Risk Of Intercompany Loans In A Group Of Companies

Overview Of Risk Of Intercompany Loans In A Group Of Companies

The risk of intercompany loans is that for the company that is providing the loan it is recorded on its balance sheet as an asset. And for the company that receives the loan, it records this as a creditor on its balance sheet.

It represents a risk for both companies in different ways.

For the company that receives the loan, a loan has to be repaid. For the company that has issued the loan its risk is that it might not get its money back.

Group Company Structures

The issue of intercompany transactions was touched upon recently in the case of Queensgate Place Ltd v Solid Star Ltd & Ors (Re Solid Star Ltd, Companies Act 2006 and Insolvency Act 1986) [2023] EWHC 2277 (Ch) (“Queensgate“) in which the Court noted:

… he has clearly treated the funds of a number of companies which he controls or in which he has an interest as a single pot, from which payments can be made at will without any regard as to whether the payment being made is properly a liability of the company whose money is being used to pay it and without any adequate records being kept of such transactions.

There are many instances in which a group of companies might be set up depending on the nature of the business. For example, many businesses separate the operating company from its assets through two companies. One company operates the business and another holds the assets. If the operating company goes into insolvent Liquidation the assets are not at risk – at least that is the theory. 

Alternatively, a Director might set up several special purpose vehicles for similar trading purposes with the potential thought process being that a) the accounting is simplified so the income and expenditure of each separate business are separately accounted for in an organised way and perhaps, more importantly, b) that if one business is not a success and is loss making ending up in insolvent Liquidation then this will not threaten the other businesses because they are situated in their own Limited Liability company.

Such group structures can be deployed to ringfence losses in a company in such a way that other connected companies are not threatened. 

When Intercompany Loans Can Go Wrong

The benefits of these group structures can so easily be swept away by intercompany loans that create direct trading relationships and linkages between connected companies that the initial separation was designed to avoid.

It is not at all unknown for Directors of group companies to move cash around group companies to satisfy the cash flow requirements of the companies within the group. This enables connected companies to support one another and may avoid the need to seek alternative forms of finance say from a bank, perhaps secured on company assets by way of a fixed or floating charge. 

However, there could be a price to pay for this way of operating a group of companies. Whilst it might save individual companies in need of cash financing costs, it could impact adversely on the solvency of the group of companies, particularly if one or more companies within the group starts to struggle financially. 

Ideally, each company within a group should be able to stand on its own two feet independently. If it cannot do so and needs assistance from other group connected companies it risks hoovering up cash that might later be needed by the company which has advanced the loan. 

Insolvent Companies And Intercompany Loans

The risk of intercompany loans in group companies is highlighted when the solvency of the company lending the funds depends on the receiving company being able to repay the same on demand. 

If the company receiving the funds is insolvent (or at risk of insolvency) for example, then once the money is lent, the lending company may prejudice its own solvency. Because of the Creditor Duty (as confirmed by the Supreme Court in the Sequana decision) that Directors may owe, such conduct might amount to a breach of duty and misfeasance. This could potentially put a Director at personal risk of having to pay compensation for losses caused.

Risk Of A Domino Effect Of Insolvency Caused By Intercompany Loans

The risk that intercompany loans might be storing up for the future is once a group has been trading for a period of time and intercompany loans have become a ‘way of corporate life’ they risk becoming so prevalent that each company in the group will have intercompany loan balances sitting on their balance sheets. 

This is unlikely to present a problem for a successful group in which most of the companies are thriving. However, a problem can arise once one of the connected companies goes into an insolvency procedure such as insolvent Liquidation or Administration. 

In the event the company in Liquidation has an intercompany loan due to it then it will be the duty of the Liquidator to recover that money for the benefit of the creditors. As a result, the Liquidator would typically serve a demand on any connected companies owing the insolvent company money. This is likely to be a complete contrast to the position before the Liquidator was appointed when intercompany loans may have simply sat on company balance sheets as balances and in effect seemingly supported them and their solvency. However, that position can lead to a distortion of the underlying financial position of companies within the group when it might be the case that such intercompany loans stand little chance of being repaid.

Once the first demand is triggered by the Liquidator if the company in receipt of the same cannot satisfy it, then the risk is (company by company) the group could as a whole fall into insolvency. 

Intercompany Transactions And Company Records

The importance of keeping company records cannot be overstated. This applies as much with intercompany transactions as with any other transaction.

In the Queensgate case, the Court said:

These actions by Prakash clearly involve the breach of a number of the fiduciary duties that he owed as a director of SSL. His actions in using funds from a number of companies to pay the costs of the development and then failing to keep a proper, up to date account of these payments, is in my view a breach of the duties imposed by sections 171 (duty to act in accordance with the constitution of the company and only exercise his powers for the purposes for which they are conferred), 172 (duty to act in the way he considers most likely to promote the success of the company for the benefit of its members), 174 (duty to act with reasonable care, skill and diligence), 175 (duty to avoid situations of conflict of interest) and 177 (duty to declare any interest in a proposed transaction) of the Companies Act 2006.

Are intercompany loans therefore something to avoid? Not necessarily and there is a potential calculation that might help to safeguard against the risk in any event.

One way to avoid this risk is to confine intercompany loans to no more than the equivalent of what could be distributed by way of a dividend to shareholders. This would mean that the connected company lending money to another group company could calculate based its own balance sheet (taking account of its likely future prospective and contingent liabilities) the reserves it requires to be available before lending any monies. In doing so this could assist to stop the domino effect of insolvency arising from the company to whom the money is lent. Instead of a chain reaction being set off this calculation could stop the rot in its tracks.