A LEGAL PERSPECTIVE OF

BANK GUARANTEE SYSTEM IN INDIA

(Term paper towards partial fulfillment of the assessment in the subject of Specific Contracts)

Submitted By: Submitted To:

Gajendra Bhansali & Samvid Shetty Dr. Anjali Thanvi

B.A. LLB(Hons.) Faculty of Law

Semester – II Specific Contracts

NATIONAL LAW UNIVERSITY, JODHPUR

WINTER SESSION

(JANUARY-MAY 2015)

ACKNOWLEDGEMENTS

On the completion of this project we find that there are many persons to whom we would like to express our gratitude, since without their help and co-operation the success of this educative endeavour would not have been possible.

We welcome this opportunity to express my sincere gratitude to my teacher and guide, Dr. Anjali Thanvi, Faculty of Specific Contracts, who has been a constant source of encouragement and guidance throughout the course of this work.

We are grateful to the IT Staff for providing all necessary facilities for carrying out this work. Thanks are also due to all members of the Library staff for their help and assistance at all times.

We are also grateful to all our friends and colleagues for being helpful in their differences and for their constant support.

We express our deepest gratitude to our parents, who have been the real driving force for this work.

Gajendra Bhansali

Samvid Shetty

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RESEARCH METHODOLOGY

SUBJECT: Specific Contracts

TOPIC: A Legal Perspective of Bank Guarantee System in India.

The present study is doctrinal in nature. In this study, relevant statutory material has been

examined. The decisions of the Supreme Court regarding bank guarantee system published in

various journals have been analyzed. The various reporters, digests, journals and manuals have

also been intrepretede. The statutory material and the various decisions of the courts related to

bank guarantee system from various reference and text books have been analysed.

PREFACE TO THE PROJECT

The study examines the nature and scope of bank guarantee system in India. The present study is

concerned with the law relating to the bank guarantees particularly embodied in the Indian

Contract Act 1872. The present paper also puts light on the economic functions and benefits of

the bank guarantees. Besides that, this study also explains the various types of guarantees issued

by the banks in India. This study is a doctrinal study. For this research, relevant statutory

material has been examined. The decisions of the Supreme Court regarding bank guarantees have

been consulted. The purpose of this study is to make systematic evaluation of law and judicial

approach relating to bank guarantee system in India. The objectives of this study are to make

systematic evaluation of statutory law, Judicial Approach and Policies relating to bank guarantee

system in India.

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CONTENTS

Cover Page.......................................................................................................................................1

Acknowledgements..........................................................................................................................2

Research Methodology....................................................................................................................3

Preface To The Project....................................................................................................................3

Contents...........................................................................................................................................4

Contract Of Guarantee – In A Nutshell...........................................................................................5

Essentials And Nature Of The Contract Of Guaranteee..................................................................7

Bank Guarantees – An Analysis......................................................................................................8

Bank Guarantee – The Need & It’s Kinds.....................................................................................10

Bank Guarantees & Letter Of Credit Compared..........................................................................12

Contractual Obligation In Bank Guarantee : Judicial Intrepretation.............................................13

No Injunction To Restrain Payment Under A Bank Guarantee....................................................20

Safeguards Taken By Banks..........................................................................................................22

Major Findings & Conclusions......................................................................................................23

Bibliography..................................................................................................................................26

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Nobody can really guarantee the future. The best we can do is size up the chances,

calculate the risks involved, estimate our ability to deal with them and make our

plans with confidence.

- Henry Ford II

CONTRACT OF GUARANTEE – IN A NUTSHELL

A contract is an agreement, enforceable by law, made between at least two parties by which

rights are acquired by one and obligations are created on the part of another.1 If the party, which

had agreed to do something, fails to do that, then the other party has a remedy. It is a voluntary,

deliberate, and legally binding agreement between two or more competent parties.2 Contracts are

usually written but may be spoken or implied, and generally have to do with employment, sale or

lease, or tenancy.3

A guarantee can be many a things. It can be assurance of a particular outcome or that something

will be performed in a specified manner. A guarantee is a way of assuming responsibility for

paying another’s debts or fulfilling another’s responsibilities. It can be a promise for the

execution, completion, or existence of something. A guarantee can also be a promise or an

assurance attesting to the quality or durability of a product or service.4

1 § 2(h), The Indian Contract Act, 1872.2 The Indian Contract Act, 1872, Pollock & Mulla 721 (Lexis Nexis Butterwoths Wadhwa, 14th Ed. 2012).3 M.A.Sujan, Law Relating to Building Contracts 5 (Universal Law Publishing Co., Delhi, 1999).4 Indian Contract Act, 1872 – Contract of Guarantee, Kanwarn Wordpress, (February 27, 2015). < https://kanwarn.wordpress.com/2012/03/16/indian-contract-act-1872-contract-of-guarantee-part-1-of-3/>

