Overview
A keepwell agreement is a contract between a parent company and its subsidiary, ensuring the subsidiary will remain financially solvent and receive the necessary financial support throughout the agreed term. These agreements bolster confidence among shareholders, bondholders, and suppliers, implying that the subsidiary will honor its financial obligations and remain operationally stable.
A keepwell agreement functions similarly to what is sometimes called a comfort letter but importantly focuses on financial assurances over a prescribed period.
When a subsidiary faces financial difficulties and challenges in securing funding, a keepwell agreement from the parent company can provide reassurance to all stakeholders involved.
How a Keepwell Agreement Works
Subsidiaries enter into keepwell agreements primarily to improve their creditworthiness for debt instruments and corporate borrowing. The arrangement involves a legal commitment from the parent company to maintain the subsidiary’s financial health. This may include keeping certain financial ratios or equity levels intact. In essence, the parent company pledges to meet all of the subsidiary’s financing needs during the specified period.
The guarantee period depends on the terms agreed upon by both parties at the inception of the agreement. Throughout this period, the parent company must cover any interest payments or principal repayments that the subsidiary is unable to meet. If the subsidiary faces insolvency, its bondholders and lenders can turn to the parent company for recourse.
Keepwell Agreements and Creditworthiness
One of the key advantages of a keepwell agreement is the enhancement of a subsidiary’s creditworthiness. Credit enhancement aims to reduce credit or default risk, improve credit ratings, and lower borrowing costs. By obtaining a keepwell agreement, a subsidiary can secure more favorable terms from lenders and suppliers alike. These agreements thereby improve a subsidiary’s attractivenes to investors, potentially leading to better financing conditions compared to companies without such agreements.
Key Takeaways
- A keepwell agreement is a contract to maintain a subsidiary’s solvency and financial support over a specified period.
- These agreements assure lenders, shareholders, bondholders, and suppliers of the subsidiary’s financial health and operational continuity.
- They play a significant role in enhancing the subsidiary’s creditworthiness, positively impacting debt instruments and corporate borrowing.
Enforcing Keepwell Agreements
While keepwell agreements signify a parent’s intent to provide support to the subsidiary, they do not serve as absolute legal guarantees. Their enforceability, especially in financial trouble, is limited. However, bond trustees, representing bondholders’ interests, can attempt to enforce the agreement if the subsidiary defaults on bond payments.
Inspirational Example of a Keepwell Agreement
Consider Tech Components Ltd., a subsidiary of GadgetWorks Inc. Tech Components is experiencing financial difficulties and needs a loan of $2 million to continue producing a new hard drive line. Due to its lower credit rating, securing this loan would be challenging.
To maintain production and secure favorable loan terms, Tech Components can enter into a keepwell agreement with its parent company, GadgetWorks Inc., ensuring its financial solvency for the loan term. This agreement would reassure lenders, making it easier for Tech Components to secure the necessary financing.
Related Terms: Comfort Letters, Solvency, Credit Enhancement, Corporate Credit Rating, Bond Trustees.
