What is a keepwell agreement?
A keepwell agreement, or comfort letter, is a legal agreement between a parent company and one of its subsidiaries. This agreement applies to parent organizations that own at least 50% of the subsidiary company. Parent firms use keepwell agreements to provide subsidiary organizations with debt guarantees, financial stability, and solvency for the agreement duration.
Subsidiaries with keepwell agreements are more likely to secure loans and favorable terms from lenders, suppliers, and banks. Keepwell contracts also boost the confidence of shareholders, stakeholders, and bondholders. Organizations use contract management software or legal agreement drafting software to create and manage these agreements.
Grades of keepwell agreements:
Financial institutions classify keepwell agreements and comfort letters into three grades, depending on some basic patterns.
- Grade C states the degree of ownership, acknowledges the credit, and guarantees notification of ownership changes.
- Grade B states the terms of a grade C letter and mentions its support to a subsidiary.
- Grade A promises the credit obligation’s performance in addition to all clauses of a grade B letter.
Keepwell agreement example
Suppose ABC Inc. is a subsidiary of A2Z International Systems. ABC Inc. is running short on supply and needs a $4 million loan for raw materials management and operations. Banks or suppliers aren’t willing to lend to ABC Inc. because of its low credit rating. ABC Inc. can then enter into a keepwell agreement with A2Z International Systems for financial solvency and stability guarantee during the loan term.
Importance of keepwell agreements
Keepwell agreements enable subsidiaries to meet long-term debts and other financial obligations in case of financial troubles. The parent company’s support makes the subsidiary company more creditworthy and eligible to attract investors. This credit enhancement also lowers debt risks and interest rates, and improves the bond credit rating of a subsidiary organization. Third-party credit support from parent companies is essential for subsidiaries looking for financial stability.
Common terms in a keepwell agreement:
- Agreement to keep well: Refers to a parent company’s liability to pay and discharge financial obligations
- Successors: Specifies that the agreement should benefit both parties and their respective successors
- Third-party beneficiaries: Restricts conferring of rights, benefits, or obligations towards the subsidiary organization’s public stockholders
- Governing law: Outlines the law of the land in which an agreement takes place
- Amendment: Prevents modification of terms and conditions without the explicit consent of the parent and subsidiary company
How does a keepwell agreement work?
A keepwell agreement is effective when a parent and subsidiary firm enter into a contract. This contract enables the parent organization to maintain the subsidiary's equity levels or financial ratios and keep it solvent.
In simpler terms, the parent company guarantees the subsidiary’s interest payments or principal payment obligations during the contract period. Such agreements remain valid for a period both parties agree upon.
Keepwell agreement in financial reporting
A keepwell agreement acts as a loss contingent and appears under the guarantees section of a financial accounting statement. A court of law considers keepwell agreements that contain specific language criteria legally enforceable. That’s why auditors must identify undisclosed contingent liabilities and review third-party information to gauge the validity of a keepwell agreement.
Keepwell agreement vs. guarantee agreement
A keepwell agreement holds a parent entity responsible for monitoring a subsidiary’s financial health. This agreement is an enforceable contract for a parent company to provide financial support to its subsidiary for the agreement period.
A guarantee agreement holds a guarantor responsible for paying back a creditor's debt to an investor. Such deals consider the guarantor liable for an investor’s obligation to a creditor. Guarantee agreements are standard in the fund finance market because of their enforceability.
Sudipto Paul
Sudipto Paul is a Sr. Content Marketing Specialist at G2. With over five years of experience in SaaS content marketing, he creates helpful content that sparks conversations and drives actions. At G2, he writes in-depth IT infrastructure articles on topics like application server, data center management, hyperconverged infrastructure, and vector database. Sudipto received his MBA from Liverpool John Moores University. Connect with him on LinkedIn.
