Bank Guarantee and Liability of the Banker

Author : VS Warrier

Bank guarantees as well as Letters of credit are common features of commercial transactions today. A bank guarantee and a letter of credit are similar in many ways but they’re two different things. 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 it. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn’t go as planned.

A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures the payment will be made as long as the services are performed.
For example a letter of credit could be used in the delivery of goods or the completion of a service. The seller may request that the buyer obtain a letter of credit before the transaction occurs. The buyer would purchase this letter of credit from a bank and forward it to the seller’s bank. This letter would substitute the bank’s credit for that of its client, ensuring correct and timely payment.
A bank guarantee might be used when a buyer obtains goods from a seller then runs into flow difficulties and can’t pay the seller. The bank guarantee would pay an agreed-upon sum to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the opposing party in the transaction.
BANK GUARANTEE
A bank guarantee is a tripartite agreement between the banker, the beneficiary and the customer, whereby the bank gives an undertaking to pay the beneficiary a definite sum of money, or arrange the performance of the obligations of the client 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.
The ingredients of a valid bank guarantee are;
(i)it should be for a specified period or definite period,
(ii)for a specified amount,
(iii)for a well defined purpose,
(iv)a defined period of validity,
(v)grace period for enforcing rights, and
(vi)The events of default under which the guarantee can be enforced.
A bank guarantee contract is independent and totally different from the underlying contract that subsists between the beneficiary and the creditor. It is extremely important in determining the liability of the banks in the event of default by the debtor.
In, Jacsons Veneers and Panels Pvt. Ltd. v. State Bank of Travancore and Anr. , the Court was required to enforce the bank guarantee simplicities without probing into the nature of the transactions between the Bank and the customer that led to the furnishing of the bank guarantee. It is well settled that the Bank guarantee is an autonomous contract and imposes an absolute obligation on the Bank to fulfill the terms and the payment in the Bank guarantee becomes due o the happening of contingency on the occurrence of which the guarantee becomes enforceable.
The Supreme Court has further reiterated in the case of Ansal Engineering projects Ltd v. Tehri Hydro Development Corporation Ltd that 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 person at whose instance the bank guarantee is given. As the bank unconditionally and unequivocally promised to pay, on demand, the Court thus held that the liability of the bank was absolute and unconditional and could not be circumvented in any manner.
It is settled law that 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 person at whose instance the bank guarantee was given and the beneficiary. Unless fraud or special equity exists, is pleaded and prima facie established by strong evidence as a treatable issue, the beneficiary cannot be restrained from en-cashing the bank guarantee even if dispute between the beneficiary and the person at whose instance the bank guarantee was given by the bank, had arisen in performance of the contract or execution of the works undertaken in furtherance thereof.
The bank unconditionally and irrevocably promised to pay, on demand, the amount of liability undertaken in the guarantee without any demur or dispute in terms of the bank guarantee. The object behind is to inculcate respect for free flow of commerce and trade and faith in the commercial banking transactions unhedged by pending disputes between the beneficiary and the contractor.
INVOCATION OF A BANK GURANTEE
Invocation of a bank guarantee is dependent upon the terms of the guarantee. It was held that, when an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realize such bank guarantee irrespective of pending disputes and that a bank guarantee constituted a bargain between the two parties, by which the banker creditor was unconditionally required to pay the amount in question .
The law relating to invocation of such bank guarantees is well settled. When the course of commercial dealings an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realize such a bank guarantee in terms thereof irrespective of any pending disputes. The bank giving such a guarantee is bound to honour it as per its terms irrespective of any dispute raised by its customer. The very purpose of giving such a bank guarantee would otherwise be defeated. The courts should, therefore, be slow in granting an injunction to restrain the realization of such a bank guarantee.
The courts have carved out only two exceptions. A fraud in connection with such a bank guarantee would vitiate the very foundation of such a bank guarantee. Hence if there is such a fraud of which the beneficiary seeks to take the advantage, he can be restrained from doing so. The second exception relates to cases where allowing the encashment of an unconditional bank guarantee would result in irretrievable harm or injustice to one of the parties concerned. Since in most cases payment of money under such a bank guarantee would adversely affect the bank and its customer at whose instance the guarantee is given, the harm or injustice contemplated under this head must be such an exceptional and irretrievable nature as would override the terms of the guarantee and the adverse effect of such an injunction on commercial dealings in the country.
