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The structure of a Guarantee

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Trade Finance Global / Introduction to Guarantees / The structure of a Guarantee

The structure of a Guarantee

Amount and Currency

A Guarantee must clearly state the maximum amount and the currency the Guarantor is liable for. The bank’s pricing is based on the Guarantee amount, which is the amount the Instructing Party is liable to pay for the Guarantee’s commission.

The amount for which the Guarantee is valid is important as it represents the amount the Applicant/Instructing Party is liable for to the Guarantor if a complying demand is made. Moreover, the fees for the Guarantor are calculated on that amount. Sometimes the bank’s liability extends to payment of interest in addition to the principal amount. When issuing advance payment Guarantees, a bank may undertake to repay the advance payment plus interest by expressing clauses as follows:

“We undertake the repayment to you of the advance payment of X-plus-interest thereon at the rate of 6% per year, calculated from the date of receipt of the advance payment by the principal until the date of repayment of the same by us.”

However, the main rule is that the bank’s liability only covers the Guarantee amount unless otherwise stated in the Guarantee wording.

It is possible for the Guarantee amount to be reduced over time. Since the Guarantee is issued to secure the Beneficiary’s interests, a reduction of the bank’s liability under a Guarantee must be approved by the Beneficiary, either by a separate confirmation or by including a reduction clause in its wording. Of course, it would be in the interest of the Instructing Party to have the Guarantee amount reduced in accordance with the progress of its performance under the underlying contract, by presenting a certain document to the bank.

This, however, makes the bank’s position difficult as before it partially releases the Instructing Party of its liability to the bank, it must be absolutely sure the Beneficiary agrees with the reduction in amount. As a result, the Guarantee wording contains a reduction clause which should be indisputable and clear. The simplest way to ensure this is for the Guarantee wording to stipulate a calendar date, after which the Guarantee amount will be reduced to a lower amount i.e.“This Guarantee remains valid for X until (calendar date) and, provided that no demand for payment has been presented to us on or before that date, this Guarantee remains valid for the reduced amount of X until X.”

Because it is not always possible to set a specific calendar date, it could be helpful for the Guarantee wording to state that the amount of the Guarantee will be reduced against presentation of a specific named document signed by both the Applicant/Instructing Party and the Beneficiary (or an independent third party).

The parties involved in a Guarantee transaction

Referring to Guarantees incorporating URDG 758, below is a description of the parties as defined in the rules. Please note that the same party might have different names: for instance, ‘principal’ is the same as ‘Instructing Party’.

URDG 758 Article 2:

Advising party: “The party that advises the Guarantee at the request of the Guarantor.” This will often either be a correspondent of the Guarantor or the bank that has a relationship with the Beneficiary.

Applicant: “The party indicated in the Guarantee as having its obligation under the underlying relationship supported by the Guarantee.” In many cases, the Applicant and Instructing Party are the same, but this needn’t be the case.

Beneficiary: “The party in whose favour a Guarantee is issued.” This is normally the counterparty of the Applicant/Instructing Party with whom the Applicant/Instructing Party has the underlying contract/relationship.

Counter-Guarantor: “The party issuing a counter-guarantee, whether in favour of a Guarantor or another Counter-Guarantor, and includes a party acting for its own account.” In most cases, the Guarantor is the bank of the Applicant and/or Instructing Party.

Guarantor: “The party issuing a Guarantee.” In most cases, the Guarantor is the bank of the Applicant or Instructing Party.

Instructing Party: “The party, other than the Counter-Guarantor, who gives instructions to issue a Guarantee or counter-Guarantee and is responsible for indemnifying the Guarantor or, in the case of a counter-Guarantee, the Counter-Guarantor.” Often, the Applicant and Instructing Party are one and the same.

Presenter: “A person who makes a presentation as or on behalf of the Beneficiary or the Applicant, as the case may be.” When the Beneficiary presents a demand directly to the Guarantor, the Beneficiary becomes the presenter.

The steps of a URDG 758 Guarantee

Now, let’s walk through the process of a demand Guarantee issued subject to URDG 758. This transaction is used to exemplify the use of Guarantees and is a standard Demand Guarantee issued by a Guarantor on behalf of an Applicant/Instructing Party.

