In this article, we examine the difference between a letter of comfort and a guarantee – an important distinction in these times of heightened distressed positions.
Historically, little consideration appears to have been given to the signature of comfort letters by the boards of Luxembourg holding companies, it having seemingly become something “standard” that is simply requested by the auditors or the suppliers of operating subsidiaries each year. However in these times of increased distressed debt restructurings, the spotlight should again be focused on these letters.
While it seems that the common perception is that a traditional letter of comfort does not provide the third party addressee with a right to demand payment from the issuer but merely to provide comfort to the relevant creditors with regards to the (stable) financial position of the group to which the operating company belongs, in the absence of a legal or commonly agreed definition, the actual scope and terms/conditions of letters of comfort vary significantly. As a result, there is a risk of a board of a parent company unintentionally agreeing to incur liability towards a subsidiary or its creditors under the familiar title of “letter of comfort”.
Consideration should therefore be taken by any board of a Luxembourg holding or financing company as to whether it is in fact signing a traditional letter of comfort (typically limited to statements and/or obligations of means (obligations de moyens)) or a guarantee letter (implying liability, an obligation to pay and typically obligations of result (obligations de résultat)). The legal ramifications of the difference between the two are significant. The liability of directors or managers is higher in the event of non-performance of a guarantee as opposed to inability to perform under a traditional letter of comfort providing only obligations of means.
To differentiate between the two letters, it is important to understand the facts of the matter and the reason for requesting same from the Luxembourg company.
A letter of comfort is often requested as a result of the Luxembourg entity being the parent company of the wider group with more significant means to obtain finance, i.e. from group cash pools, other subsidiaries of the group or shareholder facilities etc. In other words a traditional letter of comfort is usually requested to ensure a going concern analysis or “clean audit” for the operating subsidiary, or to give comfort to suppliers providing goods on their payment terms, based on the position of the Luxembourg entity as parent of the group (i.e. with access to the group’s funding resources as a whole). This is a lighter obligation on the Luxembourg parent company which provides “comfort” as to the financial position of the group but does not assume any direct liability with regards to the payment of any (specific or general) debt of the relevant subsidiary.
A guarantee is stronger and is ordinarily requested to provide security for payment in the event of a payment default by the underlying subsidiary. This is requested based on the ability of the Luxembourg parent to pay based on its own resources (whether group resources, external financing resources, etc). A guarantee is a much stronger obligation on the Luxembourg parent company which provides a certainty as to ability to pay and often triggers a security enforcement on default.
As a “letter of comfort” is not clearly defined in Luxembourg law, the difference between the obligations arising from the traditional letter of comfort and the letter of guarantee as noted above becomes crucial. Only upon clearly understanding the different obligations created, can a board can consider whether the wording of the letter signed is one of comfort (in its traditional interpretation) or a guarantee (i.e. creating a payment obligation).
Whether the obligations assumed by the Luxembourg entity under the letter of comfort are qualified as obligations of means (obligations de moyens) or obligations of result (obligations de résultat) is of critical importance as it will directly determine the content of the obligations assumed by the company and the burden of proof of their non-performance.
The obligation of means (obligation de moyens)
An obligation of means exists where the debtor’s obligation is not to achieve a particular result, but only to take the measures to achieve such result. In other words, the object and purpose of the contract is not a particular result, but rather the means of action that the debtor must endeavour to (potentially) achieve such particular result, without the result being the object of the contract.
An obligation of means is breached if the obligor has not used the diligence or efforts provided for in the relevant instrument or, if no specific diligence is provided or required, a reasonable standard of care by reference to the standard of the bonus pater familias (bon pére de famille) (although certain particularities of the debtor (such as its profession or proven knowledge) may increase the standard of care required). The burden of proof of breach of an obligation of means is on the beneficiary (i.e. the creditor).
