Bank guarantee is the backbone of commercial transactions. It is said that business proceeds on beliefs or judgment of probabilities and not on certainities. Thus when a commitment is made it must be honoured, otherwise people will lose faith in the commercial system.
According to Halsbury’s Laws of England, a guarantee is an accessory contract by which the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person, whose primary liability to the promisee must exist or be contemplated.
Under the Indian law, 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 is, thus, a promise by one person, who is called the guarantor or surety to answer for the present or future debt of another person who is called the principal-debtor, such promise being made to the party to whom the principal-debtor is or will become, liable.
A bank guarantee is a tripartite agreement between the banker, the customer and the beneficiary, whereby the bank gives an undertaking to pay the beneficiary a definite sum of money, or arrange the performance of the obligations of the customer in the possible event of his default. Banks are usually approached to give such guarantees, as they possess the financial capability to meet such obligations.
A bank guarantee is an independent and distinct contract between the Bank and the beneficiary and is not qualified by the underlying transaction and the validity of the primary contract between the beneficiary and the customer, at whose instance the bank guarantee is given. The bank unconditionally and unequivocally promises to pay on demand and thus the liability of the bank is absolute and unconditional and cannot be circumvented in any manner.
Bank is mandated to make payment of the amount of Bank Guarantee, without any demur, claimed within the stipulated period on the basis of enforcement of Letter of Invocation and on the ground of allegation of Breach of Agreement by the beneficiary.
Essentials of a Contract of Guarantee:
- There must be a debt existing, which should be recoverable.
- Existence of three parties i.e., principal-debtor, creditor and surety.
- There must be a distinct promise, by the surety to pay the debt in case of default committed by the principal-debtor.
- The principal-debtor must be primarily liable. Surety’s liability is secondary, i.e., surety’s liability arises only in case of default of the principal-debtor.
- There should be some consideration.
- The liability must be legally enforceable.
- It must have all the essentials of a contract.
The purpose of this contract is to provide surety of the performance of the contract. Surety’s obligation is dependent on principal-debtor’s default.
Invocation of Bank Guarantee
The rule is well established that a Bank issuing a guarantee is not concerned with the underlying contract between the parties to the contract. The duty of the Bank under a bank guarantee is created by the document of guarantee itself. Once that document is in order, the Bank giving the guarantee must honour the same and make payment.
In case there is an unequivocal and unconditional bank guarantee and the bank agrees to pay without any demur the stipulated amount on demand being made by the beneficiary, then for the purpose of encashment of a bank guarantee, it is not for the beneficiary to show that he has suffered any loss by reason of non fulfillment of any obligation under the primary contract. In case of such an interpretation, the very purpose of furnishing a bank guarantee would be frustrated as no bank guarantee can be encashed till court gives a verdict that the beneficiary had suffered loss due to non fulfillment of obligation under the contract. In fact the whole purpose of providing for a scheme of bank guarantees will become futile.
A bank guarantee can always be invoked by the beneficiary, when there is a case of not honouring the principal contract. Once it is apparent that the conditions of principal contract could not be fulfilled, invocation of bank guarantee would not be premature or unjustified. It is not necessary for the beneficiary to stipulate specifically in invocation letter giving details about nature of defaults and about outstanding amounts due to such defaults. Invocation has to be in terms of bank guarantee itself and not in terms of contract between parties.
The law is that the beneficiary can invoke the bank guarantee always in terms of the bank guarantee which is an independent and distinct contract.
If the principal-debtor does not commit a default, there is no liability of the guarantor. However, immediately on the occurrence of a default, the guarantor becomes liable. When a guarantee is given, on that day the guarantor may not be liable, but when the default is committed, the guarantor becomes liable.
When court may grant injunction against invocation of Bank Guarantee?
The matter relating to encashment of a Bank guarantee is governed by Sec. 126 of the Indian Contract Act, 1872. Very often the parties who furnish such bank guarantee rushes to the bank and tries to stop the encashment of the bank guarantee. The question arises as to what is the scope of Sec. 126 of the Contract Act and also as to when such a stay can be granted. This shall also include an answer to the question whether the dispute of accounts by itself will provide a ground for grant of stay against encashment of bank guarantee. A dispute of accounts, by itself, will not provide a ground for grant of stay against encashment of bank guarantee. If this is permitted to be done, the purpose behind resting transaction on the basis of bank guarantee will be marred which would ultimately affect trade and commerce and economic development.
Courts have time and again held that the commitment of Banks under a bank guarantee 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 is to say in case of irretrievable injustice or fraud that the Court should interfere.
A bank guarantee creates an irrevocable obligation on the bank to perform the contract in terms thereof and on occurrence of the event mentioned therein, the bank guarantee becomes enforceable. It is only in rare or exceptional cases like:
- a case of fraud of egregious nature of which the bank has knowledge; or
- if allowing an encashment would result in irretrievable harm to one of the parties concerned that the court may interdict encashment of a bank guarantee.
The nature of fraud is fraud of an egregious nature as to vitiate the entire underlying transaction. It is fraud of the beneficiary, not the fraud of somebody else. There must be a specific plea of fraud. The party alleging fraud must necessarily plead and produce all necessary evidence in proof of the fraud in execution of the contract of guarantee. Moreover, fraud like any other charge of a criminal proceedings must be established beyond reasonable doubt. A finding as to fraud cannot be based on suspicion and conjecture. The material and evidence have to show it.
Irretrievable injustice should be of a kind arising in irretrievable situation. The irreparable harm should not be speculative. It should be genuine and immediate as well as irreversible. It should be a case where the party seeking restraint on invocation of bank guarantee has no adequate remedy in law at all and the harm to him would be irreparable.
The subsequent dispute in the performance of the contract does not give rise to cause nor would the Court be justified on that basis to issue an injunction from enforcing a bank guarantee, because the party is not left without remedy in such a case. He is entitled to damages and other consequential reliefs.
The same principles will apply to cases where injunction is sought against a party seeking to invoke the bank guarantee because the net effect of such an injunction is to restrain the Bank from performing the bank guarantee. That is so, because one cannot do indirectly what one is not free to do directly.
In Geo Tech Construction Co. v. Hindustan Steel Works Ltd1 it was stated that the following points have decisive role in the matter of granting or refusing injunction against the enforcement of bank guarantee:-
- The obligations arising under the Bank guarantee are independent of the obligations arising out of specific or underlying contract.
- The plea of fraud or irretrievable injustice shall not be allowed unless a prima facie case is made out as a triable issue by strong evidence.
- The plea of fraud must be an established fraud and it must be a fraud known to the bank.
- The fraud alleged must be a fraud of an ‘egregious nature’ as to vitiate the entire underlying transaction.
- The fraud shall be fraud of beneficiary and not the fraud of anybody else.
- The subsequent dispute in the performance of the contract does not give rise to issue of an injunction.
- In the event of the dispute if the main contract ends in party’s favour, he is entitled to damages or other consequential reliefs.
- The irreparable injury should not be speculative. It should be genuine and immediate as well as irreversible.
- Irretrievable injustice must be of such a nature that, if the bank guarantee is realized, the injury could not be legally remedied.
- The fraud alleged should be apparent with minimal investigation.
1AIR 1999 Ker 72