Foreign Subsidiaries: Potential Sources of Cash for Distressed Companies

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Foreign Subsidiaries: Potential Sources of Cash for Distressed Companies
By Lisa E. Herrington and Mark Podgainy

In recent years, several factors, including the lowering of trade barriers, growth in foreign markets, the search for lower manufacturing costs and the increasing globalization of business, have led many middle-market U.S. companies to establish or acquire foreign subsidiaries. Typically, companies do so with long-term goals in mind, as it often requires significant time to generate the expected return on investment. The recent strong economic growth in both developing and developed economies has resulted in many foreign subsidiaries exceeding performance expectations. As a result, even young foreign subsidiaries may generate positive cash flow and provide their U.S.-based parents with relatively high returns on investment early in their life cycles. In times of distress, a company usually will turn inward and focus primarily on issues in its troubled domestic operations. Foreign subsidiaries are often ignored, left alone to be run by their country or business unit managers. But foreign subsidiaries should not be forgotten, as they can be valuable sources of much-needed cash.

This proved to be the case with one distressed company. The story of a U.S.-based company ("Domestic Corp.") and its efforts to realize value from its foreign subsidiaries in a time of financial distress provides a telling example of not only the potential value of a foreign subsidiary to a U.S.- based parent in a liquidity crisis but also some of the potential difficulties that can be encountered in repatriating cash and the creative solutions that can be employed.

Background

Domestic Corp. manufactured products and provided services to business customers worldwide. Six of Domestic Corp.'s foreign subsidiaries (located in the Netherlands, Italy, Canada, Brazil, China and the United Kingdom) collectively accounted for approximately 75 percent of Domestic Corp.'s total revenue. Domestic Corp.'s domestic operation sold components or fi nished products to most of the foreign subsidiaries, which in turn either incorporated Domestic Corp.'s products into their own fi nished products or sold them directly to customers overseas.

Despite strong sales to its foreign subsidiaries due to robust demand in Europe and developing countries, Domestic Corp. began experiencing a downturn in its domestic business. The timing was terrible: The downturn occurred as a deadline approached for Domestic Corp. to make significant interest payments to its bondholders. Domestic Corp. had previously drawn down the remainingcash on its domestic credit line, assuming that the cash flow that was originally forecasted from its operations would be suffi cient to fund the required payments to bondholders. However, in addition to the downturn, there were severe, unanticipated delays in customer collections that quickly led to a cash crisis. Although management regularly prepared short- and long-term cash flow projections to manage its cash flow, the downturn and working capital issue were sudden, leaving management, which had no contingency plan, with little time to react. Domestic Corp.'s chief financial offi cer, noting large cash balances at some of the foreign subsidiaries, realized that the immediate cash crunch could be resolved, at least partially, by repatriating cash from the subsidiaries.

Repatriating Cash

Accelerating Repayment of Intercompany Debts
Prior to Domestic Corp.'s liquidity crisis, its foreign subsidiaries often took advantage of relaxed intercompany payment terms in order to reduce borrowings under their own credit lines with local lenders. In many cases, the subsidiaries had the ability to pay intercompany invoices well within 60 days after invoices were issued. The CFO's first course of action was to instruct the subsidiaries' controllers to accelerate repayment of outstanding intercompany accounts. In instances where paying on terms of fewer than 60 days would have a negative effect on a subsidiary's liquidity, such subsidiary was instructed to borrow funds under its existing credit lines or negotiate increases in their credit lines.

Despite the seeming ease of implementing this directive, Domestic Corp. encountered significant obstacles. Regulations that directly and indirectly affect payments to foreign affi liates vary from country to country. For example, Domestic Corp.'s Chinese subsidiary ("CS") was prohibited under Chinese law from paying outstanding invoices until the goods were cleared through Chinese customs and actually received by the CS. Such clearance typically took a minimum of eight weeks from the date of delivery, making it difficult to accelerate the payment of amounts owed by the CS. In addition, due to China's tight restrictions and bureaucracy related to currency conversion, the Chinese subsidiary could only pay outstanding receivables approximately every two weeks. Under Brazilian law, invoices more than 180 days old require a "Financial Operation Register," which sets forth the terms of the sale and states that accelerated payments thereof can only be made upon a letter from the exporter and an authorization from the Central Bank of Brazil at least 30 days prior to the date the accelerated payment is to be made. These requirements made it more difficult and timeconsuming for the Brazilian subsidiary (BS) to satisfy old payables owed to Domestic Corp.

