The purpose of a Guarantee

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The purpose of a Guarantee

Another way of grouping Guarantees is to classify them according to whether they cover a commercial or a financial transaction. This becomes relevant for the Applicant/Instructing Party in determining the Guarantee commission to be paid to the Guarantor.

In general, financial Guarantees are considered riskier than commercial Guarantees, as the latter are linked to day-to-day business. Therefore, the commission to be paid for a financial Guarantee will often be higher than the one for a commercial one, covering a commercial transaction, e.g. the delivery of goods, the completion of a project or the building of a factory, or several kinds of services. Again, the obligation of a Guarantor does not depend on the actual fulfilment of the Applicant/Instructing Party’s obligation: the Guarantor only commits itself to pay, in whole or in part, the amount stated on the Guarantee.

As we have already stated, Guarantees are flexible and can be structured in order to cover a variety of needs. There are three main categories: Export, Import and Other Guarantees.

Export Guarantees

If the company is not awarded the tender, the Guarantee should be released immediately by the Beneficiary.

Advance Payment, Down Payment or Repayment Guarantee: Although they have different names each of these Guarantees means the same thing. Their purpose is to ensure the repayment of an advance which the Applicant/Instructing Party of the Guarantee has received or will receive for a delivery or for when a certain work is executed.

In connection with large contracts, especially international transactions, parties sometimes agree that the supplier or contractor, shall receive a certain percentage, usually ranging from 10% to 30% of the contract amount, once the contract is signed. This provides the supplier/contractor with the financial basis for getting the project under way.

In order to safeguard the Beneficiary against losing the advance payment, the recipient of the amount may provide a Guarantee to secure the repayment of the amount, should the goods not be delivered or the work not done.

Because the Guarantee is usually provided before the amount is transferred, the Guarantee should stipulate that claims under the Guarantee cannot be made until the guaranteed amount has been credited to an account specified by the supplier/contractor. The contract between the parties will therefore stipulate how the outstanding amount is to be paid, whether as a lump sum on delivery or in instalmenAn Export Guarantee is one in which the seller/exporter acts as Applicant/Instructing Party of the Guarantee itself.

Bid/Tender Guarantee: When a company invites you to a tender, it will often require the tender bid to be accompanied by a specific Guarantee to cover the risk that the company submitting the tender will not abide by its offer, will not sign the contract if awarded to it, or will not submit the required performance Guarantee.

A tender Guarantee is usually issued for a percentage ranging from 2% to 5% of the contract value. It is often the case that the tender documents indicate that the tender Guarantee is to be replaced by a performance Guarantee when the contract is signed.

ts when the goods have been delivered or the work has been carried out.

Performance Guarantee: A performance Guarantee is used to secure the Applicant/Instructing Party’s fulfilment of its contractual obligations towards the Beneficiary. The Guarantor undertakes to pay compensation up to a certain amount to the Beneficiary in case the Applicant/Instructing Party fails to deliver the goods or to carry out certain work.

This type of Guarantee is often issued for 5-10% of the contract value, although the percentage varies case by case.

Warranty Guarantee: The purpose of this Guarantee is to cover the Applicant/Instructing Party’s obligations once it has delivered the goods or completed its work during the contractual warranty period.

Retention Money Guarantee: A retention money Guarantee is used to secure the correct repayment of an amount settled in advance by the Beneficiary, should the Applicant/Instructing Party fail to meet its contractual obligations during the warranty/guarantee period. It is often used in projects where full payment is made against shipping documents, but the completion of the contract will occur in the future as the Guarantee secures the final proper fulfilment of the contract.

It usually features a clause stating that it is a condition for the payment of any claim under the Guarantee that the retention money, i.e. the amount paid in advance, has been received by the Applicant/Instructing Party. A contract may stipulate that payment of the last instalment, usually 5 or 10% of the total contract amount, may be postponed until all contractual obligations of the Applicant/Instructing Party have been fulfilled, usually against a Final Acceptance Certificate (FAC). In plain terms, it secures the proper finalising of the Applicant/Instructing Party’s contractual obligations.

The postponement of the last instalment may affect the Applicant/Instructing Party’s cash flow and the actual date of payment, as well as the actual payment, may be uncertain. Since this Guarantee replaces the retention part of the amount of the contract, it is often called a retention money Guarantee.

Import Guarantees

An import Guarantee is a Guarantee in which the buyer/importer serves as the Applicant/Instructing Party to the Guarantee. There are several types of import guarantee.

Payment Guarantee: The purpose of a payment Guarantee is to cover the Applicant/Instructing Party’s ability to meet its payment obligations and the most common type covers the buyer’s obligation to pay for goods received or services rendered. Once the Beneficiary has performed the contract by delivering the goods or by completing the work (and the buyer does not meet its payment obligation, due to a lack of ability or a willingness to pay), the Beneficiary may demand payment under the Guarantee, usually for the full amount of the contract or, in case of down payment already settled, for the outstanding amount.

It may be used for covering a specific consignment or contract, or the Applicant/Instructing Party’s outstanding balance arising from its regular business with the Beneficiary. In the latter case, and in connection with, for instance, the regular delivery of goods, the Beneficiary must ensure the Guarantee amount is enough to cover the outstanding balance at any time, which means that when calculating the Guarantee amount, the seller must take into account the value of the individual deliveries, the frequency of deliveries and the tenor granted.

