Guarantee and Indemnity for Loan/Credit

Generally loans and advances are made against tangible securities. When a customer has no tangible security to offer or when the security offered is inadequate, a guarantee is demanded by the banker.

A guarantee is a promise by a third person to the lender for the present or future debt of the borrower. The person who gives the guarantee is called a surety or guarantor. The person to whom the guarantee is given is called creditor or beneficiary. The person in respect of whose default the guarantee is given is called the principal debtor.

Example: P lends Tk. 5000/- to Q and R promises to P that if Q does not pay the money R will do so. This is a contract of guarantee. Here Q is the principal debtor, P is the creditor or beneficiary, and R is the guarantor or surety.

Section 126 of the contract Act, 1872 defines a contract of guarantee as,” a contract to perform the promise or discharge the liability of a third person in case of his default.”

Essential Features of Contract of Guarantee

i) The essential feature of a contract of guarantee is that the guarantor is liable when the principal debtor fails to repay the debt. The liability of the principal debtor is primary and that of guarantor is secondary.

ii) A guarantee may be either oral or written. Banks, however, do not accept oral guarantees. The contract must be in writing and should satisfy all legal requirements as to signature, stamp duty etc.

iii) A guarantee may be either (a) specific guarantee or (b) a continuing guarantee. A specific guarantee covers a single transaction. It comes to an end when the specific promise is fulfilled. The continuing guarantee is applicable to a series of transactions. The surety can fix up a limit on his liability as to time or amount of guarantee when the guarantee is a continuing one. For example, X enters into cash credit arrangement with Modern bank for a credit limit of Tk.50,000/-. Y stands as guarantor for this amount for a period of one year. Under this arrangement, X can undertake any number of transactions subject to the amount and time specified.

iv) The party must be competent to enter into contract.

v) Minor’s guarantee is not allowed but if any major gives guarantee in favor of minor, the guarantor becomes principal debtor.

vi) Credit worthiness of the guarantor is to be considered before obtaining guarantee.

vii) As per contract, the guarantee must be supported by lawful consideration.

viii) The contract must be entered into with free consent.

ix) A guarantee obtained under misrepresentation, fraud and undue influence is void able.

Indemnity

A contract of indemnity is defined as ‘a contract by which one party promises to save the other from the loss caused to him by the conduct of the promise himself or by the conduct of any other person. The person who makes such promise is called the ‘indemnifier’ and the other person is called the ‘indemnified’ or ‘beneficiary’. For example, X who has lost a fixed deposit receipt issued by modern bank may claim the amount by furnishing an indemnity bond. By this act, X promises to reimburse the bank any loss that may be caused to it for paying the amount without the receipt.

Banks and letters of indemnity

Banks may obtain the letters of indemnity in the following situations;

1. Loss of term deposit receipt: The bank is not entitled to withhold payment of the money if a deposit receipt is lost or destroyed. The depositor is asked to sign a letter of indemnity duly stamped when the payment is made or duplicate is issued.

2. Issue of duplicate draft: In case of issuing a duplicate draft in lieu of the original reported lost, the banker should immediately notify the office on which the draft is drawn and enquire whether it is outstanding. A stamped letter of indemnity should be taken, on receipt of nonpayment advice from the drawee branch. The letter of indemnity should be signed by the purchaser and by two sureties’ good for the amount of the draft.

3. Loss of traveler’s cheque: In case the purchaser of a traveler’s cheque claims refund of the value of the cheque reported lost, the request should be entertained by the selling branch of the bank only when the cheque had not been endorsed before it was lost and a letter of indemnity is obtained from the purchaser. The letter contains special stipulation that the cheque was unendorsed at the time of lost.

4. Loss of safe custody receipts: In case of a customer losing a safe custody receipt, he has to give a stamped indemnity letter before he is given delivery of a duplicate receipt of articles kept with the bank for safe custody.

5. Loss of gift cheque: In the event of loss of gift cheque, a duplicate may be issued obtaining a letter of indemnity from the concerned person as follows:

a) Where the gift cheque was in possession of the purchaser, at the time of its loss or where it has been lost in the course of postal transit, the banker should issue a duplicate cheque after obtaining a stamped letter of indemnity from the purchaser.

b) Where the name of the payee had been inserted in the cheque and it was lost while in the actual possession of the payee, the issuing branch, after verifying from the concerned purchaser and obtaining a stamped letter of indemnity from him with sureties, issue a duplicate cheque.

