Lecture 11: Methods of Payments p. 2 Bank Guarantees

AGENDA: Introduction & Definition Demand Guarantees (D/G) Types of D/G: Direct Guarantee Types of D/G: Indirect Guarantee Main uses of D/G Specifics of D/G

Bank Guarantees: Introduction & Definition Definition: A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. A bank guarantee enables the customer (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand business activity.

Bank Guarantees: Introduction & Definition It is an arrangement between 3 parties: creditor has a claim against the principal debtor, with the participation of a guarantor who undertakes to be liable to the creditor => => Creditor + guarantor = contract of guarantee

Demand Guarantees: Explanation A type of protection that one party in a transaction can impose on another party in the event that the second party does not perform according to predefined specifications. In the event that the second party does not perform as promised, the first party will receive a predefined amount of compensation by the guarantor, which the second party will be required to repay. Demand Guarantees are like substitutes for cash and must be honored on presentation of a written demand that complies with the provisions of the Demand Guarantee.

Demand Guarantees: Explanation They have a number of uses and are frequently required: ex. in construction project contracts and for doing business in countries throughout the Middle East, but can also be found in other business sectors as well, even replacing rent deposits in leases on homes. They are widely used in contracts for international sales of goods

Demand Guarantees: Explanation Demand Guarantees are payable upon first demand by the beneficiary against presentation of documents and are unconditional Conditional guarantees – obligation of the guarantor is normally activated by the non-performance of an underlying obligation

Demand Guarantees: the Basics An importer who wishes to have security that an exporter will perform its obligations can ask the exporter to provide a Demand Guarantee. This would be a written undertaking by a guarantor (usually a bank), to pay the importer up to the maximum sum quoted on the demand guarantee upon presentation of a demand together with any other documents specified under the terms of the bank’s guarantee.

Demand Guarantees: the Basics The exporter undertakes to repay the bank Guarantees are procured by the seller to protect the buyer against non-performance Performance bonds – a form of demand guarantees Advance (repayment) guarantees – procured by the seller to secure a refund to the buyer in cases in which part of all of the purchase price has been paid in advance

Demand Guarantees: an illustration An importer of cars in the U.S. can ask a Japanese exporter for a Demand Guarantee The exporter goes to a bank to purchase a guarantee and sends it to the American importer If the exporter does not fulfill its end of the agreement, the importer can go to the bank and present the demand guarantee. The bank will then give the importer the predefined amount of money specified, which the exporter will be required to repay to the bank

Types of Demand Guarantees A Direct Guarantee is provided by the exporter’s bank directly to the importer with the exporter giving its bank sufficient funds, or an indemnity, or other form of security, against the cost of meeting claims.

Types of Demand Guarantees In this scenario, there are 3 distinct contracts: 1. the underlying contract between the exporter and the importer 2. the counter-indemnity (re-imbursement contract) between the exporter and its bank 3. the guarantee between the exporter’s bank and the importer

Types of Demand Guarantees

Types of Demand Guarantees An Indirect Guarantee is provided by the importer’s own bank. The exporter’s bank will provide a counter-guarantee to the local bank with the exporter providing sufficient funds, or an indemnity, or other form of security, to its bank (as in a direct guarantee) against the cost of meeting claims.

Types of Demand Guarantees Here there are 4 distinct contracts: the underlying contract between the exporter and the importer, the reimbursement contract between the exporter and its bank, the counter-guarantee between the exporter’s bank and the bank in the importer’s country, guarantee between the importer’s bank and the importer

Types of Demand Guarantees

Main Uses of D/G 1. Tender or bid guarantee - this is to safeguard the party inviting the tenders against the withdrawal of a tender after the tender closing date from or the non-signing of the resulting contract by the successful tenderer. It is also provided to safeguard against the successful tenderer signing the contract, but not providing the agreed performance guarantee.

Main Uses of D/G 2. Performance guarantee - A performance guarantee is to safeguard the importer against the consequences of non-performance of the contract by the exporter. 3. Advance payment guarantee - An advance payment guarantee is to safeguard the importer against giving an advance payment and the exporter subsequently failing to perform the contract.

Main Uses of D/G 4. Retention guarantee - A retention guarantee safeguards the importer against the early release of retention monies (required as a form of warranty security), as opposed to stage payments, and the exporter failing to perform what remains of the guarantee. 5. Warranty guarantee - A warranty guarantee safeguards the importer against the nonperformance of the warranty by the exporter.

A little bit of law A fundamental feature of Demand Guarantees is that the guarantee is completely separate from the underlying contract (i.e. the contract for sale of goods or services) (ex. under English law ) between the importer and the exporter This feature is incorporated into the Uniform Rules for Demand Guarantees (URDG 458) published by the International Chamber of Commerce –ICC (ICC Publication 458)

A little bit of law Additionally the guarantee given by the bank to the importer is separate from the counter-indemnity given by the exporter to its own bank and also from any counter-guarantee given by the exporter’s bank to the importer’s bank in an indirect guarantee This means that if a demand is made by the importer, accompanied by any additional documents called for under the guarantee, payment must be made, regardless of whether or not the exporter has failed in any of its contractual obligations

Difficulties when using demand guarantees 1. Cash Flow Problems - For any company, providing a Demand Guarantee may well have an affect on its cash flow or banking facilities. This is especially problematic for smaller companies who do not have the cash flow to cope with a sum of money being tied up indefinitely.

Difficulties when using demand guarantees 2. Unfair Calling One of the inherent risks of a guarantee payable on demand is that it may be called in “unfairly” when the conditions of the contract have been met. It is worth remembering that, although it can be a difficult experience for anyone affected by unfair calling, it is not a common occurrence in practice.

Difficulties when using demand guarantees 3. Expiry Date - Some countries, particularly in the Middle East, may not accept a Demand Guarantee which includes an expiry date as this may not be enforceable in law. Therefore the local bank guarantor may not be prepared to cancel the liability, after expiry, without the beneficiary’s agreement. This can cause problems, especially an open-ended balance sheet liability.

Recap Direct Guarantee Indirect Guarantee Guarantor Contracting bank 3. Counter guarantee Advising bank Guarantor Guarantor Contracting bank 2. Request 2. Request 4. Guarantee 4. Advising Ordering party Ordering party Beneficiary Beneficiary 1. Underlying Contract 1. Contract