BANK GUARANTEES AND BID

BONDS
Learning Objectives:

To understand meaning of a

Guarantee and a Bond
To understand the various types
of guarantees and bonds
To understand the essential features of
a Guarantee and a Bond
Chapter 8 Corporate Banking 1
 BANK GUARANTEES AND BID BONDS

• 8.1 Introduction
• Bank guarantee is an assurance by a bank that
should a specified situation occur or a certain
event (such as non performance of a contract)
that it would pay the individual/entity to
whom the guarantee has been given a certain
amount of money.

Chapter 8 Corporate Banking 2

 BANK GUARANTEES AND BID BONDS

• It is to be remembered that the invocation of

the guarantee is contingent on an event
happening or not happening. It is therefore a
contingent liability in the books of the bank.

Chapter 8 Corporate Banking 3

 BANK GUARANTEES AND BID BONDS

• 8.2 DEFINITION OF GUARANTEE

• Section 126 of the Indian Contract Act 1872
defines a contract of guarantee as “ a contract
to perform the promise, or discharge the
liability of a third person in case of his
default.” The section further declares that “ a
guarantee may be written or oral”.

Chapter 8 Corporate Banking 4

 BANK GUARANTEES AND BID BONDS

• Guarantee is a contract and therefore the

four requisites of a contract must be present,
namely competent person, free consent,
lawful consideration and contract not
declared void.

Chapter 8 Corporate Banking 5

 BANK GUARANTEES AND BID BONDS

• 8.3 PARTIES TO A GUARANTEE

• There are 3 parties to a contract of guarantee.
(a)The principal (applicant) on whose behalf the
guarantee is issued. ( principal debtor)
(b)The beneficiary in whose favour the
guarantee is issued(creditor)
(c)The guarantor, the bank which has issued the
guarantee (surety/guarantor)
Chapter 8 Corporate Banking 6
 BANK GUARANTEES AND BID BONDS

• There are three contracts :The contract

between the creditor and the principal
debtor, contract between the creditor and
the surety(bank) and the contract between
the surety and the principal debtor.
• The guarantee is a collateral contract
consequential to a main contract between
the applicant and the principal debtor.

Chapter 8 Corporate Banking 7

 BANK GUARANTEES AND BID BONDS

• Mr. Raman Menon leases his flat to Mr. Pratap Mehta

for Rs. 100,000 per month. Mr. Menon insists on a
bank guarantee from Mr. Menon’s bankers, the Bank
of Bharat for Rs.250,00,000 to compensate him
should Mr.Mehta refuse to hand over possession at
the end of the lease period.
• As would be seen from this illustration there are
three parties to the contract.
•  Mr.Raman Menon is the principal debtor
•  The Bank of Bharat is the surety
•  Mr.Pratap Mehta is the creditor.
Chapter 8 Corporate Banking 8
 BANK GUARANTEES AND BID BONDS

• It must be noted that it is not only banks that

issue guarantees. Individuals may also do so.
Let us take the case of an educational loan
that a student has taken from a bank and the
bank seeks an assurance from an adult of
some standing that it will be repaid. In this
case the student is the principal debtor, the
adult who gives the guarantee(guarantor) is
the surety and the bank is the creditor.
Chapter 8 Corporate Banking 9
 BANK GUARANTEES AND BID BONDS

• Under some circumstances the surety is liable

even though the principal debtor is not. This
happens where the original contract is void
as in the case of a contract with a minor, the
surety is liable not only as a surety but also as
a principal debtor. In such instances the
contract of the so called surety is not a
collateral but the principal contract.

Chapter 8 Corporate Banking 10

 BANK GUARANTEES AND BID BONDS

• Ttanatha Karayalar vs Central Bank of India,

AIR SC 1856: It must be noted that although a
guarantor may join the principal debtor in
executing a promissory note, he will not be a
co-obligant where the underlying transaction
and conduct of the parties show that he is a
surety.

Chapter 8 Corporate Banking 11

 BANK GUARANTEES AND BID BONDS

• 8.4 INDEMNITY
• A guarantee differs from an indemnity.
Section 124 of the Indian Contract Act, 1872
states, “ A contract by which one party
promises to save the other from loss caused
to him by the promisor himself or by the
conduct of any other persons, is called a
contract of indemnity”.

