Law of Bank Guarantee

1.Bank guarantees are called “ the life blood of international commerce”. These
guarantees are independent commitments taken by the banks on behalf of their
customers.
2.In most bank guarantees , banks undertake to make payment merely on demand by the
beneficiary. Irrespective of the underlying contract and any dispute between parties to the
contract of bank guarantee , banks make payment if the guarantee has been invoked
properly.

3.The obligation of a banker to honour its commitment on a guarantee given by it , is

primary. A bank guarantee casts a duty upon a bank to honour it, irrespective of any
dispute between the beneficiary and debtor( who is a customer of the bank).

4.The Hon’ble Supreme Court in the case of U.P. Cooperative Federation Vs Singh
Consultant(1988 (1) SCC 174) held that the commitments of banks must be honoured
free from interference by courts. It is only in exceptional cases like fraud or
irretrievable injustice be done, the courts should interfere.

5.In a bank guarantee , the amount has to be specifically stated both in figures and
words. The liability of a bank under a bank guarantee depends on two important
criteria, viz, the amount guaranteed and the period of the guarantee. These two factors
have to be specifically stated in a bank guarantee to avoid future disputes.

6.If the amount and period are not specifically mentioned in a bank guarantee then , the
liability of a bank could be unlimited either in the amount guaranteed or the period
during guarantee.

7.Banks always specify the period for which their guarantee subsists and an additional
period during which a claim has to be made upon the bank to make payment. A) The
period during which a bank guarantee subsists is called “validity period”. B) On the
expiry of validity period another period called “claim period” during which a claim
has to be made on a bank to make payment. In a bank guarantee, it is necessary to
provide for a period slightly longer than the validity period for the beneficiary to make
a claim.

8.On invocation , a bank is liable to pay the whole amount of bank guarantee unless
stated earlier a case of fraud has been brought to its notice. If any default has been
committed by the debtor(bank’s customer), it should be within the validity period . The
period of a bank guarantee has to be specifically stated to the exact date, For example,
“ this guarantee is valid upto 31 December,2005”.

9.Once the period of bank guarantee is specifically mentioned therein, then the
beneficiary /creditor/owner can make a claim only if the default has occurred within the
date of the bank guarantee , and for any default beyond the date of a bank guarantee , the
bank cannot be held liable. Once a default is made then the beneficiary/creditor/owner
has to make a claim on the bank to make good the loss within the claim period.
10.The main contract and bank guarantee are two independent contracts. Both surety
(the bank) and the principal debtor(the contractor) should sign the bank guarantee.
In a contract of bank guarantee , at least one witness should sign it. Under the provisions
of Transfer of Property Act, attestation of witness is mandatory.

11.In M.S.E.B, Bombay Vs Official Liquidator, HC of Kerala & Another AIR 1982
SC-1497, The SC has held that a discharge which a principal debtor may secure by
operation of law in bankruptcy or in liquidation proceedings of a company, would not
absolve the bank from its liability under the bank guarantee.

12.A bank guarantee must be irrevocable, unconditional and be payable on demand in

writing. The bank which gives a guarantee, must pay the guaranteed amount without
any contestation, demur or protest and/or without reference to the
buyer/contractor/principal debtor. In the absence of any special equities and in the
absence of any clear fraud, the bank must pay the guaranteed amount on demand.

13.A bank which gave a guarantee ,must pay the guaranteed amount without questioning
the legal relationship subsisting between a contractor and a beneficiary. A bank
guarantee is an independent contract between a contractor and a beneficiary and it is
not affected by or suspended by operation of any statute or notification.

14.The liability of a bank in a bank guarantee is not dependent on the underlying contract
between a contractor (bank’s customer or principal debtor) and a beneficiary
(owner/creditor) but is an independent contract which the courts would enforce/honour
except in case of clear cut fraud.

15).In case of bank guarantees issued on behalf of companies that are under liquidation,
the bank ,on invocation of the guarantee by the beneficiary, must pay the beneficiary.

