Letter of Guarantee

About Guarantees

Standby letters of credit are remarkably versatile instruments for a bank to represent to a third party that they are willing to make payments on their customer’s behalf, if and when called for. Most often, these payments are to be made when the customer has failed or refused to do so themselves. The value of the bank’s commitment lies in the fact the bank is obligated to pay, even in the event of a dispute, as long as the documents specified in the L/C are presented as required.

Federal regulations prohibit most banks in the U.S. from issuing guarantees. To fill this void, American banks developed the standby letter of credit as a means of financial support for a variety of trade and investment needs. Originally, these same regulations even required that all letters of credit be "conspicuously titled" as letters of credit. Banks in other countries have long issued letters of credit that they have designated to be "demand guarantees" or "independent guarantees." These are not to be confused with "ancillary" or "contract" guarantees, which are not letters of credit. As U.S. banks are now, as of 1996, free to use any desired designation, the important thing to keep in mind is not what the arrangement is called, but how it works. Any letter of credit should state that it is subject to the Uniform Customs and Practice for Documentary Credits to ensure that it will work as expected.

Regardless of what it’s called, a letter of credit represents the issuing bank’s undertaking to pay the named beneficiary a sum of money upon presentation of specified documents conforming to the terms and conditions of the credit. As with a commercial L/C, the intent of a standby letter of credit is to substitute the creditworthiness of the bank for that of its customer, the applicant. The commercial letter of credit facilitates a commercial transaction through the use of shipping documents and negotiable drafts. A standby letter of credit, however, often takes the form of an obligation by the issuer to the beneficiary (1) to repay money borrowed by or advanced to or for the applicant, (2) to make payment of an indebtedness of the applicant, or (3) to make payment because of a claimed default by the applicant in the performance of an obligation. As such, it may require documents are simple as a statement signed by the beneficiary attesting to the existence of one of these types of situations.

Note that although the beneficiary of a standby credit may be required by the L/C to present a written statement claiming that some sort of default has occurred, in no case does the issuing bank agree to guarantee the completion of any project or contract nor is it bound to make determinations of fact regarding the underlying transaction (as is generally the case with a "contract" or "ancillary"

guarantee). The bank’s responsibilities and liabilities are financial only. If the beneficiary presents documents that comply with the letter of credit requirements, the bank must pay regardless of any assertions of fraud or non-validity made by the applicant. Furthermore, the applicant is legally bound to reimburse the bank. For this reason, the applicant for a standby letter of credit must trust the beneficiary not to draw improperly under the L/C.

The applicant for a standby letter of credit should consider the risks involved in having a bank issue a standby letter of credit for its account and can take two important steps to minimize these risks. The applicant should, just as in the commercial letter of credit transaction, know the beneficiary and be comfortable with the beneficiary’s character and business reputation. Many sources can assist the applicant: trade associations, credit reporting firms, chambers of commerce, etc. Second, the applicant and the beneficiary should negotiate and document the terms of the underlying transaction. This may take the form of a written contract or be as simple as a purchase order or pro forma invoice. Once the issuing bank has made payment, the applicant’s recourse to recover the payment through legal channels is only as strong as his ability to prove that the beneficiary has violated the contract.

If the beneficiary of a standby letter of credit is in a foreign country and the letter of credit is to remedy non-performance, the applicant should be sure that his contract with the beneficiary relieves the applicant from responsibility for non-performance due to force majeure. Strikes, military coups, hurricanes, and other events beyond the control of the applicant which prevent the applicant from fulfilling the contract should not constitute non-performance of the applicant’s obligations.


Bid Bonds

Government buyers and buyers involved in sizable projects frequently request suppliers and contractors who are bidding on a sale or project to post "bid bonds" in the form of standby letters of credit, usually for a percentage of the contract amount. These are used for the bidding process only and assure the buyer that the original bid will be honored by the bidder selected. The winning bidder is commonly required to post a "performance bond" (see below) to prove his ability to honor his bid. If the performance bond is not posted in a timely manner, the amount of the bid bond will be forfeited as a penalty.

Performance Bonds

When a buyer awards a large contract for goods and/or supplies, especially commodities like oil and grain, to a particular seller, he wants assurance that the agreed price will be honored and that the seller will not otherwise default on the contract. Similarly, throughout the life of a project, the contracting party is interested in ensuring that the project will in fact be completed in accordance with the terms and conditions of the contract. In cases like these, a standby letter of credit may be required to provide financial compensation in the event of default. These are generally designed to decrease in amount over the life of the contract until completion.
Performance bonds are also used to back up international warranties that machinery or other goods will work properly for a certain period of time. If the machinery breaks down and the manufacturer fails to provide timely repairs, the buyer may arrange repairs himself and draw on the L/C for costs incurred and/or a penalty.


Advance Payment Bonds

When the manufacturer who has been awarded a sale begins work, partial payment may be required in advance for materials, start-up costs, or general working capital. The buyer often requests a bond or standby letter of credit for assurance that such advances will be used for the project. In the event of contract default, the advance can be recovered from the bank that issued the standby letter of credit. These standby L/Cs can be issued to decrease in amount progressively as shipments take place.


Credit Line Support

When a buyer and seller agree to an "open account" or "cash-in-advance" relationship, a standby letter of credit can be used as financial security. In these situations, payments are made directly between the buyer and seller, but, in the event of default (e.g., non-payment in an open account transaction or defective goods in a cash-in-advance transaction), the affected party has recourse to a commercial bank.


Evergreen Letters of Credit
Sometimes a standby letter of credit will be issued with an initial expiration date but containing a clause that states that it will be automatically extended for additional periods unless the issuing bank provides notice to the beneficiary stating otherwise. Such a clause is called an "evergreen clause." Such a credit, in effect, has no expiration date and will remain open until the beneficiary returns it for cancellation since the beneficiary will simply draw the full amount of the credit if he receives notice from the bank that it is not going to extend it. Of course, the applicant’s obligation to reimburse the issuing bank remains in effect as long as the credit is open.


Clean Letters of Credit

In some instances, the beneficiary will request a letter of credit in which the only document required is a draft drawn on the issuing bank. This is sometimes called a "clean letter of credit." The issuing bank is required to pay, and the applicant in turn is required to reimburse, once the draft is presented. Such a letter of credit is very open and the beneficiary’s ability to draw is limited only by the amount and expiration date of the letter of credit; it may be thought of as giving the beneficiary a cashier’s check and asking him not to cash it unless necessary.