A bank guarantee 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
generally approached because they have the financial capacity to meet such
obligations.[1] It is basically a sort of an absolute undertaking to pay the
amount whenever demanded by the guarantee holder.
A bank guarantee contract is distinct and independent from the underlying
contract that subsists between the beneficiary and the creditor[2] i.e. it has
nothing to do with the state of relations between the guarantee holder and the
person on whose behalf the guarantee is given. 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.[3]
It is basically for the free flow of the trade as guarantee given by bank , it
saves the creditor from the loss and also it give rights to the creditor to
claim debt in case of default without the lengthy process of litigation.[4]
Bank guarantee are often called ‘first demand’ or ‘on demand’ guarantee
because they are to be paid against the beneficiary’s first written demand for
payment and no further documentation or proof of default is required.
Need of Bank Guarantee
In this environment where new startups are being encouraged, bank guarantees
plays a crucial factor in encouraging these startups, it helps the new firms to
set up efficiently which is a boon for small scale businessman. At the initial
stages of their business they can raise the required money in credit keeping the
bank as a surety. The credibility of the bank reduces the transaction risk in a
business transaction.[5]
The amount of liability undertaken in a bank guarantee without any demur or
dispute under the terms of guarantee is absolute and unequivocal.[8] In a normal
guarantee the surety’s liability as per Sec. 128 of the Indian Contract
Act,1872 is co-extensive with that of the principal debtor i.e. the liability
of the guarantee is to the same extent as that of the principal debtor, whereas
in a bank guarantee the bank becomes liable when the conditions in the guarantee
instruments are fulfilled without regard to the transaction between the
beneficiary and the person for whose obligation the guarantee has been given
i.e. the liability may arise even when such latter person has not been in
default, his actual liability under that transaction would be much less than the
amount paid under the unconditional guarantee.[9]
The bank guarantee can be enforced simply without probing into the nature of the
transactions between the Bank and the customer that led to the furnishing of the
bank guarantee.[10] The bank has to pay irrespective of any dispute raised by
the person at whose instance the guarantee has been given[11] and cannot raise a
contention regarding the breach by principal debtor.[12]
Also a variation in a contract put in effect by one of the parties does not
affect the liability under the guarantee. [13] The bank may reject the bank
guarantee if the beneficiary is not able to show that the all the requisite
terms in the bank guarantee are fulfilled, incase all the conditions are
fulfilled the bank has to make the payment.[14]
A bank guarantee can be invoked anytime by the beneficiary when the terms of
guarantee are fulfilled, all that the bank has to verify that all the terms of
the contract of guarantee are fulfilled and for doing so the bank should have
reasonable amount of time to verify the documents.[15] Invocation of a bank
guarantee is dependent upon the terms of the guarantee. In cases of
unconditional guarantee the beneficiary has to realize the bank guarantee
irrespective of the fact that dispute is pending. If at the time of invocation
of the bank guarantee, it is well within the terms it is not even necessary that
the beneficiary should assess the quantum of loss and mention that figure.[16]
Exceptions
Exceptions Payment under a bank guarantee may be refused of restrained:
Fraud- The bank can put an injunction against the encashment of bank
guarantee if it is prima facie evident that a fraud has been committed by the
beneficiary and not by somebody else.[17] A strong prima facie case is necessary
to show the fraud, mere allegation of fraud will not work.[18]This is basically
to protect the credit system, otherwise the beneficiary would be claiming the
payment to which he had no entitlement.[19]
Irretrievable harm or injustice- If the bank guarantee harms or any way leads to
injustice to one of the parties concerned then the creditor is not entitled to
en-cash the bank guarantee, the harm must be genuine and immediate.[20]
Safe guards 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.
Limits:- Banks lay down maximum monetary limits up-to 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 Counter client in-respect of such guarantees etc. The limits are
reviewed are re-fixed periodically along with monetary limits for overdrafts,
cash credits etc. [21]
Margins- Banks lay down maximum monetary limits up to 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 re-fixed periodically along with monetary limits for overdrafts,
cash credits etc. The percentage of margin ranges from ten to fifty percentage
of the bank guarantee. The margin money will be released once the principal
debtor has fulfilled its obligation towards the bank i.e. has repaid the amount
to the bank. [22]
Counter Guarantee:-This is an additional method other than fixing limits
and taking margin money as security. Bank’s invariably obtain the counter
guarantee from the principal debtor before giving the guarantee, after this the
bank debits the clients accounts when invocation of bank guarantee is done by
the creditor in order to proceed legally against the client incase of default by
him to repay the amount.[23]
Limitation Period
The period of limitation for enforcing the bank guarantee is three years from
the date on which the letter of guarantee was executed.[24] Recovery procedure
initiated after three years is liable to be quashed.[25] Till the time the
account is alive i.e. it is not settled nor there is any refusal by the
guarantors to carry out the obligations, the limitation period does not start.
The bank guarantee represents a unilateral legal transaction by which a bank
guarantor undertakes an obligation to guarantee to pay the beneficiary a certain
amount of money specified in the guarantee if certain conditions are fulfilled,
or if the debtor from the original contract does not fulfill or fulfills his
contractual obligations improperly.[26] In international business, sellers are
usually not aware of the financial situation of the customer and the results of
his operations and, therefore, there is always certain risk present in the sales
contract especially when it comes to the shipment of good without securing its
payment.
Bank guarantee here reduces or eliminates the risk because the bank which gives
the guarantee is also directly responsible towards the seller, also the seller
gets assured when the bank gives the guarantee i.e. he is assured that in case
of any default the bank will pay the amount.[27]As an independent legal
transaction, banking guarantee gained great importance in matters of
international trade in recent decades, so today we can hardly imagine and
conclude any serious contract with a foreign partner without its fulfillment
being provided through a bank guarantee.
Compared to other means of personal security, bank guarantee proves to be more
suitable, since due to its abstractness and lack of accessory it provides a
broader protection of economic interests of the creditors. Bank guarantee occurs
as an institution that significantly influences the improvement of international
economic relations. In the modern scenario where there is a huge distrust among
the participants of the global business scenario, contracts or deals should be
done with well known and reliable business entities.
With bank guarantees, companies from the less developed countries get a great
deal on the competitiveness of their offerings in international affairs, because
with their acceptance contractual partners are not placed in a less advantageous
position in terms of risk of realization of their claims. Bank guarantees are,
thus, creating a higher level of security of creditors and significantly
affecting the stabilization of relations in the international market.[28]
As per RBI in terms of Regulation 4 of the Foreign Exchange Management
(Guarantees) Regulations, 2000 notified by Notification no. FEMA.8/2000-RB dated
May 3, 2000. Authorized Dealer banks are allowed to give guarantees in certain
cases, as stated therein.[29]
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