FCIB Inernational Credit and Risk ManagementHandout: Bonds, Letters of Guarantee, and IndemnitiesModule 5, Lesson 5, Section 5.3

BONDS, LETTERS OF GUARANTEE, AND INDEMNITIES

Bonds, letters of guarantee, and indemnities are, for the most part, self-identifying

instruments. An instrument that labels itself a bond is a bond, that labels itself a guarantee

is a guarantee, etc. Although the terms are often used synonymously, the following

distinctions are often made.

A bond is a commitment made by one party (the bank or other issuer) to another

party (the obligee) pledging to cover for financial loss caused by the act of default

of a third party (the bank’s customer and principal).

Bonds are generally issued to assure performance obligations, as opposed to

financial obligations.

A letter of guarantee (often simply a guarantee) is a promise made by one party

(the bank or other issuer) on behalf of some other party (the ban’s customer and

principal) that payment will be made to a third party (the oblige) at some future

date. In the event the bank’s customer does not make good its obligation to pay,

the issuer undertakes that it will make such payment.

Letters of guarantee are generally issued to assure financial, rather than

performance, obligations.

An indemnity is a promise made by one party (the bank or other issuer) to another

party (the oblige) to make payment in compensation for loss, expense or damage

incurred as a result of some action or default of a third party (the bank’s customer

and principal) or as a result of some other contingency.

Indemnities may be issued to assure either financial or performance obligations.

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FCIB Inernational Credit and Risk ManagementHandout: Bonds, Letters of Guarantee, and IndemnitiesModule 5, Lesson 5, Section 5.3

The form of guarantee that is used in any particular transaction is largely a function of

market practice and legal tradition. While U. S. banks adapted the form of the letter of

credit to meet their customers’ needs for performance guarantees, banks in the U.K. and

other countries adapted the legal form of the bond. Unlike the bonds assuring

performance issued by insurance companies, the bonds issued by overseas branches

assure payment upon the occurrence of readily ascertainable events, e.g., the delivery of a

statement that a specified event has occurred.

Function Bank Instrument

To make payment to a third party in the

event a customer fails to perform a

financial obligation

Standby Letter of Credit (primarily used in

the U.S., although can also be used outside

U.S)

Letter of Guarantee (outside U.S. only)

Indemnity (outside U.S. only)

To make payment to a third party in the

event a customer fails to perform a

nonfinancial contractual obligation.

Performance Letter of Credit (used

primarily in U.S., although can also be

used outside U.S.)

Bond (outside U.S. only)

To assure customer performance where the

bank has substantial interest or where such

an instrument is otherwise permitted under

applicable law.

Steamship Guarantee

Air Release

Indemnity Agreement on Discrepancies

article_767.docSource: FCIB, 27 December 2010

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