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Bank Guarantees: Judicial Interpretation and Recent Developments

Bank guarantees fall under section 126 of the Indian Contract Act 1872 i.e., the Contract of guarantee. They are furnished by the promisor from the bank to pay the promisee in case of the promisor’s default. When the promisor or the principal debtor fails to give money to the creditor or the promisee, the bank pays on his behalf. The amount to be given is clearly specified in the bank guarantee.

Though the contract was first in place between the promisee and promisor, now with the bank guarantee coming into the picture, the then two-party contract turns into a three -party contract. The beneficiary (promisee) and the bank form a separate contract, different from that entered into by the promisor (at whose instance the bank guarantee is furnished) and promisee. With large scale transactions taking place each day, the bank guarantees have carved out a niche for themselves in the corporate world.

With huge amount at stake during a contract, the parties in a contract furnish bank guarantees so as to escape from a loss. The beneficiary is able to get the whole amount stipulated in the contract in spite of any dispute between him and the other party. An illustration for a contract having a bank guarantee can be as follows:
“Mr. A contracts with Mr. B to sell to him 5 tonnes of sugar. Mr. A furnished a bank guarantee of Rs. 5 lakhs from the bank. In case of non-payment by Mr. A, Mr. B can invoke the guarantee of Rs. 5 lakhs from the bank.”

The bank guarantees are of two types: Unconditional bank guarantees and conditional bank guarantees. The covid situation, saw a number of disputes regarding the bank guarantee. Force majeure clause was invoked by the government due to this unprecedented situation and the beneficiaries were eager to invoke the guarantees as most of the promisors failed to perform. The courts were divided on the issue and we saw different interpretation. Also, the Insolvency and Bankruptcy Code 2016 brought developments in the concept of bank guarantee.

Types of bank guarantees
There are two types of bank guarantees:

  1. Conditional bank guarantees
    A conditional performance guarantee is a type of bank guarantee which is invoked on the breach of a condition in a contract or on the evidence of proof of breach as well as some loss. A specific clause is taken into consideration in the contract. In Hindustan Construction Co. Ltd. vs. State of Bihar and Ors. [1]it was held that the beneficiary has no right to demand immediate payment. As the name itself suggests, certain conditions have to be fulfilled if the person in whose name the guarantee is furnished wants the money. A clause (9) in the particular agreement between the defendants and plaintiffs clearly mentioned that the bank would pay to the executive engineer only on the non -fulfillment of obligation of HCCL and thus the bank guarantee was not unconditional.
     
  2. Unconditional bank guarantees
    These guarantees promise to pay on demand without any excuse. The guarantee would be unconditional if it does not have any ifs and buts. Any current or existing dispute would not cast a shadow on such a guarantee. Only fraud or instances when there is an apprehension of injustice to the parties can lead to the interference by the courts on the unconditional bank guarantees. Otherwise, they need to be fulfilled and the money should be given to the beneficiary as soon as possible. UP Coop Federation Ltd. vs Singh Consultants and engineers (P) Ltd[2] was one such case where the supreme court affirmed this view and set aside the order passed by the high court. Here appellant promised the respondent to construct a Vanaspati plant and furnished two bank guarantees for the same in name of appellant. On default the appellant wanted to invoke the guarantees which was contested by the respondent and thus the case went from the arbitration to the high court and then the apex court which gave this decision.

Judicial Interpretation
Bank guarantees have been usually found out by the courts as a matter that should be kept separate from judicial interference. In Tarapore and Co. v VO Tractors Export,[3] the court held that as the bank guarantee is a separate contract distinguishable from the original contract, the bank’s undertaking to the creditor is absolute. The very purpose of such guarantees is to avoid legal proceedings and enables the creditor to recover his money.

The judicial intervention would do injustice and would destroy the very purpose of such provision of bank guarantee. United Commercial Bank v Bank of India[4] was also one such case wherein the supreme court ruled out a temporary injunction stating that if such injunctions would be granted then the whole banking system would fail. Here the case was regarding the supply of mustard oil and herein letters of credit were issued with the appellant bank.

The appellant bank asked the respondent bank to pay the amount under the guarantee when there was a dispute between two parties. Also, the court said that the bank has nothing to do with the original contract. It has an absolute obligation towards the parties. But the courts have taken a different stand on cases where it found it that the invocation of such guarantees would lead to injustice and has led down certain exceptions when bank guarantee cannot be revoked.

