Bank Guarantee and its invocation

Introduction

The purpose of this project is to examine the power of the Court to interfere with the invocation of the bank guarantee. The project analyses the problem with the help of the case law. The project has been broadly divided in three parts. In the first, the meaning of bank guarantee, The second part brings out the mode of invocation of the bank guarantee. The third part focuses on the circumstances in which the court can interfere with the contractual obligations of the parties under a bank guarantee by analyzing judicial decisions.

The Courts generally do not interfere with the performance of the contractual obligations. The contract law provides autonomy to the parties to agree to a contract according to their convenience. Freedom of contract is a settled principle of law. The bank guarantee involves a contractual relationship. The bank is under an obligation to pay to the beneficiary under the contract of guarantee. Therefore, the freedom of contract principle provides immunity to the invocation of bank guarantees from the court's interference. The contract has to be performed in accordance with its terms and conditions and the courts refrain from issuing injunctions restraining the parties from the performance of the bank guarantee.

But, freedom of contract is subject to reasonable restrictions. In certain situations, it becomes necessary for the court, in the public interest or in equity, to interfere with the performance of the contractual obligation. The parties cannot agree to perform the contract in a way, which is against the law of the land or prejudicial to the public interest.

Meaning Of Bank Guarantee

Bank guarantee is a kind of contract of guarantee as defined under Section 126 of the Indian Contract Act, 1872. The Section reads as follows:

A ‘contract of guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’. A guarantee may be either oral or written.

It is clear from Section 126, Contract Act, 1872 that contract of guarantee involves three parties, the creditor, the surety and the principal debtor. A contract of guarantee must, therefore, involve a contract to which all those three parties are privy. Their express participation or implied assent to have such a contract must be proved by the person who wants to rely upon it. Three contracts are involved. One contract is between the principal debtor and the creditor, which is the main contract and the other contract is between the creditor and the surety (guarantor). The third contract is between the surety and the principal debtor. In the bank guarantee, the respective parties are the buyer, seller and the bank.

In the bank guarantee, the person in whose favor the bank guarantee is issued is called beneficiary. Beneficiary is one who is entitled to invoke the bank guarantee.

Bank guarantee is an instrument of trade and commerce for assuring the payment or the performance of contract. In international transactions, letter of credit is issued by the buyer in favor of the seller as an assured means of payment. If the buyer wants assurance for the performance of the contract and supply of goods according to the contract, he can ask for bank guarantee in the form of performance guarantee. In national transaction, bank guarantee is issued for the assured payment as well as for the assured performance of contract. If one party asks for a bank guarantee, the other party furnishes the same in his favor from any bank or as agreed in the contract. The party in whose favor the guarantee is issued is called the beneficiary. The bank guarantee issued by the bank, is a contract between the beneficiary and the bank.

The contract for bank guarantee is quite independent distinct from the underlying contract the performance of which it seeks to secure and to that extent it gives rise to a cause of action separate from that of the underlying contract. In State of Maharashtra v. National Construction Company[1] the Supreme Court said that a bank issuing a guarantee is not concerned with the underlying contract between the parties to the contract.  The bank's duty is created by the documents of guarantee itself. The payment under the bank guarantee has to be made upon demand if it is unconditional and on the fulfillment of the condition, if it is conditional. Whether the bank guarantee is conditional or unconditional is determined by the terms of the contract of guarantee.

Types of Bank Guarantee

Bank guarantee is mainly of two types: -

a)   Absolute guarantee or unconditional guarantee: In an unconditional guarantee, the guarantor is bound immediately upon the principal failing to perform his contract. The bank has to pay the amount claimed under the guarantee without any demur. In such kind of contract of guarantee, it is generally written that the bank will make payment immediately upon demand without any objection or demur.

b)   Conditional Guarantee: - In such kind of bank guarantee, before the invocation of the bank guarantee, the beneficiary has to comply with the conditions. These conditions are mentioned in the main contract itself. Once those conditions are satisfied, the bank is under an obligation to pay the beneficiary.

In business transactions, the referred guarantee is the unconditional guarantee. It depends upon the bargaining power of the concerned parties as to how they agree to the bank guarantee. The conditional bank guarantee does not mean that it is subject to the main contract. It implies that the bank will pay the money on invocation of the guarantee only when the stipulated conditions in the contract of bank guarantee have been fulfilled. It may be agreed that no payment will be made until the beneficiary produces certain documents to the bank. There may be other conditions also like the payment of money on the non-performance of contract etc. But, once the conditions stipulated in the contract are fulfilled, the bank is under an obligation to pay the money.

