A bank guaranty is a form of insurance provided to a party to a transaction in the event the transaction does not go as planned. The bank agrees to pay the designated party a sum of money if the buyer or seller is unable to meet contractual obligations. Large, performance-driven contracts frequently require this special letter of indemnity as part of the award or negotiation.
Prudent business transactions consider what might happen in the event the parties to a transaction can't complete their required obligations under the contract. Many contracts are negotiated to cover a long period of time, with multiple transactions underneath the same contract. In these types of contracts, each party may require a bank guaranty to be executed by the other party. The bank guaranty aims to protect each party in the event of non-performance.
Non-performance can be a factor outside the contractual party’s control. Despite the party’s intentions to fulfill its obligations under the contract, the party may not be able to perform as designated in the contract. In this circumstance, the bank will pay the party receiving the goods or services a sum of money as designated in the contract and the bank guaranty document. The parties agree in advance about what the damages would be in the event of non-performance. The purpose of the bank guaranty is to reduce the loss in the event of non-performance.
By determining in advance what the damages would be when a party can't perform, the parties to the contract can reduce the cost and delay associated with such non-performance. The designated party receives its funds in accordance with the contract and may find a third party to provide the goods or services that the contractual party was unable to provide in a timely manner. Without the bank guaranty as part of the original contract, the designated party would have to go through some form of dispute resolution process with the original provider before receiving any award of damages.
Bank guaranties are used under different names in a variety of business transactions. In the construction industry, bid bonds or performance bonds are required as part of the contracting process. These bond documents are a form of bank guaranty. When a company is shipping goods with another company, the shipping company might require a letter of indemnity from the shipper in the event documents are lost or other requirements cannot be met.