Payment of Interim Dividends
The CFO also considered authorizing the subsidiaries to pay provisional dividends from their substantial cash holdings to Domestic Corp. At fi rst glance, this would appear to be an obvious course of action, but Domestic Corp. again ran into roadblocks. BS, which had cash on hand but also had an accumulated loss on its balance sheet, was prohibited by Brazilian law from paying a dividend to Domestic Corp. In addition, BS's bylaws did not
permit the payment of dividends to Domestic Corp. To resolve these issues, Domestic Corp. recapitalized BS by forgiving payables that were significantly past due and caused BS to amend its bylaws to provide for dividend payments in accordance with Brazilian law. BS then was able to pay an interim dividend to Domestic Corp.

CS's by-laws permitted the payment of a dividend to Domestic Corp., but Chinese law allows a dividend to be paid only once per year based on profi ts. Under Chinese law, profi ts are determined by an audit of calendar year-end results. At the time of Domestic Corp.'s cash crisis, CS's audit was not expected to be completed for several months. Accordingly, Domestic Corp. was unable to repatriate CS's cash via a provisional dividend.

Based on the current cash balance and projected cash needs in the long-term cash forecast of Domestic Corp.'s subsidiary in the Netherlands ("NS"), the CFO requested that NS make an interim dividend payment to Domestic Corp. of $1.5 million. NS's general manager refused to make the payment, citing a long-running dispute with Domestic Corp. over an intercompany loan that he alleged Domestic Corp. owed to NS and concerns that the resulting cash balance would leave NS undercapitalized. With the backing of its board of directors and advice from its domestic- and Dutch-based legal professionals, Domestic Corp. ultimately persuaded NS to make the interim dividend payment, albeit with valuable
time lost.

In addition to the hurdles under the laws of various countries, domestic companies considering the repatriation of cash via the payment of a dividend must carefully consider possible tax consequences in the United States. In 2004, Congress added Section 965 to the Internal Revenue Code, which allows U.S. companies to elect to deduct, under certain circumstances, up to 85 percent of dividends received from foreign subsidiaries. A corporation seeking to capture the value generated by its foreign subsidiaries through the payment of dividends should consult its tax advisers before taking any action. While a domestic company in a liquidity crisis may have significant accumulated losses to offset any dividend income, it nonetheless makes sense to plan for any possible tax consequences in advance.

Increasing Subsidiary

Intercompany Debt
Domestic Corp. considered several options that would have had the effect of reducing the subsidiaries' cash balances through an increase in payables to Domestic Corp. One option considered was the implementation of management or consulting fees to Domestic Corp. However, there were problems with implementing a management fee in China. Domestic Corp. was advised by the CS that Chinese authorities frown upon the payment of management or consulting fees to a foreign parent corporation. Further, the CFO was reluctant to push through potential solutions to Domestic Corp.'s cash crisis that would have a negative impact on a subsidiary's fi nancial condition, possibly affecting employee morale due to lower incentive compensation and ultimately affecting the continued strong performance of the foreign subsidiary as well as negatively affecting the CFO's own incentive compensation. Another option considered was to increase transfer prices for goods shipped by Domestic Corp. to its foreign subsidiaries. While increasing the transfer prices would lead to higher payables and, therefore, additional cash payments to Domestic Corp., it would also increase customs declarations and duties. The end result would have been a negative net cash flow for a consolidated Domestic Corp. due to the higher duties and a negative impact on Domestic Corp.'s income statement.

A third option was to cause the subsidiaries to provide intercompany loans to Domestic Corp. CS considered making such an intercompany loan, but due to Chinese currency conversion restrictions, the loan could only be in local currency. The other foreign subsidiaries were restricted from providing intercompany loans by the terms of their credit agreements with their respective lenders.

