- NATURE OF BANK GUARANTEE: INDEPENDENT AND AUTONOMOUS
A bank guarantee is an undertaking by a bank or a banking institution to undertake to pay against the beneficiary’s demand for payment. Where a bank unconditionally and irrevocably promises to pay on demand (i.e. guarantees payment), the amount of liability undertaken in the guarantee without any reference to any dispute or demur happening, the liability of the bank becomes absolute and unequivocal. Under an unconditional bank guarantee, the guaranteeing bank’s liability becomes fixated when the conditions mentioned in the guarantee are fulfilled (for example, the production of a bill of lading by a seller/shipper in case of sale of goods). Such fulfillment of conditions mentioned in the guarantee instrument is to be seen without regard to the underlying main transaction between the person for whose obligation a guarantee is given and the beneficiary.
In the famous case of RD Harbottle (Mercantile) Ltd. v. National Westminster Bank Ltd., the obligation of the bank in the case of a guarantee undertaken by it was considered in the following terms:
“It is only in the exceptional cases that the Courts will interfere with the machinery of irrevocable obligations assumed by banks. They are the life-blood of international commerce. Such obligations were regarded as collateral to the underlying rights and obligations between the merchants at either end of the banking chain. Except possibly in clear cases of fraud of which the banks have notice, the Courts will leave the merchants to settle their disputes under the contract by litigation or arbitration as available to them or stipulated in the contracts. The Courts are not concerned with their difficulties to enforce the claims; these are risks that the merchants take. In this case, the plaintiffs took the risk of the unconditional wording of the guarantees. The machinery and commitments of banks are on a different level. They must be allowed to be honored free from interference by the Courts. Otherwise, trust in international commerce could be irreparably damaged.”
Therefore, the nature of a bank guarantee is that it is independent and autonomous of the underlying transaction, in the fulfillment of which it may be tendered. It and its enforcement is not qualified or circumscribed by the primary contract between the person for whom it is given and at whose instance it is given. Therefore, a bank must make good its promise to pay regardless of any dispute or proceeding between the parties. Therefore while considering whether or not a bank is liable to pay as per the terms of an unconditional guarantee, it need not, at all, in any scenario pay attention or give regard to what may be the underlying or primary transaction between the parties. In R.D. Harbottle, the Queen’s Bench of England explained the value of this feature of bank guarantees in the world of international commercial transactions.
This position was cemented in Indian law by the High Court of Delhi in the case of Banwari Lal Radha Mohan v. Punjab State Co-op Supply and Marketing Federation Ltd. Since an irrevocable bank guarantee is a separate transaction, the payment under it being at once made subject to invocation, shall not be stayed or stopped or impeded, pending any settlement of any disputes between the parties. Payment under a bank guarantee is such solid commitment that it is not even affected by any winding up order that may have been passed against the company that may have become bankrupt. A beneficiary is entitled to realize a bank guarantee only and only subject to the terms stipulated in the guarantee instrument, unaffected by any term in the main or underlying contract. The Supreme Court of India affirmed this position in the landmark case of Uttar Pradesh State Sugar Corporation v. Sumac International Ltd. In another case decided by it, it held that pendency of arbitration proceedings emanating from the underlying contract was not a reason to prevent the beneficiary from invoking the guarantees.
TYPES OF BANK GUARANTEES
There are two major types of bank guarantee used in businesses, which are as follows:
- Financial Guarantee – These guarantees are generally issued in lieu of security deposits. Some contracts may require a financial commitment from the buyer such as a security deposit. In such cases, instead of depositing the money, the buyer can provide the seller with a financial bank guarantee using which the seller can be compensated in case of any loss.
- Performance Guarantee – These guarantees are issued for the performance of a contract or an obligation. In case, there is a default in the performance, non-performance or short performance of a contract, the beneficiary’s loss will be made good by the bank. For example, A enters into a contract with B for completion of a certain project and the contract is supported by a bank guarantee. If A does not complete the project on time and does not compensate B for the loss, B can claim the loss from the bank with the bank guarantee provided.
DIFFERENCE BETWEEN BANK GUARANTEES AND LETTERS OF CREDIT
A Letter of Credit is a financial document that imposes an obligation on the bank to make payment to the beneficiary on completion of certain services as required by the applicant. Letter of Credit is issued by the bank when the buyer requests his bank to make payment to the seller on the receipt of certain goods or services. That is, when the buyer runs into cash flow difficulties or similar situations and thus cannot make immediate payment to the seller, he will approach his bank to make the payment to the seller on submission of certain documents. The bank will later recover the amount paid from the buyer along with the required charges.
On the other hand, under a Bank Guarantee, the bank is required to make payment to the third-party only if the applicant fails to make the payment to the third-party or does not fulfill the required obligations under the contract. A Bank Guarantee is essentially used to ensure a seller from loss or damage due to the non-performance by the other party in a contract.
Letters of Credit are generally misunderstood as Bank Guarantees since they share some common characteristics. They both play a significant role in trade financing when the parties to the transactions don’t have established business relationships.
- Harbottle (Mercantile) Ltd. v. National Westminster Bank Ltd (1972) 2 All ER 862
- POLLOCK & MULLA, Indian Contract & Specific Relief Acts 1369 (2012)
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