Subsidiaries Filing Bankruptcy

Will a subsidiary file bankruptcy if its parent company files for bankruptcy protection? The answer to this question is important if you as a trade creditor are selling to subsidiary - particularly if the subsidiary's business seems to be thriving, but the parent company is in serious financial trouble. The answer to this question is Not Necessarily..but credit professionals should know:

The stock of a subsidiary is an asset of the parent company. In many cases, when a parent company files for bankruptcy protection its subsidiaries also file for bankruptcy protection. Is it possible for a subsidiary to be unaffected by the bankruptcy filing of its parent company? Yes. A parent company cannot automatically place its subsidiaries into bankruptcy. The subsidiary must meet the bankruptcy insolvency requirements. In brief, those requirements are that:

• the subsidiary's liabilities exceed its assets, and/or
• the subsidiary is not paying its debts as they come due.

Under the Business Judgment Rule, the board of directors of a corporation is free to use its own judgment as to the use of corporate assets, as long as the board acts in what it believes to be the corporation's best interests. Under this standard of care, in the absence of gross mismanagement, fraud, or conflict of interest, the decisions of the board of directors are rarely questioned. The business judgment rule influences the activities of the board of directors of the subsidiary in this scenario to the extent that the board cannot act in a way that is detrimental to the subsidiary's best interests. Therefore, in theory, the board of directors of a wholly owned subsidiary could vote not to follow the parent company into voluntary bankruptcy - but this decision would be uncommon.

Can creditors legally require the assets of the subsidiary be used to help pay the debts of the parent company? Yes. Parent companies can and often do "sweep" the cash from its subsidiaries accounts, and in turn allocate cash to the subsidiary as the parent company. Using a sweep account, prior to its own bankruptcy filing a parent company could easily create a situation in which a subsidiary is unable to pay its debts. How? By sweeping the subsidiary's account and then not allocating sufficient funds back to the subsidiary to enable it to pay its creditors. In this way, the subsidiary would meet the insolvency requirement required for a voluntary bankruptcy filing. The same problem could occur after a bankruptcy filing by the parent company - and some would argue that this would be more likely after the bankruptcy rather than before.

Some other issues to consider in this scenario include these:

• Are the assets of the subsidiary pledged to the parent company's bank as collateral for debts of the parent company? [If so, a bankruptcy filing might be inevitable].
• Are there any loan covenants involving loans to the subsidiary that relate to the financial health of the parent company? [If so, the subsidiary would be out of covenant and forced into bankruptcy protection].
• Will other creditors continue to support the subsidiary by providing open account terms if its parent company files for bankruptcy protection?
• Even if the subsidiary does not file bankruptcy, would the cash demands of the bankrupt parent company damage the subsidiary's liquidity to the point that selling to it after the parent company's bankruptcy would be an unwise credit decision?
• Might talented employees of the subsidiary leave as a result of concerns about the financial health or viability of their employer?

Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.