Bank Guarantees (BGs) & Stand-by Letters of Credit (SBLCs)

Bank Guarantees (BGs) and Standby Letters of Credit (SBLCs) are financial instruments typically used in international trade and other large scale, complex projects to ensure contractual obligations are met. Despite their distinct characteristics, both serve the crucial purpose of providing assurance to the parties involved in a transaction.

1. Bank Guarantees: A bank guarantee is a promise from a bank or a financial institution that if a particular borrower defaults on a loan, the bank will cover the loss. The bank guarantee signifies that the lending institution ensures that the liabilities of a debtor will be met.
2. Standby Letters of Credit: A standby letter of credit (SBLC) is a legal document that guarantees a bank's commitment of payment to a seller in the event that the buyer–or the bank's client–defaults on the agreement. A standby letter of credit helps facilitate international trade between companies that don't know each other and have different laws and regulations.

While these instruments are typically not intended to be traded, they can be and are sometimes used in a manner similar to a tradable security. However, trading of BGs and SBLCs is a niche activity and mostly done in secondary markets. Here's a brief overview of how the trading process typically works:

1. Origination: A BG or SBLC is issued by a bank on behalf of its client, who is providing the instrument as a guarantee for a particular transaction. The instrument specifies the terms and conditions under which the bank will make payment on behalf of its client and is sent per SWIFT MT760 to the recipient. 
2. Due Diligence: Prior to a transaction, extensive due diligence is conducted to verify the authenticity of the BG or SBLC. This includes confirmation of the instrument directly with the issuing bank.
3. Transfer Agreement: Once all due diligence has been completed, a transfer agreement is executed between the seller and buyer of the BG or SBLC. The agreement specifies the terms of the transaction, including the price and transfer process.
4. Payment and Transfer: Upon execution of the transfer agreement, the buyer makes payment as agreed, and the BG or SBLC is transferred to the buyer. The transfer is completed by the issuing bank, which updates its records to reflect the new beneficiary of the instrument.

Investment Banks like us who specialize in BGs and SBLCs help facilitate transactions between parties who wish to buy and sell these instruments and will normally ask the BGs or SBLCs to be issued with an ISIN to ensure tradability in the secondary market. These banks must understand the complex nature of these instruments and the legal and compliance requirements involved in their transfer.

It's important to note that the trading of these instruments is fraught with risks, including the risk of fraud. This market is lightly regulated, and the instruments themselves are often complex and difficult to understand. As such, it's strongly recommended that any party considering engaging in such transactions seek the advice of a financial advisor or attorney who specializes in this area. Moreover, these transactions are typically large in size and only suitable for sophisticated investors or institutions. They are not suitable for small retail investors.

The trading of bank guarantees and standby letters of credit is regulated by several guidelines, including the International Standby Practices (ISP98) issued by the International Chamber of Commerce (ICC). The ISP98 reflects the accepted practices, customs, and usages of standby letters of credit and provides separate rules for these instruments, similar to the Uniform Customs and Practice for Documentary Credits (UCP) and the Uniform Rules for Demand Guarantees (URDG) for commercial letters of credit and independent bank guarantees​. 

Standby letters of credit can serve various functions and can be classified descriptively based on their role in the underlying transaction. Examples include:

• Performance Standby: Supports non-monetary performance obligations, including those arising from the applicant's default in completing the underlying transactions.
• Advance Payment Standby: Supports the obligation to account for an advance payment made by the beneficiary to the applicant.
• Bid Bond/Tender Bond Standby: Supports the applicant's obligation to execute a contract if the applicant is awarded a bid.
• Counter Standby: Supports the issuance of a separate standby or other undertaking by the beneficiary of the counter standby.
• Financial Standby: Supports a monetary obligation, including an obligation to repay borrowed money.
• Direct Pay Standby: Supports payment when due of an underlying payment obligation typically in connection with a financial standby without regard to a default.
• Insurance Standby: Supports an insurance or reinsurance obligation of the applicant.
• Commercial Standby: Supports the applicant's obligations to pay for goods or services in the event of non-payment by other methods​1​.

