Cross-guarantee structures: when accountancy and law collide
Many finance lawyers and their clients may perhaps be forgiven for not focusing on a Technical Release by the Institute of Chartered Accountants of England & Wales (Guidance on Realised and Distributable Profits under the Companies Act 2006, TECH 02/17BL) in April 2017 (the "April Tech Release"). Until the April Tech Release, lawyers at least did not previously consider that an upstream (subsidiary guaranteeing a liability of its parent) or cross-stream (guaranteeing a liability of a fellow subsidiary) guarantee would ordinarily amount to a "distribution" under section 829 of the Companies Act 2006 unless provision for it had to be made in the company's accounts (under section 829, a distribution made by a company that has no distributable reserves is an unlawful reduction of capital). The basis for that view was that, if a guarantee is not provided for in the accounts because the underlying contingent liability does not need to be immediately recognised, then there is no distributive effect on the company's net assets.
The provision of an upstream or cross-stream guarantee (as a "distribution") would only be an unlawful reduction of capital (under section 829) if, as a result of the transaction, there would be a reduction in the net assets recorded on the guarantor company's books (and that reduction was greater than the guarantor company's distributable reserves). Whether a transaction has an effect on net assets is determined according to "normal accounting principles". This was the view taken by the City of London Law Society (CLLS) in a memorandum published in 2008 (see page 3).
However the April Tech Release takes a more contrary view - indeed the Institute of Chartered Accountants of England & Wales maintains it has always had this view - that where a company provides an instrument that has value, such as a guarantee, for no appreciable return this will constitute a distribution, even if that instrument has no accounting impact or is not recognised on the balance sheet (see paragraphs 2.69 and 9.69 of the April Tech Release). Essentially the accounting treatment of the asset does not, in the ICAEW's view, determine whether something is a distribution as a matter of law, but may determine the measurement of that distribution (see paragraph 2.8F of the April Tech Release).
On that analysis, if a company providing a cross-stream or upstream guarantee has negative distributable reserves (leaving aside for one moment the commercial value of a guarantee given in these circumstances), the distribution as a consequence of the guarantee, cannot lawfully take place and therefore the principal (e.g. the parent company) must pay the guarantor (the subsidiary) an amount of consideration based on the fair market value of the guarantee (section 845 of the Companies Act 2006). The April Tech Release frames this payment in terms of a "fee". Clearly if the guarantor has positive distributable reserves then no amount is payable.
A distribution that contravenes the Companies Act 2006 is unlawful. Shareholders with knowledge of the unlawful distribution, or directors who authorise the payment of same, may be liable to repay the amount of that distribution. All other things being equal, a guarantee that constitutes an unlawful distribution (under section 829) is not void but the relevant principal debtor and directors of the guarantor company may be liable to reimburse the guarantor company (that is, in addition to any contractual liability or indemnity). Note this is a separate issue to that of corporate (sometimes called "commercial") benefit, which is typically resolved by the provision of shareholder resolutions and solvency statements. However, the validity of the guarantee may nevertheless be called into question from a corporate authority perspective if the directors of the guarantor knew that the transaction would be an unlawful act by the company.
The apparent conflict in the positions of the ICAEW and the CLLS means that the analysis of what is and is not a distribution in the context of cross-guarantees is in flux. It is worth making the point that the April Tech Release has not changed any law and we understand the CLLS are considering their position. From a lawyer's perspective, whether a transaction involves a distribution under the Companies Act 2006 is a question of law and not accountancy rules, and yet the two are necessarily inter-twined. Until such time as the position is clarified, when faced with a structure that includes upstream and/or cross-stream guarantees it would be wise – whether acting for the beneficiary of the guarantee or the guarantor - to investigate the guarantor's distributable reserves and, if they are not sufficient, to document an appropriate "fee" arrangement.