UNIT -3

The Companies Act 1980 introduced the legal term ‘quasi-loan’ in sections
concerning the restrictions on companies making loans to directors. A quasi-
loan arises when the company incurs a liability or agrees to incur such a
liability in circumstances when the director is under an obligation to reimburse
the company for the amount involved. An example would be where the
company holds a credit card and that card is used in a transaction for the sole
benefit of a director personally. The company has assumed a liability through
use of the card and the director, as beneficiary of the transaction, must
reimburse the company.

At some stage, every Business needs funding for smooth operations. There are
multiple funding sources available in the market for business organizations. Credit
Facility offered by Banks is one such source. It can be understood as an agreement or
arrangement between the borrower and banks where the borrower can borrow money
for an extended period. Credit Facilities are utilized by the Companies, primarily to
satiate the funding-needs for various business Operations. Banks on the other hand
earn profit from the interest incurred on the principal amount lent to the borrower.

The different types of Credit Facilities can be broadly classified into two parts:

 Fund Based Credit

 Non-Fund Based Credit.

Non-Fund Based Credit

On the Contrary, Non-Fund Based Credit is where the Fund is not transferred directly
to the borrower. It is offered to a third-party as agreed upon by the borrower, on
behalf of the Borrower.

The bank usually acts as a guarantee provider to the seller on the behalf of the buyer.
If the payment is not received by the seller within pre-agreed time, The bank pays the
amount to the seller. For e.g. Bank Guarantee, Buyer Credit, Letter of Credit, Supplier
Credit.
Following are the advantages of Non-Fund Based Credits:
1.It offers financial security to the seller if the buyer defaults due to any reason.
2. It offers Business expansion opportunities to the exporters.
The different types of non-fund based credit are

1. Letter Of Credit
A letter of credit is an assurance provided by the Bank to the seller on behalf of the
buyer that the seller will receive the buyer’s payment at regular intervals. It also states
that if the buyer fails to pay the seller for any reason, the Bank will be responsible for
the remaining or full payment.

Letter of Credit is offered based on the collateral of cash or certain securities. With the
rising international trading, Letter of Credit is becoming a crucial tool to manage the
payments between parties that hardly know each other and live in different countries
with different laws. The bank charges a certain percentage from the buyer as the fees
for offering the Letter of Security.

The Letter of Credit can be divided into the following parts:

A) Sight Credit
This letter of Credit is quicker than others. Here the Borrower can take the lender’s
funds by showing a bill of exchange and sight letter of Credit.

B) Revocable & Irrevocable Credit

Revocable Letter of Credits is the one that can be revoked or canceled by the issuing
bank without prior notice to any party.

Irrevocable Letter of Credit cannot be revoked or canceled by the issuing Bank. So

once the LOC is generated, Bank will have to honor the letter.
C) Confirmed Credit
In this type of Credit, a bank other than the issuing Bank confirms the Letter of Credit
by adding its confirmation. Only Irrevocable Letter of Credit is eligible for
confirmation.

D) Back-to-Back Credit
Under this type of Credit, the exporter requests the Bank to offer an LC to his/her
local supplier. The request is based on the export LC received by the exporter from an
overseas buyer. Here, an LC is issued based on an export LC and hence the name,
Back-to-Back Credit.

The advantages of a letter of credit to the buyer is as follows

1. Allows the buyer to trade with the parties from any corner of the world
2. The buyer can edit the terms and conditions that fit him/her after consulting
the seller.
3. It acts as a credit certificate for the buyer, and he/she can perform multiple
trades as a major financial institution like Bank backs him/her.
4. Letter of Credit offers better Cash flow to the buyer.
The advantages Of a  Letter Of Credit To seller is as follows

1. The seller receives the money on fulfilling the terms mentioned In the Letter of
Credit.
2. There is no risk of losing money for the seller if the buyer fails to pay the
money. Seller gets his/her dues from the Bank that has issued the Letter of
Credit.
3. The letter of Credit is easy to quick to avail based on good credit.
4. If there is a dispute in trading, the seller can withdraw funds from the Bank
even when the case is pending.
2. Bank Guarantee
Under this type of Credit, Bank offers assurance that under any circumstances, the
Guarantee issuing Bank will fulfill any financial losses incurred by the protected party
as mentioned in the Contract.

Let’s take a look at different guarantees

A) Financial Guarantee
In this type of Guarantee, the Guarantor takes responsibility for the Borrower. This
means, if the Borrower fails to repay the debt, Guarantor will be liable to pay the
unpaid amount.