Injunctions on bank guarantees
The bank and the promisor enter into a contract of guarantee for the benefit of the promisee so that he can be reimbursed in case the debtor is not able to pay. Thus, in toto we can say that bank guarantee is a noble concept with an aim to secure the promisee from a great loss. But the chances are no less that the promisee misconducts and creates a scenario so as to get the money promised under the bank guarantee.

In such a situation, either the bank or the promisor i.e., the person who has furnished the bank guarantee can go to the court demanding an injunction for the same. Before discussing when can an injunction can be granted let us first briefly understand what is an injunction.

Injunction
Injunction is a civil remedy provided under the Specific relief act (SRA) 1963. Lord Halsbury defines injunction as , “A judicial process whereby a party is ordered to refrain from doing or to do a particular act or a thing.” Injunctions can be temporary, perpetual or mandatory and are elaborated under section 37, 38 and 39 of the SRA. They provide relief to a party and their disobedience is regarded as contempt of court.

Injunctions on bank guarantees (Explained)
Though not mentioned explicitly in the India contract act 1872, with the help of judicial precedents we have figured out certain exceptions wherein injunction can be granted. Also, in a recent supreme court judgment of 2019 the court affirmed that an injunction against bank guarantees can be granted only in case of fraud, irretrievable injustice and special equities.[5]

Following are the three exceptions wherein injunction can be granted:

  1. Fraud
    The courts have straightforwardly granted injunction whenever there was a fraud. ‘Fraud’ is defined under section 17 of the Indian contract act as an intentional wrong committed and contracts entered under the garb of fraud are deemed to be void. UP State Sugar Corp. vs Sumac International Ltd[6] is taken as the supreme authority whenever we restrain any bank guarantee on account of fraud. Also, it lays down that the fraud should be such as to vitiate the very foundation of the bank guarantee.

    In General Electric Technical Services Company Inc.Vs. Punj Sons (P) Ltd. and Ors. [7]the order of the high court was quashed as there was no evidence of fraud and the bank was allowed to go forward with its commitment. Bank cannot reject to fulfill the payment under the guarantee merely on suspicion that the other party is wrong and the fact that the fraud has been committed should be proved. [8]
     
  2. Irretrievable injustice
    Whenever granting a bank guarantee leads to an injustice which cannot be reversed by the courts, then an injunction on the bank guarantees can be granted. In a case where the defendant had no assets in India was altogether rejected as a ground that would cause irretrievable injury to him.[9]

    The harm or injustice contemplated under this header must be of such an exceptional and irretrievable nature that it would override the terms of the guarantee and the adverse effect of such an injunction on commercial dealings in the country would be severe.[10] Special equities can also be included under the header of irretrievable injustice and in practice the same has been done several times.

    A war is always a devastating situation which is mostly unprecedent. The situation of war in Iran coupled with a fraud on the part of beneficiary was taken as a ground to issue an injunction against the issuance of bank guarantee.[11] Economic duress can also be one reason for granting injunctions but the economic duress should be separated from the normal commercial problems and pressure.

    Whenever we are dealing in large amount of money, there is always a risk of loss. Therefore ,any economic problem arising during fulfillment of a bank guarantee should be more than mere loss and also on the basis that one party has more bargaining power than the other.

Recent Developments
Covid-19 as a ground for granting Injunctions?
Upsurge of Covid-19 was an unprecedent, unimagined event that shook whole India. The business industry was shaken too. A lot of contracts were paused and their future was uncertain. But the government of India vide an order dated 13 May 2020 declared covid -19 as force majeure. Declaring covid as a force majeure also had an effect on bank guarantees. Can covid be taken as an excuse against bank guarantees? Bombay high court and Delhi high court had a conflicting view regarding the same. The applicability of section 56 that is when a contract becomes impossible was applied differently in both of these cases.

In Haliburton Offshore services vs Vedanta Ltd. [12] case the plaintiff was only going to complete its contractual obligations when the lockdown was announced due to which he was not able to discharge his obligations under the contract. The defendant wanted the invocation of bank guarantees as there was a default on the part of the plaintiff. The plaintiff wanted an injunction on these bank guarantees.

The court provided relief to the plaintiff and held that since covid and lockdown was the reason for the default on the part of plaintiff, his bank guarantees cannot be invoked merely on this factor. It is a situation of special equities. While in Bombay High court judgment the court took a definitely opposite approach.

In Standard Retail Pvt. Ltd. Vs. Global Corp. Co. [13], a South Korea based party exported certain steel to the other party based in India. The Indian party due to the lockdown enforcement could not perform its part of the contract. The Korean company invoked the bank guarantee and the Indian company went to the court against the invocation of bank guarantees and instead wanted injunction.

