What comfort is a comfort letter?

January 2014

Rating system:
Reading time (1-10 minutes): 4
Sophistication level (1 (idiot) – 10 (expert)): 6
Entertainment value (1 (turgid) – 10 (side-splitting)): 5

Background

If you are doing business with any company you want to know they’ll be good for their obligations and won’t go bust on you. If you’re dealing with a subsidiary of a large successful company you might be prepared to overlook the subsidiary’s weak-looking financial position (assuming you’ve checked it out in the first place) provided that you are given what is known as a ‘comfort letter’ from the parent company.

But are comfort letters worth the paper they’re written on? Shouldn’t you be asking for a proper guarantee instead? Check out this case from last year.

Case

In this case a supplier company was contracting with a subsidiary company of quite a large parent company. In each of the last three years the parent company had written letters to the subsidiary’s directors confirming that the parent would provide the necessary financial and business support to the subsidiary to ensure that it continued as a going concern.

The letters went some way further than most such comfort letters, which simply state that the parent company’s ‘present policy’ is to ensure that its subsidiary is in a position to meet its liabilities.

In reliance on this, the subsidiary’s directors had filed annual accounts on a going concern basis, with the accounts saying that this was based principally on the letter of continuing financial support from the parent company. In other words, without the assurance of the parent’s support the subsidiary would have been insolvent and its directors would have had to consider their options including winding up. And of course any supplier company doing a company search and looking at the subsidiary’s accounts would have thought twice about doing business with it.

The subsidiary went into administration owing the supplier money. Its business and assets were sold in a pre-pack to another group company. Unsecured creditors like the subcontractor received peanuts.

The supplier claimed that the comfort letters had created obligations that were enforceable by the subsidiary against the parent, and that the subsidiary (through its liquidators) should have enforced these obligations, and that the failure to enforce them was a transaction defrauding creditors.

Court decision

The judge rejected the supplier’s claim.

He said the letters did not create a contract between the parent and the subsidiary or any of its directors. He couldn’t find any consideration passing from the subsidiary in return for the assurance of financial support. He said the letters were only addressed to the subsidiary’s directors (and not so much to the subsidiary itself), and their purpose was simply to enable the directors (and the auditors) to determine whether the financial statements could be prepared on a going concern basis. He said that the fact that the subsidiary’s directors may have relied on the letters to continue trading was not consideration.

He commented that the parent could not possibly have committed itself so casually in the letters to restore the subsidiary to balance-sheet solvency, bearing in mind that for example in one of the years this would have required the parent to discharge liabilities of the subsidiary amounting to £271.5 million.

Musings

· The verdict was surprising to some. Expert evidence given in the case suggested that some auditors would have regarded these letters as binding.

· So do auditors and directors need to re-think the effect of these letters generally? If such a strongly worded parent company comfort letter is next to useless, is it right to agree that the accounts can be signed off on a going concern basis without having something a bit stronger?

· Most such comfort letters give somewhat weaker reassurances. They only refer to the ‘present policy’ of the parent company. So it does beg questions as to why directors of subsidiaries feel comfortable signing off accounts on a going concern basis in reliance on such letters. Of course, they want to sign off because they want to carry on in their jobs… Perhaps a case will come up one day deciding whether a director was in breach of any of his statutory duties by signing off on this basis.

· The distinction the judge drew between a letter addressed to a company and one addressed to its directors seems a bit odd. But the judge did make clear that he thought it would have been ridiculous if the effect of the letter might have been that the parent company was agreeing to commit to put the subsidiary in funds to discharge up to £271.5m in liabilities. So perhaps this might have influenced his reasoning…

· This case touches on old questions as to when does a duty of care arise. Does a parent company owe duties in tort (as opposed to under contract) to third parties who might rely on promises the parent makes to its subsidiaries to keep them afloat? The answer seems to be no. Does the parent company’s auditors owe similar duties? Again, the answer is now on the whole understood to be ‘no’. For example in Caparo v Dickman ([1990] 1 AC 831) the House of Lords ruled that auditors did not owe a duty of care to individual shareholders of a company, whether or not they were existing shareholders, who acquired shares in the company in reliance on the audited accounts. And in Al Saudi Banque v Clark Pixley ([1989] 3 All ER 361) the High Court held that auditors owed no duty of care to a bank lending money to a company in reliance on the audited accounts

Advice

• A comfort letter is no guarantee. If it’s not even addressed to you it’s almost certainly completely worthless. Same if there’s no consideration passing. Same if it’s expressed to be not legally binding.

• For any contract to exist you need to have the normal requirements of offer and acceptance, consideration, certainty as to terms and intention to create legal relations. If you want a contract to exist, make sure you have all these things. If in doubt about the existence of consideration, word things as a deed.

· If you are thinking of doing business with a company, and if its finances look iffy, don’t rely on any statement in its accounts saying that its parent company has said it will support it. And don’t rely on the fact that the auditors have also then signed off on the accounts. If in any doubt and you really want comfort, ask for a proper guarantee from the parent company. And check out the parent company’s financial position as well.

· If you’re thinking of doing business with anyone at any time, and you want assurances from someone else that that person will fulfil its obligations, don’t just rely on the assurances. Try and get a written guarantee.

· If you’re a director of a subsidiary, think about your duties and whether you should be signing off your accounts on a going concern basis. Satisfy yourself as to how realistic the parent company’s assurances are. But perhaps the risks are small as you’re unlikely to get into real trouble on the ‘signing off accounts’ front if you do what everyone else currently does.

· More importantly, if you’re a director of a subsidiary don’t simply rely on parent company promises of support when making ongoing decisions as to whether and how to carry on trading. Apart from anything else, you could be exposed to the risk of personal liability for wrongful trading.

Case: Simon Carves Limited sub nom Carillion Construction Ltd v (1) Zelf Hussain & Robert Jonathan Hunt (joint liquidators of Simon Carves Ltd) (2) Simon Carves Ltd (In liquidation) [2013] EWHC 685 (Ch)