Companies can return value to shareholders by making distributions, the most widely recognised form of which is a dividend. The legal definition of a distribution includes a ‘distribution of a company’s assets to its members, whether in cash or otherwise’ – so very wide.
There is a view that some intra-group transactions that regularly form part of financing transactions could be classed as distributions. In particular, guarantees (and direct third party security) and on-demand intra-group loans.
The reasoning is that where a subsidiary gives a guarantee for the debts of its parent company then this is, in effect, a distribution of that subsidiary’s assets to the parent company. The parent company is benefiting from the guarantee being given and the guarantor has a liability, even if it’s just a potential (‘contingent’) liability, as a result of entering into the guarantee.
This doesn’t just apply to transactions that benefit the parent directly but also cross group transactions where there is a common parent company.
This classification as a distribution matters as a distribution is unlawful if it is paid by a company when it does not have sufficient profits to make it – these are known as distributable reserves, essentially the profits the company has available to it to make distributions. Even if the accounting value of the distribution is nil, the company must have distributable reserves (however small) to lawfully enter into the transaction.
The Accountants’ view
There is, however, debate on this issue between the accountancy and legal sectors, both of which have differing views. The Institute of Chartered Accountants of England and Wales and Institute of Chartered Accountants in Scotland (Institutes) published updated technical guidance in 2017 (the Guidance) which said that, as a matter of law, guaranteeing the debt of a parent or fellow subsidiary without receiving an appropriate fee, may be a distribution. The Guidance goes on to say that, in some circumstances, even if there is no reduction in net assets, if the company does not have sufficient distributable reserves, the transaction may be unlawful.
The Guidance also says that an on-demand loan, if interest free, may be a distribution but that there will be no distribution if the borrower is able to repay on demand, even if there is no intention that it do so.
The Lawyers’ view
The legal community did not entirely agree with the Guidance and the City of London Law Society (CLLS), recently published two notes in response, setting out its legal view in this area. One of the notes covers on-demand intra-group loans and the other covers guarantees (although also relevant to direct third party security). Both notes consider whether these can amount to a distribution.
The CLLS view is that a guarantee given by a company to a creditor of its parent, or an associated subsidiary, will not, in the context of a ‘normal financing transaction’, be a distribution. A ‘normal financing transaction’ is, broadly, where the company’s directors conclude, at the time of giving the guarantee, that the group member receiving the guaranteed loan or credit is likely to be able to satisfy (repay or refinance) the debt when it becomes due.
If, at the time a guarantee is entered into, the company’s directors believe (or would believe had they considered it) that it is inevitable, or likely, that the guarantee will be called, there is a risk that the guarantee could amount to a distribution. In that situation, if the company receives full value for entering into the guarantee there will be no distribution.
In coming to a conclusion on whether the guarantee is likely to be called, the directors of the company need to consider the actual and prospective financial condition of the debtor company. This is likely to require sight of financial information and projections.
Alongside the note on guarantees the CLLS also published a note looking at the circumstances in which an on-demand intra-group loan may amount to a distribution. The CLLS is of the view that a ‘normal, on-demand intra-group loan’ from a company to its parent, or associated subsidiary, is not a distribution, regardless of whether or not interest is payable on it. A normal intra-group loan being one where the company’s board concludes, at the time the loan is made, that the borrower is likely to be able to immediately repay or refinance the loan when demanded.
The board has to come to this conclusion in good faith and on reasonable grounds when the loan is made. Again, the directors should properly consider the borrower’s actual and prospective financial condition.
A loan may however amount to a distribution if it is likely that the borrower will not be able to repay the loan when demanded, and the company lender does not receive appropriate value for taking on that risk. Contrary to what the Guidance says, the CLLS is of the opinion that if the intention is that the borrower will never be required to repay the loan, it is likely that it would amount to a distribution.
The publication of the notes will be welcomed by finance lawyers and lenders, and they generally reflect market practice. This is a complex area and the additional clarity is welcomed. However, all transactions need to be considered on a case-by-case basis and there are, of course, a number of other intra-group transactions (including intra-group loans on different terms) that may constitute distributions. In addition, the directors always have to bear in mind their duties to their company when entering into transactions. The directors should ensure they have all necessary information, in particular, financial information, available to them in coming to their decision and board minutes should clearly document this.
This blog post was written by Elliot Gibson and Joanna Belmonte. For further information, please contact:
Elliot Gibson, PSL assistant, Banking & Finance
T: 0161 836 7707
Joanna Belmonte, senior associate and PSL, Banking & Finance
T: 0161 836 7809
 ICAEW Technical Release (TECH 02/17BL): Guidance on Realised and Distributed Profits under the Companies Act 2006 (Tech 02/17BL)