16.Amendment to Sec. 28 of the Indian Contract Act and its impact on Bank
Guarantees:-
a)Prior to this amendment of Sec. 28 of the Indian Contract Act, 1872 most bank
guarantees had standard clause at the end of their guarantee agreements. As per this
clause , the beneficiary is required to enforce claims within a period of three to six
months , failing which , the banks liability was extinguished and the rights of the
beneficiary as well. Because of the amendment to Sec. 28 of the I.C.Act, on 01.01.1997,
the standard limitation clauses in the bank guarantee agreements by which the banks
extinguished their liability has been declared as illegal.

b)As such, at present if a beneficiary were to invoke the bank guarantee within the claim
period , for default committed by the debtor, in case the bank concerned did not make the
payment , the beneficiary can sue the bank within the normal period as provided in under
the Limitation Act, 1963. This limitation period under the Limitation Act is 30 years if the
beneficiary is Government/Govt Deptt/Municipal body and three years in all other cases.
c)As such , it is prudent to insist that the bank guarantee has to be returned after the claim
period duly cancelled by the beneficiary or a certificate has to be obtained from the
beneficiary that there are no claims under the guarantee , till such time the cash margin
and the security of the debtor(bank’s customer) has to be retained.

17).Counter Guarantee and Other Security:-

Though a bank guarantee is contingent liability , it is always prudent for a banker to
secure this liability in case it is enforced. This can be done by obtaining a counter
guarantee –cum-Indemnity executed by the customer in favour of the bank. Such counter
guarantee –cum- Indemnity should be carefully drafted to ensure that in case the bank
were to make payment on behalf of the customer , then customer in turn should not only
pay back the amounts paid by the bank to the creditor but also any expenses connected
therewith.
The counter guarantee should also include a clause that it would remain in
force till the guarantee given by the bank subsists i.e. till the bank is duly discharged by
the beneficiary or a certificate to that effect is issued by the beneficiary. Though a counter
guarantee –cum-Indemnity is taken as a security for every guarantee issued by the bank,
its value would depend on the financial standing of the person giving the counter
guarantee. As it is preferable that keeping in mind the financial worth of the counter
guarantor(bank’s customer) necessary security in the form of fixed deposits,
mortgage,etc, be obtained or the existing charge of the debtor can also be extended to
cover the guarantee.

Exceptions to General Rule

(Exception—I Cases of Fraud)
a).Fraud is held to be one of the exceptions to the general rule of guaranteed amount
must always be honoured. A bank which has the knowledge of fraud ,therefore refuse
payment of the guaranteed amount.
b).In the case of U.P.Cooperative Federation Vs Singh Consultants(AIR 1988(1)SCC174)
held that a bank cannot be compelled to honour a bank guarantee given by it when it
has knowledge of fraud committed either by the contractor or the beneficiary. If the
bank concerned detects with a minimal investigation on the fraudulent action of the
seller(the beneficiary) , the payment under a bank guarantee could be refused. More over,
the obligation of a bank on a guarantee issued by it on behalf of its customer , should not
be extended to protect an unscrupulous seller /beneficiary who is responsible for the
fraud.
c).In M/s Escorts Ltd Vs M/s Modern Insulators & Another AIR 1988 Delhi 345 ,
The Delhi HC held that banks in case of having any doubt over the fraudulent action of
the beneficiary/creditor, the banks have to seek appropriate direction from courts. In case
of any suspicion over the genuiness of the invocation of bank guaranteee, the banks
should approach the court of law forthwith.

d).Suppose a bank guarantee is invoked fraudulently, in that case it would be proper for
the bank to ask the buyer(bank’s customer /contractor) to approach the court for an order
of injunction. If a bank guarantee is not invoked properly, court may grant injunction
against the beneficiary.
 Exception—II Special Equities Infavour of a debtor
a).If there is a possibility of an irretrievable harm or injustice either to the banker or
debtor , then the court would grant injunction stopping the bank from making payment in
respect of a bank guarantee.

b).To avail this exception , therefore , exceptional circumstances which make it

impossible for the guarantor(the bank) to reimburse himself , will have to be decisively
established.

c).If there is a chance of irreparable harm either to the bank(guarantor) or to its customer
(debtor), then the bank and its customer would be found to receive the amount paid under
a bank guarantee.

RBI Guidelines for Issuance of Bank Guarantees

The following are the guidelines issued by RBI for issuance of Bank Guarantees by banks
on behalf of their customers.
1)Commercial banks should limit to financial guarantees and exercise caution with regard
to issuance of performance guarantees.

2)Guarantees covering custom/import duty on selective credit control items should be

opened only with minimum cash margin of 50%.

3).Banks should not issue guarantees covering inter-company deposits/loans.

4).Banks should not issue guarantees on behalf of Non-Banking Finance Companies

guaranteeing repayment of deposits placed to them by investors.

5).Banks should issue guarantees for shorter period and there should be no guarantees for
a period exceeding 10 years.
Expiry of bank guarantee is governed by Law of Limitation ranging from 3
years to 30 years if the beneficiary is Government/Govt body/Govt Deptt.