Letter of guarantee…issuing bank’s risks and obligations

Definition

A guarantee is an undertaking given by a person/bank to be answerable for the debt, default or

miscarriage of another person/bank.
A guarantee may be specific or continuing. When the guarantee is specific, the guarantor is answerable
for a particular loan only. In case the guarantee is continuing, the guarantor shall promise to pay whole
or part of transactions carried out by the debtor.

Characteristics of guarantee

The main characteristics of guarantee are as under:-

 There are three parties in guarantee:

1. Principal creditor

2. Principal debtor.

3. Guarantor.

 The primary liability to pay the debts falls on the original debtor. The guarantor will pay only the
principal debtor fails to pay whole or part of agreed debt.

 The guarantor is answerable for the loan if the debtor defaults. Guarantor has no interest in the
contract between principal creditor and principal debtor.

Capacity to contract

The person or firms who are able to make contracts may stand as surety for loans.

 Minors and persons of unsound mind are not eligible to enter into contract of guarantee.

 Married women have capacity to contract only against their separate estates. The bank
however should avoid accepting guarantee of married women.

Types of bank guarantee

1. Shipping guarantee: addressed to shipping companies requiring the issue of delivery orders in
the absence of original bill of lading.

2. Financial guarantee. These are guarantees given by the bank to financial institutions (e.g. IDBP)
and companies (the creditors or beneficiary) undertaking to pay the debts of its customer(the
principal debtors) in the event of the default by the customer.

3. Tender guarantee or bid bonds: These are issued by the bank to avoid the deposit of the
earnest money by its customers when they tender for contract. The amount is usually 1% to 20%
of the contract value and the duration is for very short period until the bids are opened and the
contract awarded. Once the bank issues the bid bond, it is usually committed to supporting the
project by issuing further guarantees such as performance bonds etc.

4. Performance guarantee/performance bond: These are issued by a bank on behalf of its

customer who has entered into a contract to supply goods or perform other services and the
guarantee compensation in term of money in the event of non performance of such contract. It
is usually for 5% to 10% of the value of the contract and would remain in force throughout the
period of the contract at a constant amount.

5. Advance payment Guarantee (APGs). These are issued where a customer receives an advance
payment in respect of the work to be performed or goods to be supplied under a contract
undertaken by him and the bank as a guarantor, undertakes to repay the amount or the goods

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 not supplied according to contract. Interest free cash payment is usually made to the client by
the principal to support the start up operation of the contract against the issue of the bank
guarantee.

6. Equipment bond: These are issued where the customer receives and uses equipment made
available to him by the employer. The customer progressively requires a theoretical ownership
interest through the presentation of progress certificate which include the depreciation
allowance. This represents advance payment in kind by the employer who is assured that
equipment will be effectively used on the work site

7. Transportation Bond: These bonds are issued where the customer has undertaken to transport
capital equipment (imported by the employer for the project) from the harbor to the worksite.

8. Retention money bond (RMBs). These are issued to avoid retention of money (usually) ten
percent) by the employer from each progress payment due to the customer. In order to cover
hither to untraceable mistakes or faults in the completed construction work, until usually one
following final completion o\f the project.

9. Working capital replenishment bond: (WCRG). These are issued by the bank in favor the
employer who advance funds to the contractor to bridge financial payment delays on receivable
due by himself.

10. Maintenance bond: These are issued at the end of construction period remain outstanding un
till the end of maintenance period. This is usually one year. The purpose of this bond is to
prevent the contractor from leaving the construction site after the construction is completed
and the last progress payment received.

11. Completion Bond: in many cases construction companies and turn-key contractors are
committed not only to construct but also to operate more importantly, to operate successfully
during a previously agreed period of time.

12. Custom bond These are often requested to be issued in connection with imported equipment
which is subsequently re-exported upon completion of the project. By giving such a bond,
exemption is obtained from paying import duties and sale tax to the custom authorities of the
country involved.

13. Deferred payment guarantee: Issued on behalf of an importer customer to cover deferred
payment terms agreed upon between him and the supplier of plant and machinery.

Risks for the Bank

1. The bank under takes great risk by advancing loans on sureties. The guarantor may lose his
property during the period of loan contract. If the debtor fails to pay the debt, the bank can not
recover the amount from the two parties.

2. In case the debtor fails to repay the loan, the bank may not be able to get back the money even
by suing the debtor and the guarantor. The case may fail on technical grounds.

3. If at any time the bank has to change the constitution or it has to amalgamate with other banks,
the guarantee is terminated unless otherwise stated.

Precautions: Greater need for analysis of financial standing and for ascertaining the performance ability
of the customer.

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