Subsidiary Guarantees and the Law on Distributions

The Law Society’s Company Law Committee has recently confirmed its view that a guarantee given in the context of a normal financing transaction by a subsidiary company to a creditor of its parent or fellow subsidiary does not constitute a distribution, according to a leading corporate lawyer.

“Subsidiaries of a corporate group are commonly required to guarantee the payment obligations of other group companies to institutional funders and third party creditors” says Philip Round a Partner at George Green LLP. “The Institute of Chartered Accountants in England and Wales had recently suggested that a guarantee might constitute a distribution by the guarantor company. In response, the Law Society’s note seeks to clarify the circumstances in which such a distribution might occur.”

Mr Round continues, “in its guidance note on realised and distributable profits under the Companies Act 2006, ICSA had suggested that guaranteeing the debt of a parent or fellow subsidiary without receiving an appropriate fee might as a matter of law constitute a distribution. As it is rare for a group company to charge a fee for entering into a guarantee, this raised the prospect of directors having to consider the sufficiency of the guarantor company’s distributable profits each time that it guarantees another group company’s obligations.”

According to Mr Round, the Law Society has stated that the failure to charge a fee does not of itself give rise to a distribution. “A subsidiary providing a guarantee assumes a contingent liability that might result in the transfer of assets for the benefit of a fellow group company.  This would only amount to a distribution if, at the time of the guarantee, it is intended that the guarantee will be called or, viewed objectively, this is likely.  In such circumstances a provision would normally be made in the guarantor’s accounts, reducing the guarantor’s net assets and giving rise to a distribution. If, in such circumstances, the subsidiary receives some consideration in exchange for the guarantee, or identifies some other benefit to it arising out of the guarantee, this would reduce the risk of a Court finding that a distribution had taken place. This does however depend on the value of the consideration.”

Mr Round concludes, “the Law Society’s note provides welcome clarification and reflects most directors’ understanding of the law on distributions.”