Bank Guarantee

A bank guarantee is a written undertaking issued by a bank, at the request of a customer, to pay a named beneficiary up to a stated sum if the customer fails to meet a specified obligation. It substitutes the bank's credit standing for that of its customer, so that the beneficiary can enter a contract with a party it may not know or trust. Guarantees are used in construction, international trade, public procurement, leasing and many other commercial settings. In Islamic finance the comparable guarantee contract is kafalah.

The term covers two legally different instruments. The first is the demand guarantee, which is payable on presentation of a demand that meets its terms, independently of any dispute under the underlying contract. The second is the accessory guarantee or suretyship, under which the bank is liable only if, and to the extent that, the customer is actually in default. International practice is dominated by demand guarantees; this entry uses "bank guarantee" mainly in that sense.

At least three parties are involved. The applicant, also called the principal, is the bank's customer whose obligation is supported. The beneficiary is the party in whose favour the guarantee is issued. The guarantor is the issuing bank. See also guarantee and guarantor.

Where the beneficiary wants a guarantee from a bank in its own country, an indirect structure is used. The applicant's bank issues a counter-guarantee to a local bank, which then issues the guarantee to the beneficiary and can claim under the counter-guarantee if it has to pay.

Guarantees are usually named after the obligation they support:

• Tender guarantee. Also called a bid bond, it protects a buyer if a bidder withdraws or refuses to sign the contract after winning.
• Performance guarantee. This secures proper performance of the contract and is commonly set at 5% to 10% of the contract value. It is the banking counterpart of a performance bond.
• Advance payment guarantee. The advance payment guarantee secures repayment of money paid up front if the supplier fails to deliver.
• Retention guarantee. The retention money guarantee allows a contractor to receive the full contract price in place of a sum the buyer would otherwise hold back until the warranty period ends.
• Payment guarantee. This secures a buyer's obligation to pay for goods or services.
• Other forms. Examples are customs guarantees, rental guarantees and the shipping guarantee given to a carrier to release goods without the original bill of lading.

Demand guarantees are often made subject to the Uniform Rules for Demand Guarantees published by the International Chamber of Commerce. The current revision, URDG 758, came into force on 1 July 2010. The rules apply only if the guarantee says so. They confirm that the guarantee is independent of the underlying contract, that the guarantor deals with documents alone, and that a demand must be accompanied by a statement indicating in what respect the applicant is in breach. The guarantor has five business days to examine a demand.

In the United States, banks have traditionally issued the standby letter of credit (SBLC) instead, which serves the same purpose and is usually subject to the International Standby Practices (ISP98) or to the rules for documentary credits. A commercial letter of credit differs in that it is the intended means of payment for goods, whereas a guarantee is expected to be called only if something goes wrong. Guarantees issued without reference to any rules are governed by the national law chosen in the text or determined by conflict-of-law rules.

The beneficiary presents a written demand, with any documents the guarantee requires, to the guarantor before expiry. The bank checks the presentation on its face against the terms of the guarantee. If it complies, the bank pays and then recovers the amount from the applicant under a counter-indemnity signed when the guarantee was issued.

Because the bank does not examine the underlying dispute, the applicant bears the risk of an unjustified call. Courts will stop payment only in narrow circumstances, chiefly clear evidence of fraud known to the bank. Beneficiaries sometimes send an "extend or pay" demand, asking for the expiry date to be moved and for payment if it is not.

The bank charges a commission, usually a percentage of the amount for each quarter or year the guarantee is outstanding. It treats the guarantee as a credit exposure to the applicant, records it off the balance sheet as a contingent liability, and holds capital against it after applying a credit conversion factor (CCF). It may require cash cover or other security.

Expiry needs particular care. Some guarantees have no fixed end date, and in certain jurisdictions local law allows claims after the stated expiry or requires the original document to be returned before the bank is released.

A surety bond issued by an insurance company supports the same kinds of obligation but is normally accessory, giving the surety the defences available to the contractor. A parent company guarantee relies on the group's own credit. A sovereign guarantee is given by a state. Bank guarantees are a core product of trade finance, and banks often set a single facility under which a customer can request guarantees, standby credits and documentary credits as needed.

• International Chamber of Commerce