The Law of Bank Guarantees: Important Tools of Modern Day Commercial Transactions

The Law of Bank Guarantees: Important Tools of Modern Day Commercial Transactions.

[Rangeet Poddar]

The author is a 4th year B.A.LLB(Hons.) student of WBNUJS, Kolkata.

Introduction

According to Section 126 of the Indian Contract Act, a contract of guarantee is a contract to perform the promise, or discharge the liability of a third person in case of his default.[1] A bank guarantee is a contractual assurance that is given by the bank to a third party creditor. By virtue of this commercial instrument, the concerned bank undertakes liability on behalf of the principal debtor to fulfill his contractual obligation in the event of default.  This secures the transaction by ensuring that no detriment is caused to the creditor. The nature of obligations of the principal debtor is primary while the obligations of the bank are secondary. By issuing a guarantee, a bank ordinarily undertakes to pay the amounts specified in the guarantee agreement to the beneficiary on demand made by him in accordance to predetermined terms and conditions.[2] The object of a bank guarantee is to ensure the due performance of certain works contracts. The guarantee can also be towards security deposit for a contract or of any kind.[3] In the case of State Trading Corp. of India Ltd. v. Jainsons Clothing Corp.[4], the Supreme Court held that the bank guarantee is a trilateral contract in which the bank has undertaken to unconditionally and unequivocally abide by the terms of the contract. It is an act of trust with full faith to facilitate free flow of trade and commerce in domestic or international trade or business. It creates an irrevocable obligation to perform the contract in terms thereof. On the occurrence of events mentioned in the guarantee contract, the bank guarantee becomes enforceable.[5]

There are two types of guarantees:

A conditional performance guarantee is one where the surety becomes liable to the party, claiming under the guarantee upon proof of breach of terms of the underlying contract, or on proof of both breach as well as the loss occurring from the breach. Under unconditional guarantee, the guarantor becomes liable to pay the beneficiary the stated amount whenever the demand is made in the manner provided for in the guarantee, without the need for that beneficiary to prove any breach or loss; the guarantor is bound to immediately perform the contract of guarantee without further requirements. The object of unconditional bank guarantees or on demand bank guarantees are to secure hassle-free commercial transactions. Where the bank unconditionally and irrevocably promises to pay on demand, the amount of liability undertaken in the guarantee without ‘demur or dispute’ under the terms of the guarantee, the liability of the bank is considered to be absolute and unequivocal.[6]

An on-demand bank guarantee consists of three separate and substantially independent but formally accessory agreements, namely:

  1. The underlying transaction or main agreement

  2. The indemnity agreement between the account party or principal and the guarantor

  3. The on-demand instrument between the guarantor and the beneficiary[7]

The question whether the guarantee is a conditional or an unconditional one payable on demand, is a matter of construction in each case from the terms of the bond.[8]

Independent nature and encashment of the bank guarantee

In Ansal Engineering Projects v Tehri Hydro Development Corporation[9], it was held by the Supreme Court of India that the bank guarantee is an independent and distinct contract between the bank and the beneficiary and is not qualified by the underlying transaction and the validity of the primary contract between the person at whose instance the bank guarantee was given and the beneficiary.[10] The question whether the express terms of the guarantee give rise to the contract of guarantee to be enforced will be the limited enquiry for deciding the rights and obligations flowing from such a guarantee. Bank guarantees are independent in nature.[11] It is a separate autonomous contract between the bank and the beneficiary and is not qualified by the underlying transaction and the primary contract between the beneficiary and the person at whose instance the bank guarantee is given.[12] In a bank guarantee it is not necessary to go beyond the guarantee contract between the creditor and the surety bank and one must not look at any other contract including the underlying or primary one. However the underlying contract comes into the picture only if the guarantee itself makes its encashment, subject to proof of performance of underlying contract as it happened in the Hindustan Construction case[13]. In that case, the bank guarantee was for securing mobilization advance given by State of Bihar and it was provided in the terms of the guarantee that the beneficiary would not have the unfettered right to invoke the guarantee in the event the obligations expressed in the clause of the original contract were not fulfilled by the contractor. In such exceptional scenarios, the bank guarantee loses its autonomous character and depends upon the result of inquiry to the underlying contract. [14] Besides such cases, the court does not interfere with the enforcement of bank guarantees and guarantee contracts are not qualified by underlying transactions.[15]Where the bank guarantee is unconditional and payable on demand or demur, the liability of the bank is absolute and does not depend on the ultimate decision of a pending case in a court or tribunal. The bank only has to ascertain the amount claimed within the terms of the guarantee.[16]The question of encashment of the bank guarantee is entirely upto the beneficiary to invoke the guarantee at any time as he deems to be proper.[17]

