Analytical Speaking

When does a Letter of Comfort becomes a

Contract of Guarantee?

Author:

CS Nidhi Ladha
nidhiladha@vinodkothari.com

Co-authors:

CS Aditi Jhunjhunwala
aditi@vinodkothari.com

CS Nivedita Shankar
nivedita@vinodkothari.com

Vinod Kothari & Company

January 11, 2013

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 When does a Letter of Comfort becomes a Contract of Guarantee?

Article
BACKGROUND

In this day and age of competition and change of consumer preferences at a lightning
speed, a company has to look to innovate and expand. Borrowing from external sources is
one of the preferred modes of borrowing to aid the companys growth plans as it is less
time consuming than issuing shares and relatively compliance free. Of course, the best
resources are banks and financial institutions.

Any bank loan is complete only after the execution of certain documents which help in
cementing the arrangement between the parties. Several forms of securities are obtained
by the lender in relation to the facilities granted to the borrower. Apart from the typical
ways in which such security is created, viz. charge, mortgage, hypothecation and/or a
pledge, it is also common to find the lender insisting on an assurance or guarantee from a
person, (typically an affiliate of the borrower) who would have a certain financial
position to guarantee the borrowers indebtedness.

One such form of guarantee is a Letter of Comfort, also known as letter of intent or
letter of support. Quite often, corporates mean to give a guarantee but structure it as
a letter of comfort. Quite often banks mean to make it a guarantee, but end up simply
taking it as a letter of comfort. The purpose of a guarantee and a letter of comfort being
similar, they are often confused, difference mainly lying in the content and phrasing
thereof.

In legal parlance

Legally, the main difference between a guarantee and a letter of comfort lies greatly in
terms of their enforceability. While sections 372A, 295, etc. of the Companies Act, 1956
specifically cover guarantee, there is no provision in any statute typically pertaining to a
letter of comfort (unless of course such letter takes a form of a guarantee). Consequently,
while a guarantee would be a legal binding commitment which can be enforced against
the guarantor in the same manner as against the borrower, a letter of comfort is a mere
moral obligation on the provider where chances of enforceability being minimum.

In accounting parlance

In addition to legal differences, an instrument of guarantee and letter of comfort may also
have several accounting, regulatory and disclosure implications. Guarantee has to meet
several accounting requirements that do not apply in case of a letter of company. Such
requirements, inter alia, include the following:

1. Disclosures in the balance sheet of the issuer company (i.e. the guarantor).
2. Guarantees are also counted as exposure for the purpose of NBFC exposure norms.
3. Requirement of fair valuation under IFRS.

Therefore, it becomes more so important to know when a comfort letter becomes a

guarantee and binds the issuer legally and financially and attracts the accounting,
 When does a Letter of Comfort becomes a Contract of Guarantee?

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regulatory and disclosure provisions under applicable laws. This article discusses when
does a financial obligation gets reduced to a mere moral obligation and seeks to examine
the meaning of Letter of Comfort as understood in common as well as legal parlance and
outlines some of the situations when a comfort letter does not give comfort to the issuer
and becomes a legally binding guarantee!

LETTER OF COMFORT (LOC)

LoC in the banking parlance is referred to a document which is provided by a person,

typically an affiliate (such as the holding / parent company) of the borrower (LoC
Provider) assuring the financial soundness of the borrower to repay its debt(s).
However, the LoC does not create any payment / financial obligations on the affiliate.

As discussed, in the absence of any governing legislation, the issue that arises in case of
LoC is that of enforceability of the LoC by the lender against the LoC Provider. While
this is a pragmatic issue, the LoC, unfortunately, only creates a moral obligation on the
provider of the LoC, thereby making it a weaker option to secure the lender. However,
the language of the LoC, as is discussed below, can impact this view.

Meaning of a LoC

Generally, letter of intent refers to a writing documenting the preliminary

understandings of parties who intend in the future to enter into a contract.

Blacks Law Dictionary (Abridged 6th Ed. 1991) defines a letter of intent as a
document employed to reduce to writing a preliminary understanding of parties who
intend to enter into a contract, or to intend to take some other action.

The meaning of letter of intent can further be understood by the definition as provided by
Chitty on Contract which is as follows1:

LETTER of intent: There is as yet no clear authority on the legal effect of the
practice whereby the parties to a transaction exchange letters of intent on which
they act pending the preparation of formal contracts. The terms of such letters may, of
course, negative contractual intention. But where this is not the case, it would be open
to the courts to hold the parties bound by the terms of such letters, especially if the
parties had acted on those terms for a long period of time or if they had expended
considerable sums of money in reliance on them......

