Legal Aspects of Management

“Law of Bank Guarantees”

Submitted to: Prof. C.L Bansal

Law of Bank Guarantees In India

Contract of guarantee is defined in section 126 of Indian contract Act, 1872, which defines it as a
contract to perform the promise the third person's liability if he makes any default. The person
who promises to perform the third person's liability is called the "Surety." The person guaranteed
is called the "Principal debtor," and the person to whom the guarantee is given is called the
"Creditor."
A Bank guarantee is an agreement between three parties, i.e., the banker, the beneficiary, and the
Creditor, in which Bank becomes the surety for the transactions between the Debtor and
Creditor. A bank guarantee is a written contract given by a bank on behalf of a customer that
promises to pay or discharge the debtor's liability in case of any default. The concept of bank
guarantee is introduced for the free flow of the trade as a guarantee given by the bank secures the
Creditor from loss and enables them to claim the debt in case of any default without opting for
the cumbersome process of litigation.
Due to Globalization, the increase in international trade, and domestic trade, there is a need for
some reliable source to protect and reduce the risks in business transactions. In the current
business conditions, the business transactions are done globally, parties being apart from each
other, an innovative institution is needed to provide security of payments to claims, so the
concept of bank guarantee was introduced. A Bank guarantee is considered the "life-blood" for
trade, both domestic and international.

Types of Bank Guarantee:

According to specific purposes, Bank Guarantees are categorized into various types. Some of
them are as follows.

On the basis of issuance:

1. Direct Bank Guarantee- A direct bank guarantee is when a bank is asked to provide a
guarantee by its account holder in favor of the beneficiary.
2. Indirect Bank Guarantee- When a second bank issues a bank guarantee in return for an
already issued one, it is termed an indirect bank guarantee. In this, if the second bank
suffers losses when a claim is made against a guarantee, the issuing bank will ensure that
it compensates for the losses.

On the basis of the conditions specified in the guarantee:

1. Unconditional Bank Guarantee- Unconditional bank guarantees ensure the payment to the
beneficiary "unconditionally and irrevocably" on the beneficiary's first demand against
invoking the guarantee. Thus, the beneficiary becomes responsible for the performance of
the contract, and the bank cannot ask for evidence in that regard. The demand of the
beneficiary shall be final in that regard.
2. Conditional Bank Guarantee- Where the bank guarantee has certain conditions, which
need to be fulfilled for the final invocation of the guarantee by the beneficiary, such bank
guarantees are termed conditional bank guarantees. The language of the guarantee plays
an important role in determining which kind of guarantee it is.
On the basis of the type of performance by the bank as per the guarantee:
1. Financial Bank Guarantee- A financial bank guarantee ensures that money will be repaid
if the debtor does not complete a particular project entirely. According to this agreement,
when there is a delay in completing a project, the bank will make the payment.
2. Advance Payment Bank Guarantee- This guarantee signifies an obligation of the bank to
return advance payment if, after receiving an advance, the debtor does not perform its
contractual commitments.
3. Deferred Payment Bank Guarantee- This bank guarantee is offered to the beneficiary for
a deferred period or for a specific time period. In this guarantee, payment is usually made
in installments by the bank for failure in the completion of contractual obligations by the
debtor.
4. Performance/Contract Execution Bank Guarantee- This guarantee ensures timely delivery
of goods or performance of services according to a contract. The bank makes monetary
compensation in case of any delay in the performance of services or operation of the
contract.

Main guidelines for the bank guarantee by the Reserve Bank of India (RBI)

Over the years, RBI has formulated rules and regulations related to professional associations to
meet the requirements of the current business environment. Some of the most important
guidelines are:

o No Bank Guarantee should generally have a maturity of over 10 years.

o The Reserve Bank of India has lifted the 20 percent limit on unsecured guarantees
(effective June 17, 2004) and the bank's board of directors has been given the freedom to
determine its own unsecured exposures.
o The guarantee representative issued by the bank shall have an appropriate risk weight in
accordance with the applicable guidelines for claims against the borrowing company that
issued the guarantee on its behalf.
o Banks should avoid giving guarantees to customers who do not have credit facilities. In
addition, when forwarding the letter of guarantee, the bank should remind the
beneficiaries to check the authenticity of the letter of guarantee with the issuing bank.
o Banks can provide guarantees to other banks/financial institutions/other credit institutions
for the loans they issue, provided that the guarantee bank bears at least 10% of the
guarantee risk of refinancing risk.
o When guarantees are invoked, payment must be made immediately to the beneficiary.
o Banks must comply with the recommendations of the Ghosh Commission and other
internal requirements regarding the acceptance of collateral from other banks in order to
eliminate the possibility of fraud in this area.
Issues

