What is a Letter of Guarantee?
In general, a letter of guarantee is a written promise to take responsibility for another company's financial obligation if that company cannot meet its obligation. The entity assuming this responsibility is the guarantor.
How Does a Letter of Guarantee Work?
Let's assume XYZ Company has a subsidiary named ABC Company. ABC Company would like to build a new plant and thus would like to borrow $10 million from a bank. The bank will probably require XYZ Company to guarantee the loan in writing by issuing a letter of guarantee. By doing so, XYZ Company agrees to repay the loan using cash flows from other parts of its business if ABC Company is unable to generate enough cash on its own to repay the debt.
Often a parent company will guarantee bonds issued by one of the parent's subsidiaries, but there are plenty of other situations that might involve letters of guarantee. For example, vendors sometimes require letters of guarantee from their customers if the vendor is uncertain about the customer's ability to pay (this most often happens in transactions involving expensive equipment or other physical property). In these situations, the customer's bank might issue a letter of guarantee for the customer's payment, meaning that the bank will pay the vendor if the customer does not.
Letters of guarantee don't always guarantee the entire amount of a liability. In bond issues, for example, the letter might only guarantee the repayment of interest or principal, but not both. Sometimes more than one company might guarantee a security; in these cases, each letter of guarantee pertains to a pro rata portion of the issue, but in other cases, a letter of guarantee may make a guarantor responsible for the other guarantors' portions if they also default on their responsibilities.
Why Does a Letter of Guarantee Matter?
Letters of guarantee mitigate risk, but it important to note that they do not make a security risk-free. After all, it is still possible that even the guarantor can default on the liability if the liability is too large or if the guarantor is already struggling for other reasons. Regardless, letters of guarantee provide an extra layer of security, which is why guaranteed securities often get higher credit ratings.
Historically, guarantors disclosed the nature and size of their written guarantees in the notes to their financial statements. But in 2002, the Financial Accounting Standards Board (FASB) issued Interpretation 45, stating that guarantors must book the fair value of the guaranteed obligation as a liability on the balance sheet and that they must do so at the inception of the guarantee. Some guarantees, such as those that are accounted for as derivatives, those issued by insurance companies, and some guarantees issued by leasing companies, are exempt from this rule. It is important to note that guarantees issued between parents and their subsidiaries do not have to be booked as balance sheet liabilities. Examples of this include a parent's guarantee of a subsidiary's debt to a third party or a subsidiary's guarantee of the parent's debt to a third party or another subsidiary.
All guarantees must, however, be disclosed. The guarantor must disclose the nature of the guarantee (terms, history, and events that would put the guarantor on the hook), the maximum potential liability under the guarantee, and any provisions that might enable the guarantor to recover any money paid out under the guarantee.