An upstream guaranty occurs when a subsidiary guaranties a loan made to its parent corporation or a business entity otherwise guaranties the debt of an equity owner. These guaranties may be unenforceable under creditors’ rights laws relating to fraudulent conveyances.
Section 548 of the Bankruptcy Code allows a trustee-in-bankruptcy to avoid a guaranty given prior to the filing of the bankruptcy petition if (i) the guarantor did not receive adequate consideration (i.e., “reasonably equivalent value”) and (ii) the giving of the guaranty rendered the guarantor “insolvent” or, in certain other ways, adversely affected the financial condition of the guarantor. State laws give similar avoidance powers to creditors of the guarantor. See Chapter 20, “Bankruptcy” for a discussion of fraudulent conveyances. Bank counsel should be consulted with respect to the enforceability of upstream guaranties.
Adequate consideration for this purpose means consideration which benefits the guarantor. Reliance by the Bank will not suffice. An upstream guaranty may or may not benefit the guarantor and, even if it does, the benefit may or may not be adequate to preclude avoidance as a fraudulent conveyance. If it is intended that the parent downstream (whether by loan, advance, capital contribution or otherwise) some of the loan proceeds to the subsidiary, then the subsidiary obviously stands to benefit (albeit indirectly) from the guaranty. In that situation, the issue would turn on the sufficiency of the benefit. Where (i) the subsidiary guaranties the entire amount of the loan to the parent and (ii) it is clear that, at most, only a portion of the loan proceeds will be made available to the subsidiary, a serious question will exist as to the adequacy of the consideration. It may be possible to limit the subsidiary’s obligation under the guaranty and, by so doing, enable the Bank’s counsel to satisfy himself that the guaranty is supported by adequate consideration. For example, the guaranty might limit the subsidiary’s liability under the guaranty to the amount of loan proceeds actually downstreamed to it by the parent.
Because of its complexity, this solvency of the guarantor is significantly more difficult for the Bank and its counsel to assess and, regardless of the level of their comfort, is subject to second-guessing after the fact. Frequently, provisions will be included in the guaranty limiting the liability of the subsidiary under the guaranty in such a way as to minimize the risk that the guaranty will render the subsidiary insolvent.
If, for one or more reasons, it is not desirable to contractually limit the subsidiary’s obligation under the guaranty, the Bank should obtain appropriate documentary evidence of the facts deemed necessary to satisfy the solvency test. Possibilities include carefully drafted certificates of the chief financial officer of the subsidiary and “solvency letters” from independent financial experts. As a result of a ruling issued by the American Institute of Certified Public Accountants in 1988, accounting firms are precluded from rendering solvency opinions.