Obligations included in traditional “letters of comfort” would typically be limited to obligation of means, whereby a group parent confirms its intention or otherwise undertakes - in certain circumstances and with certain caveats1 - to use its best means and available group resources, for example cash pooling, ability to upstream cash from other subsidiaries, or any other means to achieve a desired result, but is not responsible as a stand-alone entity if such result cannot reasonably be achieved.
The obligation of result (obligation de résultat)
An obligation of result exists where the debtor is not only bound to show diligence or take measures which a reasonable party would take in the same circumstances but to actually achieve a result that has been promised (and that, accordingly, constitutes the object of the contract).
A breach of contract containing an obligation of result will therefore occur whenever the obligor has not produced the promised result (thus shifting the risk of foreseeable circumstances that may prevent the debtor’s actions to the debtor). With respect to the burden of proof of an obligation of result, the debtor can only exonerate itself by proof of an external cause (notably by evoking cause étrangère or force majeure according to articles 1147 and 1148 of the Luxembourg Civil Code) in the event he does not fulfill his commitment.
This is the “letter of guarantee” described above, where the group parent undertakes an obligation to pay or fund, which it itself is obliged to fulfil, the failure to fulfil same having a direct effect on the resources and potential solvency of the parent if it does not have additional resources to fulfil such obligations.
A letter of comfort may contain obligations of result which are not obligations to pay, but focus is given in this paper to wording implying an obligation to pay, thereby creating a guarantee in a letter of comfort.
1 A letter of this kind would typically include expressions such as “to the extent possible”.
Lack of (sufficient) legal definition
Luxembourg law provides for neither a clear definition of a letter of comfort nor any specific regime applicable to same.
French legislation offers more clarity on letters of comfort with the concept being specifically introduced into the French Civil Code in 2006 in Article 2322, defined under the title “letter of intent” as “an
undertaking to do or not to do - whose purpose is to provide support to a debtor in the performance of his obligation in respect of his creditors”1.
The French Civil Code definition is, however, criticised by certain authors2 who are of the view that the definition is limited to a restrictive view of a letter of comfort which is usually referred to in the French doctrine as “letter of intent strictly speaking”, such case dealing with binding letters of comfort and what Trichardt qualifies as (a) medium strength letters of comfort (which may contain obligations of means or obligations of result), and (b) strong/hard letters of comfort which in practice correspond to guarantees.
Doctrine and Jurisprudence
There appears also to be no commonly agreed definition of letter of comfort in legal doctrine and authors tend to propose broad concepts covering the various possible scenarios. Trichardt, for example, mentions that the term “letter of comfort” is a “generic term used to denote a wide variety of promises, representations, declarations or statements made by a person or legal entity to assure or reassure a creditor or creditors of another person or legal entity of his or their chances of satisfaction of his or their claim to payment of debt”3 and the Belgian author DU JARDIN, describes a letter of comfort as “the letter that a natural or legal person (the issuer) sends to one or more determined or undetermined creditors with a view to comforting them with regard to the execution of their claim vis-à-vis a third party of which they are generally a shareholder of reference”4.
A common denominator can, however, be found in one respect as authors seem to be in agreement that the traditional letter of comfort does not intend to induce the issuer thereof to replace the subsidiary with respect to a liability or co-assume the debt(s) that gave rise to the letter of comfort (which would, in fact, correspond to a guarantee), but merely to provide “comfort” to the relevant creditors. The variation is, therefore, in how (and to what extent) the “comfort” is provided.
This is also the position adopted by the Brussels Court of Appeal, according to whom the content of a letter of comfort varies from case to case and can range from a simple description of a situation to a legal commitment. The Court of Appeal clarifies, however, that when the letter contains such a commitment, it does not confer on the creditor a second debtor but creates an obligation on the issuer to do or not to do certain actions in favour of or in connection with the debtor company.
It is not unusual for documents titled “Letter of Comfort” to include specific undertakings binding on the parent company, whether an equity funding obligation or other covenants relating to the management of the business (for example an obligation not to distribute dividends pending a target being reached, not to sell all or a portion of the shares held, etc).
