Businesses and organizations alike face the challenge of recouping losses and reviving their normal operations. The pandemic effect on the economy has been adverse, and businesses are struggling to stay afloat. One significant way to alleviate the financial struggle is to use a letter of guarantee to infuse cash flow into the business. Letter of guarantee (LG)s facilitate transactions between both parties and safeguard them from credit risk. Let’s get into what constitutes a letter of guarantee and writing one.
What is a Letter of Guarantee?
A letter of guarantee is a contract issued by the bank on behalf of their client to back the credit risk the supplier assumes in a transaction where they have entered a sales or supply deal. LGs guarantee the supplier will receive reimbursement if the buyer (bank’s client) defaults on the agreement. You can use letters of guarantee to back trades, equipment leases, construction contracts, and real estate purchases. A letter of guarantee is similar to a loan. The bank will convert the debt if the client fails to fulfill their contractual obligations and pay the seller.
Note: The funds are immediately available to the LG holder (the buyer) once the bank issues the letter of guarantee. In contrast, the supplier or seller only gets paid if the buyer defaults on the agreement.
Letter of Guarantee Templates & Examples
How Does a Letter of Guarantee Work?
A letter of guarantee assures or guarantees the seller they will receive their cash for the sales agreement they have entered with a buyer who is the bank’s client. The customer must have good standing with the bank to qualify for an LG. When you apply for an LG, the bank examines your transaction history and the underlying transaction before approving the letter of guarantee.
Note: The bank may amend the letter depending on the transaction and underlying asset. Review the letter before signing.
When the supplier fulfills their contractual obligations, they can notify the bank to verify the claim and notify their customer. If the customer defaults on the agreement within the letter’s validity period, the bank will reimburse the seller and update the customer’s account. The bank will then revoke the letter post-agreement and retain the letter in your financial records. Banks also refund the surplus involved in the transaction to your account. You will be paying a yearly fee for the letter. The bank determines the fee based on interest rates and the principal amount.
Letter of Credit vs. Letter of Guarantee
Many sellers and buyers use letters of credit and letters of guarantee interchangeably. However, the letters have different features that influence their utility.
Letter of Credit
A letter of credit is a promise to pay the seller once they supply the goods. Banks issue letters of credit when the buyer approaches them to facilitate a transaction. Import and export salespeople usually use a letter of credit when dealing with clients from other countries. A letter of credit relieves the seller from any financial risk. Usually, a letter of credit is backed by collateral.
Letter of Guarantee
A letter of guarantee fulfills the payment obligation if one party fails to fulfill their end of the deal. The seller or the buyer will get paid depending on the party that defaults on the agreement.
If a cement supplier and a construction company enter into a contract and then the cement company does not supply the cement as stipulated in the contract, the construction company is entitled to a reimbursement if they notify the bank.
How to Write a Letter of Guarantee
Having known the clear differences between an LG and an LC, you can write one to facilitate your transactions. Here’s how to write a letter of guarantee:
1. Negotiate and review your letter
The terms of the agreement vary depending on the contract. It is best to sit down with your financial institution and understand the terms of the agreement. Review the interest rates, repayment terms, and liability clauses.
If you are not comfortable with some clauses, review the agreement and seek clarification before drafting the final letter.
Tip: Use specific language in the letter. Avoid ambiguous terms that are subject to different interpretations. In the case of Development Bank of Singapore v Yeap Teik Leong, a clause allowed the bank to ‘enlarge the credit.’ The court interpreted the clause to mean the bank can increase the loan amount.
2. Type the letter
Formal documents hold better legal ground when typed instead of handwritten. Document the details of the parties involved, i.e., the guarantor, the debtor, and the creditor. Type the parties’ names, addresses, and contact information if the debtor is a company, including their certification number.
State the nature of the transaction and why you are guaranteeing the deal. Provide additional details such as income statements, SSN, and DOB. Be careful with providing sensitive information. Sit down with the bank to determine what causes and terms you need to include.
3. Finalize the letter
Proofread the letter and ensure there are no errors. Reread the letter and ensure you comprehend the terms. Sign the letter and ensure both parties also sign the letter in the presence of a notary public.
Make copies of the letter and store the original with a trusted associate or a safe deposit box.
The main types are personal, supplier, travel, and product sample letters of guarantee. Each letter has different filling instructions and requirements.
A bank, microfinance, or credit institution can issue a letter of guarantee. Even an individual can issue a letter of guarantee.
A letter of guarantee in a business is a contract that safeguards against credit risk for the seller and the buyer.
A guarantee letter of credit assures the seller they will receive payment for delivering or supplying the goods. If the buyer defaults on the agreement, the bank will also reimburse the supplier.
Letters of guarantee do not have an industry-standard validity. The validity depends on the set timeframe.
It is best to protect your transactions than live on hopes and wishes you will receive pay for selling your goods. Use letters of guarantee to protect yourself and minimize the credit risks.