What does the term 'bank guarantee' mean?

A bank guarantee is a commercial instrument in the nature of a contract, intended

between two parties, to secure compliance with the contract. It is an off-shoot of the
main contract between two parties.

A bank guarantee is a guarantee made by a bank on behalf of a customer (usually an

established corporate customer) should it fail to deliver the payment, essentially
making the bank a co-signer for one of its customer's purchases.

How do bank guarantees help in commercial contracts?

Guarantees are important instruments used to minimize the risks that are involved in
commercial contracts. For the enforcement of ordinary guarantees, as construed
dependence of the guarantee on the main contract may lead to unnecessary disputes
and litigation, arising from the main contract. These disputes may have a material
effect on the guarantee, thereby blocking funds in litigation. Hence, there was a need
for an innovative instrument which would enable the guarantee to serve its original
purpose; namely, providing a form of security.

The bank guarantee is one such innovative financial instrument whereby, if the
beneficiary perceives that there has been a breach of contract by the other party, he
can encash the guarantee and avail of the amount immediately, without having to
undergo the hassles of litigation. Thus, the relevance of a bank guarantee achieves
relevance.

How can a beneficiary restrain the invocation of a bank guarantee?

The invocation of a bank guarantee by the beneficiary can be restrained by an

injunction under the Civil Procedure Code, 1908, or the Specific Relief Act, 1963.
However, the normal considerations, which apply in granting an injunction, will not
apply in cases of a bank guarantee.

Courts are usually reluctant to grant an injunction against a bank guarantee. If a

bank guarantee has to be restrained, it has to satisfy the following conditions:

Fraud;
Irretrievable injustice or injury

Can the invocation of a bank guarantee be prevented by initiating

arbitration proceedings?

If the bank guarantee is unconditional, arbitration proceedings would in no way

affect the enforcement of the guarantee. This is because an unconditional bank
guarantee is independent of the main contract which refers disputes to arbitration.
However, if the bank guarantee includes a clause to the effect that it could not be
invoked prior to the decision of the arbitrators, such a bank guarantee, which is
conditional, cannot be invoked and an injunction can be granted.

What is the difference between a bank guarantee and a usual guarantee?

Following are some points of difference between a bank guarantee and a

usual guarantee:

1. A usual guarantee is governed by Sec. 126 of the Indian Contract Act, 1872. A
bank guarantee is not directly governed by Sec. 126.

2. An ordinary guarantee is a tri-partite (3 parties) agreement involving the

surety, the debtor and the creditor. But a bank guarantee is a contract involving two
parties i.e. the bank and the beneficiary.

3. In an ordinary guarantee, the contract between the surety and the creditor
arises as a subsidiary to the contract between the creditor and the principal debtor.
The bank guarantee is independent of the main contract.

4. In an ordinary guarantee, the inter se disputes between the debtor and the
creditor have a material effect upon the surety's liability. However, the bank
guarantee is independent of the disputes, arising ex contract (arising out of the
contract).

5. An ordinary guarantee does not have any time limit before which the debt has
to be claimed. Bank guarantees generally have a specific time within which they are
functional.

It helps to have a third party’s vetting for your business.

When running a business, you might come across a situation that your client may
ask you to provide a financial guarantee from a third party.

In such circumstances, approach your bank and ask it to stand as a guarantor on

your behalf. This concept is known as bank guarantee (BG).

This is usually seen when a small company is dealing with much larger entity or even
a government across border.Let us take an example of a company XYZ bags a
project from, say, the Government of Ethiopia to build 200 power transmission
towers.

In this case, companies all over the world would have applied. The selection would
be made on the basis of lowest cost and track record as submitted in the proposal
form.
However, the government has limited ability to assess all companies for financial
stability and credit worthiness.

To ensure the project is done satisfactorily and on time, the government puts a
condition that company XYZ will have to furnish a guarantee given by one or more
banks.

In banking nomenclature, company XYZ is an applicant, its bank is the issuing bank
and the Government of Ethiopia is the beneficiary.

Usually, the BG is for a specified amount, which is a percentage of the total money
required for the contract.

Obviously, the bank will not just issue such guarantee with its own due diligence.
The bank does its own thorough analysis of the financial well being of company XYZ
to assess the amount of guarantee it can issue. After all, the bank is at a risk too, in
case the client defaults. This amount is called a limit.

