Also known as a demand guarantee, an independent guarantee is a type of financial arrangement that ensures or guarantees that a recipient or obligee can receive payment on demand, subject to that demand being in compliance with the terms and conditions that have to do with the contract governing the transaction. This type of guarantee is usually included in the sale of a performance bond, as well as other types of financial arrangements. Typically, the ability to demand payment is predicated on the failure of the other party in the arrangement to perform certain responsibilities related to the arrangement, providing the obligee with the right to demand payment and settle the contract earlier than the originally proposed maturity date.
The general function of an independent guarantee is to make sure that the interests of the obligee are protected in various types of financial arrangements, providing some type of compensation in the event that the other party in the contract does not carry out his or her responsibilities. Often, the guarantee is in the form of a performance bond that is issued to the obligee and may be presented for payment if the issuer fails to honor those responsibilities. In this manner, the obligee is at least partially compensated for any losses that are likely to occur due to the failure of the second party to perform as promised.
One of the easiest ways to understand how an independent guarantee functions is to consider the sale of a round lot of carpets by an exporter to an importer. As part of the deal, the importer may require that the exporter obtain a formal promissory note from a bank, stating that if the exporter fails to deliver the rugs on time and in the right quantity, the importer will receive a certain amount of compensation. The note is forwarded to the importer, who holds onto it pending the completion of the sale and delivery of the rugs. If the exporter fails to make the delivery on time, or the quantity is reduced, the importer, as the obligee in the arrangement, can present the note for payment to the bank. The bank will honor the payment, then deduct the amount of that payment from the accounts of the exporter.
The purpose of the independent guarantee is to protect the interests of obligees in the event that the obligor fails to honor commitments made as part of the business deal. While the amount of the guarantee is not likely to provide total compensation for the failure, it does at least partially offset losses sustained by the obligee, either due to lost opportunities to sell goods or expenses incurred while waiting for the second party to fulfill his or her contractual commitments. Along with protecting the interests of the obligee, the use of an independent guarantee also provides additional motivation for that second party to comply with the terms of the contract so that the guarantee is never exercised.