BANKING LAW ASSIGNMENT

TOPIC: BANK GUARANTEE AND ITS TYPES

SUBMITTED BY: SOUMYA MISHRA

ENROLLMENT: A8121520052

COURSE: BBA LLB (8th SEM)

SUBMITTED TO: Mr. KARAN RAMANI

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 INDEX

Serial
Number Particulars Page number
1 Bank guarantee definition 3-4

2 Uses of bank guarantee 4

3 Types of bank guarantees 4-6

4 Advantages and disadvantages of bank 6-7

guarantee

5 Laws related to bank guarantees 7-8

6 Injunction Over Encashment of Performance 8-9

Bank Guarantee
7 Case laws on bank guarantees 9-10

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Bank Guarantee

During business, banks are often required to provide guarantees on behalf of their customers
instead of their obligations or other requirement. The Indian Contract Act 1872, section 126
says that guarantee means a contract to perform the promise or discharge the liability of a
third person in case of his default. These guarantees can be of two types; one is where a bank
gives financial guarantees while another type of guarantee is for the performance of the
contract. A bank guarantee is a kind of guarantee from a lending institution. The bank
guarantee means a lending institution ensures that the liabilities of a debtor will be met. In
other words, the bank will cover the debt if the debtor fails to settle it. A bank guarantee
enables the customer, or debtor, to acquire goods, buy equipment, or draw down a loan.

A bank guarantee is a tripartite agreement between the banker, the beneficiary, and the person
or 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 generally approached because they have the financial capacity to meet
such obligations. It is a sort of an absolute undertaking to pay the amount whenever
demanded by the guarantee holder.1

Example:

Let's say ABC Construction Company is awarded a contract to build a new office complex
for XYZ Corporation. As part of the contract terms, XYZ Corporation requires ABC
Construction Company to provide a bank guarantee to ensure the completion of the project.

Parties Involved:

- Applicant: ABC Construction Company

- Beneficiary: XYZ Corporation

- Bank: XYZ Bank (issuing the guarantee)

Guarantee Amount: - ABC Construction Company agrees to provide a bank guarantee for
10% of the total contract value, which is Rs. 1,00,00,000 (One Crore Indian Rupees).

Terms and Conditions: - XYZ Corporation can claim the guarantee if ABC Construction
Company fails to complete the project within the agreed-upon timeline of 12 months

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Legalserviceindia.com/legal/article-1380-bank-guarantee.html

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Invocation of the Guarantee: If ABC Construction Company fails to meet its contractual
obligations, such as not completing the project within the agreed timeline, XYZ Corporation
can invoke the bank guarantee. XYZ Corporation would typically provide evidence of the
breach of contract to XYZ Bank, following the terms specified in the guarantee.

Upon invocation, XYZ Bank is obliged to fulfill the guarantee by paying the agreed amount
(Rs. 1,00,00,000) to XYZ Corporation. ABC Construction Company is then liable to repay
this amount to XYZ Bank.

.Uses of Bank Guarantee

1 When large companies purchase from small vendors, they generally require the vendors to
provide a guarantee certificate from banks before providing such business opportunities.

2. They are predominantly used in the purchase and sale of goods on credit basis, where the
seller is assured of payment from the bank in case of default by the buyer.

3. Helps in certifying the credibility of individuals, which in turn, enables them to obtain
loans and also assists in business activities.

4. Though there are lots of uses for a bank guarantee for the applicant, the bank should
process the same only after ensuring the financial stability of the applicant/business. The risk
involved in providing such a guarantee must be analysed thoroughly by the bank2.

The main types of bank guarantees are as follows:

1. Direct Guarantee: A direct bank guarantee is the most commonly used bank guarantee. In
the case of a direct bank guarantee, there are three parties involved in the transaction viz. the
bank, the bank’s customer, and the beneficiary who will receive the funds.

In a direct bank guarantee, the bank guarantees the funds to the beneficiary if certain events
take place. This means that if there is proof that the performance of certain predefined tasks
has taken place, then the bank will make a payment to the beneficiary if the corporate
customer fails to do so.

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https://cleartax.in/s/bank-guarantee

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2. Indirect Guarantee: Direct bank guarantees are generally undertaken in the case of local
trade. However, when it comes to international trade, there is a need to involve another party.
This is because a supplier in a foreign country may not be comfortable with receiving the
guarantee of a local bank. In the case of an indirect guarantee, there are four parties involved.
There is a local buyer, local bank, foreign supplier, and foreign bank.

