Posted by: Financial Sith Lord | December 3, 2009

A thing or two regarding Guarantees

Over the spread of 10 years, I’ve experienced and witnessed many cases where people try to raise financing using banker’s guarantees or standby letter of credits as collateral. Out of say 10 cases, only 2 comes through.. Why? There are many aspects involved in the collateralization of guarantees and standby letter of credits. Not only in the process of securing and pegging it to the facility, but also in the process of its issuance. If any of the aspects or procedural measures are not taken care of, it could be catastrophic.

Before anything, you need to understand the variability of guarantees and letter of credits, its functions and purposes. Banker’s Guarantee (or commonly called BGs) is a documentary commitment or guarantee issued by a bank, for and on behalf of its client, for a variety of purpose. Theres:-

Tender Guarantee
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.

Payment Guarantee
This is used as security for payment obligations. It is also referred to as a Standby Letter of Credit.

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.

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.

As illustrated above, there are various types of guarantees, each with its own function and purpose. It is safe to say that not all banks offer all types of guarantees mentioned above.  The function and purpose of guarantees are reflected on the format and wordings of the guarantee itself. Such guarantee would contain the following information:-

– Guarantee Number
– Issue Date
– Expiry Date
– Name of the issuing bank & address
– Applicant’s name & address
– Beneficiary & address,
– Amount
– Advising/Receiving bank & address
– Narratives (terms and conditions of guarantees)
– 2 Names of Officers from the Issuing Bank

There is no hard copy of the Guarantee. All guarantees are in soft copy format, and transmitted to the receiving/advising bank via a special telex transmission only available amongst the international banking community, named SWIFT.

SWIFT is a secured electronic telex messaging transmission service created by The Society of Worldwide Interbank Financial Telecommunication in 1973, a cooperative organization based in Brussels that is dedicated to the promotion and development of standardized global interactivity for financial transactions.

So in the case of someone trying to raise a financial facility, they would have to obtain a Facility Guarantee or a Payment Guarantee, and use it as collateral against a slightly lowered amount financial facility. These guarantees, usually backed by cash, assets or properties, are used as a fall-back option, where should the person fails to fully repay their obligations at the end of the facility’s tenure, the bank would liquidate the guarantee by making a physical claim with the guarantee’s issuing bank.

In this case, contracts and legal documentation with the Facility giving bank are tight and thorough in nature. The Facility bank would normally request a solid claim agreement with the beneficiary or asks that the beneficiary be the Facility bank itself. On the latter, the Facility bank would be more comfortable and secured, thus enabling them to grant the facility to the person easier.

As you can see, the whole procedure and process of obtaining a facility using a guarantee as collateral are rather complexed. It is not for the lamest of persons, and requires expertise that is familiar with the trade finance business. Sometimes, even a trade finance officer may not be well verse with the whole process altogether.

In my next posting, I will elaborate on how financial traders maximize their profits by applying trade finance documents to obtain leveraging for their financial facilities.


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