Distinction between Guarantee and Indemnity:

1. Number of parties: In case of guarantee there are three parties- the principal debtor, the creditor and the surety. A contract of guarantee requires the concurrence of the three parties. In case of indemnity there are only two parties- indemnified and indemnifier.

2. Number of contracts; In case of guarantee there are two contracts, one between the principal debtor and the creditor and the second between the surety and the creditor. On the other hand, in a contract of indemnity, there is only one contract between the indemnifier and the beneficiary.

3. Request: In a contract of guarantee, the guarantor undertakes his obligation at the request, express or implied, of the principal debtor; no such request is necessary in respect of an indemnity.

4. Nature of liability: In a contract of guarantee the liability of the principal debtor is primary and that of surety is secondary. The person giving an indemnity is primarily and independently liable.

5. Purpose of contracts: A contract of guarantee is to provide necessary security to the creditor against the loan but a contract of indemnity is made for reimbursement of loss.

6. Right of parties: The surety has the right to recover from the principal debtor the amount paid by him under the contract of guarantee, the indemnifier cannot claim reimbursement from anybody else.

7. Nature of risk: The surety agrees to discharge the existing liability of the principal debtor. So it is a subsisting risk. The indemnifier promises to save the indemnified against risk of loss happening in future. So it is a contingent risk.

Rights of Guarantor

1. Right to revoke continuing guarantee

2. Right of subrogation

3. Right to claim indemnity

4. Right to know the extent of his liability

5. Right against co-sureties

Discharge of Surety

1. Death of the surety

2. Discharge on variation of terms

3. Discharge by release of the principle debtor

4. Discharge by composition

5. Discharge by creditors’ acts or omissions

6. Loss of security

Precautions to be observed in taking Guarantee

1. Ascertain the solvency and integrity of the guarantor

2. The capacity to contract

3. Banker not to approach a guarantor

4. Type of guarantee

5. Execution of contract of guarantee

6. Explanation of the clauses in the form

7. No duty to inform voluntarily

8. Joint and several liabilities

9. Periodical confirmation

10. Death, lunacy and insolvency of the principal debtor

11. Death, insolvency or insanity of the guarantor

Types of Bank Guarantee

1. Performance guarantee

2. Guarantee for Earnest money i.e.; Bid Bond, especially for International Tender.

3. Advance Payment Guarantee

4. Shipping Guarantee

5. Custom & Exercise Guarantee

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WORKING CAPITAL ASSESSMENT

What is Working Capital?

Usually, a business concern, to speak more of a manufacturing unit, needs two types of finance. Firstly, it requires capital for the purpose of acquiring fixed and other long-term assets. This type of finance is usually provided by the long-term sources of funds. Secondly, it needs finance for working capital for its current operational purposes i.e., capital required to finance the current assets generated/required for the process of manufacturing and selling is called the Working Capital. The term Working Capital is used as a gross as well as a net concept. Gross Working Capital represents the totality of fluctuating funds invested in all current assets in a business. Whereas Net Working Capital refers to the excess of current assets over current liabilities and indicates the margin or buffer for meeting obligations within the ordinary operating cycle of the business.

Management of Working Capital:

Working capital unless deployed and managed effectively in the business will not yield the desired result. Fixed assets once acquired judiciously, will not bother the management for a certain period, but Working Capital which is the life blood for the current operations of the business needs to be properly assessed, raised and deployed. Working Capital funds are raised from the following two main sources: (a) Funds generated from current operations (b) Short term bank borrowings, trade credit, short term deposits, owners' equity etc. Funds thus raised are usually deployed in various phases of Operating Cycle.

The Operating Cycle

Every on-going business has got its operating cycle. The cycle itself has different successive phases. Let us assume that initially the business has some cash and bank balances. It uses a part of these to acquire raw materials. A part is used to meet the various manufacturing costs. The raw materials are converted into stock-in-process which in turn becomes finished goods. Finished goods get sold and become Accounts Receivables. On realization, the Accounts Receivable turn into cash. The Cycle will repeat itself as the business goes on.

