In the modern business environment, characterised by spatial distance and inability of the parties to a commercial transaction in performing a realistic assessment of the creditworthiness of a business partner, there is often a need for the use of instruments that secure payments.1 “Bank Guarantee” is a commercial instrument that has emerged as a contemporary solution for securing payment of money in a commercial dealing.
The Indian Contract Act (ICA), 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.2Similarly, bank guarantee (hereinafter referred to as “BG”) can be defined as a unilateral legal contract in which a bank (guarantor) undertakes an obligation to guarantee to pay the beneficiary a certain amount of money specified in the guarantee if the debtor from the original contract does not fulfil his contractual obligations.
An Independent Contract
As per law a BG is an “independent contract” between the bank and the beneficiary, separate from the underlying contract between the beneficiary and the person (debtor) at whose instance the BG is given.3Thus, two contracts and three parties come into existence when a contract is entered into which provides for BGs being furnished.4The bank has to honour its undertaking when the guarantee is invoked, without reference to the party on whose behalf it has been issued, notwithstanding any disputes or disagreements that might have arisen in the mean time between the debtor and the beneficiary.5The doctrinal basis for this principle is that a BG is intended to secure the beneficiary by allowing it to immediately claim from a party in terms of the BG and therefore it cannot be qualified by the contract on performance of the obligations.
Types of Bank Guarantee
According to specific purposes, BGs are categorized into various types. Some of them are as follows.
On the basis of issuance:
- Direct BG
A direct BG is one where a bank is asked to provide a guarantee by its account holder, in favour of the beneficiary. Direct BG does not rely on the existence, validity and enforceability of the main obligation.
- Indirect BG
When a second bank issues a BG in return for an already issued BG, it is termed as an Indirect BG. In such scenarios, if the second bank suffers losses when a claim is made against a guarantee, the issuing bank will make sure that it compensates all the losses.
On the basis of the conditions specified in the guarantee:
- Unconditional BG
Unconditional BGs ensure the payment to the beneficiary “unconditionally and irrevocably” on beneficiary's first demand upon invoking the guarantee.6 Thus, the beneficiary becomes the sole judge of the performance of the contract and the bank cannot question the judgment or ask question/evidence in that regard. The demand of the beneficiary shall be final and conclusive in that regard.
- Conditional BG
Where the BG has certain conditions, which need to be fulfilled in order for the absolute invocation of guarantee by the beneficiary, such BGs are termed as conditional BGs. The language of the guarantee plays a vital role in determining which kind of guarantee is it. Some guarantees though mention the words “unconditionally and irrevocably,” they qualify such expressions with a condition or a situation upon occurring of which the underlying guarantee becomes encashable. In such circumstance, the BG in question would be categorised as a conditional BG.7
On the basis of the type of performance by the bank as per the guarantee:
- Financial BG
A financial BG assures that money will be repaid if the party ( debtor) does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of a project, the bank will make the payment.
- Advance Payment BG
This guarantee signifies an obligation on the part of the bank to return advance payment if, after receiving an advance, the party ( debtor) does not perform its contractual commitments.
- Deferred Payment BG
Deferred payment BG is offered to the beneficiary for a deferred period or for a certain time period. Under this guarantee, payment is usually made in instalments by the bank for failure in the completion of contractual obligations by the debtor.
- Performance/Contract Execution BG
This guarantee assures timely delivery of goods or performance of services according to a contract. Monetary compensation of will be made by the bank in case of any delay in performance of services or operation of the contract.
Invocation of Bank Guarantees
The beneficiary needs to invoke the BG on or before the expiry date of the guarantee, and in accordance with the contract/terms of the guarantee.8The issuing bank is bound to observe and honour the terms of the guarantee and therefore, the beneficiary of a BG cannot be restrained from invoking the BG.9If a bank does not receive any claim on or before the validity period mentioned in the terms of the guarantee, the bank will be discharged from its liability.