Chapter 8 Corporate Banking 12

 BANK GUARANTEES AND BID BONDS
• Parties to Indemnity
• Indemnifier : Person who promises to make
good the loss
• Indemnified : Person whose loss is to be made
good

Chapter 8 Corporate Banking 13

BANK GUARANTEES AND BID BONDS

Guarantee Indemnity

There are three parties There are two parties

Guarantor’s liability begins The indemnifier may be

only after default is asked to discharge
committed by the principal whenever the indemnified
debtor(applicant) suffers a loss

Chapter 8 Corporate Banking 14

 BANK GUARANTEES AND BID BONDS

• 8.5 SEPCIFIC AND CONTINUING GUARANTEES

• Specific guarantee = executed for a
specific/single transaction.
• Continuing guarantee = extends for a series
of transactions.

Chapter 8 Corporate Banking 15

 BANK GUARANTEES AND BID BONDS

• Guarantee for specific transactions:

•  Guarantee issued to cover a single transaction
•  Covers a specific purpose e.g. Guarantee in favour
of Sales Tax Officer in lieu of advance deposit of tax.
• The guarantor’s liability ceases as soon as the
purpose for which it is given is over. If Mr. Raman
Menon had guaranteed a loan of Rs.500,000 given to
Mr. Mehta by the Bank of Bharat, the liability ceases
as soon as the loan is repaid. If he takes a new loan
Raman Menon will not be liable.

Chapter 8 Corporate Banking 16

 BANK GUARANTEES AND BID BONDS

• Continuing guarantee
•  Covers a series of transactions
•  Upto a specified amount
•  For a particular/ specified amount
•  May be revoked at any time as to future
transactions by notice to the
creditor/beneficiary.

Chapter 8 Corporate Banking 17

 BANK GUARANTEES AND BID BONDS

• In the case of a continuing guarantee let us

assume that Pratap Mehta had taken a loan
for Rs.500,000 and had repaid it and then
taken a fresh loan of Rs 200,000. If Raman
Menon had issued a continuing guarantee he
will be liable as long as Mr.Mehta owes the
bank money on account of the loan. It is
possible however to limit the continuing
guarantees(upto Rs 200,000) and for a
period.
Chapter 8 Corporate Banking 18
 BANK GUARANTEES AND BID BONDS

• 8.6 TYPES OF GUARANTEES ISSUED BY BANKS

• 1.Performance Guarantees
• 2.Financial Guarantees
• 3.Deferred Payment Guarantees
• 4. Customs Guarantee
• 5. Advance Payment Guarantee

Chapter 8 Corporate Banking 19

 BANK GUARANTEES AND BID BONDS

• 1.Performance Guarantees
• The bank, in this instance, guarantees the
performance of obligations of their
customers. These types of guarantees are
issued on behalf of contractors, suppliers,
exporters etc, guaranteeing the completion
of the contracted job on time or for the
performance of machinery/goods etc.

Chapter 8 Corporate Banking 20

 BANK GUARANTEES AND BID BONDS

• 2.Financial Guarantees
• The bank undertakes the financial liabilities
of its customers. These guarantees are issued
in lieu of monetary obligations. Earnest
money, retention money, tender deposit and
deposit towards payment of customs duty
issued in favour of customs fall under this
category.

Chapter 8 Corporate Banking 21

 BANK GUARANTEES AND BID BONDS

• 3.Deferred Payment Guarantees

• These guarantees are issued if the client
buying goods under a deferred payment
scheme requests the bank to issue a deferred
payment guarantee. These are usually for
over a year but less than 10 years.
• These are similar to financial guarantees. The
liability crystallizes when the borrower
defaults in the payment of the installments.

Chapter 8 Corporate Banking 22

 BANK GUARANTEES AND BID BONDS
• 4. Customs Guarantee
• This is a guarantee given to customs
authorities to release goods from customs
guaranteeing to pay customs and other levies.

Chapter 8 Corporate Banking 23

 BANK GUARANTEES AND BID BONDS
• 5. Advance Payment Guarantee
• This guarantee is issued in favour of the
buyer(creditor) to ensure payment of the
advance by the seller(principal debtor) in the
event of nonperformance of the seller.
• Advance payment by sellers is sought from their
principals(buyers) to meet working capital and
other needs. In these situations principals often
insist on a bank guarantee for the advance made
by them. These are known as “advance payment
guarantees”.

Chapter 8 Corporate Banking 24

 BANK GUARANTEES AND BID BONDS
• 8.7 BID BOND
• A bid bond guarantees that the amount that needs to
be paid as security at the time the security needs to
be paid.(usually when the bid is accepted).
• In export trade, bank guarantees or bid bonds are
required in connection with contracts for sale of
capital goods, setting up of turn key projects abroad
as also for overseas service contracts. These are
required at various stages right from pre-bid stage to
completion of projects.