An irrevocable bank guarantee containing a condition that it shall be enforceable "should the contractor default in performing any of the terms and conditions of the contract or in the payment of any money due to the owner or in case the amount from the running bills of the contractor can not be deducted by the owner towards the payments of mobilization advance" is a guarantee which is independent of the contract between the parties and is enforceable without reference to any claim or counter claim arising out of the principal contract between the parties. Such a guarantee is also independent of the adjudication of disputes raised and proposed to be referred to arbitration. As to the fulfillment of the conditions incorporated in the guarantee the statement of the beneficiary should be taken at its face vale unless the contractor can establish that the beneficiary's stand is motivated by fraud, misrepresentation, deliberate suppression of material facts or the like of which would give rise to special equities in favour of the contractor. In the absence of such elements the bank guarantee has to be honoured by the bank and the beneficiary cannot

be restrained from enforcement.

Mode of Invoking Bank Guarantee

The bank guarantee has to be invoked in accordance with the terms and conditions of the contract of guarantee. If it is unconditional, the bank must make the payment on demand without any objection. If the contract requires the presentation of certain documents, the beneficiary must produce those documents. Otherwise, the bank will be entitled to refuse the payment.

In Puri International (P.) Ltd v. National Building Construction Co. Ltd and Another[2], the Indian Railway Construction Corporation (IRCON) awarded the contract of construction of railway station and commercial complex to defendant no.1. Defendant no. 1 on its part desired to split up the total contract work into smaller parts and give the same on sub- contracts. The plaintiffs submitted its tender for a part of the works proposed to be sub-contracted by defendant no1. The plaintiff got the sub- contract. In terms of the agreement between defendant no. 1 and the plaintiff, the plaintiff was entitled to raise mobilization advance to the extent of 5 % of the contract value and the said mobilization advance was payable to the plaintiff against furnishing of bank guarantees from nationalized banks on the Performa provided by defendant no.1, in addition to furnishing bank guarantees towards mobilization advance the plaintiff company also furnished bank guarantees towards security deposit for 2% of the contract value. These bank guarantees were issued by the erstwhile New Bank of India (changed to Punjab National Bank). Subsequently, IRCON terminated the contract of defendant no.1 and he in turn terminated the contracted the contract with the plaintiff. The dispute between the IRCON and the defendant no. 1 was pending. The bank guarantees were renewed from time to time on the request of the defendant no. 1. At last, the defendant no. 1 decided to invoke the bank guarantee and sent a letter of invocation of the guarantee to the bank. The plaintiff alleged that the defendant tried to commit fraud and so injunction should be granted restraining the bank from making the payment. It was also contended that the invocation has not been made in accordance with the terms and conditions of the contract of guarantee. The contract of guarantee provided that the payment would be made without any demur on demand if the amount is due by way of loss or damage caused to or would be caused to or suffered by the defendant no.1.The defendant no.1 did not mention in the letter of invocation as whether there has been a loss or damage or not. Simply, they claimed the money under the guarantee and said that the payment has to be made without any demur. But, the condition that the damage or loss must be mentioned was not fulfilled. Therefore, the court refused to allow the invocation of the guarantee as it was not in accordance with the contract. The court did not look into the issues of fraud as alleged by the plaintiff once the letter of invocation of the guarantee itself was declared not to be according to the contract. The court relied on the decision of Supreme Court in UP. Sugar Corporation Ltd v. Sumac International Ltd[3], where the court had held that the bank giving such a guarantee is bound to honor it as per its terms irrespective of any disputes raised by its customer.

If the terms of guarantee stipulate a notice in writing to be served on the bank by the beneficiary, then, needless to add, a notice must be served. In a nutshell, the Courts seem to attach considerable importance to the expressions and language of the guarantee document in arriving at a conclusion regarding reciprocal rights and duties; and liabilities of the parties involved in the transaction. The terms of this contract alone must, therefore, be looked upon to determine the rights of parties. It may in this context be pointed out, that the guarantee is given by the bank at the instance and on behalf of the supplier and, secondly, the guarantee can be invoked by the beneficiary only in the event of default or failure of supplier in the observance of the terms of the principal contracts in respect of which the guarantee is given. Thus, the contract of guarantee may be said to have closer connection with, though not an integral part, of the principal contract.

