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.

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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 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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