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02 December 2018

Bank guarantees in international trade

M S Siddiqui

Bank guarantee (BG) to exclusively describe a transaction in which one party makes an independent
guarantee commitment in respect of another party's liabilities, regardless of the latter's form and
enforceability. A and B come to an agreement that A will supply certain quantity of product P to B
within some specific term and condition. C a Bank has issue a BG to B guarantying the performance
of A. C will make the payment of agreed amount of performance guarantee (PG) upon claim. PG in
the form of BG is widely used in local and foreign trade.

The term "bank guarantee" has no precise definition, particularly in international law. Nordea Trade
Finance, 2010 defined BG as: An independent, documentary undertaking by which a bank or other
legally qualified entity (the guarantor), issues, at the request of its customer (the instructing party), its
irrevocable guarantee to pay a sum of money to a third party, (the beneficiary), provided a complying
demand/document(s) is presented. This definition contains some of the core principles concerning
these kinds of guarantees.

A guarantee is an independent undertaking by a bank (guarantor). This undertaking means that the
guarantor becomes obligated to pay an amount, specified in the guarantee, provided the terms of its
guarantee are complied with. A guarantee is irrevocable, meaning that once issued it cannot be
amended nor cancelled during the validity period without the consent of the parties, i.e. the
guarantor and the beneficiary.

ABG is a contract between the bank and the beneficiary, in general concluded at the request of the
bank's customer (principal). BGs are known by various names, such as 'independent undertakings',
'performance bonds/guarantees', 'tender bonds/guarantees', 'independent (bank) guarantees',
'demand guarantees', 'first demand guarantees', 'bank guarantees', and 'default undertakings'. In
international trade has another form of guarantee is the 'stand by letter of credit'.

BG plays a vital role in international trade and other business transactions. They are used in almost
every phase of the transaction between the buyer and the seller. Trade with counterpart in other
country is different from trade with a company inside the own country. Both parties may experience
unforeseen difficulties to meet their contractual obligations. The law and culture of different countries
are also different.

In these circumstances there may be a requirement for some form of security.BG is considered as
life blood of domestic and international business. BG is a widely used and globally accepted
instrument for securing and enforcing the claims of parties to foreign trade contracts in a way that
optimally protects the interests of all participants.
The bank's obligations for payment against PG is autonomous from the underlying contract between
the beneficiary and the principal; which means that, in principle, the bank must pay if proper
complying documents are presented, even if the beneficiary and the principal have not stipulated
that there is a default under the original underlying contract.

Most categories of PGs are payable on first demand without any additional documents, which
reflects their origin in replacing cash deposits, although increasingly guarantees require at least a
statement indicating that the principal is in breach.

The beneficiary is not obligated to furnish proof to the guarantor that the "material" guarantee event
arising from the underlying transaction has occurred, i.e., that the preconditions for the claim under
the guarantee have been fulfilled also in relation to the principal.

If the beneficiary makes a complying claim under the guarantee declaring that an event giving rise to
the guarantee, as defined in the text of the guarantee has in fact occurred, the bank is generally
obligated to make payment to the beneficiary.

The guarantee shall remain valid even if the underlying obligation is extinguished for any reason.
The guarantor must pay upon demand, without making any objection or invoking any defense. On
receiving a claim, the guarantor can therefore merely check that it has been validly made, i.e. that
the formal conditions laid down in the wording of the guarantee have been met.

Therefore, a demand guarantee is like a substitute for cash and must be honoured on presentation
of a written demand that complies with the provisions of the guarantee.After the bank has made
such payment, the principal will be entitled, at its own risk and peril, to bring a counter-claim directly
against the beneficiary due to non-occurrence of the "material" guarantee event.

BGs are governed almost exclusively by the law of the country of domicile of the bank that issues
the guarantee to the beneficiary. Banks around the world tend to stipulate their own wording in
accordance with local practices and the local legal background. In 1992, the International Chamber
of Commerce (ICC) in Paris issued new regulations titled "ICC Uniform Rules for Demand
Guarantees" (URDG) in an attempt to harmonize these different wordings and customs. In some
countries the law also regulated the guarantees.

