Directors often rely upon letters of support issued by parent companies to determine whether their company is, and will remain, able to trade as a going concern. While such letters may contain statements to the effect that the parent will stand behind the subsidiary financially, it is often unclear whether they can be treated as a legally binding commitment, or conversely, as an aspirational statement of intention given that they are issued in a wide range of circumstances, take many forms and are used for a variety of purposes (eg. for finance/insurance purposes and to win new work/ tenders).
More often than not, these letters serve their purpose on their face and are never given a second thought. But Buffett said it best: “Only when the tide goes out do you discover who’s been swimming naked”. In times of financial distress or formal insolvency, the unintended consequences of poor drafting surface and the extent to which such a letter contains enforceable obligations may be the difference between a subsidiary’s survival and a terminal insolvency.
In this article, we examine:
- What letters of support are and the circumstances in which they arise.
- How letters of support may be used “for audit purposes only” — which having regard to the importance and function of independent audits seems to be a contradiction in terms.
- The key factors that determine the enforceability of a letter of support having regard to the Full Court of the Federal Court’s decision in Re Forest Enterprises Ltd (2011) 195 FCR 97 and the New South Wales Supreme Court’s decision in Gate Gourmet Australia Pty Ltd (In Liquidation)  NSWSC 149.
- Why letters of support might give directors an uncertain or false sense of security from insolvent trading liability and how they may create a real dilemma for parent companies (who might have to choose between liability under the terms of the letter on the one hand and parent company insolvent trading liability on the other).
What is a letter of support?
A letter of support is a document issued by a parent company to a subsidiary (or, in other cases, by a lender to a borrower) often containing statements to the effect that the parent will stand behind the subsidiary financially, provide sufficient funding to allow the subsidiary to continue to trade as a going concern, forbear from calling upon or enforcing any intercompany debt owed by the subsidiary for a specified period or maintain a minimum shareholding in the subsidiary. Letters of support are often given in lieu of a formal security or guarantee. The enforceability of a letter of support varies from case to case, with the terms of such letters ranging from ironclad promises to non-binding statements of intent.
Letters of support are often issued for the following reasons:
- To provide credit support without accepting liability for the subsidiary’s debts (ambiguous territory for the issuer and any parties relying upon the letter in their dealings with the subsidiary, such as contractual counterparties, auditors and financiers, as will be seen from the authorities referred to below).
- To avoid having a contingent liability recorded against the issuer’s balance sheet in circumstances where the issuer is not willing, or unable by virtue of its financing documents, to do so (as finance arrangements will generally contain, for example, permitted indebtedness clauses and negative pledge clauses, which would be triggered by a contingent liability or formal security).
In addition to the above, a letter of support might also be issued at the request of a subsidiary ahead of its directors making an annual declaration as to the company’s financial position or as it undergoes an independent audit. An independent auditor might also want evidence of financial support from a parent, particularly if parent support appears to provide the basis for the subsidiary’s solvency (noting that auditors have statutory obligations under section 308 of the Corporations Act 2001 (Cth) to give an opinion on compliance with accounting standards and on whether the subsidiary’s financial reports give a true and fair view of its financial position and performance).
What does it mean to audit financial reports to determine whether they are “true and fair”? There is little authority on the subject, but in Grant-Taylor v Babcock & Brown Ltd (in liq) (2015) 322 ALR 723, Justice Perram stated:
"[I]t is possible for accounts to fail to give a true and fair view of the financial position of a company notwithstanding that those accounts have been prepared in accordance with relevant accounting standards. The circumstances in which this may occur may be relatively rare but they can exist. They will occur when the accounts do not give a “true” and “fair” view of the financial position or performance of the company. I do not think “true and fair” is a composite expression. Rather it reflects the reality that financial accounts not only deal with ascertainable facts but also with matters of opinion and impression. A financial statement will not be “true” when it contains facts which are incorrect or where material facts are omitted. It will not be “fair” where the opinions it contains are not reasonable in the context in which they appear. What is material to the former inquiry or contextual in the latter will usually include issues of accountancy but they are not determinative. It will follow that the obligation created by section 297 is substantive."
Letters of support will often create a serious tension between the interests of parents, subsidiaries, subsidiary directors and auditors. In particular, a parent will probably tread a fine line between suggesting that a letter is non-binding while also seeking audit sign-off and its subsidiary to continue trading. Company directors will be familiar with the general duties of care and diligence (including proper monitoring and management of the company’s business). Hand in glove are directors’ obligations to ensure that true and correct written financial records are kept by the company. In the case of public companies, large proprietary companies, registered schemes and disclosing entities, these obligations extend to engaging external auditors to provide an independent assessment of the company’s financial position and performance.
