A bank guarantee is an assurance given by the bank to any third person wherein the bank agrees to undertake the risk of payment on behalf of the debtor to the creditor. The parties enter into a contract of guarantee, and the bank acts as a surety. Bank guarantees are commonly used for business and personal transactions and seek to protect the creditor from suffering any financial losses in case of default in payment by the debtor. This guarantee secures the creditors and helps businesses grow. Under a contract of bank guarantee, the creditor becomes the beneficiary and is entitled to claim the advanced amount from the bank. If the bank fails to fulfil its obligations under the BG, the creditor can proceed to bring an action before the Courts.
Validity period and claim period of a Bank Guarantee
The validity period is the period of existence or the lifetime of a bank guarantee (BG). A beneficiary (the creditor) can make a written demand to the bank in furtherance of the BG during the validity period. However, in certain cases, the BGs contain a clause that lays an additional period within which the claims can be made. This grace period is known as the claim period. Though it is generally expected that these dates are different, still there is no compulsion to keep both the dates different, as such, the expiry date of the claim period ranges from one to twelve months after the validity period.
Liability of banks upon invocation of bank guarantee
A bank that is a party to the BG undertakes an obligation to make payment when the beneficiary creditor makes a legitimate claim within the validity period of the concerned BG. By virtue of the contract of guarantee, a creditor becomes entitled to claim payment of the bank when the borrower defaults and can even enforce this claim before the Courts. Before making payment upon the presentation of a claim, the banks first notify the debtor of the same and requires them to arrange for funds to pay the claimed amount. However, if the borrower fails, the Bank has to pay.
In UP State Sugar Corporation Vs Sumac International Ltd, the Supreme Court held that when an unconditional bank guarantee is provided or accepted, the beneficiary is entitled to realize such bank guarantee regardless of the ongoing disputes and a bank guarantee constituted a bargain between the two parties, by which the bank unconditionally had to pay the amount in question.
Section 128 of the Indian Contract Act talks about the concept of a surety’s liability, and it states that the liability of the surety is co-extensive with that of the principal debtor unless it is proved otherwise by the contract.
In M/S Adani Agri Fresh Ltd Vs Mahaboob Sharif & Ors, it was highlighted by the Supreme Court that the bank guarantee is an unconditional one, and the respondent thus cannot raise any dispute and prevent the appellant from encashing the bank guarantee.
Similarly, in the case of Ansal Engineering Projects Ltd Vs Tehri Hydro Development Corporation Ltd, the Supreme Court stated that a bank guarantee is a separate contract entered into between a bank and a beneficiary and is not subject to underlying transaction and also that since the bank had unequivocally agreed to pay on demand, the liability of the bank was absolute and unconditional and could not be circumvented in any manner whatsoever.
When the question of liability of bank in case the beneficiary presents a claim during the claim period arises, one has to consider Section 28 of the Indian Contract Act, 1872. Section 28 lays down that any agreement in restraint of legal proceedings shall be void. However, exception 3 to this section saves the guarantee agreement of a bank or financial institution from the application of the general rule. Moreover, the Limitation Act, 1963 provides for a time limit of one year for a normal bank guarantee, but on the other hand, it has prescribed thirty years for all suits to be instituted by the government. This prescribed limitation period made the banks apprehensive about Section 28 of the Indian Contract, which before the amendment of 2013, had declared all agreements containing stipulation of discharge of liability as null and void.
Prior to 1997, the situation was that according to Section 28, any agreement through which any party was restricted from enforcing its right in respect of any contract by the usual legal proceedings in tribunal or even limited the time within which this could be done was void to that extent. It was in 1997 that an amendment to Section 28(b) of the Indian Contract Act was made to provide for agreements that extinguished the rights of any party or discharge any party from any liability under or in respect of any contract on the expiry of a specified period to restrict any party from enforcing its rights.
It can be seen through the judgement pronounced in Union of India v. Bhagwati Cottons Ltd, in which the Court held that any agreement containing a clause stipulating that rights of a party shall be suspended and another party shall be discharged from liability if the claim is not filed within the stipulated time, would be hit by the 1997 amendment.
Despite this decision by the Division Bench of the Bombay High Court, in the case of Explore Computers Pvt Ltd v. CALS ltd and Anr, the Court took a different stance by stating that though the clause within the agreements specifying the time limit within which beneficiary has to enforce its claim within sometime after expiry of bank guarantee is considered to be void in nature but the clause terminating the forfeiture or suspension of the right of claim is not brought within the specified time after the expiry of bank guarantee is valid.
In Union of India & Ors. v. IndusInd Bank Ltd & Ors, while upholding the validity of a clause limiting the claim period for the assertion of a right, the Supreme Court observed that it's clearly stated under the law that a clause that restricts the Limitation Period is not always hit with the aid of using Section 28 of the Indian Contract Act. The amendments to Section 28 are a substantive change in the law which provides that even where an agreement seeks to extinguish the rights or discharges the liability of any party to an agreement having the effect of restricting such party from enforcing their rights on the expiry of a stipulated period would be void to that extent.