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The English law defines a ‘guarantee’ as a ‘promise to answer for the debt, default or

miscarriage of another’.5

The Indian Law lays down that a Contract of Guarantee is a contract to perform the promise or

discharge the liability or a third person in case of his default.6 Anything done, or any promise

made for the benefit of the principal debtor, may be sufficient consideration to the surety for

giving the guarantee.7

Surety, Principal Debtor & Creditor – Primary Inter-Relationship :- Surety is the person

gives the guarantee, the Principal Debtor is one for whom the guarantee is given and the creditor

is the person to whom the guarantee is given. Contract Act uses the word ‘surety’ which is same

as ‘guarantor’ Prima facie, the surety is not undertaking to perform should the principal debtor

fail; the surety is undertaking to see that the principal debtor does perform his part of the bargain.

A contract of guarantee pre-supposes a principal debt or an obligation that the principal debtor

has to discharge in favour of the creditor.8

The most basic function of a contract of guarantee is to enable a person to get a job, a loan or

some goods as the case may be. Such an undertaking by a third person results in a contract of

Suretyship or Guarantee. Guarantee is security in form of a right of action against a third party

called the surety or the guarantor.9

5 Guarantee or Guaranty Legal Definition, Duhaime.org (February 28, 2015). < http://www.duhaime.org/LegalDictionary/G/GuaranteeorGuaranty.aspx>6 § 126, The Indian Contract Act, 1872.7 § 127, The Indian Contract Act, 1872.8 Supra.note 3, p.9.9 Avtar Singh, Law of Contract and Specific Relief, (Eastern Book Company 11th ed. 2006).

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ESSENTIALS AND NATURE OF

THE CONTRACT OF GUARANTEEE

Since Contract of Guarantee if a species of a contract, the General Principles governing contracts

are applicable here. There must be free consent, a legal objective to the contract, etc. Though all

the parties must be capable of entering into a contract, the principal debtor may be a party

incompetent to contract, ie., a minor. Secondly, a principal debt must pre-exist: A contact of

gurantee seeks to secure payment of a debt, thus it is necessary there is a recoverable debt. There

can’t be a contract to guarantee a time barred debt.

The contract of guarantee has to be clear and unambiguous. A letter clearly stating the intention

to guarantee a transaction will go on smoothly or one will behave appropriately, conduct himself

at work place will suffice. But a promise to pay extra attention or to take care of it does not

constitute a guarantee.

In India, a contract of guarantee may be oral or written. It may even be inferred from the course

of conduct of the parties concerned. Under English Law, a guarantee is defined as a promise

made by one person to another to be collaterally answerable for the debt, default or miscarriage

of the third persons and has to be in writing.10

There are three parties in a contract of guarantee; the creditor, the principal debtor and the surety.

In a contract of guarantee, there are two contracts; the Principal Contract between the principal

debtor and the creditor as well as the Secondary Contract between the creditor and the surety.

10 Anil Rego, How Bank Guarantees Work, Business Standard, Mumbai, August 29, 2010. <http://www.business-standard.com/article/pf/how-bank-guarantees-work-110082900033_1.html>

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The contract of the surety is not contract collateral to the contract of the principal debtor but is an

independent contract. Liability of surety is secondary and arises when principal debtor fails to

fulfill his commitments. Even an acknowledgement of debt by the principal debtor will bind the

surety.11

The object of a contract of guarantee is to provide additional security to the creditor in the form

of a promise by the surety to fulfill a certain obligation, in case the principal debtor fails to do

that.12 The contract of guarantee is no doubt tripartite in nature but it is not necessary or essential

that the principal debtor must expressly be a party to that document. In a contract of guarantee,

the principal debtor may be a party to the contract of implication. Thus there is a possibility that

a person may become a surety without the knowledge and consent of the principal debtor. In a

sense, it is a collateral engagement to be liable for the debt of another in case of his default.

“Guarantees are usually taken to provide a second pocket to pay if the first should be empty.”13

BANK GUARANTEES – AN ANALYSIS

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. It 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

11 P.C. Markanda et. al., Unconscionable Clauses in Construction Contracts, XLV, Indian Council of Arbitration Quarterly, 2, 6 (2009). <http://www.icaindia.co.in/icanet/quterli/july_to_sept_09.pdf>12 Halsbury’s Laws of England, “Guarantee and Indemnity”, 4th edn., Reissue, Vol.20, para 101.13 Wood, Law and Practice of International, Finance, (1980) p. 295.

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performance of the obligations of the client in the possible event of his default.14 Banks are

usually approached to give such guarantees, as they possess the financial capability to meet such

obligations.

