What is a bank guarantees

Bank guarantees, or as they are called in the American banking practice, standby letters of credit are relatively new legal phenomenon. Seems to us that first time they appeared on the U.S. domestic market somewhere in the the mid-60s, although bankers believe that international operations they began to be used in any significant purposes since the early 70's.

An increasing wealth of oil producing countries in the Middle East, gave them an opportunity to enter into contracts with foreign companies for bigger sums mainly for the t the  projects, such as infrastructure development (roads, airports, ports), the construction of social infrastructure (housing, hospitals), communication lines , power plants, industrial and agricultural projects, upgrading weapons. This was the beginning of demand for bank guarantees, and especially on guarantees, payable on demand.

Nowadays, the use of bank guarantees is common, and their value has dramatically increased. We can surely say that almost everyone who works with large contracts, use some kind of guarantee, while for non-significant deals, demand for warranty depends on many factors. Bank guarantees using increased in domestic operations, that’s why we can say the bank guarantees can be used to support any transactions. Using of bank guarantees is increased for non-financial transactions: sales contracts, leasing and construction contracts, as well as in financial transactions: loans and overdraft facility services, participation in joint ventures, the issue of securities, reinsurance and others.

Commercial risk

Commercial risk is decisive factor in international trade. The bigger deal is, the bigger investments involved in it. Today the contracts have become complicated, large-scaled and comprehensive. A distinctive feature of the trade today is its international dimension. For example, construction companies of UK and the Netherlands establishing a joint venture in which also involved other companies. This joint venture is building the airport and ancillary buildings in Saudi Arabia and their subcontractors are South Korean firms and suppliers from France and Germany. As a result: a huge number of contracts, each of them have its own time limits and a lot of other features, which could lead to delays in construction. It is important to point out that many of the contracts are long-term. These reasons and many others are increasing the risk of not putting the object in time, which in turn leads to large fines. But all this can be avoided.

Letter of credit and bill of exchange

Before it were only two ways in international trade - documentary letter of credit and accepted by a bank or guarantor (aval) bill of exchange. These mechanisms are known for a long time. Later came the situations that are not related to fulfillment of the obligation of payment. Now the traditional types of guarantees - accessorial (optional) and the surety have become uncomfortable and unprofitable for lender, because accessory guarantorcan protect himself of claims in many methods. It is clear that in such cases, the creditor has to start legal proceedings, which leads to even more inconvenience and risks. Banks have no interest to act as guarantors of the accessory, as they may be involved in the proceedings between the two parties under the main contract. To avoid such situations were devised an independent guarantees, issued by a financially strong institutions - banks. This new type of financial instrument is much similar to the documentary credit.

By the way, the American version - Standby Letter of Credit (LC standby) is directly comes from the usual letter of credit that is used in sales transactions. The modern type of warranty has many similarities with the documentary credit, especially in independence of a mandatory payment under the terms of the guarantee observance, and the rules of strict correspondence. Accordingly, if the warranty conditions are met, the bank is obliged to pay, and he cannot resort to remedies (argumentation) (defenses), which follows from the basic contract. Unlike the documentary letters of credit, guarantees, serve as financial security: they guarantee financial compensation in case of failure of the principal his obligations.

Payment mechanisms

Structure of independent guarantee allows different payment mechanisms. Type of guarantee, which attracts increased interest, is guarantee that must be paid on demand. It allows the beneficiary to receive payment from a bank without any evidence of default by the debtor/exporter. This type prevails in certain sectors, regions and in certain circumstances, but the increase in the number of such guarantees is caused by the fact that international trade is now mainly on the market buyer. If the exporter is stronger than the importer, he can insist on the extradition of this guarantee, the payment is to be made only if the creditor/importer will submit evidence, confirmed by a third party, or even a judicial or arbitral decision justifying the right of a creditor to payment.

Before the Iranian revolution of 1979-1980 year there were no situations where claims payments on guarantees and stand-by letters of credit in favor of the Iranian Government were so massive; and when companies rushed to courts trying to stop payments, lawyers were forced to become interested in a new kind of independent guarantee. This period was marked by the development of a new mechanism of transaction ensuring.