Basics of Debt Funding – Indian Non-Fund Based

Table of Content

1. Difference between Letter of Guarantee and Bank Guarantee
2. Condition for Granting Non-Funded Facilities to Customers
3. Types of Letter of Credit
4. Types of Bank Guarantees
5. Various types of Letter of Credit
6. Standby Letter of Credit (SLOC)
7. Documents handled under Letter of Credit
8. Parties involved in Letter of Credit Finance
9. Assessment of Limit of Bank Guarantees
10. Purpose of issuing of Bank Guarantees
11. Bank Guarantee Limits; Aspects examined by Banks while issuing Bank Gurantees
12. What is the purpose of issuing Performance Bank Guarantees?

1. Difference between Letter of Guarantee and Bank Guarantee

1. 1. “Letter of Guarantee”:
      • Letter of Guarantee (also known as “Letter of Credit”) referred to as a documentary credit acts as a promissory note from a bank. Letter of Guarantee represents an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed.
      • Letters of credit are especially important in international trade due to the distance involved and potentially differing laws in the countries of the businesses involved. In these transactions, it is not always possible for the parties to meet in person. The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped.
   2. “Bank Guarantee”:
      • Bank Guarantees insure both parties in a contractual agreement from credit risk. For instance, a construction company and its cement supplier may enter into a new contract to build a mall. Both parties may have to issue bank guarantees to prove their financial stance and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank, which then pays the company the amount specified in the bank guarantee.
      • Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary unlike a letter of credit the sum is only paid if the opposing party does not fulfil the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to non-performance by the other party in a contract.

While letters of credit are used mostly in international trade agreements, bank guarantees are often used in real estate contracts and infrastructure projects. Both bank guarantees and letters of credit work to reduce financial risk.

2. Condition for Granting Non-Funded Facilities to Customers

Banks can grant non-funded facilities including partial credit enhancement to customers, not availing fund based facility from any bank in India under following conditions:

1. 1. Banks are to ensure that the borrower has not availed any fund based facility from any bank operating in India. At the time of granting non-funded facilities, bank to obtain declaration from the customer about the non-funded credit facilities already enjoyed by them from other banks.
   2. Banks are to undertake similar credit appraisal as for fund based facilities.
   3. Credit information relating to such facility shall be mandatorily be furnished to the Credit Information Companies.

3. Types of Letter of Credit

4. Types of Bank Guarantees

5. Various types of Letter of Credit

Following are various types of Letter of Credit:

• Sight Credit: In this Letter of credit, documents are payable at sight/upon presentation, i.e., Payment is made to the seller immediately (maximum within 7 days) after the required documents have been submitted.
• Confirmed Credit: A confirmed letter of credit is one when a banker other than the Issuing bank, adds its own confirmation to the credit. In case of confirmed letter of credits, the beneficiary’s bank would forward the LC to the confirming banker with a request to add their confirmation. The liability of the confirming bank is same as the issuing bank. Note: Only Irrevocable letter of credit can be confirmed.
• Transferable Credit: A Transferable letter of credit is one in which a beneficiary can transfer his rights to third party/parties in whole or in part (in that case the unused portion can be transferred back to the original beneficiary). Such letter of credit should clearly indicate that it is a ‘Transferable’ letter of credit. Transferable Letter of Credit is transferrable only once.
• Red Clause Letter of Credit: In case of red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc
• Green Clause Letter of Credit: Green Clause Letter of Credit provides the advance not only for the purchase of raw materials, processing and packaging of goods, etc. but also for pre-shipment warehousing at the port of origin and insurance expense.

In normal situations, the advance under this letter of credit is granted only after the purchased goods are stored in bonded warehouses. This type of letter of credit is usually used in transactions related to commodity market such as wheat, rice, gold, etc.
Note: Green clause letter of credit is an extension of red clause letter of credit.

6. Standby Letter of Credit (SLOC)

1. 1. Standby letter of credit is a lender’s guarantee of payment to an interested third-party in the event the client defaults on an agreement.

Standby letters of credit are formal documents that specify the duties and obligations of each party and serve as an act of good faith. The bank issuing the SLOC performs general underwriting duties to ensure the financial credibility of the party seeking the letter of credit. Afterwards, it sends a notification to the bank of the party requesting the letter of credit (typically a seller or creditor).Example: An exporter sells goods to a foreign buyer who guarantees payment in 30 days. When no payment is received by the deadline, the exporter presents the SLOC to the buyer’s bank to receive payment.