The ISP differs from the UCP in style and approach to accommodate a broader range of stakeholders involved in standby law and practice. This includes not just bankers and merchants but also corporate treasurers, credit managers, rating agencies, government agencies, regulators, and indenture trustees, as well as their counsel. Standbys are often intended to be available in the event of disputes or applicant insolvency, necessitating detailed scrutiny of their texts. The ISP provides guidance to lawyers and judges in interpreting standby practice and provides clear and widely accepted answers to common problems​. 

To apply the ISP to a standby, the undertaking should include language such as "This undertaking is issued subject to the International Standby Practices 1998" or "Subject to ISP98." The ISP provides neutral rules acceptable in most situations and a useful starting point for negotiations in other situations. It can save parties, including banks that issue, confirm, or are beneficiaries of standbys, considerable time and expense in negotiating and drafting standby terms​. 

The ISP is designed to be compatible with the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit and local law, whether statutory or judicial. It embodies standby letter of credit practice under that law. If these rules conflict with mandatory law on issues such as assignment of proceeds or transfer by operation of law, applicable law will control. Nonetheless, most of these issues are rarely addressed by local law, and progressive commercial law will often look to the practice recorded in the ISP for guidance in such situations, especially with respect to cross-border undertakings​. 

The ISP can also be used in arbitration as well as judicial proceedings, such as the expert-based letter of credit arbitration system developed by the International Center for Letter of Credit Arbitration (ICLOCA) Rules or general commercial ICC arbitration or with alternative methods of dispute resolution​1​.

Differences between BGs and SBLCs

The distinction between a Bank Guarantee (BG) and a Standby Letter of Credit (SBLC) lies primarily in their purpose and the nature of the guarantee they offer, though they are both used in international trade transactions to provide security and reduce the risk of non-payment.

1. Nature of Guarantee:

• Bank Guarantee (BG): This is a broader type of financial instrument issued by a bank, providing a guarantee of performance or payment. The bank guarantees that if the applicant (the one who requests the BG) fails to fulfill their contractual obligations, the bank will cover the loss. This makes it a guarantee of performance, ensuring the completion of contractual obligations.
• Standby Letter of Credit (SBLC): An SBLC, on the other hand, is primarily a guarantee of payment. It's a document issued by a bank guaranteeing the payment of a specific amount of money to a seller if the buyer defaults on the agreement. This is typically used as a payment of last resort and is not intended to be used as a primary method of payment.

2. Usage Context:

• BGs are often used in situations where there is a need to guarantee the performance or commitment of a party. For example, in construction contracts, a BG might be used to ensure that the contractor completes the project as per the agreed terms.
• SBLCs are frequently used in international trade transactions to ensure payment, especially in cases where buyers and sellers are unfamiliar with each other or operate in different countries with different laws and regulations.

3. Parties Involved:

• In a BG, there are usually two parties involved: the applicant and the beneficiary.
• In an SBLC, there are typically three parties: the applicant, the issuing bank, and the beneficiary.

4. Payment Conditions:

• In an SBLC, payment is made only when the applicant fails to fulfil their obligations under the underlying contract.
• In a BG, payment may be made even if the applicant has not yet failed to fulfill their obligations under the contract.

5. Types:
Both BG and SBLC can be categorized into different types such as Performance, Financial, Advance Payment, etc., based on their specific use in the underlying transaction.

6. Regulatory Framework: 
The trading of BGs and SBLCs is regulated by several guidelines, including the International Standby Practices (ISP98) issued by the International Chamber of Commerce (ICC) for SBLCs, and the Uniform Rules for Demand Guarantees (URDG) for independent bank guarantees.

Each of these instruments has its unique characteristics and is suited to specific types of financial transactions, making the choice between a BG and an SBLC dependent on the specific requirements of the transaction involved.

Purchase Procedure SBLCs/BGs

1. Initial Deposit into the Client's Account at IFB

The first step: the client deposits the required funds into their account at International Financial Bank (IFB) after opening the necessary account(s) and fulfilling all compliance requirements.

2. Due Diligence and Compliance Process

The bank conducts due diligence and compliance checks on both the client and the seller/issuer of the MTN/SBLC.

3. Engagement of a Transaction Intermediary (If Applicable)

An intermediary may be engaged to help structure the deal, ensuring favorable terms for both the client and the issuer.

4. Escrow Account Setup (If Required)

An escrow agreement is established to ensure that the funds and the financial instruments are protected during the transaction.

