The significance of commercial benefit when granting a guarantee

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 short-hand.

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.

The term downstream guarantee is used 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. But the situation can become less obvious with upstream guarantees (that is where a subsidiary grants a guarantee for the debts of its parent or holding company) and more so across groups, where guarantees are being granted by sister companies of the borrower.

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 what exactly 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

So 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. In addition, lenders can take comfort that under the Act, if they have acted in good faith they may be able to rely on the ability of directors to bind the relevant company anyway, even if they are acting outside their powers.

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 make 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.