BANKING - Bank Guarantee (BG) & Letters of Credit (LC)

 BANK GUARANTEE

With the development of trade and commerce, the guarantor, who earlier typically was a friend or an associate, became a professional. Banks in the business of transferring funds & lending were the natural ones to take up the role.

Being a neutral party, they were considered trade worthy and would not default when called upon to pay. 

The bank could guarantee a valued customer who has accounts with them on requiring a deposit, at least for a part of the sum for a commission. 

A surety provided by the bank came to be called bank guarantee.

• As Earnest Money Deposit 
• As security against performance of the contract
• As security against initial (advance) & stage payments
• Towards liquidated damages
• Towards specified operational parameters of the equipment…. 
• Towards meeting warranty claims in respect of the equipment.
• Towards performance of maintenance during a specified period (usually one year) in respect of civil works contracts

Bank guarantees lead to invoking and payment only if there is a default by the supplier/contractor. 

Bank guarantees figure, therefore, as a contingent liability in the accounts of the bank.

Notwithstanding clause in BG (Example)

Notwithstanding anything contained herein:

• The bank’s liability under the bank guarantee shall not exceed Rs. 10,00,000 (Rupees ten lakh only)
• This bank guarantee is valid up to 30th September 2020

The bank is liable to pay the guaranteed amount or any part thereof under this bank guarantee only and only if the beneficiary serves upon the bank a written claim or demand on or before 15th October 2020.

Bank Guarantee - Features

Bank Guarantees should be unconditional guarantees by the bank to the beneficiary, undertaking to pay the sum specified in the guarantees on demand. 

When a bank guarantee is given by a bank to the beneficiary, a direct relationship gets established, and a contract comes into being between the bank and the beneficiary, independent of the main contract between the buyer/employer & the supplier/contractor. 

The beneficiary's right under a bank guarantee is governed by the bank guarantee itself and not by the terms and conditions of the original contract. 

 The bank's liability under the guarantee is absolute, and courts would not generally interfere with the contractual obligation of the banker by issuing an injunction against the payment when the guarantee is validly invoked. (The only exception is when there is a clear case of fraud or misrepresentation) 

Through a series of judgments of the supreme court, it is well established that the party seeking an injunction against enforcement of a bank guarantee must show a prima facie case of established fraud and irretrievable injury to it.

 Enforcement of a guarantee cannot be made the subject matter of any arbitration.

NOTE: When there is a pending arbitration under which the liability of all the parties had to be ascertained, the court upheld the decision of the bank to withhold payment against a bank guarantee. 

Safeguards by the Bank

Important

Banks must honour the guarantee issued by them and pay the amount claimed when they are invoked except where fraud by the beneficiary is established, or there is misrepresentation or deliberate suppression of material facts.

• It would be for the banks to safeguard themselves by other means and generally not for the courts to come to their rescue with injunctions unless there is established fraud.

Limits

Maximum monetary limits are fixed based on the financial standing, the extent to which the account has been maintained by the customer satisfactorily, the volume of transactions, past track record of the client in respect of guarantees etc. 

Limits are reviewed and re-fixed periodically.

Margins

Clients requesting the issue of guarantees are required to place, in an interest-bearing fixed deposit with the bank, a margin (amount) expressed as a percentage of the value of the bank guarantee. 

The percentage of margin money could range from 10% to 100% of the value of the guarantee. 

In the case of foreign BG, the margin could even be 110% of the value to cover fluctuations in foreign exchange rates. 

Counter Guarantee

Banks obtain counter-guarantees on non-judicial stamp paper from the clients for equal value before furnishing bank guarantees on their behalf. 

This document is an undertaking by the client on whose behalf the bank guarantee is issued that he will reimburse the amount paid by the bank when the guarantee is invoked by the beneficiary.

Safeguards by the Beneficiary

If the bank guarantee is obtained from a supplier’s/contractor’s bank in another country, the beneficiary runs the risk of not getting paid when it invokes the bank guarantee, as the judiciary may be liberal in granting injunctions against the bank, preventing it from honouring the bank guarantee. 

Bank guarantees are valuable documents and must be kept in safe custody.

Bank Guarantee - Extension

A Bank guarantee is an independent contract between the bank & the buyer/employer.

• To safeguard his interest, the buyer/employer should address the bank for extending the bank guarantee with a copy to the supplier/contractor.

• While asking for an extension, the buyer/employer should also intimate the supplier/contractor that if the bank guarantee is, for any reason, not extended, the letter should be treated as a notice invoking the bank guarantee, and the bank should pay the amount covered by the bank guarantee on the due date. 

• This will ensure that the supplier gives a direction to the bank to extend the bank guarantee as the only option is to pay the amount if it is not extended. 

