Character of Performance Bank Guarantees 

The Reserve Bank of India ["RBI"] in its Master Circular on Guarantees and Co-Acceptances notes that banks execute both, performance guarantees and financial guarantees. These form a part of the contingent commitments of banks and are a useful tool for ascertaining the soundness of a financial system. Guarantees may be structured according to the terms of agreement, taking into account the terms of agreement, with respect to security, maturity and purpose. Interpreting the clauses of the contract to distinguish whether the guarantee is 'conditional' or 'unconditional' becomes vital to assess enforcement.

In this article, the method which courts use to interpret a contract to determine whether a guarantee is conditional or unconditional is elaborated upon. Further, the general characteristics of a bank guarantee determining the contractual obligations and liabilities of the parties under it are also discussed.

Distinguishing Conditional and Unconditional Guarantees

A conditional guarantee is one where the liability of the guarantor arises when proof of breach of terms of the underlying contract is given or proof of loss caused or both are given. In an unconditional guarantee, the liability attaches as soon as the demand is made in the manner given in the terms of the contract. Courts often interpret contracts to determine whether the guarantee is conditional or unconditional, since the nomenclature used may not be conclusive.

In Hindustan Construction Co. Ltd. v. State of Bihar & Ors. (1999), the Supreme Court was confronted with the question of whether the contract in question was a conditional or an unconditional guarantee. It noted that although the guarantee contained the phrase "agree unconditionally and irrevocably to guarantee" in the initial part, it was later qualified by the amount being payable in case the obligations in the original contract were not fulfilled "giving the right of claim to the employer for recovery of the whole or part of the advance mobilisation loan from the contractor under the contract." The guarantee contract in this case had referred to the original contract and postulated that the Bank would pay the amount due under guarantee only if the contractual obligations were not fulfilled or a portion of "advance mobilization loan" was misappropriated as specified in the clause of the original contract. In such a case, the beneficiaries could not be said to have an unfettered right to invoke the bank guarantee. The guarantee became conditional.

Mere reference to the principal agreement without reference to a specific clause in the preamble of the guarantee contract would not make the guarantee furnished by the bank a conditional one. On the basis of this, the Court in Mahatma Gandhi Sahakra Sakkare v. National Heavy Engg. Coop. Ltd. (2007) concluded that the guarantee was an unconditional one and refused to allow injunction against the guarantee. In Vinitec Electronics (P) Ltd. v. HCL Infosystems Ltd., (2008) it was further clarified that the recitals in the preamble of the guarantee contract could not control the operative part of the contract.

Character of Bank Guarantees:

1. A contract of guarantee is autonomous and independent of the underlying contract.

The Bank guarantee is an autonomous contract and imposes an absolute obligation on Banks to fulfill the terms of the contract (¶10). It is not qualified by the contract on performance of obligations, unless the terms of the underlying contract are specifically incorporated as was done in the Hindustan Construction Co. v. State of Bihar case (see above). Banks have their own credit at stake when granting such guarantees and cannot be prevented by the party at whose instance the guarantee was given, from honouring its commitment [Svenska Handelsbanken v. M/s Indian Charge Chrome and Ors. (1994)].

In Hindustan Steelworks Construction Ltd. v. Tarapore & Co. & Anr (1996), the question arose as to whether the liability under guarantee arises only after ascertainment of liability on account of breach of the underlying contract. It was contended that such liability could only be ascertained by the courts or arbitrator. The Supreme Court held that the contention was misplaced since a contract of guarantee is an independent contract and does not depend upon the underlying contract. The debt due could be ascertained by the beneficiary itself.

2. Bank is not bound by any arbitration agreement between the beneficiary of the guarantee and the party at whose instance the guarantee is issued.

Often, through an application under §9 of the Arbitration and Conciliation Act, 1996, parties attempt to get an injunction against the invocation of bank guarantee.^[1] In cases of unconditional bank guarantees, however, the encashment does not depend upon the adjudication of disputes between the parties. In U.P Coop. Federation Ltd. v. Singh Consultants & Engineers (P) Ltd. (1988) when a case from Allahabad High Court UOI v. Meena Steels Ltd. (1985) was cited to state that if the matter could be referred to arbitration, the guarantee was permitted to not be invoked, the Supreme Court stated that this view was unsustainable in light of the well settled principles of invoking guarantee.

