Upstream Guarantee: a Worked Example

Groups borrow at the top. The holding company signs the facility, often because it is the company the owners and the accounts present, or because it bought the business and is repaying the price. But a holding company usually owns little except shares. The plant, the stock, the customers and the cash flow sit in the subsidiaries, and so do the subsidiaries' own creditors: suppliers, employees, landlords, the tax authority.

Without a guarantee, the lender's claim is on the parent, and the parent's claim on the subsidiary is as its shareholder. In a failure the subsidiary pays its own creditors first and passes up only what is left. That ranking is structural subordination, and it applies however senior the lender's security over the holding company is. An upstream guarantee moves the lender down into the subsidiary, so its claim is made against the company that holds the assets.

The subsidiary signs the guarantee, or accedes to the group's facility as a guarantor, and commonly grants security over its own assets for the same debt. Its board resolves to do so and records why: the subsidiary's access to the group's funding, its reliance on the group's facilities and customers, and that it will remain solvent with the guarantee in place. The lender asks for those minutes because the duty that has to be satisfied is owed to the subsidiary, not to the group.

The three markets give directors different room. New Zealand's Companies Act lets a director of a wholly owned subsidiary act in the parent's best interests if the constitution expressly permits it, and a director of a partly owned subsidiary do the same where the constitution permits it and the other shareholders have agreed in advance. Australia's Corporations Act gives directors of a wholly owned subsidiary a similar safe harbour where the constitution authorises it, the director acts in good faith in the parent's interests and the subsidiary is not insolvent and does not become so as a result. The UK has no equivalent, so the benefit to the subsidiary itself has to be found. In all three, a liquidator can challenge a transaction the company entered for too little in return while it was unable to pay its debts, or that left it so.

A food group, constructed for this page, borrows US$40m at its holding company, which owns all the shares of one operating subsidiary and nothing else. The subsidiary owes US$18m to its own creditors. A failed product launch and a lost customer bring the group down, and the subsidiary's assets realise US$45m. Three versions of the file, with figures that are the example's:

Without a guarantee the lender stands behind every supplier. With an unsecured one it stands beside them, sharing the subsidiary's assets in proportion to claims. With security it stands in front, and the subsidiary's own creditors carry the loss. The example leaves out the preferential claims, such as certain employee entitlements, that in all three markets rank ahead of some security over a company's circulating assets.

The third line is also the one a liquidator examines. The subsidiary's creditors lost US$13m to a debt whose proceeds went to the parent. If the subsidiary was solvent and the guarantee served its own business when given, the security stands. If it was already unable to pay its debts, the liquidator has a case.

A downstream guarantee runs the other way: the parent guarantees its subsidiary's debt. The benefit there is usually easier to show, because the parent owns the subsidiary and supporting its borrowing protects the parent's own investment. An upstream guarantee asks a company to support its owner, and the benefit, though often real, is indirect: the group's funding keeps the subsidiary trading. A side-stream guarantee, between sister companies, has no ownership link at all, and its benefit can be harder still to show.

That is why corporate benefit is argued over upstream and side-stream guarantees, and seldom over downstream ones. Where a guarantee also helps someone buy the guarantor's shares or its parent's, as in an acquisition, financial assistance rules apply as well.

DEFINED IN ONE PARAGRAPH → · CORPORATE BENEFIT → · CROSS-GUARANTEE, DEFINED →

In a group facility the question is coverage: how much of the group's earnings and assets sit in companies that have guaranteed. A guarantor coverage test sets the share and makes the borrower add guarantors as the group changes. Subsidiaries that cannot easily guarantee are where the gap opens: one with outside shareholders whose agreement is needed, one overseas whose local law limits the guarantee, one already near insolvency whose directors cannot give it.

The credit paper reads the guarantee beside the subsidiary's own position. A guarantee that would leave the guarantor insolvent on the day it is given protects less than it appears to, because it is the first thing a liquidator will test. A lender that sizes the group's debt to what the guarantors can carry, and keeps their board minutes on file, has a guarantee it can enforce.

GUARANTOR COVERAGE TEST → · CORPORATE LENDING →