B) Performance Guarantee
The Guarantor issued a security bond that assures the lender that the Contractor will
complete the work satisfactorily in the stipulated time.

C) Deferred Payment Guarantee

This type of Guarantee is usually given on deferred or postponed payments. The
banks generally offer DPG on the purchase of certain machinery and goods.

3. Letters Of Comfort For Availing Buyers Credit

Letter of Comfort can be understood as the Guarantee offered by the Bank of Importer
or buyer. The Importer can use this Letter of Comfort to avail Buyer’s Credit from the
Overseas banks. The Importer or Buyer’s Bank charges certain fees for offering the
Letter of Comfort.

4. Derivative Products
Derivatives are a type of financial security or financial contracts that are backed by
some underlying securities. These underlying securities can be anything, ranging from
currencies, bonds, commodities to stocks.

5. Buyer Credit
It is a short-term funding option, offered to the Indian Buyers or Importers by the
Bank to manage their import Business. Using Buyer’s Credit, the Importers can avail
loans from foreign financial institutions which offer Credit at comparatively lower
rates. Buyer’s Credit can be availed for importing almost all types of capital and non-
capital goods.

6. Supplier Credit
This type of Credit is used to support the importers financially in India. Here any
overseas Financial Institute or Supplier offers the Credit to the Importer on the Libor
rates, which are comparatively low. Such Credit is backed by the Letter of Credit
offered to the Importer via Importer’s Bank.
Assessment of LC limits

The assessment LC/LG limits are fixed by banks based on annual consumption of  raw material
to be purchased against LC or LG. The raw material holding in terms of consumption is worked
out as under.
Ascertain from customer the requirement of Consumption of Material (CM) per annum, which
is  to be purchased under LC or LG
(Procurement Time or Lead time means the time taken in recving the goods including transit
period after the LC is opened)
If the material is purchased under credit, add usance period or  Credit Period (CP) to
procurement time.
We get Total Time (TT) when we add credit period to procurement period. TT=PT+CP
If CM is Annual Consumption of Material to be purchased against LC or LG
We can compute the LG or LC limit required to the company by dividing the annual
consumption of raw material to be purchased against LC or LG and same is divided by 12 and
multiplied by total time.(i.e.Monthly purchases ×total time) . Note: Purchase value of goods for
assessment of LC is done on the basis of CIF (cost, insurance and frieght) of goodsWht is EOQ-
economic order quantity which is calculated by source of supply,means of transport and any
discount.
Thus the formula for LC/LG Limit=CM×TT ÷ 12
However, if minimum quantity  (EOQ-economic order quantity) to be procured is more than the
limit arrived, such request should be considered. This equation is to be adapted for LC under DA
terms as well as for inland LG.( The EOQ-economic order quantity is calculated taking into
account of source of supply,means of transport and any discount for order of larger quantity etc.).
Illustration 1: calculation of DP- LC limit:
(i)Total annual purchase: 12000000
(ii) of which purchase under LC (50%) :6000000
(iii) Of import of RM under LC (50%): 3000000
Assessment of Inland LC:
Lead time: 2 months
Monthly purchase for indigenous RM (6000000-3000000)/12 =2, 50,000
Therefore, Inland LC requirement (Monthly purchase x lead time i.e 250000×2 = 5, 00,000……
(A)
Assessment of import LC:
Monthly purchase of import RM (3000000/12) = 250000
Lead time: 4 months
Import LC requirement: 250000×4= 1000000 (B)
Total LC requirement (A+B) = 500000+1000000= 1500000 i.e. LC limit of Rs.15 lakh with the
sublimit of Rs.10 lakh for import LC and Rs.5 lakh for domestic LC.
Illustration 2 : Calculation of LC-DA limit
In the above example assume that there is usance of 2 months available in both for domestic and
import cases. While assessing the LC under Usance, the usance period is to be added to the lead
time.
 Inland LC requirement= (monthly purchase x (lead time+ usance period
= (250000 x (2.00+2.00) = 10, 00000
 Import LC requirement =(monthly purchase x (lead time+ usance period)
= (250000 x (4.00+2.00) = 15, 00000
Total LC requirement (i) +(ii)= 25 lakhs with the sublimits of Rs.10 lakh for domestic   LC and
Rs.15 lakh for import LC.
Illustration 3: Calculation of (import) DA- LC limit with EOQ (Economic order quantity)
Total annual purchase of import RM = 30 00000…………. (A)
Monthly requirement of import RM=250000………………   (B)
Minimum order level (EOQ) = 1000000……………………….. (C)
No. of LC required to be opened (A/B) 3000000/1000000=3………  (D)
Frequency of LCs: (12/ No. of LC required to be opened) =12/3 =4 months…………………… (E)
Therefore Import order will be placed under LC once in 4 months.
However,Credit (usance)available for 6 months and lead time is 2 months
Total lead time is (2+6) = 8 months…………………………………  (F)
Since the second order of RM under LC shall be placed by the customer before the retirement of
first LC is for Rs.10lakh, therefore LC outstanding at any point of time shall be less than Rs.20
lakhs.
In the instant case Import LC requirement without EOQ:
LC limit without EOQ = (monthly purchase x (lead time+ Usance period)
= (250000x (2.00+6.00) = 2000000/- (Twenty Lakhs]

