September 23, 2021

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Guarantee and bank guarantee contracts and effect of COVID-19 on the passing of injunction against the bank guarantee

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This article is written by Kshitij Pandey, a student of Dr. Ram Manohar Lohiya National University, Lucknow.

Table of Contents

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In the era of Globalisation and free trade, the need has occurred to protect high value investment and deals through some reliable source and reduce risks in these high stakes transactions. While financial institutions are protecting their loans through guarantee agreements, corporations and businessman have put their faith in Bank guarantees. Large trade or investment deals are backed by bank guarantees today to provide security in payments and have been considered “life- blood” in this case.

This paper will explain in depth about the guarantee and bank guarantee contracts and how they differ each other. Further, it will be explained whether injunction can be granted against issuing bank guarantees.

Guarantee contracts are defined under sec. 126 of the Indian Contract Act, 1872. It defines contract of guarantee as ‘a contract to perform the promise, or discharge the liability, of a third person in case of his default.’ The key function of a contract of guarantee is to secure the money borrowed from the lender by making a third party voluntarily liable in case of default from the borrower. The borrower in turn gets a loan, Goods on credit or an employment. In English Law, the contract of guarantee is defined as ‘a promise to answer for the debt, default or miscarriage for another’ i.e. It is a collateral agreement to be liable for the debt of another in case of his default.

The main parties to this contract are also defined in the section 126 of the Indian Contract Act, 1872. The person who secures the lending and gives the guarantee is called the Surety. The person in behalf of whom the guarantee is given i.e. the borrower is called principal debtor. The person who loans out the money or to whom the guarantee is given is called the creditor. Both the guarantor and the principal debtor are jointly and severally liable under the contract of guarantee. 

  • MODE OF SIGNING THE CONTRACT

A guarantee of guarantee in India may be either oral or written. In English law it should in written form and signed by the respective parties to the contract.

  • A PRINCIPLE DEBT

A contract of guarantee pre- supposes a principal debt or an obligation to be discharged by the principal debtor. It is the key ingredient of this kind of contract that there should be someone liable as a principal debtor and the surety undertakes to be liable on his default. The surety undertakes to be liable only if the principal debtor fails to discharge his obligation. 

  • A TRIPARTITE AGREEMENT

‘A contract of guarantee is a tripartite agreement which contemplates the principle debtor, the creditor and the surety’, this was held in the case of Swan vs Bank of Scotland in 1836

In P.J. Rajappan vs Associated Industries, the guarantor was involved in the debtors deal with the creditor as evidence showed, but he didn’t sign the contract while promising to do the same later on. Having not signed the contract, the guarantor said that he does not stand as the surety of the performance of the contract. The Kerala High court rejected the guarantor’s argument and stated that the contract of guarantee is a tripartite agreement. In a case where it is showed the involvement of the guarantor in the contract, the mere failure of not signing the contract does not completely discharge him of his duties as a guarantor i.e. paying the debt on the behalf of the debtor.

  • CONSIDERATION

As like any other contract, the consideration is also needed for a contract of guarantee. It is defined in section 127 of the ICA, 1872. It states that any promise or benefit done to the principal debtor should be a sufficient consideration to the surety for giving the guarantee. For the surety’s promise, it is not necessary that there should be direct consideration between the creditor and the surety, It is enough to show that the creditor had done something for the benefit of the principal debtor.

In State Bank of India vs Premco Saw Mill, the bank gave notice for the repayment of the loan and also threatened the debtor with legal action. The debtor’s husband however, agreed to repay the loan by becoming a surety and executed a promissory note in favour of the bank and the bank withdraws their legal suit. The court held that the patience and acceptance from the bank for not initiating legal proceedings against the debtor was a good consideration for the surety.

  • LIABILITY OF THE PARTIES

In a guarantee contract, the liability of the surety or guarantor is secondary. Primary liability is on the Principal Debtor to pay off the money borrowed from the creditor. Only on his default, the guarantor or the surety will be liable.

  • CONSENT OF SURETY SHOULD BE FREE 

As like any other contract, the consent of the surety should be free. This has been stated in section 142 or 143 of the ICA, 1872.The creditor should not obtain guarantee either by any misrepresentation or concealment of any material facts concerning the transaction. If the guarantee has been obtained this way, the guarantee is invalid. 

