A keepwell agreement is an arrangement initiated between a parent company and one of its subordinate businesses. The parent company promises that it will provide the subsidiary with all the financing requirements for a specific time period. A keepwell agreement can be referred to as a comfort letter.
A keepwell agreement enables the subsidiary to look more creditworthy to the lenders. It implies that the subsidiary is more likely to get loans approved if there is a keepwell agreement in place. The guarantee period is predetermined by both parties and set at the time of outlining the contract.
However, a keepwell agreement is a product of negotiation preceding its creation, and it is usually more unclear and less specific than traditional legal commitments. There is no guarantee that such an agreement will be enforced since it cannot be invoked legally.
With the keepwell agreement, the parent company commits to offer the subsidiary help with all its financing requirements for a specific time period.
The agreement enables the subsidiary to enhance its credit rating and look more favorable to lenders and bondholders.
A keepwell agreement acts as a loss contingent and should be reported as a guarantee under the Statement of Financial Accounting Standard.
Significance of a Keepwell Agreement
When a subsidiary finds it difficult to access financing for continuing its business operations, a keepwell agreement proves to be helpful. Its parent company will support it financially and help it in maintaining solvency for the time period specified in the agreement. When a company puts a keepwell agreement in place, the creditworthiness of corporate borrowing and debt instruments increases.
A keepwell agreement assures the bondholders and lenders that the subsidiary can meet its financial commitments and continue to operate smoothly. A cash-strapped subsidiary can be seen favorably by suppliers in the presence of the agreement.
The parent company guarantees interest payments and other payment obligations of the subsidiary until the contract is active. The lenders and bondholders can resort to the parent company in case the subsidiary faces financial distress.
Moreover, a keepwell agreement helps to enhance the credit of the subsidiary through the credit support of the parent company. It attracts investors and reduces the risk of default, increasing the credit rating of the subsidiary and decreasing interest rates.
A keepwell agreement can also be drafted to enhance the credit of a bond. If a subsidiary fails to make bond payments, the trustees of the bond can enforce the agreement in the interest of the bondholders. The parent company accepts the responsibility of keeping the subsidiary in sound financial health.
Suppose ABC Co. is a parent company, and XYZ Inc. is one of its subsidiaries. XYZ Inc., a mobile phone manufacturer, is facing financial distress, and there is a shortage of supply. To continue the manufacturing of its new model of mobile phones, XYZ Inc. needs to secure a loan of $5 million. However, due to its low credit rating, it’s been difficult for XYZ Inc. to secure a loan.
Thus, to continue with the production and also keep interest rates low, XYZ Inc. can enter into a keepwell agreement with its parent, ABC Co., for a period equal to the term of the loan. ABC Co. will guarantee that XYZ Inc. remains financially stable during the loan term. It will increase the credit rating of XYZ Inc., and it can secure the loan with lower interest rates.
Financial Reporting of a Keepwell Agreement
Keepwell agreements act as loss contingents and should be reported as guarantees under the Statement of Financial Accounting Standard. Courts hold such agreements as a legally enforceable obligation if they agreement meet certain standard language criteria.
Hence, auditors must review the language of the keepwell agreement and attempt to find out the contingent liabilities that are not disclosed in the financial statements in cases when a keepwell agreement exists. The information regarding contingent liabilities related to the agreement can be obtained from management and third parties.
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