Power Of The Court To Restrain The Invocation Of Bank Guarantee

As a general rule, the court does not interfere with the performance of the contractual obligations of a bank under the bank guarantee. In a bank guarantee, the bank pledges its reputation. If it is frequently restrained from making the payment, its credit will go down, which will mean the fall in business. Secondly and importantly, the bank guarantee is one of the significant modes of documentary credit used in the international as well as national commerce, if delays or frequent obstructions take place in its invocation, it will be detrimental to the trade and commerce.

Therefore, only in exceptional circumstances, the courts issue injunction under order XXXIX of the Civil Procedure Code, 1908.

In R.D. Harbottle v. National Westminster Bank Limited[4], there was an invocation of the bank guarantee by the buyers. The bank guarantee was unconditional. The guarantees were performance bonds. The sellers alleged that the buyers were demanding the payment fraudulently. The invocation of guarantee by the buyers was unconditional and so the bank initiated the process to pay. The sellers approached the court to grant an injunction to restrain the bank from making the payment. The Court observed:

It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by the banks. They are the life and blood of international commerce. Except possibly in clear cases of fraud of which the banks have notice, the courts will leave merchants to settle their disputes under the contract by litigation or arbitration as   available to them or stipulated in the contracts. The courts are not concerned with their difficulties to enforce such claims; these are risks, which merchants take. In this case, the plaintiffs took the risk of the unconditional wording of the guarantees. The machinery and commitments of banks are on a different level. They must be allowed to be honored, free from interference by the courts. Otherwise, trust in international commerce could be irreparably damaged. In the instant case, no case of fraud was established, so the court refused to grant injunction to restrain the bank from making the payment.

In United Commercial Bank v. Bank of India and other[5], M\S Godrej Soaps Limited (plaintiffs) entered into an agreement with the Bihar State Food and Civil Supply Corporation to supply one thousand metric tones of ‘Sizola Brand Pure Mustard Oil’, the total value of which was 86 lakhs. The contract required the Bihar Food Corporation to open a letter of credit in favor of the suppliers. The letter of credit was opened with the United Commercial Bank. The negotiating bank on behalf of the suppliers was the Bank of India. When the documents were presented before the bank for the encashment of the payment under the letter of credit, the bank refused. The Railway Receipt described the supplied goods as 'Sizola Brand Mustard Oil unrefined'. It was not in consonance with the contract. The contract required the supply of pure mustard oil. In the end, the United Commercial Bank made the payment to the Bank of India ‘under reserve’ on the guarantee of the Bank of India.

When the bill of exchange was presented before the Bihar Food Corporation, it dishonored it saying that the sellers had supplied defecting goods. The chemical analysis proved that the oil was not fit for human consumption. Thus, the United Commercial Bank demanded the payment made under reserve to the Bank of India. The seller approached the court for restraining the bank from making the payment and restraining the invocation of the bank guarantee executed by the Bank of India. The main issue was whether the court should in a transaction between a banker and a banker grant an injunction, at the instance of the beneficiary of an irrevocable letter of credit, restraining the issuing bank from recalling the amount paid under reserve from the negotiating bank, acting on behalf of the beneficiary against a document of guarantee at the instance of the beneficiary?

The Court observed that:

         The rule is well established that a bank issuing or confirming a letter of credit is not concerned with the underlying contract between the buyer and seller. Duties of a bank under a letter of credit are created by the document itself, but in any case it has the power and is subject to the limitations, which are given or imposed by it, in the absence of the appropriate provisions in the letter of credit.

In UP. Co-operative Federation Ltd. V. Singh Consultants and Engineers (P) Ltd.[6], the respondent was a private company who entered with the State Government enterprise (UP Cooperative Ltd) for the supply and installation of a vanaspati manufacturing plant at Halduchaur in UP. The contract bond contemplated, according to the appellant, guaranteed performance of work at various stages in accordance with the time schedule prescribed therein and provided for completion and commissioning of the plant after due trial run by May15, 1984. It was contended by the appellant that the time was the essence of contract. According to the contract, the respondent furnished a performance bank guarantee for Rs.16.5 lakhs and another bank guarantee of Rs.33 lakhs as security advanced by the appellant to the respondent for undertaking the work. Both these two guarantees as also the contract bond entitled the appellant to invoke them and call for their realization and encashment on the respondent's failing to perform the obligations for which the appellant was made the sole judge.

