Guarantee

What is a Guarantee?

A guarantee is a legally enforceable contract in which a guarantor agrees to fulfill a borrower's obligations if the borrower defaults.  It ensures that the guarantor will reimburse the lender if the borrower defaults.

Any third party may sign a guarantee; however, the guarantor typically has a financial or personal relationship with the borrower.

For example, a corporation might receive a commercial credit line secured by personal guarantees from one or more of its business owners. Given that the borrower has little to no income at the time of underwriting, the borrower's parent(s) may be backing a student loan in the context of personal lending.

The lender views a guarantee as an additional form of security that reduces credit risk. Generally, a guarantee does not make a high-risk loan low-risk, but it can enhance the attractiveness of an already sound loan for lenders.

Aspects of a Guarantee

Guarantees come in various formats and variations. When drafting any guarantee, it is essential to consider the following issues:

1. Extent of Liability: Clearly define the scope and limits of the guarantor's liability.
2. Several or Joint Liability: Determine whether the guarantee is several (each guarantor is liable for their share) or joint (all guarantors are collectively liable).
3. Specific Obligations Guaranteed: Specify the particular obligations or debts covered by the guarantee.

Additionally, it is crucial to precisely express:

1. Circumstances for Calling the Guarantee: Clearly outline the conditions under which the guarantee can be invoked.
2. Guarantor's Liability Timescale: Define the time period during which the guarantor can be held liable.

The conditions in the home country of your trading partner

Before signing the contract, ensure you understand your country's terms clearly and are aware of the conditions in the countries you deal with. Domestic responsibilities may differ significantly from those in other countries, leading to potential discrepancies in obligations.

For instance, it's common practice in several nations to disregard a guarantee's expiration date. Additionally, local law may mandate that the contract be granted by a local bank instead of a bank in the exporter's nation providing a counter-indemnity.

Importance of the order

The sequence of banking transactions is crucial, especially when coordinating guarantees and documentary credits for international projects.

Importers require bank guarantees to ensure labor or delivery of goods, while exporters often seek documentary credits to secure commodity payment.

So, what should be released first? The guarantee or the documentary credit?

Occasionally, importers may file a claim under an issued guarantee, demanding payment due to a contract violation before the exporter sees the documentary credit.

This can be prevented by conditioning the guarantee on the documentary credit and making it a required document.

Payment under a Guarantee

You and your business partner must agree upon the conditions for satisfying claims under the guarantee.

Should the bank wait for a settlement between parties, or should payment be made upon a straightforward statement of violation, making the guarantee payable on first demand?

The guarantee text must clearly specify when and how all parties should be informed about claim fulfillment. It will occasionally be essential to seek guidance regarding the contract's wording.

Parties to a Guarantee

There are several parties involved in a guarantee:

• The Applicant: The party requesting the contract.
• The Guarantor: The bank that warrants the agreed compensation amount to be paid in the event of a failure to meet contractual obligations.
• The Beneficiary: The party for whom the contract is issued.

Types of Guarantees

Guarantees play a pivotal role in international trade and finance, providing assurance to parties involved in transactions. Let’s understand some of the different types of guarantees below:

Direct Guarantees

Direct Guarantees involve a direct obligation from the guarantor to the beneficiary, who must present a demand for payment that meets the specific terms set out in the guarantee. This requirement may be sent via SWIFT, phone, or letter.

In this, the guarantor directly issues the guarantee to the beneficiary, bypassing the Applicant's bank.

The advising bank acts as an intermediary, relaying the guarantee from the guarantor to the beneficiary without any obligation under the guarantee.

Indirect Guarantees

A bank in the beneficiary's home country gives them a bond. Even though the applicant might have originally issued it, it's usually from their own bank. This bond is called a counter-guarantee. It's like an extra promise to ensure the beneficiary is protected.

The beneficiary's bank issues its own guarantee based on the counter-guarantee provided by the applicant's bank.

One way to characterize a counter-guarantee is:

An undertaking provided to a third party by the counter-guarantor designating that third party as the beneficiary with the aim of obtaining the issuance of a local guarantee to be granted to the beneficiary in the underlying contract/relationship.

