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Guarantees

CS M Pota , 15 April 2014  
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What is Guarantee

Guarantee the term that provides Calm to the person in the form of Security that the thing for which it is given will be done if not done financial compensation will be paid.

So the guarantee is a security for getting done the work for which the guarantee is given, as per the agreed terms and conditions and if not done the person in whose favor the guarantee is given will have the right to invoke the Bank guarantee for the compensation to make good loss suffered on account of the work for which the guarantee is given not done.       

Generally, there are main two types of Guarantees in the market as follows:

1. Financial Bank Guarantee

2. Performance Bank Guarantee

1. Financial Bank Guarantee: 


Like the name Financial Guarantee is directly involved with the financial transaction. In other wards we may say that the financial guarantee is given to secure financial transaction. There are three parties in the Financial Guarantee one is the person who wants to have guarantee issued by the other party let says Bank other is Bank which will issue Guarantee and third one is the person in whose favor the Bank will issue the guarantee. Financial Guarantee is a Bond which is issued by the Guarantor giving guaranty to the person in whose favors the Guarantee is given that if any of the specific conditions strictly stipulated in the bond of Guarantee will not be fulfilled  the guarantor will be responsible for making payment of the value mentioned in the Guarantee Bond.

Lets we understand the concept of the Financial Guarantee with the help of example.

Suppose, Mr. A is the owner of ABC Limited, the company borrows some loan from XYZ bank for the period of 5 years. XYZ bank puts a condition before ABC Limited that XYZ Bank will give financial assistance but the ABC Limited will have to give a Guarantee that if the company makes default in payment of Interest and or the Principal money at the due date the Guarantor will pay the money. The Company approaches its Banker CAB bank with which the Company is maintaining account and line of credits.CAB bank agrees to provide Guarantee subject to margin money of 10% of the Guarantee amount. ABC Limited agrees CAB bank issued bank guarantee in favor of XYZ bank.

So, here except and until XYZ Limited is regular in payment of interest and at the end of the tenure of the loan CAB Bank can enjoy sound sleep but, the sound sleep of CAB bank will be disturbed as soon as ABC Limited makes defaults either in payment of Interest /or the principal amount of the loan XYZ bank will invoke the Guarantee by lodging a claim for the amount due. In turn CAB bank will make payment to XYZ bank immediately and debit the amount of Guarantee to the Current account being maintained by ABC Limited.

1.1 Corporate Guarantee:

Corporate Guarantee is one type of the Financial Guarantee. When any Guarantee is given by a Corporate entity to secure the debt given to other by the financial institution, Bank etc. it will be called as the Corporate Guarantee.

For example, GVCM LLC is a subsidiary of ABC Limited. GVCM is in need of funds of about USD 20, 00,000 for 5 years for its expansion program. GVCM approaches KGMC Bank for extending the financial help. KGMC bank shows its readiness to extend the financial help to GVCM LLC with a condition that a guarantee for payment of interest and repayment of the principal amount as per the repayment schedule should be provided by the holding Company ABC Limited. ABC Limited provides the guarantee as per the requirement of KGMC bank. The Guarantee provided by ABC Limited is having nature of Financial Guarantee but provided by ABC Limited a Corporate entity that why it is called Corporate Guarantee.

1.2 Third Party Guarantee

When a Guarantee is provided by the party to secure the debt given by the one party to other in which the guarantee proving party is not in any way involved such guarantee is called third party guarantee. We may say that the Bank guarantee and the Corporate Guarantee is the Third party Guarantee.

1.3 Counter Guarantee

 Counter guarantee means guarantee issued to indemnify the interest of the Bank issuing the first guarantee in case of invocation of the first guarantee.

Sometimes it happens that when an applicant who is customer of Bank approaches its bank with a request to issue a guarantee in favor of the so and so party. The Bank due to any reason may be due to financial standing of the applicant or recent market trends of the business in which the applicant is, may advice the applicant that the bank is ready to issue guarantee but the applicant is required provide counter guarantee issued by the first class bank indemnifying the losses that may occur in case of the guarantee issued as per the request of applicant is invoked.

For example, Ajay Limited approaches its banker UTZ bank to issue a bank guarantee for Rs. 1 crore in favor of R J Industries the beneficiary of the guarantee. UTZ bank shows its readiness but advice Ajay Limited to provide counter guarantee issued by the first class bank for Rs.1.10 crore which includes  the cost and expenses which may be incurred for invoking the counter guarantee if the guarantee so issued in favor of R J Industries is invoked. Ajay Limited approaches its another banker State bank of India with a request to issue counter guarantee for Rs. 1.10 crore in favor of UTZ bank. State Bank of India issues the counter guarantee as requested by Ajay Limited and Ajay Limited thus completed the transaction.

