The 2% Performance Bond: Who Issues It, When It Is Drawn and How Sellers Abuse the Term

Almost every draft contract for ICUMSA 45 sugar or copper cathodes contains a clause reading "Seller shall issue a 2% performance bond". The clause is standard in institutional trades and is harmless when the sequence is right. It becomes a tool for extracting money when the sequence is reversed. This article explains who issues the 2% performance bond, when it is drawn and how to recognise its misuse.

What a performance bond is

A performance bond, also called a performance guarantee or PB, is an independent undertaking by a bank to pay the buyer a fixed sum if the seller fails to perform the supply contract. The sum is typically 2 % of the contract value; 5 % and 10 % are common in construction under FIDIC and in government tenders. The bond is independent of the underlying contract: the bank pays against a compliant demand without investigating whether the seller actually defaulted.

The governing rules are URDG 758 (ICC Uniform Rules for Demand Guarantees) for a demand guarantee, or ISP98 if the bond is drafted as a standby letter of credit. The instrument is transmitted by SWIFT MT760 from the seller's bank to the buyer's bank, which advises it to the buyer. An MT799 is not a performance bond, and neither is a scanned letter.

Who issues it and when

The seller's bank issues the bond in favour of the buyer. It does so against the seller's credit line or cash cover, which is why only a seller with a real banking relationship can provide one. The timing follows the letter of credit:

1. The parties sign the sale and purchase agreement.
2. The buyer's bank issues the documentary letter of credit by MT700, subject to UCP 600, with a clause making it non-operative until the performance bond is received, or operative from issue with a right to cancel if no bond arrives.
3. Within the agreed period, commonly three to seven banking days, the seller's bank issues the 2 % performance bond by MT760, referencing the contract and the credit.
4. The credit becomes operative; the seller ships; documents are presented and paid.
5. The bond expires on its stated date, usually a short period after the final shipment, and is returned or lapses.

The buyer's instrument comes first because it is the larger and more decisive commitment: the credit is for 100 % of the cargo value, the bond for 2 %. A seller who holds a letter of credit has a bankable document; a buyer who holds only a performance bond has 2 % of nothing if no cargo exists.

Rule: the performance bond is issued by the seller's bank after the buyer's letter of credit, never before, and never against a fee paid by the buyer. Any structure that reverses this order has reversed the risk.

When the bond is drawn

The buyer may demand payment when the event described in the bond occurs, typically failure to ship within the contract shipment period. Under URDG 758 Article 15 the demand must be accompanied by a statement indicating in what respect the applicant is in breach. The demand must be presented at the guarantor's counters before expiry, in the form the bond requires. The bank then has five business days to examine and pay. The bond does not compensate the full loss; it covers the cost of a failed first shipment and shows that the seller had the standing to obtain a bank undertaking at all.

Quality shortfalls, demurrage and late delivery penalties are usually not drawing events; they are settled under the contract unless the bond text says otherwise.

How the term is abused

What the clause should say

• Issuer: a bank acceptable to the buyer, with SWIFT BIC stated, or a surety company named in the contract.
• Amount: 2 % of the value of the first shipment or of the contract, stated in figures and currency.
• Form: demand guarantee subject to URDG 758, or standby subject to ISP98, transmitted by MT760.
• Trigger: non-shipment within the shipment period stated in the SPA, with the demand statement wording.
• Timing: within a fixed number of banking days after the credit is advised, with the credit non-operative until then.
• Expiry: a stated date, not "until completion".

Practical checks for buyers

Ask which bank will issue the bond and confirm bank to bank that the seller is a customer. Refuse any fee linked to the bond. Confirm that bond, letter of credit and SPA use the same contract number, quantity and shipment period. Treat a seller who cannot name an issuing bank as a seller without product. A sugar mill or a copper producer with a supply contract will have no difficulty with any of these points.