[By Ashutosh Kumar & Shambhavi Shani]
The authors are students at the Hidayatullah National Law University.
An inextricable knot between the limitation period and Exception 3 of Section 28 of the Indian Contract Act has time and again, been subjected to judicial and legislative scrutiny and is yet again in limelight after Justice Jayant Nath of Delhi High Court in the case of Larsen & Toubro Limited &Anr. V. Punjab National Bank and Anr., clarified that Exception 3 to Section 28 doesn’t deal with the “Claim Period” but with the “Enforcement Period” which was grossly misinterpreted by banks.
Section 28 dictates that any contract which restricts any party from enforcing his rights under the contract or limits the period during which such recourse can be adopted is void to that extent. Exception 3 saves banks and financial institutions from getting hit by Section 28 for including a clause providing for “Enforcement Period” after which, if any suit is filed for the enforcement of guarantee will fall flat. Such enforcement period may be less than the limitation period as laid down in the Limitation Act but should not be less than one year.
In this article, the authors analyze the detrimental effects of wrongful interpretation by banks, which violates rights of the principal debtors (PD) under Article 19(1)(g) of the Indian Constitution and the impacts following the course correction by the Court.
BACKGROUND
Under the contract of Bank Guarantee (BG), the beneficiary has the right to make the guarantor bank compensate for the default made by the PD by invoking the guarantee within the lifetime of BG i.e. the “Validity Period”. In cases of performance guarantees, it takes time to assess the performance of the PD and hence a “Claim Period” is negotiated between the PD and the creditor which provides for a grace period in addition to the validity period. Once such guarantee is invoked and if the bank dishonours the claim, the beneficiary has the right to bring an action before the relevant court/tribunal to enforce his right within the “Limitation Period/Enforcement Period” which is, by default, 3 years in case of private entities and 30 years in case of government entities. But, the 2013 Amendment to Section 28 inserted Exception 3 which shortened the minimum limitation period to one year instead of three or thirty years as the case may be.
This one-year enforcement period was confused with the claim period by the Respondent, Bank Punjab National Bank (PNB) which issued a circular dated 18/08/2018 addressed to the Petitioner Larsen & Toubro (L&T) stating that a claim period of less than a year shall be void and the period will get increased to 3 years by default under the Limitation Act, 1963. Indian Banks Association (IBA) through a communication dated 05/12/2018 addressed to all the banks, fortified the above interpretation dictating that if any bank issues a BG with a claim period of less than one year, such BG will not get the benefit under Exception 3 of Section 28. Owing to this, L&T had to pay commission charges and maintain collateral security for an extended period which would have been shorter under the contract between PD and creditor. L&T contended that such an extended period affected their business as they could not enter into new contracts and hence infringed their fundamental right to do business under Article19(1)(g).
OBSERVATIONS BY THE COURT
The Court struck down the Circular issued by PNB to L&T and agreed with the contentions of L&T and held that PNB erroneously interpreted the minimum one year “Enforcement Period” under Exception 3 to be a one year mandatory “Claim Period”. It further observed that the one year clause under Exception 3 “deals with right of the creditor to enforce his rights under the bank guarantee in case of refusal by the guarantor to pay before an appropriate court or tribunal.”
While adjudicating the matter, the Court thoroughly delved into the historical perspective to ascertain the legislative intent behind the enactment of such exception and it further dealt with the theory of relinquishment of right and remedy to conclude that such provision was grossly misused by the banks. The rationale behind the Verdict has been discussed below:
Historical Perspectives
Before 1997, the principle followed by the courts was that the rights and remedies accrued under a contract may be relinquished but only remedy cannot be relinquished. This was based on the reasoning that for a remedy to exist there must be rights which implied that once the rights are relinquished; the remedy would be automatically relinquished. The Law Commission observed the potential of misuse of such principle and stated in its 97th Law Commission Report that such a distinction between relinquishment of right and remedy was utopian but in practice, might lead to the misuse by parties in a dominant position who may create a law of prescription of their own by limiting the period of relinquishment of rights and in turn remedy. This resulted in the 1997 Amendment which included Clause (b) and the first two Exceptions to Section 28 which automatically increased the enforcement period to 3 or 30 years depending on the nature of the entity. Post such amendment, an expert committee headed by Sh.T.R.Andhyarujina was constituted which in its report cited the concerns of the banks who had to carry obligations, maintain liabilities and hold securities for 30 years affecting the issuance of fresh guarantees. According to the report, “this will pre-empt the available capital to meet the capital adequacy requirement and will also overstretch the exposure to the customers beyond acceptable levels.” This lead to the Amendment of 2013 which included Exception 3 to Section 28.
Misinterpretation by PNB
Much reliance was placed on a 2016 verdict of Union of India &Anr. v. Indusind Bank &Anr. by the Counsels appearing for PNB but the Court held that the ratio of the verdict was actually against the cause of PNB. Herein, two clauses were in question, which limited the period within which a claim may be raised by the creditor/beneficiary before the guarantor bank. The Court held that these clauses did not limit the enforcement period but any stipulations concerning the enforcing period which is not less than one year would pass muster after 2013. Further, the Court observed that PNB, under Para 14 of their Counter Affidavit agreed to the interpretation that Exception 3 was enacted for the very purpose of curtailment of the limitation period which was 3 or 30 years as the case may be. But by including a mandatory one-year claim period, PNB contradicted itself despite being aware of the legislative intent. The Court further observed that the stipulations regarding the grace period is a matter of negotiation between the principal debtor (L&T) and the Creditor concerned and the guarantor bank had no authority to impose such clauses.
ANALYSIS AND CONCLUSION
This Verdict marks the course correction of wrongful interpretations made by banks and financial institutions giving due consideration to legislative intent and commercial interests of the parties. Perhaps, the most crucial impact of this decision would be that the principal debtor would no longer have to pay commission to the banks and maintain securities for a period longer than what the creditor and PD had agreed upon. Further, such a mandatory period becomes a matter of concern when the validity period itself is less than one year.
This Judgment also addresses the malicious intent of banks of extracting commissions from the PDs by taking advantage of their dominant position in the contract by giving an impossible choice of “taking it all or leaving it all”.
The banks, despite being aware of the fact that such Exception was brought in to curtail the limitation period and not to stipulate a compulsory claim period kept on including such clauses. These conditions hampered the day to day business activities and cash flow of the PDs as they had to maintain securities and collaterals for a longer period than required and their assets froze restricting them from acquiring further guarantees from banks thus infringing their right to do business guaranteed under Article 19(1)(g)
Furthermore, this judgment would inhibit the infringement of privity of contract caused by banks by stipulating a mandatory claim period which is a matter privy only to the PD and creditor concerned and time required in the assessment of the debtor’s performance should be negotiated between the debtor and creditor without any influence from the guarantor.
The Judgment brings huge relief to the MSME sector which already suffers from high costs of BGs as banks demand upfront margin money and more than 100% collaterals against BG. Moreover, the cost of a BG is directly proportional to the duration of validity or claim period, the longer the claim period higher the cost of BG affecting their cash flow and day to day operations. Such practices were termed as “Grossly Unfair” and “Economically Disastrous” by the Federation of Indian Micro and Small & Medium Enterprises (FISME) as they have negative impacts on MSMEs which rely on exports and supply through tender.
Hence, it would be safe to conclude that the decision correctly interprets the provision and ends the arbitrary practices of banks and financial institutions resulting in a conducive environment for the businesses to operate.