TAMIL NADU NATIONAL LAW SCHOOL

This Project on Contracts Submitted in Partial Fulfilment of B.A. LL.B (Hons.) 3rd Semester

TOPIC:

NATURE AND EXTENT OF BANK GUARANTEE.

SUBMITTED ON: 18TH NOVEMBER, 2014

SUBMITTED TO: SUBMITTED BY:

PROF.KGR KUMAR NISCHAY

ROLL NO (80)

Acknowledgement

At the outset, I thank the Almighty who gave me the strength to accomplish the project

with sheer hard work and honesty.

I take this opportunity to observe protocol to show my deep gratitude to the revered

Contracts Teacher Sunil Gladson, for his kind gesture in allotting me such a dynamic and

burning issue as research project. His timely advice, direction and valuable assistance

tremendously boosted me during the making of this project.

Secondly, all this wouldn’t have been possible without my friends who sacrificed their

precious time for guidance and helped me a lot in completing this project without any

drawbacks. Hence I am forever indebted and grateful to them.

Thirdly, I am very much thankful to the staff and administration of TNNLS who provided

valuable sources of information in the form of library and database connections.

The successful creation of this project is due to the background work and co-operation

of many persons. So I once again take this opportunity and privilege to convey my

deepest regards and thanks to all those who was involved directly or indirectly in the

making of this project.

DECLARATION

I, Kumar Nischay hereby declare that the project work entitled ‘NATURE AND

EXTENT OF BANK GUARANTEE.’ submitted to Tamil Nadu National Law School;

Tiruchirappalli, is the record of a bonafide work done by me under the supervision and

guidance of Prof. KGR, Faculty of law of contracts, Tamil Nadu National Law School;

Tiruchirappalli.

KUMAR NISCHAY

ROLL (80)

CERTIFICATE

This is to certify that the project entitled “Nature And Extent of Bank Gurantee”

submitted to Tamil Nadu National Law School in partial fulfillment of the requirement of

the award of the degree of B.A. LL.B (Hons) done by Kumar Nischay {Law of Contract}

under the supervision and guidance of Mr. KGR (mentor) Under Graduate Department

of Tamil Nadu National Law School.

Place: Tiruchirappalli KGR

Date: 18th November, 2014 (mentor)

List of cases.

1. United commercial Bank v Bank of India and others

2. Rawala construction co. V Union of India

3. National Telecom of India Ltd. v. Union of India

4. Daewoo Motors India Ltd. v. Union of India

5. Bank of Baroda v. Ruby Sales Corporation (Agency)

6. Punj Lioyd Ltd V. India Cements Ltd

7. Mula Sahakari Karkhana v. State Bank of India

8. Veer Prabhu mktg v .N.S.C.

9. Man Industries India Ltd., Indore v. N.V. Kharote Engineers and Contractors,

Pune

10. Hindustan Steelworks Corpn ltd v. Tarapore and co

11. A.C. Roy & co.v. Union of India

12. U.P. COOP Federation Ltd v. Singh Consultants and Engineering ltd

13. General Electric Technical Co Inc v Punj Sons(P) Ltd

Table of contents

Chapter 1

Introduction.

Bank Guarantee means a comfort, which is being given by issuing bank, to a party

(Beneficiary in whose favour the guarantee is issued) of losses or damages if the Client

(on whose behalf the guarantee is being issued) fails to complete or conform to the

terms of agreement.

Bank Guarantee is a type of guarantee in which bank promises to repay the liabilities of

a debtor in the event the debtor is unable to1. A bank guarantee enables the customer

(debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand

business activity2. A bank guarantee is a commercial instrument in the nature of a

contract, intended between two parties, to secure compliance with the contract.3

Bank guarantee is a contract involving two parties i.e. the bank and the beneficiary. The

bank guarantee is financial instrument in which if the beneficiary perceives that there

has been a breach of contract by the other party, he can encase the guarantee and avail

of the amount immediately, without having to undergo the hassles of litigation. As

ordinary guarantee is construed dependent on the main contract of guarantee for

enforcement of such guarantee it may lead to unnecessary disputes and litigation. These

disputes may have a material effect on the guarantee, thereby blocking funds in

litigation. Hence, there was a need for an innovative instrument which would enable the

guarantee to serve its original purpose i.e. providing a form of security.