7. Documents handled under Letter of Credit

Two important documents handled under Letter of Credit are broadly classified as:

1. 1. 1. Bill of Exchange: Bill of exchange is drawn by the beneficiary (exporter) on the LC issuing bank. When the bill of exchange is not drawn under a LC, the drawer of the bill of exchange (exporter), draws the bill of exchange on the drawee (importer). In such a case, the exporter takes credit risk on the importer.
      2. Bill of Lading (B/L): The B/L is the shipment document, evidencing the movement of goods from the port of acceptance (in exporter’s country) to the port of destination (in importer’s country). It is a receipt, signed and issued by the shipping company or authorized agent. It should be issued in sets (as per the terms of credit).

8. Parties involved in Letter of Credit Finance

1. 1. Applicant: The buyer/importer of goods: This person has to make payment of letter of credit to the issuing bank if the documents are in accordance with the terms and conditions of LC.
   2. Issuing Bank: Importer’s or buyer’s bank who lends its name or credit, is issuing Bank. It is liable for payment of LC in case the documents are received by it from the nominated or negotiating bank and the documents are in terms of letter of credit. This bank gets 5 days to check the documents.
   3. Beneficiary: The party to whom the credit is addressed e. seller or the exporter or the supplier of the goods. It gets payment against documents as per LC from the nominated bank within validity period of negotiation maximum 21 days from date of shipment.
   4. Reimbursing Bank: Third bank which repays settle or funds the negotiating bank at the request of its principal, the issuing bank.
   5. Confirming Bank: The bank adding confirmation to the credit, which undertakes the responsibility of payment by the issuing bank and on his failure, to pay. The confirmation is added on request of the opening bank.

9. Assessment of Limit of Bank Guarantees

The Specimen Illustration for assessment of Limit of Bank Guarantee is as follows:

10. Purpose of issuing of Bank Guarantees

Following are purpose of issuing Performance Bank Guarantee:

• • For securing any claims by the buyer on the seller arising from default in delivery or performance of the terms of the contract (example construction, assembly, execution).
  • For Execution of Long Term Infrastructure Projects such as Seaports, Airports, Road Construction, Bridges, Sanitation and Sewerage Projects, Telecommunication Services, Construction of Educational Institutions and Hospitals, Generation/Transmission/Distribution of Power, etc.
  • For Due performance of a specific contract undertaken by a customer in favour of Government Bodies/Others.

Example: Construction of Roads, Buildings Dams, Civil Work, etc

• • For Due performance of an equipment/project after completion for a specific period due to possible defects appearing after delivery during warranty period of the equipments.

11. Bank Guarantee Limits; Aspects examined by Banks while issuing Bank Gurantees

Whenever an application for the issue of bank guarantee is received bank examines & satisfy about the following aspects:

1. 1. Margin
   2. Need of the bank guarantee & whether it is related to the applicant’s normal trade/business.
   3. Whether the requirement is one time or on the regular basis.
   4. Nature of bank guarantee (e. financial or performance).
   5. Applicant’s financial strength/capacity to meet the liability/obligation under the bank guarantee in case of invocation.
   6. Past record of the applicant in respect of bank guarantees issued earlier.
   7. Present outstanding on account of bank guarantees already issued.
   8. Collateral security offered.

12. What is the purpose of issuing Performance Bank Guarantees?

1. 1. For securing any claims by the buyer on the seller arising from default in delivery or performance of the terms of the contract (example construction, assembly, execution).
   2. For Execution of Long Term Infrastructure Projects such as Seaports, Airports, Road Construction, Bridges, Sanitation and Sewerage Projects, Telecommunication Services, Construction of Educational Institutions and Hospitals, Generation/Transmission/Distribution of Power, etc.
   3. For Due performance of a specific contract undertaken by a customer in favour of Government Bodies/Others.Example: Construction of Roads, Buildings Dams, Civil Work, etc.
   4. For Due performance of an equipment/project after completion for a specific period due to possible defects appearing after delivery during warranty period of the equipments.

Ans.