Although a bank guarantee is intended to protect the creditor, there are specific circumstances in
which the creditor is unable to exercise his right of encashment. The following are the issues:

1. Fraud:
o When the bank notices clear deception on the side of the beneficiary, an injunction
against encashment of the bank guarantee might be granted. The deception must be such
that the entire transaction is tainted.
o The main rationale for the injunction in the instance of fraud is to protect the credit
system from being abused. This thought exemplifies the phrase "ex turpi causa non obiter
actio," which states that "truth unravels all."
o In the case of Rigoss Exports International (P) Ltd. v Tartan Infomark Ltd. (AIR 2001
Delhi 285), it was also decided that because the bank guarantee was obtained by fraud, it
was void, and the beneficiary was not entitled to receive the money. It was also decided
that in such cases, the court has the authority to intervene and prohibit the bank guarantee
from being encashed.

2. Irretrievable harm or injustice:

o Another issue to the encashment of a bank guarantee is irreversible harm or injustice to
one of the parties involved.
o In most cases, the encashment of money under a bank guarantee has a negative impact on
both the bank and the customer on whose behalf the guarantee is given, the harm or
injustice contemplated under this heading must be of such exceptional and irreversible
nature.

3. Special Equity:
o The term "special equities" refers to a broad and encompassing concept that allows for
injunctions against the encashment of bank guarantees only under exceptional situations.
o In the case of Texmaco Ltd. vs State Bank of India, the Calcutta high court invented the
word. The supreme court adopted the idea of exceptional equities as an exemption to
injunctions against bank guarantees in the case of Ansal Engineering Projects Ltd. vs
Tehri Hydro Development Corporation.
o The concept of unique equities is viewed as a means of offering redress to parties who
have been harmed in unusual or unusual situations.
o To warrant an injunction to give bank guarantees, special equities need also be linked to
irreversible harm or injustice. In the case of Svenska Handelbaken vs Indian Charge
Chrome, this was decided.
o In this case, the court relied on Itek Corp. vs First National Bank of Boston, a case from
the United States. Due to the warlike circumstances in Iran, the restriction against
granting bank guarantees was lifted. In the case of Dwarikesh Sugar Industries Ltd. vs.
Prem Heavy Engineering Works (P) Ltd. & Others., this principle was clarified.
o The court stated that an injunction should only be granted where there is no chance of
recovery and the contract's execution has become impossible.
Solutions

CAN INJUNCTION BE SOUGHT BY A PERSON OTHER THAN THAT NAMED IN THE

BANK GUARANTEE?

Supreme Court of India in HINDUSTAN CONSTRUCTION CO LTD v. STATE OF BIHAR

1999 stated that Bank Guarantee is to secure "Advances“given to the contractor while also
securing the performance of the work and can be invoked by ‘Chief Engineer who is its
beneficiary.
Although the framing of a guarantee may seem to be unconditional, it is in fact conditional and
may be invoked by the Chief Engineer in whose favor it was furnished
Term ‘Chief Engineer’ is not defined in the General contracts and it cannot include ‘Executive
Engineer’ by whom it had actually been invoked on the ground of abandonment of contract by
the Contractor. Court ruled that invocation by the Executive Engineer was therefore wrong as he
was not authorized and the bank was justified in refusing to honor the same since facts are in
favor of the appellant.
CAN BANK GUARANTEE BE INVOKED PENDING ARBITRATION OF DISPUTE
between principal debtor AND BENEFICIARY?
The bank guarantee provided stated that Bank guarantees and undertakes the obligation to pay
the beneficiary immediately on demand all/part of the moneys payable by the contractor any time
until 31st December of 1986, without any reference to the Contractors. Such demand made by the
owner shall be conclusive and binding notwithstanding any conflict of interests between the
owner and the Contractor or any dispute pending before any Court, tribunal, or any other
Authority”
In total, four bank guarantees were formulated with similar framework.
It was ruled that injunction cannot be issued if the Bank guarantee is payable on demand, and the
bank must pay as and when demanded by the beneficiary. Also ruled was that, irrespective of
any legal tussle or dispute ongoing between the beneficiary and the Principal Debtor, encashment
of the bank guarantee by beneficiary cannot be prevented/hindered on any such grounds.
Related Cases

Power Mech Projects Limited Vs. SEPCO Electric Power Construction Corporation

Summary:

The dispute involved in the two applications (heard jointly by the court) as to whether an
application under Section 34 of the Act, listed and the current application, could be adequately
heard against the award unless the applicant first verifies the completed amount.