5. Signing of the Purchase Agreement

This stage now requires a deeper understanding of the contractual terms, particularly concerning the volume, tranches and timing of the financial instruments, I.e. of MTNs or SBLCs:/BGs

• Volume: The total face value of the SBLC/BG to be transacted must be explicitly defined in the contract.
• Tranches: If the SBLC/BG is being issued in multiple tranches (batches), this must be clearly outlined in the purchase agreement. Tranches help manage the risk and timing of the transaction. 
• Tranche size: The contract should detail the size of each tranche (e.g., $500 million per tranche).
• Delivery schedule: The timeline for the issuance of each tranche should be set, which could be monthly, quarterly, or as negotiated.
• Conditions for tranche release: The agreement should specify any conditions or milestones (e.g., successful KYC and due diligence) that must be met before subsequent tranches are released.

These elements ensure that the transaction is staggered to manage risk and liquidity, particularly in large-volume deals.

6. SBLC Transaction Process and Analysis of SBLC Text

The issuance of the Standby Letter of Credit (SBLC) is a separate transaction from the MTN, but often part of the same overall financial strategy. The SBLC serves as a guarantee, typically used normally in trade finance, where the issuer (usually a bank) guarantees payment to the beneficiary in the event the applicant (the client) defaults on an obligation.

A. Verification of the SBLC/BG Issuing Bank
As with MTNs, it is vital to ensure the SBLC/BG is issued by a top-tier bank (often A rated or higher), ensuring the credibility and enforceability of the SBLC.

B. SBLC/BG Text Structure and Analysis
The SBLC/BG itself is a formal, structured document, generally delivered via SWIFT MT760 messaging. An expert analysis of the SBLC’s or BGs terms is crucial. Here’s an in-depth breakdown of key clauses found in the SBLC/BG:

• Beneficiary Information: This section details who will receive the payment if the SBLC/BGis drawn upon. This could be a supplier or another counterparty. Precise information on the beneficiary is vital to avoid disputes.
• Amount and Currency: The maximum amount that can be drawn under the SBLC/BG must be clearly stated, along with the currency (typically USD or EUR).
• Expiration Date: SBLCs and BGs have a fixed term. The expiration date specifies when the SBLC/BG lapses, and this can be aligned with the underlying transaction’s duration. A typical SBLC/BG might have a 12-month expiration period, with an option for renewal.
• Conditions for Drawing: These are critical clauses that dictate under what conditions the beneficiary can demand payment. Common conditions include:

  - A written declaration of the applicant’s default.
  - Presentation of specified documents, such as invoices or shipping receipts.
  
The conditions should be very specific to prevent unintended or fraudulent draws on the SBLC.

• Governing Law: This clause dictates the legal jurisdiction that will govern the SBLC/BG. English law, New York law, or Swiss law are commonly chosen because they are highly respected in international financial transactions.
• Non-Transferability: Unless otherwise stated, SBLCs/BGs are typically non-transferable. If transferability is a requirement, this must be specifically included in the text.
• SWIFT Messaging Protocol: The SBLC/BG will be issued via SWIFT MT760. The SWIFT messaging format is globally recognized and allows banks to communicate securely. The text of the SBLC/BG should include a specific reference to the SWIFT MT760 message format, ensuring that the guarantee is conveyed in a standardized manner.

C. Legal Review and Customization
Legal experts should review the SBLCs or BGs terms to ensure that they meet the client’s specific needs. This may involve customizing clauses around the:

• Scope of obligations guaranteed.  
• Permitted extensions or rollovers of the SBLC.
• Notification procedures for drawdowns.

Any ambiguity in the SBLC text could lead to costly disputes, so clarity is paramount.

7. Final Funds Transfer

After the MTN or SBLC has been authenticated and transferred, the final payment is executed via RTGS, ensuring both immediate settlement and irrevocability.

8. Post-Transaction Safekeeping and Utilization

Once the MTN or SBLC has been transferred, the client must ensure proper custody and, for SBLCs, manage the instrument's utilization in accordance with its intended financial or trade strategy.

9. Regulatory Reporting and Taxation

Finally, the client needs to fulfill regulatory obligations and address any taxation implications resulting from the transaction.