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Bank Guarantee

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 Guarantees are guarantee basically given by Suppliers/Contractor’s Bank in favour of the Buyer/Principal:

  1. Towards earnest money deposit
  2. As security against performance of the contract
  3. As security against initial and stage payment made by the Buyer to the Supplier
  4. Towards liquidated damages in exceptional cases of large value contracts etc.

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]

Types of Bank Guarantee

  1. Advance Payment guarantee- This type of guarantee is mostly used in export and import business but is now extended to Domestic trade. Buyers of goods generally use this guarantee to secure the advance payment made by them. Advance guarantee paid can be recovered as it is the primary obligation of the bank which is giving the guarantee.[6]
  2. Payment Guarantee- This guarantee makes the debtor bound for the payment, this is a more secure guarantee as collateral securities is given with these type of guarantee , in case of default by the debtor the bank can recover the given amount from the collateral securities given by the debtor.[7]


Liability under Bank Guarantee

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]

Invocation of Bank Guarantee

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.

Bank Guarantee and International Business

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]

  1. Issue of Bank Guarantee in favor of Foreign Airlines/IATA

    The Indian agents of foreign airline companies, who are members of International Air Transport Association (IATA), are required to furnish bank guarantees in favor of foreign airline companies/IATA, in connection with their ticketing business. This being one of the standard requirement of the business, Authorized Dealer banks in their ordinary course of business have the power to issue guarantees in favor of the foreign airline companies/IATA on behalf of Indian agents of foreign airline companies, who are members of IATA, in connection with their ticketing business.

  2. Issue of Bank Guarantee on behalf of Service Importers

    In order to liberalize the procedure regarding the import of services, it was decided by the RBI to increase the limit for issue of guarantee by AD Category-I Banks from USD 100,000 to USD 500,000 i.e. Category-I banks cannot issue guarantee exceeding USD 500,000 in favor of a non resident service provider on the behalf of a resident service importer, given that The Authorized Dealer Category-I bank:-
    1. Is satisfied about the bona-fide nature of the transaction.
    2. Ensures submission of documentary evidence for import of services in the normal course.
    3. And the guarantee is to secure a direct contractual liability arising out of a contract between a resident and a non-resident.
    However in the case of a Public Sector Company or a Department/ Undertaking of the Government of India/ State Governments, an approval is required from the Ministry of Finance, Government of India for issue of guarantee for an amount exceeding USD 100,000 (USD One hundred thousand).[30]

  3. Invocation of guarantee

    In case of invocation of the guarantee, the Authorized Dealer bank should send a detailed report to the Chief General Manager-in-Charge, Foreign Exchange Department, External Payments Division(EPD), Reserve Bank of India, Central Office, Mumbai 400 001, explaining the circumstances leading to the invocation of the guarantee.[31]

End-Notes:

  1. Ms. Amrita Ganguli, Bank Guarantees: An Analysis, MANUPATRA, ( July 11, 2018, 11:05), Avaibale at:-http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=70c1051d-5804-409a-a55b-5e0243dfc004&txtsearch=Subject:%20Finance/Banking.
  2. Ibid.
  3. Hindustan Steelworks Construction Ltd v. Tarapore & co. (1996) 5 SCC 34.
  4. Akshay Anurag, Bank Guarantee and Judicial Intervention , MANUPATRA ( July 11, 2018, 11:05), Avaiable at:-http://docs.manupatra.in/newsline/articles/Upload/1A60C2E6-874F-4655-8821-CA4915F9D4F6.-%20banking.pdf
  5. Akshay Anurag, Bank Guarantee and Judicial Intervention , MANUPATRA ( July 11, 2018, 11:05), http://docs.manupatra.in/newsline/articles/Upload/1A60C2E6-874F-4655-8821-CA4915F9D4F6.-%20banking.pdf.
  6. Meritz Fire & Marine Insurance Co. Ltd v Jan. De Nul. NV, [2011] EWCA Civ 827.
  7. Akshay Anurag, Bank Guarantee and Judicial Intervention , MANUPATRA ( July 11, 2018, 11:05), http://docs.manupatra.in/newsline/articles/Upload/1A60C2E6-874F-4655-8821-CA4915F9D4F6.-%20banking.pdf.
  8. Ansal Engineering projects Ltd v. Tehri Hydro Development Corporation Ltd,(1996) 5 SCC 450.
  9. Pollock & Mulla, The Indian Contract Act, 1872 (14th edition, 2013) at 1369.
  10. Syndicate Bank v. Vijay Kumar, AIR 1992 SC 1066.
  11. Dwarikesh Sugar Inds. Ltd. v. Prem Heavy Engg. Works, AIR 1997 SC 2477
  12. Dena Bank v. Fertilizer Corpn. Of Ltd., AIR 1990 Pat 221.
  13. Loyds Steel Inds. Ltd. v. Indian Oil Corpn. Ltd., AIR 1999 DEL 248.
  14. Bank of India v. Nangin Construction (India) Pvt. Ltd, (2008) 7 SCC 290.
  15. Pollock & Mulla, The Indian Contract Act,1872 (14 edition, 2013) at 1373.
  16. Hindustan Constn. Co. Ltd. v. State of Bihar , AIR 19997 SC 3710.
  17. U.P. Co-Op. Federation Ltd. v. Singh Consultants & Ers. Pvt. Ltd,(1998) 1 SCC 174.
  18. Ibid.
  19. Deutsche Ruckversicherung AG v. Walbrook Insurance Co. Ltd., (1994) 4 ALL ER 181; POLLOCK & MULLA, THE INDIAN CONTRACT ACT, 1375 (14th ed. Lexis Nexis 2013)
  20. Itek Corpn. v. First National Bank of Boston, 566 FED Supp 1210,at 1217 quoted with approval in Svenksa Handelsbanken v. Indian Charge Chrome, (1994) 1 SCC 502, at 507.
  21. https://efinancemanagement.com/sources-of-finance/bank-guarantee(Last visited:-27/06/2018).
  22. CA Manoj kumar Gupta, Article On Bank Guarantee, (Last Modified:-27/06/2018) http://voiceofca.in/siteadmin/document/25_12_10_2_ArticleonBankGuarantee.pdf
  23. Anubhav Mathur, Guarantees and Counter-guarantees (Last Modified:- 27/06/2018) https://www.teb.com.tr/sme/guarantees-and-counter-guarantees.
  24. New Bank of India v. Sajitha Textiles, AIR 1997 Ker 201, Article 55 of the Limitation Act, 1963 is applicable.
  25. Annama Jose v. Kerala Financial Corpn, AIR 2002 Ker 396.
  26. Pavicevic, B. (1999). Bank guarantee in theory and practice, Belgrade, Official Gazette of FRY; Mirjana Knežević and Aleksandar Lukić. The importance of bank guarantees in modern business (business environment in Serbia) Investment Management and Financial Innovations, Volume 13, Issue 3, 2016.
  27. Ariana, A. & Damirchiyeva, M. (2013). Bank Guarantees, Journal of Basic and Applied Scientific Research, 3, pp. 436-438; Mirjana Knežević and Aleksandar Lukić. The importance of bank guarantees in modern business (business environment in Serbia) Investment Management and Financial Innovations, Volume 13, Issue 3, 2016.
  28. Mirjana Knežević and Aleksandar Lukić. The importance of bank guarantees in modern business (business environment in Serbia) Investment Management and Financial Innovations, Volume 13, Issue 3, 2016.
  29. https://rbi.org.in/scripts/NotificationUser.aspx?Id=5813&Mode=0 (LastVisited:-09/07/2018).
  30. https://rbi.org.in/scripts/NotificationUser.aspx?Id=5813&Mode=0 (Last Visited:-09/07/2018).
  31. Ibid.

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