Other Options
The subsidiary based in the United Kingdom ("UKS") considered accelerating cash receipts from its own customers by offering discounts to customers who paid outstanding invoices early so that it, in turn, could accelerate payment of amounts owed to Domestic Corp. UKS's management grew concerned, however, that doing so would give customers the appearance that it was offering discounts because it was short on cash. Management feared this would send the wrong message to customers and disrupt UKS's business. Upon hearing this feedback from UKS, the CFO realized that news of Domestic Corp.'s domestic crisis might soon reach the customers of the foreign subsidiaries and have a negative impact on both the subsidiaries' and Domestic Corp.'s businesses. As a result, in conjunction with management of each foreign subsidiary, Domestic Corp. created a customer communication plan to address potential rumors of the crisis or negative publicity.

Given the expanded reach of U.S. banks in foreign countries, Domestic Corp. considered refi nancing all of its and its subsidiaries' bank debt to increase its total availability. Management contacted several banks to solicit term sheets and initiate the due-diligence process. Given the scope of Domestic Corp.'s operations and the nature of the fi nancing process, the process took much longer than management had hoped. Had Domestic Corp. forecasted the cash crunch further in advance, there may have been enough time to refinance its debt and gain some breathing room.

Although Domestic Corp. did not consider this option, a cash-strapped domestic corporation with an underleveraged foreign subsidiary might consider obtaining additional credit for itself secured by a guaranty from the foreign subsidiary. While this might be a successful strategy in some situations, domestic companies again must consider the possible tax consequences. Under certain circumstances, the Internal Revenue Code treats
the benefi t derived (that is, the additional credit obtained) from a guaranty provided by a foreign subsidiary as a "deemed dividend," that is, taxable as income. If the domestic corporation has experienced significant losses, however, this might not pose a significant concern.

Lessons Learned

Using the various strategies described above, Domestic Corp. ultimately succeeded in securing enough cash from its foreign subsidiaries to meet its bondholder obligations. In the process, Domestic Corp.'s management learned some valuable lessons that all companies with foreign subsidiaries should think through in advance of a liquidity crisis.

Companies with foreign subsidiaries should have a thorough understanding of the options
for repatriating cash, including the laws affecting the repatriation of cash in each of the countries in which its subsidiaries operate and the provisions in its subsidiaries' bylaws and other corporate governance documents that affect the ability to repatriate cash. In addition to considering the mechanics of repatriating cash, it is vitally important to think about the possible tax implications, both domestically and abroad, that are triggered when cash is repatriated or the value of a foreign subsidiary is leveraged. Finally, companies should carefully think through the potential impact of planned repatriation efforts on a subsidiary's employees and customers.

Commercial lenders that have made loans to companies with foreign subsidiaries should, of course, consider all of the foregoing issues, as well as a few others. Commercial lenders should look beyond the "typical" monthly reporting package (e.g., borrowing base certificate, financial statements) to review monthly financial and operational information in order to detect potential problems before they arise. In the case of Domestic Corp., had the lender reviewed Domestic Corp.'s key drivers (such as its new orders and order backlog), monthly accounts payable agings and reports comparing the forecasted monthly cash flow to the actual monthly cash flow, it is possible that the lender would have seen early indications of the cash crunch to come.

Commercial lenders should also consider their borrower's foreign subsidiaries in the context of the collateral that will be pledged to secure the loan. At the very least, a lender should be sure that the collateral includes the borrower's intercompany receivables. Better yet, a lender should see to it that the stock of a borrower's foreign subsidiary is pledged to the lender as collateral. The best option for the lender, if possible, is to see to it that the foreign subsidiary guarantees the borrower's obligations and grants the lender a security interest in its own assets. Special care should be taken to ensure that a security interest in the assets of a foreign corporation is perfected under the laws of the relevant jurisdiction. As always, it is important to consider the tax implications of these actions. For example, there can be negative tax consequences for a borrower if it pledges more than 65 percent of the stock of a foreign subsidiary.

A company or a lender seeking to extract value from foreign subsidiaries, particularly in a distressed situation, should get its legal and tax advisers involved early on in the process, before it takes any action. Most important, companies and their lenders should plan ahead—a cash crunch could be just around the corner.

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