The court held that the defence of force majeure cannot be used here and the party can invoke its bank guarantee. Thus, we got two different judgments from two different authorities and now we are looking up for a Supreme Court decision. Whatever the Supreme court decides would become the law as precedents of Supreme court are binding on all subordinate courts.

Insolvency and Bankruptcy Code 2016 and Bank Guarantee
The banks have an obligation to revoke the guarantee but the conflict arises when third party guarantees are enforced during the moratorium period of a corporate debtor in relation to which a CIRP (Corporate Insolvency Resolution Process) has been initiated. The mention of the same through the Insolvency and Bankruptcy code is a recent development in the field of bank guarantee.

According to this act Non-performance guarantee cannot be invoked during the moratorium period.[14] While performance guarantee can. Security interest mentioned under section 14 of the IBC 2016 include non-performance guarantee but not performance guarantee.[15] GAIL (India) Ltd. Vs. Rajeev Manaadiar [16] held the same and the recent cases of NCLAT showed us certain new developments in the law of bank guarantees.

But a contradictory view was expressed in the case of ICICI Bank Ltd. V. Vista Steel Pvt. Ltd.[17], where the invocation of bank guarantee was stayed owing to the fact that the moratorium period was under operation. Thus, we see that the law is still evolving and we need more decisions to validate the same.

Conclusion

Bank guarantees have emerged as the backbone of several commercial transactions. Big companies enter into such guarantees so as to secure their money. Judges have interpreted such guarantees as a contract between the bank and the promisor and have said that they should not interfere in the same. Banks have an obligation to fulfill the same without any excuse of either the bank or the debtor. Importance of bank guarantee cannot be neglected by anyone.

But it itself has suffered from certain problems. Covid-19 emerged as a recent issue in the grant of such guarantees and we saw two High courts taking two opposite decisions. Judicial precedents have chalked out exceptions when such guarantees cannot be invoked ensuring that justice prevails. The insolvency and bankruptcy code added the factor of moratorium in such guarantees.

Though bank guarantees are not new and have been included in section 126 of the Indian Contract Act 1872, other mercantile laws like IBC, arbitration have influenced it and we can see more developments in the coming future. IBC being a newly enacted code with just five year of enactment would see amendments coming up and with amendments in it, we would see changes in grant of bank guarantees too. Bank guarantees need to be made more bank friendly as sometimes banks end up with losses when they are not indemnified by the principal debtor then only, we will end up having a fair system.

End-Notes:

  1. Hindustan Construction Co. Ltd. vs. State of Bihar and Ors., MANU/SC/0654/1999
  2. UP Coop Federation Ltd. vs Singh Consultants and engineers (P) Ltd., MANU/SC/0021/1987
  3. Tarapore and Co. v VO Tractors Export ,AIR 1970 SC 891
  4. United Commercial Bank v Bank of India,1981 AIR 1426
  5. Standard Chartered Bank vs . Heavy Engineering Corporation Ltd . and Ors., MANU/SC/1775/2019
  6. UP State Sugar Corp. vs Sumac International Ltd., (1997) 1 SCC 568
  7. General Electric Technical Services Company Inc.Vs. Punj Sons (P) Ltd. and Ors MANU/SC/0442/1991
  8. Zillion Infra Projects (P) Ltd v. Fab-Tech Works & Constructions Pvt Ltd. & Another.,1978 QB 159
  9. Himadri Chemicals Industries Ltd. vs. Coal Tar Refining Company, MANU/SC/3256/2007
  10. U.P. State Sugar Corporation v. Sumac International Ltd., (1997) 1 SCC 568.
  11. Itek Corp. V. First National Bank 730 F.2d 19
  12. Haliburton Offshore services vs Vedanta Ltd. 2020 SCC OnLine Del 542
  13. Standard Retail Pvt. Ltd. Vs. Global Corp. Co. 2020 SCC OnLine Bom 704
  14. Insolvency and Bankruptcy Code 2016, § 14,No. 31,Acts of Parliament,2016(India)
  15. Insolvency and Bankruptcy Code 2016 , § 3(31), No. 31,Acts of Parliament,2016 (India)
  16. GAIL (India) Ltd. Vs. Rajeev Manaadiar Company Appeal 2018 SCC OnLine NCLAT 374
  17. ICICI Bank Ltd. V. Vista Steel Pvt. Ltd. 2018 SCC OnLine NCLAT 230

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