Bills Purchase/ Discounting under LC

Process flow of Letter of credit:

Terms of Contract: When both the parties agree, they determine the nature of business
and type of goods the seller should supply to the buyer. Given the contract, a letter of
credit is being issued between buyer and seller.

Issuance of LC: Buyer approaches the issuing bank to issue the LC in favor of seller
and sellers bank i.e. confirmation bank which will pay to the seller on behalf of the
buyer.

Documents and payment: As per LC terms, the seller will submit documents to
confirmation bank, for the payment which includes Bill of Exchange, packing list, e-way
bill. Then these documents are forwarded to issuing bank if there is no discrepancy in
the documents the issuing bank will honor the LC. Finally, the documents are submitted
to the buyer, only if the payment is made by the buyer.

If the above process is clear, what if the seller requires funds immediately and not on
the due date. In that case, the discounting of LC becomes a great tool. LC discounting
is a short- term credit facility provided by the bank to the seller. In this case, LC issuing
bank confirms all the original documents and provide acceptance to the confirming
bank. After the due diligence from the bank, the seller will get the credit amount after
deducting the discount. The bill discounting is categorized into two types namely sales
and purchase. If the discounting is done by the seller, it is the sales side and the buyer
will be called purchase side bill discounting. The rates of discounting vary depending
upon the amount, period and creditworthiness of the client.

Advantages of LC Discounting

 It speeds up the cash flow and helps in the smooth flow of the working
capital
 LC discounting takes away the risk and gives assurance to the seller for
the funds
 It is customizable and both the parties can mutually arrive at the list of
clauses for the payment
 LC assists in boosting the business through various geographies.

Disadvantages of LC Discounting

 In LC discounting, there is no physical verification of the quantity and

quality of goods.
 There is a set of documentation which needs to be followed by both
seller and buyer, which can be tedious due to non-availability for the
same.
 The final amount which is credit is less, due to being discounted by the
bank.
Loan commitments, Un-funded lines of credit and their Characteristics

Loan Commitments

A loan commitment is an agreement by a commercial bank or other financial institution

to lend a business or individual a specified sum of money. A loan commitment is useful
for consumers looking to buy a home or a business planning to make a major purchase.

The loan can take the form of a single lump sum or in the case of an open-end loan
commitment a line of credit that the borrower can draw upon as needed (up to a
predetermined limit).

Financial institutions make loan commitments based on the borrower’s creditworthiness

and in if it’s a secured commitment on the value of some form of collateral. In the case
of individual consumers, this collateral may be a home. Borrowers can then use the
funds made available under the loan commitment, up to the agreed-upon limit. An open-
end loan commitment works like a revolving line of credit: When the borrower pays back
a portion of the loan’s principal, the lender adds that amount back to the available loan
limit.

A loan commitment is a formal letter from a lender stating that the applicant has met all
of the qualifications for receiving a loan, and that the lender promises a specific amount
of money to the borrower.

Many loan commitments are open-ended, meaning the loan is not just a one-time, lump
sum payment that the borrower must pay back. Instead, the borrower can continue to
use this amount as long as he or she keeps paying it back. This makes it similar to a
revolving line of credit, such as a credit card. If the borrower uses a portion of the loan
amount and pays it back, the lender applies the payment to the borrower’s principal
balance.

An open-ended loan commitment is contingent upon the borrower’s credit status and
requires meeting certain qualifications. A loan commitment can be either secured or
unsecured. An unsecured loan requires no collateral, but a secured loan does.

Un-funded lines of credit and their Characteristics

An unfunded line of credit is one that a bank issues to a borrower, but is not borrowed
upon at the moment it is issued. The bank or lending institution will honor any future
draws upon the unfunded line of credit, but does not need to make any money available
until the moment the customer requests it.
Borrowers Of Unfunded Lines of Credit

Borrowers of unfunded lines of credit can be either individual retail customers or

businesses. Businesses such as hedge funds and insurance companies are customers
of unfunded lines of credit, and they most commonly use them as an emergency fund.
Retail customers can also acquire unfunded lines of credit in the form of home equity
lines. Unfunded loan commitments, whether to retail or corporate clients, represent
liabilities to both borrowers and banks.