Bank guarantee is also similar to Letter of Credit as it is discussed below.

1.3 Letter of Credit and bank guarantee

A letter of credit is a binding document which buyers can request from the bank as a

guarantee that payment for goods purchased will be transferred to the seller. The letter

serves as a reassuring letter that the seller will receive payment due to him. The

1 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 4252 Retrieved from http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2BUrtCDb.3 Retrieved from http://www.business-standard.com/india/news/how-bank-guarantees.

payment will only occur once the seller presents the necessary shipping documents to

the bank. This will serve as confirmation that shipment of the goods to the buyer was

completed in the given time frame. A letter of credit can also be defined as an obligation

given to a bank so that criteria can be followed before payment is made. As soon as the

terms from both parties have been confirmed and completed, it is now the bank’s role

to transfer the funds. A letter of credit ensures payment for performed services4.

A letter of credit can be used upon the completion of a service or delivery of goods.

Before the transaction occurs, the seller can send a request to the bank to obtain a letter

of credit. The buyer will purchase the letter of credit from the bank and forward it to his

seller’s bank. As such, the letter will act as a replacement or substitute for the credit of

the client, so that correct and timely payment is assured.

A bank guarantee can be used if a buyer obtains goods or services from a seller and then

encounters cash flow difficulties. As a result, he is unable to pay his seller in time. A bank

guarantee is suitable in such instances because it would pay an agreed-upon amount to

the seller. Alternatively, if the seller is unable to provide the goods, a bank will pay his

buyer the agreed-upon sum. For any side of the transaction, the bank guarantee serves

as an extra safety measure.

Because of these two facilities individuals are able to participate in international trade

with customers around the world. Because of these options, the risks are lessened. It

also helps build the mutual trust between the two parties involved in the trade.

In this project I have answered the question of the need of bank guarantee and

enforcement of Bank guarantee. As bank Guarantee is independent of the main contract

so it is no interference of courts but there are exceptional cases in which bank guarantee

is enforced through courts, which is mentioned in this project. We have discussed in

detail the nature of bank guarantee laid down by courts in various landmark judgments.

Chapter 2

4 Rupnarayan Bose, Bank Guarantee and Letter of Credit, Economic Law Journal, University of Chicago Press 12 1995, p.76

Need for Bank Guarantee

Bank guarantee is used to reduce many business transactions risks. It is a reliable

security instrument in both international and domestic trade. Many genuine business

requirements like obtaining goods, purchasing machinery can be fulfilled even when the

enterprise does not have enough money. It enables to use bank's creditworthiness to

facilitate many genuine business transactions. It provides immediate funds to the

business in the form of payment guarantees. It gives us ample time to make our

payments in case of deferred payment guarantees. It is a quality security instrument

which ensures a healthy business transaction and provides better negotiable terms and

conditions to the buyer and seller5.

There are various kinds of bank guarantee which are used in different situations which

are discussed as follows:

1. Tender bond is bank guarantee which is used in the export business for project

tenders. They are short term guarantees. Its purpose is to secure any claims by

the party inviting the tender on the tenderer in the event of withdrawal of the

bid before its expiry date or if the bid is modified unilaterally. It is also used if the

tenderer, upon being awarded the contract, refuses to sign the contract or

provide further guarantees on request.

2. There is another type of Bank Guarantee, the Advance Payment

Guarantees which is used in the import-export business and also in domestic

commercial business, trade and industry. The Performance Bond Guarantees

used to secure any claims by the buyer on a seller arising from default in delivery

or performance of the terms of a contract e.g. construction, assembly, execution.

