Corporate groups are special in many respects, including the way group entities attract financing. They frequently provide guarantees and collateral or serve as co-obligors to secure performance by each other. These relations can be collectively referred to as cross-entity liability arrangements. They enable a group of companies to be financed as a single economic enterprise, therefore securing more beneficial conditions (eg lower interest rates and costs, and larger amounts) from outside lenders. Another advantage of cross-guarantees and other forms of cross-liability is the protection of lenders against uncontrolled asset shifting within the group—the ‘protective function’ of cross-guarantees.
At the same time, cross-guarantees transmit credit risk across parent-subsidiary lines, allowing simultaneous filing of claims against several related companies. As a result, in case of financial distress, the ‘race to the courthouse’ or a ‘grab race’ transforms into multiple races to multiple courts, which worsens the financial position of a group and complicates a group-wide restructuring. Cross-guarantees, co-debtorship and cross-collateralisation can also dilute the returns to non-guaranteed (unsecured) creditors in insolvency. The fact that group-specific financial arrangements may increase the expected recovery of a guaranteed creditor at the expense of other creditors and may lead to opportunistic behaviour of the debtor (eg preferential treatment) indicate the ‘opportunistic risk’ of cross-guarantees.
The difficult task of insolvency and restructuring law is to preserve the protective function of group-specific liability arrangements (eg cross-guarantees), while mitigating or eliminating their opportunistic usage. Directive (EU) 2019/1023 of 20 June 2019 on preventive restructuring frameworks (the Restructuring Directive) does not help establishing a balance, since it does not address group restructuring. However, this does not prevent European countries from experimenting and supplementing their national restructuring or insolvency regimes with relevant mechanisms. Among them are third-party releases.
Third-party releases: comparative overview
A third-party release entails a total or partial discharge or amendment of claims against third parties, such as co-obligors, guarantors and collateral providers (typically, group entities) in insolvency or restructuring proceedings of a principal debtor. It can also be used to release a principal debtor in the proceedings opened with respect to a guarantor or a co-debtor.
In a recent paper entitled ‘Third-Party Releases in Insolvency of Multinational Enterprise Groups’, I explore the underlying rationale of third-party releases and examine their application in a number of jurisdictions. The approaches to third-party releases are not harmonized and differ from one jurisdiction to another. English courts generally adopt a pro-release approach and consider third-party releases a common practice in schemes of arrangement. This pro-release approach is also prevalent in Singapore, Ireland and Australia. Most recently, third-party releases have been proposed in the Netherlands, as a tool in the toolbox of the Act on Court Confirmation of Extrajudicial Restructuring Plans (Wet homologatie onderhands akkoord or WHOA), which tailors their operation to financial distress in closely integrated corporate groups. The possibility of releasing group entities from liability is also envisaged in the German draft Law on the Stabilization and Restructuring Framework for Enterprises (Stabilisierungs- und Restrukturierungsrahmen für Unternehmen or StaRUG). In contrast, courts in the USA either disallow third-party releases or permit them only in very limited, rare and unusual circumstances, after applying close scrutiny. It should also be pointed out, that while the minority of circuit courts in the USA do not accept them, other keep using different tests.
Third-party releases: extension effect and centralised group restructuring
Without a third-party release, restructuring attempts may be undermined by subrogation (ricochet) claims, arising from intra-group liability arrangements (cross-guarantees, co-debtorship), as well as by destabilizing outcomes of enforcement actions against group entities, acting as guarantors, co-debtors or collateral providers. In other words, a single-entity-restructuring, neglecting group financial and operational links and interdependence, risks being economically inefficient.
One way to restructure debts of enterprise group members is to open parallel restructuring or insolvency proceedings against each of them. Clearly, this solution is cumbersome, costly and time-consuming. An alternative is to solve financial problems of the enterprise group in a single forum and in one proceeding. Third-party releases facilitate centralised resolution of group distress. They embrace the ideology of unity and universalism (as extrapolated to the enterprise group context), implementing a global solution that imitates the commercial reality of integration and avoids business fragmentation and liquidation of economically viable group entities. The latter may be caused by simultaneous enforcement of cross-liability instruments. But the significance of third-party releases goes further than simple cost-saving or administrative convenience. They pierce the boundaries of a single company, subject to debt restructuring, and cover related but separate entities. As a result, the liberating effect of debt alteration or debt discharge is extended to cover third parties, without additional proceedings being contemplated or opened. This effect can be referred to as an ‘extension effect’.
Creditors’ expectations and protective function of group guarantees
The economic benefits of third-party releases are clear—they safeguard the continuity of a single enterprise against the opportunistic function of cross-guarantees. Nevertheless, the divergence of approaches to third-party releases, noted above, highlights their controversial nature. There are several reasons for this lack of harmonisation.
First, the extension effect attributed to third-party releases does not sit well with the traditional entity-by-entity approach to corporate insolvency. According to this approach, each company should be subject to a separate insolvency or restructuring proceeding, with its own pools of creditors and assets. Second, third-party releases may disrupt the protective function of guarantees and other forms of cross-entity liability arrangements. Essentially, the amendment or discharge of creditors’ claims, being an extraordinary feature of a restructuring or insolvency proceeding, is carried out in its absence. Third, and finally, third-party releases might run contrary to the legitimate expectations of creditors relying on them, touching upon party autonomy and freedom of contract.
Protection of legitimate expectations and certainty of transactions is a fundamental principle of insolvency law. Cross-guarantees and other forms of cross-liability arrangements should not be disregarded for the sole reason that they have been provided by affiliated companies. The application of rules affecting third-party rights must be foreseeable and predictable. It should also be allowed only in cases of closely integrated enterprise groups where third-party releases are indispensable to facilitate efficient (ie speedy, cost-effective and feasible) group financial restructuring, where there is an identity of interests between the primary debtor and a third party and where rights of the affected creditors are sufficiently protected.
Ilya Kokorin is the Meijers PhD Candidate at the Department of Financial Law, Leiden University.