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Bank Guarantee/LG: a fee based credit facility to bank customers

Bank Guarantee is a fee based credit facility which is also known as non-fund based credit facility extended by the banks to their customers. The non-fund based facilities means issuance of letter of guarantee or letter of credit by the banks wherein banks get fee income and also there is no immediate outflow of funds from the banks. However in case of non-fund based credit facility, the bank has to discharge the financial liability of the contract agreed in the guarantee or documentary credit, if the contract is partly or fully not performed by the customer.
There are different types of guarantees issued by banks on behalf of their customers. Bank Guarantees (BG) is also known as Letter of Guarantees (LG) which can be broadly classified as (i) Financial Guarantees and (ii) Performance guarantees. Earnest money Deposit guarantee or Bid Bond Guarantee, Guarantee for Payment of Custom duty (specific or continuing), Advance Payment Guarantee (APG),Deferred Payment Guarantee (DPG),Shipping Guarantee, Performance guarantee, Retention Money guarantees etc are some of the prominent types of guarantees issued by the banks.
The full picture of bank guarantees
Sec 126 of Contract Act 1872 defines a contract of guarantee as “A contract of guarantee is a contract to perform the promise or discharge liability of third person in case of his default.” A bank issues a guarantee on behalf of its customer means the bank undertakes to pay the guaranteed amount to the person in whose favour guarantee is issued. The person in whose favour guarantee is issued is called beneficiary of the guarantee. The party on whose behalf guarantee is issued is called applicant. Though there is no immediate commitment of funds while issuing the guarantee, it becomes a commitment of funds when guarantee is invoked by the beneficiary. Therefore all the risks associated with fund-based facilities are also applicable to non-fund based facilities. Hence while considering a proposal for issuance of guarantee, banks analyse financial position of their customers and their capacity to discharge business obligation. Banks charge commission for the service rendered by them which may vary depending upon margin/securities offered by the applicant. Bank guarantees can be broadly classified as (i) Financial Guarantee and (ii) Performance guarantees.
Financial Guarantee (issued in lieu of money)
Financial guarantees are issued by the banks whenever a contract is awarded to their customer, who is generally a contractor of civil work or a supplier of goods, machinery, equipment by a Government Department or a large industrial undertakings, the customer is under obligation to deposit cash security or earnest money as a token of due compliance of the terms and conditions of the contract. This cash security provided by the contractor or supplier is forfeited by the Government Department or the company which awarded the contract, in the event the contractor or supplier fails to comply with the terms stipulated in sanction. The customer normally will have an option to furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The guarantees issued by banks for above purpose is called financial guarantee wherein the banks undertake to pay the guaranteed amount during a specified period on demand from the beneficiary. The examples of Financial Guarantee are as under.
1. Guarantee for Earnest money Deposit (Local Tender)/Bid Bond Guarantee (international tender):
[ A bid bond guarantee is a guarantee issued by the bank to the effect that bidder would not withdraw the bid before the expiry of bid/tender period or in case the contract is awarded to bidder that he would comply with the terms of the tender and enter into contract.].
2. Guarantee for Payment of Custom duty (specific or continuing): a customer may require a guarantee favouring custom department for payment of custom duty covering import of raw materials. It means that the guarantee covers custom duty in arrears to the Custom Department by the customer up to a limit (stating maximum of amount) of guarantee undertaken by the bank.
3. Advance Payment Guarantee (APG): Although Advance Payment guarantee is associated with financial guarantee it has inherent risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he receives advance payment. Since supplier receives an advance from the purchaser for supply of raw material or finished goods on a future date, it is a substitution of working capital funds. In case of execution of contract, if any one of the terms of contract is not fulfilled, the guarantee is likely to be invoked. While accepting request from customer for APG limit the banker should thoroughly analyse all risk factors.
4.Deferred Payment Guarantee (DPG): In the cases of purchase of capital goods/machineries where the seller offers credit to the buyer and buyer’s bank guarantees the due payments to the seller. Here the seller draws drafts of different maturities on the buyer which are accepted by the buyer and co-accepted by the Buyer’s bank. Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the total consideration of contract of sale/supply. The seller avail refinance from his bank against co-accepted bills. DPG involves substitution of term loan. Hence procedure applicable for assessment of term loan must be followed for DPG limit viz. projection under operating statement, Funds flow statement, DSCR, BEP etc.
5. Shipping Guarantee: Shipping guarantee is issued to the shipping company to release the goods by the shipping companies on the basis of bank guarantee. Shipping guarantee is issued due to arrival of consignment (Ship carrying the goods already arrived) but non-receipt of relative documents of title to goods.
6.Performance Guarantee (Issued for specific performance): Performance guarantees is issued by the banks on behalf of a Service Contractor, who has to effectually perform all the conditions of the contract between him and the department/company that awarded the contract. The bank has to discharge the financial liability of the contract agreed in the guarantee, if the contract is partly or fully not performed by the customer. Such type of guarantees issued by the bank is called Performance Guarantee. Many a time the terms of contract may be of highly technical in nature and bank is generally not expected to know the technical aspects of the contract. Therefore the bank assumes only the financial liability of the contract. Since issuance of performance guarantee is more complicated and risky, before issuing performance guarantees, bank has to ensure that the customer has sufficient experience in the line of business and he has capacity and means to carry out the obligation under the contract.
7.Retention Money guarantees: Retention money is a part of the amount payable to the contractor, is retained and payable at the end after successful completion of the contract. Retention Money guarantee is issued to ensure that retention money withheld by the beneficiary is released to the applicant (contractor) so that he gets sufficient working capital to complete the contract.
Invocation of Guarantee: The bank is obliged to honour any legitimate claim within the validity period of guarantee. If invocation is in order and there is no court order prohibiting the payment, bank is required to honour payment to the beneficiary. The applicant should be advised of the invocation and ask him to arrange for funds for payment of claim amount.
Cancellation of Guarantee: When an original Guarantee issued by the bank not returned to the bank for cancellation after expiry of guarantee, a registered notice to be sent to the beneficiary to return the original guarantee immediately. If no reply is received or original guarantee is not surrendered for cancellation, guarantee can be cancelled by the issuing branch of the bank after waiting for a reasonable time.
Limitation: As per the revision to sec.28 of contract act, with effect from 08.01.1997 guarantees can be invoked by the beneficiary within the following limitation period. (i) Government Department: 30 years from the date of expiry of Guarantee (ii) Non-Government Department: 3 years from the date of expiry of Guarantee.
IBA format of limitation clause: All commercial banks apply following limitation clause standardized by IBA as a concluding Para of the guarantee. This is to avoid ambiguity if any in the body of the guarantee agreement in respect of banks liability under the guarantee and its validity period. “Not withstanding anything contained herein: (i) Our liability under this guarantee shall not exceed Rs…….(Rupees) (ii) This bank guarantee shall be valid up to……. (iii) We are liable to pay the guarantee amount or any part thereof under the bank guarantee only and only if you serve upon us a written claim or demand on or before…..(date of expiry of the guarantee)”.
RBI norms: Guarantees are to be issued for existing customers only. Commercial banks to limit themselves to the issuance of financial guarantees and exercise due caution with regard to issuance of performance guarantee.

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