Nature of the Contract :- A bank guarantee is a commercial document. It is a contract between

the issuing bank and the beneficiary in whose favour the guarantee has been furnished. It is an

act of trust to facilitate the fine flow of trade and commerce in internal and international trade or

business. Even though the genesis of a bank guarantee lies in the primary contract between the

parties, it is nevertheless, autonomous and independent. Though the bank guarantee may have

been issued by the Banker at the instance of his client, it is a contract between the banker and the

beneficiary in whose favour such bank guarantee has been issued. The party at whose instance

the guarantee has been furnished is, in a way, a stranger to the contract of bank guarantee. In a

bank guarantee, the bank binds itself to pay unconditionally and unequivocally without protest or

demur or performance by the principal debtor.15

The bank issuing the guarantee is not concerned with the relationship between the seller and the

customer nor it is concerned with the question whether the seller performed its contractual

obligation or not. The bank must be allowed to honour its commitments in a bank guarantee,

otherwise, the trust in international commerce will be irreparably damaged.16 Respectability and

reliability of the assured mode of payment through bank guarantees is essential for the growth

and promotion of trade.

14 Amrita Ganguli, Bank Guarantee : An Analysis, Manupatra Article, March 01, 2015. <http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=70c1051d-5804-409a-a55b-5e0243dfc004&txtsearch=Subject:%20Finance/Banking>15 Mohd Yasin Wani & Rais Ahmad Qazi, A Legal Perspective of Bank Guarantee System in India, 3, International Journal of Research in Commerce & Management, 161, 163 (2009). <file:///C:/Users/hp/Downloads/ijrcm-1-vol-3_issue-9-art-30.pdf>16 Sankalp Jain, Commercial Instruments : Bank Guarantee & Letter of Credit, March 05, 2015. <file:///C:/Users/hp/Downloads/SSRN-id2460246.pdf>

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BANK GUARANTEE – THE NEED & IT’S KINDS

Bank guarantee is used to reduce many business transactions risks. It is a reliable security

instrument in both international and domestic trade. Many genuine business requirements like

obtaining goods, purchasing machinery can be fulfilled even when the enterprise does not have

enough money. It enables to use bank's creditworthiness to facilitate many genuine business

transactions.17 It provides immediate funds to the business in the form of payment guarantees. It

gives one ample time to make one’s payments in case of deferred payment guarantees. It is a

quality security instrument which ensures a healthy business transaction and provides better

negotiable terms and conditions to the buyer and seller.18

There is a range of ‘avatars’ of bank guarantee which are used in different spectrum of situations,

according to the need and purpose.

Tender bond is bank guarantee which is used in the export business for project tenders. They

are short term guarantees. Its purpose is to secure any claims by the party inviting the tender on

the tenderer in the event of withdrawal of the bid before its expiry date or if the bid is modified

unilaterally. It is also used if the tenderer, upon being awarded the contract, refuses to sign the

contract or provide further guarantees on request.

The Performance Bond Guarantees are used to secure any claims by the buyer on a seller

arising from default in delivery or performance of the terms of a contract e.g. construction,

assembly, execution. It is used in import-export businesses as well as in domestic commercial

17 A.C. Moitra, Law of Contract and specific relief Act (Universal Law publishing Co. Pvt. Ltd., 7 th edn., 2006 Reprint).18 Bank Guarantee, Investopedia, March 06, 2015.< http://www.investopedia.com/video/play/bank-guarantee/>

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business, trade and industry. The terms of the guarantee are intact until the contractual

obligations have been fulfilled.

The Bank Guarantee for Warranty Obligations is type of bank guarantee whose purpose is to

secure any claims by the buyer on the seller due to possible defects appearing after delivery in

the export-import or the inland domestic transactions. In the construction trade, the guarantee for

warranty obligation in the form of a simple guarantee or a joint and several guarantee is known

as a building (or works) contractor's guarantee.

The Payment Guarantees are used in the import-export business or in any circumstance where

payment of an obligation needs to be guaranteed. It is used to secure any claims by the seller on

the buyer for payment of the contract price by the agreed date. The use of this guarantee is to

secure any claims by the lender on the borrower due to a credit not being repaid in accordance

with the terms of the lending contract. The amount of the guarantee is the amount of the credit or

loan, and it usually includes a margin to cover accrued interest and incidental expenses. The term

of the guarantee is until the expiration date of the loan plus a few days for instance 15 days.19

A bank guarantee, for all purposes, should be taken to be a credit not issued by the bank in

favour of the person in whose favour the bank guarantee has been issued, and it should be

encashable just like a credit note ordinarily, unless the intention of the parties is otherwise20

19 Jessy Ramchandran, Types of Bank Guarantee, March 06, 2015. Available at - <http://www.americancharomical.com>20 Handerson Wade, Bank Guarantee Explained, March 06, 2015. Available at - < http://ezinerticles.com/>

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BANK GUARANTEE & LETTER OF CREDIT COMPARED

Bank Guarantees and Letter of Credits are financial instruments often used in inland or

international trade when suppliers or vendors do not have established business relationship with

their counterparts. The difference between the two instruments is the position of the bank relative

to the buyer or seller of goods or services.

