Bank Guarantees: Judicial Interpretation and Recent Developments

By:- Janvi Vishnani

Introduction

With globalization there is an expansion in both international and local commerce, there is a demand for a trusted source to safeguard and decrease risks in commercial transactions. In today’s business environment, where business transactions are conducted globally and parties are geographically separated, an innovative concept is required to fulfill the original purpose of guarantee, which is to provide security in payments for our claims. Thus, the concept of bank guarantee was developed. For both local and foreign trade, bank guarantees are regarded as “life-blood.”

Meaning: Bank Guarantee

A Bank guarantee is a separate contract between the beneficiary and the bank. It is a contract in which the bank agrees to return the amount of the debtor default and release the debtor from all its liabilities. The bank acts as a guarantor in this scenario, assures that the debtor’s loan will be repaid. Bank guarantees are contracts that are separate from and unrelated to each other. It has nothing to do with the major debtor’s or creditor’s relationship.

Section 126 of the Indian contract act 1872 describes the ‘Contract of guarantee’, which states that is an agreement to fulfil a third party’s commitment or relieve his liability if he fails to do so. The ‘surety’ is the person who gives the guarantee; the ‘principal debtor’ is the person in whose default the guarantee is given, and the ‘creditor’ is the person to whom the guarantee is given. Here in this case surety is Bank.

These banks are professional guarantors who provide a financial service in return for a fee by providing bank guarantees. The fundamental goal of implementing bank guarantees is to promote free commerce by protecting creditors from losses and assisting them in reclaiming debts in the event of a loss. The financial risk associated with a commercial transaction gets reduced when the bank gives a guarantee.

It promotes the seller/beneficiaries to build their business on a credit basis because of the minimal risk. Guarantees are usually charged at a cheap rate by banks, which is advantageous to even small businesses. When banks examine and verify a company’s financial viability, it gains credibility, which leads to more commercial prospects. The guarantee usually needs less paperwork and is handled swiftly by banks (if all the documents are submitted).

Types of Bank Guarantees

There are two types of guarantees, which are as follows: –

  • Conditional Guarantee: – In this instance, the bank will only pay the money if the debtor complies with specific requirements that may be spelled out in the guarantee contract. A specific requirement such as Proof of default, third-party consent, and so forth.  The contract’s criteria must be met to initiate the bank guarantee’s encashment.
  • Unconditional Guarantee: – Unconditional bank guarantee payment to the beneficiary “unconditionally and irreversibly” on the beneficiary’s first demand once the guarantee is invoked. In this instance, the bank is required to pay the money as soon as the bank guarantee is invoked. In contrast to a conditional bank guarantee, the bank agrees to pay the guarantee regardless of the terms, making the demand to invoke decisive and binding.

Invocation of Bank Guarantee

The recipient must use the Bank Guarantee on or before the guarantee’s expiration date. If the Bank does not receive a claim within the specified validity time, the Bank is released from the obligation. The beneficiary must write a letter to the Bank explaining the circumstances that led to the guarantee being encashed. On the other hand, the party on whose behalf the guarantee was written enjoin the recipient from cashing it? A slew of decisions has been issued specifically for this purpose, which is briefly detailed here.

Unconditional Guarantee: –

Unconditional bank guarantee usually reveals that the guarantor agrees to pay without objection, rendering the demand definitive and enforceable.

The Bank agreed in U.P. Co-op. Federation Ltd. v. Singh Consultants and Engineers (P) Ltd to repay the amount on “first demand” and “without contestation, and without reference to such party and without questioning the legal relationship between the party in whose favor guarantee was given and the party on whose behalf guarantee was given” Regardless of any dispute between the parties, the Hon’ble Supreme Court determined that the Bank was required to pay once demand was made without objection.

In such a circumstance, the person on whose behalf the guarantee was granted was not entitled to an injunction preventing the bank from performing its guarantee.

The court took the case of Sztejn versus J. Henry Schroder Banking Corp, as a precedent, in which the beneficiary faked some documents and made a false representation concerning the commodities sent in, which claimants said were “worthless/rubbish.” The claimant applied for an injunction against the bank guarantee. The highest court ruled that the beneficiary had committed fraud and that an injunction should be issued to prevent the bank guarantee from being issued and payment made.

Given the strictness of the rule, there are two exceptions to the injunction against the invocation of an unconditional bank guarantee: –

  • Fraud: – The Supreme Court in Reliance Salt Ltd. v. Cosmos Enterprises held that commission of fraud would include any act committed by a party to deceive another party or his agent or to induce him to enter into a contract, referring to the definition of “Fraud” as provided under Section 17 of the Contract Act, 1872. And the person making the accusation who bears the burden of proof.

The Supreme Court stated in U.P. State Sugar Corporation v. Sumac International Ltd. that a fraud involving an unconditional bank guarantee should “vitiates the fundamental foundation of such a bank guarantee.” No other type of fraud will pass the test, and the Bank must be notified of any such fraud. The Hon’ble Supreme Court found that, because the bank commits its credit, which involves its reputation, it had no justification for refusing the payment unless it was fraudulent. The Supreme Court further stated that fraud must be of such an “egregious kind” that it “vitiates the entire underlying transaction.” Furthermore, the beneficiary must be the perpetrator of the deception, and no third parties may be involved.

Even in the case of Hindustan Steelworks Construction Ltd. v. Tarapore & Co, the Hon’ble Supreme Court stated that the exception of fraud must have the effect of vitiating the entire underlying transaction, citing the judgment in U.P. Co-op. Federation Ltd. (Supra). The Supreme Court also held that the fraud must be of such an egregious nature that it would vitiate the entire underlying transaction or the very foundation of such a bank guarantee, whether committed at the time of contract execution or as a result of circumstances or events that occurred afterwards.

  • Special Equities – irretrievable injustice: –   The phrase “special equities” refers to encompassing notion that allows for injunctions against the encashment of bank guarantees only under exceptional situations. In the case of Texmaco Ltd. versus State Bank of India, the Calcutta high court invented the word. The supreme court accepted the idea of exceptional equities as an exemption to injunctions against bank guarantees in the case of Ansal engineering Projects Ltd. versus Tehri Hydro Development Corporation. The notion of unique equities is viewed as a means of offering redress to parties who have been harmed under unusual situations.

In the case of Dwarikesh Sugar Industries Ltd. vs. Prem Heavy Engineering Works (P) Ltd. & Others., this concept was defined. The court noted that injunctions should only be granted where there is no chance of recovery and contract fulfillment is frustrated or impossible.

Conditional Guarantee: –

In the event of a conditional bank guarantee, the beneficiary does not have an unrestricted right to invoke the guarantee, and the court can impose an injunction against it based on the facts of the case. When a bank guarantee is conditional, the invocation of the guarantee must be done in exact accordance with the terms of the guarantee.

The bank guarantee in dispute in Hindustan Construction Co. Ltd. v. State of Bihar and Ors, developed the phrase “accept absolutely and irreversibly” to guarantee payment to the beneficiary on his first demand without any protest. However, the abovementioned term was immediately qualified by a clause that related to the parties’ original contract. The clause stated that if the person on whose behalf the BG was issued failed to meet specific contract duties, the beneficiary would have the right to collect the entire or part of the guarantee.

Judicial intervention

Corona Virus (COVID – 19), the virus which shattered the whole economy. The unimagined virus took up various businesses, employment. All the activities come to standstill. Many contracts were put on hold, However, the Indian government declared the covid situation as “Force Majeure”. The declaration of covid as a force majeure had an impact on bank guarantees as well. However various courts refused to grant injunctions, solely due to pandemics.

In the case of Haliburton Offshore Services vs. Vedanta Ltd., the petitioner entered into a contract with Vedanta Ltd. for the installation of infrastructure, including oil wells. The work was on the verge of completion but suddenly the nationwide lockdown was imposed, as there was a total shutdown of all industrial activity, the petitioner failed to meet his contractual duties, and the project was not completed within the agreed time frame.

The Delhi High Court decided in favor of the petitioner and issued an order prohibiting the bank guarantees. The court determined that the petitioner’s failure to fulfill their contractual commitments was solely due to the statewide lockdown imposed by the COVID-19 outbreak, which was prima facie evidence of force majeure. The case of Standard Chartered Bank Heavy Limited versus Heavy Engineering Corporation Limited was used as a precedent.

The court also held that the mere existence of the covid- 19 and statewide lockdown would not excuse every violation or non-performance of the contracts. The parties’ actions before lockdown will be evaluated in terms of their contract performance, and the court will then decide whether or not to award an injunction. In the matter of Standard Retail Pvt. Ltd against M/S G.S. Global Corp. and Others, the petitioners claimed that due to lockdown and COVID-19, they were unable to fulfill their contractual commitments, but the opposing party, domiciled in South Korea, was able to do so.

Thus, the petitioners filed a petition for restraining the respondents and granted an injunction against enforcing the bank guarantees under section 9 of the arbitration and conciliation act of 1996. The Bombay High Court rejected the petitioner’s position, determined that Covid-19 and subsequent Lockdown would not be considered force majeure in this situation because, to invoke the force majeure clause and to seek injunctions under specific equities, the contract must be completely impossible to fulfill.

Conclusion

First, the paper outlines the idea of a bank guarantee in line with the relevant statutory conditions. A bank guarantee is an assurance given by the bank that if the debtor or creditor fails, the bank would compensate the party that has suffered a loss, as we’ve discussed. Bank guarantee plays an important function in the business sector and aids in the efficient growth of national and international commerce. It should be unconditional to be easily claimed. This notion was established to avoid the parties from having to go through a lengthy judicial process to get their money back.

A bank guarantee is tripartite contracts: -one with the bank, one with the creditor, and one with the debtor. The courts should not be involved in enforcing or invoking a bank guarantee, but in rare cases, such as fraud, the courts must intervene to safeguard the parties’ interests. The parties must be free to carry out their obligations following the contract’s provisions, with little judicial intervention. As we all know, the banking system is the backbone of the economy, and if bank guarantees cannot be encashed by the parties themselves without court intervention, the bank guarantee system as a whole will fail, and people will lose trust in it over time.


Janvi Vishnani is a first-year law student at Narsee Monjee Institute of Management Studies (NMIMS) Navi Mumbai campus, currently pursuing BA.LL. B (Hons).