Bank Guarantee

India– Indian Contract Act discusses Contract of Guarantee and could be of guidance in understanding the concept of Bank Guarantee. S.126, Indian Contract Act, 1872 deals with “Contract of guarantee”, “surety”, principal debtor” and “creditor”. S.127 deals with Consideration for guarantee, and S.128 focuses on Surety’s liability.

Bank guarantees are of two types- conditional and unconditional. A bank guarantees which provides that it is payable by the guarantor on demand is considered to be an unconditional bank guarantee. Correspondingly, what exactly constitutes a condition? If the material part of the bank guarantee requires that when the bank guarantee  is invoked, the beneficiary has to satisfy certain conditions, then and then only the bank guarantee is a conditional one. Mere fact that the bank guarantee refers to the principal agreement in the preamble of the deed of guarantee does not make the guarantee furnished by the Bank to be a conditional one unless any particular clause of the agreement has been made part of the deed of guarantee. The recitals in the preamble in the deed of guarantee do not control the operative part of the deed. What is relevant, therefore, is the terms incorporated in the guarantee executed by the bank. The bank guarantee has to specifically refer to the original contract and postulate that if the obligations expressed in the contract, are not fulfilled then alone the bank would be liable to pay the amount due under the guarantee. Furthermore, where the amount covered by the bank guarantee becomes payable the same could be invoked only in the circumstances referred to in a specific clause of the principal agreement.

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 was given and the beneficiary. A bank issuing a guarantee is not concerned with the underlying contract between the parties to the contract. The duty of the bank under a performance guarantee is created by the document itself. Once the documents are in order the bank giving the guarantee must honour the same and make payment ordinarily. The bank is always obliged to honour its guarantee as long as it is an unconditional and irrevocable one. The dispute between the beneficiary and the party at whose instance the bank has given the guarantee is immaterial and of no consequence. The dispute, if any, between the parties with regard to the liability in any proceedings either before the Arbitral Tribunal or court in no manner affects the right of the purchaser to invoke the bank guarantee and realise the guaranteed sum from the guarantor. It is not permissible for the bank to refuse payment on the ground that the buyer is claiming that there is a breach of contract. Nor can the bank try to decide this question of breach at that stage and refuse payment to the seller. The person in whose favour the guarantee is furnished by the bank cannot be prevented by way of an injunction in enforcing the guarantee on the pretext that the condition for enforcing the bank guarantee in terms of the agreement entered between the parties has not been fulfilled.

The courts have carved out only two exceptions. First, when there is a clear fraud of which the bank has notice and a fraud of the beneficiary from which it seeks to benefit. The fraud must be of an egregious nature as to vitiate the entire underlying transaction. A fraud in connection with such a bank guarantee would vitiate the very foundation of such a bank guarantee. Hence if there is such a fraud of which the beneficiary seeks to take advantage, he can be restrained from doing so. The nature of the fraud that the courts talk about is fraud of an “egregious nature as to vitiate the entire underlying transaction. It is fraud of the beneficiary, not the fraud of somebody else.

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. The second exception relates to cases where allowing the encashment of an unconditional bank guarantee would result in irretrievable harm or injustice to one of the parties concerned. Since in most cases payment of money under such a bank guarantee would adversely affect the bank and its customer at whose instance the guarantee is given, the harm or injustice contemplated under this head must be of such an exceptional and irretrievable nature as would override the terms of the guarantee and the adverse effect of such an injunction on commercial dealings in the country. The two grounds are not necessarily connected, though both may coexist in some cases.

Unless fraud or special equity exists, is pleaded and prima facie established by strong evidence as a triable issue, the beneficiary cannot be restrained from encashing the bank guarantee.

Please see the following judgments on this topic: Vinitec Electronics (P) Ltd. v. HCL Infosystems Ltd. (Supreme Court of India, 2008); Mahatma Gandhi Sahakra Sakkare Karkhane v. National Heavy Engg. Coop. Ltd., (Supreme Court of India, 2007); Hindustan Construction Co. Ltd. v. State of Bihar (Supreme Court of India, 1999); Tarapore & Co. v. V.O. Tractors Export (Supreme Court of India, 1969); United Commercial Bank v. Bank of India (Supreme Court of India, 1981); U.P. Coop. Federation Ltd. v. Singh Consultants and Engineers (P) Ltd. (Supreme Court of India, 1988); General Electric Technical Services Co. Inc. v. Punj Sons (P) Ltd. (Supreme Court of India, 1991); National Thermal Power Corpn. Ltd. v. Flowmore (P) Ltd. (Supreme Court of India, 1995); Ansal Engineering Projects Ltd. v. Tehri Hydro Development Corpn. Ltd. (Supreme Court of India, 1996); Hindustan Steelworks Construction Ltd. v. Tarapore & Co. (Supreme Court of India, 1996); U.P. State Sugar Corpn. v. Sumac International Ltd. (Supreme Court of India, 1997); Federal Bank Ltd. v. V.M. Jog Engg. Ltd (Supreme Court of India, 2001); BSES Ltd. (Now Reliance Energy Ltd.) v. Fenner India Ltd. (Supreme Court of India, 2006); Himadri Chemicals Industries Ltd. v. Coal Tar Refining Co. (Supreme Court of India, 2007); Daewoo Motors India Ltd. v. Union of India (Supreme Court of India, 2003); State Bank of India v. Mula Sahakari Sakhar Karkhana Ltd. (Supreme Court of India, 2006); United Commercial Bank v. Bank of India (Supreme Court of India, 1981).

Author: Vikrant Narayan Vasudeva

Photo by rockcreek/ CC BY