Keepwell Agreement: Definition, Purpose & Benefits

A keepwell agreement is an arrangement initiated between a parent company and one of its subordinate businesses. The parent company promises that it will provide the subsidiary with all the financing requirements for a specific time period. A keepwell agreement can be referred to as a comfort letterComfort LetterA comfort letter is a document of assurance by a parent company to reassure a subsidiary company of its willingness to provide financial support..

A keepwell agreement enables the subsidiary to look more creditworthy to the lenders. It implies that the subsidiarySubsidiaryA subsidiary (sub) is a business entity or corporation that is fully owned or partially controlled by another company, termed as the parent, or holding, company.  Ownership is determined by the percentage of shares held by the parent company, and that ownership stake must be at least 51%. is more likely to get loans approved if there is a keepwell agreement in place. The guarantee period is predetermined by both parties and set at the time of outlining the contract.

However, a keepwell agreement is a product of negotiation preceding its creation, and it is usually more unclear and less specific than traditional legal commitments. There is no guarantee that such an agreement will be enforced since it cannot be invoked legally.

Summary

• With the keepwell agreement, the parent company commits to offer the subsidiary help with all its financing requirements for a specific time period.
• The agreement enables the subsidiary to enhance its credit rating and look more favorable to lenders and bondholders.
• A keepwell agreement acts as a loss contingent and should be reported as a guarantee under the Statement of Financial Accounting Standard.

Significance of a Keepwell Agreement

When a subsidiary finds it difficult to access financing for continuing its business operations, a keepwell agreement proves to be helpful. Its parent company will support it financially and help it in maintaining solvency for the time period specified in the agreement. When a company puts a keepwell agreement in place, the creditworthiness of corporate borrowing and debt instrumentsDebt InstrumentA debt instrument is a fixed-income asset that legally obligates the debtor to provide the lender interest and principal payments increases.

A keepwell agreement assures the bondholders and lenders that the subsidiary can meet its financial commitments and continue to operate smoothly. A cash-strapped subsidiary can be seen favorably by suppliers in the presence of the agreement.

The parent company guarantees interest payments and other payment obligations of the subsidiary until the contract is active. The lenders and bondholders can resort to the parent company in case the subsidiary faces financial distress.

Moreover, a keepwell agreement helps to enhance the credit of the subsidiary through the credit support of the parent company. It attracts investors and reduces the risk of default, increasing the credit rating of the subsidiary and decreasing interest rates.

A keepwell agreement can also be drafted to enhance the credit of a bond. If a subsidiary fails to make bond payments, the trustees of the bond can enforce the agreement in the interest of the bondholders. The parent company accepts the responsibility of keeping the subsidiary in sound financial health.

Practical Example

Suppose ABC Co. is a parent company, and XYZ Inc. is one of its subsidiaries. XYZ Inc., a mobile phone manufacturer, is facing financial distress, and there is a shortage of supply. To continue the manufacturing of its new model of mobile phones, XYZ Inc. needs to secure a loan of $5 million. However, due to its low credit ratingCredit RatingA credit rating is an opinion of a particular credit agency regarding the ability and willingness an entity (government, business, or individual) to fulfill its financial obligations in completeness and within the established due dates. A credit rating also signifies the likelihood a debtor will default., it’s been difficult for XYZ Inc. to secure a loan.

Thus, to continue with the production and also keep interest rates low, XYZ Inc. can enter into a keepwell agreement with its parent, ABC Co., for a period equal to the term of the loan. ABC Co. will guarantee that XYZ Inc. remains financially stable during the loan term. It will increase the credit rating of XYZ Inc., and it can secure the loan with lower interest rates.

Financial Reporting of a Keepwell Agreement

Keepwell agreements act as loss contingents and should be reported as guarantees under the Statement of Financial Accounting Standard. Courts hold such agreements as a legally enforceable obligation if they agreement meet certain standard language criteria.

Hence, auditors must review the language of the keepwell agreement and attempt to find out the contingent liabilities that are not disclosed in the financial statements in cases when a keepwell agreement exists. The information regarding contingent liabilities related to the agreement can be obtained from management and third parties.

Related Readings

CFI offers the Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• CreditworthinessCreditworthinessCreditworthiness, simply put, is how "worthy" or deserving one is of credit. If a lender is confident that the borrower will honor her debt obligation in a timely fashion, the borrower is deemed creditworthy.
• Shareholders’ AgreementShareholders’ AgreementA shareholders’ agreement is an arrangement among the shareholders of a company. It contains provisions regarding the operation of the
• Contingent LiabilityContingent LiabilityA contingent liability is a potential liability that may or may not occur. The relevance of a contingent liability depends on the probability of the contingency becoming an actual liability, its timing, and the accuracy with which the amount associated with it can be estimated.
• SolvencySolvencySolvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held.