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Bank Guarantee (BG)

Bank Guarantees are of two types – Performance Bank Guarantee and Financial Bank Guarantee.

In many businesses, the terms of the contract are such that if the work is not completed as per the specification or as per the time lines, there are penalties payable by the contractor. In such instances, the contractee insists on issuing performance bank guarantees in favor of contractee before the work starts.

In certain other cases, the contracts are not granted unless one pays earnest money or deposits. Sometimes, they also ask the contractor to furnish Financial Bank Guarantee, which is in replacement of Deposit or Earnest Money.

Key Benefits of Bank Guarantees are:

·         They are Cost Effective compared to other working capital finance

·         One doesn’t have to block his full cash, which he would have to, if he has to pay deposits or earnest money.

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What is Bank Guarantee?

It is primarily known as non-fund based working capital financing. Bank guarantee is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of the agreed task which may be repaying money or providing of some services etc. A buyer ‘B1’ is buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from the bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower quality goods or late delivery of goods etc. In essence, a bank guarantee is revoked by the holder only in case of non-performance by the other party. Bank charges some commission for same and may also ask for security.

A promise made by the bank for meeting the liabilities of a debtor when a person fails to fulfill his contractual obligations. There are two types of bank guarantees — Direct or indirect:

A direct guarantee is one where a bank is asked to provide a guarantee by its account holder, in favor of the beneficiary.

In an indirect guarantee, a second bank issues a guarantee in return for an already issued guarantee. When the second bank suffers losses when a claim is made against a guarantee, the issuing bank will make sure that it compensates all the losses.

Guarantees provide comfort to the beneficiary; in case the applicant fails to meet his obligations (either financially or by performance) as per the contract made between the applicant and the beneficiary, the beneficiary will have the guarantee to turn to for payment.

Having a guarantee issued in support of a client’s transaction can help the client grow and expand their business by postponing current payments for goods and/or services to a later date, provide comfort to buyers, allow clients to bid on transaction , without requiring that ITF’s clients tie up their available cash.

Following are the different bank guarantee types that are available:

A Bank Guarantee is a versatile tool which can function as a number of instruments: a bid bond, a performance bond, and advanced payment guarantee, a warranty bond, a letter of indemnity, a payment guarantee, a rental guarantee, or a confirmed payment order.

1.      A BID BOND is usually issued for bidders on construction or similar tender based projects. A bid bond is a debt secured by a bidder. In effect, it serves to secure the bidder’s investment in the project and to discourage bidding by less serious players. A bank guarantee could be presented as a partial alternative to the financial capital typically required by a project owner.

2.      A PERFORMANCE BOND or CONTRACT BOND is utilized in the real estate industry to make sure a contractor completes a designated project. A performance bond is issued by a bank, insurance company or a financial institution in favor of a beneficiary by order of an applicant, against the applicant’s failure to meet its obligations as per an underlying contract. A performance bond often covers 100% of the contract value and can replace a bid bond when the applicant has been awarded a contract. If effect, applicants use performance bonds to comfort suppliers who are concerned with the prospect that the applicant might become insolvent or otherwise unable to fulfill his contractual obligations. In case of insolvency of the applicant, the beneficiary receives compensation that should ease financial stresses or other damages caused by the contractor.

3.      An ADVANCE PAYMENT GUARANTEE, or ADVANCED PAYMENT BOND is an agreement where an issuer undertakes responsibility to return an advanced payment to the buyer, should the seller fail to meet his obligations.

4.      A WARRANTY BOND is a contract between a project/property owner, a contractor, and a surety company. The bond promises that any defects found in the original project will be repaired during the warranty period. Frequently used in the housing and construction sector, a warranty bond guarantees an investor that a contractor will resolve all covenants that relate to materials used and work done before the warranty on the materials expires.

5.      A LETTER OF INDEMNITY is an instrument guaranteeing contractual provisions will be met; otherwise financial reparations will be made. A letter of indemnity is often utilized to request replacements for lost shares from a company’s treasury.

6.      A PAYMENT GUARANTEE provides the supplier with financial security in case the applicant fails to pay for goods or services supplied. Payment guarantees mitigate credit or country risk when the supplier ships the goods on an open account basis, which is to say, before receiving payment. Payment guarantees are typically issued to cover debts in cases of non-payment arising under a transaction or over a period of time. The instrument’s wording is based on the terms outlined in the original debt agreement between the applicant and the beneficiary. The applicant will make a repayment based on these terms. Sometimes a payment guarantee can be backed with collateral, such as property or asset that is pre-approved by the lender.

7.      RENTAL GUARANTEES promise payment to a landlord in case a tenant defaults financially. Since the risk of a tenant defaulting can be extremely harmful to a property owner, rental guarantees are extremely valuable tools which give security to industrial and commercial landlords.

8.      A CONFIRMED PAYMENT ORDER is an irrevocable obligation to pay. In most cases, the confirmed payment order is conditional on successful completion of a project.

There are certain terms and conditions that the guarantee by the bank is subject to. This stipulates that it is mandatory for the ban to pay the beneficiary the fixed amount promised on the behalf of the client once the conditions are satisfied.