Category: Blog

Bank Guarantee

Introduction

A bank guarantee is a promise from a bank or other lending institution that if a specified debtor defaults on a loan, the bank will cover the loss. It is a critical instrument in commerce, providing a layer of financial security that facilitates transactions between parties who may not have an established relationship or sufficient trust. Essentially, it acts as a safety net, assuring a beneficiary that the applicant will fulfill their contractual obligations.

Use of bank guarantee

  • Performance Guarantee/Bond: Ensures a contractor or supplier completes their contractual obligations (e.g., delivering goods, finishing a project).
  • Tender/Bid Bond Guarantee: Provided when bidding on a project, guaranteeing the bidder will sign the contract if selected.
  • Advance Payment Guarantee: Protects a buyer who makes an advance payment, ensuring the money is returned if the seller fails to deliver.
  • Payment Guarantee: Secures a buyer’s payment obligations to a seller, ensuring timely payment.
  • Customs Guarantee: Covers duties and taxes owed to customs authorities.
  • Retention Guarantee: Replaces money held back (retained) by a client as security for proper contract performance.
  • Warranty Guarantee: Covers obligations during a product or service’s warranty period which is commonly used for regular imports of commodities like petroleum products, sugar, oil, etc. 
  • Court Guarantee: Covers obligations of a party (defendant) in order to release collateral or relief the defendant.

Mechanism

A bank guarantee involves three primary parties: The Applicant (Principal): The party that requests the bank guarantee (e.g., a contractor bidding on a project):

  • The Applicant (Principal): The party that requests the bank guarantee (e.g., a contractor bidding on a project).
  • The Beneficiary: The party that receives the guarantee and is protected by it (e.g., the project owner).
  • The Guarantor (The Bank): The financial institution that issues the guarantee and is responsible for payment if the applicant defaults.

Unlike a Letter of Credit (LC), which is a primary payment mechanism, a bank guarantee is a secondary obligation. The bank is only obligated to pay the beneficiary if the applicant fails to perform their duties as stipulated in the underlying contract. This distinction is crucial, as it means the bank’s liability is contingent upon a breach of contract.

Importance bank guarantee

  • Risk Mitigation: They significantly reduce the credit risk for the beneficiary. If the applicant becomes insolvent or simply refuses to perform, the beneficiary is protected from financial
  • Facilitating Trade: They enable businesses to enter into contracts with new or international partners with confidence, as the risk of non-performance is transferred to a reputable financial institution.
  • Competitive Advantage: An applicant backed by a bank guarantee is often viewed as more credible and financially stable, which can be a deciding factor in securing a contract, especially in competitive tender processes.
  • Contractual Compliance: They ensure that the applicant adheres to the terms and conditions of the contract, as failure to do so will trigger the guarantee and a subsequent claim from the bank against the applicant.

Key Feature

  • Nature of Obligation as Secondary: The bank pays only upon the applicant’s default.
  • Purpose: To secure a contractual obligation (e.g., performance, payment, bid). Risk Bearer: The bank bears the risk of the applicant’s default, but is indemnified by the applicant.
  • Documentation: Usually requires presentation of a demand and a statement of breach of contract.
  • Governing Rules: Often governed by the international Uniform Rules for Demand Guarantees (URDG 758 or latest) or local law.

In summary, the bank guarantee is an indispensable tool in modern commerce, transforming commercial risk into bank risk and allowing businesses to operate with greater security and confidence. Understanding its mechanics is the first step for any business looking to expand its contractual capabilities.

Note: This article is for informational purposes only and does not constitute financial or legal advice.

Strategia Finance Consultancy facilitates all types of bank instruments including guarantees (BG), Standby Letter of Credit (SBLC), Letter of Credit (LC), etc. from United Arab Emirates based top banks like HSBC at affordable rates and minimal procedures and documentation with no advance fee.

Documents required

  • Applicant’s company trade license
  • Passport copy of the authorized signatory
  • Purpose for issuing the instrument like Sales Purchase Agreement, Project Assignment Letter, Construction Agreement, Court Order, etc.