The following are the Working Capital cycles which include operating cycles drawn up for manufacturing concerns and trading concerns respectively:

Factors affecting the Working Capital Requirements :
(1)    Nature of Industry.
(2)    The Operating Cycle.
(3)    The Manufacturing Cycle.
(4)    Vagaries in supply of raw-materials.
(5)    Production policies.
(6)    Shift in demand for products.
(7)    Competitive conditions.
(8)    Growth and expansion programs.
(9)    Operating efficiency.
(10)    Taxation.
(11)    Dividend Policy.
(12)    Depreciation policy.
(13)    Price level changes.
 

Different Phases of Operating Cycle and their lengths of Period:
The length of the operating cycle of a business is the sum of the lengths of period of different phases of the cycle which can be computed as follows :-

Working Capital Requirements:

From the preceding paragraph, it is possible to compute the working capital requirements first in terms of days and then to convert it into TAKA.
In case of existing units, the first step is to calculate the various components of working capital for the last 3 years interms of days by the method already described, where the past data so permits. After this, the existing situation in physical terms, is to be understood and appreciated. Finally, on the basis of a discussion with the party, the number of days of various components of the working capital he proposes to keep for the coming year is to be  decided. Note that this is not an arithmetical exercise where the past trends, howsoever extrapolated, are simply projected into the future. Frequently the past is a poor guide to the future. No amount of sophisticated analysis of past financing can be substituted for a forecast of what is likely to happen in the future. This is where good bankers are differentiated from bad bankers.
In case of new unit there is no past data to go by. In case there are other units in the same industry, their past components of working capital can be analyzed in terms of days. Where there are no such units or for some reason the other unit's experience is not applicable to the new unit, then the only thing a banker can do is to check the reasonableness of the party's projected holding of the components of working capital. Obviously there is a greater chance of an error here, and for this reason bankers tend to be conservative in financing new units. But being too conservative in financing new units, results in its strangulated growth.
There are two approaches to the next step of converting the working capital in terms of days into TAKA. The approaches differ in only the amount of work to be put in by the borrower and the banker.
 

The simpler approach, the one which will work well with the smaller units, is to ask the borrower to give its projected figure of sales for next one year. This figure given by the borrower needs to be evaluated  against items like its production capacity, past increases in sales, its marketing organization, order book position and future state of the industry and the economy. After evaluation, an acceptable figure of projected annual sales is arrived at. The next step is to calculate the past ratios of the following items : (a) raw material consumption to sales, (b) cost of production to sales, (c) cost of sales to sales. But multiplying the past ratios by the projected annual sales the following projected figures are obtained: (1) Projected raw material consumption (2) Projected manufacturing cost and (3) Projected cost of sales. Dividing these by 360 gives us the daily figures. On multiplication of these daily figures by number of days of future holding of working capital components we get the corresponding amount. Here again, the number of days of future holding is to be determined on the basis of past holding and the existing situation, in consultation with the past, as explained above. It is necessary to sound a note of caution about the projection of past ratios of (a) raw material consumption to sales (b) cost of production to sales (c) cost of sales to sales into the future plans. They will hold good, so long as the party has not switched over to a different product or product-mix or has not changed the technology.

Margin for Working Capital:

The margin for working capital is the balance of net working capital requirements after deducting bank finance. As regards to it, the banker should decide what margin percentage he wants to insist on raw-materials, work in progress, finished goods and receivables. But in our country, varying rates of margin on different individual components of working capital requirement are not widely practiced. So, a flat rate of 25% (say) margin amount can be suggested which has to be provided by the borrower, however the same depends on Banker — Customer relationship.
In the case of new project, it should be ensured that the margin is taken care of by issue of share capital or by long term ldans from financial institutions.

Trading Concern's Assessment:

The assessment of working capital limit for a trading concern is very much simple as compared to an industry. There is no raw-material or work in process to worry about, only stocks of finished goods, receivables and sundry creditors. Very often days of credit received and credit given are approximately the same and therefore, they cancel each other.