Bank guarantee

A Bank guarantee is an independent contract between the bank and the beneficiary. It is a contract on the behalf of the debtor who undertakes to pay the money and discharge the debtor of any liabilities in case of default.. In this case, the bank is the surety or the guarantor which provides for covering up or repaying the loan taken by the debtor. Bank guarantees are separate and independent contracts. It has nothing to do with the state of relations between the principal debtor and the creditor. 

These banks are professional guarantors for whom issuing bank guarantee is a financial service in exchange for a certain fee. The main idea behind introducing bank guarantees is for the free flow of trade as guarantees given by the banks secures the creditor from any losses and consequently help them to claim the debt in case of any default. For Ex: X leases his flat to Y for Rs. 2 Lakh Per Month. X insisted for securing this transaction for the lease and demands a bank guarantee from Y’s Bankers to compensate X in case of default or if Y refuses to hand over the possession of the flat after the expiry of the lease period. In this case Y is the principal debtor, Bank of India is the surety, and X is the creditor.

In the case of Maharashtra SEB vs Official Liquidator, A bank became a guarantor and undertook to pay the SEB a sum of Rs50,000 within 48 hours of demand on behalf of a supplier. The board demanded the payment. The supplier was a company which went into liquidation. The liquidator prevented the board from realising the guarantee and the bank from paying it. However, the supreme court held that the board has the right to enforce payments as the payments are made ‘On demand’ in guarantee.

Difference between guarantee contracts and bank guarantee

The difference can be stated as follows:

Parameters

Bank Guarantee Contracts

Guarantee Contracts

The parties

The parties under Bank guarantee contracts are the bank and the creditor. 

The parties under guarantee contracts are the surety, the principal debtor and the creditor.

Nature

A bank guarantee is an assurance or security provided to the lender/ creditor that it will repay the money in case of default from the debtor’s side.

A guarantee is a type of contract between the creditor i.e. an individual, a company or corporate institution and the borrower.

Payment 

When the debtor fails to make the payment, the bank is obligated to cover it.

When the debtor fails to make the payment, the guarantor is obligated to cover it.

Relation with the main contract/transaction

Under a bank guarantee, the contract is not qualified by the underlying transaction.

Under a guarantee contract, the guarantors are linked to the underlying transactions or contract.

Suitability

It is suitable for businesses as well as personal dealings with high money at stakes and have an uninterrupted flow of trade and business.

It is suitable for any individual, corporate institutions or businesses.

Injunction against invocation of bank guarantee

There are 2 types of bank guarantees on the basis of invocation can be granted :

  1. Conditional Bank Guarantees- In this case, the bank only pays the amount after certain conditions which might be enumerated in the guarantee contract, are fulfilled by the debtor. Conditions can be like- Proof of default, approval of a third party etc. To invoke the encashment of the bank guarantee, the conditions put forth in the contract have to be fulfilled. Injunction against encashment of conditional Bank guarantees can be granted by the courts in view of the facts of the case present and the beneficiary can’t have an unrestrained right to invoke the bank guarantees. Therefore, the invocation of the bank guarantee should be in strict conformity with the conditions on which the guarantee is issued.

In the case of Hindustan Construction Co. Ltd. vs State of Bihar and othrs. The supreme court held that that Under conditional bank guarantees, the beneficiary does not have an unfettered right to invoke the guarantee and demand immediate payment. The court further held that the conditions stated in the bank guarantee contracts have to be fulfilled in order to invoke the encashment of the bank guarantee.

In National Telecom of India Ltd. vs Union of India, 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 agreement, the amount was payable without on demand. 2 conditions were put up to be fulfilled for the bank guarantee :

  • There was a failure on the part of contractor to perform his obligations,
  • The amount claimed was by way of loss and damage to the government due to breach of contract like failure of supplying the goods beyond deadline etc.

The court held that the bank guarantee is invoked with the fulfilment of the above 2 condition.

To make a contract conditional, reference should be made to the specific clause present in the preamble of the guarantee agreement. Only referring to the underlying agreement will not suffice. In the case of Mahatma Gandhi Sahakra Sakkare vs National Heavy Engineering Corporation. The court stated retreated the above principle and held the contract to be unconditional and refused to grant injunction. In the case of Vinitec Electronics Ltd. vs HCL Infosystem Ltd., the court further clarified that the operative part of the contract will not be controlled by the preamble of the guarantee contract. 