It is used in import-export businesses as well as in domestic commercial business,

trade and industry. The terms of the guarantee are until the contract has been

fulfilled.6

3. The Bank Guarantee for Warranty Obligations is type of bank guarantee used in

the import-export business and in domestic commercial business, trade and

5 Retrieved from www.eagletraders.com6 Retrieved from www.nordea.ru

industry, where it is more often a surety. Its purpose is to secure any claims by

the buyer on the seller due to possible defects appearing after delivery. In the

construction trade, the guarantee for warranty obligation in the form of a simple

guarantee or a joint and several guarantee is known as a building (or works)

contractor's guarantee.

4. The Payment Guarantees are used in the import-export business or in any

circumstance where payment of an obligation needs to be guaranteed. It is used

to secure any claims by the seller on the buyer for payment of the contract price

by the agreed date. The payment guarantee is often used instead of a

documentary credit – upon delivery against “open account”.7 The use of this

guarantee is to secure any claims by the lender on the borrower due to a credit

(loan, etc.) not being repaid in accordance with the terms of the lending contract.

The amount of the guarantee is the amount of the credit or loan, and it usually

includes a margin to cover accrued interest and incidental expenses. The term of

the guarantee is until the expiration date of the loan plus a few days (e.g. 15

days).

These are often abstract guarantees in favour of a foreign or domestic lending bank e.g.

letter of indemnity for Missing Bill of Lading. This guarantee is specifically used for

importers when the bill of lading is missing. Its purpose is to secure any claims by the

shipping line/shipping company on (i) the buyer resulting from the goods arriving from

overseas being released without the original bill of lading being presented (e.g. due to

postal delays or even loss) or (ii) the supplier due to issuance of a replacement bill of

lading (original misplaced or lost).8

Attributes of Guarantees as Security an unsupported guarantee is a very simple security

to take - no registration is involved and no complications concerning proof of title arise.

A guarantee can easily and immediately be enforced by court action.

7 Retrieved from www.universalwealthcreation.com

8 Agasha Mugasha, The Law of Letters of Credit and Bank Guarantees, Central Law Publisher, Allahabad,

2003, p. 137

As with any other security given by a third party (collateral security), it can be ignored

when claiming against the principal debtor. As several parties can guarantee a loan, it is

useful security where the principal debtor is unable to provide security but offers a

viable business loan proposition.

Chapter 3

Nature of bank guarantee

The nature of bank guarantee is discussed in various judgments of Supreme Court and

High courts. In case of United commercial Bank v Bank of India and others 9 SUPREME

COURT laid down “... a bank guarantee is very much like a letter of credit. The courts will

do their utmost to enforce it according to its terms. They will not, in the ordinary course

of things, interfere by way of injunction to prevent its due implementation.”10 It was also

said in this case “ if the seller has complied with terms of letter of credit, however, there

is an absolute obligation upon a banker to pay irrespective of any dispute there may be

between the buyer and the seller as to whether the goods are upto contract or not”

In case of Rawala construction co. V Union of India11 SC laid down “the bank guarantee

constitutes an agreement between bank and the government under which there is an

absolute obligation of the bank to make payment to the government merely on the

demand of the government. The bank is prohibited under the guarantee from raising

any objection.” 12

Contractual obligation in bank guarantee.

Bank Guarantee is important as it enables the debtor to acquire goods, buy equipment,

or draw down loans, and thereby expand business activity. So there is need for law to

govern the Bank Guarantee. The concept of Bank Guarantee has evolved out from the

Indian Contact Act, 1872 and various judicial pronouncements. A Bank Guarantee is a

contract between the issuing Bank and the beneficiary in whose favour the Guarantee

has been furnished. Though the Bank Guarantee may have been issued by the Banker at

the instance of his client, as far as the Bank Guarantee is concerned, it is a contract

9 AIR 1981 SC 142610 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 42511 AIR 1997 Delhi 20512 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 425

between the Banker and the Beneficiary in whose favour the Bank Guarantee has been

issued13.

