Bank Guarantee: A Judicial Approach

Author: - Arju Jambhulkar

2nd Year B.A. LL.B (Hons.)
National Law University, Nagpur

ABSTRACT: This article deals with the concept of bank guarantee and explains the difference between a bank guarantee and a Letter of Credit but these terms have been used interchangeably for this article. It explains the invocation of bank guarantee and the exceptions when it cannot be invoked. The two main exceptions laid down in various judicial pronouncements are Fraud and Special equity. In certain cases, the ambit of special equity is widened. It also deals with the decision taken regarding the invocation of bank guarantee in the lockdown period. Further, it explains the role of Arbitration while tackling the cases of bank guarantee. It discusses how the bank guarantee eases the transaction and hence enhances International Business.

1. INTRODUCTION

A Bank Guarantee is a tripartite agreement done between a bank (surety), a debtor, and a creditor. The one who gets the benefit of the guarantee is the beneficiary, the one on whose instance guarantee is given is the applicant and the one who gives the guarantee is the surety i.e. bank in the cases of Bank guarantee. The main principle behind this concept is for the ease of doing modern business as keeping the bank as a surety reduces the risk of business transactions and commonly used as collateral while doing the same.[1] For example: to encourage the new start-ups, as in the commencing stage the new firms may not be having a sufficient amount of money but they can uplift the needed amount in credit by keeping the bank as a surety. There are prominently two types of Bank Guarantees[2]:

  • Conditional performance guarantees
  • Unconditional conditional performance guarantees

 

The conditional guarantee is such that in which the liability of the surety comes into the picture only after the fulfilment of specific provisions as outlined in the guarantee itself. To invoke the guarantee there is a need to prove that there is a loss to the beneficiary due to a breach of the term’s cardinal to the contract. As per Section 126 of Indian Contract Act, 1872, the performance of the promise of exemption from liability of the third person is done in a situation of his default under a contract of guarantee and the liability is collateral in such case[3]The co-extensive liability of the creditor is by virtue of Section 128 of India Contract Act, 1872.

Contrary to this, there is an unconditional guarantee which is not performed based on completion of certain terms rather is an on-demand guarantee and there is no need to prove that there is a loss that occurred to the beneficiary to invoke the guarantee.[4]The bank guarantee which is in unqualified and unconditional form is an independent agreement and the bank is, however, an independent debtor to the beneficiary and not a surety under this kind of guarantee.[5]

The advance payment guarantee is generally used for Domestic and International Trade, basically done by the buyers to safeguard the Advances made by them.[6]

There is a need to examine the main difference between Bank Guarantee and Letter of Credit for this project. Letter of credit is specifically used in the business of International trade (seller and buyer are unaware of each other) for the ease of transaction and this, there is no concept of default, for the payment. There are two banks involved in this transaction, one is the issuing bank (that issues LC) and another is the advising bank. The LC is given to the seller by the advising bank, he ships the goods from his side, receives the bill of lading, and submit it to the advising bank and the advising bank pays to the seller.[7]

The contract between the creditor and the surety (i.e. bank) is different from the original contract between the seller (the creditor) and buyer (principal debtor) because of the undertaking of the bank is unconditional and absolute and there exist no reason for the intervention of the court in such matter otherwise it would knock down the quintessence of the bank guarantee.[8]

2. INVOCATION OF BANK GUARANTEE

When there is a conditional bank guarantee, it can be invoked only after the fulfilment of certain conditions and the court can issue an injunction in such cases subject to the facts and circumstances.

It is a general principle that, if there is an unconditional or on-demand guarantee given by the bank, although there arises a dispute between the parties, the bank is compelled to pay the amount as per the contract and the court cannot issue an injunction for the payment by the bank.[9] The bank guarantee should be in unequivocal terms and recapitulate that the amount paid should be without any objection or demur regardless of any dispute that might have raised or there might have any pending issue between the beneficiary or the person on whose instance the guarantee was equipped under the contract of guarantee.[10] The settled law in this regard says that a bank guarantee is an independent contract between the bank and the beneficiary and once it is invoked by the beneficiary the bank is bound to honour the guarantee irrespective of any argument between the parties.[11]When an unconditional guarantee is given by the bank, it is obliged to pay the amount whenever it is demanded without cross-examining the relationship between the parties and even if there is any dispute between them the party on whose behalf guarantee is given cannot invoke an injunction restricting the bank to perform its guarantee.[12]But there exist certain exceptions(unconditional guarantee) that an injunction can be granted by the court if there is a prima facie case of fraud, irretrievable injury, and special equity[13] in a form of averting the irretrievable unfairness between the parties.[14] The irretrievable disservice should be of such nature that no requisite remedy is there for the beneficiary at law and the injury happening should not be speculative but an immediate and genuine one.[15]Nevertheless, financial distress cannot be a ground to injunct the encashment of an unconditional bank guarantee.[16]