The contract was not performed within the stipulated time or even the within the extended time, then the appellant invoked the bank guarantees. The respondent approached the court for the grant of injunction restraining him from invoking the same.

The Court observed that it is a settled principle of law that the commitments of banks must be honoured free from interference by the Courts. Otherwise, trust in commerce, internal and international would be irreparably damaged. It is only in exceptional cases that are to say in case of fraud or in case of irretrievable injustice be done, the court should interfere. In the instant case, the Court did not grant injunction as no exceptional case had, been made out.

In General Electric Technical Services Company v. M/S Punj Sons (P) Ltd[7], the General Electric Technical Services Company had entered into a contract with Indian Airlines, which included, inter- alia, the construction and fabrication of aircraft testing center and engine repair center in Delhi. The GETSCO in turn entered into a contract with M/s Punj Sons (P) Ltd, for getting that work done for Indian Airlines. As per the contract respondent no.1 was required to provide performance bond equal to 30 % of the total value of contract price, which was to be split up into two performance bonds partly to be released upon the expiration of the warranty. The respondent no.1 was also required to furnish a bank guarantee to secure the mobilization advance of 25% of the contract value. Respondent no.1 furnished the bank guarantee to secure the mobilization advance of the required amount. The guarantee was furnished by the Hong Kong & Shanghai Bank, respondent no.2. The contract of guarantee provided that the amount due and payable under the Guarantee would be paid by the bank without demur, merely on demand from the owner stating that amount claimed is due by way of loss or damage caused to or would be caused to or suffered by the owner by reason of any breach by the Contractor of any of the terms or conditions contained in the Agreement or by reason of the Contractor's failure to perform the Agreement. It further stated that any such demand made on the bank should be conclusive with regard to the amount due and payable by the Bank under this Guarantee.

The contract was not performed according to the terms and conditions of the contract and therefore the appellant invoked the bank guarantee according to the contract of guarantee. The respondent 1 approached the Court for issuance of injunction restraining the bank from making the payment. The Court observed:

The bank must honour the bank guarantee free from interference by the Courts. Otherwise, trust in commerce internal and international would be irreparably damaged.

It is only in exceptional cases that are to say in case of fraud or in case of irretrievable injustice, the Court should interfere.

Therefore, the Court did not allow the injunction to be issued in the absence of fraud or special equities in the form of preventing irretrievable injustice between the parties. The bank was obliged to honor its contractual obligation under the contract of guarantee.

In Hindustan Steel Works Construction Ltd. v. Tarapore Co. and Another[8], HSCL awarded a contract to the contractor for construction of civil works in its Visakhapatnam Steel Plant. The time was of the essence of the contract. But, the contract was not performed even during the extended time. The bank had undertaken to indemnify HSCL against any loss or damage caused to or suffered by it by reason of any breach by the contractor of any term and condition of the contract. It is also stipulated in the bank guarantees that HSCL shall be the sole judge on the question as to whether the contractor has committed any breach of the contract and what the extent of loss or damage is. On the very day, the appellant rescinded the contract, it revoked the three bank guarantees furnished under the contract. The respondent urged for an injunction against the payment. The ground was that there were genuine disputes between the parties and those disputes have been referred to the arbitrators for adjudication. But, the Court on the analysis of previous cases refused to grant the injunction as no genuine case was made out. The Court observed:

We are, therefore, of the opinion that the correct position of law is that commitments of bank must be honoured free from interference by the Courts and it is only in exceptional cases where irretrievable injustice would be done if bank guarantee were allowed to be encashed, the Court should interfere. In this case fraud has not been pleaded and the relief for injunction was sought by the contractor/ Respondent no1, on the ground that special equities or the special circumstances of the case required it. The special circumstances and special equities, which have been pleaded in this case, are that there is a serious dispute on the question as to who has committed breach of the contract, that the contractor has a counter- claim against the appellant. That the disputes between the parties have been referred to the arbitrators and that no amount can be said to be due and payable by the contractor to the appellant till the arbitrators declare their award. In our opinion, these factors are not sufficient to make this case an exceptional case justifying interference by restraining the appellant from enforcing the bank guarantees.