A Letter of Credit is a bank’s direct undertaking to the supplier to pay. When a letter of credit is

in use, the issuing bank does not wait for the buyer to default, and for the seller to invoke the

undertaking.21 In contrast, a guarantee is a written contract stating that in the event the primary

party is unable or unwilling to pay it’s dues to the supplier, the bank as a guarantor to the

transaction and an issuer of the bank guarantee, would pay the debt to the supplier. In other

words, a bank guarantee is an undertaking of a bank on behalf of it’s customer . But this comes

into play only when the principal party has failed to pay it’s supplier.

Essentially, the bank becomes a co-signer for it’s customer’s purchases. Hence in a Bank

Guarantee the initial claim is still settled primarily against the bank’s client, and not the bank

itself. Should the client default, only then would the bank agree to pay for it’s client’s debts on

behalf of it’s client. This is a type of contingent guarantee.22

A bank guarantee, therefore, is more risky for the client and less risky for the bank. But this is

not the case with a letter of credit. With a bank guarantee, if a client defaults the bank assumes

liability. (With a letter of credit, liability rests solely with the issuing bank, this being the key

21 Herman N. Finkelstein, Performance of Conditions under a Letter of Credit, 25 Colum. L. Rev. 724 (1925). Available at - <http://home.heinonline.org/>22 Rupnarayan Bose, Bank Guarantee and Letter of Credit, 12, Economic Law Journal, University of Chicago Press 76 (1995).

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difference and main advantage in a letter of credit) which then must collect the money from it’s

client . Therefore, the principal character of a letter of credit is that it is a potential claim against

the bank, rather than the bank’s client. A Letter of Credit the bank’s credit for its clients. The

seller’s risk is mitigated from the risk that the buyer will not pay to the risk that the bank will be

unable to pay, which is unlikely. Also, a letter of credit is less risky for the merchant but more

risky for the bank, though banks accept full liability in both cases.

1. A letter of credit is a “direct” responsibility of the issuing bank. The buyer does not at all

come into the picture. The letter of credit is a primary instrument in the transaction.

2. In contrast, a bank guarantee comes into operation ‘only when’ the buyer has failed to

perform his bit Therefore the bank issuing the bank guarantee is the second line of

defence , it is not a primary party.

CONTRACTUAL OBLIGATION IN BANK GUARANTEE

JUDICIAL INTREPRETATION

The Supreme Court and various High Courts over the years have passed numerous judgements

which have dealt with various circumstances and disputes which can take place when dealing

with bank guarantees. The following are some of the cases that deal with the same:-

Name of the Case: United Commercial Bank V. Bank of India and Ors.23

HELD: The Supreme Court was of the opinion that a bank guarantee is very much like a letter of

credit. The courts will do their utmost to enforce it according to its terms. They will not, in the

23 AIR 1981 SC 1426

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ordinary course of things, interfere by way of injunction to prevent its due implementation.It was

also said in this case that if the seller has complied with terms of letter of credit, however, there

is an absolute obligation upon a banker to pay irrespective of any dispute there may be between

the buyer and the seller as to whether the goods are upto contract or not.

Name of the Case: Rawala Construction co. V. Union of India24

Held: The Supreme Court laid down that the bank guarantee constitutes an agreement between

bank and the government under which there is an absolute obligation of the bank to make

payment to the government merely on the demand of the government. The bank is prohibited

under the guarantee from raising any objection.

Name of the Case: Hindustan Steel Workers Constn. Ltd. V. G.S. Atwal & Co.25

Held: Supreme Court laid down that there are two types of Performance Guarantees. The first

one is absolute and is encashable on the very demand of the beneficiary and the demand

according to the terms of the Guarantee is conclusive. In such types of Guarantees the

Beneficiary is the Sole Judge or Arbiter as to whether there is any breach of underlying or

primary contract on the part of the other party and as to how much amount is due to the former.

The other type is where the Guarantee is not encashable without proof of breach of underlying

contract. However, in both types of Guarantees, the Bank issuing the performance Guarantee is

not concerned with the underlying contract. The duties in such Guarantees are created by the

document itself which in other words is independent and autonomous and is not concerned with

24 AIR 1997 Del 20525 (1995) 6 SCC 76.

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the underlying contract unless the Guarantee itself says that it will be enforceable on the proof of

breach of the primary underlying contract.

