DEFINITION of Keepwell Agreement
A keepwell agreement is a contract between a parent company and its subsidiary to maintain solvency and financial backing throughout the term set in the agreement.
Keepwell agreements are also known as comfort letters.
BREAKING DOWN Keepwell Agreement
Credit enhancement is a risk-reduction method whereby a company attempts to increase its creditworthiness in order to attract investors to its security offerings. Credit enhancement reduces the credit or default risk of a debt, thereby, increasing the overall credit rating of an entity and lowering interest rates. For example, an issuer may use credit enhancement to improve the credit rating on its bonds. One method of enhancing a company’s credit is by obtaining third-party credit support through a keepwell agreement.
Subsidiary companies enter into keepwell agreements to increase the creditworthiness of debt instruments and corporate borrowing. A keepwell agreement is a contract entered into by a parent company and its subsidiary company in which the parent company provides a written guarantee that it will keep the subsidiary solvent and in good financial health by maintaining certain financial ratios or levels of equity. In effect, the parent company commits to provide all the subsidiary’s financing needs for a specified period of time. The predetermined guarantee period depends on what both parties agree upon when creating the contract. As long as the keepwell contract period is still active, the parent company will guarantee any interest payments and/or principal repayment obligations of the subsidiary. In the event that the subsidiary runs into solvency issues, its bondholders and lenders have sufficient recourse to the parent firm.
Since a keepwell agreement enhances the subsidiary’s creditworthiness, lenders are more likely to approve loans for a subsidiary than for other companies without keepwell agreements or any other form of credit enhancements. In addition, suppliers are also more willing to offer more favorable terms to companies with keepwell agreements. Due to the financial obligation placed on the parent company by a keepwell agreement, the subsidiary company may enjoy a better credit rating than would be possible without a signed keepwell agreement.
Although a keepwell agreement indicates a parent’s willingness to provide support for its subsidiary, these agreements are not guarantees. The promise of enforcing these agreements is not a guarantee and cannot be legally invoked. However, a keepwell agreement can be enforced by the bond trustees, acting on behalf of bondholders, if the subsidiary defaults on its bond payments.