Legal Implication of a Bank Guarantee

Submitted in partial fulfillment for internal component

for the award of the degree B.Com. LL.B. (Hons)

Submitted by

YASH ANAND
BC0160055

Submitted to

Professor K.G.R

TAMIL NADU NATIONAL LAW SCHOOL

TIRUCHIRAPPALLI – 620 009

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 DECLARATION
I, Yash Anand hereby declare that the project work entitled “Legal Implication of a 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. K.G.R, Faculty of Law ,
Tamil Nadu National Law School; Tiruchirappalli.

All information furnished in the project is true to the best of my knowledge and belief devoid of
plagiarism. If under the circumstances plagiarism is truly established, then the Law School may
be pleased to proceed with any action against me according to the University’s rules and
regulations.

Yash Anand

B.Com, LL.B (HONS.)

CERTIFICATE
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This is to certify that the Research Project entitled: “Legal Implication of a Bank Guarantee”
submitted to the Tamil Nadu National Law School; Tiruchirappalli, in fulfillment of the
requirements for internal component for B.COM; LL.B (HONS.), second Semester is an original
and bonafide research work carried out by Yash Anand under my supervision and guidance. No
part of this study has been submitted to any University for the award of any Degree or Diploma
whatsoever.

Date: 28-04-2017

Place: Tiruchirappalli

ACKNOWLEDGEMENTS
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At the outset, I take this opportunity to thank my Professor K.G.R, who has been of immense
help during moments of anxiety and torpidity while the project was taking its crucial shape.

Secondly, I convey my deepest regards to the administrative staff of TNNLS who held the
project in high esteem by providing reliable information in the form of library infrastructure and
database connections in times of need.

Thirdly, the contribution made by my parents and friends by foregoing their precious time is
unforgettable and highly solicited. Their valuable advice and timely supervision paved the way
for the successful completion of this project. Hence as a student, I am extremely grateful and
forever deeply indebted to him.

Finally, I thank the Almighty who gave me the courage and stamina to confront all hurdles
during the making of this project. Words aren’t sufficient to acknowledge the tremendous
contributions of various people involved in this project--- as I know ‘Words are Poor
Comforters’. I once again wholeheartedly and earnestly thank all the people who were involved
directly or indirectly during this project making which helped me to come out with flying colors.

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 Table of Contents

Chapter 1 MEANING OF A BANK GUARANTEE…………………….………………..…06

1.1. Introduction.…….….…………………… ………………….…………...…………06

1.2.  Meaning of Guarantee………………..…………………..……….………….……06

1.3.  Meaning of Bank Guarantee………………………………..…….………….……06

1.4.  Need for Bank Guarantee……….………………..…………………………….…07

Chapter 2 Contractual obligation in Bank Guarantee- analysis………….………….…….08

              2.1 Nature of Bank Guarantee .................................................................................….08

              2.2 Enforcement of Bank Guarantee ………………………………………………….09

              2.3 Unconditional Bank Guarantee ………………………………………….………...09

              2.4 Performance Guarantee by the Bank……………………………………………….10

             2.5Bank Guarantee vitiated by fraud………………………..…………………………10

2.6 General Principles Of Bank Guarantee …………………………………………11

Chapter 3 Judicial interpretation of legal obligation arising of Bank Guarantee………….13

              3.1 Invocation of Bank Guarantee…………………………………………………...…13

              3.2 Injunction against Invocation of Bank Guarantee ……………………….…..........14

Chapter 4 Conclusion………………………………………………………………………..…16

Bibliography…………………………………………………………………………………..17

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 CH 1: MEANING OF A BANK GUARENTEE:

CH 1.1: INTRODUCTION:

A contract is an agreement, enforceable by law, made between at least two parties by which
rights are acquired by one and obligations are created on the part of another. If the party, which
had agreed to do something, fails to that, then the other party has a remedy. It is a voluntary,
deliberate, and legally binding agreement between two or more competent parties. Contracts are
usually written but may be spoken or implied, and generally have to do with employment, sale or
lease, or tenancy1.

CH.1.2: MEANING OF GUARANTEE:

A contract of guarantee is a contract to perform the promises or discharge the liability of a third
person in case of a default. Anything done, or any promise made for the benefit of the principal
debtor, may be sufficient consideration to the surety for giving the guarantee2.