3.1 Statutory Provisions

Section 126 of the Indian Contract Act, 1872 provides “Contract of Guarantee”, ‘‘surety’’,

‘‘principal debtor and creditor’’ – A ‘‘contract of Guarantee’’ is a contract to perform

that promise, or discharge the liability of a third person in case of his default. The person

who keeps 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.”14

And Section 127 provides for “Consideration for Guarantee – Anything

done, or any promise made for the benefit of the principal debtor may be a sufficient

consideration to the surety for giving the Guarantee.”15

So, a Contract of Guarantee is a Tripartite Agreement which contemplates the Principal

Debtor, the Creditor or Beneficiary and the Surety. A Contract of Guarantee may be said

to be an Accessory Contract i.e., a contract of accessory nature, being always ancillary

and subsidiary to some other contract or liability on which it is founded and without the

support of which it must fail. By this Contract, the Promisor undertakes to be the

answerable person, whose primary liability to the Promisee must exist or be

contemplated.16 But it is not necessary or a Sine qua non, that the principal debtor must

expressly be a party to the document or Guarantee, as it is adequate, if the principal

debtor is a party by implication. A careful reading of Section 126 and 127 of the Contract

Act would clearly indicate that the primary idea of a surety ship is an undertaking to

indemnify the debtor in case he does not fulfil his promise, the contract of Guarantee,

being thus, a contract to indemnify.

13 Alok Ray, Enforcement of Bank Guarantee: Limits of Court’s Interference, Economic Law Journal, University of Chicago Press 12 1995, p.7614 Indian contract Act, 187215 Indian contract Act, 187216 H.S. Pathak, Indian Contract Act, Lexis Nexis, Delhi,2011,p.47

A bank guarantee is not directly governed by Sec. 126. Bank guarantee is a contract

involving two parties i.e. the bank and the beneficiary. In an ordinary guarantee, the

contract between the surety and the creditor arises as a subsidiary to the contract

between the creditor and the principal debtor. The bank guarantee is independent of

the main contract. In an ordinary guarantee, the inter se disputes between the debtor

and the creditor have a material effect upon the surety's liability. However, the bank

guarantee is independent of the disputes, arising ex contractu (arising out of the

contract). An ordinary guarantee does not have any time limit before which the debt has

to be claimed. Bank guarantees generally have a specific time within which they are

functional17.

17 R.L.Meena, Law of Contract, Universal Law Publishing Co., Delhi, 2008, p.319

Chapter 4

Judicial interpretation of legal obligation arising of Bank Guarantee

Bank guarantee is a guarantee from a lending institution ensuring that the liabilities of a

debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover

it18. The guarantor incurs secondary liability, that is, the guarantor becomes liable only if

the principal debtor fails to pay. If the principal debtor's liability to the bank is void, the

guarantor will not be liable. A guarantee must be evidenced by a written note or

memorandum signed by the guarantors or their agent. Without such written evidence, a

guarantee is unenforceable. Bank guarantees are, of course, always written

contracts. An indemnity imposes direct or primary liability to pay and need not be

evidenced in writing.

4.1 Invocation of Bank Guarantee

If an agreement of bank guarantee requires fulfilment of certain conditions or

requirements necessary for the invocation of the bank guarantee, the guarantee can be

invoked if those conditions are fulfilled.

In National Telecom of India Ltd. v. Union of India19, there was a bank guarantee in

favour of the government in respect of supplies to be made by the contractor as per the

purchase order. As per the guarantee agreement, the amount was payable without any

demur and on demand.

To invoke the bank guarantee it has to be shown that there was existence of one of the

two conditions:-

a) That there failure on the part of the contractor to perform the contract, and

b) That the amount claimed was by way of loss or damage to the government due to the

breach of contract.

18 Retrieved from, “ http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2Av86oUML”19 AIR 2001 Delhi 236

If the contractor fails to supply the goods against purchase order, in spite of extension of

time, and the government writes to the Bank to claim compensation stating that the

same has arisen due to non-performance of the contract by the contractor, the

guarantee, in such a case, has been properly invoked in accordance with the terms of

the contract.