FORMAT OF ASSESSMENT OF WORKING CAPITAL REQUIREMENTS AND THE BANK FINANCE CONSIDERED PERMISSIBLE FOR A MANUFACTURING INDUSTRY

                                                                                                                               (Taka in hundreds)
                                                                                                                                   Amount (Tk.)
(a)    Stock of Imported raw materials
for (say) 3 months   
(b)    Stock of Indigenous raw-materials
for (say) 11/2 months   
(c)    Stock of Work-in-process
for (say) 1/2  months   
(d)    Stock of finished goods for
for (say) 11/2 months    
(e)    Stocks of consumable stores and spares
for (say) 2 months   
(0    Amount blocked in Receivables
for (say) 2 months,   

Less:
Credit received on purchase
for (say) 1V2 months   
WORKING CAPITAL REQUIRED

Less:    Margin requirement (say) 25%
BANK FINANCE CONSIDERED PERMISSIBLE


Note: The requirement of non-production expenses have to be met by the sponsors from their own source.

TEXTILE SPINNING INDUSTRY:

01.    Capacity Utilization : 

a)    Existing unit                        : 5% above last year's actual capacity utilization subject to maximum of 75%

b)    New unit                            : 70% of sanctioned/rated capacity whichever is lower

02:    Inventory : 

a)    Imported raw materials      : 90 days (cost at factory site)
b)    Local raw materials           : 30 days (cost of factory site) 3
c)    Work-in-process              : days (at production cost) 10
d)    Finished goods                 : days (at production cost) 90
e)    Stores and spares             : days (cost of factory site)

3.    Receivables                    : 15 days (at production cost)

4.    Cash in hand                   : Cash requirement for other day-to day expenditure (e.g. salary,  

                                                transportation, postage, utilities, etc.) should be arranged by the sponsors.

Format after working capital estimate:

Items                                             Tied-up period                                Working capital  requirement (Tk.)

Raw Materials

a)    Imported                                                                                      90 days

b)   Local                                               30 days

Working-in-process                               03 days

Finished goods                                      10 days

Stores & spares                                    90 days

Receivables                                          15 days

Cash                                                    Lum sum

Note : Margin/Security will be as per Bank Client relationship.

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RECOVERY OF STUCK-UP LOANS AND ADVANCES: MONITORING AND SUPERVISING OF CREDIT

Banks lend money to their customers for various purposes with a view to making profit after meeting all relative costs (Cost of fund, establishment cost, administrative cost, etc.) Bank collects fund from depositors i.e. Banks borrow fund from depositors. So advanced money comes from outside of the Bank repayable on demand and or as per schedule fixed earlier along with Interest. So we must recover money from the borrower after proper utilization to refund the same to the depositors and also to accommodate new customers afresh and to continue Bank's activities on revolving /cyclic process.

But it is experienced that in most of the cases money advanced to the borrower is very difficult to recover as per agreed terms due to failure of proper identification of following factors:

(a) Failure to identify genuine borrower.

(b) Failure to identify honest and sincere borrower for honoring financial commitment.

(c) Failure to identify capacity of the borrower to run the business successfully

(d) Failure to assess inherent risks (Financial, business, management & security risk) in the business and its mitigating factors.

(e) Failure in proper utilization of fund.

(f) Failure in protecting diversion of fund.

(g) Lack of supervision, follow-up and monitoring process..

All the above causes for non-recovery and poor recovery of loans are not under the control of the bank's authority. But some of the above causes are controllable by the bank which may improve recovery position. In this respect Bank officials must discharge their due responsibilities to study credit proposal keeping in mind to address the above points.

Despite strict compliance of the points mentioned above if we find that timely repayment of bank's dues is not made we must identify reasons whether the loan has become non-performing due to some genuine uncontrollable reasons or willful default.

If it happens for acceptable reasons we may go for re-schedule arrangement or nurse the same by allowing further facility with more time. The rescheduling arrangement must be allowed as per directives Central Bank. The main features are as follows:

Rescheduling proposals may be considered if-

(a) Borrower is not a willful defaulter.

(b) Borrower's cash flow statement, audited balance sheet & income statement justifies proposed rescheduling arrangement.