2. Unconditional Bank Guarantees- In this case, the bank has to pay the amount immediately after the invocation of the bank guarantee. An unconditional bank guarantee ensure the payment “unconditionally and irrevocable” on beneficiary’s demand on invoking the guarantee. Unlike conditional bank guarantee, the bank undertakes to pay the guarantee without any conditions which makes the demand to invoke conclusive and binding. 

Injunction can’t be granted against unconditional bank guarantees as they are’ irrevocable’ in nature. The bank guarantees are separate and independent in nature. They have no connection with the underlying dispute and that’s why even if the underlying disputes between the debtor and the beneficiary is pending, the unconditional bank guarantees can’t be revoked.

In Hindustan Steelworks Construction Ltd. vs Tarapore & Co. the supreme court laid down the law in terms of the following propositions:

  • A bank guarantee is and independent and distinct contract between the bank and the beneficiary and is not qualified by the underlying transaction and the primary contract between the person on whose instance the bank guarantee is given and the beneficiary.
  • In the case of Unconditional bank guarantees, the nature of the obligation of the bank is absolute and not dependent upon any dispute or proceeding between the party at whose instance the bank guarantee is given.
  • It is only in exceptional cases where the injunction can be granted For ex- In the case of fraud or in the case where irretrievable injustice would be done if bank guarantee is allowed to be encashed.

These propositions were reiterated in the case of UP Coop Federation Ltd. vs Singh Consultants and engineers (P) Ltd. 2 bank guarantees were furnished by a contractor for the construction work of a Vanaspati plant. The bank in the case took the responsibility to repay the amount ‘On First demand’ and not revoke to revoke the guarantees up to a fixed date. Dispute arose between the Board and the contractor. The contractor wanted an injunction against the encashment of the bank guarantees. The Supreme court held that the bank has to pay at the moment when the demand is made without any complaints and contestation, irrespective of the dispute between the parties. The court further stressed on the point that the unconditional bank guarantees should only be restrained in cases of fraud, irretrievable harm and special equities.

The court cited a New York Supreme court case of Sztejn vs J. Henry Schroder Banking Corp. where the beneficiary forged some documents and created a false representation about the materials shipped in, which were ‘worthless/rubbish’ according to claimants. The claimant moved the motion of granting injunction on the bank guarantee. The supreme court held that there was fraud on the part of the beneficiary and an injunction should be granted to stop issuing the bank guarantee and make payment.

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To narrow it down, there are 3 exceptions where injunction can be granted against the encashment of the bank guarantees.

The supreme court in the case of Reliance Salt Ltd. vs Cosmos Enterprises referred to section 17 of the Indian contract act, 1872 and held that fraud would include any act committed by any party so as to deceive another party and induce the party to enter into the contract thereby without free consent. 

In the case of Up State Sugar Corp. vs Sumac International Ltd., the supreme court held that in case of unconditional bank guarantees, fraud should be of such nature that ‘It vitiates the very foundation of bank guarantees’. The supreme court further held in the case of General Electric Technical Services Co. Ltd. vs Punj Sons (P) Ltd., that fraud committed should be of ‘egregious in nature’ and should only be committed by the beneficiary. This principle was also retreated in Hindustan Steelworks Construction Ltd. vs Tarapore & Co. that the fraud committed should be egregious and should vitiate the entire underlying transaction. 

The same principle was also retreated in the case of State trading corporation of india vs Jain sons clothing corporation where the nature of fraud was interpreted. The court held that that the injunction in the case of fraud will be granted only if the fraud occurred at the time of entering into the underlying transaction or contract with the bank or at the time of issuing the bank guarantee. This was reiterated in the case of Adani Exports Limited vs Marketing Services, where one of the parties who were the supplier fraudulently changed the dates of shipment to invoke the bank guarantees. The court granted the injunction and also on the ground that the fraud had been made on the underlying transaction.

  • Irretrievable harm/ injustice and unjust enrichment

Under this head, If the bank guarantees are invoked, it can cause irretrievable harm or unjust enrichment to one of the parties to the contract. Unjust enrichment principle is derived from the maxim ‘Nemo Debet Locupetari ex aliena jactura’ i.e. no man should grow rich from someone else’s losses. 

