Introduction to Guarantees

Last updated on 22 Aug 2024

08 Nov 2019 . 2 min read

Nikhil Patel

Nikhil Patel is a journalist at Trade Finance Global, covering commodity finance markets, trade technology, and cash / treasury management.

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A bank guarantee is a formal assurance from a lender or a financial institution that a borrower will be able to pay its counterparty, irrespective of any financial circumstances. This guarantee, assures a third party that payment will be made, even if the borrower cannot repay the debt. Doing business with companies abroad is not the same as doing business with national companies. For parties involved in international transactions, there can be unpleasant surprises, which makes it difficult for them to meet their contractual obligations. Therefore, both parties will often require some form of security, such as a guarantee.

A Guarantee is a simple and practical way of ensuring that a business – or its trading partner – receives compensation in the event of a breach of contract.

Aspects of a Guarantee

A Guarantee can take many forms and include different aspects. Below are some typical aspects to bear in mind when creating a Guarantee.

The conditions in the home country of your trading partner

You must be aware of the conditions in the countries you trade with and ensure you make your own country’s conditions clear before signing a contract. The obligations in your own country will not necessarily match those in other countries. For example, in some countries it is normal to ignore the expiry date of a Guarantee. Furthermore, local law might also require that the Guarantee is issued by a local bank against counter indemnity by a bank in the exporter’s country.

Importance of the order

The order of individual banking transactions is very important with projects abroad. Exporters often require documentary credits as security for payment of goods, while importers require a bank Guarantee to ensure that work is carried out or goods are delivered. So, what should be issued first? The documentary credit or the Guarantee?

Sometimes, importers make a claim under an issued Guarantee, i.e. require payment under the Guarantee because of a breach of contract, before the exporter even sees the documentary credit. This can be avoided by including the Guarantee as one of the documents required under the documentary credit, that is, by making the Guarantee subject to the terms of the documentary credit.

Payment under a Guarantee

It is important that you and your trading partner agree on the terms for meeting claims under the Guarantee. Should payment take place against a simple declaration of breach, which makes the Guarantee payable on first demand, or should the bank wait for a settlement between the parties?

This must be clearly stated in the wording of the Guarantee to let all parties know when a claim must be met. In some cases, it will be necessary to ask for advice with respect to the wording of the Guarantee.

Parties to a Guarantee

There are several parties involved in a Guarantee:

The Applicant i.e. the party requesting the Guarantee
The Guarantor i.e. the bank that guarantees the agreed compensation amount to be paid in the event of a failure to meet contractual obligations
The Beneficiary i.e. the party for whom the Guarantee is issued