In the wake of Covid-19, many companies are finding themselves in the position of having to assess solvency. Under Australian insolvency law, solvency is determined on the basis of a “cash flow” test, and in making an assessment of solvency, directors may have regard to the company’s ability to access financial support from financiers, parent companies and shareholders. To give the directors comfort as to the availability of such financial support, a letter of comfort may be offered. Alternatively, a letter of comfort may be offered in a financing transaction in lieu of a formal guarantee and indemnity.
But just how much comfort do letters of comfort give to the recipient? Are they binding on the issuer?
A letter of comfort is an instrument given by a third party to a party (or to a financier of the party) with the intention of giving some assurances to the recipient. There is no standard wording for a letter of comfort, and they are not readily identifiable as a distinct type of legal document (in the same way as a guarantee is, for example). They may include one or more statements along the following lines:
- an undertaking that the issuer of the letter will maintain its shareholding in the relevant company;
- an agreement that the issuer of the letter will use its influence to see that the relevant company is in a position to meet its financial obligations;
- a confirmation that the issuer is aware of the relevant company’s financial or other obligations (but without taking responsibility for those obligations); or
- statements concerning the issuer’s intentions and policy with regard to the relevant company.
What is the difference between a letter of comfort and a guarantee?
Under a guarantee, the issuer agrees to be liable for the debts of the relevant company. However, under a letter of comfort, the issuer gives certain assurances or makes certain statements in respect of the company, but without taking responsibility for the debts of the relevant company.
Letters of comfort may be issued to give some assurance to the recipient (and to encourage the parties to enter into a particular commercial relationship or transaction) without the issuer having to formally guarantee the performance of the obligations of the relevant company. They may also be issued in circumstances where:
- the issuer does not have legal power to enter a guarantee due to restrictions in its constituent documents;
- there may be tax or stamp duty implications for the issuer in giving a guarantee;
- the issuer may not wish a contingent liability to appear on its balance sheet; or
- the issuer may be restricted from giving a guarantee under its own documentation with its financiers.
Are they binding?
Yes, they can be. Australian courts have been willing to find in some cases that undertakings in a letter of comfort are legally binding, but this will turn on the precise words used in the letter and the context of the letter within the surrounding facts of the transaction. There are two Australian cases on point.
In Banque Brussels Lambert SA v Australian National Industries Limited (1989), the Supreme Court of New South Wales considered a letter of comfort in which the holding company:
- asserted to a bank that “it is our practice to ensure that our affiliate will at all times be in a position to meet its financial obligations as they fall due.”; and
- undertook to not sell its interest in the subsidiary company without notifying the bank.
The court took a commercial view of the construction of the document and found that a court should give a letter of comfort proper effect in a commercial transaction:
“If the statements are appropriately promissory in character, a court 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.”
The court found that the statements in the letter of comfort had been made to induce another to enter a transaction and that the statement of policy that the subsidiary could meet its obligations was a binding promise. In arriving at this outcome, the court:
- examined at length the various stages of drafting the comfort letter and it was noted that during the negotiation of the drafting of the letter of comfort, the bank attempted to strengthen the language used in the letter, whereas the holding company expressed opposition to clear and strong terms;
- concluded that the holding company was clearly aware that the bank wanted the letter of comfort to be more than a mere statement of the holding company’s current policy; and
- noted that the terms were of commercial significance to the bank, and they had made it clear that it would not lend the money without a strongly worded comfort letter.
The decision in Banque Brussels was followed in Gate Gourmet Australia Pty Limited v Gate Gourmet Holding AG  NSWSC 149.
The facts in Gate Gourmet were as follows:
- Gate Gourmet Australia Pty Limited (Gate Gourmet Australia) was a member of the Swiss Air Group and was established as the trading arm of the Gate Gourmet group to provide airline catering in Australia. Gate Gourmet Australia successfully tendered for the catering contract for the Ansett airline business in late 1999.
- Gate Gourmet Australia did not have significant capital of its own and was heavily indebted.
- In preparing the financial statements for the year of 31 December 2000, the auditors requested the Swiss parent to provide a letter of comfort to the Australian Gate Gourmet Group given its nominal capitalisation and the fully drawn nature of its external banking facilities. Evidence suggested that the directors were seeking the letter of comfort in order to be satisfied that Gate Gourmet Australia was not trading while insolvent.
- A letter of comfort was provided by the Swiss parent on 16 February 2001. The letter provided:
“Gate Gourmet Holdings AG will provide financial support that may be necessary to enable Gate Gourmet Holdings Pty Limited and its controlled entities to meet its financial commitments as and when they fall due.”
It was noted that in a prior draft, the letter had been referred to as a ‘guarantee’.
- Gate Gourmet Australia went into administration and then liquidation. The liquidator brought proceedings against the Swiss parent to enforce the letter of comfort.
The decision turned on whether there existed an intention to create legal obligations and whether the letter was of a sufficiently promissory nature as to be contractual.
The Court found that:
- the letter of comfort was promissory in nature; and
- the Swiss parent was obliged to indemnify Gate Gourmet Australia against its financial commitments.
The Court considered the following factors:
- in commercial transactions, there is a presumption of an intention to create legal relations (Edwards v Skyways Limited (1964) 1 WLR 349) and the onus to prove otherwise rested with the Swiss parent. Given the commercial circumstances and the terms of the letter, this onus had not been discharged and so it was found that there was an intention to create a legally binding arrangement; and
- it was known and understood by the Swiss parent and Gate Gourmet Australia that the letter, and the implied provision of financial support, were necessary to enable the directors of Gate Gourmet Australia to allow the company to continue trading. This evidenced the intention of the parties that the letter was intended to be enforceable.
Issuers of letters of comfort need to be aware that Australian courts have been willing to find that undertakings in a letter of comfort are legally binding. In commercial transactions, there will be a presumption that this is the case. Issuers also need to be aware that if the letter of comfort is legally binding, it is not only the original recipient who may be entitled to rely on it, but also an insolvency practitioner appointed to the original recipient (as was the case in Gate Gourmet).
A letter of comfort needs to be very carefully drafted to ensure that it reflects the intention of the parties. To give as much certainty as possible, factors such as:
- whether the letter of comfort is intended to be legally binding;
- whether the letter survives the insolvency of the subject company;
- whether it can be revoked by the issuer (and if so, in what circumstances); and
- who is able to rely on the letter of comfort and for what purpose,
should be expressly addressed in the drafting of the letter of comfort. The parties should also ensure that the related correspondence, and the conduct of the parties, are consistent with the language used in the letter of comfort.
However, even if these steps are taken, whether or not the letter of comfort is binding and in what circumstances, will turn on the precise words used in the letter, the context of the letter and the surrounding facts of the transaction.
For more information, please contact Tricia Moloney.