The supreme court dealt with the principle of unjust enrichment and irretrievable harm to a party relating to bank guarantees in the case of Klenn & Marshall Manufacturers vs Reserve Bank of India. In this case a contract was entered between 2 parties for supply of certain equipment. The plaintiff had furnished 2 bank guarantees for delivery of goods and payments. The defendant invoked the bank guarantees but the bank refused to pay on demand. The Banking Ombudsman had passed an order after being approached by the defendant, for paying the amount of guarantee stipulated on demand. The plaintiff on the ground of irretrievable harm filed a petition for an injunction to the encashment of the bank guarantees. The plaintiff defended his stance by arguing that the goods were supplied but the defendant didn’t make any payment and also invoked the bank guarantees for his own profits and unjustly enriching himself at the cost of the plaintiff. Further, the issuing of bank guarantees could lead to a complete loss and shutdown of plaintiff’s business. The court however ruled in favour of the plaintiff and rejected the plaintiff’s argument.

The principle was retrieved in the case of Himadri Chemicals vs Coal Tar refining Co. where the court laid down the exception of irretrievable harm or injustice if certain encashment of bank guarantees are allowed.

  • Special Equity 

The term ‘special equities’ is a wide and a broad concept which allows injunction against encashment of bank guarantees only in special circumstances. In India, the term was coined by the Calcutta high court in the case of Texmaco Ltd. vs State Bank of India. In the case of Ansal engineering Projects Ltd. vs Tehri Hydro Development Corporation, the supreme court adopted the principle of special equities as an exception to injunction against bank guarantees. The concept of special equities is considered as a measure for providing relief to the parties due to harm suffered in special and extraordinary circumstances. 

Special equites should also be interlinked with irretrievable harm or injustice to justify an injunction to issue bank guarantees. This was held in the case of Svenska Handelbaken vs Indian Charge Chrome. In this case, the court cited an American case which is Itek Corp. vs First national bank of Boston. Where the injunction against issuing the bank guarantees was allowed due to war like situation in Iran. This principle was clarified in the case of Dwarikesh Sugar Industries Ltd. vs Prem Heavy Engineering Works (P) Ltd. & Othrs. Where the court stated that injunction should be allowed only when there is no possibility of recovery and the performance of the contract becomes frustatedor impossible.

In Other nations, injunction against issuing of bank guarantees is given owing to war like situations. In Bhel vs Egyptian Electricity Transmission Company, some of the part of supplies could not be made due to war situation in Egypt. The Delhi high court held that this will amount to force majeure and special equities will exist because the plaintiff cannot recover the amount under guarantee. If the amount is encashed, it will unjustly enrich the defendant. Similarly was the case in Transrail Lighting Limited vs Public electricity corporation where the court granted the injunction to the plaintiff on account of civil unrest in Yemen

Whether The term special equities can be used interchangeably with irretrievable injustice exception is still unclear. Although in practise it is used. In the case of General Electric Technical Services Comp. Inc. vs Punj Sons (P) Ltd., The court spelled out the exceptions as ‘ fraud and special equity in the form of preventing irretrievable injustice between the parties’. Here, special equity and irretrievable injustice or harm was interlinked together in the judgement. Another case is of Indu Power Projects vs UOI, where the Delhi HC that the terms irretrievable injury or injustice can be used interchangeably with special equities. However, in the recent judgement of Standard Chartered Bank vs Heavy Engineering Corporation, the exceptions were stated as ‘ fraud, irretrievable injustice and special equities’. Under this case judgement the exception ground on Irretrievable injustice and special equities were held to be separate and distinct from each other.

COVID-19 under special equities as a ground for Injunction

COVID-19 has shocked the people and the world economy. Large companies and industries have been shut done, trade deals have been cancelled and have also reports all time high losses in this period. The pandemic has also deeply affected the contractual obligations of the parties and covid- 19 has been considered as a force majeure event which comes under the exception of special equities. However, most of the courts have not yet agreed to grant injunction on bank guarantees solely on the basis of the pandemic.

