International Trade and Finance: VII. Special Letters of Credit and Bank Guarantees

Prof. Dr.
Bernhard Müller
International Trade and Finance
VII. Special Letters of Credit

and Bank Guarantees
1. Introduction
2
© Prof. Dr. Bernhard Müller, 2013 all rights reserved
1. Introduction
a) Special credits are designed to meet the specific needs

of buyers, suppliers and intermediaries.
b) Special credits involve increased participation by banks,

so financing and service charges are higher.
3
2. Types of special credits
4
2.1. Standby Credit
a) In a standby documentary credit the issuing bank is

obligated to pay the beneficiary based on the non-
performance of the applicant.
b) A standby documentary credit is generally obtained and
held in reserve or paid out only as a result of non
compliance with some underlying contract.
c) Standby letters of credit can be used to secure the
following types of payment:
- Repayment of loans
- Receivables resulting from deliveries by third parties
- Non-performing documentary collections.
5
2.2. Revolving Credit
a) This credit is designed to facilitate ongoing relationships

between buyers and sellers where buyers wish to
purchase either a fixed maximum value of product per
period of time, a certain maximum value of product or
as much product as the seller can supply.
b) This credit form is used in situations where a buyer and
seller agree that goods will be shipped on a continuing
basis and where the parties to the credit wish to
establish one credit to handle all the shipments rather
than to establish L/Cs for each shipment.
6
2.2. Revolving Credit
c) The L/C can be designed on cumulative basis. Any sum

not utilized by the beneficiary during an installment
period may be carried over and added to a subsequent
installment period.
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2.3. Red Clause Credit
a) The credit is an obligation on the part of an issuing bank

to guarantee advance payment made by
confirming/advising bank to the beneficiary prior to
presentation of documents.
b) This type of credit is often used to assist manufacturers
in paying for labour and materials used in
manufacturing.
8
2.4. Transferable Credit
a) A transferable credit is characterized by the

beneficiary’s request that parts of the credit proceeds
will be transferred to one or more other parties who
become second beneficiaries.
b) This credit form is often used by sales agents who act as

intermediaries between seller and buyer.
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2.4. Transferable Credit
c) The buyer opens a L/C naming the intermediary as the

beneficiary who transfers both the obligation to deliver
the goods as well as part of the proceeds to the actual
supplier.
d) This system is used in situations where the intermediary

does not wish the buyer and the actual supplier to
know each other’s identity.
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3. The role banks in the L/C
process
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3. The role banks in the L/C process
a) So long as the documents presented to the banks

appear on their face to comply with the terms and
conditions of the credit, banks may accept them and
initiate the payment process as stipulated in the credit.
b) Banks may offer additional services beyond the L/C
process like providing guarantees or finance services
(purchase of drafts or deferred payments)
c) Banks are not liable for the acts of third parties like
freight forwarders, forwarding agents, customs
authorities or insurances.
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3. The role banks in the L/C process
d) Banks deal in documents and not goods, they assume

no responsibility regarding to the quantity or quality of
goods shipped.
e) Banks also assume no liability or responsibility for loss

arising out of delays or loss in transit of messages,
letters, documents.
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4. Bank guarantees in inter-
national trade
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4.1. Introduction
a) Guarantees are widely used in international trade to
support performance and payment obligations.
b) Bank guarantees may appear as true guarantees when the
guarantor is secondarily liable. Hence it follows that the
beneficiary cannot call for payment under the guarantee
until he can show that he has first requested repayment
of the debt from the principal without success.
c) It is also possible that a bank guarantee appears as on-
demand guarantee. In this form the guarantor is primarily
liable, the beneficiary has only to make a demand,
worded precisely as indicated in the guarantee and he will
be paid.
15
4.2. Types of guarantee
4.2.1. Bid bond:
a) The bid bond accompanies any bid by a supplier or

contractor seeking to win a contract abroad which has
been put out to tender.
b) It is a matter of fact that it is a very expensive procedure
for an overseas buyer to set up an invitation for tenders
which is advertised throughout the world.
16
4.2.1. Bid bond:
c) For that reason, the buyer cannot afford to allow a

supplier to walk away from a contract once it has been
awarded to him.
d) If a winner of an international tender doesn’t perform
anyhow, possible losses of the buyer resulting from the
re-launch of the tender process will be covered by the
bid bond.
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4.2.2. Performance bond:
a) Sometimes overseas buyers want to be certain that if a

contractor defaults or fails in ay way to carry out the
contract, they will be financially compensated for the
resultant loss.
b) The bond does not guarantee the supplier’s ability to
complete the transaction, it just provides for payment
of liquidated damages on financial assessment of the
principal’s loss.
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4.2.2. Performance bond:
c) Traditionally, this bond is payable on demand which can

lead to stressed bank-customer relationships in cases of
unfair calling since the guarantee issuing bank has to
pay on first demand although the exporter insists on
having carried out all his obligations.
19
4.2.3. Advance payment bond:
a) If necessary advance payments are generally for a

maximum of twenty per cent of the contract amount.
b) Understandably, the buyer wishes to ensure that he can
get his advance back if the seller fails to carry out his
obligations.
c) Therefore, he asks his bank, which makes the advance,
to obtain an advance payment guarantee issued by a
foreign bank acceptable to the buyer.
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Case study:
Your Egyptian customer „Cairo Heavy Industries“ has

opened in your favour through “Pharao Bank of Cairo” a
letter of credit which contains the following components:
- the l/c is irrevocable
- the l/c has to confirmed by an Egyptian bank
at Frankfurt only
- the l/c is denominated in US $
- the l/c is payable at Cairo.
Analyse the risk situation under the given circumstances
from the beneficiary’s point of view.
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Prof. Dr.

International Trade and Finance

VII. Special Letters of Credit

a) Special credits are designed to meet the specific needs

b) Special credits involve increased participation by banks,

a) In a standby documentary credit the issuing bank is

a) This credit is designed to facilitate ongoing relationships

c) The L/C can be designed on cumulative basis. Any sum

a) The credit is an obligation on the part of an issuing bank

a) A transferable credit is characterized by the

b) This credit form is often used by sales agents who act as

c) The buyer opens a L/C naming the intermediary as the

d) This system is used in situations where the intermediary

a) So long as the documents presented to the banks

d) Banks deal in documents and not goods, they assume

e) Banks also assume no liability or responsibility for loss

4.2.1. Bid bond:

a) The bid bond accompanies any bid by a supplier or

4.2.1. Bid bond:

c) For that reason, the buyer cannot afford to allow a

4.2.2. Performance bond:

a) Sometimes overseas buyers want to be certain that if a

4.2.2. Performance bond:

c) Traditionally, this bond is payable on demand which can

4.2.3. Advance payment bond:

a) If necessary advance payments are generally for a

Your Egyptian customer „Cairo Heavy Industries“ has

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