  • Fraud

The traditional understanding of fraud[17] is that, if a person commits certain fraudulent acts due to which other party is induced to enter into a contract, so basically it talks about the fraud committed while entering into the contract. In the cases of bank guarantee, the nature of fraud occurred should be egregious that tends to debauch the basis of that bank guarantee[18] and mere contention of the fraud with uncorroborated statements is insufficient to prove it and the court won’t interfere in such situations for invoking guarantee.[19]The court has however mentioned now that the demand made under a bank guarantee underlying a contract by the beneficiary can be fraudulent not only because of the acts committed by the beneficiary but also by the following events and occurrences and the court should not abstain from impeding a person making this kind of fraudulent demand by enforcing the bank guarantee.[20] The invocation of the guarantee would not be fraudulent merely because there arises a dispute between the parties regarding the transaction.[21] The situations where the beneficiary is demanding the guaranteed amount by concealing the recoveries already made, such special cases also lead to fraud.[22]If fraud was raised between the parties at a preliminary stage regarding the transaction, before the examination of the imposition of the guarantee between the parties has arisen, the court can grant an injunction in such a case.[23]In all, the fraud in the cases of bank guarantee must have or due to the circumstances occurred successively.[24] 

  • Special Equity

The situation where the guarantor cannot recompense himself, if he eventually succeeds then it would be considered as an outcome of irretrievable injury and this should be emphatically established and proved as per the convenience of the Court that there is no possibility to recover the amount from the beneficiary, by even restitution.[25]The court has made clear that irretrievable injustice and special equity are not synonymous and the irretrievable injustice comes under the ambit of the special equity concept.[26]

The court has also mentioned that there is a need to satisfy the ‘Balance of Convenience test’ under which the Court makes an effort to balance the injury caused to either of the parties concerned due to its decision.[27]The court visualized that the presence of special equity and irretrievable injury areas in different occurrences and the establishment of either of them would lead to granting an injunction by the court.[28] In the case of Itek Corporation v. The First National Bank of Boston,[29] there was a contract between an American Company (USA) and an Iranian Company (Republic of Iran), and a bank guarantee was given on the behalf of the American corporation. Subsequently, the relation between the USA and Iran deteriorated and the antagonist behaviour was done with US citizens who were travelling to Iran. The court of Itek stated that even if a bank guarantee was allowed to be invoked and successively the American company got successful in obtaining the same against the Iranian company but that decree could not be executed in Iran due to the ongoing conflict between the countries. This kind of situation leads to special equity in the favour of the American Company and hence the court holds back any invocation of the bank guarantee.

In one of the recent judgment of Bombay High Court in the case of Trans rail Lighting Ltd. v. Public Electricity Corporation Republic of Yemen,[30] There was a contract between the plaintiff and defendant, subsequently, Yemen started a civil war in 2015 due to which there arises a security threat to the foreigners travelling to and from Yemen and Indian Nationals were advised through the MEA, India to avoid their travel to Yemen. On March 30 2015, the Trans rail wrote to PEC regarding the termination of the contract due to present circumstances. The court in the present case has taken the same stand as per the Itek Corporation’s case.

  • Cases during the COVID-19

According to the doctrine of Supervening impossibility,[31] there might arise a situation when the parties to the contract are unable to perform it & reason is neither because of the act of either of the parties nor there was anything as such when they got entered in the contract. The impossibility to perform is due to certain events and the parties are not responsible for it. However, the impossibility should be physical or legal. The contracts in which parties are restricted from performing their contract due to certain circumstances that are beyond their control are force majeure events and the clause can be invoked for the same.[32]

 In the case of Standard Retail Private ltd v. G.S. Global Crop,[33] the Bombay High Court made a certain observation regarding the issue of covid-19: “(i) for invocation of force majeure clause, there should be an impossibility to perform the contract (ii)there must be restrictions on the movements of the said goods under the contract  (iii) the temporary restrictions due to ongoing lockdown in India, are for a specific period and can’t rescue to the petitioner from its contractual obligations.” The court held that Covid-19 and the lockdown imposed eventually imposed because of it won’t consist of force majeure and hence it can be a ground to invoke Section 56 of the Indian Contract Act. Contrary to this, in the case of Halliburton Offshore Services Inc. v. Vedanta Ltd,[34]where almost the facts were on the same footing, the Delhi High Court held that there is the impossibility of performing the contract due to imposed lockdown and Covid-19 is prescribing special equity here and issued an interim stay on the encashment of the bank guarantee. The court here relied on the principle of special equity leading to irretrievable injury between the parties following the Supreme Court in one of their cases[35] and held that injuncting the invocation of the eight Bank guarantees would be in favour to justify the interest of parties. The Supreme Court has also come out with ground while dealing with such cases in this period of lockdown to grant an injunction in the form of special equity.[36]

