In this era of globalization, large scale transactions are undertaken involving huge amounts of money through the different types of bank accounts. There is always a risk that a party might default and the other party would have to suffer huge losses. So a need was felt for an institution that could act as a reliable source to reduce the risk in such colossal transactions. The concept of “Bank Guarantee” is used for this security purpose. It is considered as the “lifeblood” for the purpose of both domestic as well as international trade. there are different types of Bank guarantees in India that can be used according to the need to reduce the risk.
In this article, we will explore the meaning and example of bank guarantees along with various types of Bank Guarantees in India.
What is a Bank Guarantee?
A bank guarantee is a contract in which the bank, as a financial institution, promises or guarantees to repay or compensate an amount to a lender on behalf of a borrower. In simpler words, the bank will fulfil the obligation of a lender, if the borrower fails to do so. The Bank guarantee is also a contract that is created between Bank and person or company with their free consent.
A bank guarantee is similar to the contract of Guarantee provided under Section 126 of the Indian Contract Act, 1872. The person who promises to perform or discharge the liability of the third person is called the “Surety”. The person for whom the guarantee is given is called the “Principal debtor” and the person to whom the guarantee is given is called the “Creditor.
A bank guarantee involves a tripartite agreement between the debtor, creditor and the surety in which the bank promises the surety to repay the amount of the debtor defaults. Bankers are generally approached for issuing the guarantee because they have the financial capacity to pay such an obligation.
It is important to note that the bank guarantee is a separate and distinct contract that takes place between the bank and the creditor. It has nothing to do with the original contract between the debtor and the creditor. The bank guarantee can be invoked at any time during the subsistence of the contract. The creditor needs to demonstrate that the borrower has defaulted on his obligation. The bank, on its part, will ensure that all the terms of the guarantee are fulfilled or not.
The invocation of a guarantee also depends upon the terms of the contract, for example, In an unconditional guarantee, the beneficiary has to realize the bank guarantee irrespective of the fact that the dispute is pending.
Example of Bank Guarantee
Mr A gives a contract to B (contractor) for making a 5-star restaurant at a specified place in Delhi. The total cost of the project was 50 crore. Mr A asks the contractor (B) to furnish a bank guarantee, in case, he defaults on the completion of the project. The State Bank of India (SBI) gives the guarantee for the same.
Now, A is the creditor, B is the debtor and SBI is the Surety. In case of any default on the part of B, SBI would be directly liable to compensate A.
Types of Bank Guarantees
According to specific purposes, BGs are categorized into various types of bank guarantees in India. Here is the list of types of bank guarantees in India:
- Direct Bank Guarantee
- Indirect Bank Guarantee
- Conditional and Unconditional Bank Guarantee
- Advance Payment Guarantee
- The Payment Guarantee
- Financial Guarantee
- Performance Guarantee
- Loan Guarantee
- Bid Bond Guarantee
- Foreign Bank Guarantee
- Deferred Payment Guarantee (DPG
Now, let us discuss all types of bank guarantees in detail-
Direct Bank Guarantee
It refers to that type of bank guarantee in which a bank is asked to provide a direct guarantee in favour of the beneficiary. This guarantee doesn’t rely on the existence, validity and enforceability of the main obligation.
Indirect Bank Guarantee
An Indirect Bank guarantee comes into play when a second bank issues a bank guarantee in return for an already issued guarantee. In this scenario, if the second bank suffers losses, the issuing bank will compensate for the same.
Conditional and Unconditional Bank Guarantee
A Conditional Bank Guarantee refers to that type of guarantee in India that can be invoked only on the fulfilment of certain conditions. The language of the guarantee plays a crucial role in determining the scope of the guarantee.
The unconditional bank guarantee is one which surely would be straight away liable for any loss incurred by the creditor due to the default of the debtor. In this type of guarantee, the words like “unconditionally and irrevocably” are used.
Advance Payment Guarantee
This type of guarantee generally comes into play in international business transactions (like exports and imports), but recently it is also extended to domestic trade. This guarantee is issued by the bank against the advance money paid for the goods purchased.
For Example – A person named “X” orders machinery for his factory from “Y” the seller. Y wants some advance before the delivery of goods and X duly paid the amount. Later on, Y didn’t send the machinery to X. Now, X can invoke the bank guarantee asking the bank to refund the advance money along with the interest. The liability to pay the amount is unconditional.
The Payment Guarantee
It is a kind of bank guarantee or promise given by the debtor or buyer that makes him bound for the payment of the goods that were purchased on credit. The extra benefit of a “payment guarantee” is that it ensures an “extra security”, as the guarantee is supported with some collateral securities such as shop, land, etc.
The bank generally prefers this type of bank guarantee because, after the payment of money due to the creditor, the bank restores the money due to the debtor through the collateral securities offered by him. This is an extra non-conditional guarantee which enhances the security of the transaction.
It refers to a contractual promise made by a bank or any other similar entity to guarantee payment of a debt obligation of a third party – such as a company. It is a sort of warranty attached to a debt. Individuals can also provide a financial guarantee, for example, when a parent becomes a co-borrower in an educational loan for his child.
