Letter of Guarantees in detail

Meaning
A bank guarantee is an undertaking by the bank at the request of a party, whereby the bank – in the event of default by the principal in the fulfillment of his obligations to make payment to the beneficiary within the limits of specified sum of money and within the specified period of time. So, bank guarantees are usually limited with respect to amount and time. As for as the time is concerned - a grace period is usually granted to the beneficiary to claim under the guarantee. This is basically given for the time taken by the beneficiary to present his claim.

Guarantees are generally given by banks, insurance companies and other guarantors.

These guarantees are given in the form of tender bonds, performance guarantees and repayment guarantees in relation to projects in the same country or another country which involves supply of goods or services or the performance of work. These guarantees are currently an important tool of international trade.

Parties involved in guarantees and their interest differs. Lets see the same:

1.The beneficiary: He is the party inviting the tender or He is the party awarding the contract or He is the person who wants to receive a compensatory sum of money incase the tenderer fails to perform his obligations or fails to perform the contract in accordance with its terms or to secure repayment of any payment or advances made by him if the principal fails to perform the contract.

2.The principal : He is the party tendering the contract or He is the party to whom the contract has been awarded.

3.Guarantor : Guarantor is a party who will meet his commitment in terms of the guarantee, without becoming involved in possible disputes between beneficiary and principal.

4.The Instructing Party : The new rules recognise the existing widespread practice whereby an instructing party may forward to the guarantor instructions received from or on behalf of the principal and counter-guarantee such instructions.

Need for a Guarantee
1.To provide an assurance of the intention of the principal to sign the contract.
2.To safegaurd against the principal failing to meet his obligations under such a contract
3.To protect interest of a party awarding the contract (beneficiary) in respect of the repayment of payments and advances made by him in the even of principal not fulfilling the contract terms.

Types of guarantee :

1.Conditional and Unconditional Guarantees.
2.Fixed and Fluctuating Guarantees.
3.Financial Guarantees.
4.Performance / Non-financial guarantees.

1.Conditional and Unconditional Guarantees :

In case of conditional guarantees, the right to claim payment is conditional on external factors besides the beneficiary’s demand for payment. For example – If a guarantee states the clause that this guarantee is payable only on a particular ruling of a court

An unconditional / demand guarantee on the other hand, is payable on first demand by the beneficiary. Generally, banks prefer to issue unconditional guarantees so that they can avoid their obligation to pay being contingent on external factors. Because, these unconditional guarantees will afford them certainty about their obligation.

Fixed and Fluctuating Guarantees :

Under a fixed guarantee, the bank;s liability can be ascertained at the time of issuance.

On the other hand, in case of fluctuating guarantee, the bank’s liability can fluctuate subject to a fixed maximum amount.

1.Banks can exercise control over the fluctuating liability by retaining the right to cancel the guarantee at any time and crystallising their obligation on the date of cancellation.
2.Enough care should be taken in the text of guarantee which should not prohibit bank from terminating the guarantee before the expiry date.
3.The bank should give prior intimation to the parties involved in the guarantees for termination of guarantee.
4.The termination of guarantee should take place only upon the receipt of notice by the respective parties.
5.The bank’s liability would then be limited to the debt incurred prior to the receipt of notice.

Financial guarantees : A guarantee to ensure adherence to a financial commitment is a financial guarantee.

1.Disputed income tax / Customs & excise duties : Banks will issue guarantee to guard against non-payment of tax / duty amount.
2.Customs / Excise guarantee for clearance of goods : To guard against non-payment of duty amount after final assessment by the competent authority.
3.Insurance premium guarantee : To guard against non-payment of premium on demand from the insurance company.
4.Guarantee for grant of facilities to another company : To guard against non-payment of dues by the company to whom such facilities are granted.
5.Deferred payment Guarantee : To guard against non-payment of bill of exchange / loan instalment on the due date.
6.Bill of lading / Shipping guarantee : Indemnifies the transporter against all adverse consequences resulting from the delivery of goods without surrender of the transport document.

Performance / Non-financial guarantees : A guarantee to ensure adherence to a commitment to perform a certain act as per stipulated conditions is a performance guanrantee.

1.Advance payment guarantee / Prepayment bond : To guard against non-delivery of goods/services for which advance has been received from the buyer.
2.Performance guarantee / Retention bond : to guard against non-performance of contracted obligations by the seller of the goods or the provider of the services.
3.Security deposit / Tenders / EMD / Bid bonds : To guard against failure of the principal to accept the contract as per the terms and conditions laid down in his tender / bid.
4.Retention money guarantee : To guard against non-compliance (with the terms of the contract) of the project executed by the principal.
5.Export performance guarantee : To guard against non-performance of the contracted export obligation.

General Aspects of Guarantee :

1.Benefits to the parties:

Benefits to the bank : It gets commission income.
Benefits to the principal / Instructing party : (a) It enables better liquidity by deferring payment and making it contingent on non-performance. (b) Cheaper than fund-based facilities except where it involves credit substitution.
Benefits to the beneficiary : Certiainty of payment, in the event of non-performance, guaranteed by the bank.

2.Important points to be noted before issuing a guarantee :

Since the bank is liability to pay on behalf of the principal, it must be protected against any loss arising out of meeting such an obligation. So, principal need to indemnify the bank against all losses that the bank may incur in the performance of its obligation to pay. Such indemnification is called counter guarantee / counter indemnify.

The bank can obtain further comfort by specifying the place of payment under a guarantee and the governing law. So that the beneficiary cannot claim with another branch / head office of the guarantor bank.

Date of expiry of the guarantee.

Total amount payable in local currency, for guarantees issued in foreign currency, and whether the extent exchange control regulations permit remittance in case of invocation.

Forece majeure clause – A guarantee should not be invoked due to non-performance arising on account of factors beyond the control of the principal.

For safety sake – the principal’s liability under the counter guarantee or any cash collateral / margine, should not be released until the expiry of the claims period or the return of the cancelled guarantee, whichever is earlier.

3.Bank guarantees are different from letters of credit. Payment under bank guarantee is contingent on non-performance whereas under LCs it is contingent on performance

4.A bank guarantee can be amended and whenever an amendment ‘weakens’ the BG for the beneficiary, his prior written permission should be obtained. Ex. Increase in amount requires a written permission from the principal whereas the decrease in the amount should have the written permission of the beneficiary.

5.Bank guarantee expires when – the validity period has ended or the BG is returned for cancellation or the entire amount of BG is paid by the bank or the bank is released from its obligations.

6.Documents required :
For grant of Bank guarantee limits
Hypothecation / Pledge agreement for collateral security formalities connected with registration charges where necessary.

For guarantee issuance :
Counter guarantee / indemnity from the principal.
Formal application for BG issuance.