Name of the Case: Hugglunds Drives AB V National Heavy Engineering Co-op. Ltd. 26

Held: The issuing bank is bound to observe and honour the terms of the guarantee. The

beneficiary of a bank guarantee cannot be restrained from invoking the bank guarantee, and the

issuing bank cannot be injuncted from paying over the proceeds of Bank Guarantee save and

except in the case of fraud which vitiates the entire underlying transaction or in case where

irretrievable injustice would be caused by the invocation or encashment of the Bank Guarantee.

Name of the Case: Rigoss Exports International (P) Ltd. V. Tartan Infomark Ltd27

Held: Bank Guarantee obtained by beneficiary through fraud, held that Court could intervene in

such cases.

Name of the Case: National Telecom of India Ltd. V Union of India28

Held: There was a bank guarantee in favour of the government in respect of supplies to be made

by the contractor as per the purchase order. As per the guarantee agreement, the amount was

payable without any demur and on demand.

To invoke the bank guarantee it has to be shown that there was existence of one of the two

conditions:-

26 AIR 2002 Bom 305.27 AIR 2001 Del 285.28 AIR 2001 Delhi 236.

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a)     That there failure on the part of the contractor to perform the contract, and

b)    That the amount claimed was by way of loss or damage to the government due to the

breach of contract.

If the contractor fails to supply the goods against purchase order, in spite of extension of time,

and the government writes to the Bank to claim compensation stating that the same has arisen

due to non-performance of the contract by the contractor, the guarantee, in such a case, has been

properly invoked in accordance with the terms of the contract.

It was further held in the case that if there is a breach of contract in the judgment of the

beneficiary of the contract, the bank has a obligation to pay the amount covered under the bank

guarantee on demand by the beneficiary without raising any objection. The bank is not to judge

that whether there is breach of contract or not.

Name of the Case: Daewoo Motors India Ltd. V. Union of India29

Held: The Appellant Company agreeing to fulfill export obligations had obtained various import

licenses from the government after furnishing bank guarantee in that regard. There was a term in

the bank guarantee that made the President under guarantee would be conclusive. Such guarantee

was held to be absolute and equivocal, hence invocation of guarantee on failure to fulfill export

obligation was held not arbitrary and its encashment could not be resisted by the bank.

Name of the Case: Bank of Baroda V Ruby Sales Corporation Agency30

29 AIR 2003 SC 1786.30 AIR 2001 Del 285

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Held: One of the parties demanded for discharging Bank guarantee by producing proper

documents. No proceedings had been initiated by party for alleged breach of agreement against

other party. Bank was not concerned with dispute between parties. Unless it was a case of fraud,

bank was bound to discharge bank guarantee. Plea that there was negligence on the part of bank

in discharging bank guarantee though it was informed not to make payment was rejected by the

Gujarat High Court. Action of Bank in discharging Bank Guarantee was not improper.

Name of the Case: Mula Sahakari Karkhana V State Bank of India31

Held: Document was supplied between the plaintiff and the bank and the supplier of the goods

was not a party to it. The document and the intention of the parties was clear covering

comprehensive claim of plaintiff to the extent of Rs. 3,40,000/- . The guarantor was invoked

within the prescribed time. Since there was no dispute between the plaintiff and the supplier as

also there being no fraud or misrepresentation involved, the Bank was held bound to honour the

guarantee.

Name of the Case: Prabhu Mktg. V. N.S.C 32

Held: The Calcutta High Court was of the opinion that where the is a very strong prima facie

case of element of fraud in connection with the invocation of bank guarantee, the party giving

the bank guarantee can lawfully seek injunction against the invocation of bank guarantee. But

there was no finding of fraudulent injunction against encashment of bank guarantee cannot be

granted.

31 AIR 2005 Bom. 38532 A.I.R. 2006 Cal. 301

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Name of the case: Man Industries India Ltd., Indore V N.V. Kharote Engineers and

Contractors, Pune33

Held: The Bombay High Court was of the opinion that there was a contract for supply of goods

by the company to the contractor. Dispute arose between parties regarding outstanding amount.

Bank guarantee executed at the instance of contractor in favour of company was unconditional. It

was not dependent on extent of goods supplied. Condition was stipulated in bank guarantee that

it could become en-cashable in the event of default of payment. No prima facie case for

injunction was made out by contractor. No irretrievable injustice would be caused to him.

Balance of convenience was also not in his favour. Injunction against encashment of bank

guarantee was refused as there was no finding of fraud recorded.

Name of the Case: Hindustan Steelworks Corp. Ltd. V. Tarapore and Co.34

Held: The Supreme Court laid down the law in terms of following propositions:

1.     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 primary contract between

the person at whose instance the bank guarantee is given and the beneficiary.