Bank Guarantee - Discharge

If the particular aspect of the transaction between its client and the beneficiary covered by the guarantee has been completed satisfactorily, Banks insist on the bank guarantee being returned to them duly discharged to confirm the non-existence of liability against such guarantees. 

Discharge & Notwithstanding clause in BG

A BG with a notwithstanding clause & validity having expired and no written notice for a claim having been served by the beneficiary, the bank is no longer authorised to entertain any claim against an expired bank guarantee.

• Upon serving the issuing bank a written notice to close the expired BG and refund the margin money, the bank is required to send a written notice to the beneficiary asking them to return the expired original guarantee. If the original guarantee is not returned by the beneficiary after a lapse of 30 days, the issuing bank is required to cancel the BG and return the margin money without further delay as per RBI guidelines. 

LETTERS OF CREDIT

Meaning

LCs are guarantees issued by a buyer’s bank in favour of the supplier, guaranteeing that payments will be made against documents listed in the LC, inter alia evidencing completion of supplies/services/stages of progress of work before the delivery dates specified in the LC & subject to the conditions specified therein. 

The documents are also required to be presented for payment to the advising bank before the last date for negotiation of documents mentioned in the LC.

There are thus two dates – one the last date for shipment/completion of work, and the other is the last date for negotiation of documents.

The gap between the two dates enables the beneficiary to collect and assemble the documents specified before presenting them to the advising bank for payment.

Two banks are involved in an LC. The buyer has/opens an account in a bank (issuing bank) in his country, which guarantees payment.

This bank opens a credit with a bank in the supplier’s country in favour of the supplier. This bank is known as the advising bank (normally the supplier nominates the advising bank)

The advising bank advises the supplier:

1. the last date for delivery of goods, 
2. the documents which the supplier must deliver to the bank and the time within which he must do so, 
3. and any other conditions stipulated in the LC. 

All LCs are irrevocable.

Documents

• Bill of lading

Adherence to the delivery date for goods is evidenced by a bill of lading, an airway bill, a railway receipt or a lorry waybill, showing the date the consignment is made over to the carrier. 

• Supplier’s invoice

• Certificate of quality or acceptance

If the buyer, under the contract, conducts an inspection for quality and other parameters and accepts the items.

• Certificate of Origin

           Issued normally for imports.

Last date for Negotiation…

• A reasonable time is allowed (10 -15 days) from the completion of supplies/service to enable the supplier to assemble the stipulated documents. 

• This is fixed as the last date for negotiation, and the supplier must present documents to the advising bank before this date to receive payments against the letter of credit.

Payment

On presentation of such documents, the payment under the LC is released by the advising bank to the supplier, after scrutinizing the documents for completeness and fulfilment of conditions (particularly w.r.t. the delivery date and the date for negotiation)

This system is also known as documentary credit.  

Liability

An LC is a contingent liability both to the bank and the buyer who has established the LC till it is operated and till the expiry of the validity (or extended validity) of the LC. 

Once it is operated by the supplier in accordance with the conditions, it ceases to be a contingent liability but gets converted to a definite liability.

Charges

Opening charges (one-time charge)

Maintaining charges (recurring charges, mostly every quarter, as a percentage of the value of the credit, established)

Confirmation charges (one-time charge – in International trade, it is common practice for suppliers to demand a confirmed letter of credit as opposed to an unconfirmed letter of credit)

Margins (Issuing Bank)

Clients requesting an issue of LC are required to place, in an interest-bearing fixed deposit with the bank, a margin (amount) expressed as a percentage of the value of the LC. 

The percentage of margin money could range from 10% to 100% of the value of the LC. 

In the case of foreign LC, the margin could even be 110% of the value to cover fluctuations in foreign exchange rates. 

Counter Guarantee (Issuing Bank)

Issuing Bank obtains counter-guarantees on non-judicial stamp paper from the client undertaking to reimburse the amount paid by the bank against the LC and also authorizing the issuing bank to debit his account when payment is made against the LC.

Sequence

• The supplier delivers goods to the carrier obtains a bill of lading, airway bill, railway receipt etc.
• Prepares the invoice.
•  Presents invoice and all documents specified in LC to advising bank for payment.
• Advising bank scrutinizes document:
• Completeness.
• Evidence of delivery with a scheduled delivery date.
• Documents presented before the date set as the last date of negotiation.
• If documents are in order & conditions of LC are met, the advising bank credits the supplier’s account with the amount due & advises the issuing bank and the buyer of having debited its account with the amount paid. 
• The advising bank forwards the documents to the issuing bank.
• The issuing bank advises the buyer of having debited his account, with the amount paid & bank charges, and forwards the documents to the buyer to enable the latter to clear the consignment when it arrives at the destination.
• The issuing bank releases the fixed deposit held as security in favour of the buyer.