Bank Guarantee – An introduction | Trade Samaritan

Bank Guarantee – An introduction

Bank Guarantees demonstrate the applicant’s repayment abilities and prove his solvency and credit worthiness towards his business partners.

Bank guarantee is an instrument issued by the bank (known as the issuing bank or the guarantor) on behalf of the client (known as the applicant or the principal) which secures the payment for a third party (known as the beneficiary) in case the client fails to fulfill the contractual commitment. Bank Guarantees are facilitated in international trade transactions, as collateral and as credit enhancement instruments. Over recent years, there has seen a significant increase in the use and importance of demand guarantees worldwide.

Cross border bank guarantees are usually issued to secure transactions involving:

  1. supply of goods/services,
  2. construction and shipbuilding contracts,
  3. large scale service contracts and technology transfers,
  4. mergers and acquisitions and
  5. warranties

Bank Guarantees are governed by Uniform Rules for Demand Guarantees (URDG 758) published by International Chamber of Commerce in 2010.

URDG 758 is not a law by force hence the usage is about 50% in most countries. Bank guarantee is based on trust and confidence as the bank purely guarantees the payment basis the capacity and credibility of its client to be able to fulfill his contractual obligation. There are 35 articles in URDG 758 which set out the liabilities and responsibilities of each party, the process to present a demand, the expiry conditions and how to deal with amendments and transfers of guarantees and counter-guarantees. The rules are clear and concise.It is safe to assume that today all the big ticket transactions and projects around the world do not place without a bank guarantee.

The basic process for a guarantee to ensure performance:
Note that the ‘beneficiary’ in this case is the beneficiary of the guarantee and not the recipient of the proceeds of the underlying transaction.

Bank guarantee process flow

Usage of bank guarantee is widespread because of its unique features :

  1. A bank guarantee can be issued as a backup for both financial as well as non-financial transactions. For example it can be issued for financial transactions such as Loans, Overdrafts, Joint Ventures, Bonds and Reinsurance. And it can also be issued for non-Financial transactions such as Sale, Lease and Construction projects.
  2. A bank guarantee if individually issued can provide security to both the parties involved in the transaction. It can secure the party entitled to receive the payment – seller, contractor, lessor or lender and it can secure the party entitled to receive the goods/services – buyer, employer, lessee etc.

In international trade, the risk of payment is covered by documentary letter of credit however bank guarantee also offers to cover the risk of non-performance of obligations other than payment.

Bank guarantee also prevents the initiation of legal action in case of non-performance thereby reducing the complications. Payment under the guarantee can be called by the beneficiary by presenting the stipulated documents which usually constitute of an invoice and a letter. It is important to remember that the guarantor bank is not obliged to fulfill the contractual obligation on principal/applicant’s behalf. For instance it will not complete the bridge or build an airport or provide the service/goods mentioned in the contract; the beneficiary is entitled to merely claim the payment from the guarantor bank as a substitute or the compensation of non-performance by the applicant.

Drafting of a bank guarantee

  • Bank guarantees are usually ‘tailor made’ and are subject to the local regulations of the country hence dispute resolution can get tricky. Bank guarantees can be subjected to the domicile of issuing country by quoting its reference in the text of the guarantee.
  • Say a German exporter who is asked to provide a bank guarantee will approach his bank, a bank specialist will work with the exporter who will then draft the guarantee suitable to the circumstances of the underlying transaction.
  • Bank specialist will always try to protect the interest of the principal exporter within the framework of the underlying transaction, URDG 728, bank’s policies and the local regulations prevailing in Germany.
  • The contents of the guarantee must be precise for details such as the maximum liability, expiry date, interest, charges and the procedure to make the claim.
  • The structure of a guarantee is not pre-determined and hence there is a degree of flexibility in formulating and structuring the guarantee text. In practice there 6-7 sections in the text of the guarantee.
  1. Introduction
  2. Declaration of undertaking
  3. Identification
  4. Applicable law and jurisdiction
  5. Validity
  6. Expiry
  7. Any other provision

Claims

The guarantor bank must pay upon demand or receipt of a compliant claim without making any unjustified defensive attempt. The guarantor has a right to check the validity and the compliance of the claim however is not entitled to seek the consent or the opinion of the applicant. As long as the formal conditions of submitting a claim are being met, the guarantor bank is obliged to pay.

Bank guarantees are technical in nature and due to its association with high values and the sensitivity of the underlying transactions, guarantees are vulnerable to scams and frauds. International Chamber of Commerce has recently launched a certification program to enable Trade and Guarantee specialists to acquire and demonstrate expertise in the area of Guarantees; this program is known as ‘Certificate for Specialists in Demand Guarantees’ (CSDG). The usage and the scope of bank guarantee in the area of international trade is wide spread; in the forthcoming articles we shall cover the types, process and challenges in more detail, we will also discuss the difference between a letter of credit and a bank guarantee.

Reference

International Chamber of Commerce
Wolters Kluwer Law and Business
Credit Suisse

Comments: