Guarantees and Standby Letters of Credit

BANK GUARANTEES
&
STAND BY LETTERS OF CREDIT
1
Faculty of Management and Commerce ©Ramaiah University of Applied Sciences
WHEN A GUARANTEE OR A STAND BY LETTER OF
CREDIT IS AN ALTERNATIVE
Instead of cash collateral
When there is a need for an

additional security
When the financial strength

of the counter party is
uncertain
2
HOW GUARANTEES &
STANDBYS CORRELATE TO THE
COMMERCIAL EVENTS
Commercial event
Invitation for tender
Tende Contract Partial delivery Installation Take over Warranty period

r Advance
Payment
Time
Type of
Guarantee
Performance guarantee
Bid guarantee Advance payment guarantee Retention guarantee Warranty guarantee
Validity period
& amount
3
ADDITIONAL TYPES OF
GUARANTEES AND STANDBYS
Payment guarantee
Transfer guarantee
Loan/Credit guarantee
Customs guarantee
Duty exempt guarantee
Judicial guarantee
Guarantees in favor of governmental

entities
Rental guarantees
4
THE PARTIES INVOLVED IN A
GUARANTEE OR STANDBY
The underlying contract
Principal Beneficiary
Letter of indemnity
Direct Guarantee Local Guarantee
or
Counter Guarantee
BANK– Guarantor/ Guarantor

Instructing Party
5
THE TWO MAIN PRINCIPLES
Suretyship guarantee - ”as for a

debt of our own”
or
Demand guarantee - ”we hereby

irrevocably undertake to pay
you any sums or sums not
exceeding ......upon receipt by
the BANK of your first demand
in writing and your written
statement stating .....”
6
SURETYSHIP GUARANTEES
The underlying transaction or contract must be presented

to your bank before issuance of the guarantee
Suretyship guarantees are dependent on the underlying

legal obligation or the contract
The Guarantor is entitled to make the same objections

against a claim as the Principal
Consequently the Guarantor can wait for a legally binding

arbitration award or judgement or written agreement between
the Principal and the Beneficiary
7
DEMAND GUARANTEES
By their nature a separate transactions from the underlying
contract
The Guarantor’s duty is to pay on Beneficiary’s first written

demand and statement
The Guarantor must pay without any objections if the

Beneficiary claims in accordance with the terms & conditions of
the guarantee.
A Demand Guarantee could be enhanced with documentary

support, e.g. a court decision, an arbitration award etc. (see
article 2a URDG 458).
8
STANDBYS
The Standby is essentially the same as a
Demand Guarantee
Its appearance is different from a typical Demand

Guarantee issued by banks outside of the US
The essence of a Standby is that the issuer (the Bank)

promises to pay the Beneficiary upon presentation
of documents as stipulated in the Standby
ICC, however, applies a set of different rules for

Standbys (ISP98).
9
CLEAN STANDBYS IN FAVOR OF THE INSURANCE
COMMUNITIES
Silent to the underlying

reference/contract
Evergreen clause
Only one single draft
More than one beneficiary
Often governed by UCP
10
MULTI PARTYGUARANTEES
AND STANDBYS
Issued for the account of two or more Principals/

Applicants
Issued by two or more Issuers
Issued in favor of two or more Beneficiaries
11
TO TAKE INTO CONSIDERATION BEFORE ISSUING
A STANDBY
Commercial Letter of Credit vs. Standby Letter of

Credit
Expiry date
Confirmation vs. Counter-Guarantee
Law & Jurisdiction

Rules UCP600 vs. ISP98
12
RULES OF PRACTICE FOR
GUARANTEES AND STANDBYS
•International Standby Practices - ISP98
•Uniform Rules for Demand Guarantees - URDG

