"A written statement by one party who, while carefully refraining from expressly guaranteeing a debt, undertaking or obligation of a second party, does prepare, sign and deliver a document to a third party with the intention of soothing, relieving or encouraging the third party to enter into, or continue with, a business relationship with the second party."

A famous example was a letter from the Vatican's Institute per la Opere di Religione addressed to the Banco Ambrosiano Andino in Lina, confirming "control" of certain companies and awareness of their indebtedness to the addressee. Those letters rarely gain such public notice, but this letter is reported to have resulted in the payment of about $250 million by the letter writer. While this incident was singular as to its notoriety, the relationship among the parties was representative of cases involving comfort letters: a lender successfully demanding that an interested company provide assurances so that credit be extended to a subsidiary or beneficiary.

"Keep-Well" Agreements and Traditional

Guarantees

The legal issue surrounding these agreements is: Do they contain an enforceable promise? When sued, the letter writer contends it does not; the addresses disagrees. If both honestly entertain those conflicting intentions, why is this ambivalent but potentially explosive letter written?

The facts in case law reflect that comfort letters are written after vigorous negotiations wherein the letter writer was requested but refused to guarantee or otherwise secure the payment or performance of another party. The requesting party wanted a promise of a payment guarantee or surety undertaking. Accordingly, the statements "I (we) guarantee payment" or "I (we) guarantee collection" were the sought after binding promises. Both the lawyer and accountant would recognize these undertakings. Sec. 3-416 of the Uniform Commercial Code lays out the commitments. Here, "payment guaranteed," or equivalent wording, means that a signer agrees to pay a negotiable instrument when due without resort by the holder to the principal debtor. The commitment" collection guaranteed," or equivalent wording, creates a weaker secondary promise. The signer engages to pay only after: 1) the holder has reduced his claim against the primary party to judgment and execution has been returned unsatisfied; 2) the principal debtor has become insolvent; or 3) it is useless to proceed against the debtor. Unquestionably, it was these formal commitments that the letter writer wanted to avoid.

Case law reveals that the letter writer succeeds in escaping the traditional guarantee promises by refusing to write the "magic" words. Yet, how far has the writer really moved from a legal commitment? What enforceable promises, if any, are made by the letter writer?

By definition, comfort letters contain no express promises to pay or collect. Moreover, there are usually no specific amounts or even a particular designation of accounts, contracts or other commitments that are the subject of the assurance. Such a letter is the product of the negotiation that precedes its creation. It is less specific and frequently more vague when compared to the traditional legal commitment.

Are There Different Grades of Comfort Letters?

Analysis of the cases involving these letters suggest some basic patterns. One financial institution in an internal memorandum cleverly classified such letters as Grade A, B or C. (See Figure 1.)

The Grade C letter acknowledges the credit, states the degree of ownership and promises to notify the creditor of any ownership changes. An example might appear as:

"We understand and are pleased that you are extending credit in an amount not more than $3,000,000 to XYZ Company. We presently have a 42% interest in this company. Be assured that we shall give you thirty days notice before we change any degree of ownership in such company."

When the comforter additionally states that it intends to give "support" to XYZ Company, the letter is classified as Grade B. The strongest letter, Grade A, includes these phrases and also contains a promise by the letter writer to use" ... its best efforts in seeing to the performance" of the underlying credit obligation.

This classification cannot fully anticipate the range of creative draftsmanship attempted by the reluctant comforter. Nevertheless, the grading fairly represents the different levels of involvement.

How Do Courts Treat the Comfort Letter?

Sacasas and Wiesner ("Comfort Letters: The Legal and Business Implications," The Banking Law Journal, July-August 1987), reviewed the reported case law and offered an outline of the origin, nature and success of the letters as legal instruments. Five cases, decided in the last seven years, involved an environment relevant to auditors. While a majority were American decisions, two of the three recent cases noted herein were British. These decisions provide an insight into the potential liability that exists especially when the clients have multinational transactions.

Chemco Leasing Spa v. Rediffussion, plc, a 1985 British decision, represents a commercial application of a comfort letter in a parent- subsidiary model. Chemco, a financing company, was the beneficiary of two "letters" from the parent of a subsidiary engaged in computer leasing in Italy. The letters provided the following:

"We thank Chemco for the confidence which has been expressed in our subsidiary. We confirm our ownership, and we are in a position to exercise control on the management to ensure that its obligations are maintained. We assure you that we are not contemplating the disposal of our interests, but if we do, we will notify Chemco, and we undertake responsibility to Chemco, should the new shareholders of the subsidiary be unacceptable to Chemco."

