Bank Guarantee

INTRODUCTION

In the modern era of globalization and increase in International as well as domestic trade, there is a high need of protection of money by some reliable source to reduce the risk in business transactions.

In the contemporary business conditions the business transaction are done globally and domestically, where parties are apart from each other, therefore a mediator institution is needed so that it would serve the original purpose of guarantee that provides security to payments or to other claims, so the concept of bank guarantee came into existence or was introduced. Bank guarantee is considered as the “life-blood” for the purpose of trade both domestic as well as international¹.

DEFINITION AND MEANING

Contract of Guarantee is defined under Section 126 of Indian Contract Act, 1872, which states “contract of guarantee is a contract to perform the promise, or discharge the liability of third person in case of default of that person. The person who promises to perform or discharge the liability of the third person is called the “Surety”. The person on for whom guarantee is given is called “Principal debtor” and the person to whom guarantee is given is called the “Creditor”.

Types Of Guarantee:

• Specific Guarantee – It pertains to a single debt or a single transaction.
• Continuing Guarantee –When guarantee is given for a series of transactions. In this guarantee, liability extends till the revocation of guarantee.
• Retrospective Guarantee –When guarantee is for an existing debt or obligation.
• Prospective Guarantee– When guarantee is for a future debt or obligation.
• Fidelity Guarantee – When guarantee is on the good conduct or honesty of a person employed in a particular organization.

A bank guarantee is a type of guarantee which is usually given by a lending institution. The bank guarantee means a lending institution ensures to meet the liabilities of the debtor on due date. In bank guarantee, the bank acts as a surety for the creditor. Bank guarantee plays a vital role in expansion of Business helping Entrepreneurs to grow. In other words, if the debtor fails to pay the debt on due date, the bank would pay the amount as a guarantor. A bank guarantee enables the debtor, customer to acquire goods, buy equipments or draw down a loan, etc.

During the course of analysis of the project, It first defines Bank guarantee as according to the Indian contract Act, 1872 with some illustrations for better understanding. Secondly, the project shows the usage as well as the relevance of the concept in the law of contracts. Thirdly, this paper explains the laws relating to Bank guarantee and intervention from judiciary for the enrichment of transactions of money through Bank Guarantee.

Illustrations: Ram requests Shyam to sell and deliver him goods on credit. Shyam agrees to do so, provided Pappu guarantees the payment of the price of the goods. Pappu promises to guarantee the payment in consideration of Shyam’s promise to deliver the goods. This is sufficient consideration for Pappu’s promise.  Here, ‘Ram’ is the debtor, ‘Shyam’ is the creditor and ‘Pappu’ is the surety.

Bank guarantee is a tripartite agreement between bank, debtor and the creditor wherein “Bank” is the surety for the transactions between the Debtor and Creditor. As being a tripartite agreement, three contracts are entered in total, namely Loan Agreement,Contract of Indemnity and Contract Of Guarantee.

1. Loan Agreement:

This written contract is entered between the debtor and the Creditor wherein debtor acts as promisor and creditor acts as promisee, under this contract, debtor keeps some amount of security with the Creditor for the loan advancement.

2. Contract Of Indemnity:

This written contract is entered between the Debtor and Surety, wherein debtor acts as indemnifier while surety acts as indemnity holder, this contract ensures security of losses to surety which surety might incur due to default in payment of debtor to the creditor.

3. Contract Of Guarantee:

A Contract of guarantee is a written contract between surety and the creditor, wherein surety acts as promisor and creditor acts as promisee, here surety guarantees to repay the amount which debtor may default to pay to the creditor on due date.

The concept of bank guarantee has been basically introduced for the free flow of the trade as guarantee given by bank secures the Creditor from any loss and also enables the creditor to claim the debt in case of any default by the debtor on due date without opting for the cumbersome process of litigation.

There are different kinds of bank guarantees, including direct and indirect guarantees. Banks typically use direct guarantees in global or domestic business, issued directly to the beneficiary. Direct guarantees apply when the bank’s security does not rely on the existence, validity, and enforceability of the main obligation.

Individuals often choose direct guarantees for international and cross-border transactions, which can be more easily adapted by foreign legal systems and practices since they don’t have form requirements.

Indirect guarantees occur most often in the export business, especially when government agencies or public entities are the beneficiaries of the contact of guarantee. Many countries do not accept foreign banks as guarantors because of legal issues or other form requirements. With an indirect guarantee, one uses a second bank, typically a foreign bank with a head office in the domicile of beneficiary’s country

Examples of Bank Guarantees[1]:

Because of the general nature of a bank guarantee, there are its different kinds:

• A payment guarantee assures a seller the purchase price is paid on a set/due date.
• An advance payment guarantee acts as collateral security for reimbursing advance payment from the buyer if the seller does not supply the specified goods as per the contract.
• A credit security bond serves as collateral security for repaying a loan.
• A rental guarantee serves as collateral security for rental agreement payments.
• A confirmed payment order is an irrevocable obligation where the bank pays the beneficiary a set amount on a given date on the client’s behalf.
• A performance bond serves as collateral security for the buyer’s costs incurred if services or goods are not provided as agreed in the contract.
• A warranty bond serves as collateral ensuring ordered goods are delivered as agreed.