The National Highways Authority v Ganga Enterprises and Another[18] case laid down that that bank guarantees furnished in the form of security for not withdrawing a bid is fundamentally different from withdrawal of offer before acceptance as per the statutory provisions of the Indian Contract act. In such cases, when a person withdraws his offer within a stipulated time, he has no right to claim the earnest money that he has given in the form of a bank guarantee. He forfeits the earnest money and it does not violate Section 5 of the Indian Contract Act. The purpose behind this is to ensure that in commercial transactions especially those involving government contracts, the bids made have to be genuine so that no person who has no intention of entering into a contract makes a bid.

Honouring of bank guarantees without delay is also of utmost importance. Delays have the potential to erode the sanctity of the bank guarantee. In case of guarantees given on behalf of government departments, such delays have the can tarnish the image of the banking system because it appears as if the banks are acting in collusion with parties. There should be an effective system to monitor the guarantee business so that persons on whose behalf guarantees are issued are forced to perform their obligations. This gives a sense of security to the beneficiary and in turn, strengthens trade and commerce.[19]

Judicial restraint

Courts are against giving injunction to restraint on demand bank guarantees so that in commercial transactions, the creditor can be certain about the credentials of a principal debtor to fulfill a contract. If the beneficiary feels that there has been a breach of the terms in the guarantee contract, he should be able to encash the bank guarantee and avail the amount without having to go through the hassles of litigation.

In Hindustan Steel Works Construction v. Tarapore and Company[20] it was held by the Supreme Court of India that the correct position of law is that commitment of banks must be honoured free from interference by the law courts and it is only in exceptional cases of fraud or irretrievable injustice that the court will interfere.[21] The law regarding the enforcement of an on demand bank guarantee is well settled today. If the enforcement of the bank guarantee is according to the terms of the guarantee contract, the courts must not interfere because that it will violate the very purpose of why the guarantee was given in the first place, in the commercial transaction. Courts must not look at the underlying agreement and that agreement is irrelevant in such a scenario.[22] The fact that the guarantee issued by the bank is wider in terms than that agreed upon between the bank and the debtor is no reason to grant injunction restraining payment.[23]

The essence of an on demand bank guarantee is to satisfy the beneficiary that irrespective of disputes about underlying contract between beneficiary and the bank’s customer, the bank is liable to pay the beneficiary provided that certain conditions are met. If a court injunction allows the customer to derogate from the bank’s undertaking, the effectiveness of the instrument is compromised. The value of bank guarantees in world of commerce will considerably decrease.[24] So, the bank must honour its commitment when demand is made.[25]

When can the bank refuse payment?

Payments under bank guarantee can be restrained by courts under exceptional circumstances. Fraud and Irretrievable Injury are the two most prominent grounds recognized by Indian courts for the imposing restrictions on the injunction of a bank guarantee.

Fraud

The bank can refuse payment in case of unconditional bank guarantees if there is a fraud on the part of the beneficiary creditor or where the documents tendered for invoking the guarantee are not according to the terms of the guarantee.   The nature of the fraud has to be fraud of an ‘egregious nature as to vitiate the entire underlying transaction’; courts will not interfere unless prima facie strong case of fraud or special equity is made out.[26] The fraud of the beneficiary is only taken into account and not the fraud of a party unrelated to the transaction. In the context of bank guarantee, fraud is established when the beneficiary claims payment to which he knew he has no entitlement.  The evidence of fraud must be clear to the fact of fraud as well the bank’s knowledge that the demand for payment is fraudulent. A beneficiary’s uncorroborated statement is not enough for proving fraud.[27] In Hindustan Steel Works Construction Limited v Tarapore & Co[28], the court took the view that a demand under the guarantee may become fraudulent not because of fraud committed by beneficiary, while executing the underlying transaction, but it may become so because of subsequent events and circumstances. At the same time, the Supreme Court has also held that disputes between the parties relating to the underlying transaction do not make the invocation of the guarantee fraudulent.[29]

