Keepwell Agreement

What is a Keepwell Agreement?

An agreement known as a "keepwell" is one that is started between a parent firm and one of its subsidiary companies.

To satisfy lenders that this firm is capable of meeting its commitments and going on business as normal, keepwell agreements are essential for subsidiary businesses that struggle to control expenditures.

The parent business guarantees that it will meet all of the subsidiary's financial needs for a predetermined amount of time. A comfort letter is often referred to as a keepwell pact.

When a Subsidiary experiences financial difficulties and finds it difficult to get funding to continue functioning, it may engage in a keepwell agreement with its parent company for a certain period.

Having this agreement gives the subsidiary greater credibility in the eyes of the lenders. It means that if this agreement is in place, the subsidiary will have a better chance of getting the loans granted. 

The guarantee duration is agreed upon in advance and specified when the contract is written.

To put it another way, these agreements not only benefit the subsidiary and its parent business but also increase the confidence of shareholders and bondholders in the subsidiary's ability to manage its finances and functions effectively.

Additionally, raw material suppliers are more likely to have a favorable opinion of a failing company that has a keepwell arrangement.

A keepwell agreement, on the other hand, is the result of negotiations that took place before it was actually written, and it is typically less precise and detailed than standard legal promises. Since such an agreement cannot be invoked legally, there is no assurance that it will be upheld.

Lastly, a subsidiary is a very helpful tool to save a firm for a parent organization during tough financial circumstances. The parent company provides financial incentives and raises the subsidiary's credit rating. This would increase its overall trustworthiness.

Significance of a Keepwell Agreement

When a subsidiary finds it difficult to get financing for the continuation of its commercial activities, a keepwell agreement is advantageous. Its parent company will give financial support and assistance in ensuring solvency for the duration of the agreement.

An agreement between two parties raises the company's borrowing capacity and ability to repay debt.

The bondholders and lenders are reassured by this kind of agreement that the subsidiary can continue to operate profitably and satisfy its financial obligations. Additionally, suppliers might view a cash-strapped subsidiary positively if the agreement is in place.

The parent firm backs the subsidiary's interest and other payment obligations up to the contract's start date. If a subsidiary experiences financial difficulty, lenders and bondholders may turn to the parent business for assistance.

This agreement also improves the subsidiary's credit through the parent company's credit assistance. It draws in investors and lowers the danger of default, raising the subsidiary's credit rating and lowering borrowing costs.

A keepwell agreement can also be written to improve a bond's credit. The bond trustees may enforce the arrangement on behalf of the bondholders if a subsidiary fails to make bond payments.

The parent business agrees to be accountable for maintaining the subsidiary's solid financial condition.

While this kind of agreement shows a parent's commitment to helping its subsidiary, such agreements do not represent assurances. The pledge to enforce these agreements will not be legally enforceable and is only a promise. 

However, the bond trustees, acting on behalf of investors, may enforce this arrangement if the subsidiary fails to make a payment on its bonds.

In short, the keepwell agreement reassures bondholders and stakeholders that the subsidiary will be able to keep their side of the agreement running efficiently and smoothly and attend to financial obligations.

This gives confidence to stakeholders and bondholders while also helping the parent company and subsidiary. 

What is a Parent Company?

A parent company is a company that controls the operations of another company in that it owns a majority stake.

Depending on how much management authority is delegated to subsidiary managers, parent corporations can be either hands-on or hands-off owners of their subsidiaries. However, they will continue to exercise some level of active control.

Parent corporations may be conglomerates, like General Electric, whose diversified business divisions might profit from cross-branding. GE is made up of several various, seemingly unrelated firms. 

However, a parent company is distinct from a holding company. Unlike holding or shell corporations, created explicitly to control several subsidiaries passively—often for tax purposes—parent firms run their commercial activities.

There may be a horizontal integration between parent firms and their subsidiaries, as is the case with Gap Inc., which owns the Old Navy and Banana Republic subsidiaries. 

Or they might be vertically integrated, holding several businesses at various points along the manufacturing or supply chain.

In the case of AT&T's acquisition of Time Warner, in addition to its telecommunications networks that provide the media infrastructure, it now owns broadcasters that sell such creations to consumers and the film production industry.

An example of this is Facebook acting as the corporation's parent. In addition to having subsidiaries like WhatsApp and Instagram, it also conducts its activities. 

What is a Subsidiary Company?

A subsidiary in the business sector is a business that is a part of another business, which is typically referred to as the parent company or the holding company.

Depending on the circumstances, subsidiaries can be fully controlled or partially controlled. 

Having or owning more than half of the subsidiary company's equity, the parent has a controlling interest. A subsidiary is considered an owned subsidiary when another company owns it entirely. When considering a reverse triangle loan, subsidiaries become crucial.

To provide the parent firm with certain synergies, such as improved tax benefits, diversified risk, or assets in the form of profits, equipment, or property, the parent company develops a subsidiary or purchases an existing one. 