Subsequently, the subsidiary was sold to its original owner, and Chemco was so notified of the new ownership.

Two issues were before the court. First, was there a legal responsibility contemplated by the letters, and, if so, was there a release of any such responsibilities by notification? The court expressed no difficulty with the first question. The language in the letter bound the parent. The court stated: "I would hold that the letters of comfort provided for the (parent) to become guarantors." Fortunately for the parent company, it was able to prove that Chemco failed to object on a timely basis to the new shareholders and the comforter was released. Thus, the binding legal character of the comfort letter was acknowledged by the court, but the comforter was able to escape liability by providing a defense imbedded in the letter itself.

The comforter in Kleinwort Benson Ltd. v. Malaysia Mining Corp. was exposed to substantial monetary liability. This case, decided in 1989, is a powerful example of the judicial concern with comfort language as a binding contractual commitment in a parent/subsidiary setting.

In Kleinwort, a British merchant bank agreed with a mining company to make a loan facility of up to 10 million pound sterling available to the company's subsidiary, a tin trader. The subsidiary, although adequately capitalized, sought additional funding for future trading. As part of the credit agreement, the parent furnished two comfort letters to the bank. The bank had first offered a joint credit line totaling 5 million pound sterling to the parent and subsidiary; this was unacceptable as was a request that the parent "guarantee" the loan.

In 1984, the parent signed a document which acknowledged the pending credit line, confirmed knowledge of and approved the loan, agreed not to reduce current financial ownership, and stated that it was the parent's policy "... to ensure that the business of the (subsidiary) is at all times in a position to meet its liabilities to you." The credit line was increased, and a second comfort letter was executed using the same language.

Upon the collapse of the world tin market, the subsidiary went into liquidation. The parent refused to pay the subsidiary's loan to the bank, contending, among other grounds, that the letter was not a legal undertaking. The court was not impressed with the defense; particularly the argument that since the parent had refused to sign a guarantee, it obviously meant no legal commitment in the comfort letter. Justice Hirst stated, ruling against the comforter:

"I am quite unable to accept the underlying premise on which this argument is based, namely the suggestion that once a formal guarantee has been rejected ... there was no further scope for the possibility of any contractually binding obligation of the sort enshrined in the crucial paragraph."

The Court of Appeals, however, rescued the comforter on the narrow ground that an increased interest rate agreed to, negated an intention to fully guarantee the loan.

These letters are not restricted to the parent/subsidiary/creditor relationship. A transaction sometimes described as "off balance sheet" financing may attract the letter writer as it did in Banque de Paris et des Pay-Bas (Paribas) v. Amoco Oil Company. A dispute arose out of an agreement between Amoco and Quasar Petroleum, an independent oil trader. The agreement called for Amoco to sell Quasar a certain amount of oil at a fixed price and repurchase the oil later for the same price. The trial record suggested that the transaction was created to strengthen Amoco's cash position and allow Quasar to play the oil market. Quasar required financing, which it obtained from Paribas under conditions which obligated Amoco to open a letter of credit in Quasar's favor or to execute a separate document. This separate document, characterized as a "comfort letter" by the court, was a promise to pay Paribas for the oil Amoco received from Quasar.

Quasar suffered reverses while indebted to Amoco. Amoco argued for an offset, but Paribas maintained that it was the beneficiary of the letter. Despite the paucity of the language, Amoco's promise to pay Paribas directly for debts owed to Quasar constituted a binding commitment and, in effect, a Class A letter.

Subsequently, the FASB issued SFAS 49, Accounting for Product Financing Arrangements, which requires that sales with repurchase agreements be recorded as borrowings rather than sales, thereby reducing the incentive for such transactions. If, however, the motivation is to improve the company's financial position, management may represent the transaction as a bona fide sale and not record the transaction in accordance with SFAS 49. Accordingly, where the possibility of this condition exists, the auditor may perform procedures, outlined herein, designed to uncover a comfort letter and determine whether the financial statements are materially misleading.

The review of the case law reflects that comfort letters have commercial significance. Further, since courts are ruling that in some cases these letters do contain binding promises similar to traditional guarantees, there is concern whether they are being properly reported.

