DEFINITION of 'Downstream Guarantee'

Downstream guarantee (or guaranty) is a pledge placed on a loan on behalf of the borrowing party by the borrowing party's parent company or stockholder. By guaranteeing the loan for its subsidiary company, the parent company provides assurance to the lenders that the subsidiary company will be able to repay the loan.

BREAKING DOWN 'Downstream Guarantee'

A downstream guarantee is a form of intercorporate guarantee which refers to an obligation taken by a third party (typically a holding company) to perform another’s (its subsidiary) financial obligation on a debt. In the event that the borrowing entity is unable to make good on its repayments, the guarantee requires the parent company to repay the loan.

A downstream guarantee can be undertaken in order to help a subsidiary company obtain debt financing that it otherwise would be unable to obtain, or to obtain funds at interest rates that would be lower than it could obtain without the guarantee from its parent company. In many instances, a lender may be willing to provide financing to a corporate borrower only if an affiliate agrees to guarantee the loan. This is because, once backed by the financial strength of the holding company, the subsidiary company's risk of defaulting on its debt is considerably less. The guarantee is similar to one individual cosigning for another on a loan.

For instance, a company that wishes to borrow funds from a lending institution but does not have thecollateral required to secure the loan may have its parent company put up real estate as lien for the loan. While the property pledged as collateral provides the lender with additional assets to secure repayment of the loan, the subsidiary is able to obtain the loan on more favorable terms and at a lower cost than it could obtain as a separate legal entity. The loan is used to improve or expand the operations of the borrower which, in turn, improves the financial strength of the parent company. Since the parent owns stock in the subsidiary, it is said to receive reasonably equivalent value from the loan proceeds reflected in the increased value of the stock.

A downstream guarantee lies in contrast to an upstream guarantee, which is a loan taken by a parent company that is guaranteed by its subsidiary. Typically, a lender will insist on an upstream guaranty when it lends to a parent whose only asset is stock ownership of a subsidiary. In this case, the subsidiary owns substantially all the assets upon which the lender bases its credit decision. The problem with upstream guarantees is that lenders are exposed to the risk of being sued for fraudulent conveyance when the guarantor is insolvent or without adequate capital at the time it executed the guarantee. If the issue of fraudulent conveyance is successfully proved in a bankruptcy court, the lender would become an unsecured creditor, clearly a bad outcome for the lender. Since the subsidiary guaranteeing the debt payments owns no stock in the parent company borrowing the funds, the former does not directly receive any benefits from the loan proceeds and, hence, does not receive a reasonably equivalent value for the guarantee provided.

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