When is a corporate guarantee a distribution?

In 2017 the ICAEW and ICAS suggested that an upstream or cross-stream guarantee might amount to a distribution of profits unless a fee was payable in return for the granting of the guarantee.

This understandably caused quite a stir, as distributions have important accounting and tax implications and must be made from distributable profits or distributable reserves in order to be lawful. More recently, the Law Society of England and Wales and the City of London Law Society issued a joint response (the Joint Response) affirming the contrary: that a guarantee given in relation to a “normal financing transaction” does not constitute a distribution, whether or not a fee is payable. This was already the view commonly held amongst solicitors.

So, what’s the position now? It is commonplace for borrowers of all shapes and sizes to operate as part of a group and equally commonplace in such circumstances for a lender to seek guarantees from other entities in the group as assurance for the obligations of the borrowing entity. It is rare, however, that a fee is paid between group entities for the giving of the guarantee.

Two important factors need to be considered when a guarantee is proposed to be given in respect of the obligations of an affiliate group entity:

(1) Fair value

The definition of a ‘distribution’ is found in the Companies Act 2006 and is considerably wide: “every description of distribution of a company’s assets to its members, whether in cash or otherwise”. The definition is further broadened at common law as including the conferring of any benefit on a third party to the benefit of a company’s shareholders. Taking this definition at face value it may seem reasonable to conclude, as the ICAEW and ICAS did, that the giving on a guarantee between group entities could constitute a distribution unless a fee is paid in exchange for doing so.

Group entities can however give adequate consideration for entering such arrangements by means other than a fee. By providing a guarantee that enables a sister-company access to finance, it is likely there will be reciprocal benefits to others in the group, including the guarantor, depending on the purpose of the loan. The key issue here, therefore, is whether the company giving the guarantee has received “fair value” – either through a fee being paid (as the ICAEW and ICAS envisage) or other consideration, such as the improved financial position of the group as a whole or other economic or strategic benefits resulting from the borrower accessing loan funds.

(2) Normal transaction

The second consideration should be whether the guarantee is being given in the course of a “normal financing transaction”. By “normal” we mean that at the time the guarantee is given, the board of directors of the guarantor are able, reasonably and in good faith, to conclude that the borrower will either be able to repay or refinance the guaranteed debt when it falls due. In other words, the directors have taken the financial and other information available to them and concluded that it is unlikely that the guarantee will be called upon by the lender. In such circumstances, the giving of a guarantee will not amount to a distribution of profits and relevant provision will not have to be made in the company’s accounts even in the absence of a fee being paid.

If it is not a “normal financing transaction” (when the board of directors of the guarantor assess the borrower’s financial position and conclude that it is likely that the guarantee may be called) then it should be treated as a distribution unless the guarantor receives fair value for assuming the risk of entering into the guarantee.

The latter applies not only to guarantees but also the giving of intra-group loans: Where the loan is made upon the conclusion by the board that the borrowing entity is likely to be able to repay the loan when it falls due, it will not amount to a distribution. If however it is objectively likely that the borrower will be unable to repay the loan, and the lending entity does not receive appropriate value for assuming that risk, the transaction would likely be considered a distribution.

What the directors need to do: The Joint Response provided useful clarity not only to professional advisers but to directors also. Although a guarantee in respect of a “normal financing transaction” will not be a distribution regardless of whether a fee is payable, the considerations of the directors at the time the guarantee is entered should be properly documented as evidence of the reasonable and good faith view taken by the directors at the time. Where it is considered that a fee ought to be charged in respect of a company’s entry into a guarantee on behalf of another group entity (i.e. where it is considered likely the guarantee may be called upon) the fee charged will need to be at normal market rates and not merely a nominal fee if the giving of the guarantee is not to be treated as a distribution.