Risk Of Borrower Default

A borrower can default after drawing upon the line of credit, causing a major problem for
the bank which acted as a lender. For example, if a major catastrophe happens which
requires an insurance company to pay out claims for which it does not have sufficient
cash reserves, that insurance company may draw upon its unfunded line of credit. If the
insurance company is unable to pay back what it borrowed from the bank and files for
bankruptcy, the bank must count the unrecovered money as a loss.

Risk Of Bank Default

Unfunded lines of credit pose major risks for banks. Because the bank must honour the
line of credit at any given point in the future, it must have enough cash to do so. If a
bank issues too many unfunded loan commitments, and a high number of them are
unexpectedly drawn upon, the bank will be unable to honour the loan commitment.
Banks are required to report unfunded lines of credit quarterly to the United States
government’s Federal Deposit Insurance Corporation. Every bank limits the number of
unfunded credit lines it will issue to mitigate liability.

Typically, unfunded commitments are separated into two categories:

Multiple Advance, Closed End: This type of loan (typically a construction loan)
advances incremental amounts up to a certain limit, based upon some criteria such as
inspection and approval of a draw request. Any principal reductions received during the
loan period are not available to be drawn on, but rather have paid down the loan
balance.

Revolving or Open End: This type of loan (known informally as a Line of credit) allows
the borrower to continue to borrow up to the original loan amount. Principal reductions
are immediately available for future advances.
Various types of Bank Guarantees: Performance Guarantee, Financial
Guarantees, Deferred Payment Guarantees
Performance Guarantee

Performance guarantee is used as collateral in transactions involving a buyer and a seller. A

performance guarantee is typically invoked if the buyer incurs cost and the seller does not deliver
goods or services as promised in the contract. To invoke a performance guarantee, the
beneficiary requires to declare in writing that the seller did not fulfil his or her contractual
obligations properly or on time.

The bank has to discharge the financial liability of the contract agreed in the guarantee, if the
contract is partly or fully not performed by the customer. Such type of guarantees issued by the
bank is called Performance Guarantee. Many a time the terms of the contract may be of highly
technical in nature and bank is generally not expected to know the technical aspects of the
contract. Therefore, the bank assumes only the financial liability of the contract. Since the
issuance of performance guarantee is more complicated and riskier, before issuing performance
guarantees, the bank has to ensure that the customer has sufficient experience in the line of
business and he has capacity and means to carry out the obligation under the contract.

Financial Guarantees

A financial guarantee is an undertaking from a bank to take responsibility for another company’s
financial obligation if that company does not meet its responsibility. The bank provides financial
guarantees mostly between two related parties, i.e., a partner company providing a financial
guarantee to a subsidiary company.

This cash security provided by the contractor or supplier is forfeited by the Government
Department or the company which awarded the contract, in the event the contractor or supplier
fails to comply with the terms stipulated in sanction. The customer normally will have an option
to furnish a bank guarantee in lieu of cash security, so that his working funds are not
unnecessarily blocked. The guarantees issued by banks for above purpose is called financial
guarantee wherein the banks undertake to pay the guaranteed amount during a specified period
on demand from the beneficiary. The examples of Financial Guarantee are as under.

Deferred Payment Guarantees

Deferred payment guarantees are used when one party in a transaction undertakes to make
payment of fixed amount at corresponding times in the future. In case, the debtor is unable to
pay, then the deferred payment guarantee can be invoked to claim the money. Thereby the
buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the
total consideration of the contract of sale/supply. The seller avail the refinance from his bank
against co-accepted bills. DPG involves substitution of the term loan. Hence procedure
applicable for assessment of term loan must be followed for DPG limit viz. projection under
operating statement, Funds flow statement, DSCR, BEP etc.

Types of Performance and Financial Guarantees, Assessment of Bank

Guarantees Limit, Period of Claim under Guarantee
Types of Performance Guarantees

Performance guarantee is the agreement between a client and a contractor to assure

the client to perform the contractor’s obligation as per agreement.

In this respect, the Bank gives an undertaking to its client that contractor will do their job
as per agreement. If the contractor fails to perform his duties as per contract, the bank
will pay the damage up to the guaranteed amount. This guarantee might include a
clause to protect the client against the losses incurred if the contractor fails to perform.