In addition to the above, it is worth noting the following statutory provisions in relation to audits:
- Corporations Act section 295 — directors’ declarations in relation to financial reports must contain, among other things, declarations that the financial statements give a true and fair view of the company’s financial position and performance. They must also contain declarations that, in the directors’ opinion, there are reasonable grounds to believe that the company will be able to pay its debts as and when they become due and payable.
- Corporations Act section 297 — a company’s financial statements and notes for a financial year must give a true and fair view of the company’s financial position and performance.
- Corporations Act section 344 — the civil penalty provision in relation to failures to take all reasonable steps to comply with Pts 2M.2 or Pts 2M.3 of the Corporations Act.
- Corporations Act section 1041H — the prohibition against engaging in conduct in relation to a financial product or financial service that is misleading or deceptive or likely to mislead or deceive (with compensation claimable against the contravener and any person involved in the contravention).
- Corporations Act section 1308 — the prohibition against making or authorising the making of a statement that, to the knowledge of the person making the statement, is false or misleading in a material particular (whether positively or by omission) in connection with the preparation of a document required by the Corporations Act (eg. financial reports — consisting of the financial statements, notes and directors’ declaration).
- Corporations Act section 1309 — the prohibition against officers making available, or giving, false or misleading information to auditors (among others). A letter of support might be requested by an auditor before the auditor is prepared to give an opinion that a company’s financial reports comply with accounting standards or represent a fair and true view of the company’s financial position and performance (ie. perhaps to substantiate the directors’ views that the company is able to continue to pay its debts as and when they fall due). In those circumstances, it would be difficult for a parent to contend that a letter of support was not objectively intended to confer a binding legal commitment (particularly in light of the consequences of non-compliance with the audit statutory provisions referred to above).
Do I have an enforceable letter of support?
At the outset, it is worth repeating the words of Chief Justice Rogers in Banque Brussels Lambert SA:
"There should be no room in the proper flow of commerce for some purgatory where statements made by business men, after hard bargaining and made to induce another business person to enter into a business transaction would, without any express statement to that effect, reside in a twilight zone of merely honourable engagement. The whole thrust of the law today is to attempt to give proper effect to commercial transactions . . . If the statements are appropriately promissory in character, courts should enforce them when they are uttered in the course of business and there is no clear indication that they are not intended to be legally enforceable."
Notwithstanding the above, the twilight zone is all too common (which has led to the volume of case authorities referred to below).
- There appear to be only a handful of cases involving letters of support that were ultimately found to be binding on the issuer, with a significantly higher number of authorities involving or referring to non-binding or unenforceable letters of support. In relation to non-binding letters of support, much has been written on the leading case of Atco Controls Pty Ltd (In Liquidation).
- In this paper, we focus instead on binding letters of support, which are best illustrated by the Full Court of the Federal Court’s decision in Re Forest Enterprises Ltd and the New South Wales Supreme Court’s decision in Gate Gourmet Australia Pty Ltd (In Liquidation). Each of those decisions are discussed in turn below.
- While most claims in relation to letters of support appear to be brought in contract, we note that estoppel and misleading or deceptive conduct claims are common alternatives (particularly where representations as to future financial support have been made).
In relation to the enforceability of a letter of support in contract, we note the following three main points:
- A letter of support will only be enforceable as a contract against the parent if the subsidiary has given consideration for the promises contained in the letter (which can be shown if the parent expressly or impliedly requested the subsidiary to continue to trade in return for the promises contained in the letter.
- A letter of support must contain language that is sufficiently certain and complete (with the precision and formality of the language used in the letter being important). A letter of support is more likely to be certain and complete if the concept of “financial support” in the letter has been tied back to a funding amount (either by reference to a figure or a reference to sufficient funding being made available to allow the subsidiary to pay its debts as and when they become due and payable) and a time period for the provision of any such support.
- A letter of support will only be enforceable as a contract against the parent if it manifests a clear, objective intention by the parties to create a legally binding agreement. Again, the language used in the letter will guide the court in this inquiry (ie. as to whether the language is promissory or illusory, whether terms with clear legal significance have been used and whether there are limits on when support can be withdrawn). The negotiation of and purpose for issuing the letter may also shed light on whether the parties objectively intended to strike a legally binding agreement. Against that background, we now turn to two examples of binding letters of support in the case authorities.
