By definition, it’s a third-party guarantee on behalf of its client to another party for payment of a contract.
Banks and large financial institutes issue letters of guarantee on behalf of their business clients to their suppliers to ensure the contract payment will be made if their customer fails to make the obligation. In other words, the banks take the default risk of their customer if they refuse or cannot make the due payment.
In large business deals, the contract terms do include payment assurances, but often conflicts arise during or after post-completion stages. Especially in the case of a foreign supplier, they wouldn’t want to take the risk of completing an expensive contract with heavy risk.
This lack of uncertainty can hamper the business deal and result in a costly deal due to greater risks. Even with local suppliers, if they are unsure about the client’s creditworthiness, they’ll normally charge higher prices.
To remove this uncertainty, the banks play the role of a facilitator between the two parties. Business clients maintain their corporate accounts with banks, which puts banks in an appropriate position to assess their liquid creditworthiness.
Uses of Letter of Guarantee:
Apart from a local or foreign business deal, businesses may need these letters of guarantee for several purposes:
- Smooth contract completion with suppliers, guaranteeing the amount and timely payment
- It also safeguards the buyer; if the supplier does not supply the scope of work in the contract, the buyer can hold their payment.
- It holds a binding contract for both parties in the contract.
- It can also serve as collateral for the same or other banks for a business loan facility.
- Used in applying for a contract or tender bidding when the issuing authorities require more than only bank statements
- It serves as a more secure mode of payment than ordinary cheques and demands draft instruments from banks.
Banks charge a certain amount against issuing the letter of guarantee. They now own the risk of default in case their client cannot make the due payment. Banks also do not need collateral to issue these letters of guarantee.
Banks make the covenants for their clients on specific terms and withhold their funds until the letter’s release.
Like a bank loan, the banks may not opt to cover the full amount of the contract with the letter. The banks do also keep a cushion of default risk and cover their charges in case of default.
Types of Letter of Guarantee:
As there are different uses of the letter of guarantee, it may take different types depending on both parties’ needs. Some commonly used types of letters of guarantees are:
- Financial or payment guarantee: The most commonly used type of guarantee assures the supplier against buyer default risk.
- Performance of execution guarantee: this guarantee covers the risk on the buyer side in case the supplier doesn’t perform the contract terms.
- Advance Payment guarantee: this type will also cover the buyer if the supplier receives the advance payment for the contract and doesn’t execute the contract for any reason.
- Bidding or tender guarantee: this type of guarantee will assure the Government or other institutions offering bid and tendering for contracts. If the bidder wins the contract and cannot fulfill the job, the letter of guarantee can be executed.
Advantages of Letter of Guarantee:
As the instrument work as risk protection in documented form, it serves numerous advantages to all parties.
- Bank customers can avail of the letter of guarantee facility without collateral, unlike the loan facility.
- It serves as a risk protection document for both buyer and the seller
- It helps the buyers build their business relationships and reputation over both local and international markets
- The letters are issued normally with import/export contracts, so it also covers the customs authorities for their taxes and duties
- Sellers are usually the more concerned party with the advance shipment of the scope of work; it serves as a financial risk hedge for sellers.
- Banks charge against the facility and can cover the risk up to the full amount of the contract.
- It requires less documentation and collateral than a bank facility from the banks.
A letter of guarantee works as a risk-hedging instrument for contract parties, usually in international trades. It can also help business relations for both parties seeking international expansion and reputation.
A letter of guarantee offers more certainty and assurance to both parties than ordinary bank instruments like wire transfers, cheques, or demand drafts. A bank guarantee is also perceived as a more secure instrument than a letter of credit.