Restraining Payments "On-Demand": Liberal Or Restrictive Approach?

This article explores the situations in which the courts can interfere with the invocation of demands under these bonds. It studies the legal position and developments in the jurisdictions of United Kingdom, Singapore, India and Australia.

United Kingdom

In the United Kingdom, the threshold of interfering with the encashment of bank guarantee is very high, as demonstrated by the recent case of Tecnicas Reunidas Saudia v. Korea Development Bank.^[1] In this case, the English Technology and Construction Court went beyond the literal terms used in the guarantee bond in order to reach a commercially sound income. The high threshold of rejecting encashment has similarly been applied in other cases.

The Ground Of 'Fraud'

The ground of 'clear' or 'obvious' fraud has long been treated as the only ground for interfering with the invocation of bank guarantees. The UK Court of Appeals, in the Bolivinter Oil v. Chase Manhatton Bank, noted that beneficiary fraud known to the bank is the "wholly exceptional" ground for interfering with the payment.^[2] In RD Harbottle Ltd. v. National Westminister Bank Ltd,^[3] it was held that courts will interfere with the irrevocable obligations assumed by banks "only in exceptional cases". In fact, 'clear cases of fraud' was drawn as the only ground for allowing interference. The rationale provided was that these instruments are the lifeblood of commerce and must be allowed to be honored, lest the trust in international commerce be irreparably damaged. A similar position was taken in Edward Owen Engineering Ltd. v. Barclays Bank International Ltd.^[4]

The word 'fraud' was defined in the GKN Contractors v. Llyods Bank case, where the court accorded it to cover those situations where the beneficiary "knows at the time to be an invalid claim, representing to the bank that he believes it to be a valid claim".^[5] Thus, the ground of fraud may not be established even when the beneficiary knowingly claims an amount he is not entitled to, as long as such demand remains under the realm of 'mistaken belief'.^[6]

The reason for interference on the ground of fraud is sound. If a bank is aware of the fraudulent nature of claims, it should not be allowed to be reimbursed. The exception of fraud represents a limit on a bank's undertaking to make payments only for non-fraudulent claims. Further, the high standard of proof required for preventing payments on 'fraud' is logical since banks usually do not have time or expertise to investigate the validity of claims of fraud.

Moving Beyond 'Fraud'

The case of Simon Carves presented a unique opportunity to expand the jurisprudence to cover non-fraud cases. In this case, Ensus UK Ltd. ('Ensus') had employed Simon Carves Ltd. ('Simon') as a contractor. The terms of the contract required Simon to furnish a performance bond in favour of Ensus. However, it was also provided that the issue of 'acceptance certificate' by Ensus would render the bond 'null and void.' Shortly after, disputes surfaced about the alleged defects with the construction of the plant. Even though Ensus had issued an acceptance certificate, it nevertheless sought to enforce the performance bond. Simon sought to restrain this invocation, arguing that the bond had become 'null and void' under the terms of the contract.

In his ruling, Akenhead J. noted that "fraud" is not the only ground for granting injunctions in such cases. He further noted that if the underlying contract expressly prevents the beneficiary from making a demand under the bond, the courts can restrain the invocation.

Blurry Lines?

It is debatable whether the ground in Simon could fall under the head of 'fraud' itself, but Akenhead J. noted that it is a "second type of exception". An example covering this exception was provided: Where the parties reach a settlement to require the bond to be returned, but the beneficiary still invokes it in breach of that settlement. Notably, such an example may be covered under a clear case of 'fraud' where the beneficiary seeks to call on a bond when it is aware of the prohibition. In other cases, the example may be covered by the rather vague ground of 'unconscionability,' where the transaction itself would be in breach of good faith.