Therefore, there is no clear authority on the legal effect of the practice whereby the
parties to a transaction exchanged a letter of intent on which the parties act, pending the
preparation of formal contracts. Furthermore:2

1
Chitty on Contracts, 26th Edition, paragraph 116 on page 114.
2
Ibid at page 180 and 181.
 When does a Letter of Comfort becomes a Contract of Guarantee?

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where the language of such a document does not negative contractual intention, it is
open to the courts to hold the parties bound by the document; and they will, in
particular, be inclined to do so where the parties have acted on the document for a
long period of time or have expended considerable sums of money in reliance on it.
The fact that the parties envisage that the letter is to be superseded by a later, more
formal, contractual document does not, of itself prevent it from taking effect as a
contract.

A distinction, therefore, may be drawn on when such letter of intent is merely a

preparation for formal contract or where the parties have acted on such intent for a long
period of time. In the latter case, such letter may not remain a letter of intent but take
shape of a contract.

Though there is no set format for a LoC, typically the following clauses in a LoC
differentiate it from a guarantee and assume only moral responsibilities on the LoC
Provider:

1. This letter is not contractually binding on the parties and is only an expression of
the basic terms and conditions to be incorporated in a formal written agreement.
This letter does not obligate either party to negotiate in good faith or to proceed to
the completion of an agreement. The parties shall not be contractually bound
unless and until a formal agreement is executed by the parties, which must be in
form and content satisfactory to each party and its counsel in their sole discretion.
Neither party may rely on this letter as creating any legal obligations of any kind 3;
or

2. This agreement is a nonbinding letter of comfort and no party is bound to

anything. Notwithstanding either partys execution hereof, nothing in this letter
shall create a legally enforceable contract and no party shall be bound to anything
unless and until a definitive formal agreement has been fully negotiated, drafted
and executed for both parties4; or

3. The purpose of this document is to memorialize certain business points. The

parties mutually acknowledge that their agreement is qualified and that they,
therefore, contemplate the drafting and execution of a more detailed agreement.
They intend to be bound only by the execution of such an agreement and not by
this preliminary document5; or

4. The Letter of Comfort shall not be deemed to constitute a guarantee within the
meaning of Section 126 of Indian Contract Act, 1872.

3
Michael P. Carbone and Stephen G. Stwora-Hall, Using Letters of Intent in Real Estate Transactions,
Probate and Property, Jan./Feb. 1997 at p. 45
4
Dennis L Greenwald and Michael Asimow, Cali. Practice Guide, Real Property Transactions, Ch. 4, Form
4:G
5
Goren v. Royal Investments, Inc., 516 N.E.2d 173, 176 (Mass. App. Ct. 1987)
 When does a Letter of Comfort becomes a Contract of Guarantee?

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The following clauses are some examples in LoC which have binding effect:

1. That we shall continue to provide our support and assistance to the Borrower
for their operations and business and further confirm that the Borrower will be in
a position to meet its debt service obligation to your Bank in time

2. ....In case the Borrower fails to repay the loan or meet its obligations, we shall
take all necessary steps as the Bank may advise to us and shall ensure that the
Borrower can fulfil its obligations under the loan agreement by using our best
efforts, good office and take such pragmatic measures as may be deemed
necessary.

In the case of Turriff Construction Ltd. vs. Regalia Knitting Mills6, the letter of intent was
held to be a collateral contract to pay for the preliminary work. In yet another
pronouncement reported in Wilson Smithett & Co. (Sugar Co.) v. Bangladesh Sugar
Industries Limited7, the court held that the letter of intent had contractual significance.

Significance of terminology: substance v. form

The title comfort letter or letter of comfort, by whatever name called, is not
determinative of the substance of the letter. Some comfort letters may be contracts while
others may be mere statements. Hence, the question that arises is, in the absence of any
governing legislation, how is the LoC binding on the parties? While this is a pragmatic
question, what can be said in defence is that the LoC only creates a moral obligation
between the parties and does not bind the parties legally.

Contract of Guarantee (CoG): Meaning

A CoG has been defined in Section 126 of the Indian Contract Act, 1872 to mean:

A contract to perform the promise, or discharge the liability, of a third person in

case of his default [emphasis supplied]

Therefore, unlike a LoC, in case of a guarantee upon default of the borrower, the
guarantor steps into the shoes of the borrower. Such contract, whether oral or written,
should be a contract whereby the guarantor (or the surety) undertakes to discharge the
liability of the person in respect of whom the guarantee is given. In other words, in a
contract of guarantee, the guarantor guarantees and undertakes the financial as well as
legal obligation of a third person (i.e. the borrower) if such person defaults in its payment
obligations. It can comfortably be said that a guarantee is not limited to the moral
responsibility of the guarantor.

