Stricter Limitations on Intra-Group Financing Arrangements Following Swiss Federal Supreme Court Ruling

Pursuant to the Swiss Federal Supreme Court’s ruling 4A_138/2014 of 16 October 2014 (BGE 140 III 533), up-stream and cross-stream loans which are not at arm’s length block an intra-group lender’s freely distributable equity and limit dividend distributions in the amount of any such up-stream or cross-stream loan. In the same ruling, the Swiss Federal Supreme Court ended a controversy in legal doctrine by deciding that additional paid-in capital (Agio) is to be treated like general reserves and, hence, can be distributed as dividends.

By Marc Hanslin / Roland Lüthy (Reference: CapLaw-2015-30)

1) Factual Background

Swisscargo Ltd (“Swisscargo”), an indirect subsidiary of SAirGroup, was part of the group’s zero-balancing cash pool led by the Dutch cash pool leader, Finance BV. As per 31 December 2000, Swisscargo had a claim of CHF 7.2 million out of short term deposits against SAirGroup and of CHF 16.5 million against the cash pool leader under the cash pooling framework. Freely distributable equity, as confi rmed by Swisscargo’s auditors’ report, stood at CHF 29.2 million as per 31 December 2000. In April 2001, S Air Logistics Ltd, Swisscargo’s parent company approved the distribution of a dividend in the amount of CHF 28.5 million. In June 2001, the dividend was paid out via the cash pool. As the whole group found itself in financial distress by the end of 2001, the managing bank terminated the cash pool and Swisscargo went into composition proceedings whereas the cash pool leader was declared bankrupt. The liquidator of Swisscargo brought its claim against the pool leader in the cash pool leader’s bankruptcy proceedings and obtained a dividend in bankruptcy. Dissatisfi ed with the payment, the liquidator sued Swisscargo’s auditors (which were the auditors for the whole SAirGroup) for breach of their duties in signing off on the dividend proposal, arguing that the dividend payment in June 2001 violated Swiss law since Swisscargo’s freely distributable equity, at that time, had been reduced by the pre-existing up-stream loans, which were not entered into at arm’s length and, thus, in fact were to be treated like hidden dividend payments. As a consequence, the 2001 dividend should have not been paid out in such a high amount. The funds would then have remained in the cash pool and, hence, would have led to a higher dividend in bankruptcy.

In essence, the Swiss Federal Supreme Court confi rmed the liquidator’s view and held the auditors liable for damages.

2) Key Points of the Ruling

In general, Swiss law does not provide for special rules for groups of companies, and a Swiss subsidiary has, first and foremost, to promote its own interests and not those of the group. Hence, it is expected to treat other group companies like third parties. Legal scholars therefore have always argued that financial assistance within a group of companies is problematic if not granted at arm’s length terms and considered the granting of up-stream or cross-stream loans which are not at arm’s length terms a payment of a hidden dividend and, to the extent the relevant loan is not covered by freely distributable equity, even an illicit repayment of capital if future repayment is doubtful. Some details of this doctrine are controversial and a clear-cut test does not exist. In the case at hand, the Swiss Federal Supreme Court not only supported the established legal doctrine, but followed a small, very restrictive minority by applying a new, even stricter reading of the prohibition of the repayment of capital contributions to shareholders (Verbot der Einlagenrückgewähr) in Swiss corporate law.

Apart from a brief side note stating that it was questionable whether the participation in a cash pool could ever pass the arm’s length test, the Swiss Federal Supreme Court did not analyze the cash pooling arrangement as such in detail. Rather it dissected Swisscargo’s cash pooling into different two-party loan agreements and examined the up-stream and cross-stream loans in the light of said prohibition of the repayment of capital contributions without taking into account benefi ts stemming from the participation in a cash pool of a group of companies. It held that any up-stream or cross-stream loan which is not at arm’s length blocks the freely distributable equity of a lender in the amount of any such loan for future dividend payments because, according to the Swiss Federal Supreme Courts’ reasoning, the risk existed that the same amount of funds would be distributed to affiliated companies twice.

It has to be noted that, according to the court, the whole amount of any such loan has to be blocked and not only the difference between, for example, an interest rate agreed among the group companies which is not at arm’s length and a market interest rate, even though the court did not consider the loans fictitious and, hence, a hidden dividend payment in the whole amount (in which case it would not make sense to book them on the balance sheet as intra-group loans).

Furthermore, the Swiss Federal Supreme Court failed to elaborate on the arm’s length criteria. In particular, the court did not discuss the criteria proposed in scholarly writing nor did it decide whether the same criteria the court applied to assess arm’s length conditions in tax matters in the past were also applicable from a corporate law perspective. This leaves some uncertainty on how to apply the arm’s length test in other cases. The court simply considered the loans not at arm’s length on the grounds that there was no collateralization and no evidence that the lender monitored the creditors’ creditworthiness despite indications on financial distress on the horizon.

As to the relevant point in time to assess the arm’s length conditions and the existence of freely distributable equity, the court held that the balance sheet date and not the date of the dividend distribution is decisive.