Standby Letters of Credit: Even though the standby letter of credit, hereafter named standby, has been known for many years, its use has gained ground only in recent years in Europe. It takes the form of a documentary credit, while its function and content is that of a Guarantee. It was developed in the US around a half a century ago, when local banks were not allowed to issue Guarantees under US law. By issuing a standby, they were able to accommodate customers’ needs for products that naturally belonged to the banking business. Even though US legislation has since been modified, standbys still enjoy widespread use as a Guarantee undertaking.

Though at first it was primarily used in the US and in connection with business transactions relating to the US or countries whose banking systems were influenced by US banking practice, today, standbys have gained popularity worldwide to the extent that the issuance of standbys by non-US banks is believed to have outnumbered the one by US banks.

A standby can be defined as a Demand Guarantee that assumes the shape of a documentary credit, because similarly, the Beneficiary has to present documents in accordance with its stipulations and UCP 600, or ISP98 as the case may be, in order to claim for payment. Instead of requiring the presentation of shipping documents, under a standby, the Beneficiary must present a document or declaration stating that the Applicant/Instructing Party failed to fulfil its payment obligation to perform a job or to meet some other commitment the commercial contract calls for. It also occasionally stipulates such declarations should be accompanied by other documents supporting the demand, such as copies of invoices, transport documents or a statement of account. In most cases, these copies will not be examined for their correctness as their presentation is largely enough.

Like a Guarantee, a standby is very flexible and can be used for all types of business. It can cover anything, ranging from an ordinary guarantee commitment to more sophisticated financial tools.

Originally, standbys were issued subject to the UCP (Uniform Customs and Practice for Documentary Credits) version applicable at time of issuance. However, many bankers found that these rules, developed specifically for documentary credits, did not fully accommodate the standby, and for this reason in 1998 the Institute of International Banking Law and Practice (IIBLP) drafted a new specific set of rules for standbys, that were named International Standby Practices (ISP98) which came into effect on 1st January 1999. The ISP have been endorsed by the ICC Commission on Banking Technique and Practice, even though UCP 600 can still be used for standbys as well (UCP 600, article 1).

Guarantee for a Missing Bill of Lading: This specific type of Guarantee is used to authorise a transport carrier or its agents, to release a specified cargo to a consignee named in the bill of lading without the surrender of the original document.

The Consignee is the Applicant/Instructing Party of the Guarantee and the purpose of it is to protect the carrier in case the bill of lading is later surrendered with a claim for the goods. It is also known as indemnity, as it is used to indemnify a carrier against losses and legal challenges in connection with the release of the cargo without the original bill of lading.

Customs Guarantee: This is issued in favour of customs offices as security for payment of customs duties by an importer.

Other Guarantees

Thanks to their flexibility, Guarantees may be used for many other purposes. Below is a brief list.

Guarantee for the repayment of a loan: Essentially, this is for the repayment of a loan a bank or company has granted to the Applicant/Instructing Party. Although at first it may seem inappropriate and quite expensive to arrange financing by applying for a loan from a bank and a Guarantee from another, this is common practice, for such a situation can occur, for instance, when a company’s foreign branch or subsidiary wishes to obtain a loan from a local bank and it may be less expensive and more practical to seek for a loan locally rather than borrowing the amount from the head office.

Guarantee for a credit facility: In addition to banks providing Guarantees for loans granted by other banks, banks can often be asked to issue a Guarantee in favour of another bank which has granted its customer with another type of credit facilities. These may include credit lines for documentary credits, guarantees and overdrafts.

Guarantee for the payment of a bill of exchange: Bills of exchange are commonly used as a means of payment in international trade. The exporter, i.e. the drawer, draws it and the buyer, i.e. the drawee, accepts it. The terms of payment for the exported goods, i.e. amount to be paid, currency, due date, place of payment, etc., are determined. If the exporter and the buyer do not know each other very well, the first accepts the bill of exchange as a means of payment only if a bank known to the exporter steps in as Guarantor for the buyer’s, or the drawee’s, payment obligation under the bill of exchange. The Guarantor signs the bill of exchange.

Injunctions: When someone requests a court to issue an injunction to stop a payment, e.g. to prevent a Guarantor from paying a sum of money it is obliged to pay according to the terms of its Guarantee, the court will often require the petitioning entity that requested the injunction to provide a sum of money as security. Instead of providing cash, a court will often accept a Guarantee as collateral.

Guarantee in consortium operations: In large international projects, several contractors can be entitled to execute different parts of the contract. The main one usually relies on subcontractors, generally businesses with different sizes and legal entities, from different countries, in order to deliver parts of a plant or to fulfil a section of the contract.

The Beneficiary may require security for the fulfilment of the whole project, and the main contractor may require security for the subcontractors’ fulfilment of their obligations. The main contractor has to determine whether it is willing to, or has to, carry the whole Guarantee risk under the Guarantee issued in favour of the Beneficiary, and whether it wishes to require a proper security from its subcontractors.

Alternatively, a subcontractor and/or a subcontractor’s bank can provide separate securities directly to the main contractor’s bank in exchange for a certain part of the Guarantee to be issued in favour of the Beneficiary, in order to reduce the main contractor’s need to assume the subcontractor’s security as well as the risk.

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About the Author

Trade Finance Global (TFG) assists companies with raising debt finance. While we can access many traditional forms of finance, we specialise in alternative finance and complex funding solutions related to international trade. We help companies to raise finance in ways that is sometimes out of reach for mainstream lenders.

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