458
•Uniform Customs and Practice for

Documentary Credits - UCP500 (600)
13
PAYMENT UPON PRESENTATION OF THIRD PARTY
DOCUMENTS
Demand +
Demand + Demand +
Judgement or
Independent Beneficiary’s
Arbitration Award
Statement
Assessment
• •
Max Mini
Security
•
Security
•
Suretyship Guarantee
•
Demand +
Architect/Engineer
Certificate
14
TO TAKE IN TO
CONSIDERATION BEFORE
SIGNING THE CONTRACT
•Type of guarantee
•Reference to the Max amount

underlying contract
Reduction clause
•Rules - URDG458, ISP98
or UCP600
Foreign bank’s charges
•Documents to be
Templates and
presented
language Law and

•Time of validity/expiry
date
Jurisdiction
Types of credit
Security to beneficiary
 Confirmed
 Mode of settlement
 Payment/ deferred payment
 Acceptance
 Negotiation
Involving middlemen
 Transferable
 Back to
back advances
Involving
 Red Clause Credit
 Green Clause Credit
Involving repeated transactions
 Revolving
 Stand by
9 16
Transferable Credits
• Credit has to be opened as transferable
• The beneficiary is normally a trader or agent
• He transfers credit to his supplier - second beneficiary.
• Transferred by a bank at the request of first beneficiary
• Second beneficiary can supply goods and negotiate documents as
if he had received the credit.
• He may pay commission to first beneficiary for the order
• There can be more than one second beneficiary.
• No third beneficiary is permitted.
10 17
Transferable Credits
• The following parameters may be changed while
transferring a credit
– Amount of credit, unit price and quantity of
goods
– Date of expiry, last date of shipment and last date of
negotiation can be brought forward
– % of insurance cover may be increased.
•
First beneficiary has the right to substitute documents
negotiated by second beneficiary.
11 18
Back to Back Credits
• Exporter receives a credit from his buyer ( Selling credit)
• He has to procure goods from other suppliers
• He opens a credit for purchase of the goods ( buying credit)
• Second credit is said to be back to back to the first one.
• Bill proceeds of the export LC (Selling LC) will be used to meet
liabilities under the second (Buying LC)
• Amount of back to back credit will be lower.
• Usance period of the back to back credit should be equal to or more
than that of the export credit.
• Bank still at risk if the customer fails to export
• No concession in margin and security norms.
12 19
Revolving Credits
• Credit is opened to cover a series of regular transactions over a
longer period
• Beneficiary will submit a series of documents
• Maximum value of each document will be fixed and is the
revolving limit
• LC amount is the maximum value of documents that can be
handled under the credit.
• The credit may be reinstated automatically or after payment of
earlier bill.
• It can be opened as cumulative or non cumulative.
13 20
Standby Letters of Credit
• Credit is issued for a particular amount and for a particular period
• Trade takes place on running account basis.
• Beneficiary does not submit documents to bank.
• If there is a default, he can claim funds from opening bank giving
a certificate of default
• No quibbling over discrepancies and documents
• Opening bank will pay on demand
• Works like a bank guarantee
• UCPDC is applicable if so declared in the credit
14
21
LC Regulations
• Foreign Trade Policy requirements.
• FEMA requirements.
• Credit norms of Central Bank.
• UCPDC 600 Provisions.
• Bank’s Internal Credit Policies/ procedures.
• Public notices issued by DGFT
• Uniform Rules for bank-to-
bank reimbursements 525
• Incoterms 2010
15
22
Bank’s Obligation & Responsibilities
• Issuing Bank (opening bank)
( UCP Article 7)
-the prime obligator
-to ensure credit-worthiness and trust-worthiness
of the applicant
- Once credit is opened, the bank is placing itself
as a substitute for the buyer.
16
23
• Advising Bank has the obligation to

authenticate the credit once it is received
and passing it promptly on to the beneficiary
( Art.9).
• Confirming Bank takes over the
responsibilities of the issuing bank as far as
the beneficiary is concerned though it has
got recourse to the Issuing Bank (Art 8).
17
24
Negotiating Bank
• to examine docs. Within 5 banking days
after receipt of the documents at their
counters(Art 14b).
• to ensure compliance of credit terms ( on
the basis of documents alone) as well as
consistency of docs with each other.
18
25
Protection to Banks
• Banks are not responsible :
for the genuineness or contents of any
documents submitted (Art. 34)
For losses etc. arising from transmission
problems (Art. 35)
Force Majeure ( Art. 36)
For the failings of their correspondent Banks