Here too there is a catch. The bank will issue guarantee provided the company has
not exceeded its overall limit for BGs. And if the Government of Ethiopia is not
satisfied with the performance of the contract at a later date, it can invoke the BG.

In this situation, the bank will have to immediately release the amount of the BG to
the government.

BGs can be broadly classified into Performance and Financial BGs. As the name
suggests, Performance BGs are the ones by which the issuing bank, also known as
the Guarantor, guarantees the ability of the applicant to perform a contract, to the
satisfaction of the beneficiary.

VARIATIONS
Let us continue with our earlier example, to understand the different types of
performance BGs. XYZ might need to give a BG that guarantees it has the capability
to do the project, on winning the bid. This ensures only serious bidders are in the
fray for the project. This is called a bid-bond guarantee. XYZ also might be getting
an advance payment for buying materials, etc. Again, it will have to furnish a BG to
the extent of the advance, called an advance payment BG. To secure the project
even further, the Government of Ethiopia might insist on stage payment guarantees.
This would have milestones like 20 per cent, 40 per cent, etc and a period in which
these have to be done. As and when XYZ does that part of the work, the BG would
expire, thus freeing its limits with the bank (banks also charge for these services,
typically as a small percentage of the BG amount, even as little as 0.05 per cent).

Another interesting use of the performance BG is in importing materials into the

country. In this case, an importer might want to contest the amount of duty levied
by the customs and until the duties are paid, the goods are not released. The
importer can, in this case, present a BG for the amount of the duty (also known as
customs guarantee) and get his goods released. Once the final decision is taken, the
import duty is paid and the BG released.
 The other broader types of BGs are financial guarantees. These are used to secure a
financial commitment such as a loan, a security deposit, etc. For example,
guarantees of margin money for stock exchanges. These are issued on behalf of
brokers, in lieu of the security deposit that needs to be paid at the time of becoming
a member of the exchange.

The applicant, XYZ, has to prove credit worthiness only to one party, his bank, and
can bid for projects across the world. The beneficiary, Government of Ethiopia, does
not have to analyse how financially sound the companies are and knows that in case
something goes wrong, the bank will pay him.

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 Guarantee/Performance Guarantee | IDBI Bank Guarantee/Performance Guarantee

Bank Guarantee is an instrument issued by the Bank in which the Bank agrees to stand guarantee
against the non-performance of some action/performance of a party. The quantum of guarantee is
called the 'guarantee amount'. The guarantee is issued upon receipt of a request from 'applicant' for
some purpose/transaction in favour of a 'Beneficiary'. The 'issuing bank' will pay the guarantee amount
to the 'beneficiary' of the guarantee upon receipt of the 'claim' from the beneficiary. This results in
'invocation' of the Guarantee. IDBI Bank issues the entire range of Bank Guarantees, namely,

Bid Bond Guarantee

Advance payment Guarantee

Guaranty for warranty obligation

Payment Guarantee/Loan Guarantee

Performance Guarantee

Deferred payment Guarantee

Shipping Guarantee

Trade Credit Guarantee

Standby LC

Bank issues Guarantee favoring beneficiaries abroad either directly or through our correspondent banks
across the continents. Similarly, IDBI Bank also issues guarantees favoring resident beneficiaries on
behalf of our overseas branches / correspondents.
Tender Guarantee (also called Bid Bond)

This is usually issued for an amount equal to between 1 and 2 percent of the contract
value. It gives the employer compensation for additional costs if the party submitting
the tender does not take up the contract and it must be awarded to another party.

Performance Guarantee

Normally issued for an amount equal to between 5 and 10 percent of the contact
value, this guarantee assures payment to the employer in the event that the
contractor fails to fulfil contract obligations.

Advance Payment Guarantee

This enables the employer to get a refund of advance payments made in the event of
default by the contractor. It is issued for the full amount of the advance payment,
but may contain reduction clauses, which enable a reduction in the maximum
amount upon evidence of progressive performance.