Typically, the following clauses in a CoG make it binding and enforceable:

6
(1971) 222 E.G. 169
7
1986 (1) Lloyd's Rep. 378
 When does a Letter of Comfort becomes a Contract of Guarantee?

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1. The Guarantors, do hereby guarantee the Lender and its successors and assigns,
full, complete and due performance by the Borrower of all the provisions,
conditions, warranties, covenants and agreements contained therein the
Agreement entered into between the Lender and the Borrower; or

2. The liability of the Guarantor herein under this Guarantee Agreement shall
continue despite the insolvency or winding-up of the Borrower until such time the
Borrower shall have fully performed all the provisions, conditions, warranties,
covenants and agreements contained therein the Agreement entered into between
the Lender and the Borrower, or

3. This Guarantee shall not be discharged nor shall the Guarantors liability
under it be affected by anything which would not have discharged or affected the
Guarantors liability if the Guarantor had been a principal debtor to the Bank
instead of a guarantor, or

4. In consideration of the Lender agreeing to enter into the Agreement, the

Guarantor as principal obligor and not merely as surety unconditionally and
irrevocably guarantees to the Lender the due and punctual payment of the
Guaranteed Moneys and agrees that, if at any time or from time to time any of the
Guaranteed Moneys are not paid in full on their due date it will immediately
upon demand unconditionally pay to the Lender the Guaranteed Moneys which
have not been so paid

LoC VIS--VIS CoG

Significance of Language

There is no absolute rule as to whether a LoC can or cannot create a legal relationship. As
sated earlier, there is no specific format for the drafting of or use of language in LoC.
Since, it is a commercial instrument indicating intention to ensure that the borrower is in
a position to repay debt, the drafting should be done accordingly so as to indicate to the
same. It is important that acute caution should be taken to ensure that it does not bind the
LoC Provider itself to repay the debt in case of any default as the same shall then qualify
to be a guarantee.

A LoC may be offered to a potential creditor as an alternative to a guarantee, as a means

of re-assuring the creditor that the credit will be repaid. However, it refers to the typical
LoC, generally provided by a company when credit is advanced to its subsidiary and it
contains a statement of the parents support for the subsidiary. The effect of such a letter
will depend on the precise form of wording used.8

Thus, drafting and use of language are indicative of the intent of any document. Without
a factual context to indicate a contractual intent, one cannot attach contractual liability to
language of an instrument that is clearly not promissory. As there does not exist clear
8
Butterworths Common Law Series, Law of Contract,
 When does a Letter of Comfort becomes a Contract of Guarantee?

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meaning or situation when a LoC will be regarded as CoG, one needs to rely on court
rulings.

As can be seen with the judicial illustrations below, the key to distinguish a LoC from
CoG is the use of language and the act of the parties in relation thereof.

Judicial pronouncements

In Banque Brussels Lambert SA v. Australian National industries Ltd9., the Supreme

Court of New South Wales in Australia considered the LoC to be a guarantee as the
requisite intention of the parties to involve in contractual liabilities and language of the
instrument were sufficient to create a binding obligation on the author of instrument. The
Learned Chief Justice of Australia, while analyzing the instrument in this case, listed
some points which will prove the contractual obligation and make the LoC a guarantee:

1. In determining whether a letter of comfort gives rise to contractual obligations;

(a) The ordinary rules of construction and interpretation relating to contracts

apply;

(b) the overriding test is that of the intention of the parties as deduced from the
document as a whole, seen against the background of the practices of the
particular trade or industry and in the events surrounding its inception;

(c) the prima facie presumption that in respect of commercial transactions there
is an intention to create legal relations applies, and the onus of proving the
absence of such intention rests with the party who asserts that no legal effect is
intended.

2. In the circumstances, and taking into account the negotiations leading to the
final version of the letter of comfort, and a close textual analysis of its terms, the
letter of comfort contained enforceable contractual promises, breach of which gave
rise to a liability in damages where the shares .... were sold without the plaintiff
being given 90 days' notice. [emphasis supplied]

The Australian Apex Court viewed that the intention of the parties in commercial
transactions is generally to form a legal relation only, whether expressed or implied. The
Judge in this case, was strongly critical of the approach of the court of appeal in
Kleinwort Benson Ltd. v. Malaysia Mining Corp.10, as excessively technical and
commercially unrealistic, and favoured the view that commercial agreements should be
given commercial effect.

