool concepts are also saved. Further, the legal risks resulting from the physical transfer of funds are significantly reduced.For further information on any of the above topics please contact in the first instance Oleg de Lousanoff at Hengeler Mueller by telephone on +49 69 17 09 50, by fax on +49 69 72 57 73 or by e-mail at [email protected].The materials contained on this web site are for general information purposes only and are subject to the disclaimer.