However, subsidiaries are independent legal persons from their parent firms, and this is reflected in the independence of their governance, taxes, and liability. 

When a parent company has a subsidiary abroad, the subsidiary is obligated to abide by the nation's laws where it was founded and conducts business.

However, due to their position of power, parent corporations frequently exercise significant influence over their subsidiaries. 

They vote to choose the board of directors of a subsidiary firm, together with any other subsidiary shareholders. Thus, board member overlap between a subsidiary and its parent business may frequently occur.

In contrast to a merger, acquiring a subsidiary's equity often requires less investment from the parent company. Additionally, shareholder approval is not necessary to convert a firm into a subsidiary, unlike a merger. Neither is a vote required to sell the subsidiary.

A company must have another entity control at least 50% of its equity to be considered a subsidiary. The company is referred to as an associate or affiliate company if the shareholding is lower than that.

Keepwell Agreements Vs. ECLs

A letter of support or comfort letter, for example, is intended to give assurance to the lender. This is done because it assures lenders that subsidiaries can meet financial obligations. 

An ECL, on the other hand, is an agreement that demonstrates a commitment to provide capital or other financial support by one entity (the "ECL Provider") in favor of another entity (the "ECL Recipient").

It should be distinguished from other similar arrangements, such as a keepwell agreement, under which a sponsor may undertake to monitor and safeguard a fund's financial health.

In contrast to ECLs, a keepwell agreement merely offers a generic declaration of financial assistance without indicating how the parent would pay for the support. 

The fact that this agreement often does not guarantee the creditor will be paid back for their loan is another way it varies from an ECL.

When the ECL beneficiary requires money to meet its payment obligations, it might force its supplier to issue capital in return for equity in the ECL beneficiary under the terms of the agreement. 

If a creditor participates in an ECL, they need to ensure that the following provisions are included in the agreement:

1) Enforceability 

To prevent the ECL provider from disputing the ECL's enforceability, it should include a waiver of setoff, counterclaim, and defense.

2) Beneficiary Status

It is also recommended that the ECL designate the creditor as a third-party beneficiary or stipulate that the creditor be granted the same rights as the ECL beneficiary.

3) Changes 

The creditor, who is not a party to the ECL, should affirm that any changes to or terminations of the ECL require the creditor's prior approval.

Despite these variations, an ECL and a keepwell agreement should have many of the same clauses. 

Suppose the parent corporation is the beneficiary of the agreement. In that case, the creditor should be specifically named as a third-party beneficiary or be allowed to maintain the subsidiary's rights. 

Without these clauses, the creditor might be unable to make the parent a party to the keepwell arrangement.

The creditor should also demand that the parent add a covenant prohibiting certain parent conduct that might make the subsidiary unable to pay its obligations, frequently owing to a lack of finances.

When a subsidiary lacks the appropriate credit for a transaction or the creditor wants additional security over its investment, these agreements are frequently utilized to pay credit support operations.

An arrangement that calls for one corporation, sometimes the parent entity, to provide capital or other forms of financial support to another entity is known as an equity commitment letter. Typically, subsidiaries are ECL beneficiaries.

Conclusion

A subsidiary may enter into a keepwell arrangement with its parent business for a set length of time when it encounters financial difficulties and finds it challenging to obtain funds to continue operating.

In times of financial difficulties, this is a very useful instrument to save a subsidiary company for a parent corporation. The parent business boosts the credit rating of its subsidiary and offers financial rewards. This would raise its credibility as a whole.

Keepwell agreements are a crucial step for subsidiary organizations that struggle to control costs to reassure lenders that this corporation can perform its obligations and carry on business as usual.

In addition, the agreement may be signed to raise a bond's or other security's creditworthiness. The parent company assumes responsibility for ensuring the subsidiary's financial viability.

The subsidiary has higher credibility in the eyes of the lenders by having a keepwell agreement. It implies that the subsidiary will have a higher chance of obtaining loans if an arrangement is in place. 

Contrarily, an ECL is a contract that proves one party (the "ECL Provider") is willing to give money or other financial support to another party (the "ECL Recipient").

In other words, these agreements not only benefit the subsidiary and its parent business but also increase the confidence that shareholders and bondholders have in the subsidiary's ability to fulfill its obligations and run effectively.

Additionally, raw material suppliers are more likely to have a favorable opinion of a failing company that has this kind of arrangement.

Unlike traditional legal guarantees, however, this agreement results from discussions before it was formally written and is frequently less precise and complete. Such an agreement cannot be legally enforced, so there is no assurance it will be upheld.
 

Researched and authored by Dua Bakhsh | LinkedIn

Reviewed and Edited by Purva Arora | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accelerated Dividends
• Account Balance
• Account Number
• Account Statement
• Accrued Interest vs Regular Interest