M&A Vocabulary – Understanding the Experts: “Bank Guarantee”

Essential components of a transaction process include agreement on the purchase price and risk allocation between the parties. There are contractual options for this, such as warranties or purchase price adjustment mechanisms, but the parties cannot always reach an agreement. Depending on whether a fixed or preliminary purchase price is agreed upon, certain risks arise, particularly for the buyer, in the event of changes in the target company between signing and closing. Possible warranty or indemnity claims by the buyer are often secured by a purchase price holdback or by means of an escrow or blocked account. To avoid such a retention, the seller has the option, among others, of providing a bank guarantee to secure any claims by the buyer.

This is an irrevocable commitment by a bank to pay for the debts of a company or an individual under certain conditions as part of a transaction. A bank guarantee refers to a specific amount and a fixed period and defines the circumstances under which it is applicable to the contract. It is an abstract promise to pay that exists independently of the underlying transaction. The issuing bank usually requires a counter-guarantee or another form of security, as well as the payment of a fee from the party for whom the guarantee is provided. The bank guarantee therefore serves as a risk management tool for the beneficiary, as the bank assumes liability for the fulfillment of the contract.

In the case of foreign bank guarantees, e.g., in the context of cross-border transactions, a correspondent bank operating in the beneficiary’s country can also be involved as a fourth party. A distinction is therefore made between (i) a direct guarantee, which the obligor’s bank issues directly to the beneficiary, and (ii) an indirect guarantee, in which a second bank is involved. The latter is often chosen if the beneficiary wants additional security because, for example, there are concerns regarding the creditworthiness of the banks in the obligor’s country, other country risks are to be reduced, or regulatory requirements must be met. The money is then not paid directly to the beneficiary, but first to the bank; the correspondent bank then transfers the sum to the beneficiary of the guarantee.

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