Intro
Welcome to the sixth installment in our series of articles providing an overview of the various aspects relating to the venture lending industry in Israel, including some of the legal, commercial and regulatory factors that should be taken into consideration by anyone looking to enter into this realm. The main goal of this series is to equip readers with valuable knowledge and understanding of the venture lending landscape in Israel, helping them navigate and capitalize on the unique opportunities it presents, particularly for those looking to become stakeholders in the Israeli startup ecosystem. In our sixth installment below, we provide a high-level overview regarding risks associated with an upstream guarantee provided by an Israeli company, and certain considerations for creditors in such a scenario. The issues discussed in this article are of particular importance in acquisition financing transactions involving Israeli target entities in the technology space.
Upstream guarantees, in which a subsidiary guarantees the obligations of its parent company or other affiliates higher up the corporate chain, are a common feature of cross-border financing transactions, including acquisition financings where a target company or its subsidiaries are required to guarantee debt incurred by an acquirer to fund the acquisition. When the guarantor is an Israeli company, lenders and borrowers must carefully consider several legal risks with respect to Israeli law, both from corporate and tax perspectives.
Corporate Benefit Requirement
A fundamental principle under Israeli law is that a company must act in furtherance of its own interests. The Israeli Companies Law, 5759-1999 (the “Companies Law”) establishes that a company must operate for its own benefit. When an Israeli company provides an upstream guarantee, a critical question arises: does the company receive adequate corporate benefit in exchange for assuming this contingent liability?
Israeli courts have recognized that corporate benefit may be established through indirect advantages, such as continued access to group financing, operational synergies, or enhanced creditworthiness of the corporate group as a whole. Nevertheless, where the corporate benefit is tenuous or non-existent, the validity of the guarantee may be subject to challenge. Accordingly, parties should ensure that the corporate benefit justification is clearly documented in board resolutions and related transaction materials.
Distribution and Capital Maintenance Concerns in Acquisition Financing Transactions
Under the Companies Law, a company may make a distribution only if it satisfies both (i) a “profits test” which is a technical accounting examination and (ii) a “solvency test” which is a substantive test requiring a holistic, forward-looking economic review of the company’s financial position, each of which is summarized generally below:
- Profits Test – the company may only make a distribution out of its “surplus” which is defined as the greater of: (i) retained earnings accumulated over the two most recent fiscal years, as reflected in the Company’s most recent audited or reviewed financial statements, or (ii) overall retained earnings; and
- Solvency Test – the company (the board) must determine that there is no reasonable concern that the distribution will prevent the company from meeting its existing and foreseeable financial obligations as they become due.
A “distribution” is defined under the Companies Law as “granting a dividend or undertaking to grant one, either directly or indirectly, as well as an acquisition”. For this specific purpose, an “acquisition” is broadly defined as the direct or indirect acquisition or provision of financing – by a company or its subsidiary or another corporation under its control – for the acquisition of a company’s shares, including an undertaking to do so, provided the seller is not the company or a corporation wholly owned by such company.
In other words, the Companies Law prohibits a company from providing financial assistance for the acquisition of its own shares or the shares of its parent company, except in limited circumstances, and such prohibition may be implicated where an upstream guarantee secures acquisition financing used by a parent or affiliate to purchase shares in the Israeli guarantor itself. An Israeli court could determine that the enforcement of an upstream guarantee provided in the context of an acquisition financing constitutes a distribution, and that, if the company does not satisfy the requisite conditions above, such distribution would be deemed unlawful (known under Israeli law as a “prohibited distribution”).
Guarantee documentation in acquisition financing transactions often include guarantee limitation language restricting the guarantor’s obligations to amounts that would not cause a breach of the distribution rules. While this would conceivably limit the scope of the security interest under the applicable Israeli security agreement(s), typically such a limitation would be paired with a provision stating that the loan parties or guarantor may not assert that enforcement of the guarantee constitutes a prohibited distribution. In other words, only a third party may assert a prohibited distribution claim, and any such claim must be proven in court.
In addition to providing an upstream guarantee in an acquisition financing, an Israeli subsidiary is often required to pledge its assets as collateral to secure its obligations under such guarantee. The grant of security by an Israeli company implicates many of the same legal concerns that apply to the guarantee itself.
Fraudulent Conveyance Risks
Under Israeli insolvency law, a guarantee or security interest granted by a company that subsequently becomes insolvent may be challenged as a fraudulent conveyance. A liquidator may seek to set aside a guarantee and/or security interest if it was provided without adequate consideration, at a time when the company was insolvent or rendered insolvent by the transaction, or with intent to defraud creditors. Upstream guarantees are particularly vulnerable to such challenges given the inherent absence of direct consideration flowing to the guarantor. For further information regarding fraudulent conveyance and the setting aside of security interests, please see our fifth installment.
Upstream Guarantees and Potential Tax Risks
The provision of an upstream guarantee by an Israeli company also carries the risk of being deemed a distribution by the Israeli Tax Authority (ITA) from a tax perspective. For example, if such guarantee fails to satisfy the corporate benefit requirement, or is not on arms’ length terms, the ITA may impose withholding tax obligations on the company at the time of the issuance of the guarantee, and not just upon enforcement.
Conclusion
Upstream guarantees from Israeli companies remain an important credit support mechanism in cross-border financings. However, the legal risks associated with such guarantees require careful structuring, robust documentation, and thorough legal analysis. By understanding and addressing these risks at the outset, lenders and borrowers can enhance the enforceability of guarantee arrangements and reduce the likelihood of successful challenges.
About Us
Arnon, Tadmor-Levy proudly stands among Israel’s most prominent law firms, with one of the largest and most respected banking and financial services departments. We have extensive experience in cross-border and other complex financing transactions, representing both lenders and borrowers. Our trusted reputation spans a vast clientele, including leading Israeli and international banks and other financial institutions.
Our venture lending and private credit team is led by Simon Weintraub, Avi Anouchi and Idan Adar.
Should you have any questions, or are interested in learning more about the various aspects of the Israeli venture lending and private credit industry, please feel free to reach out to a member of our venture lending team, whose details are included below.
The above content is a summary provided for informational purposes only and does not constitute legal advice. It should not be relied upon without obtaining further professional legal counsel.