It was because of these conflicting judgments that an amendment was brought in the Indian Contract Act in the year 2013, i.e. exception 3 to Section 28, which was responsible for providing validity to the clause in the contracts which provided for extinguishment of rights or discharge from any liability, the period of which should not be a less than one year from the date of occurring or non- occurring of a specified event. In the IndusInd case, it was held that the effect of this exception is to limit the period provided under the Limitation Act from three years to one year in the case of banks and financial institutions which issue a guarantee.
In the case of Kaushalya Rant v. Gopal Singh, it was held that Explanation 3 of Section 28 is dealing with a special branch, i.e. the Bank Guarantee and is confined to a specific branch and therefore, to that extent and in terms of statutory interpretation, exception 3 is a special law and as such would prevail over the Limitation Act, 1963.
Furthermore, the Reserve Bank of India, in a circulation dated 9th October 2015, has confirmed the 2013 amendment by stating that the Banks are not allowed to keep margin money after the invocation period.
Thus, the Banks may be discharged of their liability in the following two conditions:
- If no claim is made within a specified claim period or,
- If Claim is made within the period of validity of bank guarantee and not less than one year is provided for enforcement of the guarantee from a specified event, after which the bank shall be discharged of its liabilities.
Rights of Parties involved in Bank Guarantee
A Bank Guarantee is considered as a tripartite agreement between three main parties, namely, the principal debtor (the customer), beneficiary (the creditor) and the surety/guarantor (the bank).
Rights of Surety
All those rights made available to the parties to the contract are made available to the surety. These rights are as the following:
- Right Against Principal Debtor:
- Right of Subrogation: According to Section 140 of the Indian Contract Act, if there is a default by the debtor in making the payment and the surety makes the payment, the surety is invested with all the rights creditor/ beneficiary had against the principal debtor. This is known as the principle of Subrogation.
- Right of Indemnity: According to Section 145 of the Indian Contract Act, if the surety (bank) fulfils the principal debtor's obligation by paying the amount in case of its default, then after payment is made, the bank can recover the same from the principal debtor. This applies only to the sums paid rightfully and not to the sums paid wrongfully.
- Rights Against Creditor:
- Right to Securities: Section 141 of ICA prescribes that once the surety has performed its obligation in case of default by the debtor, he is subrogated to all the rights available to the creditor/ beneficiary against the debtor. Similarly, the surety is entitled to the benefit of every security which the creditor has against the principal debtor at that time when the contract of surety is entered into. It is irrespective of whether the surety was aware of the existence of securities at that time.
- Loss of Securities: It means that if the creditor loses securities, then the surety is discharged from liability, though if securities are lost not due to negligence of creditors/ beneficiary, then the surety is not discharged from the liability.
Rights of Beneficiary
As the surety's liability is co-extensive with that of the principal debtor, according to section 128 of the Indian Contract Act, then the beneficiary can sue the bank in case of default by the principal debtor to fulfil the liability.
Is default by performing party essential for invocation of guarantee?
Bank Guarantees are an exception to the general rule as contained under Section 126 of the Indian Contract Act that there must be default in performance by the performing party, and there is a need to establish a default on the part of the performing party by invoking party. To enjoy the benefits of invocation, the beneficiary in a BG needs to do it before the expiry date of the guarantee. If the bank does not receive any claim on or before the validity period, it is discharged from its liability. The beneficiary has to send a letter to the bank detailing the circumstances requiring the encashment of the guarantee.
In Maharashtra SEB v. Official Liquidator, the Supreme Court stated that the board has a right to enforce payment of guarantee as money is payable on demand and not on the breach. A bank guarantee is also called as ‘on-demand guarantee’ or ‘unconditional performance of guarantee’, which means that in any case, the bank is liable to pay without the need of the creditor to prove that any breach or loss occurred because of that breach. It was further held that in case of default by the debtor, the creditor could ask for performance, and the bank is bound to indemnify the creditor without default.
In Road Machines India (p) Ltd v. Projects & Equipment Corporation India, it was observed that the invocation of a bank guarantee must not necessarily be initiated with the aid of setting out the whole case in the form of a plaint with a definite cause of action and also that it was a commercial document, not a legal notice or a pleading. It is enough if there's substantial compliance regarding the guarantee within the notice issued.
Despite this, the government, in a separate stance to counter the problem of non-honouring of guarantees by the banks in cases related to government departments, has come up with the solution of advising their departments to invoke guarantees only after careful consideration of the fact that there is a default according to the terms and conditions specified.
Many BGs contain clauses providing for a claim period. Suppose the beneficiary presents a claim after the expiry of the validity period but within the claim period. In that case, the bank can still be obliged to pay but the obligations of the bank to make payment on behalf of the debtor ends with the expiry of the claim period.