9
(1989) 21 NSW LR 502
10
[1989] 1 WLR 379Court of Appeal
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In the matter of Kleinwort Benson11, the plaintiffs made a loan to a company on the
strength of a letter of comfort from its parent-the defendants, which, following the normal
form of such letters, contained (i) a statement that the defendants were aware of the loan
to their subsidiary, (ii) an undertaking not to give up control of the subsidiary and, finally,
(iii) a statement that: it was the defendants policy to ensure that the business of the
subsidiary is at all times in a position to meet its liabilities to the plaintiff under the loan
agreement. When the subsidiary went into liquidation, the creditors sought payment of
the debt from the parent company on the basis of the letter of comfort, which the
defendant refused to pay. The case turned on the construction of the words quoted above.
The defendants argued that those words had no contractual effect on the alternate bases
that (a) on their proper construction they contained only a statement of present intention,
rather than a promise as to the future and (b) that if the words were construed as
promissory, they were not intended to create legal relations. The plaintiff succeeded in
the court of first instance which held that the circumstances in which the letter of comfort
was given, feasibly created the presumption of a legal agreement since the transaction
was of a commercial nature.

However, the court of appeal unanimously overturned this decision which judgment is
reported at (1989) 1 All ER 785. The court of appeal held that the crucial question was
not whether the party intended to create legal relations, but whether the words in question
were promissory at all, and the court accepted the contention that they contained no
warranty to the future but merely a statement of the defendant's present policy. The words
therefore imposed upon the defendant, at best, a moral rather than a legal obligation.

The Court of Appeals analysis of the comfort letter in Kleinwort turned on the
interpretation of the statement in the letter and specifically whether the statement could
be considered a promise as to future conduct or as a contractual warranty. It was noted
that the use of the future tense is an indicator of an intention to make a promise about
future conduct. However, the court also conceded that the use of the present tense did not
bar the conclusion that the language in the statement above was an enforceable
contractual promise.

In Lucent Technologies Inc. v. ICICI Bank Limited & Ors.12, question arose before the
Delhi High Court for consideration relating to construction and legal impact of LoC. The
Court also, relying on the principles laid by the international courts, concluded in this
case that the language of letter of comforts tendered by Lucent Technologies were
not creating any legal relations between the parties and hence, were not in form of any
guarantee. The circumstances and documents in this case did not indicate that the parties
intended to create any legal relations. The letters in this case use phrases and concepts
having clear technical legal significance and do not manifest any intent that a final and
concluded contract had been entered into. In fact, the letters were conditional and
equivocal in creation of the liability of the issuer as same were made subject to
fulfillment of some conditions precedent. Hence, it was held that the communications

11
supra Note 10
12
http://www.indiankanoon.org/doc/1461224/
 When does a Letter of Comfort becomes a Contract of Guarantee?

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placed before the court does not contain the kind of assent required to make for a binding
contract.

In a nutshell, the test for enforceability of the LoC is stated alternately from jurisdiction
to jurisdiction, but the basic factors used in deciding the enforceability are:

1. Nature of the statements in LoC (drafting of the instrument and words used);

2. Intention of parties; and

3. The language and surrounding circumstances of each letter.

Drafting and use of language in LoC

In the case of Commonwealth Bank of Australia v. TLI Management Pty Limited13

wherein the relevant letter of comfort read as follows:

We hereby acknowledge that the Commonwealth Bank of Australia has agreed to

make temporary credit facilities totalling two hundred and fifty thousand Australian
dollars $A250,000 available to Hovertravel Australia Pty Ltd which represents
payments for ongoing operating costs and salaries. We confirm that the company will
complete takeover arrangements (subject to shareholders' approval) of Hovertravel
Ltd as soon as legally possible. These arrangements include the injection of sufficient
capital to repay the temporary facility as mentioned above to takeover date or within
30 days of this date. [emphasis supplied];

The court, constructing and interpreting the nature of the latter, held that:

In the circumstances the draft did not, in my judgment, contain words conveying to
the defendant the idea that, by having it engrossed and signed, the defendant would be
undertaking a contractual obligation. It would have been very simple, if that had been
intended, to have used words of promise, such as we agree, we undertake, or
even we promise. The words we confirm that we will . . . were, in the
circumstances, at least ambiguous. What was stated in the remainder of the sentence
beginning with those words was in essence a statement of no more than was already
known or believed by the plaintiff to be the defendants intention ...

