—–For general audience—-–
Also checkout:
Banking: How Deposits and Loans are always linked (agents between Depositors and Borrowers).
Best practices of disclosing Intra-group Guarantees in financial statements.
Intra-group guarantees are usually used by companies within the same multinational enterprise to obtain beneficial conditions for funding arrangements. For instance, lower interest rates due to the decreased level of the credit risk assumed by the lender (such as a bank), tenure of repayment, and/or extended borrowing capacity (quantum of loan). To which extend Intra-group guarantees trigger Intra-group Loans depends on how the guarantee is exactly structured. In this article a closer look at the two main types of guarantees often associated with cash management.
By Shining Lin (l), Jiaxin Huang (m) and Norbert Braspenning (r)
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Parent guarantee (downstream guarantee, widely in-use)
A parent guarantee is a guarantee of performance (required by a bank) from a parent when a subsidiary is entering into a contract. The parent indicates its willingness to vouch for the creditworthiness of its subsidiary but may restrict this to certain legal relationships (i.e. for a specific purpose, a specific counterparty of for a specific amount). It will be clear from the wording of the agreement that the parent’s liability only arises if its subsidiary commits a breach of its obligations and fails to rectify the breach. In this occurrence (the breach), the bank deals with parent, not the subsidiary anymore. In other words, bank’s credit risk “shifts” to the guarantor (only in case of a breach). This setup is particularly relevant when the subsidiary belongs to a parent company which is financially stronger, or in case the subsidiary does not have any audited financials which the bank can analyse, whilst the parent obviously has.
Credit risk aspects
Credit risk on the obligor, assumed by the oblige, is substituted by a credit risk on the guarantor.
In more understandable language, with or without the parent guarantee, the lender (such as a bank) has a credit risk. However, the risk on the subsidiary (borrower) is replaced by a risk on the parent.
Theoretically the parent monitors creditworthiness and the possibility of a default of the borrower to ensure a potential loss is sustainable. In practice however, the parent usually has full control of the subsidiary. Therefore, such monitoring is not pragmatically in use. For joint ventures other practices apply.
Intra-company aspects
Does a parent guarantee constitute related party debt? No. Why not? Well, simply because the credit risk is still with the lender (the bank). But here is a point in time when this changes. If the bank exercises its rights under the parent guarantee, the parent will have to assume the obligations to the bank (repay the bank). At that moment the credit risk transfers from the bank to the parent. The parent will immediately record this as a loss upon repayment. Consequently, there is no claim following repayment by parent to subsidiary, in other words, no inter-company claims as result of this guarantee.
A parent guarantee does not constitute related party debt simply because the credit risk is still with the lender (the bank).
Does this mean there are no intra-company aspects to consider? No. Transfer Pricing (TP) aspects related to intra-group financial guarantees (OECD TP Guidelines) still need to be considered. As the parent guarantee is used to secure more favourable conditions for a loan (lower interest rates, better tenure, extended borrowing capacity), there clearly is an advantage which needs to be factored in. See “a deliberate concerted action that actually provides a benefit” below.
Cross guarantee
Cross guarantees are arrangements between two or more related firms to provide reciprocal guarantees towards each other. This type of guarantee is often used for the purpose of cash management (Cash Pools). Like a parent guarantee a cross guarantee serves a similar purpose with respect to better terms and conditions. The risk of the bank can be significantly mitigated because a creditor of any one firm of the group becomes the creditor of every other firm of the group. (This closely resembles – so called – joint and several liability). Be mindful that in some instances the credit risk of the bank is not merely reduced but eliminated entirely. Obviously, this affects how the guarantee is treated.
Credit risk aspects
If the credit risk on a single subsidiary (borrower) is replaced by a risk on a group of subsidiaries, with or without the cross guarantee, the lender (such as a bank) still has a credit risk. It is quite common in cash management (Cash Pools), to draft documentation in a way that a claimant may pursue an obligation against any one party as if they were jointly liable.
In case a subsidiary commits a breach of its obligations and fails to rectify the breach, like not repay its debit balance, the bank has two options.
- Claim against any of the other parties and seek repayment of the debit balance.
- Terminate the agreement for all parties (step out), not offset or seek repayment for debit balances, but also not repay credit balances.
In the latter case the group of subsidiaries need to sort things out amongst themselves. In some instances, a breach of obligations is not even a prerequisite to the bank stepping out.
Intra-company aspects
Do cross guarantees constitute related party debt? That depends. Likely not. As long as, with or without the cross guarantee, the credit risk remains with the lender (the bank). The bank seeks repayment of the debit balance by claiming against any of the other parties (item i above).
However, cross guarantees likely constitute related party debt if the agreement is drafted in a way that (if a trigger like a breach of obligations and failure to rectify the breach occurs) the bank can step out (item 2 above) without taking any relevant action. No need for the bank to claim and seek repayment. No need for the bank to physically offset. This is absolutely a game changer.
Depending on how the agreement is drafted, cross guarantees can constitute related party debt. But not all Cash Pool agreements use cross guarantees.
Subsidiaries that want the deposit back, turn into claimants that pursue an obligation against any of the group subsidiaries (jointly liable). This is possible because the subsidiaries provided reciprocal guarantees towards each other (not to the bank). In terms of Cash Pooling, this is in essence depositors lending directly to the borrowers (i.e., intercompany loans).
Deliberate concerted action that actually provides a benefit
To assess if an intra-group guarantee-fee is payable, two questions need to be answered with respect to determining the arm’s length nature of the provision of guarantee i.e. (i) whether an intra-group service has been provided, and (ii) if so, whether the intra-group charge is in accordance with the arm’s length principle.
The answer to the first question depends on whether the guarantee provides a group member with economic value to enhance its commercial or financial position. This can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay an unrelated party for the service.
The arm’s length level of the guarantee-fee should generally be determined from the perspective of the guarantor by establishing a range of fees it would want to receive (typically covering all its costs and risks) and the fee that the guaranteed recipient would (at most) be willing to pay.
Besides service fee, other economic benefits (such as interest optimism) shall be examined to gauge if the risk is acceptable. In some countries additional requirements of listed companies apply. For example, listing rules in China require stringent disclosure and approval as pertaining to intra-group guarantee in any form.
Conclusion
As Cash Pools come in many different flavours, to generalize that “Cash Pools result in related party debt” is not appropriately judged. In order to assess to which extent a guarantee triggers intra-group concerns, a close look at the documentation is required. On the one hand there are guarantees that for instance are used to lower interest rates, improve tenure of repayment, and/or extended borrowing capacity, whilst the credit risk for the lender remains. On the other hand, there are guarantees that create joint and several liabilities, whereby the lender does not take the credit risk and can step out without undertaking any action. This will undoubtedly result in intercompany loans.
This is the second or three articles on Banking:
- How Deposits and Loans are always linked (agents between Depositors and Borrowers). (click here)
- How Intra-group Guarantees trigger Intra-group concerns. (not yet published).
- Best Practices of disclosing Intra-group Guarantees in financial statements (click here).
Visit the blog-page for this and more articles (click here).
Featured image: Trees Blossoming in Amsterdam (Museumplein) (Photo: Norbert Braspenning).
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