Re Forest Enterprises Ltd v FEA Plantation Ltd & Anor (2011) 280 ALR 470
Forest Enterprises Ltd was the parent of FEA Plantation Ltd (ie. the subsidiary). The subsidiary was also the responsible entity of a number of managed investment schemes involving forestry operations and was required to hold and maintain an Australian Financial Services Licence (AFSL). As a condition of the AFSL, the subsidiary was required to maintain cash flow projections for the foregoing three months and hold in cash 20% of the amount of expected outgoings for that period. “Cash” was defined to include “a commitment to provide cash from an eligible provider that can be drawn down within the next 5 business days and has a maturity of at least a month” and “Eligible Provider” was defined to include an ASX-listed company whose net assets exceeded $50 million.
On 27 August 2009, the parent gave a letter of support called “Commitment to Provide Financial Resources” to the subsidiary. The relevant parts of the letter stated:
"We understand that in order to comply with its cash needs requirements as set out in ASIC Regulatory Guide 166 (RG 166), FEA Plantations Limited (FEA Plantations) requires an “eligible provider” to provide a commitment to provide cash to FEA Plantations to enable it to satisfy its financial obligations.
As Forest Enterprises Australia Limited (FEA) is an ASX listed company with net assets (excluding intangible assets) of $228 Million (as shown in the most recent audited financial statements lodged with the Australian Securities and Investments Commission), FEA qualifies as an “eligible provider”. FEA hereby agrees to provide this commitment to FEA Plantation and in doing so, agrees to provide FEA Plantation with sufficient cash to meet its ongoing financial obligations and to satisfy its cash needs requirements from time to time.
In accordance with RG 166, requests for provision of funds by FEA Plantation will be honoured by FEA within five business days of receipt of a request from FEA Plantation. However, the maximum amount which FEA agrees to provide FEA Plantation by way of a cash commitment in any calendar month is $5.5 Million. If FEA Plantation requires additional funds, then it can lodge a special request with FEA for these additional funds. FEA can, in its absolute discretion, provide the additional funds or deny the request.
This commitment is ongoing. However, FEA may withdraw this commitment at any time by providing FEA Plantation with one month’s written notice of termination of this commitment."
On 14 April 2010, voluntary administrators were appointed to the subsidiary and, shortly thereafter, a demand was made against the parent to pay $5.5 million to the subsidiary pursuant to the letter of support. The parent claimed that the letter was not intended to create legal relations between the parties, that it was not supported by consideration, and that its terms were too uncertain and incomplete to constitute a contract.
At first instance, the trial judge held that the letter created a legally binding obligation upon the parent to provide funds to the subsidiary to enable it to meet its financial obligations. This aspect was upheld with the Court of Appeal relevantly noting the following:
- The terms of the letter and the circumstances in which it was made (ie. by reference to the subsidiary’s AFSL requirements) conveyed an objective intention between the parties to create a legally binding agreement. For example, the penultimate paragraph of the letter made a distinction between the parent’s commitment to provide $5.5 million in any calendar month and the parent’s “absolute discretion” to consider any subsidiary requests for funding that exceeded that amount (ie. leading to the conclusion that the parent bound itself to provide at least $5.5 million per calendar month).
- On the issue of consideration, it was open to infer that the parent knew that without the letter the subsidiary would not be able to maintain its AFSL and could not continue to act as a responsible entity of the managed investment schemes. It was also open to infer that the parent wished to avoid this occurring (which prompted it to provide the letter to the subsidiary). Further or alternatively, the parent impliedly requested that the subsidiary continue to act as a responsible entity, and the subsidiary agreed to do so (constituting good consideration).
- There was nothing uncertain about the terms of the commitment given by the parent. The letter stipulated a maximum figure ($5.5 million) of monthly financial support. There was no temporal uncertainty in relation to the commitment because it could be terminated by giving one month’s written notice.
Gate Gourmet Australia Pty Ltd (In Liquidation) v Gate Gourmet Holding AG
Gate Gourmet Holding AG was the parent company of Gate Gourmet Australia Pty Ltd (ie. the subsidiary). The subsidiary, an Australian trading company, provided exclusive catering services to Ansett Airlines (over an 8-year period). To maintain its business, the subsidiary relied upon substantial working capital and term debt facilities provided by its bank to service its contract with Ansett Airlines (which in turn meant that it needed to rely upon the support of its parent and other branch companies within the corporate group to service those facilities).
At the requests of auditors demanding to see proof of financial support in favour of the subsidiary, two letters of support were issued — the first was from a branch company in the first year and the second letter was from the parent in the following year.
The parent’s letter of support was in the following terms:
"This is to confirm that the parent entity, Gate Gourmet International AG, will provide the financial support that may be necessary to enable Gate Gourmet (Holdings) Pty Ltd and its controlled entities to meet its financial commitments as and when they fall due. This guarantee will not be withdrawn before Gate Gourmet (Holdings) Pty Ltd and its controlled entities have sufficient means to meet their obligations without the support of the parent entity."