It is pertinent to note that Unconditional BGs ensure the payment to the beneficiary “unconditionally and irrevocably” on beneficiary's first demand upon invoking the guarantee,10 while in case of Conditional BGs, the beneficiary does not have an unfettered right to invoke that guarantee and demand immediate payment thereof.11BGs can be invoked by the beneficiary irrespective of pending disputes between him and the debtor.12 Moreover, a BG constitutes a bargain between the two parties, in which the banker creditor is unconditionally required to pay the amount in question.13
Limitation Period for Invocation of Bank Guarantees
Under the Indian Limitation Act, 1963, the period for invoking the BG is 30 years, if the beneficiary is government Department or Municipal Corporation and 3 years in all other cases. Prior to the amendment made by the Contract (Amendment) Act, 1996 in the ICA,14BGs used to have a clause that “…unless the claim under this bank guarantee is made within six months from the expiry of the bank guarantees, the liability of the bank will be extinguished under the guarantee…”. After the amendment, if a beneficiary of a BG invokes the guarantee with the claim period, for a default committed by the debtor during the validity period, then the bank will not make payment, the beneficiary may file suit against the bank within the period mentioned in the Limitation Act, 1963 and any clause restricting the bank's liability will be illegal and void ab initio. Therefore, the bank should obtain the bank guarantee duly cancelled by the beneficiary or a certificate from the beneficiary that there is no claim under the guarantee. If the guarantee, duly cancelled or certificate is not obtained from the beneficiary, the bank should retain the security of the debtor and cash margin till the expiry of the limitation period under the Limitation Act, 1963.15
Stay on Invocation of Bank Guarantees
There are instances when giving absolute discretion to someone can lead to misuse of power resulting in corrupt and illicit practices. For instance, when a a beneficiary is aware of his faulty goods and is not entitled to payment, but still invokes BG with the mala-fide intentions for monetary gains is a case in point. Therefore, in order to define an ambit of independence and the scope of Unconditional BGs, it is essential to have certain parameters towards invocation of BGs. The courts16 in India have narrowed down two exceptions where injunction on invocation of unconditional BG can be granted:
- Fraud17of an egregious nature as to vitiate the entire underlying transaction, of which the bank has notice.
- Special equities18in the form of preventing irretrievable injustice19 between the parties.
Egregious Fraud
An injunction against encashment of BG can be issued when there is clear fraud on the part of a beneficiary, which the bank notices.20 The fraud must be as to vitiate the whole transaction21 and vague and indefinite allegations made do not satisfy the requirement in law constituting any fraud much less than the fraud of an egregious nature.22 It is apposite to state here that a demand by the beneficiary under the BG may become fraudulent not because of any fraud committed by the beneficiary while executing the underlying contract but it may become so because of subsequent events or circumstances.23
Special Equities in the Form of Preventing Irretrievable Injustice
“Special Equities ”has been considered as a prima facie ground that would prevent irretrievable injustice between the parties.24While the courts have not ventured to define or even describe the term “Special Equities”,25every case has to be decided with reference to the facts of the case involved therein.26 However, special equities might entitle the party to an injunction restraining the performance of BG.27 The courts have often opined that allowing encashment of an unconditional BG would result in irretrievable harm or injustice to one of the parties concerned;28 however, to avail of the exception of irreparable harm or injury, the party seeking relief would necessarily have to show exceptional circumstances, which would make it impossible for the guarantor to reimburse himself in the event of succeeding in the main dispute. In other words, a case of irretrievable injury and/or irreparable harm would have to be made out clearly.29
Key Guidelines for Bank Guarantee by the Reserve Bank of India (RBI)
The RBI has, over the years, developed rules and regulations around BGs, in order to befit the contemporary requirements of the business environment. Some of the key guidelines30 are as follows:
- Tenure
No BG should normally have a maturity of more than 10 years.
- Unsecure Guarantees
The restriction of 20% on unsecured guarantees has been withdrawn (w.e.f.17.6.2004) by the RBI and bank boards have been given the freedom to fix their own policies on their unsecured exposures.
- Precautions for averting frauds
Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. Moreover, banks should, while forwarding guarantees, caution the beneficiaries that they should, verify the genuineness of the guarantee with the issuing bank.