Is a Comfort Letter a Loss Contingency?

For financial reporting purposes, a loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible loss that will be resolved when one or more future events occur or fail to occur (SFAS 5, Accounting for Contingencies). A common loss contingency is a guarantee of the indebtedness of another. Thus, if a commitment in a comfort letter is held to be similar to a guarantee, it can become a loss contingency that should be reported. Moreover, SFAS 5 requires disclosure of guarantees, irrespective of likelihood of loss.

Currently, there is no law defining the language or substance of the guarantee made by the signer of a comfort letter. However, the cases show that some letters have been found to contain enforceable promises akin to formal guarantees. The grading of comfort letters not only provides a handy guide to reading those letters, but also can be useful in answering the question: Does the letter writer make an undertaking similar to a guarantee?

The answer appears to be in the negative when the letter receives a Grade C. Such letter merely acknowledges a financial interest in another company (e.g., subsidiary or contractor) combined with a recognition of the indebtedness or liability being undertaken by the other company. Only in the remarkable Vatican Bank situation does one witness the practical effect of the letter. Unless there is other language activating some reliance aspect or fraud theory, the Grade C letter does not seem notable.

However, when the letter writer attempts to give more "comfort" by stating that "it intends to give support" (Grade B language) or even more assuring, give "its best efforts in seeing to performance" (Grade A language), counsel should be sought to evaluate a document that might qualify as a contingency which must be reported under SFAS 5. For example, it seems reasonable to assign the type of letters written in the Chemco and Kleinwort cases to counsel for legal review. This review would be for the purpose of confirming the presence of binding language and determining whether the additional language may have impaired its legal standing.

One cannot be too optimistic, however, to find language such as, "This is not a binding legal commitment by the writer." In a classic 1924 House of Lords decision, language which cautioned that the arrangement was" ... not entered into ... as a formal legal agreeent" was enforced. Nevertheless, the likelihood that a bank would accept a letter with such debilitating language seems slim.

What Should the Auditor Do?

In situations where these letters have been issued, the auditor's primary concern is failing todiscover a material contingent liability not disclosed in the financial statements and thereby being associated with misleading statements. If the letter subsequently results in a material loss to the writer, then the writer's auditor is exposed to legal liability. One of the auditor's best defenses is to have exercised due diligence and care; that is, to have performed the auditing procedures that the prudent auditor would have performed.

The authoritative literature provides no specific guidance on discovering comfort letters. SAS 12, Inquiry of a Client's Lawyer Concerning Litigation Claims and Assessments, however, provides some guidance for testing contingencies arising from litigation, claims, and assessments. This SAS setsforth a pattern of search that begins with the auditor making inquiries of management concerning litigation, claims, and assessments. The auditor then examines related documentation and corresponds with a third party--the client's lawyers. In addition, the auditor should consider whether other procedures (e.g., reading minutes of meetings of stockholders, directors, and appropriate committees held during and subsequent to the period being examined), even if undertaken for different purposes, might also disclose litigation, claims, and assessments. As a final step, the auditor should obtain assurances from management, ordinarily in writing, that management has disclosed all such matters required to be disclosed by SFAS 5. Such assurances may be included in the client representations letter. Similar procedures can be adopted in testing for contingencies arising from comfort letters.

The Auditor's Inquiry of Management

Management is the auditor's primary source of information concerning contingent liabilities arising from commitments contained in these letters. Accordingly, the auditor should inquire whether the company has any comfort letters outstanding. It would be logical to make such inquiries when asking about management's policy on guaranteeing indebtedness of others. Remember, many comfort letters are issued after a request for a guarantee has been rejected.

A simple question maynot adequately elicit the necessary information. Since the letter may have several labels, the auditor may need to inquire about letters of awareness, letters of assurance, or keep-well letters. Or, it may be necessary to define what is meant by such a letter and provide examples of commitments that might have been made. (See Figure 2.)

If management admits to issuing such letters, then the auditor should obtain a copy of each outstanding letter along with management's evaluation of the commitment (i.e., Grade A, B, or C) and the likelihood of loss. The auditor should review the letters and any related documentation. As previously discussed, it may be that the auditor will need corroboration from the client's legal counsel on the nature of the commitment.