CH.1.3: MEANING OF BANK GUARANTEE:

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 to 3. A bank guarantee enables the customer (debtor) to acquire
goods, buy equipment, or draw down loans ,and thereby expand business activity4. A bank
guarantee is a commercial instrument in the nature of a contract, intended between two parties, to
secure compliance with the contract5.

1
M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 5
2
Section 126 , Indian Contract Act 1872
3
M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 425
4
Retrieved from http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2BUrtCDbP on 16 October 2017 at
7:21pm
5
Retrieved from  http://www.business-standard.com/india/news/how-bank-guarantees-work on 16th October 2017 at
7:21pm

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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 encash 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

CH.1.4: 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 you ample time to make your 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 seller6.

6
Retrieved from  www.eagletraders.com on 18th Oct 2012 at 10:00 a.m.

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 CH.2: Contractual Obligation in Bank Guarantee- Analysis:

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 between the Banker and the Beneficiary in whose favour
the Bank Guarantee has been issued7.

CH.2.1: 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 others8  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.” 9 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 India10 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.” 11

7
Alok Ray,  Enforcement of Bank  Guarantee: Limits of Court’s Interference, Economic Law Journal, University of
Chicago Press 12 1995, p.76
8
AIR 1981 SC 1426
9
M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 425
10
AIR 1997 Delhi 205
11
M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co., Delhi,1999,p. 425

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CH.2.2: Enforcement of Bank Guarantee

The proposition of law in respect of the encashment of a Bank Guarantee is well established. In
case of Hindustan Steel Workers Constn. Ltd. –vs- G.S. Atwal & Co. Supreme Court laid
down that there are two types of Performance Guarantees.  The first one is absolute and is
encashable on the very demand of the beneficiary and the demand according to the terms of the
Guarantee is conclusive.  In such types of Guarantees the Beneficiary is the Sole Judge or
Arbiter as to whether there is any breach of underlying or primary contract on the part of the
other party and as to how much amount is due to the former 12. The other type is where the
Guarantee is not encashable without proof of breach of underlying contract. However, in both
types of Guarantees, the Bank issuing the performance Guarantee is not concerned with the
underlying contract13. The duties in such Guarantees are created by the document itself which in
other words is independent and autonomous and is not concerned with the underlying contract
unless the Guarantee itself says that it will be enforceable on the proof of breach of the primary
underlying contract.

CH.2.3: Performance Guarantee by the Banks

Sometimes, banks give “performance guarantee” on behalf of a party to contract. The bank
giving such kind of guarantee is bound by the obligations undertaken by it. The performance
guarantee is an “autonomous” contract and imposes an “absolute obligation” on the banks in the
terms14. A bank guarantee, for all purposes, should be taken to be a credit not issued by the bank
in favour of the person in whose favour the bank guarantee has been issued, and it should be
encashable just like a credit note ordinarily, unless the intention of the parties is otherwise15.

CH.2.4: Unconditional Bank Guarantee

12
S.K.Kapoor, Contract -II, Central law Agency, Allahabad, 2007, p.9
13
ibid
14
Banwari lal v. Punjab state co-operative supply and marketing Federation limited, Chandigarh, A.I.R. 1982 Delhi
357, 360.
15
AIR 1986 Raj

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The nature of the obligation of the bank in case of Bank Guarantee was thus explained
in Hugglunds Drives AB v. National Heavy Engineering Co-op. Ltd.“The issuing bank is
bound to observe and honour the terms of the guarantee. The beneficiary of a bank guarantee
cannot be restrained from invoking the bank guarantee, and the issuing bank cannot be injuncted
from paying over the proceeds of Bank Guarantee save and except in the case of fraud which
vitiates the entire underlying transaction or in case where irretrievable injustice would be caused
by the invocation or encashment of the Bank Guarantee.

CH.2.5: Bank Guarantee vitiated by fraud

An unconditional bank guarantee is vitiated by fraud or likelihood of causing irreparable loss. If

there is fraud, etc, an injunction against encashment of bank guarantee can be issued.  In Rigoss
Exports International (P) Ltd. v. Tartan Infomark Ltd 16. The petitioner was engaged in a
business of readymade garments of different specifications. The respondent No. 1 was agents of
various garment importers at Singapore and other countries. The export agent procured
documents which were found to be forged.  The agent induced the party to give bank guarantee
with fraudulent intention to dupe the party. In other words, the bank guarantee was obtained by
fraud and, therefore, they stood vitiated. It was held that in such circumstances, the court can
intervene, and prevent encashment of bank guarantee.

