Guarantees are flexible instruments. They can be issued to benefit both buyers and sellers, guarantee the performance of a wide variety of obligations, may be on-demand or under accessory, and cover a fixed period or only expire in particular circumstances (such as the completion of the project). Jennifer Gåfvels from Nordea Trade Finance explores how to get the most from this versatile trade finance instrument.
Enabling trust in transactions
Bank guarantees are a simple but powerful instrument for de-risking nearly every stage of a commercial transaction. ICC research found that bank guarantees account for nearly 13% of total export trade finance volumes and nearly 14% in imports (Rethinking trade finance, 2015). And they’re growing in popularity.
The principle is simple: your business engages a bank to issue a guarantee to your counterparty (the beneficiary). The bank guarantees that if you fail to meet your contractual obligations for any reason, it will pay out a sum, either on demand or once certain conditions stated in the guarantee are met.
Guarantees are flexible instruments. They can be issued to benefit both buyers and sellers, guarantee the performance of a wide variety of obligations, may be on-demand or under accessory, and cover a fixed period or only expire in particular circumstances (such as the completion of the project).
If you’re exploring how your business can take advantage of guarantees, what do you need to know? We spoke to Jennifer Gåfvels to identify the most common pitfalls and best practices that businesses should follow. As part of Nordea’s trade finance team, she has been giving customers expert advice on guarantees since 2004.
Q: What kinds of business should use guarantees?
A: No matter what business you’re in, guarantees are absolutely relevant to you. Our customer base is really diverse. We work with small companies doing their first import or export deal, as well as large corporates that have their own trade finance departments and a global banking network. That’s one of the fascinating things about all of trade finance, but especially guarantees: the same instruments can be used for importing shoes as for exporting complex construction projects — you just have to adapt to the product, market and value.
We’ve described some of the most common varieties of bank guarantees on our trade finance services page.
Q: Who really benefits from guarantees?
A: Although every guarantee has an issuer and a beneficiary, you shouldn’t think of a guarantee as a one-sided deal. A well-constructed guarantee should benefit both parties, because it enables activities and transactions to happen that would otherwise have been impossible.
For example, take one common form of guarantee, the advance payment guarantee. Without the protection that guarantees offer, customers would be less willing to pay cash in advance. While the seller has the burden of issuing a guarantee, in return they get the liquidity boost of getting money upfront — overall, this may be more cost-effective than other ways of financing operations.
Q: What’s the most important factor in the success of a guarantee?
A: It’s vital for all parties involved — the applicant and their issuing bank, and the beneficiary — to have close contact and understand each other’s needs, to appreciate the true nature of the deal. At Nordea we work hard to make sure that happens, because it’s essential to making sure the guarantee’s terms and conditions are fit for purpose. Sometimes customers might just not be aware of all the complexities of the transaction, but it could also be that there are tensions in the negotiations between the applicant and beneficiary. It’s important to resolve those issues and have a smooth working relationship right from the start.
Q: How much room is there for negotiation in practice?
A: Quite often the guarantee wording and the terms and conditions have been presented by the beneficiary on the understanding that they are completely non-negotiable. In practice, the wording is almost always negotiable — but you need to understand what you can change and why, and that will vary not only based on the nature of the individual transaction, but the particular market you are in and industry norms.
My advice is simple: listen to your advisors at the bank. They can draw on their experience across hundreds or thousands of guarantee negotiations to tell you whether it’s worth fighting for a specific guarantee wording. It’s important to note that clear and unambiguous wording is good for everyone in the transaction.
Q: How can a company stop things going wrong?
A: As Elisabeth Berg from Skanska says in our interview with her, only a small percentage of guarantees end with a claim. Problems more often stem from poor drafting of two types of clauses: reductions clauses and expiry clauses.
Reductions clauses are used when, for example, a construction company has partly delivered a multi-year project. It provides evidence to the bank of what’s been delivered, and the bank reduces the potential payout to the beneficiary accordingly. Expiry clauses without an explicit expiry date are used when the applicant must prove that they’ve completely fulfilled their part of the contract, allowing the guarantee to expire.
We’ve seen cases where the applicant is unable to meet all the criteria required by the wording of these clauses — for instance, the need to presenting certain documents. In these cases, the guarantee remains in force and the bank is unable to release the collateral.
That’s why we recommend using our standard guarantee templates as a basis — they include expiry dates and termination is therefore not a problem. We are also big supporters of the ICC’s URDG 758 guarantee rules. They fill in many of the gaps that another guarantee doesn’t cover.
Q: How should a business choose a guarantee provider?
A: Experience counts for a lot. Your chosen bank should understand your business, your sector, your markets, your customers and of course the practice of issuing and administering guarantees. Ratings are also important, particularly in larger projects. After all, a bank guarantee only functions because the beneficiary can trust that the bank will make good on the contract if things go wrong. Both parties need to be confident that the bank will still be around and solvent potentially several years down the line. At Nordea we’re proud to be one of the best-rated banks in the region.
Want to learn more about bank guarantees? Read about how Skanska uses them to create business advantage here, or visit our trade finance product page to download templates and find out more about our range of guarantee types.
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