In most cases demands are not made under the Guarantee. The main advantage of URDG 758 is that it includes rules for the other aspects of the Guarantee process as well.

Agreement between the parties: The Applicant/Instructing Party sends its bank an application for the issue of a Guarantee. This should be based on the agreement with the Applicant/Instructing Party’s counterpart, i.e. the Beneficiary of the Guarantee. The agreement, outlined in a contract, proforma invoice and so on, should preferably include information about the Guarantee(s) to be issued, this being the information that will be included in the final Guarantee: it is therefore essential that it reflects the agreement made and that it be clear and precise.

Guarantee application: Once the contract is finalised, the following step is to apply for issuance of the Guarantee. Most banks have dedicated application forms. The Applicant/Instructing Party fills in all relevant facts that should be included in the Guarantee, such as Beneficiary, amount and required documents, etc.

This should reflect what has been agreed upon in the contract. Furthermore, all instructions for the issuance of a Guarantee and the Guarantee itself should be clear and precise and avoid redundant details (URDG article 8). At least the following shall be included in a Guarantee (URDG article 8):

  • Applicant
  • Beneficiary
  • Guarantor
  • A reference number identifying the underlying relationship
  • A reference number identifying the issued Guarantee
  • The amount and currency payable (for currency see URDG article 21)
  • The expiry of the Guarantee
  • The terms for demanding payment
  • In what form a demand or other document shall be presented, i.e. in paper and/or electronic form
  • The language of any document specified in the Guarantee
  • The party liable for the payment of any charges (for charges see URDG article 32)

Names and addresses of the Applicant/Instructing Party and the Beneficiary must be complete and correct. Moreover, it should be clear which obligation the Guarantee covers and who is entitled to make a demand under the Guarantee. This is particularly important for companies operating under several names and with independent units that may be separate legal entities.

It is of course essential that the amount of the Guarantee and currency is correctly stated.

If the Guarantee is to cover interest or expenses in addition to the principal amount, these must be explicitly stated. In addition, the parties should consider which bank should issue the Guarantee. When receiving the Guarantee, the Beneficiary ‘transfers’ a defined risk, e.g. of non-performance or non-payment, from the Applicant/Instructing Party to a Guarantor, which is often a bank. It is therefore important to indicate which bank will do the issuance.

As we stated before, the Guarantee is a ‘documentary instrument’, meaning that presentation of a complying demand must be made to the Guarantor in order to trigger the obligation to pay. For that reason, the Guarantee should clearly specify the documents to be presented when demanding payment under the Guarantee.

The application may also include information on how the Guarantee is to be advised to the Beneficiary. As the application also serves as agreement between the Guarantor and the Applicant/Instructing Party for the issuance of the Guarantee, it should also contain general terms and conditions under which the bank is prepared to issue the Guarantee.

The application must also be duly signed by the Applicant/Instructing Party (this may be an electronic signature) and, in many cases, for example when the application is sent electronically, the general terms and conditions may be agreed via a general agreement between the customer and the bank covering all Guarantees issued.

The Applicant/Instructing Party is committed to the Guarantor according to the information in the application and the latter is bound by the terms and conditions stated in the Guarantee vis-à-vis the Beneficiary, while all the terms and conditions stipulated in the trade agreement are a matter solely between the buyer and the seller.

If a specific Guarantee wording has been agreed by the parties, it should be attached as an appendix to the application.

The Guarantee application will also be the place where the Applicant/Instructing Party chooses which rules should apply to the Guarantee. In order for URDG 758 to apply, the Guarantee must expressly indicate that it is subject to these rules (article 1(a)).

Issuing the bank Guarantee/amendment

The issuance of the Guarantee by the Guarantor is based on the application received from the Applicant/Instructing Party. The Guarantor will only issue the Guarantee after having checked and accepted the application form.

This process may take place in a number of ways, for example through SWIFT via an advising party, but it may also be issued in paper format and handed over to the Instructing Party for further delivery to the Beneficiary or sent directly to the Beneficiary. According to the instructions received an amendment is either requested by a signed letter from the Applicant/Instructing Party or a bank’s amendment request application.

When the Guarantee leaves the control of the Guarantor, it is issued (article 4(a)) and is irrevocable (article 4(b)), meaning that an amendment made without the Beneficiary’s agreement is not binding on the Beneficiary (article 11(b)).