For example, Desky Pilt is a new hotel which wants to buy $3 million worth kitchen equipment. The equipment vendor requires Desky Pilt to provide a bank guarantee to cover payments before they ship the equipment to Desky Pilt. Desky Pilt requests a guarantee from the lending institution, i.e. bank keeping its cash accounts. The bank essentially agrees to the purchase contract with the vendor as a guarantor.

Illustrations:

Mr. ‘Baldev’ leases his flat to Mr. ‘Amit’ for Rs. 100,000 per month. Mr. ‘Baldev’ insists on a bank guarantee from Mr. ‘Amit’s’ bankers, the ‘Bank of India’ for Rs.250,00,000 to compensate him in case Mr. ‘Amit’ refuse to hand over possession at the end of the lease period.

Here, ‘Amit’ is the principal debtor, The ‘Bank of India’ is the surety and ‘Baldev’ is the creditor, For any default of Mr. ‘Amit’, Mr. ‘Baldev’ can be indemnified directly by the ‘Bank Of India’.

Case Review[2]:

In the case ‘Maharashtra SEB v official liquidator’(AIR 1982 SC 1497) in Ernakulam, the Hon’ble Supreme court said that the board has a right to enforce payments of the guarantee as money is payable on demand and not only on breach. Bank guarantee can also be termed as the “On Demand guarantees” or unconditional Performance of guarantee which means that if any dispute arises the bank is liable to pay without the need of creditor to prove any breach or loss occurred because of that breach. In case of any default by the debtor in payment, the creditor is free to ask for the performance from bank, and the bank is bound to indemnify the creditor without any proof of default. Then it can be said that bank guarantee is “Absolute” and “Unconditional”.

This is necessary to save the creditor or debtor in case of advance, from the Very recently in the case of ‘M/S Adani Agri Fresh Ltd V Mahaboob Sharif & Ors’ Supreme court said that the Bank guarantee is an unconditional one. “The respondent, therefore cannot be allowed to raise any dispute and prevent the appellant from encashing the bank guarantee.” Also in the case of ‘Ansal Engineering projects Ltd v Tehri Hydro Development Corporation Ltd’(1996) 5 SCC 450), it was held that “a bank guarantee is an independent and distinct contract between the Bank and the beneficiary and is not qualified by the underlying transaction.” As the bank unconditionally and unequivocally promised to pay the due amount on demand, the Court thus held that “the liability of the bank was absolute and unconditional and could not be circumvented in any manner.” Further in the case of ‘Rawala construction co. v Union of India’(ILR 1982 Delhi 44), Hon’ble Supreme Court laid down that 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 to raise any objection.

NEED OF BANK GUARANTEE

The concept of bank guarantee was basically introduced to reduce the transaction risks. Bank guarantee enables various new firms to set-up quickly and efficiently, now firms can start-up with small sum of money as well. The Entrepreneurs who are starting their business and don’t have large sum of money to invest are benefited a lot as now they can raise their money in credit with the help of bank performing as a Surety and the creditor also in the bank’s name can easily provide loans without any risk as, if the debtor is unable to pay the debt on due date then, the creditor can be reimbursed by the Bank. The Bank guarantee not only secures the seller rather it also secures the advances or the payment made by the buyer.

There are various types of Bank guarantee being used in different circumstances according to their relevance and needs[3]:

Advance Payment Guarantee: This type of guarantee is generally used in the business transactions including exports and imports but it is also extended to Domestic trade. This guarantee is exercised by the buyers of goods to secure the Advances made by them.

Illustrations: ‘A’ orders machineries for his factory from ‘B’ the seller, Further ‘B’ wants some advances before the delivery of goods, advances made by ‘A’ but latter on the goods were not delivered and ‘B’ declared the agreement to be void, in these cases ‘A’ can recover his advanced money from the guaranteeing bank .

Thus it can be stated that there are many ways in which Bank Guarantee can be seen, but the major outlook is that, whether Bank is able to act as a surety, bearing some risk and helping individuals to grow or not.

 

 

 

 

[1] “Contract and Specific Relief” by Avtar Singh

[2] Manupatra

[3] Available at: http://www.indianlawcases.com

Author: Arunabh Srivastava,
Symbiosis Law School, NOIDA, 2nd Year