It was, therefore, held that the legal status of the letter was merely that of a serious
acknowledgment by the defendant of its understanding of the commercial position
between the plaintiff and its customer, and a serious statement confirming the defendant's
intention with respect to the parent of the customer.......

In Australian European Finance Corporation Ltd. v. Sheahan14 wherein the relevant

letter of comfort read as follows:

13
(1990) V.R. 510
14
(1993) 60 40 SASR 187
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This company which is 100% owned by The Duke Group Limited will continue to be
supported by this company so long as necessary. In the event that any subordinated
loans are required to ensure the companys requirements under the necessary
legislation or licensing requirements, these will be provided. I confirm that such
support as is necessary will be given to this company and its subsidiaries. [emphasis
supplied]

On a construction of this letter and after the reference to several academic works
authorities and judicial precedents, the court concluded that the vague words of the first
and third sentences contain a contractual promise. Support can mean many different
things, and so long as is necessary or as is necessary gives indefinite support. They
are woolly expressions to say the least. The second sentence is even more ambiguous,
and the evidence contained no attempt to explain it. The Court further held that the letter
contained a non-promissory statement of intention of having a legal binding.

In the case of Rose & Frank Go v. Grompton Bros15 the letter at issue contained both
promissory language and the language of disclaimer. The Court utilized a dominant
language test to determine if legal liability should be ascribed to the assurance
language. It compared the strength of the assurance language with the disclaimer
language and concluded that the letter was neither intended nor should have been relied
upon as a contractually enforceable document. The Court focused on the clause in the
letter claiming that it was not a formal or legal agreement and asserting that the
document was rather only a definite expression and record of the purpose and intention of
the three parties concerned to which they each honorably pledge themselves. The court
held that an honorable pledge implies only a moral and not a legal obligation.

Intention of the Parties to contract

The intention of the parties is to be gathered only from the expressions used in the
correspondence and the meaning it conveys and in case it shows that there had been
meeting of mind between the parties and they had actually reached an agreement, upon
all material terms, then and then alone can it be said that a binding contract was capable
of being spelt out from the correspondence16.

No written contract is ever complete; even the most carefully drafted document rests
on volumes of assumptions that cannot be explicitly expressed.17

As quoted above, binding nature of even a well drafted document is dependent on

volumes of assumptions and intent of parties to such document, LoCs also require some
form of assumptions and intention of parties needs to be taken into consideration while
ascertaining the nature of a LoC. In Banque Brussels (supra) case, the Court made this

15
[1923] 2 K.B. 261 (Eng. C.A.)
16
Rickmers Verwaltung GNBH vs. Indian Oil Corporation Ltd. [(1999) 1 SCC 1]
17
Arthur Rosett, Critical Reflections on the United Nations Convention on Contracts for the International
Sale of Goods, 45 OHIO ST. L.J. 265, 283 (1984) at page 287
 When does a Letter of Comfort becomes a Contract of Guarantee?

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clear that in commercial transactions, the intent of the parties is nothing but to enter into a
binding contract, however, concluding its order, the Court took into consideration other
guiding factors like the language and the circumstances of the case while deciding upon
the nature of the letter of comfort. In other words, though the intention of the parties in
commercial transactions is quite clear, the other factors also play significant roles and the
intention alone does not make a LoC a guarantee.

CONCLUSION

Needless to say, the parties involved mutually agree upon the preferable form of
guarantee, whether a LoC or a CoG. While a CoG is a stronger form of security, as
compared to LoC, it is upto the parties involved to execute a LoC or a CoG, depending
upon the requirement of the lender.

In India, the State governments used to issue letters of comfort fairly generously to
corporations promoted by it and for special purpose vehicles. However, the Government
Accounting Standards Advisory Board (GASAB), on the government accounting
standard on sovereign guarantees, has taken the view that the letter of comfort issued by
the government may be treated as good as an implicit guarantee.

The title comfort letter is not determinative of the substance of the letter. While a CoG
would at any given point of time be an enforceable contract, some comfort letters may be
contracts while others may merely be statements. There is no absolute rule on whether or
not a LoC can create a legal relationship. It is, therefore, of utmost importance that the
language of a LoC shall be given due attention and shall be drafted with care, vigilance
and caution. The words of the LoC shall match the intent of the parties. As comfort
instruments become more detailed and contractual in nature, the likelihood of
enforceability increases. Generally accepted principles of contract law may be applied to
determine what is fair and equitable in terms of what best serves the business efficiency
of the relationship. In principle, the intention of the provider and the receiver of the CoG
or the LoC shall be aware of what is being provided or received, respectively.

This Article has been published in Manupatra journal, January 2013 issue.