2.     In the case of an unconditional bank guarantee the nature of the obligation of the bank is

absolute and not dependent upon any dispute or proceeding between the party at whose instance

the bank guarantee is given and the beneficiary.

33 AIR 2005 Bom 31134 (1996) 5 SCC 34

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3.     The commitment by banks must be honoured free from interference by the court and it is

only in exceptional cases, that is to say, in case of fraud, or in a case where irretrievable injustice

would be done if bank guarantee is allowed to be encashed, that the court would interfere.

Name of the case: A.C. Roy & Co.V. Union of India35

Held: The Calcutta High Court held that the person claiming the guarantee must establish that

conditions for invoking the guarantee do exist. In another case of Natioanal Telecom of India

Ltd. V. Union of India36 the government was required to show at least one or two conditions for

invoking guarantee, ie. either that the amount had become due because of loss caused by breach

or that the amount was being forfeited by reason of the contractor’s failure to perform his

commitment.

Name of the case: U.P. Co-op Federation Ltd V. Singh Consultants and Engineering Ltd37

Held: The Supreme Court held that the operation of a bank guarantee should be stayed only in

cases of serious dispute, fraud or special equities.

Name of the Case: General Electric Technical Co Inc V Punj Sons(P) Ltd38

Held: The Supreme Court dealt with a case of bank guarantee given for securing mobilization

advance, it was held that the right of a contractor to recover certain amounts under running bills

would have no relevance to the liability of the bank under the guarantee given by it.

35 AIR 1995 Cal 246.36 AIR 2001 Delhi 236.

37 AIR 1988 SC 2239.

38 AIR 1991 SC 1994.

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A bank guarantee is a sort of an absolute undertaking to pay the amount whenever demanded by

the guarantee-holder. It has nothing to do with the state of relations between the guarantee-holder

and the person on whose behalf the guarantee was given. While ordinary guarantees are linked to

and dependent on the underlying transaction, a bank guarantee is an arrangement where the

guarantee is independent of the underlying transaction.

NO INJUNCTION TO RESTRAIN PAYMENT UNDER

A BANK GUARANTEE

Where a bank gives a guarantee to pay on ‘first demand’ and ‘without contestation and ‘without

reference to such party’ or ‘notwithstanding any disputes between the parties …..’, the guarantee

bank is obliged to pay according to the contractual obligation, and the court will not give an

injunction restraining the bank for payment. The fact that the guarantee issued by the bank is

wider in terms, than that agreed between the bank and the debtor is also no reason to grant

injunction restraining payment. Where however, there is no unconditional or irrevocable promise

to pay in the guarantee in which it was only undertaken to indemnify the company from any loss

or damage that was caused to it or was suffered by it by the act of the contractor, that temporary

injunction could be granted, restraining the company from realizing the bank guarantee, since the

guarantee sought to be enforced amounted to a contract of indemnity and the beneficiary has to

show the loss or damage caused to it. It is settled law that a contract of guarantee is a complete

and separate contract by itself. The law regarding enforcement of an on demand bank guarantee

is very clear. If the enforcement is in terms of the guarantee, then courts must not interfere with

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the enforcement of bank guarantee. The court can only interfere if the innovation of on demand

guarantee in accordance with its terms by looking at terms of the underlying contract.39

EXCEPTIONS - Payment under a bank guarantee may be refused or restrained:

1. Where the bank knows that the documents presented by the beneficiary for seeking

enforcement are forged or fraudulent.

2. Where a fraud by one of the parties to the underlying contract has been established and

the bank has notice of the fraud.

3. Where a case of apprehension of Irretrievable Injustice is made out.

4. Where the guarantee is conditional and the condition has not been complied with.

5. Where the conditions necessary for invoking a conditional bank guarantee have not

arisen.

6. Where the purpose for which a conditional guarantee was given has been accomplished.

7. Where the period stipulated for innovation of the guarantee has expired.

Therefore, as a general rule, bank guarantee must be honoured in accordance with its terms,

there are, however, two exceptions: The first is when there is clear fraud of which the bank

has notice and a fraud of the beneficiary from which it seeks the benefit. The fraud must be

of an egregious nature as to vitiate the entire underlying transaction. The second exception to

the general rule of non-intervention is when there are special equities in favour of injunction,

such as when irretrievable injury or irretrievable injustice would occur if such an injunction

were not granted.

39 M.L. Tannan, Tannan’s Banking Law and Practice in India, Vol I (Wadhwa and Company, Nagpur, 2 nd edn., 2005).

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SAFEGUARDS TAKEN BY BANKS

To reduce the risks to which the banks are exposed while furnishing bank guarantees on behalf

of their clients, banks resort to the following to safeguard their interest.

