Advance Payment Guarantee: a Worked Example

A buyer that pays a deposit on equipment or works has made the supplier an unsecured loan. The money funds mobilisation: design, long-lead materials, the first payroll. If the supplier fails, the buyer's refund claim ranks with every other creditor's. A guarantee from the supplier's bank replaces that claim with one on the bank, and many are written as demand guarantees, so the bank pays on a complying demand and recovers from its customer under the counter-indemnity.

Public and private buyers both ask for them. On contracts procured internationally under the World Bank's procurement regulations, which govern projects it finances, the bidding documents must state what security is needed for any advance. Banks are the usual issuers, and insurers and sureties write them too. Where a supplier cannot give its bank enough security, an export credit agency can carry part of the risk: UK Export Finance guarantees banks up to 80% of a bond's value, Export Finance Australia guarantees bank-issued bonds or issues its own, and New Zealand's Export Credit Office has guaranteed banks issuing advance payment bonds for exporters.

Three clauses do the work. The first decides when the guarantee bites. It is often stated to come into force only once the advance has been received, and better still received into a named account at the issuing bank. Under the ICC's Uniform Rules for Demand Guarantees (URDG 758), a condition with no document to prove it is disregarded unless the guarantor can confirm it from its own records, which is one reason banks ask for the advance to be paid to them: they can see it arrive.

The second decides how it falls. The contract usually recovers the advance by deducting a share of each progress payment or invoice. The guarantee follows only if its text says so. URDG 758 lets a guarantee reduce on stated dates or events, but an event counts only when a document the guarantee names is presented, such as a certified payment statement, or when the guarantor's own records show it. A reduction schedule written only into the contract binds the buyer, not the bank.

The third decides when it ends: a date, an event such as delivery or commissioning, or the amount reaching nil. Under URDG 758, a guarantee that states neither an expiry date nor an expiry event ends three years after issue.

A fabricator, constructed for this page, wins a US$12m contract to build and install a sorting line for a food processor. The buyer pays 20% up front, US$2.4m, and recovers it by deducting 20% from each certified milestone payment. The fabricator's bank issues an on-demand guarantee for US$2.4m, effective when the advance reaches the fabricator's account with the bank, and reducing as each certified payment is presented. The percentages are the example's, not a market norm.

The schedule is not the risk profile. Two months in, the fabricator has spent US$1.8m of the advance on steel, drives and a controls subcontractor's deposit, and has certified nothing. The bank carries the full US$2.4m. If the fabricator fails then, the buyer calls, the bank pays, and it claims from a customer whose cash is in half-built equipment. That month is what the credit decision was about.

Now suppose the guarantee had no reduction clause. After milestone 2 the contract shows US$1.0m still to be recovered, but the guarantee reads US$2.4m. A buyer that terminates can present a complying demand for the face amount, and the fabricator's claim to the excess US$1.4m lies against the buyer under the contract, after the bank has paid.

The same contract often carries both, from the same bank. A performance bond answers for what the buyer may lose if the work is not done; its amount is commonly a fixed share of the price and stays in place through the job, sometimes stepping down at completion to cover defects. An advance payment guarantee answers for money the buyer has already handed over, and its amount follows the unrecovered advance down. Early in the contract both stand at full value, so the bank's combined exposure peaks then. With a performance bond of 10% (the example's figure), the fabricator's bank holds US$3.6m at month two and US$1.6m after milestone 3.

A red clause letter of credit solves the same problem from the other side: the buyer's credit lets the supplier draw an advance before shipment, and the risk of that advance sits with whoever funds it.

DEFINED IN ONE PARAGRAPH → · THE ON-DEMAND GUARANTEE → · PERFORMANCE BOND, DEFINED →

The credit decision turns less on the guarantee than on the contract behind it. Is the advance large against the cost of the early work? Has the supplier built this before, at this size? Where does the advance go once it lands: into materials for this contract, or into a hole left by the last one? A bank that sees the advance arrive in its own account can also see it leave, and some ask for it to be held in a controlled account and released against the supplier's invoices.

In negotiation the supplier wants the reduction and expiry written into the guarantee itself, with documents it can produce without the buyer's cooperation. The buyer wants the guarantee in hand before it pays. The bank wants the guarantee to fall as fast as the risk does, because a guarantee that outlives its advance is lending the customer no longer needs.

PRODUCT FILE: BANK GUARANTEE → · HOW BANKS READ EXPORTERS → · THE COUNTER-GUARANTEE →