There are different types of guarantees that a bank will offer to its clients and parties.
Following two types of Guarantees are very familiar and commonly used in the
corporate field. These two are:

Advance Payment Guarantee

Advance taken from the buyer is a very common practice in today’s business. In this
respect, the bank provides a guarantee to the buyer that the money given by him to the
seller against advance payment to deliver the required goods. If the seller fails to
comply with the requirements mentioned in the sale agreement, the seller will be liable
to back the amount to the buyer. The Bank offered the guarantee to back the advance
payment for non-compliance with the conditions.

Tender Guarantee

This guarantee is also referred to as the “Bid Bond” guarantee. Both in International
Tender and Local Tender, this guarantee is used where a contractor/supplier is obliged
to comply with the conditions as mentioned in the agreement.

Types of Financial Guarantees

A financial guarantee is a contractual promise made by a bank, insurance company, or
other entity to guarantee payment of a debt obligation of another party such as a
company. Essentially, a financial guarantee is a type of warranty attached to a debt.
Individuals may also provide financial guarantees, such as when a parent co-signs a
loan for their child.

Types:

1. Individual financial guarantees

Financial guarantees provided by individuals occur all the time. Parents with good,
established credit may become a guarantor of debt by co-signing a loan agreement or
rental agreement for one of their children who lacks an established credit history or has
a poor credit rating.

2. Bond guarantees

Many bonds issued by companies are supported with a financial guarantee of the
bond’s payments to investors by an insurance company. In such cases, the insurance
company may provide either a full or partial guarantee of the bond payments due.

3. Financial guarantees from companies

Public or private companies commonly provide financial guarantees for their subsidiary
companies. The parent company of a subsidiary typically has more extensive financial
resources than the subsidiary company does. Therefore, if the subsidiary is seeking a
large loan, the lender may require the parent company to act as a guarantor of the loan.

The lender may simply require a contractual obligation by the parent company to cover
the debt repayment if necessary, or it may require that the parent company pledge
assets as collateral for the loan. A company involved in a joint venture may also act as a
guarantor of a debt obligation if it is financially much larger and financially sound than its
partner in the joint venture.

4. Bank financial guarantees

Banks frequently provide a wide variety of financial guarantees for their clients. One of
the most commonly issued types of bank guarantees is a guarantee of payment to a
seller by a buyer. Such a guarantee is often used in the case of large international
transactions. As the seller may not lack sufficient knowledge about the buyer, they may
require a guarantee of payment from the buyer’s bank.
The buyer’s bank may, in turn, require the buyer to deposit the necessary funds for the
purchase with the bank. A bank may also provide what is known as a performance or
warranty bond that essentially guarantees that the goods provided to a buyer are as
promised and delivered as agreed by contract with the seller.

Banks also sometimes provide an advance payment guarantee, which is a promise to

refund any advance payment on goods made by a buyer in the event that the seller fails
to deliver the goods.

Assessment of Bank Guarantee Limit

Bank Guarantee a promise made by the bank to any third person to undertake the
payment risk on behalf of its customers. Bank guarantee is given on a contractual
obligation between the bank and its customers. Such guarantees are widely used in
business and personal transactions to protect the third party from financial losses. This
guarantee helps a company to purchase things that it ordinarily could not, thus helping
business grow and promoting entrepreneurial activity.

The advantages are:

 Bank guarantee reduces the financial risk involved in the business

transaction.
 Due to low risk, it encourages the seller/beneficiaries to expand their
business on a credit basis.
 Banks generally charge low fees for guarantees, which is beneficial to
even small-scale business.
 When banks analyse and certify the financial stability of the business, its
credibility increases and this, in turn, increase business opportunities.
 Mostly, the guarantee requires fewer documents and is processed
quickly by the banks (if all the documents are submitted).

Features of a Valid Guarantee

 The period until which the guarantee holds is clearly specified

 The guarantee issuance is always for a specific amount
 The purpose of the guarantee is very clear.
 The guarantee is valid for a particular period of time.
 The grace period allowed to enforce guarantee rights is also stated in
the guarantee
 Guarantee clearly states the events under which it is enforceable.
Period of Claim under Guarantee

“Exception 3; Saving of a guarantee agreement of a bank or a financial institution: This

section shall not render illegal a contract in writing by which any bank or financial
institution stipulate a term in a guarantee or any agreement making a provision for
guarantee for extinguishment of the rights or discharge of any party thereto from any
liability under or in respect of such guarantee or agreement on the expiry of a specified
period which is not less than one year from the date of occurring or non-occurring of a
specified event for extinguishment or discharge of such party from the said liability.”

That said, the banks have often been stipulating a claim period of one year, or in some
instances of less than one year.