Letter Of Comfort

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21 Aug, 2024

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A letter of comfort (LoC) is a document a third party provides that assures the borrower's financial capabilities to meet its financial or contractual obligations against the lender. An external auditor issues the letter in the event of statutory audits, reports, and statements. It can also be issued by the parent company on behalf of its subsidiary to help them secure loans or financing.

Obtaining the letter helps individuals or businesses gain trust and prove creditworthiness in the eyes of parties with whom they are dealing and obligated. The letter of credit guarantee includes a declaration of holding and awareness, a disclaimer, and credit service details. Even though it confirms the individual's or firm’s financial stability before entering into a transaction, it does not guarantee payments or repayments.

Letter Of Comfort Meaning

A letter of comfort (LoC) is a document issued by a third party that certifies the borrower's ability to meet its financial or contractual commitments against the lender.
External auditors, such as accountants, underwriters, corporations, banks, and governments, can provide lenders with LoC.
The letter, also known as a keepwell agreement, assists individuals and enterprises in obtaining trust and demonstrating trustworthiness in the eyes of those with whom they are working and obligated.
A comfort letter is more of one party's moral duty than a legally binding vow and generally includes terms for non-competition, secrecy, or compensation.

Letter Of Comfort Explained

A letter of comfort (LoC) ensures that the obligations of a party will be ultimately fulfilled under a contract. It typically includes non-competition, secrecy, or compensation if one party quits the deal. However, it does not have an expiry date. Its origin dates back to the 1980s, giving lenders some reassurance about the borrower's financial position.

It is often found that letter of comfort drafts is vaguely worded to ensure protection for the issuer from legally binding or legally enforcing obligations. It can also be issued by a parent company to help its subsidiary to secure financing or loans.

External auditors can issue LoC to lenders, such as accountants, underwriters, corporations, banks, and governments. Also known as a keepwell agreement, it can be a part of the initial public offering, loans, or mortgages. It can be treated as a letter of intent in some cases or as a solvency opinion in a few. However, it does not guarantee that the company will remain viable or the party will make the payment.

#1 - In Business

When a company needs to start a project but does not have enough cash on hand, a comfort letter can help. The letter confirms the company's trustworthiness to the lending institution in repaying a loan. Furthermore, it is usually a financial document establishing a parent company's commitment to providing its subsidiary with the resources it needs to meet its financial obligations or get credit.

#2 - In Banking

In the case of banks, LoC refers to a written document that assures the lender that its client is financially capable enough to meet its financial obligations. It also confirms that the client has access to short-term financing to complete the transaction. LoC guarantees the financial stability of an individual or firm. However, it does not serve as an assurance for payment. It only ensures that a person or firm can pay its share of obligation financially.

#3 - In Accountant

An accounting firm may also give underwriters a LoC to research new securities offerings. A certified public accountant issues the letter to certify that the financial statements do not contain misleading or inaccurate information. It also assures that the financial statements comply with widely accepted accounting principles (GAAP).

Features

Let us understand the features of a letter of comfort guarantee through the explanation below.

The comfort letter is not a legally binding commitment. Instead, it is a third-party assurance of one party's financial ability to meet its financial obligations to another. It, thus, is a moral rather than a legal obligation for the borrower.
LoC assists individuals and businesses in gaining trust and demonstrating trustworthiness in the eyes of those with whom they are dealing and obligated.
It lays down the contract conditions and steps to complete the transaction successfully.

Types

The entities that issue comfort letters are divided into the following categories. Each category has its own set of ebbs and flows. Therefore, it is important to understand the types of letter of comfort drafts to fully understand the concept.

#1 - Banks

The bank issues the LoC to the supplier, confirming that their client is financially secure enough to participate in and maintain the trade. However, the letter of comfort in banking does not guarantee the payment but only assures the capability of the borrower to pay the lender for their services. It often includes a purchase order or sales and purchase agreement.

#2 - Accountants

An accountant provides the required financial statement to confirm a borrowers’ financial stability to be consistent enough to meet their financial obligations. In addition, the accountant offers extensive updates on the financial situation of the concerned person and comments on the amount that is subject to change or requires professional attention.