It was further held in the case that if there is a breach of contract in the judgment of the

beneficiary of the contract, the bank has a obligation to pay the amount covered under

the bank guarantee on demand by the beneficiary without raising any objection. The

bank is not to judge that whether there is breach of contract or not.

In Daewoo Motors India Ltd. v. Union of India20, the Appellant Company agreeing to

fulfill export obligation had obtained various import licenses from the government after

furnishing bank guarantee in that regard. There was a term in the bank guarantee that

made the President under guarantee would be conclusive. Such guarantee was held to

be absolute and equivocal, hence invocation of guarantee on failure to fulfill export

obligation was held not arbitrary and its encashment could not be resisted by the bank.

In Bank of Baroda v. Ruby Sales Corporation (Agency)21, one of the parties demanded

for discharging Bank guarantee by producing proper documents. No proceedings had

been initiated by party for alleged breach of agreement against other party. Bank was

not concerned with dispute between parties. Unless it was a case of fraud, bank was

bound to discharge bank guarantee. Plea that there was negligence on the part of bank

in discharging bank guarantee though it was informed not to make payment was

rejected by the Gujarat High Court. Action of Bank in discharging Bank Guarantee was

not improper. Again in, Punj Lioyd Ltd V. India Cements Ltd22, supply of cement by

defendants to plaintiff for its project, the plaintiff had furnished Bank guarantees for

ensuring timely payments.

20 AIR 2003 SC 178621 AIR 2006 Guj. 25122 AIR 2005 Del. 389

In Mula Sahakari Karkhana v. State Bank of India23, document was supplied between

the plaintiff and the bank and the supplier of the goods was not a party to it. The

document and the intention of the parties was clear covering comprehensive claim of

plaintiff to the extent of Rs. 3,40,000/- . The guarantor was invoked within the

prescribed time. Since there was no dispute between the plaintiff and the supplier as

also there being no fraud or misrepresentation involved, the Bank was held bound to

honour the guarantee.

4.2 Injunction against Invocation of Bank Guarantee

Where the is a very strong prima facie case of element of fraud in connection with the

invocation of bank guarantee, the party giving the bank guarantee can lawfully seek

injunction against the invocation of bank guarantee. This was held in Veer Prabhu mktg

v .N.S.C.24 but there was no finding of fraudulent injunction against encashment of bank

guarantee cannot be granted.

In Man Industries India Ltd., Indore v. N.V. Kharote Engineers and Contractors,

Pune,25 there was a contract for supply of goods by the company to the contractor.

Dispute arose between parties regarding outstanding amount. Bank guarantee executed

at the instance of contractor in favour of company was unconditional. It was not

dependent on extent of goods supplied. Condition was stipulated in bank guarantee that

it could become en-cashable in the event of default of payment. No prima facie case for

injunction was made out by contractor. No irretrievable injustice would be caused to

him. Balance of convenience was also not in his favour. Injunction against encashment

of bank guarantee was refused as there was no finding of fraud recorded.

4.3 Important Case Laws and Their Rulings

In Hindustan Steelworks Corpn ltd v. Tarapore and co.: The Supereme court laid down

the law in terms of following propositions:

23 AIR 2005 Bom. 38524 A.I.R. 2006 Cal. 30125 AIR 2005 Bom. 311

1. A bank guarantee is an independent and distinct contract between the bank and the

beneficiary and is not qualified by the underlying transaction aand the primary contract

between the person at whose instance the bank guarantee is given aand the beneficiary.

2. In the case of an unconditional bank guarantee the nature of the obligation of the bank

is absolute and not dependent upon any dispute or proceeding between the party at

whose instance the bank guarantee is given and the beneficiary.

3. The commitment by banks must be honoured free from interference by the court and it

is only in exceptional cases, that is to say, in case of fraud, or in a case where

irretrievable injustice would be done if bank guarantee is allowed to be encashed, that

the court would interfere.

Some litigation in connection with the bank or demand guarantees is generated by the

fact that there can be abusive or unfair callings, which is to a large extent due to the

independent nature of both documentary credits and unconditional on demand

guarantees.