The process is the same as above. However, the local bank issues a guarantee to the foreign
bank which then issues the guarantee to the foreign supplier

3. Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that
is offered to the exporter for a deferred period or for a certain time period. When a buyer
purchases capital goods or machinery, the seller will give credit to the buyer when the buyer's
bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this
type of guarantee, payment will be made in installments by the bank for failure to supply raw
materials, machinery, or equipment3.

4. Financial Guarantee: Suppose a party does not fully execute a particular project or
activity. In that case, money will be refunded according to a financial bank guarantee. Per the
financial guarantee agreement, the bank will pay any late fees associated with project
completion.

5. Advance Payment Guarantee: The seller will get an advance payment under this type of
guarantee. There will also be a guarantee that the buyer will get their money back if the seller
doesn’t provide the service or product on time.

6. Foreign Bank Guarantee: A bank offers a foreign bank guarantee on behalf of a

borrower. It will be made on behalf of the foreign beneficiary or creditor.

7. Performance Guarantee: In the case of a performance guarantee, the bank will

compensate you financially for any delays in the performance or operation.

8. Bid Bond Guarantee: The bank will use a supply bidding process for this kind of
guarantee. This will be done on behalf of the business owner, whether it is an industrial
enterprise, a construction project, or something else.

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https://www.bankbazaar.com/personal-loan/bank-guarantee.html

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Furthermore, the project’s contractor will ensure that the highest or best bidder has the power
and ability to carry out a project according to their preferences. The bank will give the
project’s owner a bid bond as security, meaning the project must follow the bid contract.4

Advantages of Bank Guarantees

Bank guarantees are helpful for many people and companies who are doing different kinds of
transactions. Here are some of the best reasons to use bank guarantees,

1. Risk Mitigation: This is an advantage Bank guarantees to give everyone interested in a

transaction some peace of mind and lower their risk. They give buyers and sellers peace of
mind that their interests will be protected in case of non-performance or failure.

2. Credibility: A bank guarantee makes the person giving it look more trustworthy. It shows
that you are committed and have a lot of money, which can be very important in business
deals, especially with people you don’t know.

3. Enables Global Trade: When you deal with other countries, bank guarantees are often
accepted. They help people from different countries trust each other more, which makes it
easier for businesses to do business across borders.

4. Flexible Payment Alternatives: Bank promises give you options for how to pay. As an
example, an advance payment promise lets buyers get advance payments and gives sellers
peace of mind that the money will be used correctly.

5. Smooth Real Estate Deals: When buying or selling real estate, bank guarantees are often
used to make sure that rent is paid on time or that building projects are finished. Adding this
protects both of you even more.

6. Protection in Advance Payments: Parties making advance payments can use bank promises
to make sure the money is safe. This makes sure the loan is used for what it was meant for
and gives the borrower a way to get their money back if they don’t follow through.

Disadvantages of Bank Guarantees

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https://navi.com/blog/bank-guarantee/

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While bank promises have some benefits, they also have some problems that come with using
them. People who are involved in deals need to be aware of these possible problems:

1. Costs and Fees: There are usually fees and costs involved in getting a bank guarantee, such
as issuance fees and yearly renewal fees. These costs can make the deal more expensive for
both the applicant and the recipient.

2. Getting Credit Lines Locked Up: For the person who gets the bank guarantee, it could
mean that they have to use some of their credit line or put up cash. This could make it harder
for them to get more credit for other things.

3. Complicated Process: The application process is complicated, which is a downside. The

steps needed to get a bank promise can be complicated and take a lot of time. There is usually
a lot of paperwork involved, and the approval process can take a long time.5

Laws regarding Bank Guarantees in India:

1. Indian Contract Act, 1872: Bank guarantees are essentially contracts between three
parties: the applicant (party seeking the guarantee), the beneficiary (party to whom the
guarantee is provided), and the bank (issuing the guarantee). The Indian Contract Act 1872,
section 126 says that guarantee means a contract to perform the promise or discharge the
liability of a third person in case of his default.

The provisions related to contracts, consideration, and obligations under the Indian Contract
Act govern bank guarantees.

2. Reserve Bank of India (RBI) Guidelines: The RBI, being the central bank of India,
issues guidelines and regulations related to banking activities, including the issuance of bank
guarantees. The guidelines may cover aspects such as the format of bank guarantees, the
permissible uses, and the terms and conditions for issuing guarantees.

RBI INSTRUCTIONS ON BANK GUARANTEES

1. Tenure- No bank guarantee should normally have a maturity of more than 10 years.

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2. Unsecured guarantees: The restriction of 20% on unsecured guarantees has been
withdrawn (w.e.f.17.6.2004) by RBI and banks' boards have been given the freedom to fix
their policies on their unsecured exposures.

