Letters of support
LETERS OF COMFORT AND SUPPORT
By – Dr. Steven Firer
1. Introduction
A common response to factual insolvency is for a parent company or fellow-subsidiary to provide a so-called “letter of comfort” also known as "letters of support". The value and benefit of such letters to an auditor (and indeed to the company itself and to its creditors) depends on the specific wording thereof, and in particular whether the letter amounts to a financial guarantee and enforceable legal undertaking, or merely records a “best efforts” or a general corporate governance commitment. The auditor must be cautious regarding the degree of importance attributed to such letters. A letter of comfort cannot be regarded as a substitute for a subordination agreement. These types of letters vary, but commonly include statements from a parent company or related party that, it is aware of the subsidiary’s financial position; the group policy is that group companies should meet their obligations; it will ensure that the company is properly managed; and it supports its subsidiary to meet their obligations. A letter of comfort or support indicating a general intention to provide support may not create a legally enforceable obligation.
A letter of comfort or support is only one factor to be considered by an auditor. A letter of comfort or support cannot be conclusive in relation to the consideration of commercial solvency or going concern, which requires various other exercises and considerations. An auditor examines and considers each letter of comfort or support on its own merits and in the particular circumstances – considering in particular the practical effect of the letter of comfort or support on the company and its creditors, and the enforceability thereof.
This note attempts to deal with the following question as regards letters of comfort and support: Are they legally binding?
2. My Opinion
In interpreting comfort and support letters the key question will normally be whether the relevant statement in the letter amounts to a contractual promise, typically to ensure that a subsidiary will be able to meet its liabilities to the lenders or a merely a representation as to existing fact. Where the statement can be construed as a contractual promise as to the future (i.e. an implied promise by the parent that the subsidiary will at all times be able to meet its liabilities), the subsidiary would normally have a remedy in breach of contract against the parent in the event the subsidiary becomes insolvent. However, if the statement is only one of existing fact, the subsidiary will only have a claim against the parent if the statement was in fact untrue at the time it was made. This will generally be very difficult to prove. In commercial transactions and absent clear words to the contrary, comfort and support letters will create binding enforceable obligations. However the problem with comfort and support letters is to know what they actually mean. Whether a letter of comfort and support is capable of giving rise to a legally binding undertaking will depend on the intention of the parties and the circumstances. The meaning of an agreement is to be discovered from the words used, read in the context of the circumstances in which the agreement was made. While there is a presumption with commercial arrangements that parties intend to create legal relations, and that the courts should strive to give effect to the express arrangements and expectations of those engaged in business, nonetheless there can be no binding and enforceable obligation unless the terms of the bargain, or at least their essential and critical terms have been agreed upon.
Classifying and categorising the legal rights that flow from one of these comfort and support letters is very tricky. There must be some purpose to a comfort and support letter, some value that is provided by the writer of the letter. That being said, ostensibly the letter is not a full guarantee, otherwise the author of the comfort letter would have simply agreed to give a guarantee in the first place.
The difference between comfort and support letters and a guarantee lies in the terms of their enforceability. While guarantees create an independent financial obligation on the guarantor in case of any default by the parent company, this need not necessarily be the case with a comfort and support letter. International practice distinguishes between so-called 'hard' and 'soft' comfort letters on the basis of the definiteness of the undertaking.
However, soft comfort letters, whereby the issuer refrains from giving express assurances regarding its intentions, are uncommon. In general, the external auditor expects a subsidiary's parent company to make a commitment to use its best efforts to ensure that the subsidiary performs the obligations arising from the underlying comfort and support letter.
Typical provisions found in comfort and support letters vary in their wording, but most will contain one or more of the following provisions: the parent company indicates that it is aware of its subsidiary's loan. The parent company states that it will not reduce its shareholding or participation in the subsidiary during the currency of the loan. The parent company states that it will provide its subsidiary with the financial means to meet its obligations. The parent company states that it will do everything in its power to ensure that the subsidiary is properly managed in accordance with prudent fiscal policies so as to ensure repayment of any loan. The parent company states that it will exercise its influence on the subsidiary to meet its obligations. The parent company states that it is its policy to ensure that the subsidiary is in a position to meet its obligations.
There are various reasons why a parent company may prefer to issue a comfort and support letter instead of a guarantee. The following are probably the principal reasons: the parent company may wish to avoid a legal obligation and merely make a policy statement or moral commitment; the parent company may not want to show its commitment as a contingent liability in its balance sheet; the parent company may wish to avoid unfavourable tax consequences; and the parent company may be concerned about its general credit standing and credit rating and consider it to be below its standard to issue a guarantee for its subsidiaries.
Comfort and support letters should, be drafted very meticulously so as to reflect clearly the true intentions of the parties. A few practical hints which may be useful for the meticulous drafting of comfort letters follow: A comfort and support letter should clearly stipulate the nature of the support which a parent company intends to give to its subsidiary. A statement of the effect that a parent company will "fully support its subsidiary" is vague because no indication is given as to the nature of the support. It could be of either a financial or nonfinancial nature. A comfort and support letter should clearly stipulate the extent of the support which a parent company intends to give to its subsidiary. Reliance can be placed only on obligations which clearly fall within the ambit of the comfort and support letter.
A comfort and support letter should clearly stipulate the period for which the letter is operative. A stipulation concerning the period of operation is extremely important in the case where a subsidiary goes into liquidation prior to the repayment of its debts. In this case, the comfort and support letter must be construed to determine whether it provides any cover in the case of liquidation. This contingency should always be borne in mind and the intention of the parties as to whether a comfort letter should cover liquidation or not should be clearly stated. Declarations to the effect that it is a parent company's policy to provide full financial support to its subsidiary to ensure that the latter fulfils its obligations, should be avoided.
Where the parties intend their comfort and support letter to be binding it is always useful to indicate a period of time within which the parent company must be informed that the recipient of a letter will exercise its rights. If no express provision to this effect is inserted, a date will have to be implied.
3. Conclusion
In spite of the uncertainties surrounding the legal nature of comfort and support letters, they are used increasingly in South Africa, and only time will show the significance which South African courts will attach to these letters, the legal scope of which ranges from clearly non-committal language (often referred to as "cold comfort letters") over a legally grey area to letters which come close to, or are identical with, guarantee by the parent company for the respective subsidiary's financial standing and ability to meet at all times its financial obligations. In my opinion there are strong grounds to believe that soft comfort and support letters indicate merely a moral undertaking by the issuer, which does not create enforceable obligations.
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