(a) Limits :- Banks lay down maximum monetary limits upto which they would furnish

guarantees and open letters of credit at any point of time. The limits are fixed on the

basis of the financial standing, extent to which the account has been maintained by

customers satisfactorily, the volume of transactions, past track record of the client in-

respect of such guarantees etc.40 The limits are reviewed are re-fixed periodically along

with monetary limits for overdrafts, cash credits etc.

(b) Margins :- Banks lay down maximum monetary limits upto which they would furnish

guarantees and open letters of credit at any point of time. The limits are expired on the

basis of the financial standing, extent of which the account has been maintained by the

customers satisfactorily, the volume of transactions, past track record of the client in

respect of such guarantee etc. The limits are reviewed and refixed periodically along

with monetary limits for overdrafts, cash credits etc.

The percentage of margin money could range from ten to fifty percent of the value of the

guarantees. The margin money will be released once the bank guarantee has expired and is

returned to the bank duly discharged.41

(c) Counter Guarantee :- In addition to fixing limits and taking ‘margin money’ as

security, banks invariably obtain counter guarantees from the client’s for equal value

40 Supra.note 3, p.156.41 R.K. Gupta, Banking Law and Practice. (Modern Law Publications, 2nd edn., 2005).

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before furnishing bank guarantees on their behalf. This document provides the basis for

the bank to debit the clients’ accounts when it has to honour a bank guarantee invoked by

the beneficiary, and to proceed legally against the client, if it is unable to fully reimburse

itself of the amount from the client.42

Bank Guarantee And Arbitration Clause in the Contract –

The enforcement of a bank guarantee cannot be made the subject-matter of arbitration

proceeding but where a bank found that there was a pending arbitration under which the liability

of all the parties had to be ascertained, the bank can rightfully decide to withhold the payment

under the guarantee.43

MAJOR FINDINGS & CONCLUSIONS

Guarantee is an undertaking to be collaterally responsible for the debt, default or miscarriage of

another. In banking context it is an undertaking given by the guarantor to the banker accepting

responsibility for the debt of the principal debtor if he defaults. Undoubtedly, Bank guarantees

are simple, flexible and effective guarantee and play a major role in the promotion of national

and international trade. So far, it can be safely concluded that a bank guarantee is an independent

and distinct contract between bank and the beneficiary, and is not qualified by the underline

transaction and the primary contract between the people at whose instance the bank guarantee is

given. When bank gives absolute and unconditional guarantee then the courts cannot issue an

injunction restraining the bank for the payment.

42 Supra.note 15, p. 163-164.43M.A. Mir, The Law Relating to Bank Guarantees in India. (Universal Book Traders, 1st edn., 1992).

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The Apex Court in its significant ruling in the landmark case of Himadri Chemicals Industries

Ltd. V. Coal Tar Refining Co.44 has culled out the principles that should be noted in the matter of

injunction to restrain the encashment of a bank guarantee.

First, banks that give such guarantees are duty-bound to honour them as per terms agreed upon

between the parties concerned, irrespective of any dispute raised by its customer. In the matter of

invocation of a bank guarantee, it is not open for the bank to rely upon the terms of the

underlying contract entered into between parties concerned, court said.

Second, the existence of any dispute between parties to the contract is not a ground for issuing an

order of injunction to restrain enforcement of bank guarantee. The apex court said that the bank

guarantee or LoC is an independent and a separate contract and absolute in nature.45

Third, the beneficiaries are entitled to realise an unconditional bank guarantee in terms of the

agreement, irrespective of any pending disputes relating to the term of the contract.

Fourth, the courts should be slow in granting an order of injunction to restrain the realisation of a

bank guarantee or.46

However, there is a grave need for improvisation in Bank guarantee regime in India. There is no

written law for Bank Guarantee, therefore there is an immediate need for codified law as

situations are becoming more technical. Moreover court cannot issue injunction in bank

guarantee except in exceptional cases which are decided by the courts so there should be written

laws. As we have progressed now bank guarantees are transmitted electronically on a bank-to-

bank basis. So one must be very concerned if presented with a hard copy of a bank guarantee; it

44 AIR 2007 SC 2798.45 Sanjay K Singh, Bank Guarantees LOCs are absolute, The Economic Times, August 09, 2007. <http://articles.economictimes.indiatimes.com/2007-08-09/news/28484612_1_bank-guarantee-loc-encashment>46 Supra.note 28, ¶15.

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may likely to be fraudulent instrument. This is not to preclude pro forma writings of bank

guarantees where the parties agree on the terms, and the applicant takes these terms to the bank

and has the bank incorporate them into the electronic bank guarantee.

