Bonds and Guarantees
In the event that there is failure to deliver the services or goods to the Buyer, the bond can be ‘called’ and the Buyer can receive financial compensation from the bank.
A Bid or Tender Bonds
A Tender or Bid Bond is usually for between 2% and 5% of the contract value, and the aim is to guarantee that the contract will be taken up if it is awarded. In the event that the contract is not taken up, then there will be a resultant penalty for the value of the Bond. The Tender Bond usually commits both the Seller and its Bank to joining in a Performance Bond if the contract is granted. A Tender Bonds will serve to not permit the submission of frivolous tenders.
Performance Bonds guarantee that a product will be of a certain standard and a penalty is payable if they are not. The amount that is payable will be around 10% of a stated percentage of the contract price. This will usually be issued when a Tender Bond is cancelled. The Bonds act as financial guarantees and have no warranty that a bank will complete on a contract in the event that the customer fails to do so.
A performance bond is usually issued by a bank or insurance company to guarantee satisfactory completion of a project by a contractor.
When there is a task where a payment and performance bond required then it will need a bid bond, to bid for the job. At the point where the work is awarded to the winning bid, a payment and performance bond will be needed as security of the job completion.
Advance Payment Bonds
This will provide protection to the Buyer when an advance or progress payment is made to the Seller prior to completion of the contract. The Bonds undertake that the Seller will refund any advance payments that have been made to the Buyer in the event that the product is unsatisfactory. This is typical in large construction matters where a contractor will purchase high-value equipment, plant or materials specifically for the project. The bond will protect in the event of failure to fulfil its contractual obligations e.g. due to insolvency. They will usually be on-demand bonds, meaning that the value set out in the bond is immediately paid on a demand, without any need for preconditions to be met. This is in contrast to a conditional bond where there is only liability if there is a breach of contract (or certain event has occurred as set out in the bond).
Warranty or maintenance bonds
These provide a financial guarantee to cover the satisfactory performance of equipment supplied during a specified maintenance or warranty period. The undertaking is by a bond issuer to pay the buyer an amount of money if a company’s warranty obligations for products that are provided are not met and the amount will often be as a stated percentage of the export contract value. A warranty bond may be conditional or unconditional. If conditional, it may be a condition of the contract that a warranty bond is purchased before a buyer makes the final payment. In the event that obligations are not met, the buyer can call the warranty bond (requesting payment). The bond is returned by the buyer at the end of the warranty period if the product that is provided has met the specifications.
A guarantee is issued by a bank on the instruction of a client and is used as an insurance policy, to be used when one fails to fulfil a contractual commitment. A financial institution issuing a Letter of Credit will carry out underwriting duties to ensure the credit quality of the party looking for the Letter of Credit before contacting the bank of the party that requests the Letter of Credit. Letters of Credit are usually open for a year.
The Letter of Credit is usually requested by the buyer and can be redeemed on demand if there is no payment by the Buyer on the date specified as set out within the contract. The cost of a letter of credit is usually between 1-8% of the amount stated per year. The letter can be cancelled when the terms of the contract have been met.
Unlike a trade letter of credit, a standby letter of credit is not created to be used for payment. The standby letter of credit is used as a “back-up” guarantee that can be used for a number of purposes.
Performance Standby’s are used to guarantee some sort of performance of a contractual obligation. However, a Financial Standby Letter of Credit works like the Performance Standby, but acts as a guarantee for payment of monetary obligations. A Performance Standby may be used by a builder in relation to a project, but a company that is listed on a stock market may have a Financial Standby in place, with the beneficiary being the exchange. This will allow confidence that they can settle all trades.
It is important to note that all standby’s are created to act as a “back-up” guarantee.
Normal trade letters of credit are used for pre-specified shipments of products. Documents are used that evidence the transaction took place and a Letter of Credit acts as the vehicle for payment in relation to the transaction.
Specifics are not usually mentioned in transactions where standby (guarantees) are used when there are ongoing shipments over a period of time.
Bonds, Guarantees and Letters of Credit
Structured Terms of Payment
Currency Exposure and Risk Management
Shariah Compliant Finance
Benefits of Bonds, Guarantees and Letters of Credit
- If the contractual obligations of the seller are not met, the product/ payment is still guaranteed
- Letters of Credit are globally regulated
- Build good relationships with global businesses
- Reduce financial risks when importing goods
Frequently Asked Questions
- What is the difference between MT799 and MT760?
- OPINION: What are the issues SMEs face when it comes to international trade?
- What’s the difference between factoring and asset based loans?
- Bills of Exchange versus Promissory Notes – What’s the Difference?
- Letters of Credit Demystified: Who? What? Where? When?
- What is trade finance in banking?
- Pre Export Finance – What is it and how is it used?
- GUIDE: General Agreement on Trade in Services (GATs)
- What is a trade loan?
- What is MT799?