Letter of Guarantee

A letter of Guarantee is a written consent issued by the bank stating that if the concerned customer fails to make the payment for goods purchased from the supplier, then the bank will pay on the customer's behalf. It helps the supplier to have confidence in the transaction and supply the product. The bank/party assuming the responsibility to pay is termed the guarantor.

A loan letter of guarantee is usually issued when one party in the transaction is not confident that the other party might be able to fulfill their financial obligations. It is common during the purchase of expensive machinery or equipment. It is a common facet across industries such as construction, export and import businesses, and contracting.

A letter of guarantee refers to the motion of confidence from a bank on behalf of their customer during the purchase of goods or materials from a supplier. This letter is to reiterate that if the customer defaults on their payments to the supplier, the bank shall step in to pay the dues.

Bank and personal letter of guarantee is an important part of the economy now. It helps in the smooth running of the business across borders. A letter of guarantee has made the bond market more secure, and investors are willing to invest in risky bonds with bank guarantees.

It is also important to note that this letter does not cover the whole amount of the purchase. Banks negotiate and come to terms with their customers to reach a consensus on how much they will be able to cover if there is a default.

The banks charge an annual fee for this service, which is usually a percentage of the amount they will owe if the customer defaults. The application process for this service is similar to applying for a loan.

Other than drafting a loan letter of agreement, this arrangement is used at multiple other levels, across industries. Let us understand the different types through the explanation below.

• Bid Guarantee: A bid guarantee refers to a situation where a party submits a tender to complete a project for a government, large corporation, or company. Usually, this letter is attached to their tender proposal. The amount covered in these letters ranges from 2-5 percent of the project value.
• Shipping Guarantee: It is a common facet of the logistics industry that goods are lost during shipping quite often. To ensure all the goods are delivered at the right place and right time, this letter is attached to the contract between the two parties. It acts as an interim insurance for the receiver.
• Customs Guarantee: When large consignments are shipped, not all parties have the liquid cash flow to pay excise and customs duties immediately. Therefore, as an interim solution, they provide a letter of guarantee to ensure they fulfill these obligations as per the norms in due course of time mentioned in the letter.
• Performance Guarantee: When an individual or an entity bags the contract to do a specific job, there are two factors that come into play instantly- timely performance and quality of work. This type of letter requires a larger cash margin and collateral security and can be correlated to fulfilling a tender or with relation to the performance in a job.

Writing a personal letter of guarantee is a task filled with responsibilities and repercussions if the other party defaults. Therefore, it is critical to understand the intricacies of the concept and the steps involved in writing an appropriate letter sufficing the best interests of all parties involved. Below is a step-by-step guide on how to write a letter that ensures all bases are covered and all parties involved are satisfied.

1. The first step is to go through every document of the contract and understand the specifics of the agreement and if there are any clauses that have to be read between the lines and any hidden agenda from any of the parties involved.
2. After complete understanding of the contract is achieved, it is important to meet and negotiate the terms with the individual or the organization that is seeking for a guarantor. Since there is an inevitable risk involving this contract, the fee percentage must be clearly discussed and agreed upon.
3. Once the contract is understood and the terms have been negotiated with the party, it is important to draft the letter in such a way that it is clear to the supplier that the party intends to pay the amount or fulfill the task under the agreed circumstances. However, in unavoidable circumstances, if they default, which might or might not happen, the guarantor shall step in and fulfill obligations as per the agreement.
4. Once these steps are completed, the letter can be submitted for approval.

Let us understand the concept of a loan letter of guarantee and other such letters with the help of a few examples from different industries and scenarios.

Example #1 - Overseas Trade

Say there is a supplier of expensive antique products in Brazil. A customer from London wants to buy products from the supplier. The customer will not be willing to make the payment before the delivery of the product as he is thinking, what if the supplier doesn’t supply after receiving the payment. The supplier is also thinking the same way if the customer doesn’t pay after receiving the product.

So what the customer can do is go to a bank and apply for a “letter of guarantee.” In this letter, it will be written that if the customer doesn’t pay the money, the bank guarantees that the bank will pay. Once the customer has the letter, he can send it to the supplier, and in return, the supplier will send the goods to the customer as he will not have to worry about the default in payment. Bank will charge a fee for this service from the customer.

Example #2 - New Supplier in Business

When a supplier knows its customer very well, then he is fine in supplying goods to the customer without worrying. In the case of new suppliers, the supplier may want a guarantee that he will be paid once the customer receives the product. So, in this case, the customer will have to reach a bank and apply for a “letter of guarantee.”

Example #3 - Companies at Start-Up Stage

Companies during the start-up stage don’t have goodwill in the market. For them, getting products from the supplier is difficult without full payments. So they rely on a letter of guarantee to get products delivered to them.

Example #4 - Call Writer

In incall writing, if the share price increases, then an unlimited loss is probable. So in call writing the broker asks for cash or equivalent securities as guarantees. Many institutional investors maintain an investment account with custodian banks. So say that an institutional investor holds 1000 shares of ABC company and writes a call option on the shares.

Hence, if the share price starts to rise, he will lose money on the contract he has written. So for this, the broker needs the guarantee that he will pay when he incurs a loss. So the institutional investor can go to the custodian bank and ask for a letter of guarantee. As the custodian bank is holding the shares for the company, they can give a letter that if the share price rises, they can pay on the institutional investor's behalf.

Example #5 - Bond Issuance

It is common in the case of bond issuance. When a company issues bonds with a "letter of guarantee" by the bank, it is treated as a secured bond and trades at a premium. Here the bank may guarantee to pay the interest or principal or both in case of default.

Now that we understand the different aspects of the concept and even writing a personal letter of guarantee as a guarantor, let us understand how to get this letter from a bank or any other financial institution through the steps mentioned below.

The advantages of securing a loan letter of guarantee through the points below.

• It helps new businesses grow as banks help them get goods from suppliers.
• It helps in overseas trade and increases export and import.
• It protects the buyer of bonds from defaults.

Despite the advantages mentioned above and through other sections in the article, there are disadvantages that repel most players in the market. Let us understand them through the discussion below.

• It doesn’t guarantee 100% protection. If the claim amount is big, then the party who has acted as a guarantor may not be able to cover up the claim completely.
• As the bank acts as a guarantor, it enables bond issuers to issue more bonds than required, and if they default, the bank will make the payment. So the default rate increases.

This has been a guide to a letter of guarantee and its meaning. Here we discuss examples of letters of guarantee along with advantages and disadvantages. You can learn more about finance from the following articles –

• How Does Line of Credit Work?
• Causes of Credit Risks in Banks
• Types of Bank Draft
• Bank note
• Temporal Method