How, then, does a bank guarantee provide protection against non-performance? In three ways:

Legitimation:

A bank guarantee testifies to the principal’s ability to carry out the contract. Since the issuance of a guarantee constitutes an irrevocable payment undertaking, a bank will not enter into such

a commitment without first thoroughly examining the principal’s financial status and technical capability.

Motivation:

The principal stands to lose the guarantee amount if it fails to fulfil the contract terms. This is a strong incentive to complete the contract, even if the transaction has lost its appeal in the meantime.

Compensation:

If the principal fails to fulfil its obligations, the buyer is entitled to demand payment of the guarantee sum, which will compensate fully or partly for the financial consequences of the breach of contract.

• payment of term bills of exchange
• repayment of bank loans and advance payments
• payment for goods delivered
• contract fulfilment of all types, etc.

Like guarantees, standby letters of credit are payable on demand and no defence against the claim is permitted. As such, they constitute abstract commitments that are independent of the underlying transaction. To trigger payment, the documents stipulated in the wording of the standby letter of credit must be submitted in accordance with the applicable regulations.

Alongside UCP, ISP98 (International Standby Practices) has been in force since January 1, 1999. This set of rules was developed and approved specifically for standby letters of credit by the International Chamber of Commerce (ICC). In practice, use of ISP98 is now becoming increasingly widespread.

In July 2010 these rules were updated to ICC Publication no. 758. The main difference being that the underlying contract (the reason and purpose of the Guarantee) should form part of the Guarantee. It is this URDG ICC 758 protocol that is now current. It superseded ICC 458 which is no longer used.

Demand guarantees may be subjected to the new rules by including a simple statement to this effect in the guarantee agreement. To qualify as a demand guarantee, the guarantee document must not stipulate any conditions for payment other than the presentation of a written demand and any other specified documents. In particular, the guarantor must not be required to decide whether or not the beneficiary and principal have fulfilled their contractual obligations. Restrictions on entry into force – such as the receipt of a down payment – may nonetheless be imposed.

The rules are intended to balance the interests of the beneficiary with the principal’s wish for protection against unjustified claims. The beneficiary wishes to protect itself against the risk that the principal will not fulfil its contractual obligations. A demand guarantee provides quick, easy access to a guaranteed sum of money if these obligations are not met. However, for the sake of equity and fair dealing, the rules contain a provision to the effect that any demand should be accompanied by a statement by the beneficiary explaining in what respect the principal is in default. This is intended as a safeguard against unfair calling. It should be emphasized that the rules do not in any way prejudice national legislation with respect to fraudulent or fraud claims.

The term “bank guarantee” has no precise definition, particularly in international law. Some use the term exclusively to describe a transaction in which one party makes an independent guarantee commitment in respect of another party’s liabilities, regardless of the latter’s form and enforceability. Others describe guarantees as all transactions in which security is offered; from letters of comfort (which often are morally binding at most) to surety bonds and abstract payment undertakings. The custom and protocol in international trade is to have undertakings that are payable on first demand and that are legally separate from the underlying transaction, (Uniform Rules for Demand Guarantees).

The common element in all these arrangements is that the guarantor undertakes to be answerable for the payment of a debt or the fulfilment of a payment obligation in the event of default by the party that is responsible for it.

Thus the basic function of a bank guarantee is to provide security.

The main difference between a bank guarantee and a documentary credit is that the latter also functions as a means of payment. A bank guarantee acts as security for a payment, not as a means of payment.

Bank guarantees are governed almost exclusively by the law of the country of domicile of the bank that issues the guarantee to the beneficiary. This means that the legal position must be studied in each case.

Every declaration that is designated a “bank guarantee” must be examined carefully to ascertain its legal significance and implications. A particularly clear distinction must be made between a surety bond and an abstract payment undertaking.

A lien over shares takes on two different forms:

Legal mortgage

The shares are transferred into the name of the mortgagee who is registered as a member of the company. There must be a charging document reciting that the charge is by way of security, providing for a re-transfer on redemption, setting out the mortgagors obligations, the events of default, dealing with dividend and voting rights if these are to be removed from the mortgagee and perhaps containing a topping up clause obliging the mortgagor to mortgage further securities if the value of those charged falls below the outstanding amount of the debt plus a certain margin.

