Have you ever needed a letter of guarantee from your bank to secure a business deal, but didn’t know which type to choose? You’re not alone. Although letters of guarantee are commonly used in business, there is no one-size-fits-all approach. In this blog post, we provide the Ultimate guide on bank guarantees.
What is a Bank Letter of Guarantee (BLG)?
A Bank guarantee is a financial undertaking by the bank on behalf of its customer to remedy the occurrence of an agreed risk for benefit of a third party. It is a written commitment from a bank on behalf of its client to pay a third party a sum of money if the client fails to meet its obligations. The purpose of a BLG is to provide financial protection to the third party in case the client defaults on its contractual obligations.
Bank guarantees can also be used to demonstrate a company’s creditworthiness to potential lenders or investors.
Categories of Bank Letters of Guarantee
Broadly, guarantees can be categorized as either Financial or Performance-based.
Financial Guarantees
With a financial guarantee, the bank commits to pay the third party a specified sum of money if the client defaults on its obligations. Financial guarantees are typically used in cases where there is a high risk of default, such as in construction contracts or other large-scale projects.
Performance Guarantees
A performance guarantee is similar to a financial guarantee, but instead of committing to pay a specified sum of money, the bank commits to taking action to remedy the situation if the client defaults on its obligations. Performance guarantees are typically used in cases where there is a lower risk of default, such as in-service contracts.
What are the features of a valid guarantee?
A valid guarantee has the following features:
– It must be in writing and signed by an authorized representative of the bank. SWIFT message issued by the bank is acceptable
– It must state the obligations of the client that are covered by the guarantee
– It must state the amount of money that the bank will pay if the client defaults on its obligations
– It must have an expiration date and place
– It must be accepted by the third party
Bank guarantees are governed by the Uniform Rules for Demand Guarantees (URDG), which are a set of international rules that provide guidance on how demand guarantees should be interpreted and enforced. URDG 758, which came into effect in January 2017, is the most recent version of the URDG.
Types of Guarantees
Let us go deeper into different types of bank guarantees
Bid Bonds
A bid bond is a type of financial guarantee that is typically used in the construction industry. It is issued by the bidder’s bank and guarantees that the bidder will enter into a contract if they are awarded the project.
Performance Bonds
A performance bond is a type of bank guarantee that is typically used in construction contracts. It guarantees that the contractor will complete the project according to the terms and conditions set forth in the contract.
In the event that the contractor defaults on its obligations, the surety (i.e., the bank) will be required to pay the owner an agreed-upon sum of money. The amount of the performance bond is typically 10-20% of the contract value.
Advance Payment Bonds
An advance payment bond is a type of bank guarantee that is typically used in situations where a construction contractor needs to purchase materials or equipment before starting work on a project.
Typically advance payment bonds are issued by the contractor’s bank undertaking to refund the employer in case the contractor defaults on its contractual obligations. The amount of the advance payment bond is typically 10-20% of the contract value whose usage is to cover mobilization costs. Upon receipt of the advance payment, a contractor will use the funds to perform under the guarantee until the value of work done is more than the funds advanced.
Wait a minute. Who is an employer in a contract? An employer is an organization that issues the contract. It can the government entity that issues a tender for a road project or a company that has offered a tender to construct a factory.
Tender Bonds
A tender bond is a type of bank guarantee that is typically used in situations where a company needs to submit a bid for a project. The purpose of the tender bond is to guarantee that the company will actually enter into the contract if it is awarded the project. It is also referred to as Bid Bond
The amount of the tender bond is typically 3-5% of the contract value.
Performance Guarantees
A performance guarantee is a type of bank guarantee that is typically used to guarantee the performance of a service. Unlike a performance bond, which is issued by the contractor’s bank, a performance guarantee is typically issued by the company that will be providing the services.
The amount of the performance guarantee is typically 10-20% of the contract value.
Financial Guarantees
A financial guarantee is a type of bank guarantee that is typically used in situations where a company needs to obtain financing from a bank. The purpose of the financial guarantee is to provide security for the loan. In the event that the company defaults on its loan obligations, the bank will be required to pay the lender an agreed-upon sum of money.
The amount of the financial guarantee is typically 10-20% of the loan value.
Determining the Right Type of Bank Guarantee
The type of bank guarantee that you will need will depend on the specific situation in which it will be used. You should carefully consider all of the options before making a decision.