Retention Money Guarantee

Most major projects call for stage payments as work progresses. Often the employer
retains a percentage of the payment (retention money), as cover for any hidden
defects in the completed work. A retention money guarantee allows for immediate
release of retention money to the contractor. The employer can get a refund of
retention money released, in the event of default by the contractor.

Payment Guarantee

This is used as security for payment obligations. It is also referred to as a Standby

Letter of Credit.

Facility Guarantee

This is normally not trade related. Its purpose is to provide security to another bank
to advance money to an individual or company. It is often used when a company
does not have any credit record and wishes to expand offshore.

Maintenance Guarantee

This ensures that the contactor does not abandon the contract after completion of
the construction phase, but continues to honour any maintenance obligations as per
the original agreement.
Customs Guarantee

Contractors often need to import equipment temporarily to carry out a contract.

Import duty would normally be payable, but the customs authorities will grant
exemption if the contractor undertakes to re-export the equipment on completion of
the contract. The contractor then has to provide the customs authority with this
guarantee, which prevents the contractor from selling the goods instead of re-
exporting them.

Shipping Guarantee

This enables the buyer to obtain release of the goods from the carrier, despite the
bills of lading being lost or delayed.

Difference between Letter of credit and Bank Guarantee

What is the difference between BG and LC? How does Letter credit work and how LC
differs from Bank guarantee.

A letter of credit is written commitment document issued by a bank or other financial

institutions to assure payment to seller on the basis of documentary proof on
fulfillment of performance by seller as per terms and conditions mentioned in LC.
Under an LC, the seller gets guarantee on payment of his sale of goods from the
buyer’s bank. I request readers to go through my different articles in detail in this
website, already explained.

What is a bank guarantee and how does BG work?

A bank guarantee is a commercial instrument guaranteeing by bank to a party

(parties) on behalf of his customer, assuring the beneficiary to effect payment on
default of obligation.

How to differentiate a Letter of Credit and a Bank guarantee?

As per Letter of Credit, once the obligation on production of documents on fulfillment

of contract, the bank pays amount to beneficiary. However, in a bank guarantee, the
beneficiary is paid on non fulfillment of obligation as per contract of BG.

Do you have different opinion about the difference between Letter of Credit and Bank
Guarantee? Please share your thought on Bank Guarantee Vs Letter of Credit.
What is the difference between the BANK GUARANTEE and LETTER OF
CREDIT?

A bank guarantee and a letter of credit are similar in many ways but they're two
different things. The main difference between the two credit security instruments is
the position of the bank relative to the buyer and seller of a good, service or basket
of goods or services in the event of the buyer's default of payment. These financial
instruments are often used in trade financing when suppliers, or vendors, are
purchasing and selling goods to and from overseas customers with whom they don't
have established business relationships.

A bank guarantee is a guarantee made by a bank on behalf of a customer (usually

an established corporate customer) should it fail to deliver the payment, essentially
making the bank a co-signer for one of its customer's purchases. Should the bank
accept that its customer has sufficient funds or credit to authorize the guarantee, it
will approve it. A guarantee is a written contract stating that in the event of the
borrower being unable or unwilling to pay the debt with a merchant, the bank will act
as a guarantor and pay its client's debt to the merchant.

The initial claim is still settled primarily against the bank's client, and not the bank
itself. Should the client default, then the bank agrees in the bank guarantee to pay
for its client's debts. This is a type of contingent guarantee. A bank guarantee is
more risky for the merchant and less risky for the bank. But this is not the case with
a letter of credit.

While a letter of credit is a similar, the principal difference is that it is a

potential claim against the bank, rather than a bank's client. For example, a seller
may request that a buyer be provided with a letter of credit, which must be obtained
from a bank and which substitutes the bank's credit for that of its client. In the event
that the borrower defaults, the seller would go the buyer's bank for the payment.
The seller's risk is mitigated because it is unlikely that the bank will be unable to pay
the debt. A letter of credit is less risky for the merchant, but more risky for a bank.

Banks accept full liability in both cases. With a bank guarantee, a client can default
and the bank assumes the liability. With a line of credit, liability rests solely with the
bank, which then collects the money from its client.
 BANK GUARANTEE

INTRODUCTION:

A contract of guarantee is defined as ‘a contract to perform the liability of a third

person in case of default’. The parties to the contract of guarantee are: a.
Applicant : The principal debtor : The person at whose request the guarantee is
executed. b. Beneficiary : The person to whom the guarantee is given and who
can enforce it in case of default. c. Guarantor: The person who undertakes to
discharge the obligations of the applicant in case of his default Thus, a contract of
guarantee is a collateral contract, consequential to a main contract between the
applicant and the beneficiary.