Equitable mortgage of shares

It may be created by:­

1. simple deposit of the share certificate in which case the mortgagee will need to apply to the Court for an enforcement order for sale or foreclosure; or
2. a deposit of the share certificate together with a blank transfer form undated but signed by the mortgagor. The mortgagee can insert his name or another’s name as the transferee in the event of default. However if the articles requires transfers to be made by deed then the mortgagee does not have the implied authority to fill up the blanks except if he has a power of attorney under seal to do so; or
3. deposit of the share certificate coupled with a blank transfer and a memorandum of deposit under seal containing an irrevocable power of attorney by way of security pursuant to s.4 of the Powers of Attorney Act 1971. Thus the mortgagee will be able to complete and execute the transfer on behalf of the mortgagor.

Points to note:

Legal mortgages

The mortgagee becomes a member of the company and

a)      he is liable for calls on partly paid shares;

b)     remains a contributor if the winding up commences within a year of the re-transfer of his shares to the mortgagor;

c)      if he receives dividends he will be liable to account to the mortgagor for this income;

d)     he runs the risk of acquiring a subsidiary (interestingly the company may be a subsidiary both of the mortgagee by virtue of his holding and of the mortgagor by virtue of his control if the voting rights have been assigned to the mortgagor under the charging document);

e)      stamp duty is not payable if the transfer is by way of security for a loan or re-transfer to the original transferor on repayment of a loan (please see form of certificate on the back of stock transfer form);

f)       a transfer of shares by way of security is not a capital gains tax disposal until the security is enforced, if this indeed applies in the jurisdiction of Bronte;

g)     where the mortgaged shares represent a controlling interest there may be tax implications flowing from a company being or not being connected, grouped or linked with another company.

Equitable mortgage

(a)             Capitalisation issues need to be brought into the charge. This cannot be done of course if there is mere deposit of the share certificate with or without blank stock transfer form or the equivalent.

(b)            It is not secure. However, the mortgagee can serve a stop notice on the company by filing an affidavit and a notice in the central office of the Supreme Court or a District Registry and serving them on the company. Whilst the stop notice remains in force the company will be obliged to give him notice of proposed transfers which will enable him to apply for an injunction.

Points to note in both types of mortgages

1)     There may be restrictions in the articles of association where the mortgage is over shares of a private company relating to:-

(a) directors’ powers to refuse registration (in order to avoid this risk, it is advisable to make them parties to the charge wherever possible);

(b) pre-emption rights on transfer (waivers will need to be obtained when taking the mortgage and also when realising the security);

(c) the creation and enforcement of mortgages over shares (a special resolution may be necessary to avoid a specific restriction in the articles).

(2) Registration at Companies House may be necessary if the mortgage over shares constitutes a charge over book debts (ie dividends).

(3) Notification of interests of directors under s.324 Companies Act 1985 (‘CA’) may be necessary if the mortgagor or the mortgagee is a director of the company (or the company’s subsidiary or holding company or the holding company’s subsidiary) as the granting of the mortgage may constitute the entering into a contract to sell shares.

(4) Disclosure of interests in shares under s198 (1) CA may be necessary if the mortgage gives certain voting rights on shares in a public company (or on shares of a company which is, or through a subsidiary is, a shareholder in a public company).

(5) If the shares are vested in the mortgagee, as shareholder he will share last in a return of capital after the secured, preferential and the unsecured creditors of the company have been repaid. Coupled to the lack of marketability of a minority interest a mortgage on shares may not be an attractive security.

(6) The articles may give liens over the shares not only for unpaid calls but also for any moneys due from the shareholder to the company.

(7) Priorities of legal and equitable mortgages over shares or between such mortgages and liens may need to be considered.

Conclusion

As indicated a mortgage on shares is not always a popular security instrument. The legal mortgage on shares gives better formal security than the equitable mortgage. However the mortgagee’s name appears on the register of members of a company and this can mislead creditors into thinking the company has a substantial shareholder and endanger the mortgagee’s reputation. Thus equitable mortgages while more risky are generally more common.

