Bank Guarantees in Trade: Bid, Performance and Advance Payment

Bank guarantees in trade under URDG 758: bid bonds, performance, advance payment and payment guarantees, how calls work, what they cost and how to limit risk.

A buyer who pays you a 30% advance wants to know it will get the money back if you do not deliver. A public utility that awards you a supply contract wants compensation if you walk away from it. You, selling on open account, want to be paid if your buyer does not. In all three cases the answer is the same instrument: a bank guarantee, a promise by a bank to pay a sum of money on demand.

Guarantees are everywhere in international trade, especially in tenders, projects and large supply contracts, and they are widely misunderstood. A demand guarantee is not insurance and it is not a contract enforcement tool: the bank pays on a compliant demand, without asking whether the default is real. That makes it extremely effective for the beneficiary, and potentially dangerous for the party who provides it.

This lesson explains how demand guarantees work under the ICC's URDG 758, the main types and their usual amounts, the step-by-step issuance through a local bank, what they cost, and how an exporter limits the risk of an unfair call.

What is a demand guarantee?

A demand guarantee is a bank's irrevocable undertaking to pay the beneficiary a stated amount on presentation of a complying demand. Its key feature is independence: the guarantee is separate from the underlying contract, and the guarantor is not concerned with whether the contract was performed. It checks only whether the demand, and any documents required, comply with the guarantee on their face.

This distinguishes it from an accessory guarantee or suretyship, where the guarantor pays only if, and to the extent that, the principal is actually liable under the contract. Accessory guarantees give the guarantor every defence the principal has; demand guarantees give it almost none, apart from fraud or manifest abuse, which courts admit only rarely and on strong evidence.

URDG 758: the rules for demand guarantees

The ICC Uniform Rules for Demand Guarantees, Publication No. 758 (URDG 758), came into force on 1 July 2010. They apply when the guarantee says it is subject to them. The main rules every exporter should know:

• Supporting statement: unless the guarantee excludes it, a demand must be accompanied by a statement from the beneficiary indicating in what respect the applicant is in breach of its obligations. It does not need proof, but it forces the beneficiary to identify a breach.
• Examination: the guarantor has five business days following the day of presentation to examine a demand and decide whether it complies.
• Rejection: a guarantor that rejects a demand must send a single notice listing each discrepancy, without delay and at the latest by the end of the fifth business day; otherwise it cannot claim the demand does not comply.
• Extend or pay: if the beneficiary demands payment or an extension, the guarantor may suspend payment for up to 30 calendar days following receipt of the demand.
• Expiry: a guarantee should state an expiry date or an expiry event. If it has neither, it terminates three years after issue; a counter-guarantee without expiry terminates 30 calendar days after the guarantee.
• Governing law: unless otherwise stated, the law of the guarantor's place of business governs the guarantee.

The main types of guarantees in trade

The first four are given by the exporter's bank to protect the buyer. The payment guarantee is given by the buyer's bank to protect the exporter, as an alternative to a standby letter of credit, which plays the same role under ISP98 or UCP 600. See the kinds of letters of credit.

Direct or indirect: why you often need two banks

• Direct guarantee: your bank issues the guarantee directly to the foreign beneficiary, often through an advising bank that confirms its authenticity.
• Indirect guarantee: the beneficiary, often a public body, requires a guarantee from a bank in its own country. Your bank issues a counter-guarantee to that local bank, which then issues its own guarantee to the beneficiary. If the beneficiary calls the local guarantee, the local bank calls your bank's counter-guarantee, and your bank debits you.

How an indirect guarantee is set up:

1. The tender or contract specifies the guarantee's amount, form, rules and validity, often with a mandatory text.
2. You apply to your bank, which checks your credit line or asks for cash collateral.
3. Your bank issues a counter-guarantee by SWIFT to a correspondent bank in the beneficiary's country, asking it to issue the local guarantee.
4. The local bank issues the guarantee to the beneficiary, under its own law and fees.
5. On expiry, or when the beneficiary returns the guarantee, both undertakings are released and your bank releases your credit line.

What does a guarantee cost?

The cost has three parts. The issuing bank charges a commission, usually a percentage per year or per quarter of the amount, which depends on your credit standing, the type of guarantee and its duration; a range of roughly 0.5 to 3% a year is common, with performance and advance payment guarantees usually priced higher than bid bonds. Under an indirect guarantee, the local bank adds its own commission. And the guarantee uses your credit line or blocks cash collateral, which has an opportunity cost for a small company.

Worked example: transformers for a utility in Nouakchott

An Algerian manufacturer bids in a tender from a Mauritanian utility for distribution transformers worth EUR 1,200,000.

1. Bid bond: 2% required, EUR 24,000, valid 120 days, issued by a Mauritanian bank against a counter-guarantee from the exporter's bank.
2. Award: the exporter wins and signs the contract. The bid bond is released.
3. Performance guarantee: 10%, EUR 120,000, valid until provisional acceptance plus 30 days.
4. Advance payment: the utility pays 20%, EUR 240,000, but only against an advance payment guarantee of the same amount with a reduction clause: the amount reduces in proportion to the value of goods shipped, as evidenced by bills of lading. After shipping half of the order, the guarantee falls to EUR 120,000.
5. Warranty: on acceptance, the performance guarantee is replaced by a 5% warranty guarantee for 12 months, EUR 60,000.

At a commission of 1.2% a year at the exporter's bank, the performance guarantee costs about EUR 1,440 a year; the advance payment guarantee, with an average outstanding of EUR 140,000 over 8 months, about EUR 1,120; plus the Mauritanian bank's commissions and the SWIFT and courier fees.

How to limit the risk of an unfair call

• Use URDG 758, which requires a statement of breach, rather than a bare "pay on first demand" text.
• Fix a precise expiry date or an expiry event evidenced by a document, never an open-ended validity.
• Add an effectiveness clause to advance payment guarantees: the guarantee becomes effective only when the advance is received in your account.
• Add reduction clauses linked to documents you control, such as bills of lading or acceptance certificates.
• Require documents where possible, such as a certificate from an independent engineer.
• Ask for the original back on expiry where local practice keeps guarantees alive until returned, and follow up on releases.
• Insure the call risk: some export credit agencies and insurers cover unfair calling of guarantees. See export credit insurance.

Guarantees and exchange control

In countries with exchange controls, a bank guarantee given in favour of a non-resident, or received from one, may involve specific procedures, and some public buyers only accept guarantees from banks approved in their country. Ask your bank early how long it needs to issue a guarantee or counter-guarantee to the country concerned: tenders do not wait.

Common mistakes

• Accepting the beneficiary's text without reading it, including clauses that make the guarantee valid "until returned".
• Forgetting to cancel or reduce guarantees after performance, and paying commission for years.
• Issuing an advance payment guarantee that is effective before the advance is received.
• Treating a performance guarantee as a penalty cap: the buyer may call it and still claim damages under the contract.
• Underestimating the time and fees for a local guarantee in the buyer's country, which can delay contract signature.
• Not checking that the guarantee's terms match the sales contract obligations it secures.