Subject : FINANCE/BANKING

 
   Title :       Bank Guarantees: An Analysis
   Author : Ms. Amrita Ganguli  
   
 

Bank Guarantees: An Analysis

Introduction.

The banking system, which is an integral part of commerce, has steadily evolved from the simple acceptance of deposits and lending to its highly developed state that it is today. Bank guarantees as well as individual guarantees are common features of commercial transactions today.

Both individual as well as bank guarantees and the resultant liability of the guarantor operate from a contract. A contract of guarantee as per the Indian Contract Act may be defined as “a contract to perform the promise, or discharge the liability, of a third person in case of his default.” The need for individual guarantee arises when the banker finds that the position of the customer indebted to him is weakened due to the depreciation in the value of the collateral security deposited thus leaving the banker’s advance inadequately secured in the event of default.

A bank guarantee on the other hand is a tripartite agreement between the banker, the beneficiary and the person or the customer, whereby the bank gives an undertaking to pay the beneficiary a definite sum of money, or arrange the performance of the obligations of the client in the possible event of his default. Banks are usually approached to give such guarantees, as they possess the financial capability to meet such obligations.

The ingredients of a valid guarantee are (i) it should be for a specified period or definite period, (ii) for a specified amount, (iii) for a well defined purpose, (iv) a defined period of validity, (v) grace period for enforcing rights, and (vi) the events of default under which the guarantee can be enforced.

Nature Of Contract

A bank guarantee contract is distinct and independent from the underlying contract that subsists between the beneficiary and the creditor. This is extremely important in determining the liability of the banks in the event of default by the debtor.

In the case of Syndicate Bank v. Vijay Kumar the Court was required to enforce the bank guarantee simpliciter without probing into the nature of the transactions between the Bank and the customer that led to the furnishing of the bank guarantee. The Supreme Court has further reiterated in the case of Ansal Engineering projects Ltd v. Tehri Hydro Development Corporation Ltd that a 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 is given. As the bank unconditionally and unequivocally promised to pay, on demand, the Court thus held that the liability of the bank was absolute and unconditional and could not be circumvented in any manner.

Manner Of Invocation.

Invocation of a bank guarantee is dependent upon the terms of the guarantee. In UP State Sugar Corporation v. Sumac International Ltd it was held as, above, that when an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realize such bank guarantee irrespective of pending disputes and that a bank guarantee constituted a bargain between the two parties, by which the banker creditor was unconditionally required to pay the amount in question.

If the language of the guarantee entitles the beneficiary to receive payment from the bank, the dispute between the initiating party and the bank would not be a bar for the beneficiary to enforce the guarantee.

In the case of Road Machines India (p) Ltd v. Projects & Equipment Corporation India it was observed that the invocation of a bank guarantee does not necessarily have to be initiated by setting out the entire case in the form of a plaint with a specific cause of action, and that it was a commercial document and not a statutory notice or a pleading. It was further stated that if the bank concerned understood that the beneficiary in terms of the guarantee was invoking the guarantee, the bank guarantee may be invoked. It is sufficient if there is substantial compliance in terms of the guarantee in the notice that may be issued. However, banks may even delay giving a response to the demand for notice in the hope that the specified claim period expires.

Bank guarantees usually contain clauses to the effect that the guarantees would be honoured only by an initial written demand without any demur and would also mention that the principal debtor has committed default in payment of the loaned amount. The amount demanded must be contemplated within the guarantee contract.

The contracts may also contain clauses that give the beneficiary a unilateral right to determine the question of default of the debtor. In such cases there is no discretion on the part of the banks and the bank guarantee essentially becomes absolute in nature.

The beneficiary must intimate the bank or the guarantor that the event for which the guarantee was issued has happened or did not happen and that, in terms of the guarantee, it has been invoked demanding payment. The guarantee should be invoked within the specified period stated within the documents, and not afterwards as the contract would have come to an end.

Judicial Interference.

The Supreme Court has thus made it clear that the liability of the bank remains intact and does not cease with any pending disputes with respect to the primary underlying transaction between the beneficiary and the creditor. However, this has always been subject to a single condition in that the bank guarantee must be unconditional or absolute in nature. The terms of the bank guarantee are crucial in determining the nature of the bank guarantee, and whether or not it is an absolute guarantee or a conditional one.

An irrevocable commitment either in the form of confirmed bank guarantee or irrevocable letter of credit cannot be interfered with since frequent court intervention would not be in keeping with the very purpose and object of bank guarantees for fear of jeopardizing that which forms the very basis of commercial transactions. As a general rule especially in the case of unconditional or absolute bank guarantees, the banks must honour their commitments as per the terms of the contract, irrespective of any dispute between the customer and the bank with respect to the primary contract. The Courts are therefore reluctant to grant an injunction preventing payment or interfering with the liability of the bank to pay the amount due on the guarantee.

The Courts have culled out two exceptions to the general rule of non-interference by the Courts, namely (i) fraud and (ii) the resulting of irretrievable injustice or harm. The following cases further illustrate this point in detail: In the case of Bolvinter Oil SA v. Chase Metropolitan it was stated that an injunction may be granted where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly fraudulent; though the evidence must be clear as to the fact of fraud and as to the bank’s knowledge, and it cannot rest on the uncorroborated statement of the customer or else irreparable damage can be done to a bank’s credit.

The Supreme Court affirming long standing jurisprudence on the subject in the aforementioned case of UP State Sugar Corporation v. Sumac International Ltd stated that whenever a bank guarantee is sought to be encashed by the beneficiary, the bank is bound to honour the guarantee irrespective of any dispute raised by the customer against the beneficiary. This is however subject to two exceptions that is, a fraud committed in the notice of the bank which would vitiate the very foundation of the guarantee or encashment of the bank guarantee would result in irretrievable harm or injustice of the kind which would make it impossible for the guarantor to reimburse himself.

Conclusion.

Bank guarantees are of significance in the banking sector and are simple, flexible and effective and play a major role in the promotion of national and international trade.

A bank guarantee operates by way of a contract or agreement in which the bank itself stands as guarantor to a particular advance made by a creditor to a debtor, independent of the underlying contract and the primary contract of the person at whose instance the bank guarantee is given. It is extremely important to note that the enforcement of the guarantee is actually dependent on the terms of the contract subsisting between the bank and the beneficiary and is generally not interfered in by the Courts.

Beneficiaries or the creditors may charge a rate of penal interest in the event of delayed payment of the due amount. Hence, it is imperative that banks remain cautious, when signing a contract of guarantee with the beneficiary, which may contain provisions pertaining to the payment of penal interest in the event of delay in payment on default of the principal debtor.

   

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