An amendment should be routed through the same parties as the original Guarantee (article 10(f)). In case this is made without the Beneficiary’s agreement, it is not binding on the Beneficiary (article 11(b)) before it has accepted all aspects of the amendment. Partial acceptance of an amendment will result in refusal of the whole amendment (article 11 (e)).

Advising/amending the bank Guarantee

When advising the Guarantee, the advising party will check its authenticity and will be responsible for ensuring the advice sent to the Beneficiary is accurate in order to reflect the terms and conditions of the Guarantee received (article 10(a)).

On receipt of the Guarantee, the Beneficiary should immediately examine it to make sure that it is in accordance with the contract or any other agreement, and that it will be possible to comply with all of its terms and conditions if a demand for payment is to be made.

Demand/presentation/payment under the bank Guarantee

The purpose of most Guarantees is to serve as security. In a perfect world, demands will not be made under the Guarantee, and this will simply expire unutilised as the commercial parties each perform as they are supposed to according to the commercial contract.

When it is necessary to make a demand under the Guarantee, URDG 758 has a number of provisions to regulate the process.

Demand/presentation: URDG 758 makes a clear distinction between demand and presentation (article 2). A demand is a demand for payment, while a presentation is to be understood in a broader sense and may also serve other purposes e.g. presentation of a document reducing the amount of the Guarantee. In other words, a demand is always a presentation, but a presentation is not always a demand.

The presentation must be made to the Guarantor at the place where the Guarantee has been issued or a place stated in the Guarantee and must be made on or before expiry (article 14(a)).

It is also important for the presentation to identify the Guarantee under which the presentation is made, usually by stating the Guarantor’s reference number of the Guarantee. In case there is no such identification, the examination of the demand will only begin after this identification has been achieved. In case this process is delayed because of problems with identification, this does not mean that the expiry of the Guarantee is extended (article 14(f)).

Examination of the presentation: When a presentation is made to the Guarantor, it will be examined in order to determine if it is in compliance with the requirements set out in the Guarantee. If it is a complying demand, this obligates the Guarantor to pay the Beneficiary. The examination is based solely upon the documents presented. In this respect, it is important that the examination be based upon the documentary requirements expressed in the Guarantee, since non-documentary conditions are generally disregarded (article 7).

For example, a requirement such as: “This Guarantee will expire once the plant has been successfully installed at the site of the Applicant,” is a non-documentary condition. While Guarantors may disregard this condition for document examination purposes, this does not mean it will be disregarded when it comes to performance of the parties under the Guarantee.

The example above relates to dates or the lapse of a stated period, i.e. statements that trigger an event by a determinable date or specified period. Another example relates to conditions/events that may increase or decrease the amount of the Guarantee, for instance: “The Guarantee will automatically be reduced by EUR 120.000,00 on 1 September 2020 unless a complying demand has been made to the Guarantor on or before that date”. This condition, while non-documentary, still remains a term of the Guarantee that must be met.

Likewise, the fulfilment of a stated requirement that can be determined from the Guarantor’s own records, i.e. the reduction of the Guarantee amount based on a payment transfer from the Applicant’s account held with the Guarantor is a non-documentary condition that must be adhered to, even though it may be disregarded during the examination process. Required documentation cannot feature information colliding with the Guarantee’s terms, which applies to non-documentary requirements.

While it is expected each Guarantee will contain all the documents necessary to fulfil a complying demand, URDG 758 includes a common, best practice default requirement that a statement (supporting statement) must be provided by the Beneficiary, indicating in what respect the Applicant is in breach of its obligations under the underlying relationship (article 15(a)). This provision is only effective should a Guarantee not be issued in accordance with the standard format and if it is silent with regard to the Beneficiary’s requirement to provide a demand supporting statement.

The examination by the Guarantor will be made on the basis of the presentation alone, whether it appears on its face to be a complying presentation (article 19(a)) and is independent of the underlying relationship. The Guarantor will compare data within and between documents and with data in the Guarantee in accordance with ‘international standard Guarantee practice’, instead of local ones. The data need not to be identical to other data on the Guarantee (article 19(b)), but it must not conflict with it.

Time for examination, payment and rejection: When a demand is made to the Guarantor, the Guarantor shall, within five business days following the day of presentation, examine the demand and determine if it is a complying demand (article 20(a)).