Dear Banker Letter: Third Party Confirmation

Auditors may also use a third party confirmation with creditors to confirm client's representations and detect previously undisclosed contingent liabilities. Auditors have used the standard bank confirmation not only to obtain information about the client's deposits and loan balances, but also to disclose any contingent liabilities. This confirmation, however, has proven to be ineffective in detecting a variety of undisclosed contingent liabilities. This occurs because the confirmation is normally completed by a bank employee who works primarily with systems that control the dollar amount of deposits and loan balances and has no knowledge of contingent liabilities. Additionally, the question regarding contingent liabilities is too vague in light of volume and complexity of modern business transactions.

The Auditing Standards Board is revising the standard confirmation so that it requests information only concerning balances and loans. If the auditor desires information about other transactions, such as comfot letters, he or she should clearly ask client banks in a separate letter whether they hold or are aware of any such letters that the client may have issued.

Client Representations Letter

The auditor might wish to obtain assurances from management that all loss contingencies that are required to be reported in accordance with SFAS 5, including comfort letters, are so reported. A way to document these assurances would be to have them included in the client representations letter. Thus, management is reminded that the auditors did inquire about commitments arising from these letters and that management said that none existed, or alternatively, that such commitments are properly disclosed.

When a Comfort Letter Isn't a Comfort Letter

As trong warning must be inserted. On occasion, the comfort letter may not be the entire negotiated agreement. The party demanding the letter wanted an absolute guarantee, and the party writing the letter was willing to give the guarantee, but not in writing. This situation is precarious for the auditor, in that the written agreement does not reflect the guarantee actually given.

In a case against PepsiCo, Inc., and others in 1985, the SEC alleged that a $40 million transaction with TransUnion was improperly recorded as a sale. In its complaint, the SEC stated PepsiCo was allegedly involved in the improper removal of substantial assets from the balance sheet of a foreign subsidiary by a purported sale of such assets to an unrelated foreign company. The alleged scheme was effected to improve the subsidiary's debt-to-equity ratio. However, no sale occurred under GAAP because the risks of ownership never passed to the unrelated foreign company. These material misstatements were not discovered by PepsiCo's independent auditor, in part, because a bank responding to an audit confirmation request allegedly failed to report a material oral guarantee.

PepsiCo's subsidiary was allegedly obligated, by side letters and oral agreements, to repurchase assets sufficient to enable the unrelated foreign company to pay its debt incurred in purchasing the "sold" assets. To finance the transaction, the unrelated foreign company sought standby letters of credit from several banks. To assist the unrelated foreign company to obtain the standby letters of credit, Pepsico allegedly told the banks it would issue comfort letters stating that PepsiCo had full knowledge of the obligations of its subsidiary arising from its agreement with the unrelated foreign company.

A senior financial executive, with the approval of his superior, allegely assured one bank that PepsiCo viewed its comfort letter as a guarantee. In deciding to extend credit, the bank relied on, among other things, this oral guarantee. However, the bank did not report the guarantee to PepsiCo's independent auditor in response to an audit confirmation request. The bank's failure to respond accurately, allegedly caused, in part, the filing of financial statements with the SEC which were materially false and misleading. Without admitting or denying the allegations in the complaint, PepsiCo consented to a Final Judgment restraining and enjoining it from violations of pertinent legislation and rules.

The possibility that a comfort letter is understood by both parties to provide more than comfort, masking a legal guarantee, must be entertained by the auditor. Accordingly, the letters themselves, as well as the confirmations, must not only be examined for patent representations, but also for material clues as to the true "bargain" of the parties.

Conclusion

Contemporary court decisions and business practices suggest that "kee- well" agreements, providing they meet certain standards, qualify as enforceable commitments for the purpose of contingency reporting. The procedures described herein for unearthing these agreements, as manifested in comfort letters, as well as n evaluation technique, can be a part of the working package between auditor, management, and their counsel in determining the proper financial reporting of contingencies arising from these letters.

Rene Sacasas, JD, is an Assistant Professor of Business Law at the University of Miami, and has written and published numerous articles on business law topics.

Kay Tatum, PhD, CPA, is an Assistant Professor of Accounting at the University of Miami. Dr. Tatum is a member of the AICPA and the Florida Institute of CPAs and has published auditing articles in accounting literature, including The CPA Journal.

Don Wiesner, JD, LLM, is a Professor and Chairman of the Business Law Department at the University of Miami. Professor Wiesner is the author of two books and numerous articles on business law topics.