In Larsen & Turbro Ltd. v. Maharashtra State Electricity Board & Ors. (1995) as well, declining to interfere with invocation on the basis of a pending arbitration was held to be justified. If the invocation is permitted to be delayed on account of a pending dispute between the parties, the purpose of granting such a bank guarantee would be defeated [UP State Sugar Corporation v. Sumac International Ltd. (1997)]. Where a party has observed forbearance in invoking the guarantee in light of the pending arbitration proceedings, but decided to invoke the guarantee when the contract of guarantee is about to expire, the Supreme Court held that such act of the party does not act as a bar in encashing the guarantee [National Thermal Power Corporation Ltd. v. Flowmore Pvt. Ltd. & Anr. (1995)].

The parties are still free to settle their disputes with regard to liability or amount after the invocation of guarantee. As was aptly stated in State of Maharashtra & Anr. v. M/s National Construction Company, Bombay (1996), "The remedy arising ex-contractu is not barred and the cause of action for the same is independent of enforcement of the guarantee."

3. Beneficiary is the sole judge of amount payable.

Even in cases where the matter may be seized by the courts or arbitration proceedings, invocation of the guarantee cannot be interfered with. In ONGC v. SBI (2000), the right to defend a suit filed for encashment of the guarantee was sought on grounds that the amount of liquidated damages was not stated and that arbitration proceedings were pending. The Supreme Court stated that these are not sufficient grounds to stop the encashment of the guarantee. In Larsen & Turbro Ltd. v. Maharashtra State Electricity Board & Ors (1995), the Supreme Court held that declining grant of injunction in light of dispute pending before the arbitrator was justified. Moreover, assessing the quantum of loss or damages or determination of debt due by the bank was not relevant, since beneficiary is the sole judge of the amount due and payable. This was clarified in Hindustan Steel Workers Construction Ltd. v. G.S. Atwal & Co. (Engineers) Pvt. Ltd. (1995).

Right of the contractor to recover amounts under running bills has no impact on the liability of the bank [General Electric Technical Services Comp. Inc. v. Punj Sons (P) Ltd. (1991)]. Further, it would not matter if the amount is payable towards 'security deposit' or 'mobilisation advance' or any other heading. The bank's liability attaches as soon as the guarantee is invoked and the amount becomes payable and the beneficiary remains the sole judge of whether there has been a breach of contract or not and also of the amount payable [Hindustan Steelworks Construction Ltd. v. Tarapore & Co. & Anr (1996)].

In Ansal Engineering v. Tehri Hydro Development Corporation (1996) it was reiterated that the bank would not be concerned about the finally determined sum payable after the award or adjudication; the only material consideration would be the quantification of liability when the guarantee is invoked. This quantification can be done by the beneficiary. If the invocation is within the terms of the contract, the amount becomes payable.

4. The guarantor cannot go into the merits of the demand.

This is an extension of the above principle that the beneficiary is the sole judge of the amount payable in cases of unconditional guarantees. A surety/guarantor cannot go into the merits of the demand and delay the encashment process. This principle follows the spirit of irrevocable letter of credit, as quoted by Justice Shientag in sztejn v. Henry Schsoder Banking Corporation, wherein he said:

"It would be a most unfortunate interference with business transactions if a bank before honouring drafts drawn upon it was obliged or even allowed to go behind the documents, at the request of the buyer, and enter into controversies between buyers and the seller regarding the quality of the merchandise shipped."

This judgment was quoted with approval in UP State Sugar Corporation v. Sumac International Ltd. (1997), where it was expressly provided that the guarantor could not question the demand or require proof of liability of the seller before fulfilling the terms of the guarantee.

5. Guarantee invocation must follow the terms of the contract.

Where the invocation does not follow the terms of the contract, it cannot be said to be a valid invocation. For instance, in Hindustan Construction v. State of Bihar (1998), the person authorized under the contract had not invoked the guarantee and this led to the invocation being bad. Banks were under no obligation to pay the amount. In the context of letters of credit, the Supreme Court in United Commercial Bank v. Bank of India (1981) had held that the documents required in invoking letters of credit must be in accordance with the contract; documents which are almost the same or which will do just as well will not be sufficient (¶37). Similarly, since bank guarantees are treated analogous to letters of credit (¶41), banks must honour performance guarantees in accordance with the terms of the same. Failure to do so, despite proper presentation of documents would amount to a repudiation of the contract as a whole.^[2]

In the next part, the rules and exceptions concerning invocation of bank guarantees are analyzed.