(Art. 37) 19
26
Protection to Banks
• Issuing Bank is responsible for all Bank

charges and other costs at home or abroad
even if they are supposed to be paid by other
party (Art. 37 c).
• Applicant is responsible for any adverse

consequences of foreign laws (Art. 37d).
20
27
LETTER OF CREDIT
Appraisal / Assessment
• satisfactory track record.
• dealings with only one bank.
• Liabilities of the applicant to the Bank and third
parties.
• Means by which the applicant is expected
to meet his commitment once the bills
arrive.
• Margin he should deposit.
21
28
Appraisal Issues..
• Limit to be commensurate with turnover and

CC limits.
• Should be for genuine trade/ manufacturing
activity.
• Usance period of the LC should ordinarily have
relation to the working capital cycle.
• Level of inventory carried should be commensurate
with industry norms / past trends.
22
29
Appraisal Issues….
• LCs for purchase of machinery / capital goods should be
backed by borrower’s own funds or a term loan
sanctioned for the purpose.
• Wherever warranted, in addition to margin, where

prescribed, we may also retain a lien on the undrawn
portion of the CC limit for the value of bills to be
received under the LC.
23
30
Appraisal Issues
• Sister concerns:
– Where the opener and beneficiary are sister concerns,
LCs should not normally be necessary.
– Take care of kite-flying operations.
– Standing of the beneficiary.
• D/A facilities to applicants of undoubted standing and
where security available is much more than the value of
LC.
24
31
Appraisal Issues
• While computing purchase of imported material on LC
basis take net of import duty.
• Assess limits for usance and sight LC separately.
• Usance period should not exceed the production cycle
excepting in the case of bulk imports.
• Keep in mind the accepted projections regarding Sundry
Creditor levels.
• Margins & security depending on track record.
• Cash budget monitoring to track availability of funds.
25
32
Appraisal Issues….
Revolving LCs:
– To be valid for not more than 1 year
– The limit should be a sub-limit.
– The LC value should be restored for further
negotiation only after the advice of retirement of the
previous bill has been received from the issuing bank
by the beneficiary bank.
26
33
ASSESSMENT OF LC LIMIT
• While assessing Letter of Credit Limit, the
following points need to be noted:
 Purchases of RM on LC basis should be net
of Import Duty; LC amount should cover FOB,
or C&F value of goods- should not include
CIF
customs duty and other charges payable in India.
Payment of these charges should be taken care of
by the main working capital(CC) A/C of
Applicant.
 Transit time should be treated as ‘Nil’ if usance
period starts from shipment date.
27
34
Other issues
Arriving at D.P:
– Ensure that the stocks covered by bills which have been
received under LCs opened by us, and not yet retired, are not
included for computing the D.P. in CC account.
Devolvement of LCs:
– In case of irregularity in CC account do not open further LCs.
– Take adequate margins and step up in case of it becoming a
habit – in worse cases stop further issues.
– Mark lien on DP so that usance bills are properly retired on due
date.
28
35
Treatment of stocks covered by Usance
LC
Lien should be earmarked against advance value of
stocks for the outstanding usance LC bills.
This ensures provision of margins on the stocks covered
by usance LCs right from the time the stocks are bought
on credit backed by the Bank’s commitment.
Thus, it ensures that the margin is available well before
the CC a/c is debited for the matured LC bill.
29
36
Treatment of stocks covered by Usance LC
In some cases it is quite possible that the units