The beneficiary’s right to payment is absolute or almost absolute. In A.C. Roy & co.v.

Union of India26, it was held that the person claiming the guarantee must establish that

conditions for invoking the guarantee do exist. In another case of National Telecom of

India ltd v. Union of India27 the government was required to show at least one or two

conditions for invoking guarantee, i.e. either that the amount had become due because

of loss caused by breach or that the amount was being forfeited by reason of the

contractor’s failure to perform his commitment.

The Supreme Court in case of U.P. COOP Federation Ltd v. Singh Consultants and

Engineering ltd28, the bank that the operation of a bank guarantees should be stayed

only in cases of serious dispute, fraud or special equities.

In an another milestone case, General Electric Technical Co Inc v Punj Sons(P) Ltd.29 The

SC dealt with a case of bank guarantee given for securing mobilization advance, it was

26AIR 1995 Cal 24627 AIR 2001Del 23628 1988 1 SCC 17429 1991 4 SCC 230

held that the right of a contractor to recover certain amounts under running bills would

have no relevance to the liability of the bank under the guarantee given by it.

A bank guarantee is a sort of an absolute undertaking to pay the amount whenever

demanded by the guarantee-holder. It has nothing to do with the state of relations

between the guarantee-holder and the person on whose behalf the guarantee was

given. While ordinary guarantees are linked to and dependent on the underlying

transaction, a bank guarantee is an arrangement where the guarantee is independent of

the underlying transaction.

Chapter 5

Conclusion

Bank guarantees are simple, flexible and effective guarantee and play a major role in the

promotion of national and international trade. A bank guarantee operates by way of a

contract or agreement in which the bank itself stands as guarantor to a particular

advance made by a creditor to a debtor, independent of the underlying contract and the

primary contract of the person at whose instance the bank guarantee is given. It is

extremely important to note that the enforcement of the guarantee is actually

dependent on the terms of the contract subsisting between the bank and the beneficiary

and is generally not interfered in by the Courts.

The bank guarantee is an innovative financial instrument whereby, if the beneficiary

perceives that there has been a breach of contract by the other party, he can encash the

guarantee and avail of the amount immediately, without having to undergo the hassles

of litigation. It enables the debtor to acquire goods, buy equipment, or draw down

loans, and thereby expand business activity. It also facilitates the mode of payment.

Bank Guarantee has dual aspect. It is not merely a contract between the bank and the

beneficiary of the guarantee. It is also a security given to the beneficiary by a third party.

Bank should not interfere with the dispute related to the encashment of bank

guarantee. As far as possible the dispute should be solved by Arbitrators. Commitment

of banks must be honoured free from interference by the courts. It is only an in

exceptional case that is to say in case of fraud or in case of irretrievable injustice, that

the court should interfere. Thus in commercial transactions bank guarantees achieve

relevance. Beneficiaries or the creditors may charge a rate of penal interest in the event

of delayed payment of the due amount. Hence, it is imperative that banks remain

cautious, when signing a contract of guarantee with the beneficiary, which may contain

provisions pertaining to the payment of penal interest in the event of delay in payment

on default of the principal debtor.

Chapter 6

Bibliography.

Books:

1. Bangia, R.K. Contract II. Allahabad Law Agency, Faridabad,2010

2. Jain, J.D. Indian Contract Act. Faridabad: Allahabad Law Agency

3. Kapoor, S.K., Contract -II, Central law Agency, Allahabad, 2007

4. Meena, R.L., Law of Contract, Universal Law Publishing Co., Delhi, 2008

5. Pathak, H.S., Indian Contract Act, Lexis Nexis, Delhi,2011

6. Singh, Avtar. Law of Contract and Specific Relief. New Delhi: Eastern Book Company.

7. Sujan, M.A., Law relating to Building Contracts, Universal Law Publishing Co.,

Delhi,1999

Bare Act

Indian Contracts Act, 1872

Websites

1. www.business-standard.com

2. www.eagletraders.com

3. www.investopedia.com

4. www.universalwealthcreation.com