3. ROLE OF ARBITRATION IN BANK GUARANTEE CASES

Section 7(5)[37] The Arbitration and Conciliation Act is specifying the reference made in a particular contract to any document which mentions an arbitration clause accounting to an arbitration agreement provided the contract is in written form and reference made is in a manner to add the arbitration clause to the part of the contract. The scope of section 7(5) of the Arbitration Act is made clear by the Court as whenever executing terms of a contract are mentioned about another contract (terms regarding performance and for dispute settlement through arbitration) then only the terms regarding execution alone would be applied and not the agreement of arbitration unless specified otherwise.[38]A mere reference to an ECC contract or performance bank guarantee won’t make an arbitration clause read into the bank guarantee and the above interpretation of section 7(5) should be applied here and therefore a specific reference should be made in the bank guarantee regarding the arbitration clause to invoke it.[39]The bank guarantee is considered as a separate agreement between the concerned parties without having any link with the arbitration agreement provided that there is an enabling provision in the bank guarantee as out-turn to subsume the said agreement. However, if the specific conditions laid down for Section 7(5) are not followed then the invocation of Section 9[40] of the Arbitration and Conciliation Act against the bank guarantee would not be maintainable.[41]

In the case of Technimont Pvt. Ltd. & Ors v. ONGC Petro Additions Ltd.[42], the court held that while exercising the jurisdiction of the court under Section 9, if the losing party to an arbitration invokes a bank guarantee in a post-award stage then such a bank guarantee is administered to be returned and the court restrained the respondent in this case from invoking or extending the guarantee furnished by the petitioner.

The procedural questions regarding bank guarantee need to be resolved. From the Swiss perspective if a party thought that the other contractual party would call upon the bank guarantee on unjustified grounds and if it acts against the bank by requesting an order to impede a bank from issuing payments under the contract of bank guarantee then that particular party is not supposed to rely on arbitration clause mentioned in the contract.[43] Contrary to this if a party claims against the other contractual party in a competent court to order that she/he should not call the guarantee, the arbitration clause (if mentioned) in the contract can be enforced.[44]

4. BANK GUARANTEE AND INTERNATIONAL BUSINESS

 In International trade or business, the letter of credit is used for the transaction. The beneficiary is in a very strong legal position because of the unconditional guarantee and she/he can ask for immediate payment and the surety and the principal can’t object it[45]; the beneficiary doesn’t have any risk regarding the insolvency of the principal[46]. The companies from less-developed countries have a great advantage as the acceptance of their contract on an international level won’t keep their contractual partner in any kind of position of risk realizing their claims. In all, ease of transaction is there and hence promoting the International Business.[47]

In India, as prescribed by the Reserve Bank of India through Notification No. FEMA.8/2000-RB, certain authorized banks are allowed to give guarantees in favour of Foreign Airlines or on the behalf of Service Importers.[48]

5. CONCLUSION

The legal aspects regarding the invocation of bank guarantee in unconditional guarantee can be injuncted if there is fraud or special equity. As per the judicial pronouncements, the irretrievable injury comes under the ambit of special equity. The granting of an injunction against invoking bank guarantee by the Delhi High Court in this period of lockdown was the correct decision on the ground of special equity as one of the parties was not able to fulfil its obligation. The injunction was granted for a specific period of lockdown and accordingly, the obligations will be fulfilled as the conditions get to normalcy. For the invocation of the arbitration clause in cases of bank guarantee, the mere reference to the performance of guarantee in the original contract would not suffice rather point should be made in the guarantee regarding the arbitration clause. The concept of bank guarantee or letter of credit plays a very significant role in the daily business life and the sector of International trade as it increases the ease of transaction and either of the contracting parties is at less realization of the risk and hence encourages the same.

 

References:

[1] Mirjana Knezevic and Aleksander Lukic, “The Importance of Bank Guarantees in modern business (business environment in Serbia)”, Investment Management and Financial Innovations Journal, 13(3-1), pp. 215-221.

[2] Mohd Yasin Wani, “A legal perspective of bank guarantee system in India”, International Journal of Research in Commerce & Management Vol III, pp 161-162.

[3] Mahabir Shamsher v. Lloyds Bank A.I.R. 1968 Cal. 371: Nagpur Nagarik Sahakari Bank Ltd. V. Union of India A.I.R. 1981 A.P. 1537.

[4] R Yashoda Vardhan and Chitra Narayan(ed.), Pollock & Mulla The Indian Contract & Specific Relief Acts, 15th ed. 2017, Vol II, pp. 1092-1093.