The person who gives the financial guarantee is referred to as the guarantor of the debt obligation. Its main purpose is to mitigate the risk of the lender. A common example of this guarantee can be seen when an insurance company provides such a guarantee for bonds issued by a company for financing. The insurance company ensures that the subscriber to the bond will get their principal investment along with the interest if the company defaults on repayment.
There are different kinds of Financial Guarantees which include-
- Individual financial guarantee
- Bond guarantees
- Financial guarantees from companies
- Bank financial guarantees
It refers to that guarantee in which a contractor promises to complete the project undertaken. In simple words, it is a document that is issued by a bank or insurance company providing that the contractor will perform the job as specified in the contract. In case of the contractor defaults, the bank will compensate the full amount on behalf of the contractor.
For example – In a construction contract, it was stated that the kitchen should be made as per a specified model, but the contractor doesn’t adhere to the design. In this case, the client can invoke the bank guarantee to claim the monetary losses on account of this.
This is the widely used bank guarantee, as it provides a cushion that the work will be completed as per the given structure within the due time. It is also important to note that this type of bank guarantee in India involves a comparatively higher degree of risks for the bank; they charged a high rate of commission while providing this facility.
The Loan Guarantee refers to a promise made by one party (the guarantor) to discharge the debt obligations of a borrower in case the borrower defaults. It can be limited or unlimited, which makes the surety liable to discharge the whole or a specified portion of a debt.
This type of bank guarantee is used in cases wherein the borrower is an unattractive candidate for a regular bank loan. The Loan guarantee enables the candidate to get a loan with the help of a person, whose financial credibility is sound in the eyes of a bank. With the guarantor coming into the picture, the risk of lending is also reduced for the bank.
This loan guarantee is also used widely by the government to encourage small businesses. The government plays the role of a surety if the borrower defaults. This helps vulnerable small businesses to get loans from the bank. Further, the government also acts as a surety for those large companies on which the entire economy depends.
Bid Bond Guarantee
A bid bond is a kind of construction bond that safeguards a developer or an owner in a construction bidding process. A bid bond provides a guarantee to a project owner that a bidder will complete the allocated work if chosen. In the absence of bid bonds, project owners will not be able to provide a guarantee that a bidder they chose for a project would be able to finish the job correctly.
What Is a Bid Bond?
It is a type of bond which guarantees compensation to the bond owner in case the bidder fails to start a project or is unable to complete it within the due time. The bid bond is mainly used in construction jobs or other projects in which tenders are floated.
The bid bond gives a security to the project owner that the work will be completed as per the terms of the contract and if there is some foul play, he can get the compensation by invoking the Bid bond. Since these bonds are backed by the banks, it is also an indicator of the financial soundness of the bidder.
The bid bond amount usually varies between 5-10% of the total project amount. However, in certain complicated projects, it may be as high as 20% depending upon the various factors such as jurisdiction of the project work, contractual terms, etc.
Foreign Bank Guarantee
It refers to that guarantee which is provided by a bank located overseas. This type of bank guarantee comes into play when the parties of the contract don’t belong to the same country.
For example – ABC Pvt Ltd is situated in London, and it purchased goods on credit from an Indian company named Ram Pvt Ltd. Since the goods are sold on credit, the seller must need some protection or cover related to it. So, the buyer gives a bank guarantee issued by the Chartered Bank of England. Now, this guarantee will be termed as a Foreign Bank Guarantee.
Deferred Payment Guarantee (DPG)
It refers to a guarantee for payment of an amount that has been deferred or postponed. This guarantee is mainly used when the buyer purchases the capital goods in credit, and in return offers a bank guarantee to protect the payment due to the seller. Since the amount is quite large, the payment occurs in periodic instalments.
The seller draws a bill on different dates which is accepted by the buyer and co-accepted by the bank. The special feature of this type of bank guarantee is that the payment to the seller is made by the bank itself, and later on the bank recovers the instalment from the borrower on whose behalf the payment has been made.
The DPG involves the substitution of a term loan and is followed by some limits including, projection under the operating statement, Funds flow statement, DSCR, BEP etc. While issuing this type of bank guarantee, the bank assesses the credibility of the buyer to ensure that it could recover the instalment from the borrower in a timely manner.
Shipping guarantee works as the contract of Indemnity. It refers to a written guarantee which is issued by the bank which will have joint liability. It aims to indemnify the shipping company against all the potential losses or liabilities relating to the shipping of goods. Shipping guarantee is presented by the importer to the carrier, for picking up the goods in case the cargo arrives prior to the handling of shipping documents. This type of guarantee is mainly used under a Letter of credit with a complete set of documents.
It doesn’t have a concrete expiry date and it is valid until the bill of lading is presented to the shipping company.
A Bank guarantee is a tripartite agreement in which the Bank promises the lender or the surety to compensate all the losses on account of the default of the borrower. This contract is distinct from the original contract entered between the lender and the borrower. The bank charges some commission for providing this facility. There are various types of bank guarantees in India, namely – Financial Guarantee, Performance Guarantee, Advance Payment Guarantee, Payment Guarantee, Loan Guarantee, Bid Bond Guarantee, Foreign Bank Guarantee, Deferred Payment Guarantee and Shipping Guarantee.