In today’s interconnected financial world, the ripple effects of distress in one part of a business can quickly cascade through an entire organization, and even beyond. Enter ring-fencing, a strategic mechanism involving an effort to wall off certain assets or liabilities within a corporation. This is done by creating a new subsidiary, for instance, or cutting off internal financing to an existing subsidiary. So, what exactly is ring-fencing and how does it impact credit risk?

While originally a regulatory requirement in the banking sector, ring-fencing has evolved into a broader business strategy applicable across industries. At its core, ring-fencing is the legal and operational separation of a specific business unit, subsidiary, or asset pool from the wider group to which it belongs. Think of it like building a fortress around a particular part of your estate to protect it from external threats or internal turmoil within the rest of the property. Ring-fencing is often perceived as an attempt to hide assets that would otherwise be available to creditors.

The companies doing the ring-fencing suggest that they restructure their assets to maintain the viability of the company. The difference between hiding and restructuring may depend in part on timing — for example, whether the new entity was in place before or after the liabilities were incurred.

The financial distress of a subsidiary can be a difficult event for its parent company. When the subsidiary faces the prospect of a bankruptcy filing, the parent likely will need to address many more issues than simply its lost investment in the subsidiary. Unpaid creditors of the subsidiary instinctively may look to the parent as a target to recover on their claims under any number of legal theories, including piercing the corporate veil, breach of fiduciary duty, and deepening insolvency.

There are certain factors that need to be met to determine whether an entity is successfully ring-fenced (or to justify a “standalone” credit rating). Most importantly, the subsidiary in question should have “separateness covenants” to avoid being substantively consolidated with its parent. Substantive consolidation is an equitable remedy that allows the bankruptcy court to pool the assets and liabilities of two separate but affiliated entities, and to treat them as though they are the assets of a single debtor.

Criteria for Effective Ring-Fencing:

• The entity should maintain its own separate financial statements, have standalone financing and bank accounts, and have its own corporate books and records.
• The company should be able to pay its own expenses and debts from its own funds.
• There should be no commingling of assets with its parents or any of the parent’s affiliates.
• The company should also be free from any cross-default provisions or subsidiary guarantees at the parent level.
• Essentially, the ring-fenced company must be sufficiently capitalized and have enough liquidity to withstand shocks, without relying on other parts of the group for financial support. 

Ring-fencing directly impacts credit risk by altering the risk profile of both the ring-fenced entity and the wider group, which is why it is vital to understand the organizational and debt structure of your customers.