What are guarantees and surety bonds?
Guarantees and surety bonds are surety bonds or guarantees issued by banks and, increasingly, credit insurers on behalf of their applicants in favour of third parties. These third parties are generally referred to as “beneficiaries”, while the applicant is also known as the “guarantee facility borrower” or “principal debtor” and the guarantee issuer as the “surety” or “guarantor”.
Unlike a financing loan, under which cash or account money is made available to the applicant, guarantee facilities are referred to as a form of “lending creditworthiness”, because no funds are transferred to the beneficiary until a claim is made. Instead, the debtor effectively borrows the good name and credit standing of a bank or credit insurer.
Strictly speaking, however, the term “lending creditworthiness” is not entirely accurate, since loans for use are free of charge under Section 598 of the German Civil Code (BGB). For issuing surety bonds or guarantees, however, lenders generally charge a guarantee commission, which is calculated periodically and depends on the amount of the obligation, the applicant’s creditworthiness or the agreed collateral arrangements, and the term of the commitment. The commitment may have a clearly defined expiry date, in which case it is referred to as a fixed-term surety, or it may be open-ended, meaning that it remains valid until the original document is returned or a waiver of the right to make a claim is issued. If the beneficiary requires a physical guarantee document, an additional one-off issuance fee may also be payable.
What is the difference between surety bonds and guarantees?
Guarantees are abstract in nature, meaning that the guarantor is liable for a specific future outcome, irrespective of any reduction in the outstanding underlying obligation over time, for example under a payment guarantee, warranty guarantee or bid guarantee.
Surety bonds, by contrast, are linked to an underlying principal obligation and are therefore accessory in nature. As a general rule, any reduction in the guaranteed principal obligation over time would also reduce the surety’s liability. However, surety bonds may also be structured so that the liability amount does not decrease while remaining subject to an agreed maximum amount.
Suretyships have been used for a very long time, including in private-law transactions, and are therefore governed by law under Sections 765 et seq. of the German Civil Code. Under a surety agreement, the surety undertakes towards the creditor of a third party to assume responsibility for the fulfilment of that third party’s obligation. Surety bonds are often directly enforceable, meaning that the surety waives the right to require the creditor to pursue the principal debtor first, known as the defence of prior recourse. This means that, if the principal debtor defaults on a payment, the beneficiary may immediately approach the bank providing the surety and demand payment without first taking legal action against the principal debtor. A surety under which the beneficiary must first demonstrate an actual loss resulting from the debtor’s inability to perform, usually through enforcement proceedings, is referred to as a “deficiency guarantee” or “loss guarantee”. In this case, the defence of prior recourse is permitted, and the surety is liable only for the proven shortfall. Where several parties act as sureties for the same obligation, they generally assume joint and several liability. This is referred to as a “co-suretyship”.
In the global business activities of companies, the German Civil Code is of limited relevance because it applies specifically under German law. Guarantees are therefore generally used instead. Due to the absence of detailed statutory provisions, guarantees offer greater flexibility, and the term “guarantee” is more widely understood and accepted internationally. In principle, guarantees may be issued without any specific formal requirements. To avoid misunderstandings, however, the applicable terms and conditions are documented in written agreements, which are increasingly executed digitally.
What do surety bonds and guarantees have in common?
In both cases, they are generally unilateral contracts that provide additional security for the performance of a commercial transaction. Since the surety is only required to pay if the principal debtor fails to meet its contractual obligations, the commitment represents a contingent liability from the surety’s perspective. From the beneficiary’s perspective, it represents a contingent asset, which, like a contingent liability, must be disclosed below the line in the financial statements.
Since banks and credit insurers generally seek to avoid making such payments, they provide their good name and credit standing only on behalf of applicants with sufficiently strong creditworthiness. The collateral required for the guaranteed obligations reflects this assessment, meaning that guarantee facilities are often provided on an unsecured basis.