Chapter 8 Corporate Banking 25

 BANK GUARANTEES AND BID BONDS
• 8.8 ESSENTIAL FEATURES OF GUARANTEES
• 1. To be issued for specific periods only
• 2. Normally issued for periods not exceeding two
years
• 3. Not to be issued for periods more than 10
years even if secured by cash margin
• 4. Where it is necessary to issue such guarantees
( for more than 10 years), prior approval from
senior management at appropriate level is to be
obtained.

Chapter 8 Corporate Banking 26

 BANK GUARANTEES AND BID BONDS
• 8.8 ESSENTIAL FEATURES OF GUARANTEES (contd)
• 5. Guarantees containing onerous clauses should not
be issued.
• 6. Every guarantee should contain standard protective
clause, which determines and restricts amount of
guarantee and period of enforceability of claim.
• 7. Without having proof of issue of license, guarantees
to the collector of customs to cover the delivery of
goods without production of relative import license
should not be issued.

Chapter 8 Corporate Banking 27

 BANK GUARANTEES AND BID BONDS
• ( Nandlal Chanadas vs Firm Kishinchand AIR
1937 Sindh 50) Normally guarantees should
be signed by the surety. However, this is not
absolutely necessary if there is overwhelming
evidence that the surety had guaranteed.

Chapter 8 Corporate Banking 28

 BANK GUARANTEES AND BID BONDS
• 8.9 CONSIDERATION
• Section 127 of the Indian Contract Act, 1872
defines consideration as “ Anything done, or
promise made, for the benefit of the principal
debtor may be a sufficient consideration to the
surety for giving the guarantee”.
• A contract of guarantee is valid only if there is
consideration. It is not necessary that something
has to be done for the benefit of the guarantor.
Chapter 8 Corporate Banking 29
 BANK GUARANTEES AND BID BONDS
• 8.10 RIGHTS OF THE BANKER AGAINST SURETY
• (a)Right of lien
• This right to exercise a general lien does not arise
until a default has been made by the principal
debtor, in which the banker should immediately
inform the guarantor that the former has
exercised his lien on the latter’s money or
securities deposited with him. The banker is not
bound to sue the debtor before claiming the
amount from the guarantor.
Chapter 8 Corporate Banking 30
 BANK GUARANTEES AND BID BONDS
• Surety’s liability co-extensive with that of the
principal debtor
• The liability of the surety is co-extensive with
that of the principal debtor ( Section 128, Indian
Contract Act, 1872), unless it is provided
otherwise by the contract of guarantee.
• The surety will be liable not only for the
principal but also for the interest and charges
that may be due.
Chapter 8 Corporate Banking 31
 BANK GUARANTEES AND BID BONDS
• Banker’s claim against a bankrupt surety’s
estate
• In the event of the bank to prove bankruptcy
of the surety, the banker is entitled to prove
his claim against the estate of the surety.

Chapter 8 Corporate Banking 32

 BANK GUARANTEES AND BID BONDS
• 8.11 RIGHTS OF SURETY
• The surety can call for the particulars of the
extent of his liability. The banker is bound to
supply the information, but he should do so
with all possible care without committing
himself in respect of other details relating to the
contract.
• The surety has however no right to inspect the
account of the debtor or obtain from the bank
any other information of a confidential nature.
Chapter 8 Corporate Banking 33
 BANK GUARANTEES AND BID BONDS
• If a father guarantees an overdraft of his son
studying at a college and the latter taking undue
advantage of the opportunity begins squandering
money on luxurious living, the former can ask the
bank to pay no more cheques drawn by the latter.
If the bank declines to accede to this request and
points to the three months notice clause in the
guarantee signed by the father, the guarantor of
the overdraft, it would not be acting equitably
towards him.

Chapter 8 Corporate Banking 34

 BANK GUARANTEES AND BID BONDS
• 8.12 TERMINATION OF GUARANTEE
• Termination of guarantee by insolvency :
• The insolvency of a guarantor terminates his
guarantee so far as further advances to the
principal debtor is concerned.

Chapter 8 Corporate Banking 35

 BANK GUARANTEES AND BID BONDS
• Surety succeeds to all rights and equities of
the creditor :
• A surety on the payment or performance of all
that he is liable for, or which is due to the
creditor, succeeds to all the rights and equities
of the latter.