(c) Bank satisfy to the borrower's proposal.

Rescheduling incase of terms loan:

(a) Borrower must deposit 15% of overdue amount or 10% of outstanding whichever is less for 1st time rescheduling.

(b) Borrower must deposit 30% of overdue amount or 20%

of outstanding whichever is less for 2nd time rescheduling.

(c) Borrower must deposit 50% of overdue amount or 30% of total outstanding whichever is less for subsequent rescheduling arrangements.

Rescheduling for demand loan and continuous loan: 

Amount over dues                          Down payment

Up to Tk. 1.00 core                       15%

From Tk. 1.00 to 5.00 crore          10% (but not less than Tk. 15 lac)

For Tk. 5.00 crore & above           5% (but not less than Tk. 50.00 lac)

If any demand loan/continuous loan is converted into term loan, in that case down payment shall be 30% of overdue installment or 20% of outstanding amount which ever is less and 50% of overdue installments or 30% of outstanding amount for subsequent rescheduling arrangement. The rescheduling accounts must be monitored with special care and if any failure is noticed following actions may be taken:

(a) Periodical reminders shall be given.

(b) Guarantor (if any) shall be informed: He may be requested to peruse the borrower and arrange adjustment of Bank's dues.

(c) Seek assistance of local elite persons (if any) to assist the Bank for recovery of stuck-up loans.

(d) Frequently visit customer's business centre.

(e) Repeatedly visit customer's residence so that borrower may understand that either he shall have to repay/adjust the liability or make suitable arrangement afresh.

(f) Final notice may be given.

(g) Legal notice through Bank's penal lawyer may be given.

(h) Notice for encashment of security may be given.

If the account is by way of pledge and pledgor makes default in payment of debt, the Bank has to sell pledged goods through public auction as per directives of Head Office and sale proceeds to be deposited in borrower's account towards reduction of debt.

If the account is collateralized by Mortgage of immovable property (Land & building) having irrevocable power of attorney to sell the mortgaged property Bank shall have to arrange for auction by publishing notice in 02 daily News Papers and shall ensure getting best price. In this case Bank's enlisted lawyer's opinion should be obtained so that provisions mentioned in the law may be followed meticulously.

All other securities such as liened FDRs, Credit balances and balances of scheme deposits may be appropriated after due notice to the borrower as well as Guarantors /account holders etc.

After appropriation of proceeds (Sale proceeds of pledged goods/mortgaged property/ FDRs/scheme deposit/Credit balance etc.) for realization of balance outstanding if any, Bank may go for filing suit against the borrower/Guarantor before claim is barred by limitation.

The Bank should be very cautious in maintenance of non-performing loan accounts so that suit may be filed within next one year when:-

(a) Minimum 10% of overdue amount in the 1st year

(b) Minimum 15% of overdue amount in the 2nd year

(c) Minimum 25% of overdue amount in the 3rd year is not recovered/realized.

If the total period of loan repayment according to the repayment schedule is less than 03 years and if amount of realization within that total period is less than 20%, the Bank file suit within next one year.

If any suit is instituted after the period mentioned above, the Court shall inform the matter in writing to the Ca9 of the Bank immediately and if such suit could not be filed within the stipulated period due to failure of an officer to carry on his duty, appropriate authority shall have to take disciplinary action against such officer liable and inform the Government and the Court about action taken within 90 days of receiving information.

Recovery process in case of borrower's death:

After a borrower's death (in case of an individual or sole proprietor of a concern), no further withdrawal or debit in his advance account should be permitted. If the borrower's successors and heirs approach the bank for continuation of the facility, the case will have to be examined from all angles.

If the bank agrees to the request, debit balance in the account of the deceased may be transferred to a new account in the name of his heirs or successors along with the securities held in the account. Legal opinion shall have to be taken before this is done. If the desired facility is refused or no application is made by the heirs or successors in this behalf, the securities, if any, may have to be sold and the guarantee, if any to be invoked/encashed. For the balance, if any, a suit shall have to be filed for obtaining decree of the court, if adjustment is not possible out of the court. It should be noted that the heirs of the deceased borrower are responsible to pay the debt only to the extent of the assets of the deceased, which come to their hands.

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