3) Distribution of Dividends out of Additional Paid-in Capital

In the ruling, the Swiss Federal Supreme Court also had to decide whether additional paid-in capital could be distributed as dividends. So far, a minority of Swiss legal scholars held the view that this is not admissible, arguing that the prohibition of the repayment of capital would also include additional paid-in capital. The Swiss Federal Supreme Court ended the controversy by following the majority view and stating that additional paid-in capital is by law, i.e., without the need of reclassifying the reserves from additional paid-in capital (which have to be booked separately for tax reasons), part of the general reserves and can therefore be paid out as dividends, subject to the same limits as the other general reserves.

4) Reaction of Auditors

In scholarly writing and amongst legal practitioners and auditors, the ruling led to a vivid discussion as to the implications of the verdict on intra-group financing arrangements. Especially, to what extent and under which conditions cash pooling arrangements are still admissible. The lack of a thorough analysis of the cash pooling arrangement in the case at hand and the vague side note issued by the Swiss Federal Supreme Court created considerable uncertainty in that respect.

Auditing companies were especially alarmed by the decision for obvious reasons. EXPERTsuisse, which also represents Swiss audit companies, published a Q&A paper (Selected Questions and Answers on the Assessment of Intragroup Receivables, Cash Pooling Structures and Dividends with regard to Article 680 Paragraph 2 of the Swiss Code of Obligations) for its members discussing the consequences of the new ruling and suggesting stricter standards for auditors when assessing up-stream and cross-stream loans and when deciding on proposed dividend distributions when up-stream and cross-stream loans are in existence.

As regards the arm’s length test for up-stream and cross-stream loans in general, EXPERTsuisse lists the criteria based on which an overall assessment should be made. These criteria mostly correspond to the criteria proposed in legal writing and applied by the Swiss Federal Supreme Court in tax matters and are essentially the following:

  • documentation of loan agreement and arm’s length test in writing;
  • use of market interest rates (taking into consideration the currency of the loan, the lender’s creditworthiness, etc.) and terms (term of loan and termination provisions);
  • regular payment of interest and amortization (willingness of debtor to repay the loan);
  • existence of collateralization (or adequate compensation in case of missing collateralization) and quality of collateral (e.g., guarantees by other participants of the cash pool should not be considered recoverable collateral);
  • relative size of the loan on the balance sheet (no concentration risk); and
  • assessment of the debtor’s solvency and creditworthiness when entering into the agreement and ongoing monitoring thereafter (ability of debtor to repay the loan).

For cash pools, in particular, EXPERTsuisse also suggests to take into consideration whether a company’s role within the cash pool is static (i.e., it only provides funds into the cash pool) or whether it changes (i.e., the same company at times acts as a lender and at times draws upon funds in the cash pool) and whether the cash pool is a company’s only access to cash or whether it has other liquid assets.

According to EXPERTsuisse, it is the responsibility of the board of directors to assess and document the lawfulness of any intra-group financing activities vis-à-vis the auditors, including to provide evidence for an arm’s length test in case of up-stream and cross-stream loans. In the opinion of EXPERTsuisse, a mere confi rmation of the lawfulness of such intra-group financing in the board’s representation letter to auditors (Vollständigskeitserklärung) should not be considered sufficient.

In the absence of enough freely distributable equity and evidence for the passing of the arm’s length test, EXPERTsuisse recommends to its members to refuse to sign off (Versagung des Prüfungsurteils) on any proposed dividend distribution and to issue an adverse opinion regarding the proposed dividend in its report to shareholders.

EXPERTsuisse furthermore recommends its members to also take into consideration any negative developments after the balance sheet date when conducting an audit of up-stream or cross-stream loans.

5) Conclusion and Outlook

Even though the Swiss Federal Supreme Court ruling was rendered in the very specific context of the cash pooling arrangement in the collapse of the SAirGroup, its legal consequences apply broadly. This has led to some uneasiness and uncertainty amongst legal practitioners. Until the Swiss Federal Supreme Court addresses a similar matter and gets the opportunity to state or restate more precisely its newest doctrine, this uncertainty will remain and intra-group financing arrangements will come under much greater scrutiny by auditors. The ruling has also strengthened the position of  auditors in the discussion on the admissibility of intra-group financing and the assessment of dividend proposals.

Given the auditor’s liability established in the Swiss Federal Supreme Court Ruling, we expect auditing companies to largely follow EXPERTsuisse’s recommendations going forward. Therefore, a prudent approach would imply that up-stream and cross-stream loans be granted at arm’s length conditions and that this be properly documented for the auditors. Otherwise, the freely distributable reserves will have to be blocked in the amount of any existing up-stream or cross-stream loan, thereby limiting future dividend payments.

As regards cash pooling, in our opinion, it serves a legitimate purpose in a group of companies and the latest Swiss Federal Supreme Court ruling, despite its general applicability and in spite of the negative side note on cash pooling arrangements in general, should not be read as to render cash pooling impossible altogether. However, it is clear that existing and future cash pooling arrangements should be critically analyzed and, to the extent necessary, adapted in the light of the new Swiss Federal Supreme Court ruling and existing legal practice (as, for example, set out by EXPERTsuisse and discussed above) with regard to arm’s length conditions.

by Marc Hanslin (
by Roland Lüthy (