Some factors that you should take into account include:
-The amount of money involved in the transaction
-The type of project or contract
-The jurisdiction in which the transaction will take place
– The creditworthiness of the parties involved
– The length of time that the guarantee will be in place
– The specific terms and conditions of the guarantee
Requesting a Bank Guarantee
If you decide that you need a bank guarantee, the next step is to request one from your bank. The process for doing so will vary depending on the bank and the jurisdiction in which the transaction will take place.
In most cases, you will need to fill out a formal application and provide the bank with information about the transaction. The bank will then review the application and make a decision on whether or not to issue the guarantee.
How to increase chances of being approved for a bank guarantee
There are a few things that you can do to increase your chances of being approved for a bank guarantee:
– Choose a reputable bank
– Have a good relationship with your bank
– Provide detailed information about the transaction
– Demonstrate that you have the financial ability to repay the loan
– Offer collateral to secure the loan
Risks Associated with Bank Guarantees
There are a few risks associated with using bank guarantees in business transactions.
First, if the company defaults on its obligations, the bank may be required to pay the full amount of the guarantee. You will need to refund the bank for this money.
Second, there is always the risk of an unjust claim under the guarantee. If this happens, the bank will be required to pay the claimant even if the claim is later found to be baseless.
Finally, if the company goes bankrupt, the bank may be forced to pay out the guarantee even if the underlying transaction is never completed.
Despite these risks, bank guarantees can be a valuable tool for companies doing business in high-risk industries.
When used correctly, they can help to reduce the risk of losses and ensure that projects are completed on time and on budget.
Other types of guarantees
Corporate Guarantees
A corporate guarantee is a type of bank guarantee that is typically used in situations where a company needs to obtain financing from a bank. Usually, the corporate guarantee is issued by one company for the benefit of another. For example, a company issuing a corporate guarantee on behalf of the subsidiary company.
Standby letters of credit
A standby letter of credit (SBLC) is a type of bank guarantee that provides security for a loan or financial transaction. Unlike letters of credit, SBLC’s are not used to make payments, instead, they are held by the lender as collateral. In the event that the borrower defaults on their loan obligations, the bank will be required to make a payment to the lender. Some companies prefer to get this instrument instead of bank guarantees.SBLC is a popular trade finance product. Read more about trade finance.
Warranty guarantees
A warranty is a type of guarantee that is often used in situations where a product or service is being purchased. Warranties can be issued by the manufacturer, seller, or service provider and they offer protection to the buyer in the event that the product or service is not as described.
Retention guarantees
A retention guarantee (RG) is a type of bank guarantee that is typically used in construction contracts. The purpose of an RG is to protect the employer from loss if the contractor fails to complete the project. Usually, at the end of a project, the contractor is under a defects liability period. This period is the time during which the contractor is responsible for rectifying any defects in the work.
The employer retains a certain value (usually 10% )of the contract value until the defects liability period has expired. The contractor will need to provide a retention guarantee before accessing funds during the liability period.
Personal guarantees
A personal guarantee is a type of bank guarantee that is typically used in situations where a company needs to obtain financing from a bank. Persons that issue personal guarantees are usually shareholders or directors of the company. In case of default on loan repayments, a personal guarantee gives the bank the right to claim assets from the person that issued them. The idea is to make that shareholder or director personally liable for the loan to the company.
Custom Bonds
A customs bond is a type of bank guarantee that is typically used in import and export transactions. The purpose of a customs bond is to provide security for the payment of import duties and taxes. If the importer fails to pay, the customs authority can make a claim against the bond.
Deferred payment guarantee
A deferred payment guarantee (DPG) is a type of bank guarantee that is typically used in situations where a company needs to finance the purchase of goods or services. Under a DPG, the buyer pays for the goods or services over time, with the payments spread out over an agreed-upon period. The seller provides the buyer with a DPG, which guarantees that the seller will receive payments as agreed. In the event that the buyer defaults on their payments, the bank will make a payment to the seller.
Shipping guarantee
A shipping guarantee is a type of bank guarantee that is typically used in international trade transactions. The purpose of a shipping guarantee is to provide security for the payment of freight and other charges related to the shipment of goods. If the shipper fails to pay, the carrier can make a claim against the bond. It is normally issued where the original bills of lading are not present at the time of discharge of goods.
Shipping guarantees are discharged on the presentation of original bills of lading to the shipping company.
Uniform Rules for Demand Guarantees
We shall now discuss how bank letters of guarantee are governed. Bank letters of guarantee are issued subject to Uniform Rules for Demand Guarantees(URDG). URDG is a set of uniform rules that have been formulated by the ICC. The URDG 758 is the latest version and it came into effect on 1st July 2010.
