When drawing up a contract for a trade deal, it is best to work in a set of guarantees to ensure the deal meets the requirements of all invested parties.
A guarantee is an instrument by which a guarantor, usually a bank, will agree to pay a sum of money, if the exporter doesn’t fulfill its obligations to the importer.
A guarantee is sometimes an unconditional instrument, meaning the beneficiary, usually the importer, can obtain payment from the guarantor on simple demand. Sometimes documentation outlining the reason for the claim is required. The bank doesn’t have the right to oppose the demand for payment unless the conditions haven’t been met, for example the required documentation, milestones, or expiry date. There are various types of guarantees that can be used to mitigate risk. Let’s explore four of these guarantees.
1) Bid Guarantee
International public tenders often require all bidders provide cash deposits or an irrevocable guarantee for between two and 10 percent of the total contract amount. Issuing such tenders is a complex and costly process. As a result, the prospective importer only wants serious candidates to submit bids.
A bid guarantee is usually valid for the tender period which, on average, is up to six months.
By making a bid bond a condition of submitting a proposal, the importer ensures serious bids are made and each bidding company intends to carry through on its undertakings.
In the case of an international tender, the bid guarantee can only be called if the exporter fails to follow through after being awarded the contract. If that happens, the guarantee compensates the foreign importer for the costs of having to find another company to complete the contract. If the contract is awarded to another company, the bid guarantee is usually returned for cancellation.
In several countries, the contracting party will require the guarantee to be issued by a local bank. In this scenario, a bank from another country, usually the country of the bidding party, will issue a counter-guarantee in favour of a local bank, which will in turn issue the bid guarantee.
2) Performance Guarantee
For larger, long-term international contracts, an importer will usually require a performance guarantee to be posted for about 10 percent, but sometimes up to 25 percent, of the total contract. A performance guarantee is a type of instrument that will undertake payment if the exporter (or applicant) fails to perform in accordance with the terms of the commercial contract or fails to perform to the satisfaction of the importer or beneficiary. Payment is usually effected against a certificate from the importer (or beneficiary) stating the exporter has failed to perform its contractual obligation under the contract.
In several countries, a statute of limitations will apply and the exporter (or beneficiary) will hold the guarantee for several years beyond the contract completion, in anticipation of later claims. In some cases, a longer-term expiry date will be required or a guarantee will be requested without a fixed expiry date. Some cases will utilize a guarantee with evergreen or auto-renewal clause.
These situations can result in longer exposure for the supplier than anticipated, and consequently, may use up credit capacity with their bankers. The local requirements should be investigated before entering into contracts. Unfortunately, matters such as bid guarantees and performance guarantees are often not given sufficient thought and attention until it’s too late.
3) Advance Payment and Progress Payment Guarantee
In large contracts, importers will sometimes make an advance payment to the exporter or contractor to enable them to begin acquiring or producing goods, or delivering services. An advance payment guarantee will undertake to refund all or part of this advance payment in the event that the exporter does not produce or deliver the goods as promised in the contractual agreement. The amount of the original guarantee will often be reduced as the exporter performs their obligations and earns the advance payments, reducing it to zero.
Exporters may be paid progress payments upon completion of various stages of a project.
Progress payment guarantees undertake repayment if a particular stage of the contract is not completed in accordance with the contract or within the required time frame.
4) Warranty/Retention Guarantee
At times referred to as a hold-back guarantee, a warranty or retention guarantee provides financial compensation if goods and/or services supplied under a completed contract don’t perform as required or are of inferior quality. Such guarantees are usually for a fixed period of time, but may be subject to a statute of limitations in certain countries.
In some contracts, there may be a payment hold-back of five to 25 percent of the contract amount. Such hold-backs serve the same function as warranties, to ensure the importer is satisfied with goods or work performed. They are often favoured when a significant amount of ongoing service and maintenance is involved, after the goods are supplied, or the project is in production.
Such hold-backs can extend for long periods and may create financial strain on the exporter. To enable the exporter to receive cash up front instead of waiting, a financial institution may issue a hold-back guarantee to the importer, providing the importer has agreed to pay the exporter the funds that would normally be held back. This may require the exporter provide some financial incentive to the importer and will depend on the willingness of the financial institution to assume the underlying risk, at a price, as they will be responsible for repaying funds, if any subsequent claims are made.
When drafting a contract, a guarantee should be in place to safeguard your business. These four guarantees will help you safeguard your business when dealing with foreign markets.