The law stipulates a special type of bank guarantee which contains the clause "without protest",
"first-call" or other words with the same meaning, which specifies that when it comes to this type of
bank guarantee, the bank cannot point out those kinds of objections to the creditor from the main
business, which the principal, as a debtor, has towards the guarantee beneficiary (Law on Obligatory
Relations, Art. 1087).

The principal elements of a guarantee are the following:

(1) it should have a preamble describing the underlying transaction to which the guarantee refers the
type of underlying transaction, the contract number and / or date of signature, and the type of
guarantee to be issued. (

2) It should include the names and addresses of the business partners of the underlying transaction.

(3) The irrevocable and unconditional undertaking of the bank to pay a sum of money up to the
amount of the guarantee, upon the first written demand of the beneficiary, accompanied by a
declaration to the effect that the event giving rise to the guarantee claim, as defined in the terms of
the guarantee, has occurred.
(4) An expiry date that clearly limits the duration of the guarantee to a certain date, by which any
claim must have been received by the bank; or in exceptional cases, the duration of the guarantee is
indefinite. (5) Any other special clauses depending on the type of guarantee and also nature of the
underlying transaction.

There is no uniform "international law" that applies to bank guarantees. The governing law of a bank
guarantee is the law chosen in the guarantee or the applicable law determined pursuant to the
conflict of laws rules. Depending on the governing law of the bank guarantee country-specific
requirements may also have to be taken into account of law of contract.

There are two types of guarantee: Direct / indirect guarantees. A "direct" guarantee is issued by a
bank to the foreign beneficiary, constituting a direct legal relationship between the issuing bank and
the beneficiary. The direct guarantee offers several advantages, including the lower cost of such a
guarantee, because there are no fees or costs to be charged by a second bank in a foreign country
of beneficiary.

The indirect guarantee issued by guarantor bank and endorsed or reissued by local of the
beneficiary country. Due to the legal requirements or bank practices of certain countries, the
beneficiary cannot accept direct guarantees issued by a bank domiciled in a foreign country.

The guarantor Bank request their counterpart Bank in country of beneficiary to issue a guarantee in
favor of beneficiary. Furthermore, the guarantee issued by the local Bank will be subject to law of the
own country. Bangladesh does accept guarantee with counter guarantee from any local bank.

The rule of un-conditional encashment of guarantee places the beneficiary in a very strong legal
position. The beneficiary can demand immediate payment, and the guarantor and principal have no
right to raise any objections or present any defence on the strength of the underlying transaction.
Thus the beneficiary is relieved not only of the risk of the principal becoming insolvent but also of the
risk of having to enforce a claim through the courts. As in the case of documentary credits, the rule is
"pay first, sue later."

BG provides protection against non-performance. BG testifies to the principal's ability to carry out the
contract. Since the issuance of a guarantee constitutes an irrevocable payment undertaking, a bank
will undertake a thorough examination of financial status and management and technological
capability to fulfill contractual obligations. The original contract gets legitimacy with the process.

The guarantee is a motivational for the second party due to lose of a certain amount due failure of
abide by the contract. This is a strong incentive to complete the contract, even if the transaction has
lost its appeal in the meantime. If the principal fails to fulfill its obligations, the buyer is entitled to
demand payment of the guarantee sum, which will compensate fully or partly for the financial
consequences of the breach of contract.

International trade transaction use to do through Letter of credit or Transfer of money etc. PG is a
guarantee of the transaction under an independent contract. The main difference between a BG and
a documentary credit is that the latter also functions as a means of payment.

PGs guarantees are typically used in construction contracts, Heavy technology based project
contracts and contracts for the international sale of goods. However, they could also be used for any
other type of contract. Whereas commercial letters of credit are used to ensure that the seller,
exporter or supplier is paid, demand guarantees are intended to safeguard the other party (e.g.,
buyer) against non-performance or late or defective performance by the seller, exporter or supplier
to the underlying contract.
Bangladesh government widely use BG in public procurement to ensure act of suppliers and are not
using in export trade. Bangladesh can allow import and export shipment against contract supported
BG from overseas suppliers / buyers without Letter of credit and advance payment.

The writer is a legal economist.

Email: mssiddiqui2035@gmail.com