Guarantees under master credit agreements
To make use of guarantees and surety bonds, companies generally receive guarantee facilities that define the maximum total amount of surety bonds and guarantees they may request from their bank. Guarantee facilities are therefore often included in a master credit agreement. These facilities are frequently combined with overdraft facilities under an overall credit facility. This means that any increase in the utilisation of one type of credit automatically reduces the remaining available headroom under the other, while the lending bank’s overall risk exposure remains manageable. In connection with large syndicated financing arrangements, banks may also provide sub-facilities, known as ancillary facilities, where there is only a limited requirement for surety bonds and guarantees. To simplify administration, these facilities are generally arranged bilaterally with one of the syndicate banks.
What are guarantees and surety bonds used for?
By effectively “borrowing the credit standing” of a bank or insurance company, businesses can facilitate commercial transactions in many different ways. A bid guarantee may, for example, be an essential requirement for participating in a tender for a major project. In other cases, guarantees may be used to secure contractual performance or customs payments, or to provide security in legal proceedings.
Bid guarantees are required in public tender procedures and international transactions to ensure that the bidding company is able to comply with the tender conditions. If the guarantee facility borrower fails to do so, the guarantee issuer pays the agreed contractual penalties or liquidated damages. In Austria, this type of guarantee is known as a “Vadium” and is governed by the Austrian Enforcement Code. For example, a Vadium must be deposited as security in connection with the compulsory auction of real estate. Without providing this security, a bidder is not permitted to participate in the auction. In Switzerland, the corresponding instrument is referred to as an “Offertgarantie”, which enables a company to participate in certain tender procedures. The amount and cost of bid guarantees depend on the contract value and generally range from 5% to 10%.
Once a company has been awarded a contract, delivery and performance guarantees may be used. If the guarantee facility borrower fails to provide the agreed goods or services, the bank or credit insurer pays an agreed amount to the beneficiary. A performance guarantee therefore results only in financial compensation, as guarantors are generally not in a position to provide replacement goods or perform the contractual services themselves.
For very large contracts, such as the construction of buildings, roads, power plants or ships, the customer is often required to make advance payments. If the contractor subsequently fails to deliver, the customer will naturally want the advance payment to be refunded. This obligation is secured by the contractor’s bank in the form of an advance payment guarantee or refund guarantee.
When goods are transported across national borders, customs duties may be payable in certain countries. Customs authorities may require customs guarantees to secure their claims, particularly where payment of the customs duties is deferred and subsequently settled from the proceeds of the sale. Trade finance also includes bills of lading guarantees and various forms of payment guarantees, which may be used to secure an exporter’s payment claim.
Where a recipient is dissatisfied with goods or services provided, they may be able to make a claim under a warranty guarantee, which may be individually agreed and may extend beyond the requirements of national legislation. However, banks and insurance companies acting as guarantors would generally only provide financial compensation up to an agreed amount and would not carry out repairs, provide replacements or arrange for the underlying transaction to be rescinded. Similarly, contractual performance guarantees can be agreed for almost any purpose.
Guarantees may also be required in legal proceedings. Court guarantees may serve as security in connection with provisionally enforceable judgments or may be used to prevent or suspend enforcement proceedings.
Which types of guarantees do companies commonly use?
The types of surety bonds and guarantees used primarily depend on the company’s business activities, geographical presence and position within the supply chain between suppliers and customers. In principle, a company may request any of the guarantee and surety instruments described above in order to conduct its business. At the same time, it may require such instruments from its contractual partners as the beneficiary. Banks or counterparties may also require members of a company’s management to provide credit guarantees or other forms of liability undertaking.
Additional security is often required in connection with cross-border expansion. A parent company may support its subsidiaries by providing letters of comfort. These “intra-group guarantees” are not specifically governed by law and can therefore be structured freely. In most cases, the parent company provides a declaration to a lender of its subsidiary confirming, for example, that it will
- provide the subsidiary with sufficient financial resources to enable it to meet its obligations, or
- disclose the ownership structure and maintain it for the agreed period, or
- absorb any losses incurred.
A “letter of comfort” is intended to provide the beneficiary with a degree of reassurance, while the expression “to give comfort” may also mean to provide consolation, perhaps in anticipation of the subsidiary failing to meet the obligations expected of it. Depending on its wording and legal substance, the accounting treatment of such letters of comfort may range from “goodwill” to an enforceable financial undertaking. Because of this ambiguity, statutory surety arrangements or guarantees with clearly defined valuation and liability provisions are generally preferable to self-drafted letters of comfort.
