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Bank Guarantee (BG) is an agreement between 3 parties viz. the bank, the beneficiary (party to whom the guarantee is given) and the applicant (party who seeks the bank guarantee from the bank). BGs are an important banking arrangement and play a vital role in promoting international and domestic trade.
BG is issued by the bank on the receipt of the request from the “applicant” for the “guarantee amount” towards some purpose / underlying transaction towards the “beneficiary”. If the bank i.e. “the guarantor” receives the “claim” from the beneficiary, it results in “BG invocation”. In the case of foreign BG, apart from these 3 parties, there is also a “correspondent bank”. If a bank does not have a branch in some foreign country, it issues BG in that country through its “correspondent bank”. The bank does all the required due diligence, financial and business analysis before issuing the guarantee.
Example of Bank Guarantee
An exporter called “ABC LLC.” In Dubai seeks a bank guarantee from an importer called “XYZ Pvt. Ltd” in India. In this case, “XYZ Pvt. Ltd” approaches Corporation Bank to give a bank guarantee on his behalf to the exporter. Now, if corporation bank does not have a branch in Dubai, corporation bank would issue the guarantee through State Bank of India (SBI). Here, “XYZ Pvt. Ltd” is the applicant; “ABC LLC” is the beneficiary; “Corporation Bank” is the issuing bank and “SBI” is the correspondent bank.
This BG agreement acts as an undertaking assuring the beneficiary that the bank would pay the specified amount, in the case of its applicant’s default in delivering the “financial” or “performance” obligation as mentioned in the guarantee. In effect, the BG acts as a promise that in case the liabilities of the debtor/applicant (bank’s customer) are not met, the contractual liability will be met by the bank. It is to be noted that the obligation to pay is not of the applicant, but of the bank since bank acts as the guarantor. BG contract is independent from the underlying transaction/contract that exists between the beneficiary and the applicant.
Features of a Valid Guarantee
- The period till which the guarantee holds is clearly specified
- Guarantee is always issued for a specific amount
- The purpose of the guarantee is clearly stated
- Guarantee is valid for a specific defined period
- The grace period allowed to enforce guarantee rights is also stated in the guarantee
- Guarantee clearly states the events under which it can be enforced
Types of Bank Guarantees
- Financial Guarantee: Here, the bank guarantees that the beneficiary will meet the financial obligation and in case he fails, the bank as a guarantor is bound to pay.
- Performance Guarantee: Here the guarantee issued is for honoring a particular task and completion of the same in the prescribed/agreed upon manner as stated in the guarantee document.
- Advance Payment Guarantee: This guarantee assures that the advance amount would be returned, in case the agreement for which the advance is given does not get fulfilled.
- Payment Guarantee/Loan Guarantee: The guarantee is for assuring the payment/loan repayment. In case, the party fails to do so, a guarantor is bound to pay on behalf of the defaulting borrower.
- Bid Bond Guarantee: As a part of the bidding process, this guarantee assures that the bidder would undertake the contract he has bid for, on the terms the bidding is done.
- Foreign Bank Guarantee: When a guarantee is issued for a foreign beneficiary, it is called foreign BG.
- Deferred Payment Guarantee: When the bank guarantees some deferred payment, the guarantee is termed as Deferred Payment Guarantee. For example, A company purchases a machine on credit basis with terms of payment being 6 equal installments. In this case, since the payment is deferred to a later period, creditor seeks deferred payment guarantee for an assurance that the payment would reach him in the given time period.
- Shipping Guarantee: This guarantee protects the shipping company from all kinds of loss, in case the customer does not pay. This document helps the customer to take possession of goods.
- Guarantee for Warranty Obligation or Warranty Bond: This is an assurance that the goods ordered would be delivered as agreed.
Bank Guarantee Limits
In case some company or firm has regular requirement of BGs in their course of business, banks also provide a facility of fixing “BG Limit” for that company/firm after BG assessment based on their track record, financial position, security offered by the company, margin and financial position of the business. For example: If a small company deals with Government Departments or Public Sector Units, the regular requirement of BG occurs. In such case, getting a BG limit is beneficial; this means the bank from time to time can issue BGs to the applicant with upper limit being the sanctioned “BG Limit Amount”. BG limits are classified as “Non-Fund Based” limits.
Why are Bank Guarantees Important?
Importance of bank guarantee is reflected in below points:
- Adds to Creditworthiness: BGs reflect the confidence of the bank on your business and indirectly certify soundness of your business.
- Assessment of Business: In the case of foreign transactions or transactions with Government organizations, the foreign party or a Government Undertaking is constrained and cannot assess the soundness of each and every applicant to a project. In such cases, BGs act as a trusted instrument to assess stability and creditworthiness of companies applying for projects.
- Confidence of Performance: When new parties associate in the business and are sceptic about the performance of the company undertaking the project, performance guarantees help in reducing the risk of the beneficiary.
- Risk Reduction: Advance payment guarantees act as a protection cover wherein the buyer can recover the advance amount paid to the seller if a seller fails to deliver the goods or services. This protects against any probable loss that a party can suffer from a new seller.