Protection Instrument: Bank Guarantee Minimizes Risks in Cross-Border Transactions

The recent news of Croatia being placed on the FATF (Financial Action Task Force) grey list and the subsequent decision by the American digital bank Mercury to cease operations with numerous Croatian development companies (startups) has stirred the Croatian business community and once again reminded that the banking system can sometimes slow down and complicate economic processes and transactions.

However, let us return to an institution that, on the contrary, often significantly facilitates cross-border business, strengthens the trust of the contracting parties that the obligations from the contract will be fulfilled, and serves to minimize risks. This is the bank guarantee – a security instrument that the bank issues as a guarantor at the request of the principal (debtor) and guarantees to a third party as the beneficiary of the guarantee (creditor) that it will make payment of the amount specified in the guarantee in case the principal does not fulfill its obligation to that third party under their fundamental contract (for example, a sales contract or a contract for the execution of works).

Reduction of Risk

In the case that you are negotiating, for example, the purchase of goods or the execution of construction works, regardless of whether you are the client or the supplier, a bank guarantee will allow you to reduce business risk in case the other party does not fulfill its obligation (delivery or payment). In that case, the bank will pay you the amount of the guarantee specified in the bank guarantee provided by the principal. Therefore, bank guarantees represent an important tool in facilitating business in a globalized, international business environment, ensuring trust and security for all parties involved. They are thus an instrument of protection against the risk of non-performance of assumed obligations or their improper performance.

In the mentioned cross-border transactions, a correspondent bank operating in the country of the beneficiary of the guarantee may also be involved. Thus, we distinguish between a direct guarantee, which the principal’s bank issues directly to the beneficiary of the guarantee, and an indirect guarantee, which also involves another (correspondent) bank from the beneficiary’s country. The latter option is often chosen if the beneficiary of the guarantee wants additional security, for example, due to the need to mitigate risks specific to a certain country or due to regulatory requirements that need to be met. In that case, the funds are not paid directly to the beneficiary of the guarantee, but to the bank, which then transfers them to the beneficiary of the guarantee.

Establishment of Contractual Relationship

At the moment of delivering the bank guarantee to the beneficiary of the guarantee, a special obligatory relationship arises between the beneficiary of the guarantee and the bank. The beneficiary of the guarantee can then, within the validity period of the guarantee, submit a request to the bank as the guarantor to pay him the monetary amount specified in it.

Whether the beneficiary must also provide certain documentation to the bank along with the request, for example, proof that the other party has not fulfilled its obligation under the fundamental contract, depends solely on what is specified in the guarantee. Therefore, additional caution is recommended when drafting and negotiating the text of the guarantee. Additional documents that the beneficiary must submit to the guaranteeing bank for the bank to make the payment from the guarantee are included in the text of the guarantee as an ‘effective clause’.

Bank Guarantee on Demand

Although many types of guarantees are present in practice today, the Law on Obligations explicitly regulates the bank guarantee on demand, in such a way that in Article 1039 it stipulates: ‘A bank guarantee on demand is any written obligation to pay, regardless of how it is named, by which the bank (guarantor) undertakes to pay the beneficiary a specified monetary amount upon the written request of the beneficiary if the conditions of the guarantee are met.’ Therefore, if the guarantee, for example, contains a clause ‘without objection‘ or words of similar meaning, the bank cannot raise objections to the beneficiary based on the fundamental transaction that the principal as the debtor may raise against the beneficiary under the secured obligation.

Thus, this guarantee is independent of the legal transaction concluded between the principal and the beneficiary. In the case of a demand guarantee, it will be sufficient for the bank’s obligation to pay the beneficiary to arise if the beneficiary submits a request to the bank for payment of the guaranteed amount within the validity period specified in the guarantee. Such guarantees are the instrument of the highest degree of security against the risk of non-performance or improper performance of the obligation from the fundamental contract.

Possible Abuses

The legal significance of such a guarantee is that the bank does not have the right to review the legal basis of the submitted request for payment, but only whether the condition contained in the guarantee, on which its fulfillment of the obligation to the beneficiary depends (that the beneficiary has submitted a request to the bank), has been met. However, this also allows for abuses by the beneficiary of the guarantee. For example, the beneficiary may, upon the first request, if the guarantee does not specify the documents that must be submitted to the bank with the request for payment of the amount specified in the guarantee, submit a request even if the principal has not fulfilled its obligation under the fundamental legal transaction.

Of course, in that case, the principal has legal remedies available to prevent the collection of the amount under the guarantee. Therefore, although the bank guarantee is today an indispensable instrument for securing payment or performance of obligations, the content of the guarantee should always be thoroughly checked, as well as the creditworthiness and previous conduct of the beneficiary in similar or the same transactions.