There may be situations wherein counter-parties to the underlying trading contracts may insist that importers or exporter provide guarantees of highly reliable third parties about the ability of the importers or exporters to complete the underlying contracts, and the event of failure of the importers or exporters to do so, pay compensation to the counter-parties. The third-party (a guarantor) acceptable to the counter-party, in almost all cases, is a reputable bank. In all the situations, exporters and importers request their banks to issue a variety of guarantees on their behalf to back-up their performance ability or, alternatively, to pay loss claims to counter-parties with whom the exporters and importers would be dealing.
Technically, issuing a guarantee on behalf of a customer amounts to substituting that customer’s credit (financial standing) with that of the guarantee-issuing bank. It implies taking the risk of paying claims under the guarantees in the event bank’ s customers fail to perform under contracts executed with guarantee beneficiaries. Thus, while issuing a guarantee, the bank assumes the risk of failure of its customer to perform, which implies that banks should have a clear idea about:
a) Customers’ ability to perform under various, each with different risk, depending on the task being undertaken,
b) Customer’s resources for performing on the contracts keeping in view customer’s other engagements or commitments,
c) The time within which the task is to be completed, and
d) External factors that could impede the completion of the task.
In foreign trade, guarantees need to be examined from several angles to understand what could be the possible compulsions for guarantee beneficiaries to demand them, and what possible risks they would like safeguarded.
Primarily, importers are concerned about exporters’ ability to comply with quality specifications that they want the goods to possess, this is a major risk because goods not lost. Secondly, importers making advance payments to exporters want to be sure that if exporters fail to ship goods by the last date of shipment specified in the LC or the sales contract, they will be refunded the advance payment along with mark-up/interest thereon for the period those funds remained with the exporters. This is the worry of those importers who import goods for selling in a season or for supply to their buyers, within a specific timeframe.
The other types of guarantees that importers often need have to do with port and customs authorities. For instance, good may arrive before the arrival of the relevant shipping documents in which case it would not be possible for the port authorities to establish their ownership. Port authorities allow clearance of such goods only after a bank guarantees that should another party later on claim ownership of the good in question, the bank will pay the value of the goods to the concerned shipping company for compensating the rightful owner of the goods.
Then there are instances wherein there is a dispute between the importer and the customs authorities over the applicable rate of import duty. In such situations too, port authorities allow the clearance of goods only after a bank guarantees that should the demand of the customs authorities be upheld by an arbitration council or court of law, the bank will pay the amount of the import duty demanded by the customs authorities. Aside from these, there can be special-purpose guarantees as well.
Exporters often ask importers to make advance payments for the goods they agree to export. These are situations wherein exporters have to undertake huge investment in the goods they have to manufacture and export. Thus, the advance payments demanded could be for the partial or full amount of the goods, depending on exporters’ strength as suppliers, or the buyers’ weaknesses as buyers. While exporters do get the advance payment they need, they have to provide bank guarantees to the importers to assure them that, either the exporter will supply them the contracted goods, or they will get a refund of their advance payment. Exporters, therefore, request their banks to issue these advance payment guarantees.
When exporters act as supply contractors, they have to provide all the guarantees that a project sponsor or tendering authority may require. Thus, they could request their banks to issue bid bonds, performance bonds, advance payment guarantees, and retention money bonds.