Each of these contracts pays upon presenting a complying demand. The local guarantor will claim under the counter-guarantee if the demand is made under a local guarantee. Many countries in the Middle East follow this custom.

In this type, the guarantor owes the beneficiary, and the counter-guarantor owes the guarantor. If a complying demand is made under the guarantee, the counter-guarantor agrees to reimburse the guarantor.

Corporate vs. Personal Guarantees

The key differences between Corporate and Personal Guarantees:

Multiple Guarantors

Commercial lenders often deal with multiple business owners, and depending on the company's credit structure and risk profile, various guarantors may be necessary.

Let's give an illustration using this:

A company is owned by three partners who each hold an equal share. The company wanting a $1.5 million loan must provide a covering guarantee — 33.33% from each partner, totaling $500,000 in limited guarantees.

The partners sharing both ownership and responsibilities are deemed "joint guarantors." They may choose to sign a single "joint and several" guarantee or arrange separate guarantees. This arrangement illustrates their shared but individual liabilities.

Independent Guarantees

Two partners handle a real estate project. Both own 40% of it. They look at a $2 million loan from a lender who wants a 60% guarantee; that is $1.2 million.

Each partner can guarantee part of it. Partner A could back $480,000 — 40% of $1.2 million — while Partner B ensures the same amount.

This setup means each partner is liable only for their portion; it is called a "several guarantee."

If enforcement action were initiated, each guarantor would be liable for their pledged amount. However, the lender cannot pursue Partner A for Partner B's portion if Partner A fulfills their obligation and Partner B does not.

The partners may sign guarantees for fractions of the total required amount. For example, each partner could sign a separate guarantee for 50% of the $1.2 million, amounting to $600,000 each.

This setup ensures that neither partner would be required to pay more than their agreed-upon share, protecting against excessive liability.

Joint and Several Guarantees

In a joint and several guarantee, multiple guarantors are collectively and individually responsible for the full amount of the loan. Let's illustrate this with an example:

Two partners co-own a software firm, each holding 30% of the business. The firm needs a $1.5 million loan and seeks quick approval. The venture capital firm requires a 70% coverage guarantee, amounting to $1.05 million.

Both partners agree to sign a guarantee for $1.05 million. They will be jointly responsible for any action taken by the venture firm. If one partner fails to pay— for instance, if Partner A defaults— the entire sum could fall on Partner B.

After settling, Partner B can claim Partner A's share. This illustrates the joint and several nature of their agreement.

Lenders typically prefer joint and several guarantees, while business owners generally want to avoid them.

This is because certain guarantors may have claims against them that are simpler to settle than others when lenders seek repayment, possibly because of expenses or easily accessible net worth.

Business owners may make side agreements to ensure that no single partner will be held solely responsible for the entire repayment when they act as joint and several guarantors.

Independent Legal Advice (ILA)

A non-operating shareholder or an owner's spouse could occasionally need to serve as a joint guarantor. Some examples of people who could fill this job are these parties.

The majority of lenders demand that these inactive guarantors see a lawyer of their choice for independent legal counsel. By taking this step, it is ensured that the guarantors are completely aware of the duties and expectations that are expected of them.

Independent Legal Advice  is crucial for 

1. Well-Informed Decisions: It guarantees that the guarantor is aware of their obligations and the associated dangers.
2. Protection: It shields the guarantor from accusations that they were forced or deceived.
3. Legitimacy: It increases the guarantee agreement's legitimacy and lessens the possibility of disagreements.

Without independent legal advice, a guarantor not associated with the firm might argue that they were misled about what they were signing.

Conclusion

A guarantee is a vital financial instrument to ensure that the guarantor meets the commitment on the part of the borrower in case the borrower fails.

A guarantee, being on the lender's side, enhances the chances of paying back the loan, thus reducing the credit risk. 

Currently, there are three types of guarantees in place: direct and indirect guarantees, corporate and personal guarantees, as well as joint and several guarantees, all of which have peculiarities and repercussions on the parties involved. 

This means that all the parties must ensure they understand it before they give the guarantee in a manner that avoids ambiguity and unenforceability. 

Properly structured, with independent legal advice, guarantees can protect the interests of all the parties and assist in formally smoothing financial transactions.

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