The URDG are not laws but they are widely accepted by banks around the world as the de facto standard for demand guarantees.
The URDG provides a framework for the issuance, amendment, expiry, extension, revocation, and payment under a demand guarantee.
There are three key parties involved in a demand guarantee:
– The issuer: This is the bank that issues the guarantee on behalf of their customer (the account holder).
– The beneficiary: This is the person or company that receives the guarantee.
– The applicant: This is the account holder who is requesting the guarantee from their bank.
When a demand guarantee is issued, the issuer (bank) is making a commitment to the beneficiary that they will pay a certain amount of money if the applicant (account holder) fails to meet their obligations under the contract.
Some of the key provisions of URDG 758 include:
– Issuance: requires that demand guarantees must be issued in writing and signed by an authorized officer of the issuer.
– Amendment: allows demand guarantees to be amended by the issuer with the consent of the beneficiary.
– Expiry: requires that demand guarantees must specify a place and date of expiry. This is the date by which the guarantee must be honored by the issuer.
– Payment: requires that demand guarantees must be paid within 5 banking days of receipt of a valid demand for payment.
-Governing law: shall be that of the location of the guarantor unless otherwise provided for in the guarantee.
-Jurisdiction: disputes between the guarantor and the beneficiary shall be handled by a competent court in the country of the guarantor.
How to claim against a guarantee
What happens when you need to claim under a guarantee?
There are a few steps that you need to follow in order to make a claim:
1. Notify the issuer of your intention to make a claim. This must be done within the timeframes specified in the guarantee.
2. Send a written demand for payment to the issuer, along with all supporting documents.
3. The issuer has 5 banking days to make a decision on the claim.
4. If the claim is accepted, the issuer will make a payment to the beneficiary within 5 banking days.
5. If the claim is rejected, the issuer must provide a written explanation for their decision.
It is important to note that the URDG 758 does not require the issuer to make a payment if they have a legitimate reason for rejecting the claim.
Reasons for rejecting a claim can include:
– The beneficiary has not complied with the terms and conditions of the guarantee.
– The demand for payment is received after the expiry date of the guarantee.
– The demand for payment is not received within the timeframe specified in the guarantee.
– The supporting documents are not complete or are not originals.
– The applicant has failed to provide evidence that they have met their obligations under the contract.
If you are thinking of making a claim under a URDG 758 guarantee, it is important to seek legal advice to ensure that you are following the correct procedures and to increase your chances of success.
How do banks charge for bank guarantees?
Banks charge a percentage of the guarantee. For example, a bank may charge 4 % per year. If the guarantee is valid for 6 months, the bank may apply a pro-rata formula. Banks do not charge interest on bank guarantees.
Can you apply for a bank guarantee online?
Yes, you can. Most banks have set up systems to make an online application for bank guarantees possible.
Discharge of guarantor
What is the discharge of the guarantor?
Discharge of guarantor is when the guarantor is released from their obligations under the guarantee. This can happen in a number of ways, including:
– The expiry of the guarantee.
– The revocation of the guarantee by the issuer.
– The payment of the guarantee by the issuer.
– The amendment of the guarantee by the issuer.
– The death or bankruptcy of the applicant.
– The termination of the contract between the applicant and the beneficiary.
It is important to note that the URDG 758 does not discharge the guarantor in all cases. In particular, the death or bankruptcy of the beneficiary does not discharge the guarantor from their obligations under the guarantee.
What is the difference between bank guarantees and letters of credit?
Bank guarantees and letters of credit are both types of financial instruments that can be used to provide security for a contract. However, there are some key differences between the two:
-Bank guarantees are promises by a bank to step in the event of default. Letters of credit are undertakings by a bank to the beneficiary of payment on the production of documents confirming that they have performed under the contract.
– Bank guarantees are typically used for services such as construction contracts. Letters of credit are typically used in trade contracts.
– The URDG 758 governs bank guarantees. The UCP 600 governs letters of credit.
– The URDG 758 provides for the discharge of the guarantor in certain circumstances. The UCP 600 does not provide for the discharge of the applicant.
-Letters of credit are a payment mechanism for trade. Bank guarantees are only risk mitigation instruments.
Both bank guarantees and letters of credit can be useful financial instruments in the right circumstances. However, it is important to understand the key differences between the two before deciding which one is right for your needs.
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