What Is an Upstream Guarantee?
An upstream guarantee, also known as a subsidiary guarantee, is a financial guarantee in which the subsidiary guarantees its parent company's debt.
An upstream guarantee can be contrasted with a downstream guarantee, which is a pledge placed on a loan on behalf of the borrowing party by the borrowing party's parent company or stockholder.
- An upstream guarantee is when a parent company's debt or obligation is backed by one or more of its subsidiaries.
- Such a guarantee may be required by a lender when the parent company's primary asset base is its ownership in the subsidiary itself.
- Upstream guarantees are also utilized in leveraged buyouts when the parent company owns insufficient assets to back the buyout syndicate's debt-financed purchase.
How Upstream Guarantees Work
Upstream guarantees enable a parent company to obtain debt financing on better financing terms, by expanding the available collateral. They often occur in leveraged buy-outs, when the parent company does not have enough assets to pledge as collateral.
A payment guaranty obligates the guarantor to pay the debt should the borrower default, regardless of whether the lender makes a demand on the borrower. Alternatively, a collection guaranty only obligates the guarantor if the lender cannot collect the amount owed after bringing a lawsuit and exhausting its remedies against the borrower. Guaranties can be absolute, limited or conditional.
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.
Upstream vs. Downstream Guarantees
An upstream guarantee, like a downstream guarantee in which the parent company guarantees the subsidiary company’s debt, does not have to be recorded as a liability on the balance sheet. However, it is disclosed as a contingent liability, including any provisions that might enable the guarantor to recover funds paid out in a guarantee.
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.