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It is standard practice in corporate financing for financial institutions to request that the borrower’s subsidiaries provide security. The management boards of such subsidiaries frequently ask themselves whether providing security in a situation where the company they represent does not use the financing directly is permitted.
Are subsidiaries allowed to provide security for the liabilities of their parent company?
The security requested from subsidiaries by banks may be provided in the form of surety, which means that the subsidiary undertakes to repay the debt if the principal debtor (borrower) fails to repay it, or in the form of security in rem, such as a pledge or mortgage over the subsidiary’s assets. Combining various forms of security is also a frequently used solution. Security from subsidiaries is also required in situations where the subsidiaries do not directly draw on the funds made available under the financing scheme (they are not co-borrowers). They may use those funds in the form of cash-pooling or intercompany loans, but the internal distribution of money within the group is not formally linked to the provision of security by the subsidiaries.
From the financing entity’s perspective, there is no doubt that the provision of security by group companies is allowed even if those companies are not co-borrowers. This results from contract law and the general principle of freedom of contract, which permits the creation of security to secure other persons’ debts. Thus, security created by subsidiaries will be valid and effective. Where does the above concern come from, then?
The potential problems do not stem from the lack of validity or effectiveness of the security but from the risk of liability of the management board members of the subsidiaries providing the security. This is because the Polish legal system does not contain solutions specific to holding law, and therefore, when taking any action, the management board of a (Polish) subsidiary should be guided primarily by the individual interest of the company it represents, and not by the interest of the entire holding. This is compounded by a provision of Polish law that prohibits the issuance of binding instructions to the management board by the supervisory board, and in the case of joint-stock companies also by the general meeting.
Despite all those concerns, according to the views presented in legal literature and court rulings, when taking decisions concerning their company, management board members in Polish companies belonging to a group may, to a certain extent, be guided by the interest of the whole group because the success of a company that is a part of a group depends, to a great extent, on the success of the entire holding. As regards corporate financing transactions, it is important to note that so far there have been no court judgements questioning subsidiaries’ right to provide security or imposing penalties on members of the management boards of such companies for the provision of such security.
An amendment to company law is currently being prepared that will introduce into the Polish legal system such notions as a group of companies and group interest, which should resolve the above concerns at the statutory level. Nevertheless, it should be remembered that as long as these issues are not directly regulated in the Polish legal system, the management board of a subsidiary should, when deciding to provide security for the parent company’s financial obligations, consider first and foremost whether such action is in line with the interests of the entity they represent.
Ineffectiveness of some security in the event of bankruptcy
Furthermore, the provisions of Polish bankruptcy law may limit the effectiveness of some security created by a Polish subsidiary to secure the financing for its parent company (or another company from the group). This stems from a regulation providing that a pledge or mortgage created over a subsidiary company’s assets is considered ineffective in the event that company is declared bankrupt if at the time of creating the pledge or mortgage that company was not the personal debtor of the creditor (the financing entity), and the security in question was created within one year prior to the date of filing the petition in bankruptcy. A pledge or mortgage is not declared ineffective if it is proved that the creditors of the bankrupt (subsidiary) have not been wronged as a result of the creation of the security. Paradoxically, the above prerequisite for declaring a pledge or mortgage to be ineffective does not apply to surety, which is personal security, and not security in rem. Thus, in a situation where a pledge or mortgage was created by a subsidiary as security for previously granted surety, such encumbrances will be fully effective also in the event of the bankruptcy of the subsidiary company. This does not, however, exclude the possibility of the surety being declared ineffective under other provisions of bankruptcy law (e.g. where the bankrupt provides security for a debt that is not yet due within six months prior to the date of filing the petition in bankruptcy).
Tax implications of security provided by subsidiaries
The creation of security for the parent company’s liabilities by that company’s subsidiary (both personal security in the form of surety and security in rem in the form of a pledge, mortgage, etc.) without remuneration may have tax implications.
According to decisions of Polish administrative courts, the provision of security by a subsidiary increases the parent company’s creditworthiness and may result in a lower interest rate on the loan. At the same time, by providing security for someone else’s debt, the subsidiary reduces its ability to incur its own liabilities. Therefore, from the tax perspective, the provision of security is treated as “performance” with a measurable market value. Under the provisions of civil law, there is nothing to prevent a subsidiary from providing security free of charge, but this will cause tax implications because the free-of-charge creation of security by a subsidiary results in a financial benefit for the parent company, the value of which corresponds to the market value of the consideration that the parent company would pay to an unrelated third party for providing the type of security in question.
In order to avoid the tax implications of providing security free of charge, the parent company and the subsidiary in question should agree on the consideration for the created security. Its amount should be set at the market level, taking into consideration factors such as the value of the secured claim, duration of the security and the financial situation of the parent company.
The information contained in the publication is of a general nature and should not be treated as legal advice. Prior to taking or refraining from any decisions or actions to which the content of this publication refers, its intended recipient should seek legal advice.