The Law Society and the City of London Law Society (CLLS) have published two joint notes on whether certain transactions would qualify as “distributions” under English company law.
The first note discusses whether a subsidiary makes a distribution when it guarantees its parent’s or sister company’s obligations to a third party (such as a bank).
The second note discusses whether a normal on-demand intra-group loan from a subsidiary to its parent or sister company is a distribution.
The two notes have been prompted by recent guidance issued by the Institute of Chartered Accountants of England and Wales (ICAEW).
In June 2017, the ICAEW published Technical Release 02/17BL (“Tech 02/17”). Tech 02/17 is non-binding guidance that assists with deciding whether a company has “realised” or “distributable” profits, which in turn helps directors to decide whether they can pay a dividend or distribution. It replaced the ICAEW’s previous guidance on this subject (Tech 02/10).
The ICAEW published Tech 02/17 following a consultation. However, the final form of Tech 02/17 contained certain views that were not in the exposure draft. In particular, it said the following:
- If a subsidiary guarantees a liability of its parent or a sister company (an “upstream guarantee”) without receiving a market fee in return, this can amount to a distribution.
- If a company provides an interest-free loan, repayable on demand, to its parent or a sister company (an “intra-group loan”), this can amount to a distribution if it is “at undervalue”.
This would mean that a subsidiary would need to have an appropriate level of distributable profits before it could enter into an intra-group loan or an upstream guarantee, or it would need to receive some kind of compensation in return. In each case, this could cause significant problems (see below).
What is a “distribution”?
Broadly speaking, a “distribution” is when a company transfers an asset to one or more of its members (for most companies, their shareholders) without receiving the full market value in return.
Most commonly, this happens when a company makes a cash payment to its shareholders in order to distribute the profits it has earned. This is known as a “dividend”.
However, distributions can also happen where a company transfers non-cash assets to its members and receives nothing in return (a “distribution in kind”), or where it sells an asset to a member for less than its market value. This is so even if the sale is not formally described as a “distribution”.
English case law also states that an asset does not need to be transferred directly to a company’s member(s) to be a distribution. A company may also make a distribution if it gifts an asset, or sells an asset at an undervalue, to a company under common control with it (such as an indirect holding company or a sister company).
In order to justify making a distribution, a company must have distributable profits available to cover the entire amount of the distribution. If a company makes a distribution with insufficient profits, the portion of the distribution that exceeds those profits is “unlawful”. This has several consequences, the most important of which are as follows:
- The company’s directors may be in breach of their duties and may be personally liable.
- The person receiving the distribution may be required to hold it on trust and pay it back.
- If the company goes into liquidation or administration, the liquidator or administrator may be able to challenge the distribution (and claw it back) as a transaction at an undervalue.
- If the company or its holding company has prepared individual or group accounts on the basis of the dividend, those accounts may be wrong and may need to be restated. This is important for publicly traded companies, which may be liable to compensate anyone who buys their shares on the basis of inaccurate financial statements and suffers a loss as a result.
Why is this important?
Upstream guarantees commonly form part of financing packages provided by external lenders, often in context of an acquisition or other leveraged financing. They can be secured or unsecured but either way are designed to support the repayment of a loan by the principal borrower. There is currently no practice of paying fees for giving upstream guarantees.
If an upstream guarantee were to amount to a “distribution”, the implications for debt financing could be severe. Lenders would need to undertake financial due diligence on subsidiaries’ distributable reserves, and fees may need to be put in place to ensure that the guarantees could not be invalidated.
Intra-group loans are a common way of moving funds efficiently and easily around groups of companies. If an intra-group loan were to amount to a “distribution”, businesses would need to spend considerable time and money obtaining advice on their subsidiaries’ distributable reserves and what rates of interest would be appropriate to compensate the subsidiary for the risk of non-repayment.
As mentioned above, Tech 02/17 says that, if a subsidiary guarantees its parent’s or sister company’s obligations towards a third party and doesn’t receive a market fee in return, the guarantee can be a distribution.
The Societies’ view, however, is that an upstream guarantee will be a distribution only if:
- the subsidiary’s directors believe the guarantee will be called (or it is likely the guarantee will be called); and
- the subsidiary does not receive any value in return for paying out under the guarantee.
This is because only in these circumstances has the subsidiary effectively transferred an asset to its parent or sister company (by agreeing to pay its liability and receive nothing in return). Otherwise, the subsidiary has not actually parted with any assets.
According to the note, a subsidiary’s directors must judge this when giving a guarantee, not when it is called. On this basis, the note says that an upstream guarantee given on a “normal financing transaction” will not be a distribution. It does not matter whether the subsidiary receives a fee.
This goes a long way towards alleviating the concerns above. However, it is important to remember that, outside a “normal financing transaction”, an upstream guarantee could be a distribution. If the subsidiary’s directors know that its parent will never be able to satisfy the liability in question or reimburse the subsidiary, it will be much harder to conclude that the guarantee is not a distribution.
As mentioned above, Tech 02/17 says that, if a company provides an interest-free loan to its parent or a sister company which is repayable on demand, this can be a distribution if it is “at undervalue”.
The Societies’ view, however, is that merely making an on-demand loan to a parent or sister company without charging interest (or charging interest at a sub-market rate) is not a distribution, because the subsidiary can always demand repayment at any time.
The note says that an intra-group loan could be a distribution only if:
- it is likely that the parent or sister company will not be able to repay the loan; and
- the subsidiary does not receive any value in return for assuming that risk.
In essence, the test is the same as for an upstream guarantee: is there a risk that making the loan could result in the subsidiary being out of pocket? For example, a loan may well be a distribution if the subsidiary never intends to demand repayment from its parent or sister company.
The subsidiary’s directors need to judge this when making the loan, not when it is repaid. On this basis, the note says that a normal on-demand intra-group loan will not be a distribution.
Again, this view helps to address the concerns above. However, as with upstream guarantees, the note does not give carte blanche to make loans to parent and sister companies. A subsidiary’s directors must still consider carefully and assess the likelihood that the parent or sister company might default on the loan. If that likelihood is material, the subsidiary should refrain from making the loan, or at least fix an appropriate interest rate to reflect the risk of non-repayment.