Thus, the Supreme Court has established certain legal principles with regard to the minimal interference in the execution of an unconditional bank guarantee. The legal principles can be summarised as follows:

1.   A bank guarantee is an independent and distinct contract between the beneficiary and the bank and the rights and obligations therein are to be determined on its own terms;

2.   A bank guarantee which is payable on demand implies that the bank is liable to pay as and when demand is made upon the bank by the beneficiary and the person at whose instance the bank had issued the bank guarantee;

3.   The Courts must honour commitments of the banks free from interference. Otherwise, trust in commerce, internal and international, would be irreparably damaged;

4.   An irrevocable commitment in the form of confirmed bank guarantee cannot be interfered with except in case of established fraud of an egregious nature as to vitiate the entire underlying contract;

5.   Allegations of fraud and irretrievable harm must be genuine, established and immediate as well as irreversible.

CONCLUSION

The assurance of payment is of much significance for smooth functioning of trade and commerce. This is one of the reasons behind the policy of law Courts not to intervene in the invocation of bank guarantees. The other important reason is that the parties must be allowed to perform their contractual obligations without interference. The parties themselves agree to the terms and conditions of a contract and therefore they must fulfill them when called for.

Therefore, the Court does not interfere with the invocation of bank guarantee as long as there is an established case of fraud or irretrievable harm or injury. The fraud must be of an egregious nature and must have been committed by the beneficiary himself. The harm to be caused is irretrievable or not, is to be decided by the facts and circumstances of each case. In case, there is no scope of recovering the money once paid and there is a dispute between the parties for with regard to the contract, it can be a situation where the invocation of bank guarantee would cause irretrievable harm. On this second exception, one case of United States Court can be illustrative.

In Itek Corporation v The First National Bank of Boston[9], an exporter in the USA entered into an agreement with the Imperial Government of Iran and sought an order terminating its liability on stand by letters of credit issued by an American Bank in favour of an Iranian Bank as part of the contract. The relief was sought on account of the situation created after the Iranian revolution when the American Government cancelled the export licenses in relation to Iran and the Iranian Government had forcibly taken 52 American citizens as hostages. The US Government had locked all Iranian assets under the jurisdiction of USA. In such a case, the Court upheld the contention of the exporter that any claim for damages against the purchaser if decreed by the American Courts would not be executable in Iran under these circumstances and realization of the bank guarantee would cause irretrievable injury to the plaintiff. Thus, for establishing the second exception, there must be a certainty of harm and the Court should be prima facie satisfied that there is such a situation to cause irretrievable harm to the person asking for the injunction.

The object behind it is to, inculcate respect for free flow of commerce and trade and faith in the commercial banking transactions unhinged by pending disputes between the beneficiary and the contractor. The whole purpose for which the system of confirmed irrevocable documentary credits had been developed in international trade was to give the seller of goods an assured right to be paid before he parted with control of the goods without risk of the payment being refused, reduced or deferred because of a dispute with buyer.

Once the terms of guarantee are complied with and the technicalities are observed the bank is under an obligation to honour the demand from the beneficiary under the guarantee, regardless of any disputes between the parties. This is an established principle of law, which has to be followed by the Courts, while dealing with the application for injunction against the invocation of bank guarantee. Banking system is the backbone of the economy and it is necessary that there should be confidence in the banking system itself. If the bank guarantees are not encashable just like a credit note or there is an impediment in encashing the bank guarantee then the whole foundation of the banking system will collapse and the people will loose faith in it. It will have an adverse impact on the smooth functioning of trade and commerce. The instruments of documentary credit are the life and blood of trade and commerce and they must not be stopped from being running properly.

References

Books

§  Dr. Sharma, B.R. & Dr. Nainta, R.P., “Banking Law & Negotiable Instruments Act”, 2^nd Edition, 2004, Allahabad Law Agency, Faridabad.

§  Suneja, H.R., “Practice and law of Banking”, 1990, Allahabad Law Agency, Faridabad.

§  Maheshwari, S.N., “Banking Law & Practice”, 1994.

§  Andrews Mary Geraldine, Millet Richard, “Law of Guarantees”, 3^rd Edition, Sweet and Maxwell, London, 2000.

Web sources

§  www.google.com

§  www.manupatra.com

§  www.lexsite.com

§  www.indlaw.com

§  www.supremecourtofindia.nic.in

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[1] (1996) 1 SCC 735

[2] (1997) SC 646 (Del)

[3] AIR 1997 SC 1644

[4] (1977) 3 WLR 752

[5] AIR 1981 SC 1424

[6] (1988) 1 SCC 174

[7] AIR 1991 SC 1994

[8] AIR 1996 SC 2268

[9] 566 Federal Suppl. 210