What is a 'Letter Of Guarantee'

A letter of guarantee is a type of contract issued by a bank on behalf of a customer who has entered a contract to purchase goods from a supplier and promises to meet any financial obligations to the supplier in the event of default. A letter of guarantee may also be issued by a bank on behalf of a call writer guaranteeing that the writer owns the underlying asset and that the bank will deliver the underlying securities should the call be exercised. Call writers will often use a letter of guarantee when the underlying asset of a call option is not held in their brokerage account.

BREAKING DOWN 'Letter Of Guarantee'

A customer often provides a vendor with a letter of guarantee when the vendor is uncertain whether the customer can pay an invoice. This is especially common with purchases of costly equipment or other property. However, a letter of guarantee may not cover the whole amount of the debt. For example, a letter of guarantee in a bond issue may promise either interest or principal repayment, but not both. Also, in some cases, a letter of guarantee holds a guarantor responsible for other guarantors’ repayments if they default on their agreements.

Letter of Guarantee for a Call Writer

Because many institutional investors maintain investment accounts at custodian banks rather than at broker-dealers, a broker often accepts a letter of guarantee for call writers with short options as a replacement for holding cash or securities. The letter of guarantee must be in a form that the exchange, and potentially the Options Clearing Corporation, accepts. The issuing bank agrees to give the broker the underlying securities if the call writer’s account is assigned.

Example of a Letter of Guarantee

In July 2016, results of the MeHAS City project’s arbitration hearing were announced. The Taipei City Government was allowed to claim $108.65 million from real estate developer Radium Life Tech Company due to undervalued land properties.

In 2001, the Taipei Department of Rapid Transit Systems signed a contract with Radium to build the MeHAS City project. In 2012, the Control Yuan filed an amendment to the contract, suggesting that Radium undervalued the land used in the project, overvalued the complex being built, and created large monetary losses for the city. Because Radium refused to negotiate and repay the city $7.6 billion, the case went through arbitration.

After announcing the results of the arbitration, Hau Lung-bin, former mayor of Taipei who signed the contract, stated that he had secured a guarantee of approximately $219.6 million from Radium. Half the guarantee was in a cashier’s check from the company’s chairman, and the other half in a letter of guarantee from Mega Bank. Lung-bin did not anticipate any issues receiving the money.

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