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Guarantees and unlawful distributions: new guidance

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The Institute of Chartered Accountants in England and Wales (ICAEW) and its counterpart in Scotland (ICAS) issue guidance on a host of matters. One of the frequently referred to pieces of guidance is that applying to distributions under the Companies Act 2006, known as TECH 02/10. TECH 02/10 now needs to be updated and so ICAEW and ICAS have recently published an “exposure draft” on updated guidance, currently called TECH xx/16 (the Guidance).

Unlawful distributions and banking transactions

The granting of an upstream guarantee (for a parent company’s borrowing) or a guarantee for a sister company’s borrowing can be deemed to be an unlawful distribution under the Companies Act 2006. The legislation is most commonly thought of as preventing dividends being paid by a company when it doesn’t have sufficient profits and to allow for them to be clawed back. However, the granting of group guarantees can also trigger the restrictions.

A distribution is defined in law as “every description of distribution of a company’s assets to its members, whether in cash or otherwise“.

Whilst there is some discussion, the common stance taken is that: where a company is granting a guarantee for its parent company’s borrowing and provision for that guarantee has to be made in the company’s accounts, the net assets of the company would be reduced and this could be deemed a distribution for the benefit of the shareholders (i.e. the parent company). A distribution will be unlawful if not made out of distributable profits.

Also, if provision has to be made for the granting of a guarantee for the obligations of a sister company, it could also be deemed to be a distribution (unlawful if not made out of distributable profits) as it is indirectly for the benefit of the same, ultimate shareholder (the common parent company). Intra-group loans, direct third party security and any other distribution should be treated the same way.

Whether or not provision has to be made in the company’s accounts for the granting of the guarantee is, ultimately, a question for the directors, although they make take professional advice. They will have to consider issues such as the likelihood of the guarantee being called upon.

Whilst the risk of a guarantee being deemed to be an unlawful distribution is something a bank usually wants to avoid, provided the company is and remains solvent, the actual financial effect on the bank is harder to pin down. The Companies Act can require the benefitting shareholder (i.e. the parent company) to repay the benefit unlawfully received (or, for a non-cash distribution, to pay the value) and the directors may have to account personally for any loss to the company. However, the lender is likely to have security from the parent company in any situation where an upstream guarantee is being granted anyway.

The Guidance

As mentioned above, the Guidance is based on the application of TECH 02/10 which, although described as guidance, has significant weight. As well as updating references to accounting standards and removing obsolete material, the proposed changes include additional guidance on the definition of a distribution.

The Guidance notes that the definition of a distribution in the Companies Act is wide. Case law that has examined it is clear that is does not matter what label is put on a transaction, it is its purpose and substance that matters.

An undervalue transaction with a shareholder or sister company can be deemed a distribution because it contains an element of gift however the state of mind of the parties will also be relevant, including the advice taken, how they tested the market and how actual terms were negotiated (in brief, whether the transaction and terms were arrived at because the other party was a shareholder or sister company). When considering the state of mind of the parties, the Guidance states that it is not a matter of whether or not they intended to make a distribution but whether or not the substance of the transaction is something that, regardless of its label, is a distribution.

The Guidance also reminds us that although the definition of a distribution refers to a distribution of assets (which includes non-cash assets) a distribution can apply to the assumption of a liability if the company does not receive consideration for the same amount. When the company commits itself to a future transfer of assets, it is that commitment that reduces the assets.

Comments on the Guidance are welcomed until 9 June 2016.

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