A) Stance of Delhi HC in Vedanta Case

In the case of Haliburton Offshore services vs Vedanta Ltd. the petitioner i.e. Haliburton offshore services entered into a contract with Vedanta Ltd. for setting up of infrastructure which included oil wells. The petitioner almost completed the project on time as scheduled and mentioned in the contract. But due to the emergence of COVID-19, Nationwide lockdown was implemented which meant complete lockdown of industrial activities as well. This consequently resulted in petitioner defaulting on his contractual obligations and non- completion of the project at the agreed timeline. The respondent terminated the contract and invoked the encashment of 8 bank guarantees. The petitioner filed a petition under section 9 of the arbitration and conciliation act, 1996 for seeking an injunction against encashing the 8 bank guarantees. 

The Delhi HC ruled in favour of the petitioner and passed an order for an interim injunction against encashment of the 8 bank guarantees. The court held that the non- performance of the contractual obligations by the petitioners side was strictly because of the nationwide lockdown due to COVID-19 pandemic which was prima facie in the nature of force majeure. The Delhi HC relied on the judgement of the case of Standard Chartered Bank Heavy Limited vs Heavy Engineering Corporation Limited. And reiterated the principle that Special equities exception is distinct from irretrievable harm and that ‘special equities’ can be used as a ground for granting injunction.

The Court further clarified in the Vedanta case judgement that mere occurrence of the covid- 19 pandemic and nationwide lockdown would not justify every breach or non- performance of the contracts. The conduct of the parties prior to lockdown will be assessed relating to their performance on their contracts and then the court will decide whether to grant an injunction or nor. Consequently based on this part of the verdict, the Delhi high court refused to grant injunction against issuing the bank guarantees in the case of Indhirajith Power Private Limited vs UOI. In this case the petitioner didn’t follow the contractual obligation on his part since April2018 and that is to construct and establish a mining project in Maharashtra. An extension of 12 months was given but they still didn’t comply with the terms and completed the project. As a result the court refused the injunction and held that the lockdown is merely an excuse to restrain the petitioner to invoke the issuing the bank guarantees.

B) Stance of Bombay HC on the Standard Retail case

In the case of Standard Retail Pvt. Ltd vs M/S G.S. Global Corp. and Othrs, the petitioners stated that they could not perform their part of contractual obligations due to Lockdown and COVID-19 while the other party based in South Korea did perform the same. Therefore, the petitioners under section 9 of the arbitration and conciliation act, 1996 filed a petition for restraining the respondents and granting injunction against encashing the bank guarantees The Bombay High court Rejected the argument and ruled in favour of the petitioner and ruled that Covid-19 and subsequent Lockdown would not be treated as force majeure in this case. Because: 

  • The force majeure clause in the said contract was wholly one- sided, where the seller would be the only one to invoke this clause.
  •  Further the exporter from South Korea had complied with his contractual obligations and therefore the contract was not impossible to perform under the Lockdown period. 

 The Bombay HC also further held these propositions:

  • Absolute impossibility of performance of the contract is needed in invoking the force majeure clause in seeking the injunctions under special equities.
  • If the movement of good is not restricted totally, the same can be performed and can’t be impossible to comply with.

Bank guarantee have been an indispensible part for big businessman and industries to protect their large investment and deals. However, it has not been free from legal suits as to its nature and the injunction against issuing them as seen from the analysis and case study in this paper. They really help in free flow of national and international trade and as seen from the study done in the paper. A lot of industries from different countries enter into high stakes commercial contract and bank guarantees are needed to reduce the risks of their investments. The grounds of exception are still not clear as courts have been dwindling and not fixating their judgements on one principle. Irretrievable harm and injustice has been partially replaced by the ground of special equities. 

The ground of Special equities have been a sigh of relief for the parties who even without their own fault are restrained from fulfilling their obligations just because of situation out of their control like war, political unrest etc. However, its stance is still not clear as COVID-19 pandemic has thrown a lot of questions to the courts. Force majeure is a complex subject in a contract as it can save parties from losses but also unjustly enriches another when the other party when they has not been fulfilling their obligations. Thankfully, the court has struck a balance between them 2 and stated held that mere lockdown and pandemic would not nullify the contract and declare impossibility of performance as seen by the judgement laid down by the Bombay and Delhi high court recently. Even though, bank guarantees have been a reliable source of recovering the payments has earned the faith of the business world.

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