[5] P. M. Bakshi, “Bank Guarantees”, Journal of the Indian law Institute, Vol 37, pp. 109-111.

[6] Akshay Anurag, “Bank Guarantee and Judicial Interventionhttp://docs.manupatra.in/newsline/articles/Upload .

[7] Ashok Luhar, “Letter of Credit and Bank Guarantee- which is more cost effective in selected Indian Industries.”, Internationally Monthly Refereed Journal of Research Management & Technology Vol. III, pp. 19-24.

[8] Tarapore and Co. v. VO Tractors Export AIR 1970 SC 891.

[9] A.I.R. 2000 HP 48.

[10] Hindustan Construction v. State of Bihar (1999) 8 SCC 436.

[11] Ansal Engineering Projects Ltd. v. Tehri Hydro Development Corporation Ltd. & Anr 1996 5 SCC 450.

[12] U.P. Co-op. Federation LTD v. Singh Consultants and Engineers (P) LTD. (1998) 1 SCC 174.

[13] Suzlon Energy Ltd. v. Zemira Renewable Energy Ltd. OMP (I) (COMM.) 340/2019.

[14] Mahabir Shamsher v. Lloyds Bank A.I.R. 1968 Cal. 371.

[15] A.I.R. 1985 Kant 73.

[16] Umaxe Projects Private Ltd v. Air Force Naval Housing Board and Another, OMP (I) (COMM.) 206/2019.

[17] Section 17, Indian Contract Act, 1872.

[18] A.I.R. 2000 HP 48.

[19] The Evidence Act, 1872.

[20]  Mercator Oil & Gas Limited v. Oil & Natural Gas Corporation Ltd 2019 SCC OnLine Bom 1378.

[21] (1704) 1 Salk 27.

[22] Mahabir Shamsher v. Lloyds Bank A.I.R. 1968 Cal. 371: Nagpur Nagarik Sahakari Bank Ltd. V. Union of India A.I.R. 1981 A.P. 1537.

[23] Ibid.

[24] Hindustan Steelworks Construction Ltd v. Tarapore & Co. (1996) 5 SCC 34.

[25] Dwarikesh Sugar Industries Ltd. v. Prem Heavy Engineering Works (P) Ltd & Anr (1997) 6 SCC 450.

[26] Vinitec Electronics Pvt. Ltd v. HCL Infosystem Limited (2008) 1 SCC 544.

[27] Klen & Marshall Manufacturers v. Reserve Bank of India 1999 IVAD Delhi 520.

[28] 2019 SCC OnLine SC 1638.

[29] 566 F Supp. 1210.

[30] Transrail Lighting Ltd. v. Public Electricity Corporation Republic of Yemen (Decided on 11 March, 2020).

[31] Section 56, Indian Contract Act, 1872.

[32] Force Majeure General Considerations, ICC https://iccwbo.org/force-maejure (Accessed on 14/09/2020).

[33]  Commercial Arbitration Petition (L) No. 404 of 2020 (decided on 08.04.2020).     

[34] [OMP (I) (COMM) & I.A. 3697/2020 as decided on 20.04.2020].                            

[35] Himadri Chemicals Industries Ltd v. Coal Tar Refining Co. (2007) 8 SCC 110.

[36] Standard Chartered Bank Ltd. v. Heavy Engineering Corporation Ltd. 2019 SCC OnLine 1638.

[37] Section 7(5)n of Arbitration and Conciliation Act, 1996.

[38] M. R. Engineers & Contractors Pvt. LTD v. Som Datt Builders Limited 2009 7 SCC 696.

[39] M/S. Geodesic Techniques Pvt. Ltd… v. M/S. Larsen & Toubro Limited.

[40] Section 9, Arbitration and Conciliation Act, 1996

[41] Himadri Chemicals Industries Ltd v. Coal Tar Refining Co. (2007) 8 SCC 110.

[42] Technimont Pvt. Ltd. & Ors v. ONGC Petro Additions Ltd 2020 SCC OnLine Del 653

[43]George Von Segesser, “A complex Matter: Bank Guarantees and Arbitration Agreements” http://arbitrationblog.kluwerarbitration.com/2009/02/13/a-complex-matter-bank-guarantees-and-arbitration-agreements/ .

[44] 4A_224/2007 of 10 October 2008.

[45] M S Siddiqui, “Bank Guarantee in International Trade” The Asian Age Eden Building to Stock Exchange https://dailyasianage.com/news/151976/bank-guarantees-in-international-trade

[46] Ibid.

[47] Mirjana Knezevic and Aleksander Lukic, “The Importance of Bank Guarantees in the Modern Business (business environment in Serbia)”, Investment Management and Financial Innovations Journal, 13(3-1), pp. 215-221.

[48] Regulation 4, Foreign Exchange Management (Guarantees) Regulation, 2000.

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