#3 - Companies

Companies issue LoC when it is difficult for them to assume an obligation. In short, it acts as a guarantee on behalf of businesses, ensuring that they will be able to meet whatever obligations they may have.

Assume that the agreed-upon deadline for meeting the obligation indicated in the comfort letter has passed, and the company involved has failed to reimburse. The bank has the right to demand payment from the guarantor in this scenario.

#4 - Underwriters

An underwriter ensures the accuracy of the information provided in the LoC. It also ensures that misstatements and financial mistakes do not result in liabilities for insurers. In addition, it confirms that accurate information and comprehensive research are provided, resulting in no failures or errors.

#5 - Governments

In the federal government's case, an LoC assures the lender, usually a public enterprise, that the obligation will be met on time.

Example

Let us take the help of a couple of examples of letter of comfort guarantee to understand the intricacies of the concept.

Example #1

Company C is a firm that is in the business only for a year. Therefore, they were finding it difficult to procure raw materials on credit. Purchasing their raw materials through cash-and-carry was inducing a lot of pressure on their cash flow. Therefore, they reached out to supplier A to supply materials on credit for 30 days.

However, Supplier A required confirmation of Company C's financial viability before signing the sales and purchase agreement. It ensured that there would be no late payments in compensation for the services provided.

As a result, Company C’s management contacted their bank and requested them to issue an LoC on their behalf to secure the deal. Therefore, the bank issued a comfort letter as an assurance document, ensuring the company's financial stability to pursue the new agreement.

Example #2

In the wake of new policies around the world after the Russia-Ukraine war, multiple countries decided to stop buying oil from Russia as a mark of protest against the country’s actions against their neighbors.

As a result, countless refineries across the world took a hit. One such refinery was Lukoil in Sicily, Italy. In October 2022, it was on the verge of shutting down permanently as it could not secure financing to purchase non-Russian oil and continue business.

Since they were facing never-ending challenges, the Italian government officials stepped in and provided them with a letter of comfort. As a result, securing financial support from banks and other financial institutions became easier.

Template

Below is a letter of comfort sample, indicating the format followed to prepare the LoC:

Letter of Comfort Vs Guarantee

Both a letter of comfort draft and a guarantee help gaining more credibility. However, there are fundamental differences that lead to differences in their implications as well. Let us understand the differences through the comparison below.

Letter of Comfort

A letter of comfort is issued by a third party to signify that the obligations of a contract shall be met. The third-party acts as an individual or entity that provides assurances.
However, it is important to understand that these documents are vaguely worded to avoid any legal obligations in case of default.
Nevertheless, the parties involved in the drafting of LoC can also be subject to a few actions depending on how the document is worded and their intentions behind drafting of the letter as well.
Despite the fact that these documents are not legally binding per se, the issuer is expected to present facts about the company they are drafting it for; failing which they could be charged for negligent-misstatement or deceit.

Guarantee

Under a guarantee, the guarantor pledges to pay on behalf of the guaranteed if the latter defaults.
These documents are drafted keeping legal framework in mind and are specific in nature, contrasting from LoCs.
If a straight guarantee, the guarantor paying on behalf of a subsidiary is automatically eligible to have a claim over the subsidiary.

Frequently Asked Questions (FAQs)

What is a letter of comfort?

A letter of comfort (LoC) guarantees that a party's contractual obligations will be met in the end. It can be a part of a public offering, a loan, or a mortgage. Furthermore, it contains rules for non-competition, confidentiality, and compensation if one of the parties leaves the contract. LoC is more of a moral obligation than a legally binding commitment from one party to another. It specifies the contract terms and procedures for effectively completing the transaction.

Who can issue a letter of comfort?

LoC, also known as a keepwell agreement, can be issued to lenders by external auditors such as accountants, underwriters, corporations, banks, and governments. In some circumstances, it can be used as a letter of intent, while in others, it can be used as a solvency opinion.

What are the types of letter of comfort?

An LoC can be of many types based on its issuers, including banks, accountants, companies, underwriters, and governments.