When a company is granting a guarantee (or, indeed, any third-party security), the guarantee must serve the guarantor company’s own commercial interests. This is something that has long been the case, and since the Companies Act 2006 (the Act), the need for directors to consider commercial benefit when entering into transactions has been a statutory duty.
The Act states that it is the duty of each director to “act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole”. You can understand why the term commercial benefit is still used as shorthand.
For the benefit of this company
The effect is that a director must consider the commercial benefit to the company when considering whether or not to enter into transactions. One thing that is often forgotten when guarantees are being taken from group companies is that for the purposes of the Act, it is not enough for the guarantee to benefit the group; there should be benefit to each individual company granting a guarantee. Sometimes this can be more obvious than other times:
- Downstream guarantees (where a parent company guarantees the obligations of its subsidiary) – it is usually fairly clear where the benefit is to the parent in doing this, as ultimately the success of the subsidiary will usually benefit the parent. For example, through an increase in the subsidiary’s value or improved performance resulting in better dividends.
- Upstream guarantees (where a subsidiary grants a guarantee for the debts of its parent or holding company) – whilst more difficult to establish, commercial benefit can sometimes be demonstrated by the benefits that the subsidiary receives from its parent as a result of its relationship with the parent.
- Cross-stream guarantees (where a guarantee is given by one subsidiary for the obligations of another subsidiary in the group) – these are more likely to present problems in showing commercial benefit; however, granting cross-stream guarantees can sometimes be justified, for example, by trading arrangements within the group.
Where matters can get particularly tricky is when a guarantee is being granted by a company that is not even in the same group as the borrower. But this doesn’t mean that the benefit does not exist, just that it can be less obvious to an outsider. This makes it increasingly useful to have a record of the directors’ reasoning.
Detailed board minutes
It is a good idea when taking a guarantee to ensure that the board minutes state exactly what the commercial benefit was to the guarantor company. If the minutes just have a statement that the directors considered that granting the guarantee was for the benefit of the company and its shareholders, then it can be very difficult for anyone to remember what that benefit was if this has to be reviewed at a later date.
Banks and their lawyers, however, need to be careful not to define the benefit for the directors. The directors have knowledge of the company that other people may not have and they are in a unique position to determine where the benefit may lie in granting a guarantee. It is still useful, however, to think about where benefit might be (or not appear to be) when structuring a transaction.
The effect of no benefit
As far as the shareholders are concerned, getting a written resolution before the guarantee is entered into can usually prevent those shareholders from taking action against the guarantee. The Act provides comfort that a lender that has acted in good faith may rely on the ability of directors to bind the relevant company free from any limitation in its constitution. However, this is unlikely to provide protection where the directors are acting in breach of their duties (such as the duty to promote the success of the company).
But benefit is also important if there are solvency issues. A guarantee can be set aside by the court as a transaction at undervalue under insolvency legislation. This can occur if the guarantee is given within a certain time period of the guarantor’s insolvency. The time periods differ depending on a number of factors and are generally referred to by lawyers as the ‘hardening period’. It is worth bearing in mind that a company can be trading with no apparent cash flow problems but still be balance sheet insolvent.
Issues that put a guarantee at risk of being a transaction at undervalue are:
- where the guarantor was insolvent when it gave the guarantee (or became insolvent as a result of granting the guarantee);
- the value the guarantor received from granting the guarantee was significantly less than the value it gave; and
- if the directors did not enter into the guarantee in good faith with reasonable grounds for believing that granting the guarantee would benefit the company giving it.
Top 4 tips to remember about commercial benefit for guarantors
- It’s a director’s duty to consider benefit.
- Benefit must be for the actual company granting the guarantee.
- Board minutes can help focus directors on considering benefit and are also useful evidence of where the benefit was thought to lie.
- Shareholder resolutions can offer some protection, but they are not a cure for all lack of benefit issues.