Lets take another example there are times when an applicant wishes to issue a Bank guarantee to a beneficiary abroad, for securing a payment  obligation or a performance obligation abroad. In these cases the beneficiary would require the BG to be payable in foreign currency, usually  in USD or the local currency of the beneficiary’s country. Banks usually take help of their correspondent banks to issue such guarantees in foreign currency. In case the original guarantee gets invoked by the beneficiary, the correspondent bank invokes the counter guarantee and is reimbursed accordingly.

1.4  Back-to-back letters of credit

Back to back credit is also work as guarantee. It occurs when a buyer gives a letter of credit to a seller who then obtains a letter of credit for a supplier.

How it works

A letter of credit is a written promise given by the bank of the Customer that it will make a payment to the beneficiary of the credit if the customer does not make the payment.

For example, Zubin Limited is a jewelry wholesaler. One of its buyers, a small department store, gives a letter of credit to Zubin Limited to assure the Company that it is placing a large order to buy the jewellery and for that it can pay.

In order to fill the large order, Zubin Limited must purchase a large amount of raw materials from one of its suppliers. The supplier asks for a letter of credit from the bank of Zubin Limited. Zubin Limited takes the  letter of credit from the department store, the Company knows it will get paid, and it is able to provide the letter of credit to the supplier of the raw material.

Because the two letters of credit are linked and dependent on one another, they are back-to-back letters of credit. It is important to note that back-to-back letters of credit typically mirror each other; that is, they have the same terms and conditions In this regard, the first letter of credit becomes the collateral for the second letter of credit.

2. Performance Guarantee

Like the name Performance guarantee is involved with the Performance of the work or duty for which the guarantee is given. In other words performance guarantee is a commitment for the execution of contract of work to be done or service to be provided within the stipulated time. If the performance/commitment is not completed or fulfilled within the stipulated time the party to whom the  Performance guarantee is given will invoke the guarantee and realize the amount of the guarantee to make the loss suffered  on account of non performance of the contract or commitment.

We  understand by example. Suppose XYZ Company Limited of  Ahmadabad has been issued an Advance Authorization (Advance License) ( hereafter called as“the Licence’) from the DGFT Office with Port of Registration of the License   as ICD Ahmadabad. The licence is  issued with a condition that the input allowed to be imported without payment of the customs duty will be used only in manufacturing of the final products which will be exported within the stipulated time or extended time, if the inputs are not so utilized and or the final products made from the inputs imported as duty free under the subject licence is not exported  XYZ Company will have to pay the duty saved plus 18% interest on the duty saved amount. As per the provisions of the Customs Act 1962 XYZ  Limited is not exempt from providing of Bank  Guarantee for  registration of the Licence, it   needs to provide Bond for the value of  the customs duty that will be saved on the inputs allowed to be imported along with 3 years interest on the duty  saved backed by the Bank Guarantee of 25% of  the Bond  amount. If XYZ Limited does not export its final product manufactured from the inputs  as imported under the subject licence without  payment of Customs duty within the   stipulated   time   period or extended time period the Customs will invoke Bank Guarantee and Bond both for realizing the Customs duty allowed as exempt at the time of import of inputs.   

So here the licence  is one type of contract between the applicant of the   licence and the DGFT Office the licence issuing authority or licensing authority. Under the contract the applicant of the licence under takes             at the time  of application that if the licensing authority issue a licence  for import of the inputs as per the application without payment of  the Customs duty within the stipulated time period or extended time period, the applicant will export the final product manufactured from  the inputs as imported under the subject licence without payment of Customs duty within the stipulated time period or extended time period. This shows that the applicant of the licence needs to show and achieve the performance/ commitment on which basis the licence is issued. If applicant fails to achieve the said performance within the given time frame the government of India will suffer financial loss in two ways one the Customs duty for which exemption allowed and other way is loss of foreign exchange in the form of export proceeds.

In the above case the Bank guarantee provided for registration of the licence is a performance guarantee because it is directly involved or linked with the performance of XZY Limited if the committed performance achieved in the given time period the guarantee will not be invoked otherwise, it will be invoked as compensation against the loss of the Customs duty to the Customs.

The guarantee either financial or performance is un cancellable and renewable by the guarantee issuing authority at the request of the party on whose behalf the guarantee is provided. Not only that in some guarantee there is a clause of self renewal which means whether the guarantee issuing authority receives request from the party on whose behalf the guarantee is issued or not the guarantee issuing authority its own renew the guarantee so issued.

There may be any other kind of guarantee like Advance Payment Guarantee, Payment Guarantee, Conditional Payment Guarantee (Conditional Payment Undertaking) Guarantee securing a Credit Line or work contract guarantee but these are type of the main guarantees which is Financial guarantee and Performance guarantee.

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