As we are aware, Bank Guarantees ("BG/BGs") are independent contracts that vest the beneficiary therein with a right to make a claim against the bank to pay for the loss suffered due to the default committed by a borrower. This arrangement is put into motion when a borrower's default under his contract with the beneficiary occurs within the lifetime of the BG i.e. the Validity Period ("Validity Period") and the beneficiary makes a written demand invoking the BG either within the Validity Period or in cases where a BG clause provides for a grace period to make such written demand i.e. the Claim Period ("Claim Period"), then within such Claim Period. In case, the Bank fails to honor its commitment, a beneficiary has the right to bring an action against the Bank before a court of law and enforce his right under the BG within a prescribed period from the date of default by the bank i.e. the Limitation Period ("Limitation Period").
The Limitation Period is generally prescribed by law i.e. the Limitation Act, 1963. Any agreement which curtails such Limitation Period would be rendered void by virtue of Section 28 of the Indian Contract Act, 1872 ("ICA"). However, in case of BGs, a specific Exception i.e. Exception 3 to Section 28 of the ICA was brought in by way of an amendment in 2013[i] ("2013 Amendment") which intends to save BG clauses containing a Limitation Period different from the one prescribed under the Limitation Act.
BGs are issued to ensure smooth cash flow in the business. Irrespective of its type, for e.g. Performance Bank Guarantee, Advance Bank Guarantee, Retention Money Bank Guarantee, Earnest Money Deposit, Bid Bonds etc., BGs come with a cost of their own. Banks generally issue BGs by taking some margin money from the borrower depending upon various factors including the borrower's financial capacity. The cost of the BG is directly proportional to the Validity Period and Claim Period of a BG which means, longer the Validity Period or Claim Period of a BG, larger the burden on the borrower.
Interestingly enough, Exception 3 itself allows, as an exception in case of BGs, what Section 28 otherwise prohibits. Exception 3 as such provides that contracts by which any bank or financial institution stipulates a term in a guarantee or any agreement making a provision for extinguishment of the rights or discharge of any party from any liability under such guarantee or agreement on the expiry of a specified period not less than one year from the date of occurring or non-occurring of a specified event for extinguishment or discharge of any party from the said liability, shall not be void in terms of Section 28. Thus, it is clear on a bare reading that, Exception 3 now allows banks and financial institutions to incorporate clauses providing for extinguishment of the rights of the beneficiary, or discharge of bank's liability on the expiry of a specified period, thereby curtailing the Limitation Period for a beneficiary to enforce his claim before a court of law. In order for such clauses curtailing the Limitation Period to pass muster of Section 28, the specified period must not be less than one year from the date when the cause of action arises.
Unfortunately, instead of incorporating clauses providing for extinguishment of the rights of the beneficiary, or discharge of bank's liability on the expiry of a specified period, the banks, on a mistaken assumption that the Exception 3 to Section 28 of ICA mandates a minimum one year Claim Period for a BG, have started the practice of stipulating a Claim Period of one year over and above the Validity Period of the BGs. This has become a cause of concern for the business community as well as the banking industry as keeping a Claim Period of one year, especially in BGs where the Validity Period itself is less than one year, invites a host of additional issues such as increase in unwanted costs, funds deposited in the form of margin money are locked in for a longer period, there is surge in working capital requirements, the liability of the bank is also extended, which all in all creates a discouraging environment for both the borrowers and the banking industry.
It is important to note at this stage that the clauses curtailing the Claim Period were never an issue as they never fell under the mischief of Section 28 and therefore have been held to be valid by various judicial pronouncements[ii]. Although, the 97th report of the Law Commission of India ("LCI") recommended that-clauses curtailing the Claim Period should also be covered under Section 28 by introducing a suitable amendment, this recommendation was not accepted by the Legislature and the subsequent amendment brought in i.e. the 1997 Amendment[iii], was conspicuously silent on this part[iv]. Clearly, Exception 3 cannot therefore, be read to mean and include Claim Period as clauses curtailing Claim Period anyway stood excepted from the ambit of Section 28.