Firstly, there is no such thing as ‘lease’ or ‘leasing’ of bank guarantees. The correct term is Collateral Transfer. Where the Provider will effectively ‘transfer’ his asset for the use of it by another party in return for a fee. The term leasing bank guarantee is used as I guess the process is very much that of commercial leasing. In as much as the provider of the guarantee will request that it is either returned at the end of the period or allowed to lapse; allowing him to take back his underlying asset used to issue it in the first place.

Secondly, there is a lot of confusion as to the ‘acceptability’ of certain banks and their bank guarantees. When the borrower receives the guarantee, they will ask their receiving bank to credit line or monetize it. The borrowers request that bank guarantees must come from internationally recognised banks due to their rating. However, since bank guarantees are not listed securities or inter-changeable debt notes and further are issued only against ‘value received’, the banks rating is not important. Moreover, the quality of a bank guarantee will be attested by the issuing banks performance, i.e. has it defaulted on guarantees in the past?

It remains the fact that if the borrower was successful in receiving a bank guarantee from a top world bank such as HSBC, Deutsche Bank or alike to his account and requested his bank to advance credit against it as security; the bank may decline to offer credit if that bank holds existing debt exposure to that issuing bank. For example, if the receiving bank received a bank guarantee from HSBC for €10 million and at that moment in time HSBC held large liability to the receiving bank, the receiving bank may decline to increase that liability. Equally, if the guarantee was remitted by a small private bank (with little or no rating) and the receiving bank held no existing liability with that bank, they would be more inclined to accept it. It should be noted that most Private Swiss banks are not rated as they refuse to give sensitive financial information to rating companies such as S&P, Moody’s and D&B.

Bank Guarantees do not have individual ratings like, for example, MTN’s and Bonds. They are private inter-bank contracts. They are not listed or registered on Euroclear. They are not tradeable. They do not carry CUSIP or ISIN numbers, despite what you may read on unscrupulous internet sites.

For more information, there is a good independent site at Bank Guarantee Facts which contains very useful information for the novice.

At this time of economic hardship and uncertainty, international companies are turning to sophisticated investors to raise adequate collateral through collateral transfer arrangements (‘lease of bank guarantees’) and securities lending to raise their much needed project capital.

It is common knowledge that lending banks, private equity investors and private lenders have all restricted their books. It is no longer attractive to place large investments into real estate or long-term assets without a short-term or instant repayment vehicle being offered alongside.

Not only as real estate, property sales and developments have become a higher risk, but also recently assets in foreign lands have also come under the attack of political risk. Mainly due to the financial condition of the state. Cyprus for example has been in the news for this reason, albeit news reports are leaning far toward the negative of what the real position actually is. Investors are now concerned that not only the value of such investment or security may be under threat, but moreover political challenge of the ownership and taxation of it may also be a potential threat to lenders’ security.

Over recent months there has been a significant up-turn in the applications for collateral transfer and ‘leasing’ bank guarantee proposals. These facilities involve two parties and their respective bankers. Whereby, the Applicant will apply to receive collateral, often in the form of a demand guarantee (a Credit Facilities Bank Guarantee) from the Provider in return of the payment of a Contract Fee (or usage fee) to the owner of the underlying asset. The Provider will place his assets with his issuing bank and instruct his bank to issue to the Applicant’s receiving bank a Bank Indemnity or Guarantee secured thereon. The Applicants receiving bank will then be more than happy to extend the required credit and loans against this readily callable security.

These are often injected by the Provider (typically a private equity company) as indirect guarantees. The main benefit to the equity provider is that by offering his  investment in this manner, he retains control of the actual cash or underlying asset as the recipient bank then holds an interest in his investment being repaid. The other alternative for the equity provider is to remit cash sums to applicants under credit or loan agreements and rely on the strength of his security, typically real estate property or liens over shareholdings, etc in the event of default.

However, the down side is that of increased costs of the borrowers. Not only do they suffer the loan interest charges but also some additional five or six percent in fees for the usage of the collateral. This increases costs (often doubles them) but assures a successful outcome to their funding requirements.

This method of making investments is rapidly growing. However, many mainstream bankers are still yet to take advantage of their position in making these transactions. There is a real growing market for bankers to literally ‘market make’ a position in this niche corner of the banking world.

Perhaps 2014 will see these facilities on the ‘menu’ of mainstream banks.