So, the Bank Guarantee is a bipartite contract between the issuing bank and the beneficiary. The
bank is not a party to the contract between the beneficiary and the person at whose behest the
Bank Guarantee is issued. The issuing bank is not concerned with the terms of the underlying
transactions between the beneficiary of the Bank Guarantee and the person at whose behest the
Bank Guarantee was issued by the bank. Where the bank assumes an obligation to pay on
demand without demur, without reference to the underlying dispute, if any, between the partied,
it must honour the terms of its obligation.

CH.2.6: GENERAL PRINCIPLES OF BANK GUARANTEE

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AIR 2001 Delhi 285

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There are general principles of Bank Guarantee which have evolved out in the various decisions
of the Supreme Court as follows17: -

1) A Bank Guarantee is ordinarily a bipartite contract between the issuing Bank and the
beneficiary quite distinct and independent of the underlying contract, the performance of which it
seeks to secure. To that extent, it can be said to give rise to a cause of action separate from that
of underlying contract. If the document of Guarantee is in order, the Bank giving the Guarantee
must honour the same to make payment.

2. The commitments of the Banks under a Bank Guarantee must be honoured and the Court
should not interfere by granting injunction to restrain the performance of the contractual
obligations arising out of Bank Guarantee. The contract of Guarantee is a contract which the
Bank has undertaken to unconditionally and unequivocally abides by the terms of the contract. It
is an act of trust with full faith to facilitate free flow of trade and commerce in internal or
international trade or business.

3. The issuing Bank is bound to observe and honour the terms of Guarantee. The Beneficiary of a
Bank Guarantee cannot be restrained from invoking the Bank Guarantee, and the issuing Bank
cannot be injuncted from paying over the proceeds of the Bank Guarantee, except in the case of
fraud which violates the entire underlying transaction or in a case where irretrievable injustice
would be caused by the invocation or the encashment of the Bank Guarantee.

4. The existence of any dispute between the parties to the Contract is not a ground for issuing an
injunction to restrain enforcement of Bank Guarantee. But that does not mean that the parties to
the underlying contract cannot settle a dispute with respect to allegation of breach by resorting or
litigation or arbitration as stipulated in the contract. The remedy arising excontrace is not barred
and the cause of action for the same is independent of enforcement of Guarantee.

5. When the Principal Debtor is a sick industry under the Sick Industrial Companies (Special
Provisions) Act, 1985, the encashment of the Bank Guarantee can be proceeded with the consent

17
S.K.Kapoor, Contract -II, Central law Agency, Allahabad, 2007, p.9

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of the Board of Industrial and Financial Reconstruction (BIFR) or as the case may be, the
Appellate Authority.

But there is need for improvement in Bank guarantee. There is no written law for Bank
Guarantee there is immediate need for law as situations are becoming more technical. Moreover
court cannot issue injunction in bank guarantee except in exceptional cases which are decided by
the courts so there should be written laws. As we have progressed now bank guarantees are
transmitted electronically on a bank-to-bank basis. So one must be very concerned if presented
with a hard copy of a bank guarantee; it is likely a fraudulent instrument. This is not to preclude
pro forma writings of bank guarantees where the parties agree on the terms, and the applicant
takes these terms to the bank and has the bank incorporate them into the electronic bank
guarantee.

 It can be concluded that A Bank Guarantee is ordinarily a bipartite contract between the issuing
Bank and the beneficiary quite distinct and independent of the underlying contract, the
performance of which it seeks to secure.. Bank Guarantee is a reliable security instrument in both
international and domestic trade.

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 CH.3: 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 it 18. 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.

CH.3.1: 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 India 19, 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.

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

18
Retrieved from, “ http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2Av86oUML”, 22 Oct. 2017
19
AIR 2001 Delhi 236

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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 Bank of Baroda v. Ruby Sales Corporation (Agency) 20, 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 Ltd21, supply of cement by defendants to plaintiff for its project, the plaintiff had
furnished Bank guarantees for ensuring timely payments.

CH.3.2: 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.22 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,
Pune23,  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
20
AIR 2006 Guj. 251
21
AIR 2005 Del. 389
22
AIR 2006 Cal. 301
23
AIR 2005 Bom. 311

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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.

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 CH.4: Conclusion

Bank guarantees are simple, flexible and effective guarantee and plays 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.

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 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

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