Be that as it may, the scope of Section 28 has always been limited to striking down agreements/clauses which restricts a party's right to enforce his claim under a contract. However, certain judicial pronouncements misinterpreted the scope of Section 28 to also strike down clauses curtailing the Claim Period in a BG which governs the assertion of right. One such case was decided by a Single Bench of the Bombay High Court in the matter of Union of India v. Bhagwati Cottons Limited & Ors.[v] This misinterpretation was shortly set by the Division Bench of the Bombay High Court in an appeal i.e. IndusInd Bank Limited v. Union of India & Ors.[vi] where the Court while distinguishing between assertion of right and enforcement of right held that despite the amendment brought about in 1997, only the provisions curtailing enforcement of right would be void in terms of Section 28. However, the matter ended up travelling to the Supreme Court.
While upholding the validity of a clause restricting the Claim Period for assertion of right, the Supreme Court in Union of India & Ors. v. IndusInd Bank Ltd & Ors.[vii] ("IndusInd Bank Case") observed that it is a settled position of law that a clause which does not restrict the Limitation Period is not hit by Section 28. It was further observed that:
"Since we are not directly concerned with this amendment, suffice it to say that stipulations like the present would pass muster after 2013 if the specified period is not less than one year from the date of occurring or non-occurring of a specified event for extinguishment or discharge of a party from liability."
The above observation which was rendered in 2016 i.e. after Exception 3 was introduced, compounded the confusion regarding its scope. At first blush, it may seem that the observation supports the incorporation of a 'minimum one-year Claim Period' clause in a BG since the issue before the Supreme Court was regarding the Claim Period/assertion of right. So, when the Supreme Court observed that 'stipulations like the present would pass muster after 2013…', it led to a confusion that the Supreme Court was referring to the Claim Period in the context of the 2013 Amendment. This therefore led to a call from various quarters seeking introduction of another suitable amendment into Section 28, specifically excepting the Claim Period.
In our view, the Supreme Court's observation in the IndusInd Bank Case cannot be construed to refer to clauses curtailing Claim Period as such a clause has already been upheld by the Supreme Court in that very judgment in the context of Section 28 as it originally stood before 1997 Amendment. Thus, there would be no occasion for the Supreme Court to again refer to the 2013 Amendment in the context of Claim Period and observe that 'stipulations like the present would pass muster after 2013…'. It appears that the Supreme Court's observation was made in the context of clauses curtailing the Limitation Period which otherwise would be void in terms of Section 28 and certainly not in the context of clauses curtailing Claim Period. The legality of clauses curtailing the Limitation Period would pass muster of Section 28 after 2013 since Exception 3 now allowed banks and financial institutions to even specify the Limitation Period provided the same was not less than one year. Thus, the observation of the Supreme Court, by no stretch of imagination, can be deemed to have injected Claim Period into Exception 3 so as to mandate banks to provide a minimum one year Claim Period.
Although, we have not come across any judicial pronouncements interpreting the scope and the ambit of Exception 3, in our understanding the position of law regarding the scope of Exception 3 is clearly discernible from the language of the provision itself that it is certainly not mandatory and it only allows banks and financial institutions to incorporate clauses providing for extinguishment of the rights of the beneficiary, or discharge of bank's liability on the expiry of a specified period, thereby curtailing the Limitation Period for a beneficiary to enforce his claim before a court of law. In order for such clauses curtailing the Limitation Period to pass muster of Section 28, the specified period must not be less than one year from the date when the cause of action arises. As such there is no need for any further clarification or amendment in this regard despite popular misconceptions. However, given the prevailing confusion, a clear and authoritative judicial pronouncement on this aspect is a need of the hour.
Milanka Chaudhury is a Partner and Chaitra Bhat is an Associate at Link Legal. Views are personal.
[i] The Banking Laws (Amendment) Act, 2012 (Act No. 4 of 2013)
[ii] The Food Corporation of India v. The New India Assurance Co. Ltd. and Ors. AIR 1994 SC 1889; Explore Computers Private Limited v. Cals Limited & Ors. 131 (2006) DLT 477
[iii] Indian Contract Amendment Act, 1996 (Act No. 1 of 1997)
[iv] the terms "on failure to make a claim" as recommended by the 97th LCI Report were not included in the 1997 Amendment, thereby limiting the scope of bar under Section 28 to agreements/clauses curtailing enforcement of right before a court.
[v] 2008 (5) Bom CR 909
[vi] Appeal No. 258 of 2008 (Bombay High Court Division Bench, decision dated 20.04.2011)