Bank should not interfere with the dispute related to the encashment of bank guarantee. As far as

possible the dispute should be solved by Arbitrators. Commitment of banks must be honoured

free from interference by the courts. It is only an in exceptional case that is to say in case of

fraud or in case of irretrievable injustice, that the court should interfere. Thus in commercial

transactions bank guarantees achieve relevance. 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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BIBLIOGRAPHY

Cases

Bank of Baroda V Ruby Sales Corporation Agency ,AIR 2001 Del 285.....................................13

A.C. Roy & Co.V. Union of India, AIR 1995 Cal 246..................................................................16

Daewoo Motors India Ltd. V. Union of India ,AIR 2003 SC 1786..............................................13

General Electric Technical Co Inc V Punj Sons(P) Ltd ,AIR 1991 SC 1994...............................16

Himadri Chemicals Industries Ltd. V. Coal Tar Refining Co ,AIR 2007 SC 2798......................21

Hindustan Steel Workers Constn. Ltd. V. G.S. Atwal & Co ,(1995) 6 SCC 76.............................11

Hindustan Steelworks Corp. Ltd. V. Tarapore and Co ,(1996) 5 SCC 34....................................15

Hugglunds Drives AB V National Heavy Engineering Co-op. Ltd ,AIR 2002 Bom 305.............12

Man Industries India Ltd., Indore V N.V. Kharote Engineers and Contractors, Pune,

AIR 2005 Bom 311........................................................................................................................15

Mula Sahakari Karkhana V State Bank of India ,AIR 2005 Bom. 385........................................14

National Telecom of India Ltd. V Union of India ,AIR 2001 Delhi 236.......................................12

National Telecom of India Ltd. V. Union of India ,AIR 2001 Delhi 236......................................16

Prabhu Mktg. V. N.S.C ,A.I.R. 2006 Cal. 301..............................................................................14

Rawala Construction co. V. Union of India ,AIR 1997 Del 205..................................................11

Rigoss Exports International (P) Ltd. V. Tartan Infomark ,Ltd AIR 2001 Del 285....................12

U.P. Co-op Federation Ltd V. Singh Consultants and Engineering Ltd ,AIR 1988 SC 2239......16

United Commercial Bank V. Bank of India and Ors, AIR 1981 SC 1426....................................10

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Statutes

The Indian Contract Act, 1872........................................................................................................1

Treatises

1. A.C. Moitra, Law of Contract and specific relief Act (Universal Law publishing Co. Pvt.

Ltd., 7th edn., 2006 Reprint).................................................................................................6

2. Avtar Singh, Law of Contract and Specific Relief, (Eastern Book Company 11th ed. 2006)

………………………………………………………………………………………2

3. Halsbury’s Laws of England, “Guarantee and Indemnity”, 4th edn., Reissue, Vol.20, para

101…………………………………………………………………………………. …….4

4. M.A. Mir, The Law Relating to Bank Guarantees in India. (Universal Book Traders, 1 st

edn., 1992)…………………………………………………………………. ……………19

5. M.A.Sujan, Law Relating to Building Contracts 5 (Universal Law Publishing Co., Delhi,

1999)…………………………………………………………………………. …… …….1

6. R.K. Gupta, Banking Law and Practice. (Modern Law Publications, 2nd edn., 2005)

……………………………………………………………………………….. ……18

7. The Indian Contract Act, 1872, Pollock & Mulla 721 (Lexis Nexis Butterwoths Wadhwa,

14th Ed. 2012)……………………………………………………………………………..1

Web Links

Bank Guarantee, Investopedia, (March 06, 2015)...........................................................................6

Guarantee or Guaranty Legal Definition, Duhaime.org (February 28, 2015).................................2

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Articles

Amrita Ganguli, Bank Guarantee : An Analysis, Manupatra Article, March 01, 2015...................5

Handerson Wade, Bank Guarantee Explained, March 06, 2015.....................................................7

Herman N. Finkelstein, Performance of Conditions under a Letter of Credit, 25 Colum. L. Rev.

724 (1925)....................................................................................................................................8

Jessy Ramchandran, Types of Bank Guarantee, March 06, 2015...................................................7

Sanjay K Singh, Bank Guarantees LOCs are absolute, The Economic Times, August 09, 2007..20

Sankalp Jain, Commercial Instruments : Bank Guarantee & Letter of Credit, March 05, 2015.....5

Journals

1. Mohd Yasin Wani & Rais Ahmad Qazi, A Legal Perspective of Bank Guarantee System

in India, 3, International Journal of Research in Commerce & Management, 161, 163

(2009)...................................................................................................................................5

2. Rupnarayan Bose, Bank Guarantee and Letter of Credit, 12, Economic Law Journal,

University of Chicago Press 76 (1995)……………………………………………..……..8

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