How can owners help their subsidiaries to weather the financial consequences of a crisis?
In the following, we present some of the instruments not (yet) widely used in Slovenian practice, available to owners to improve the financial situation of their subsidiaries.
The COVID-19 epidemic is temporarily subsiding, but many companies are still dealing with its impact on their business. While the State has provided financial support to many companies through anti-COVID measures, these measures are mainly temporary. In times of crisis, the importance of a sufficient share of equity as a long-term source of financing for the smooth operation of a company becomes even more apparent. In this article, we present some of the instruments that are not (yet) well established in Slovenia, which owners can use to help their subsidiaries and contribute to improving the company’s liquidity and solvency, thereby preventing over-indebtedness and avoiding insolvency proceedings.1
1. Letter of Comfort
One such instrument is a Letter of Comfort. This is an assurance given by the (usually) controlling company (“patron”) to a subsidiary that it will support the subsidiary’s loan application or otherwise ensure the subsidiary meets its obligations vis-à-vis all or certain creditors. The purpose of this declaration is primarily to secure and improve creditor confidence in the financial standing of the subsidiary. The main difference between a Letter of Comfort and a surety or a guarantee is that it does not give the creditor (the lender) a direct claim against the declarant. However, under certain conditions, it may be able to claim damages in the event of a breach of the undertaking.
In this respect, the theory distinguishes between hard and soft Letters of Comfort, depending on the covenant’s content. In particular, hard Letters of Comfort improve the creditworthiness and liquidity of companies as they are underpinned by a legally binding declaration given by the patron that it will take certain measures to ensure the subsidiary honours its obligations. Unlike a so-called soft Letter of Comfort, which is more of a moral obligation, a hard Letter of Comfort establishes a legally binding obligation on the part of the patron.
Please note that obtaining a Letter of Comfort does not, in principle, have a direct impact on the balance sheet of the subsidiary. That said, it could serve to rebut or prevent the creation of a presumption of long-term insolvency based on over-indebtedness. As this is an unregulated institution in most countries (including Slovenia), it is essential in practice to elaborate as much as possible on the content of the Letter of Comfort.
2. Temporary debt relief (pending improvement)
This measure is used in practice mainly in German-speaking countries. A temporary (or in certain cases conditional) debt relief until the improvement is usually more acceptable to the creditor than a normal (final) debt relief, as it remains in force only until an “improvement” as defined by the creditor and the debtor (e.g. the cessation of balance-sheet over-indebtedness) has taken place. In this case, it may, for example, be agreed that the debt will be revived to the same extent on the occasion of the improvement. In particular, from this point of view, such a waiver is also advantageous for the creditor, as it will be able to enforce the entire claim in the event of an improvement, which would not be possible in the event of insolvency proceedings. However, such an arrangement also entails certain risks for the creditor, in particular in the event the company’s business does not perform as planned, i.e. if the conditions for a debt “recovery” do not materialise.
From the point of view of the debtor’s balance sheet, such debt relief is no different from standard debt relief until improvement. The debtor’s liabilities are thus reduced, and the equity-to-other capital ratio and creditworthiness are improved.
3. Creation of subordinated claims
A subordinated claim, within the meaning of insolvency law, is any unsecured claim that, once the debtor is declared insolvent, is payable only after payment of other unsecured claims against the debtor.
The subordination relationship of a claim may be freely agreed between the debtor and the creditor by contract. Such transformation of an ordinary claim into a subordinated claim does not – as in the case of a loan made by a shareholder to a company during a crisis – change the existence of the claim, but only the entitlement to enforce this claim in bankruptcy or insolvency proceedings. This in turn, improves the position of other creditors, which may, inter alia, facilitate the acquisition of credits.
Authors: Jernej Jeraj, partner and Martin Pirkovič, Junior Associate
1 In accordance with Article 14 (3)(1) of ZFPPIPP, over-indebtedness arises if the value of the debtor’s assets is less than the sum of his liabilities. According to the law, in such case, the debtor is presumed to have become insolvent in the long term. which implies additional obligations for the management and the initiation of insolvency proceedings.
