Credit support: Overview, definition and example
What is credit support?
Credit support refers to any collateral, guarantee, or other forms of financial assurance provided by one party to another to secure a financial obligation. It is typically used in transactions where one party's ability to meet its obligations may be uncertain, and the other party requires extra protection in case of default. Credit support can include cash, securities, letters of credit, or personal guarantees, and it helps mitigate the risk of non-payment or failure to perform.
Why is credit support important?
Credit support is important because it gives the party receiving it greater confidence that they will be compensated in case the other party fails to meet its financial obligations. For businesses, it is a way to manage risk, especially in transactions involving significant sums of money or where the creditworthiness of the other party may be in question. Credit support also makes it easier to obtain financing or engage in contracts with high-risk parties, as it provides additional security.
Understanding credit support through an example
Imagine a construction company agrees to perform a large project for a client but is concerned about the client's ability to pay upon completion. To address this risk, the client offers a credit support agreement in the form of a bank guarantee, promising to pay the construction company if the client defaults on their payment. This bank guarantee gives the construction company peace of mind, knowing that the bank will cover the payment if the client is unable to pay.
In another case, a lender agrees to provide a loan to a small business but requests that the business provide credit support in the form of a lien on its equipment. If the business defaults on the loan, the lender can seize the equipment to recover the loan amount. This ensures that the lender has a fallback option if the borrower fails to fulfill its obligations.
Example of a credit support clause
Here’s how a credit support clause might look in a contract:
“The Borrower agrees to provide collateral in the form of a cash deposit or a third-party guarantee to secure the loan amount, which will be held by the Lender until the loan is fully repaid.”
Conclusion
Credit support is a crucial tool for managing risk in financial transactions. It provides assurance to one party that they will be compensated if the other party fails to fulfill their obligations. By including clear credit support clauses in contracts, businesses can protect themselves from potential losses and ensure smoother and more secure dealings.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.