may not be in a position to provide margins right
from the time of purchases against LCs. In such
cases, based on merits, earmarking of lien for the
value of usance LC bills outstanding may be
permitted against the aggregate ‘market value’ of
stocks (including the LC stocks) instead of against
the ‘advance value’ of securities.
30
37
Precautions
The limits for demand LCs and usance LCs should be
assessed separately with ample justifications.
The usance period should not, generally, exceed the
production cycle.
In case of bulk imports, establishment of LCs for longer
usance period may be considered selectively.
When liability under LC is met by creating an
irregularity in the Cash Credit account, the relative LC
limit should not be released for opening further LCs till
the account is adjusted.
Frequent Devolvement's: Warning signal!
31
38
Assessment of LC Limit
• We assume that:
- Annual consumption of material to be
purchased under LC ……… C (Rs..)
- Lead time from opening LC
to shipment: L (months)
- Transit time: T
- Credit (usance) period available: (months)
U (months)
32
39
• L+ T+ U = Purchase Cycle: P (months)
• LC Limit = P x C/12
Say, lead time, i.e. time from order placement
to shipment = 10 days
Transit period = 20
days Usance period from arrival of goods=
3m Total Purchase Cycle = 4m
Monthly consumption of material = Rs 100
lacs
LC Limit(4 x 100) = Rs 400 lacs
33
40
ASSESSMENT OF LC LIMIT :
M/s XYZ COMPANY LIMITED
LETTER OF CREDIT LIMIT OF Rs. 20 CRORES
(Rs. in crores)
Total purchase of Raw Materials (RM) 172.64
Purchase of RM under LC 69.41
Average monthly purchase of RM [A] 5.78
Average usance period [B] 3 months
Lead time & transit period [C] 1 month
Total of [B] & [C] [D] 4 months
Requirement of LC Limit [A] x [D] 23.12
LC Limit recommended 203.400 41
• Let us assume as follows: (Rs in lacs)
i) Annual purchase of RM: 3200
ii) RM purchase under LC(50%): 1600
iii) Purchase under demand LC:
800
iv) Purchase under usance LC:
800
35
42
Assessment of Demand LC
Limit
• Time gap from opening till shipment: 1m
• Transit period from date of shipment till date of
retirement:
0.5 m
• Demand LC Limit: 800 x 1.5/12 = Rs 100 lacs
36
43
Assessment of Usance LC Limit
• Lead Time, i.e from opening
LC till shipment: 1 month
• Transit Period, i.e. from
date
of shipment till date of receipt of documents by
importer: 0.5 months
• Average usance period: 2 months
• Usance LC Limit: 800x3.5/12= Rs 233 lacs
37
44
46

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Guarantees and Standby Letters of Credit

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BANK GUARANTEES

STAND BY LETTERS OF CREDIT

Instead of cash collateral

When there is a need for an

When the financial strength

Invitation for tender

Tende Contract Partial delivery Installation Take over Warranty period

Bid guarantee Advance payment guarantee Retention guarantee Warranty guarantee

Duty exempt guarantee

Guarantees in favor of governmental

The underlying contract

BANK– Guarantor/ Guarantor

Suretyship guarantee - ”as for a

Demand guarantee - ”we hereby

The underlying transaction or contract must be presented

Suretyship guarantees are dependent on the underlying

The Guarantor is entitled to make the same objections

Consequently the Guarantor can wait for a legally binding

The Guarantor’s duty is to pay on Beneficiary’s first written

The Guarantor must pay without any objections if the

A Demand Guarantee could be enhanced with documentary

Its appearance is different from a typical Demand

The essence of a Standby is that the issuer (the Bank)

ICC, however, applies a set of different rules for

Silent to the underlying

Only one single draft

More than one beneficiary

Often governed by UCP

Issued for the account of two or more Principals/

Issued by two or more Issuers

Issued in favor of two or more Beneficiaries

Commercial Letter of Credit vs. Standby Letter of

Confirmation vs. Counter-Guarantee

Law & Jurisdiction

•International Standby Practices - ISP98

•Uniform Rules for Demand Guarantees - URDG

•Uniform Customs and Practice for

•Reference to the Max amount

language Law and

• Advising Bank has the obligation to

For the failings of their correspondent Banks

• Issuing Bank is responsible for all Bank

• Applicant is responsible for any adverse

• Limit to be commensurate with turnover and

• Wherever warranted, in addition to margin, where

In some cases it is quite possible that the units

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