PURPOSE OF BANK GUARANTEE (BG):

BGs may generally be issued for the following purposes: a. In lieu of Security
Deposits / Earnest Money Deposits for participating in tenders. b. Mobilisation
advance or advance money before commencement of the project by the
contractor and for money to be received in various stages like plant layout,
design / drawings in project finance. c. In respect of raw material supplies or for
advances by the buyers. d. In respect of due performance of specific contracts by
the borrowers and for obtaining full payment of the bills.

e.Performance guarantee for warranty period on completion of contract which

would enable the supplier to realise the proceeds without waiting for the warranty
period to be over.f. To allow the units to draw funds from time to time from the
concerned indentors against past execution of contracts, etc.g. Bid bonds on
behalf of exporters.h. Export performance guarantees on behalf of exporters
favouring the Customs Department under EPCG Scheme.

GUIDELINES ON CONDUCT OF BG BUSINESS:

Banks should, as a general rule, limit themselves to the provision of Financial

Guarantees and exercise due caution with regard to Performance Guarantee
business. The subtle difference between the two types of guarantees is that
under a Financial Guarantee, a bank guarantees the customer’s (applicant’s)
financial worth, creditworthiness and his capacity to take up financial risks. In a
Performance Guarantee, the bank’s guarantee obligations relate to the
performance related obligations of the applicant (customer).

While issuing Financial Guarantees, Banks should satisfy themselves that

customers would be in a position to reimburse the Bank in case the Bank is
required to make the payment under the guarantee. In case of Performance
Guarantee, Banks should exercise due caution and have sufficient experience
with the customer to satisfy themselves that the customer has the necessary
experience, capacity, expertise and means to perform the obligations under the
contract and no default is likely to occur.
Banks should not normally issue guarantees valid for more than 18 months. For
BGs of more than 18 months, prior approval is required. No Bank Guarantee
should normally have a maturity of more than 10 years. BG beyond maturity of
10 years may be considered against 100% cash margin with prior approval.

Banks should normally refrain from issuing guarantees on behalf of customers

who enjoy other credit facilities not with them but with other banks. Unsecured
guarantees, where furnished by exception, should individually be for a short
period and for relatively small amounts. All DPGs should ordinarily be secured.

APPRAISAL OF BG LIMIT:

Banks should appraise the proposals for guarantees with the same diligence as in
the case of Fund Based Limits. They may also obtain adequate cover by way of
margin and security so as to prevent default on payments when guarantees are
invoked. Whenever an application for the issue of BG (or sanction of a regular BG
Limit as part of WC Limits) is received, Banks should examine and satisfy
themselves thoroughly about the following aspects:

a. The need for the BG and whether it is related to the applicant’s normal trade /
business.b. Whether the requirement is one-time or on a regular basis.c. The
nature of BG, i.e., Financial or Performance.d. Applicant’s financial strength /
capacity (through an analysis of his financial statements, Cash & Funds Flow
position and opinion reports) to meet the liability / obligation under the BG in
case of invocation.e. Past record of the applicant in respect of BGs issued earlier,
e.g., instances of invocation of BGs, the reasons thereof, the customers’ response
to the invocation, etc.f. Present outstanding on account of BGs already issued.g.
Margin h. Collateral security offered.

ASSESSMENT OF BG LIMIT:

Following are some of the factors to be kept in view by the Banks while
determining the margins required: a. Cash margins provide a cushion against
invocation. Margin money may be in the form of Fixed Deposit. b. The margin to
be stipulated would depend on the borrower’s means, resources,
creditworthiness, security available, past experience with regard to issue of BGs,
nature of guarantee and the nature of underlying transactions. If existing
borrower, margin on BG may generally be the same as on Stocks, Receivables,
etc.