While deciding the question and maintaining the defendant's contention that the facts and
circumstances of the case agree that 100% of the principal amount disbursed by the applicant
before the application is reasonably valid and that as held by Hindustan Construction Company
Limited Vs. The Union of India by the Supreme Court states that the awarding of a prize, as a
measure of protection, is a step towards enforcement of the award. The compensation should not
be given fraudulently by co-operation that may place the title of the prize above the enforcement.
The court held that, although it cannot be stated 100% deposit before the hearing of an
application under Section 34 of the Act or before the enforcement of the award, the amount of
the deposit will depend on the facts of the case. It is in the court's favour to hear the application.
The court found that the facts of the case revealed that the applicant did not have immovable
property in India and held that the applicant had ongoing projects in India would not be accepted
as a guarantee that the award would be enforced.

The court also went on to record that it was inappropriate for the department to enter into
disputed property appraisal questions as satisfied by the applicant, in terms of a recent ruling by
the High Court of India in Hindustan Construction Limited (supra) and held that equipment it
cannot be protected by movable assets such as industry and machinery.

The court reiterated the findings of the High Court in Hindustan Construction Company Limited
(supra), which provided the appropriate weight to be given for the legal purpose of the legislature
while declaring Section 35 on the termination and significance of the award; the interpretation of
Section 36 that, the amended Section 36, by nature, simply repeats the position that the
unadulterated Section 36 does not stand in the way of the law by providing for the existence of a
financial decision under the provisions of the CPC; the arbitral award holder is deprived of the
fruits of their award which is usually received after several years of litigation due to automatic
residency.

The court also concurred with the reliance placed upon by the Respondent on Supreme Court
decisions in SREI Infrastructure Finance Limited vs. Candor Gurgaon Two Developers and
Projects Pvt. Ltd. Were in an appeal filed against the judgment of the Calcutta High Court. The
Supreme Court has directed 100% deposit of the amount viz. 60% and 40% by cash deposit and
by security by a Bank Guarantee of a nationalized bank respectively and regards to Manish vs.
Godawari Marathawada Irrigation Development Corporation where the Bombay High Court had
ordered 60% deposit but the Supreme Court held that there should be a 100% deposit being a
money decree.
Judgement:

The Court stated that it is appropriate that the Petitioner must deposit 100% of the awarded
amount of Rs. 142 Crores (principal amount) to secure the Respondent within four weeks from
the order date according to the recent decisions of the Supreme Court, the facts and
circumstances of the present case, although it is true that in some of the orders shown by the
Petitioner of co-ordinate Benches of the High Court of Delhi have been directing to deposit 50%.
This judgment would have impacted the Delhi High Court requiring a deposit of more than 50%
of the awarded amount before entertaining any challenge to the corresponding awards.

Standard Chartered Bank vs Heavy Engineering Corporation

Summary:
The instant appeal is being preferred against the judgment and order dated 8th May 2019 passed
by the Division Bench of the High Court of Calcutta, setting aside the judgment dated 16th
October 2015 of the Single Bench and accepting the claim of the 1st respondent plaintiff holding
that the bank guarantees were properly invoked in law. Accordingly, the decree came to be
passed for Rs. 11,10,33,207.00/ as claimed in paragraph 18 of the plaint with interest at the rate
of 8 percent per annum from the date of institution of the suit until payment.
The dispute primarily arose concerning two bank guarantees amounting to Rs. 71,35,100/- and
Rs. 20,32,500/¬ in terms of the letters of intent, furnished on behalf of the 2nd defendant by the
appellant Bank in favor of the 1st respondent-plaintiff “as an advance against supply of plant and
equipment” by the 1st respondent-plaintiff to the 2nd respondent. The two bank guarantees are
on identical terms, and the only difference is the date and the amount
Judgement:
The instant appeal was preferred against the judgment dated 8th May 2019 passed by the High
Court of Calcutta, that the bank guarantees were accurately digitally signed by Arjun Bisht. The
criteria were said to be fulfilled where the court was satisfied that the party seeking refuge under
special equity was likely to suffer losses, which couldn't be recovered.

Common Law:
The Indian Contract Act 1872, Section 126.
The Indian Contract Act 1872, Section 20.
References

https://www.mondaq.com/india/contracts-and-commercial-law/1096782/bank-guarantees-in-
india
https://blog.ipleaders.in/guarantee-and-bank-guarantee-contracts-and-effect-of-covid-19-on-the-passing-
of-injunction-against-the-bank-guarantee/
https://main.sci.gov.in/supremecourt/2021/10376/10376_2021_38_1501_29510_Judgement_24-Aug-
2021.pdf
https://main.sci.gov.in/supremecourt/2019/29559/29559_2019_17_1503_19261_Judgement_18-Dec-
2019.pdf