It was observed that, the invocation of a bank guarantee does not necessarily have to be initiated by setting out the entire case in the form of a plaint with a specific cause of action, and that it was a commercial document and not a statutory notice or a pleading. It was further stated that if the bank concerned understood that the beneficiary in terms of the guarantee was invoking the guarantee, the bank guarantee may be invoked. It is sufficient if there is substantial compliance in terms of the guarantee in the notice that may be issued. However, banks may even delay giving a response to the demand for notice in the hope that the specified claim period expires.
To the effect that a bank guarantee should be invoked in an exact and punctilious manner setting out the entire case of the beneficiary under the guarantee in the same way as setting out a cause of action in a plaint. A bank guarantee is a commercial document and is neither is statutory notice nor a pleading in a legal proceeding.
Generally there will be clauses in bank guarantees to the effect that the guarantees would be honoured only by an initial written demand without any demur and would also mention that the principal debtor has committed default in payment of the loaned amount. The amount demanded must be contemplated within the contract of guarantee. The bank guarantee contracts may also contain clauses that give unilateral right to the beneficiary to determine the question of default of the debtor. In such cases there is no discretion on the part of the banks and the bank guarantee essentially becomes absolute in nature.
It is the duty of beneficiary to intimate the bank or the guarantor that the event for which the guarantee was issued has happened or did not happen and that, in terms of the guarantee, it has been invoked demanding payment. However, the guarantee should be invoked within the specified period stated within the documents, and not afterwards as the contract would have come to an end.
The terms of the bank guarantee are very important in determining the nature of the bank guarantee, and whether or not it is a conditional one or an absolute guarantee. In my view, a bank guarantee may be invoked in a commercial manner. The invocation would be sufficient and proper if the bank concerned understands that the guarantee is being invoked by the beneficiary in terms of the guarantee.
The general rule is that, irrespective of any dispute between the customer and the bank with respect to the primary contract, the banks must honour their commitments as per the terms of the contract. The Courts are therefore reluctant to grant an injunction preventing payment or interfering with the liability of the bank to pay the amount due on the guarantee.
Thus the Honourable Supreme Court has made it clear that, the liability of the bank remains integral and does not cease with any pending disputes with respect to the primary underlying transaction between the beneficiary and the creditor. However, there are two exceptions to the general rule of non-interference by the Courts, namely (a) fraud and (b) the resulting of irretrievable injustice or harm.
The Supreme Court affirming long standing jurisprudence on this matter stated that, the bank is bound to honour the guarantee irrespective of any dispute raised by the customer against the beneficiary. This is however subject to two exceptions that is, a fraud committed in the notice of the bank which would vitiate the very foundation of the guarantee or encashment of the bank guarantee would result in irretrievable harm or injustice of the kind which would make it impossible for the guarantor to reimburse himself.
However an injunction may be granted where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly fraudulent; though the evidence must be clear as to the fact of fraud and as to the bank’s knowledge, and it cannot rest on the uncorroborated statement of the customer or else irreparable damage can be done to a bank’s credit.
CONCLUSION
Banks play very important role in the economic life of the nation. The health of the economy is closely related to the soundness of its banking system. Although banks create no new wealth but their borrowing, lending and related activities facilitate the process of production, distribution, exchange and consumption of wealth. In this way they become very effective partners in the process of economic development.
Today, modern banks are very useful for the utilization of the resources of the country. The banks are mobilizing the savings of the people for the investment purposes. The savings are encouraged and saving rate increases. If there would be no banks then a great portion of a capitalof the country would remain idle. A bank as a matter of fact is just like a heart in the economic structure and the Capital provided by it is like blood in it.
In day to day financial transaction, person needs the help of Banks to assure other persons that their money is safe. This is done by issuing of letter of credit or bank guarantee under Section 6 of Banking Regulation Act. These guarantee or letters of credit are irrevocable. The law is that in respect of irrevocable guarantee, the banks cannot be restrained from making the payment.
The general rule is that, irrespective of any dispute between the customer and the bank with respect to the primary contract, the banks must honour their commitments as per the terms of the contract. Therefore the bank is not concerned with the disputes between the parties. However, bank can be restrained from making payment in cases of fraud and undue influences. In case of economic duress also injunctions can be granted.

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