- Inter-institutional Guarantees
Banks may issue guarantees favouring other banks/ financial institutions/other lending agencies for the loans extended by the latter, subject to the condition that the guaranteeing bank should assume a funded exposure of at least 10% of the exposure guaranteed.
- Payment of Invoked Guarantee
Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur.
Conclusion
BGs have proved to be a huge advantage in a modern business setting. BGs are individual contracts between the bank and the creditor, and are independent of the underlying contract between the beneficiary and the person at whose instance the bank guarantee is given. However, courts may analyse facts of a matter and may intervene and grant stay on invocation of such bank guarantees under certain conditions (Egregious Fraud, Irretrievable Harm/Injustice and Special Equities); this is done to prevent miscarriage of justice or to not let one party take advantage of a legal loophole.
Footnotes
1 Mirjana Knezevic and Aleksandar Lukic (2016). The importance of bank guarantees in modern business (business environment in Serbia). Investment Management and Financial Innovations, 13(3-1), 215-221.
2 The Indian Contract Act 1872, Section 126.
3 Delhi Lotteries v. Rajesh Aggarwal, AIR 1998 Del 332.
4 Mohd Yasin Wani & Rais Ahmad Qazi, “A Legal Perspective of Bank Guarantee System in India” available at: ijrcm.org.in/download.php?name=ijrcm-1-vol-3 (visited on June 20, 2021).
5 Ibid.
6 Vinitec Electronics Pvt. Ltd. v. HCL Infosystems Ltd., (2008) 1 SCC 544; see also Adani Agri Fresh Ltd. v. Mahaboob Sharif (2016) 14 SCC 517; see alsoMahatma Gandhi Sahakra Sakkare Karkhane v. National Heavy Engg. Coop. Ltd. and Ors. AIR 2007 SC 2716; see alsoGujarat Maritime Board v. L&T Infrastructure Development Projects Ltd., (2016) 10 SCC 46.
7 Hindustan Construction Co. Ltd. v. State of Bihar and Ors. (1999) 8 SCC 436; see also Jacsons Veeners & Panels Pvt. Ltd. v. State Bank of Travancore & Anr., (2009) SCC OnLine Ker 4210.
8 Ibid.
9 Hugglunds Drives AB v. National Heavy Engineering Co-Op. Ltd., AIR 2002 Bom 305.
10 Supra note 7.
11 Supra note 8.
12 Bank of Baroda v. Ruby Sales Corporation Agency, AIR 2001 Del 285.
13 UP State Sugar Corporation v. Sumac International Ltd., (1997) 1 SCC 568.
14 The Indian Contract Act 1872, Section 20.
15 Supra note 5.
16 Hindustan Steelworks Corp. Ltd. v. Tarapore and Co., (1996) 5 SCC 34.; see also Svenska Handelsbanken v. M/s. Indian Charge Chrome, (1994) 1 SCC 502.
17 UPCOF v. Singh Consultants and Engineers (1988) 1 SCC 174.
18 Standard Chartered Bank v. Heavy Engineering Co. and Anr., 2019 SCC OnLine SC 1638; see also Texmaco Limited v. State Bank of India, AIR 1979 Cal 44.
19 Himadri Chemicals Industries Ltd. v. Coal Tar Refining Co., (2007) 8 SCC 110.
20 Supra note 14.
21 Supra note 17; see alsoRigoss Exports International (P) Ltd. v. Tartan Infomark Ltd (AIR 2001 Delhi 285).
22 Supra note 7.
23 Mercator Oil & Gas Limited v Oil & Natural Gas Corporation Limited, 2019 SCC OnLine Bom 1378.
24 Supra note 18.
25 Cosy (India) Ltd. v. Vijaya Bank and Ors, (1991) 1 Cal LJ 39.
26 Gangotri Enterprises Ltd v. U.O.I., (2016) 11 SCC 720.
27 Supra note 19.
28 Supranote 20.
29 Supranote 14.
30 Reserve Bank of India,Master Circular - Guarantees and Co-acceptances, RBI/2009-10/70 DBOD. No. Dir. BC. 14 /13.03.00/2009-10 (2009) https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=5130 (last accessed on June 24, 2021).
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