My Business is Borrowing Money. Why is My Bank Asking for a Comfort Letter?

If you are in the process of negotiating a loan agreement with a bank, the bank may ask you to provide a comfort letter. A comfort letter is a statement that a company’s owner signs when its company borrows money from a bank. Consequently, a comfort letter makes it harder for the owners to say they were unaware of the borrowing company’s actions. This article will explain the purpose of comfort letters, the legal and commercial implications for you and your business, and some practical considerations. 

What Are Comfort Letters? 

For banks, lending is a risky endeavour since there is always the chance that the borrower will not be able to repay the loan. However, one way lenders can minimise risk is through comfort letters. 

Comfort letters are a statement that a company’s owner signs when its company borrows money from a bank. They can also go as far as to say that the borrowing company’s owner intends to support the borrowing company and help it meet its obligations. 

By design, comfort letters make it harder for the company’s owners to say they were unaware of the borrowing company’s actions. Consequently, lawyers sometimes refer to this effect as having “moral force” because most comfort letters are not drafted to create legal obligations. 

However, banks can draft comfort letters in specific ways that create legal obligations similar to a guarantee or indemnity. Therefore, you should always have a lawyer review any comfort letter. Furthermore, even if it is a comfort letter, a court may interpret it as having a legal effect. You may therefore be personally liable for the debts of your company.

Why Are Comfort Letters Necessary?

As you may know, the law considers companies to be legal entities separate from their owners. This means they own their assets and are separately responsible for their liabilities. Consequently, the owners can only ever be liable for the value of their shareholding in the company. If the value of the company’s debts exceeds the value of the shares, the owners are under no obligation to provide the company with additional funds to meet any obligations. 

From the owner’s perspective, this is a good thing since it encourages innovation and rewards risk. However, from the bank’s perspective, this limits its ability to recover the loan amount if the company defaults and does not have enough money to repay it. Furthermore, because a company enjoys legal personhood, the bank has no right to chase the owners for payment. This is because, as a general principle of law, contracts only bind the parties to it and not third parties, including the company’s owners.

Circumstances Where Banks Use Comfort Letters

The law does not automatically obligate company owners to cover their company’s debts. However, banks will often make it a condition of the loan that the company’s owners must ensure that the company will make good on its obligations. These third-party agreements either take the form of a guarantee or an indemnity. In practice, the bank will seek both a guarantee and an indemnity from the company’s owners. 

Of course, as a business owner, being asked to personally guarantee a loan defeats the protection of limited liability and is therefore disadvantageous. That said, in most cases, the bank will refuse to lend if you are not willing to enter into a third-party guarantee or indemnity agreement. However, there are circumstances where a bank will grant a loan without a third-party guarantee or indemnity agreement. If so, the bank may request the company’s owners (i.e. you or the company’s parent company) to sign a comfort letter. 

Key Takeaways 

Banks want to limit their risk when lending money to companies. Therefore, banks can ask you to sign a comfort letter. Comfort letters include statements from a company owner noting the borrowing company’s debts. However, the letter does not create any obligation on the owner to repay the company’s debts should it default. Instead, it can have moral force in the context of a loan agreement. 

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