M&A Vocabulary – Experts explain: Bank Guarantee

The basic elements of a transaction process include agreeing on the purchase price and allocating risks between the parties. For this purpose, it is possible to use contractual structures, such as warranties, or purchase price mechanisms, but the parties are not always able to reach an agreement about it. Depending on whether the parties agree on a fixed or a preliminary purchase price, especially the buyer might become exposed to certain risks if there are changes in the target between signing and closing. Warranty and indemnity claims of the buyer are often secured by a purchase price retention or by means of an escrow account or a blocked bank account. To avoid such a retention, the seller can, for example, provide a bank guarantee to secure potential claims of the buyer. 

A bank guarantee is an irrevocable commitment by a bank to stand in for a company's or an individual’s debts as part of a transaction if certain conditions are met. A bank guarantee refers to a specific amount and a specific period and specifies the conditions under which it applies to the contract. It is an abstract promise to pay which exists independently of the underlying transaction. The issuing bank usually requires the party for which the guarantee is being issued to provide a counter-guarantee or other form of security and to pay a fee. The bank guarantee thus serves as a risk management tool for the beneficiary, as the bank assumes liability for the performance of the contract. 

In the case of foreign bank guarantees, for example in cross-border transactions, a correspondent bank operating in the beneficiary's country may also be involved as a fourth party. Hence, there is a distinction between (i) a direct guarantee, which the bank of the obligor issues directly to the beneficiary, and (ii) an indirect guarantee, in which a second bank is involved. The latter is often selected if the beneficiary wants additional security, because, for example, there are concerns about the creditworthiness of the banks in the country of the obligor, other country risks should be mitigated, or regulatory requirements need to be met. The funds are paid not directly to the beneficiary but to the bank. Then, the correspondent bank transmits the amount to the beneficiary of the guarantee.