Chapter 8 Corporate Banking 36

 BANK GUARANTEES AND BID BONDS
• Surety’s right against principal debtor and co-
sureties :
• Generally before paying the amount
demanded, the surety sends a notice to the
principal debtor of his intention to meet the
bankers demand. The surety on making the
payment can claim the amount from the
principal debtor but he cannot make any
profit from the transaction.

Chapter 8 Corporate Banking 37

 BANK GUARANTEES AND BID BONDS
• Surety’s right to be discharged:
• A surety is entitled to a complete discharge :
• (a) If the creditor discharges the principal debtor
• (b) If the creditor without the consent of the surety,
makes a composition with, or promises to give time to,
or not sue the debtor.
• (c) If the creditor does any act which is inconsistent
with the right of the surety, or omits to do any act
which his duty to the surety requires him to do and
thereby the eventual remedy of the surety against the
principal debtor is impaired.
Chapter 8 Corporate Banking 38
 BANK GUARANTEES AND BID BONDS
• 8.13 CREDITOR OBLIGATIONS AND RIGHTS
• As per the contract between the principal debtor and
creditor, the obligations of the creditor are
independent of the bank guarantee. The bank is not a
co-party to obligations.
• The creditor has the right to demand the payment
from the guarantor if the principal debtor has failed to
perform as per agreement. The creditor should
nevertheless, prefer his claim on or before the claim
expiry date of the guarantee as per protection clause in
the Guarantee.

Chapter 8 Corporate Banking 39

 BANK GUARANTEES AND BID BONDS
• 8.14 RENEWAL OF GUARANTES
• Guarantees can be renewed before its expiry
and (as far as a bank is concerned) if within
the original sanctioned limit.
• Where earlier guarantees issued have been
invoked and paid by the bank, but not
recovered from the party within 7
days(number of days may vary)
renewal/extension should not be considered.

Chapter 8 Corporate Banking 40

 BANK GUARANTEES AND BID BONDS
• 8.15 REFUND OF GUARANTEE COMMISSION
• Refund of commission can be considered if the
guarantee has not been utilized for the purpose
for which it has been issued for the unexpired
period.
• No refund of commission is usually made for the
unexpired period where it has been
tendered/submitted in case of guarantees in lieu
of earnest money deposit.
• In the case of DPGs, no refund is permitted even
if such DPG are foreclosed before due date.
Chapter 8 Corporate Banking 41
 BANK GUARANTEES AND BID BONDS
• 8.15 REFUND OF GUARANTEE COMMISSION (contd)

• With regard to performance guarantee, where contract

is completed before the expiry period of the guarantee,
no refund of commission is paid for the unexpired
period.
• In instances where a guarantee is tendered for
cancellation before the expiry period (subject to above
conditions) only 50% of commission for the unexpired
period of guarantees less three months, is normally
refunded.

Chapter 8 Corporate Banking 42

 BANK GUARANTEES AND BID BONDS
• 8.16 SETTLEMENT OF CLAIMS
• (a)Immediately on receipt of invocation letter,
the same should be acknowledged without any
commitment regarding the claim.
• (b) The bank should retain postal cover along
with the invocation letter.
• (c) The matter should be referred to the
appropriate sanctioning authority.
• (d) Payment of the guaranteed amount should
not be delayed without any valid reason.

Chapter 8 Corporate Banking 43

 BANK GUARANTEES AND BID BONDS
• 8.16 SETTLEMENT OF CLAIMS (contd)
• (e)Where claims are paid, if the customer
prefers to pay the amount in cash, the
deposit held as security ( and not matured)
need not be adjusted.
• (f) The client should be informed about
adjustment of deposit through letter. The
charges should be recovered from the client.

Chapter 8 Corporate Banking 44

 BANK GUARANTEES AND BID BONDS
• 8.17 OPEN ENDED GUARANTEES :
• Guarantees that have no expiry date or a
limitation regarding the amount are known as
open ended guarantees as the risks are open
ended i.e. without limitation. There are also
certain guarantees (usually government
guarantees) which contain an automatic renewal
clause. In these instances banks would renew
them as and when they expire. These are also
viewed as open ended guarantees.

Chapter 8 Corporate Banking 45

 BANK GUARANTEES AND BID BONDS
• 8.18 STANDBY LETTER OF CREDIT
• Standby letters of credit are guarantees. These
are issued in the United States and a few
other countries. These undertake to make
payment in the event of failure to discharge
stated obligations.

Chapter 8 Corporate Banking 46

 BANK GUARANTEES AND BID
BONDS
.

Next Chapter 9
‘Letters of Credit
Chapter 8 Corporate Banking
’
47