When the managing director of the subsidiary was satisfied with the level of support provided by the corporate group, based on the information contained in the letters of support, both the managing director and the auditor signed, respectively, director declarations and auditor statements to the effect that the subsidiary could meet its debts as and when the debts fell due.
In September 2001, after Ansett Airlines went into voluntary administration, the subsidiary came under pressure from its bank and other creditors. When the subsidiary sought confirmation that the letters of support would be honoured, the parent stated that it would only cover the bank indebtedness (in respect of which the parent had provided a guarantee). The parent also stated that it would not cover payments to any other creditors. Consequently, the subsidiary went into voluntary administration and, later, the subsidiary’s liquidator brought proceedings to enforce the parent’s letter of support.
Justice Einstein held that letter of support constituted a binding contract. In summary:
- Properly construed, the letter contained language that was promissory (eg. “will provide the financial support” and “support will not be withdrawn before”) and it was not imprecise and uncertain.
- The letter was provided in the course of business and it was a “mutually known and understood circumstance” that the subsidiary could only trade with the full financial support and commitment of its parent. Consequently, the letter was issued with the effect of a promise, namely “to provide financial support that may be necessary to enable [the subsidiary] to meet its financial commitments”. That promise was relied upon when the subsidiary’s managing director signed declarations as to the good standing of the subsidiary. Given the severe penalties for contravention of the (then) Corporations Law, it seemed likely that the subsidiary’s directors would not have placed themselves at risk if they had known earlier that the parent did not intend to honour the statements contained in the letter.
Letters of support and insolvent trading liability
While it is not the focus of this article, it is worth noting that letters of support can be relevant in the context of the safe harbour regime — they are often a key consideration in safe harbour planning and advice. For the purposes of this paper, we focus instead on director and parent company liability for insolvent trading and examine the following questions:
- Having considered the authorities above, given the uncertain enforceability of some letters of support, can a director comfortably rely upon one to assist a good faith defence against insolvent trading liability?
- What about parent companies who issue letters of support to allow their subsidiaries to continue trading — are they not caught between liability under the terms of the letter on the one hand and parent company insolvent trading under Corporations Act section 588V on the other?
Director liability for insolvent trading
As a starting point, the elements of Corporations Act section 588G are well-known: (1) a person was a director when the company incurred a debt; (2) the company was insolvent when the debt was incurred, or became insolvent by incurring the debt; (3) when the debt was incurred, there were reasonable grounds to suspect that the company was insolvent or may become insolvent by incurring the debt; (4) the debt was incurred after 23 June 1993; and (5) the director was aware that there were reasonable grounds to suspect insolvency, or a reasonable person would have been aware of that matter.
There are three key points to note here:
- A person is solvent if, and only if, the person is able to pay all of their debts as and when they become due and payable, and a person who is not solvent is insolvent.
- The court will consider the resources that are available to the company to meet its liabilities as and when they fall due, whether resources other than cash are realisable, and whether such realisations are achievable. Potential asset sales and borrowings are considered in the context of whether a company is cash flow insolvent. But relevantly, in the context of letters of support, the court may take undertakings to provide financial support into consideration (even those that are not legally enforceable).
- Whether there were reasonable grounds to suspect that the company was insolvent or may become insolvent by incurring the debt is to be determined by reference to the objectively formed state of mind of a person of ordinary competence.
In Atco Controls Pty Ltd (In Liquidation), the court considered that a letter of support ultimately found to be unenforceable may have nonetheless given the directors reasonable grounds to conclude that their company would be able to pay its debts when they became due and payable. In that case, Warren CJ, Nettle and Mandie JJA stated:
"Furthermore, even, if “the contract” as found did not come into existence until after Newtronics was a wholly owned subsidiary of Atco, it would not seem unlikely that that the directors of Newtronics would still have been prepared to rely upon a non-binding undertaking. They knew that it was in Atco’s interest to keep Newtronics going. They also knew that Atco was prepared to provide Newtronics with support. Possibly, they may have expected that Atco would continue to provide such support for the foreseeable future. But assuming that the Newtronics’ board were endowed with at least a rudimentary level of commercial common sense, and so understood that holding companies tend to conduct operations through limited liability subsidiaries in order to avoid liability in the event of the subsidiary’s failure, they might also have well understood and accepted that Atco’s undertakings to provide support were intended not to be legally binding.
