Introduction: Commercial Banks extend various types of credit facilities to their constituents, to enable them carry out their business activities. These facilities may be broadly divided into two categories-Funded and Non Funded facilities.
Funded facilities are those, where Banks actually part with money. For example, a Bank sanctions a Term Loan to a Paper Manufacturing Company, for purchase of machinery. The Bank would normally make payment to the supplier of this machinery, on behalf of its borrower. In turn, the supplier delivers the machinery to the Paper Manufacturer. Similarly, the Bank may grant working capital to its borrower, to meet the day to day expenses of running the business.
Non funded facilities, on the other hand, are those where the Bank does not actually part with money, but promises to do so, contingent upon the occurrence of certain events. Which means, unless the said event occurs, the Bank will not be called upon to part with money. The most common non funded facilities offered by Banks are Letters of Guarantee and Letters of Credit.
Definition of Guarantee: A Guarantee is a contract, a legally binding agreement, given by one person, on behalf of another, to carry out or perform the task of the latter, in case of his default. In the same fashion, it may also relate to the promise of discharging the liability of one person, by the other in case of the former’s default.
Types of Guarantees: There are two types of Guarantees, taken up for discussion in this article, namely, Financial and Performance Guarantees. Apart from these, there is third type of Guarantee called the Deferred Payment Guarantee, which will be discussed at a later date.
Performance Guarantee: This guarantee, as can be seen, relates to performance. In this type of guarantee, the Bank undertakes to either ensure the performance of the contract by its customer, on whose behalf it has issued the guarantee, or to make good, the loss suffered by the third party, or the beneficiary under the guarantee, on account of the non performance by the Bank customer.
As an illustration, say, M/s. A Wind Power (AWP) contracts with the State of Arizona to supply and set up 500 wind mills across the State for a consideration of USD:1 Million. American Banking Corp., (ABC) the Banker to M/s. A Wind Power, gives a guarantee, favoring the State of Arizona, on behalf of their client, that AWP would supply and set up the 500 wind mills in Arizona, as per the terms of the contract between AWP and the State of Arizona. Further, in the event of AWP failing to execute the contract, the American Banking Corp. would reimburse the State of Arizona, a sum of USD: 1 Million in lieu of their client’s failure to execute the said contract.
In the above example, ABC, have issued a Performance Guarantee, on behalf of their client AWP, favoring the State of Arizona. In this example, two scenarios may emerge. One, the AWP executes the contract as per the terms, and gets paid by the State of Arizona and everything ends peacefully. All the three parties to the Guarantee are happy. The Bank has collected its commission/fees from the client, the State of Arizona have their wind mills in place, and the Bank client have received their payment from the State.
In the second scenario, however, the Bank client, I.e. AWP, on whose behalf the Bank had issued the guarantee, may either not perform the contracted work, or may not perform it according to the terms of the contract. In that event, the State of Arizona may invoke the guarantee, and demand payment of the guaranteed amount of USD: 1 Million. And ABC would be obliged to make the payment, without demur.
Financial Guarantee: This type of guarantee relates to money, as against performance. Under this guarantee, the Bank undertakes to make good a payment, on behalf of its client, to a third party, upon default of its client, to do so.
As an illustration, say, the World Bank floats a international Bid or Tender for the supply of 500 wind mills to be set up in the African State of Mali. The value of the Bid is USD: 1 Million. According to the terms of the bid, the competing companies are expected to deposit a sum of USD: 100,000.00 with the World Bank, as Earnest Money, to be eligible to participate in the Bid. M/s. A Wind Power (AWP), a competing company, approaches its Bankers to issue a guarantee in favor of the World Bank, on its behalf, for the stated amount. The Bank agrees to comply with the request of its client, subject to certain conditions, as per Bank policies. This type of guarantee is called a Financial Guarantee.
In the above case, the Bank has issued a guarantee in lieu of a cash deposit that its client would have had to keep with the World Bank. This enables the company to participate in the bid without having to shell out the USD: 100,000.00, which might affect its liquidity adversely. This is just one example of a Financial Guarantee. If AWP wins the bid, but refuses to accept the contract, then the World Bank would invoke the guarantee, and keep the Earnest Money deposit of USD: 100,000.00. Then the ABC would be left with the alternative of recovering the money from their client.
Both types of Guarantees, discussed above, lay down the respective rights, and responsibilities of the parties to the guarantee. The amount of the guarantee is specified. The validity of the Guarantee is specific. So also the time time limit for invoking the guarantee. Grace period, if any, is also specified in the Guarantee document. Limitations, if any, are also laid down in precise terms to avoid confusion and conflict.
Conclusion: Guarantees are one of the major financing options available to Banks, to assist their clients engaged in trade and commerce. Banks do not extend this facility to all and sundry, but only to creditworthy clients. Even though, this facility is a contingent liability to the Bank, that is, it crystallizes only upon the happening of a certain event; in this case, the default of the client, a prudent Bank assumes a default on part of its client, while considering granting of this facility.