What Is a Keepwell Agreement?

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What Is a Keepwell Agreement?

Let me tell you directly: a keepwell agreement is a contract between a parent company and its subsidiary that ensures the subsidiary has the financial resources to stay solvent and meet its obligations. If your subsidiary is facing a liquidity crisis and struggling to access financing to keep operations going, it can sign one of these with the parent company. This setup boosts confidence among shareholders and bondholders that the subsidiary will pay its debts and operate smoothly. Suppliers will also view a troubled subsidiary more favorably if it has a keepwell agreement in place.

Key Takeaways

Understand this: a keepwell agreement is essentially a contract where the parent company commits to maintaining the subsidiary's solvency and providing financial backing for a set period. These agreements reassure lenders, shareholders, bondholders, and suppliers that the subsidiary won't default and will continue its operations. Subsidiaries use them to improve the creditworthiness of their debt instruments and corporate borrowing.

How Keepwell Agreements Work

Here's how it functions: a keepwell agreement is a contract where the parent company gives a written guarantee to keep the subsidiary solvent and in good financial health, often by maintaining specific financial ratios or equity levels. Subsidiaries enter these agreements to boost the creditworthiness of their debt and borrowing. The parent essentially pledges to cover all the subsidiary's financing needs for a specified time, which keeps shareholders, suppliers, and debtors confident. The guarantee period is whatever both parties agree on when drafting the contract. During that active period, the parent guarantees interest payments and principal repayments for the subsidiary. If solvency issues arise, bondholders and lenders can turn to the parent for recourse.

Keepwell Agreements and Creditworthiness

Consider credit enhancement: it's a method to reduce risk by increasing a company's creditworthiness to attract investors to its securities. This lowers the credit or default risk of debt, improving the entity's overall credit rating and reducing interest rates. For instance, an issuer might use it to better the rating on its bonds. A keepwell agreement is one form of this, providing third-party credit support. Because it enhances the subsidiary's creditworthiness, lenders are more inclined to approve loans, and suppliers offer better terms. The financial obligation on the parent means the subsidiary often gets a superior credit rating than it would alone. Remember, keepwell agreements are also called comfort letters.

How to Enforce Keepwell Agreements

Be aware of this: while a keepwell agreement shows a parent's willingness to support its subsidiary, it's not a guaranteed promise and can't always be legally invoked. However, bond trustees can enforce it on behalf of bondholders if the subsidiary defaults on payments.

Example of a Keepwell Agreement

Take this scenario: suppose Computer Parts is a subsidiary of Laptop International, and it's in a financial crunch with short supplies. To continue production on its new line of hard drives, it needs a $2 million loan, but its low credit rating makes this tough. To keep production on track and minimize the loan's interest rate, Computer Parts can enter a keepwell agreement with Laptop International. This agreement guarantees its financial solvency for the loan's duration.

What Are the Advantages of a Keepwell Agreement?

Know the benefits: keepwell agreements come into play when subsidiaries struggle with financing access or liquidity issues. They provide financial backing or a guarantee that the subsidiary will meet its obligations. This makes lenders and suppliers more likely to extend credit. Plus, bondholders and shareholders gain confidence that their investments are secure.

How Do Companies Account for Keepwell Agreements?

In accounting terms, a keepwell agreement is treated as a contingent liability. When one exists between a subsidiary and its parent, it's recorded under the guarantees section of the financial statements.

What Is a Comfort Letter?

Simply put, a comfort letter is a guarantee that a company's financial obligations will be met. It's often the same as a keepwell agreement or a letter of intent, used to access credit or prevent insolvency.

The Bottom Line

Subsidiaries are separate legal entities from their parents, but financial troubles can hit them hard. If they can't access capital or pay debts, a keepwell agreement with the parent acts as a guarantee for their future. Keep in mind, though, that these agreements aren't necessarily legally enforceable in most cases.

What Is a Keepwell Agreement?

Highlights