A letter of guarantee is given by the bank to the customer, it is a type of contract which is entered into for purchasing the goods from the supplier. This letter gives the information and safety to the supplier that their payment will be paid. It is a guarantee that ensures to the supplier that even if the customer fails to make payment the bank will clear it. The customer has to apply for the letter of guarantee in a similar way as they apply for a loan. The bank will assess the risk associated with the customer and then decides on issuing a letter of guarantee. There is an annual fee charged by the bank to the customer. A letter of guarantee is also issued on behalf of the call writer which guarantees that the writer owns the assets and bank will issue securities once the call is exercised. A letter of guarantee is most commonly used by the call writers when assets of a call option are not held in a brokerage account.
Understanding the Letter of Guarantee
In business when a seller is unable to determine if the buyer has the ability to pay for the transaction or not then the seller will ask for the letter of guarantee. This is often for those transactions that involve higher investment sales such as property, land and building, machinery, equipment or any assets whose value is high. The letter of credit will not cover the full payment nor the bank guarantee full payment. It either guarantees for the principal or the interest repayment but it does not guarantee for both.
The bank will negotiate the amount that will be covered for payment to the supplier. The annual fee is generally a percentage of the amount that the bank owes if a client is in default.
Letter of guarantee acts as a payment instrument and is used in different kinds of business. These business types are real estate, construction business, financing, export & import deals and many others.
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Features of letter of Guarantee
- In the UAE, the letter of guarantee is governed by the URDG 758 or law of a country
- The terms & conditions can’t be changed without the agreement of parties involved in the transaction.
- Letter of guarantee is provided on demand
- At the discretion of the issuing bank, it is transferable and assignable.
Eligibility criteria
All the business units, legal entities, which are into trading, raw material, production, manufacturing and other activities which have approved credit limits are eligible. You can directly contact the bank for credit opportunities.
Documents necessary for letter of guarantee
The following documents are required by the bank to issue a letter of guarantee to the applicant.
- Completely filled in application form
- A document of the trade license
- All the documents related to the contracts or agreements
- A copy of the draft format for the guarantee, if required
- Collateral documents and collateral requirements if anything is required
- Any other documents as required by the bank officials from time to time
The applicant has to agree on the terms and conditions issued by the bank.
How to apply for a letter of guarantee?
You have to request your bank for the letter of guarantee with all the documents. Bank will assess the risk associated with the business and the history of transactions if any. They will do deeper analysis by checking the past data of the business, types of transactions, financial risks and many other factors. It will then inform their decision about the letter of guarantee. As mentioned earlier, banks also charge annual fees for issuing letters of guarantee.
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Format of a letter of Guarantee in the UAE
The commercial transaction law prescribes the format of the bank guarantee. The specific format should be followed with the below details.
- Letter of guarantee should be issued with a specific amount. A letter of guarantee which is not of any specific amount is not valid and cannot be enforced.
- There is no obligation to write the time period on the guarantee. The point to note is that if there is a time limit which is given in the guarantee letter it shall be deemed as expired once the time period has lapsed.
- According to article 418 of commercial transactions law, unless given in writing for renewal of the guarantee prior to the expiration date, the guarantor should be allowed to discharge their liability.
- According to the UAE law, If there is no time period mentioned in the letter of guarantee then it is deemed to be applicable till 10 years from the date of the letter of credit issuance.
- The beneficiary is not allowed to assign their rights to third parties under the bank guarantee without the approval of the guarantor.
Significance of letter of guarantee
In the UAE, the letter of guarantee is a significant document that is used for getting credit facilities. Even in situations like a global slowdown, the business entities have used this instrument for business financing. The continued business activities are possible with the letter of guarantee where the bank gives a guarantee of payment to the parties involved in the transaction. It is a guarantee which is issued by the bank or any registered financial institution on behalf of the customer.
To encourage the local business growth and increase the letter of guarantee usage, the UAE based registered financial entity has introduced Al Rabeh Guarantee service. This entity provides services available to the local business without any processing fee. It provides coverage for all types of guarantee like tenders, advance payments, and others. The competitive interest rates are 100% cash deposits against the guaranteed values.
Takeaway
Letter of guarantee is an important document for businesses which are into huge investments. It helps in the smooth operation of the business both in domestic and international business. It has proved and made the bond market secured and the investors invest in bonds with bank guarantees. It provides financial security to the suppliers and new business entities can get raw materials supplied for their business operations. It provides assistance in domestic business and international business.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.
