What Is an Upstream Guarantee?
Let me explain what an upstream guarantee is. It's a financial guarantee where the subsidiary guarantees its parent company's debt, also known as a subsidiary guarantee.
You can contrast this with a downstream guarantee, which is a pledge on a loan for the borrowing party by their parent company or stockholder.
Key Takeaways
- An upstream guarantee backs a parent company's debt or obligation with one or more subsidiaries.
- Lenders may require this when the parent's main asset is ownership in the subsidiary.
- These guarantees are common in leveraged buyouts where the parent lacks assets to secure the debt-financed purchase.
How Upstream Guarantees Work
Upstream guarantees help a parent company get debt financing on better terms by expanding the collateral available. They often come into play in leveraged buyouts when the parent doesn't have enough assets to pledge.
A payment guaranty means the guarantor must pay if the borrower defaults, no matter if the lender demands from the borrower first. A collection guaranty only kicks in after the lender sues and exhausts remedies against the borrower. Guarantees can be absolute, limited, or conditional.
Lenders typically demand an upstream guaranty when lending to a parent whose only asset is subsidiary stock. Here, the subsidiary holds most assets the lender relies on for credit decisions.
The issue with these guarantees is the risk to lenders of fraudulent conveyance lawsuits if the guarantor is insolvent or undercapitalized when signing. If proven in bankruptcy court, the lender becomes unsecured, which is a poor result.
Since the subsidiary doesn't own stock in the parent and gets no direct benefit from the loan, it doesn't receive reasonably equivalent value for the guarantee.
Upstream vs. Downstream Guarantees
An upstream guarantee, much like a downstream one where the parent guarantees the subsidiary's debt, doesn't need to be recorded as a liability on the balance sheet. Instead, disclose it as a contingent liability, noting any recovery provisions.
A downstream guarantee helps a subsidiary secure debt it couldn't otherwise get, or at lower interest rates, thanks to the parent's backing.
Often, lenders only finance a corporate borrower if an affiliate guarantees the loan. Backed by the holding company's strength, the subsidiary's default risk drops significantly. It's like cosigning a loan for someone else.
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