In case of Advance Payment Guarantees, lower margins may initially be

stipulated. Once the advance is actually received, depending on the amount not
likely to be immediately utilised, higher margins may be built up by impounding
of cash advances.d. In respect of non-borrower applicants, Bank’s approach
should normally be to obtain full margins. However, a credit risk can be taken on
the applicants based on the financial indicators, credit worthiness, security
available, etc.e. 100% margin should ordinarily be retained in respect of
guarantees issued in connection with disputed Customs / Central Excise duties,
unless otherwise specified in the sanction.
SECURITY:

Apart from the margin, BGs are usually secured by an extension of the charge on
Current Assets obtained to cover WC facilities. Adequate collateral security by
way of Equitable Mortgage or third party guarantee should be taken depending
on the merits of each case.

DOCUMENTS:

Whenever a guarantee is issued and / or guarantee bond is countersigned by the

Bank on behalf of a constituent, suitable Counter Guarantee should be obtained
from the constituent.

FORMAT OF BANK GUARANTEES:

BGs should normally be issued on the format standardised by Indian Banks

Association (IBA). When it is required to be issued on a format different from the
IBA format, as may be demanded by some of the beneficiary Government
Departments, it should be ensured that the BG is: a. For a definite period. b. For
a definite objective enforceable on the happening of a definite event. c. For a
specific amount. d. In respect of bona fide trade / commercial transactions.

f. Not stipulating any onerous clause. g. Not containing any clause for automatic
renewal of the BG on its expiry. BGs should be issued with a pre-printed and
numbered standard first page of the guarantee form, which contains the
limitation clause. The pre-printed form is to be used for all BGs.However, in case
of a guarantee favouring a Govt. Dept. objects to the use of the pre-printed form,
Banks may issue the guarantee on non- judicial stamp paper.

The text of the guarantee will appear on the pages succeeding the printed first
page. It should be ensured that while filling up the first page of the BG, no
separate claim period is provided.The validity period of the guarantee will be
stated inclusive of the claim period. Further, each page of the text of the
guarantee enclosed with the pre-printed form should also mention pre-printed
serial number, BG number, date of issue and amount, etc.

In all the guarantees issued by the Bank, the limitation clause suggested by IBA
should invariably be incorporated at the end of the text as concluding paragraph
of the BG “Notwithstanding anything contained herein: a. Our liability under this
BG shall not exceed Rs. ……… (Rupees ………………………… only); b. This BG shall be
valid up to…………..; and c. We are liable to pay the guaranteed amount or any
part thereof under this BG only and if only if you serve upon us a written claim or
demand on or before ……………. (date of expiry of guarantee).”
In case of BGs issued favouring Govt. Depts.,the above clause should be
incorporated in the Model Bank Guarantee (MBG) form, prescribed for BGs in
favour of Govt. Depts. If period of claim is required to be stated separately, it has
to be kept at the minimum. It should generally not exceed 3 months.The BG may
be issued on a stamp paper on which the name of the customer appears as the
purchaser thereof.

AMENDMENT OF BANK GUARANTEE:

There is no provision for amendment of Bank guarantees unlike in the case of

Letters of Credit. Instead, fresh Guarantees need to be issued, cancelling the
earlier ones.

INVOCATION OF BANK GUARANTEE:

The beneficiary of the BG can invoke in writing, the guarantee any time before
the expiry of the guarantee period. Invocation can be done by Telex / Telegram /
Hand Delivery also followed by Mail Confirmation. Banks should ensure that all
valid claims received by them under BGs issued by them are settled promptly. In
the case of any dispute, such honouring, on invocation, will be done under
protest and the matters of dispute should be pursued separately.

The Bank’s liability under BG is absolute and independent and exclusive of any
other contract entered into by the applicant and beneficiary. It is, therefore,
obligatory on the part of the Bank to pay to the beneficiary without delay and
demur the amount of BG on its invocation in accordance with the terms and
conditions of the guarantee deeds. It is not necessary for the beneficiary to
satisfy the Bank about the default or the amount of actual loss suffered by him.

Delay in honouring the claim immediately may unnecessarily put the Bank in
problems pertaining to claim of interest, damages and at times injunction orders
from Court.

Only when the Bank has received an order of restraint / injunction from a
competent / appropriate Court, the Bank can withhold payment under the BG.
The liability of the Bank under the BG will continue till the Court case is decided.