The Guarantor has some obligation to inform the Instructing Party of the demand under the Guarantee (article 16). However, this in itself does not give the Instructing Party any right to reject the demand. Any payment or rejection will be based only on the examination of the demand by the Guarantor.

In the examination process there are five possible scenarios:

1. Demand is a complying one, when the Guarantor determines that it is a complying demand it must pay under the Guarantee (article 20(b)). The Instructing Party should therefore be informed about the demand and, in addition, the Guarantor must send copies of the complying demand to the Instructing Party (article 22).

However, the payment obligation is triggered by the demand made to the Guarantor. If it is a complying demand, the Guarantor has an obligation to pay the Beneficiary, and the Instructing Party is obligated to pay the Guarantor based on the Guarantee application.

2. It is a non-complying demand. If the demand is not a complying one, the Guarantor may reject the demand. It also has the option to contact the Instructing Party for a waiver of the discrepancies noted (article 24(a)).

In case the Guarantor rejects the demand, this must be done in accordance with the provisions set out in article 24. In this respect, the rejection must be sent without delay and not later than the closing of the fifth business day following the day of presentation (article 24(e)).

3. The demand is not rejected within five business days from its date of presentation. The consequences of not making a timely rejection can be onerous as, in such a case, the Guarantor is precluded from claiming that the demand does not constitute a complying demand (article 24(f)). In other words, if a rejection of a demand for payment has not been sent by the close of the fifth business day following the day of presentation, the Guarantor is obligated to pay.

4. Extend or pay. If the Beneficiary alleges that the Applicant will not or has not been able to fulfil its contractual obligations and the Guarantee is about to expire, the Beneficiary may present an ‘extend or pay’ demand to the Guarantor. Such a demand provides the Guarantor with an alternative, namely, to extend the expiry of the Guarantee or pay the complying demand (URDG 758 article 23). The prerequisite for this is that a complying demand has to have been presented to trigger the Guarantor’s obligation to pay.

If a demand is complying, the Guarantor may suspend the payment for a period not to exceed 30 calendar days (article 23(a)) and shall inform the Instructing Party of the suspension (article 23(c)). It is the sole choice of the Guarantor whether or not to grant the extension request, but if an agreed extension is not provided, the Guarantor or Counter-Guarantor, must pay the demand (article 23(e)). This process gives the Beneficiary an opportunity to negotiate and the flexibility either to extend the validity of the Guarantee or to receive payment.

It is usually in the interest of the Guarantor to negotiate an extension with the Beneficiary, hence the 30-days suspension rule described above, and if no agreement can be reached, to make sure the Beneficiary is paid and the Guarantee is cancelled. The extend or pay demand may cause the Guarantee to be extended several times, according to the will of the Beneficiary’s and, of course the Guarantor’s. This can significantly increase the cost of the Guarantee for the Instructing Party.

5. Expiry of the Guarantee: a Guarantee should include information about its expiry, which may be expressed in the Guarantee either as a specific expiry date or as an expiry event (article 2). In the case of an expiry event, it is essential for the Guarantor to be able to determine when that event occurs, either based on a document presented to the Guarantor or an event that can be determined from the Guarantor ’s own records, such as the date of a bank transfer from the Applicant’s to the Beneficiary’s account.

If the Guarantee includes an expiry date and an expiry event, the earlier of the two is deemed to be expiry. A presentation under the Guarantee must be made on or before expiry (article 2).

URDG 758 has a special provision concerning expiry: if the Guarantee doesn’t state either an expiry date or an expiry event, the Guarantee shall terminate after the lapse of three years from the date of issue (article 25).

When using an expiry event and anticipating expiration later than three years after the event, the procedures and conditions to deal with this eventuality should be clearly stated and understood. If a Guarantee does not state an expiry date or event and is not subject to URDG 758, then local law will determine when the expiry occurs.

Although it is not recommended, some situations, e.g. Guarantees in favour of customs offices, tax or other authorities, require the Guarantee not to include any information about its expiry. For this kind of Guarantee, it is essential that the Applicant ensures the Guarantee document is returned to the bank, or that the bank is otherwise released by the Beneficiary when the Guarantee is no longer needed.

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