Irretrievable Injury

It is necessary that the injustice contemplated for refusal of encashment must be exceptional and irretrievable so much so that it would override the terms of the guarantee and the encashment will have an adverse effect on commercial transactions.[30] The circumstances have to be adequately established and mere apprehension that the other party will not be able to pay is not enough.[31] In Svenska Handelsbanken v Indian Charge Chrome[32], the Supreme Court has emphasized that irretrievable injury must be of such nature that the beneficiary has ‘no adequate remedy of law’. In Dwarikesh Sugar Industries Ltd. V Prem Heavy Engineering Works Ltd.[33], the Supreme Court observed that irretrievable injury had to be such a circumstance, which would make it impossible for the guarantor to reimburse himself, if he ultimately succeeds. This will have to be decisively proven such that no possibility of the recovery of the amount from the beneficiary by restitution exists.[34]

Conclusion

Bank guarantees are the life-blood of international commerce. Courts should normally insist upon enforcement of the bank guarantee and allow them to be honoured unless there is specific plea of fraud and special equities.[35] Besides such exceptional cases if the courts interfere with the machinery of irrevocable obligations assumed by banks, the trust in international commerce will be irreparably damaged.[36] The need for bank guarantees arises mainly out of the insecurity and lack of confidence associated with the ability of the principal debtor to perform the contract. Bank guarantees are all about the secondary liability of the surety bank that is meant to ensure that the principal debtor does not dishonour the creditor and give assurance to the beneficiary that the contractual risk that he is undertaken will be honoured. It safeguards the payment or performance under the contract.[37] As commercial tools, bank guarantees thereby become all the more important in times of economic insecurity.[38]

[1] N. Bhadbhade, The Indian Contract and Specific Relief Acts, 1352 (14th ed., 2014)

[2] R.K. Gupta, Banking Law and Practice, 1.12611 (2nd Ed. Vol. 1, 2008)

[3] Supra 1, at 1367

[4] AIR 1994 SCC 2778

[5] S.N. Gupta, Banking Law Theory & Practice, 1248 (4th Ed., 2005)

[6] Supra 1, at 1366

[7] M.S. Kurkela, Letters of Credit and Bank Guarantees Under International Law, 20 (2nd ed., 2008)

[8] Supra 3

[9]  (1996) 5 SCC 450

[10] Supra 5, at 1218

[11] National Building Construction Corporation Ltd. V State Bank of Patiala AIR 1993 Del 89; S.N. Gupta, Banking Law Theory & Practice, 1273 (4th Ed., 2005)

[12] Supra 1, at 1369

[13] Hindustan Construction Co. Ltd v State of Bihar, AIR 1999 SC 3710

[14] Supra 1, at 1368

[15] Supra 2, at 1.1256

[16] Ansal Engineering Projects Ltd. v Tehri Hydro Development Corporation Limited, (1996) 5 SCC 450

[17] Supra 2, at 1.1257

[18] National Highways Authority of India v Ganga Enterprises and Another (2003) 7 SCC 410

[19] Supra 2, at 1.1258

[20] AIR 1996 SCC 2268

[21] Supra 10

[22] National Highways Authority of India v Ganga Enterprises and Another (2003) 7 SCC 410

[23] Hindustan Steel Workers Construction Limited v G.S. Atwal & Co. (Engineers) Pvt. Ltd. AIR 1996 SC 131

[24] Bolivinter Oil S.A. v Chase Manhattan Bank 1984 1 All ER 351

[25]General Electric Technical Services Co. Inc v Punj Sons (P) Ltd. AIR 1991 SC 1984

[26] Uttar Pradesh Cooperative Federation Limited v Singh Consultants and Engineers Private Ltd. (1988) 1 SCC 174; Svenska Handelsbanken v Indian Charge Chrome, AIR 1994 SC 626; National Building Construction Corporation Ltd. V State Bank of Patiala AIR 1993 Del 89

[27] Supra 1, at 1375

[28] Hindustan Steel Works Construction Ltd. V Tarapore & Co., AIR 1996 SC 2268

[29] Uttar Pradesh State Sugar Corporation v Sumac International Ltd., AIR 1997 SC 1644

[30] Supra

[31] Uttar Pradesh Cooperative Federation Limited v Singh Consultants and Engineers Private Ltd. (1988) 1 SCC 174

[32]AIR 1994 SC 626

[33] AIR 1997 SCC 2477

[34] Supra 2, at 1.1274

[35] M.L. Tannan, Tannan’s Banking Law and Practice, 1261 (22nd Ed. Vol. 1, 2008)

[36] RD Harbottle (Mercantile) Ltd. V. National Westminster Bank Ltd. (1977) 2 ALL ER 862, reiterated in Edward Owen Engineering Ltd. V. Barclays Bank Intl. Ltd, (1978) 1 All ER 976

[37] G. Andrews & Richard Millet, Law of Guarantees, 580 (6th Ed., 2012)

[38] Supra 7, at 14