So to say is not to suggest that Atco’s undertakings to provide support were not seriously given or received. Other things being equal, the directors of Newtronics were entitled to assume that the undertakings, albeit not legally binding, would be honoured, and so to declare that there were reasonable grounds to conclude that Newtronics would be able to pay its debts when due and payable. It is conceivable that the actions of Newtronics’ directors in reliance on Atco’s undertakings could, in some circumstances, have founded an estoppel precluding Atco from resiling from the undertakings or at least resiling without first giving reasonable notice."
Conversely, in Chan, 22 a case not involving a letter of support but, rather, an informal understanding that support would be given to the relevant company by one of its directors, Justice Morrison stated at:
"[T]here is no benefit in attempting to achieve some precise formula as to likelihood, by reference to which the financial support qualifies or does not. To say that the likelihood of it being provided is “probable” or “improbable” adds no more to what has been said in the authorities to which I have referred. Given that the resolution of this issue will almost always depend upon an assessment of facts, in my view it is better to proceed on the basis that, where the financial support is being provided by a director or related entity, and in circumstances where there is no formalised agreement or understanding, what is required is cogent evidence which enables the court to conclude that there is such a degree of commitment on the part of the provider of the financial support to continue it, such that it can be said that at any point of time it was likely to be continued, with the result that, at any of those times, the company was able to pay its debts as and when they fell due."
Directors will often rely upon the defence in Corporations Act section 588H(2), claiming that they had reasonable grounds to expect that their company was solvent. Ostensibly, they are more likely to do so if they have a letter of support from a parent. But importantly, the authorities referred to above show that simply referring to a letter of support will not be sufficient — regard must be paid to the enforceability of the letter and evidence of financial support being given (and being capable of being given in the future).
Parent company liability for insolvent trading
At the outset, the concept of a “holding company” and “subsidiary” are defined by Corporations Act ss 9 and 46 respectively. A body corporate will be a subsidiary of a holding company if, and only if the holding company: (1) controls the composition of the subsidiary’s board; (2) is in a position to cast, or control the casting of, more than one-half of the maximum number of votes that might be cast at a general meeting of the subsidiary; or (2) holds more than one-half of the issued share capital of the subsidiary.
Parent company liability for insolvent trading under Corporations Act section 588V carries similar elements to director liability for insolvent trading with a key addition — at the time the relevant subsidiary incurred a debt: (1) the parent company or one or more of its directors was aware of grounds for suspecting insolvency; or (2) having regard to the nature and extent of the parent’s control over the subsidiary’s affairs and any other relevant circumstances, it is reasonable to expect that a holding company in the parent’s circumstances (or one or more of its directors) would be aware of grounds for suspecting insolvency. To this end, highly relevant considerations will include whether the parent and subsidiary had common directors at any relevant time and the frequency and content of financial reporting up the chain to the parent company.
If parent company support is required to allow a subsidiary to continue trading and it is given in the form of a letter of support, does this not mean that a parent company must ultimately choose between liability under the terms of the letter and liability for parent company insolvent trading? Pursuant to Corporations Act section 588X(2), like directors, parents can also raise a defence to insolvent trading liability by proving that they and each relevant director had reasonable grounds to expect and did expect that the subsidiary was and would remain solvent at the time a relevant debt was incurred. Clearly then, where a letter of support is central to the continued trading of a subsidiary, it will be important to examine the subjective and objective views of the parent and any relevant directors (eg. whether the letter was viewed as binding or enforceable and whether there was any intention to ever provide or withdraw the financial support referred to in the letter).
Letters of support take many forms and are issued for a variety of purposes and as set out above, they can generate a serious tension between the interests of various stakeholders — parents, subsidiaries, boards and auditors.
There are three points to note in closing:
- As is frequently the case, any legal implications from the issue, or poor drafting, of a letter of support may lie dormant until financial distress or external administration come into play. Regardless of the subjective views taken by the parties, a letter of support will be enforceable if consideration has been exchanged, the terms are certain and complete and the parties manifested an objective intention to enter into a legally binding commitment.
- If a letter of support has been issued in the context of an independent audit or following an auditor requesting evidence of financial support from a parent (ie. for “audit purposes only”), those additional facts can be central to a finding that the parties objectively intended to enter into a legally binding commitment.
- For directors relying on a letter of support, a reasonable expectation of solvency will turn on the formality or apparent enforceability of that support (and evidence that financial support had been, would be and could be given if called for). And for parent companies, there is a real risk that they might be caught between liability under the terms of the letter and liability for parent company insolvent trading (given the high likelihood of common directors and frequent financial reporting).
This article was first published in the Insolvency Law Bulletin, October 2021