The treatment of implicit and explicit guarantees is one of the issues raised in the OECD’s discussion draft paper on financial transactions, which was released for comment in July this year. The discussion in section D of that paper mainly relates to loans made by an independent third party to a group company, and the pricing of guarantee fees which may be payable by the borrower to another group company which acts as guarantor. However, the issue of guarantees also arises where the lender is intra-group.
In common with the OECD’s Transfer Pricing Guidelines, the discussion paper focusses on the analysis of transactions after the event. It’s not intended to provide a ‘how to’ guide for multinational groups in structuring their arrangements. And from a ‘how to’ perspective, clearly transfer pricing is just one of many considerations. Here’s a real life scenario which shows how the subsidiary governance / corporate benefit perspective fits in.
A well-known listed group was planning a substantial acquisition (over USD 1 billion) of a stake in an unconnected business. A new subsidiary (Bidco) was established as the purchasing entity. A sister company (Finco) was to lend the purchase funds to Bidco. One of the structuring questions was the possible role of the parent company (Parent) as guarantor in relation to that intra-group loan. In this particular case, the target company’s business was volatile, and clearly the proposed stake was an illiquid asset.
From the perspective of the directors of Finco who were being asked to approve the loan as lender, the size of the loan meant that a default would be likely to affect Finco’s solvency. It was therefore doubtful whether those directors could properly approve the loan without an explicit, legally binding guarantee. In general, a subdiary’s directors may have regard to the interests of the group as a whole, but only if (inter alia) the interests of the subsidiary’s creditors are safeguarded.
From the perspective of the directors of Bidco as borrower, the existence of the guarantee may affect whether Bidco could obtain the loan (and its terms), but it would not affect whether Bidco should proceed with the loan. That’s because a guarantee does not change the borrower’s liability – if the guarantee were to be called, the borrower would still owe the same amount, just to the guarantor instead of the original lender. Therefore an explicit guarantee alone would not be sufficient, and in order to be able to properly approve the arrangements, Bidco’s directors would also need to insist on a legally binding obligation from the Parent to contribute the funds by way of capital contribution, equity, subordinated / deferred loan or some other arrangement with similar effect.
This kind of ‘two-sided’ consideration from a subsidiary governance perspective is not rocket science, and it simply respects the existence of separate legal entities and the fiduciary duties of directors. But it does provide an essential filter leading to more robust structuring.
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