As held by the Brussels Court of Appeal, whether these undertakings (including undertaking to fund, not distribute and/or hold at least a specific per centage of equity etc) will qualify as obligations of means or obligations of result (as set forth above) will ultimately depend, not on whether these obligations are included in a letter which is titled a letter of comfort or guarantee but rather on how such obligation is drafted and the level of commitment and engagement that the issuer will be bound by as a result5.
Due to the various formats that letters of comfort may take in practice (whether related to a specific transaction, general group audit, or otherwise) it is not possible to extract a generally accepted definition or – more importantly – applicable regime. It is only on the analysis of the nature, characteristics, enforcement rules and consequences of the contractual instrument itself that the board of any Luxembourg entity can be sure of the level of commitment being undertaken by such entity when granting a letter of comfort.
1 La lettre d'intention est l'engagement de faire ou de ne pas faire ayant pour objet le soutien apporté à un débiteur dans l'exécution de son obligation envers son créancier.
2 For instance, ANTON P. TRICHARDT, Letters of Comfort: A Trans-Systemic Analysis, 2011
3 ANTON P. TRICHARDT, Letters of Comfort: A Trans-Systemic Analysis, 2011
4 La lettre qu'une personne physique ou morale (l'émetteur) adresse à un ou plusieurs créanciers déterminés ou indéterminés en vue de les conforter quant d l'exécution de leur créance vis-à-vis d'un tiers dont elle est généralement actionnaire de référence
5 Cour d'appel Bruxelles 9ème ch., 25/04/2008 - where the court states that “afin de déterminer si une lettre de patronage qui contient une obligation de faire constitue une obligation de résultat ou de moyen, il y a lieu de rechercher la volonté commune des parties en se fondant tant sur les termes de la lettre (éléments intrinsèques) que sur la qualité de l'émetteur et les circonstances qui ont entouré son émission (éléments extrinsèques).”
A letter of comfort can include a variety of different obligations and it need not necessarily be limited to obligations of means. The letter may very well include obligations of result, such as an undertaking not to sell the shares of the subsidiary. An obligation of result does not itself necessarily give rise to a guarantee. Caution must be given with respect to any undertaking to “fund”, “pay” or undertake a capital increase or any other obligation of result linked to an undertaking to pay which might create a guarantee.
In the view of the authors, any obligation of result included in a (traditional) letter of comfort should therefore be limited to ancillary actions that provide comfort to the creditor(s) of the sponsored subsidiary, such as a negative pledge etc. If the obligation of result included in such letter of comfort goes beyond this to relate to the payment of a debt of the sponsored subsidiary, the relevant instrument will, in the view of the authors, qualify as a guarantee and no longer as a traditional letter of comfort.
The conclusion to draw from the above is that careful wording of any letter of comfort is essential to create the correct intended obligations.
The important point to consider from a board liability perspective when concluding any letter of comfort, is whether the wording used (more especially, with respect to any statements relating to funding) creates an obligation of means or an obligation of result.
Any wording used should be specific enough to ensure that the intention of the Luxembourg parent issuing such letter is clear, i.e. (i) to provide comfort or (ii) to give an indemnity or guarantee.
The ability of a holding company holding a single asset consisting of an operating group, or alternatively holding various parts of an operating group through inter linked subsidiaries (a so called umbrella structure), to meet its specific obligations under the terms of the letter given must be carefully considered before issuing any such letter.
The above considerations are critical with respect to, amongst other matters: (a) board liability for directors approving conclusion of such letters, (b) potential bankruptcy of a parent linked to a bankrupt subsidiary (and therefore potential bankruptcy of other operating group entities where an umbrella structure is in place), and (c) availability of assets of the group to finance any such obligations where an obligation of result is created.
The precise wording in these letters which have become a “common request” to Luxembourg holding company boards is of absolute importance.