A Bank Guarantee is a Letter of Guarantee issued by one bank to another bank to guarantee the performance of an obligation on the part of the applicant, guaranteeing the beneficiary. It is important to note that a Bank Guarantee is not like a Letter of Credit (L/C) or Documentary Credit. The main difference between a Bank Guarantee and a Documentary Credit is that a L/C also functions as a means of payment. A bank guarantee acts as security for a payment, and not as a means of payment.
Bank guarantees are governed almost exclusively by the law of the country of domicile of the bank that issues the guarantee to the beneficiary. This means that the legal position of the Guarantee must be studied in each case. Every declaration that is designated a “bank guarantee” must be examined carefully to ascertain its legal significance and implications. A particularly clear distinction must be made between a surety bond and an abstract payment undertaking.
The custom and protocol in international trade is to have undertakings that are payable on first demand and that are legally separate from the underlying transaction Bank Guarantee’s take several forms. They can be used to guarantee the payment of a liability. Depending on the type of liability (as evidenced by an underlaying contract), the Bank Guarantee will take various formats (or wordings). In Collateral Transfer, the Guarantees issued are to secure loans or credit lines. These are referred to as Credit Facilities Guarantees and are worded.
About ‘Leasing’ Of Bank Guarantees
The ‘Lease’ or ‘Leasing’ of Bank Guarantees or indeed the ‘leasing’ of Standby Letters of Credit (SBLC’s) are undertaken through Collateral Transfer facilities. Collateral Transfer is the provision of assets from one party (the Provider) to the other party (the Beneficiary), often in the form of a Bank Guarantee. Whereas the Provider agrees (through his issuing bank) to issue a demand guarantee (the Bank Guarantee) to the Beneficiary in return for a ‘rental’ or ‘return’ known as the ‘Contract Fee’. The parties agree to enter into a Collateral Transfer Agreement (CTA) which governs the issuance of the Guarantee. ‘Leasing a Bank Guarantee’ is a common phrase associated with Collateral Transfer. Since it is not possible to physically ‘lease’ a bank guarantee, we use the term loosely as its structure resembles that of a commercial lease. However, these arrangements should be correctly referred to as ‘Collateral Transfer Facilities’ as effectively no leasing takes place. A Bank Guarantee is issued specifically for the purpose to the Beneficiary and each contract is bespoke. A Bank Guarantee cannot be transferable, purchased or sold. A Collateral Transfer facility is the Provider using his own assets to raise a specific Bank Guarantee through his issuing bank for the sole use of the specified Beneficiary, for the specified term. It is effectively a form of Securities Lending and often a derivative of re-hypothecation. There is no reference to ‘leasing’ when receiving a Bank Guarantee in this fashion.
The Guarantee is issued by the issuing bank of the Provider to the Beneficiary’s account at the Beneficiary bank and is transmitted inter-bank via the appropriate SWIFT platform (MT760 in the case of Guarantees). During the term of the Guarantee, the Beneficiary may utilise it for their own purposes which may include; security for loans, credit lines or for trading purposes. At the end of the term, the Beneficiary agrees to extinguish any encumbrance against the Guarantee and allow it to lapse (or return it) prior to expiry and indemnify the Provider against any loss incurred by default of loans secured upon it.
A Provider will often be a collateral management firm, a hedge fund or private equity company. Effectively, the Guarantee is ‘leased’ to the Beneficiary as a form of investment since the Provider receives a return on his commitment, hence the misnomer of the term ‘leasing’. Over recent years, these facilities have become more popular since they enable the Beneficiary to have access to substantial credit facilities by using the Guarantee as loan security. Since the Guarantee is effectively imported to the account of the Beneficiary, the underwriting criteria is considerably less than that of conventional lending. Guarantees received in this way are in no way different from any other form of demand Guarantee. The fact that there is an underlying agreement (the Collateral Transfer Agreement) has no bearing on the wording or construction of the Guarantee. This allows the Beneficiary to use the Guarantee to raise credit, to guarantee credit lines and loans or to enter trade positions or buy/sell contracts.