3. precautions for averting fraud: Banks should refrain from issuing guarantees on behalf of
customers who do not enjoy credit facilities with them.

4. Restrictions on guarantees of inter-company deposits/loans: Banks should not execute

guarantees covering inter-company deposits/ loans thereby guaranteeing refund of
deposits/loans accepted by NBFC/firms from other NBFC/Firms.

5. Inter-institutional guarantees: Banks may issue guarantees favoring other banks/ Fls/ other
lending agencies for the loans extended by the latter, subject condition that the guaranteeing
bank should assume a funded exposure of at least 10% of the exposure guaranteed.

6. Payment of invoked guarantee: where guarantees are invoked, payment should be made to
the beneficiaries without delay and demur.6

3. International Chamber of Commerce (ICC) Rules:

The ICC Uniform Rules for Demand Guarantees (URDG) may also be relevant in the context
of international trade and finance, providing a set of rules and guidelines for demand
guarantees.

Injunction Over Encashment of Performance Bank Guarantee7

1. Fraud- The bank can put an injunction against the encashment of a bank guarantee if it is
prima facie evident that a fraud has been committed by the beneficiary and not by somebody
else8. A strong prima facie case is necessary to show the fraud, mere allegation of fraud will
not work. This is basically to protect the credit system, otherwise the beneficiary would be
claiming the payment to which he had no entitlement.
Irretrievable harm or injustice- If the bank guarantees harm or in any way leads to injustice to
one of the parties concerned then the creditor is not entitled to encash the bank guarantee, the
harm must be genuine and immediate.

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RBI notification on Master Circular-Guarantees, Co-Acceptances& Letters of Credit-UCBs
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laid down in the case of Hindustan Construction Co. Ltd. v. State of Bihar & Ors.,AIR 1999 SC 3710.
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U.P. Co-Op. Federation Ltd. v. Singh Consultants & Ers. Pvt. Ltd,(1998) 1 SCC 174

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3. Limits:- Banks lay down maximum monetary limits up-to which they would furnish
guarantees and open letters of credit at any point in time. The limits are fixed based on the
financial standing, the extent to which the account has been maintained by customers
satisfactorily, the volume of transactions, the past track record of the Counter client in respect
of such guarantees, etc. The limits are reviewed are re-fixed periodically along with monetary
limits for overdrafts, cash credits, etc. 9

4. Counter Guarantee:- This is an additional method other than fixing limits and taking
margin money as security. Banks invariably obtain the counter-guarantee from the principal
debtor before giving the guarantee, after this, the bank debits the client's accounts when the
invocation of the bank guarantee is done by the creditor to proceed legally against the client
in case of default by him to repay the amount.

5. Limitation Period
The period of limitation for enforcing the bank guarantee is three years from the date on
which the letter of guarantee was executed. The recovery procedure initiated after three years
is liable to be quashed. 10Till the time the account is alive i.e. it is not settled nor there is any
refusal by the guarantors to carry out the obligations, the limitation period does not start11.

CASE LAWS

1. Harbans Lal Malik v. State of Punjab (1976):

This case is significant as it established the principle that a bank guarantee is an independent
contract between the bank and the beneficiary. In this case, the Supreme Court of India held
that the obligation of the bank to honor the guarantee is not affected by any dispute between
the parties involved in the underlying contract. Even if there are disputes or discrepancies in
the main contract, the bank is bound to honor the guarantee once the conditions specified in

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https://efinancemanagement.com/sources-of-finance/bank-guarantee

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Annama Jose v. Kerala Financial Corpn, AIR 2002 Ker 396.

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https://www.legalserviceindia.com/legal/article-1380-bank-guarantee.html#:~:text=Bank%20Guarantees
%20are%20guarantee%20basically,the%20Buyer%20to%20the%20Supplier

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the guarantee are met. This landmark judgment emphasized the autonomy of bank guarantees
and laid the foundation for the principle of independence of the bank guarantee.12

2. U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers Pvt. Ltd.
(1988):

In this case, the Supreme Court of India clarified the scope of the bank's obligation under a
performance guarantee. The court held that a performance guarantee is an independent and
distinct contract, and the bank is obligated to pay the beneficiary if the conditions specified in
the guarantee are met. The court also emphasized that the bank has a limited role in
examining the documents and ensuring their conformity with the terms of the guarantee. This
case reinforced the principle of the autonomy of bank guarantees and highlighted the
importance of strict compliance with the terms of the guarantee.13

12
Supreme Court of India, Harbans Lal Malik v. State of Punjab, AIR 1976 SC 2332.

13
Supreme Court of India, U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers Pvt. Ltd., AIR
1988 SC 1952.

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