Satisfying Grounds Of Injunction

After establishing fraud, and the bank's knowledge of the same, the contractor will also be required to satisfy the usual grounds of an injunction, i.e., those of prima facie case, damages not being an adequate remedy, and balance of convenience. The grounds of American Cynamid case have also been affirmed in the context of bank guarantees in the Simon Carves case. The challenges in such cases are as follows:

• The challenge of proving a prima facie case: The contractor may find it difficult to prove a cause of action against the bank. This burden may be easier discharged in case the issuing bank is the contractor's own bank. However, in most cases, the process of payment disbursal under bonds involves a chain of banks, with one bank indemnifying the other. Such cases may present a huge challenge in securing an injunction.
• The challenge of balancing bank's reputation with a contractor's: The reputation of a bank may suffer in cases of restrain and interference by the courts. However, such orders may also pose a 'very real risk' to the creditworthiness and commercial reputation of the contractor, something that cannot be monetarily compensated as well. A crucial challenge before the courts will be to balance both of these interests.

The Autonomy Principle

In Sirius, the court observed the 'autonomy principle'. It was noted that the bank itself should not be concerned with the underlying sale between buyers and sellers at the time of invocation since letters of credit were "autonomous" instruments. The case of Themehelp Ltd v. West also evidences practice that courts may be more willing to grant injunctions against the beneficiary (preferably before a demand is made) than the bank, given that it is bank's right to make the decision of payment upon demand.

Singapore

As held in Bocotra Construction,^[7] Singapore courts allow interference on two independent grounds: fraud and unconscionability. While the former standard is akin to other jurisdictions, the ground of 'unconscionability' is an elusive one. Before we delve into this ground, it is important to contextualize the reasons behind the less stringent approach adopted by the Singapore courts.

Distinguishing Between Letters Of Credit And Performance Bonds

The Singapore courts differ from the UK Courts regarding their view on the distinction of the purpose and functions of letters of credit and performance bonds. The UK approach is that of treating bonds and letters of credit as being instruments with similar commercial purposes. In Simon itself, the court relied on Edward Owen to hold that the same principles apply to both of these instruments. The court also borrowed an appreciable amount of the reasoning from the Sirius case, which was a dispute on the invocation of a letter of credit.

On the other hand, Singapore courts distinguish between letters of credit and performance bonds. While the former has been treated as the lifeblood of international commerce, the latter merely denotes a secondary obligation that is only triggered upon the contractor's breach. The rationale for this distinction was explained in the case of JBE Properties v. Gammon.^[8] Here, it was noted that interfering with payment under a letter of credit would mean interfering with the obliger's primary obligation. However, a less stringent standard can be justifiable since it is a secondary obligation.

The Ground Of 'Unconscionability'

Keeping in view of this less stringent standard, the Singapore Courts have applied the ground of 'unconscionability' in addition to 'fraud' to allow injunctions. The courts have noted that excessive or unjustified demands, even though not rising to the threshold of 'fraud', may still be detrimental to contractors. This is to be contextualized in the realities of the construction industry, where liquidity is greatly important and even modest demand can interfere with the contractor's cash flow. Keeping this in mind, the courts in cases such as Mount Sophia v. Join-Aim Pte Ltd^[9] ('Mount Sophia') and Eltraco International v. CGH Development^[10] ('Eltraco') allowed for the exercise of unconscionability as a restraining ground. The following basic principles emerge from these cases:

• Like other jurisdictions, the courts in Singapore are also slow to interfere with the parties' independent allocation of risks. They expect the parties to stick to the deal that they have carved for themselves, as per Eltraco.
• A strong prima facie case has to be established for unconscionability, and the threshold for the same has been noted to be a "high one" in Mount Sophia. To judge the threshold, court look at the 'whole context' of the case rather than select pieces of evidence.
• Unconscionability imports notions of bad faith and unfairness. At the same time, a party is entitled to protect its own interest in the case of a genuine dispute.
• Courts do not indulge in a detailed examination of the merits of the case before them. The focus is on 'breadth rather than depth,' and the courts must be "alive to the lack of bona fides".

The definition of 'unconscionability' was laid down in the case of Ryobi-Kiso, where the High Court held that unconscionability refers to "unfairness, as distinct from dishonesty or fraud, or conduct of a kind so reprehensible or lacking in good faith that a court of conscience would either restrain the party or refuse to assist the party. Mere breaches of contract by the party in question…would not by themselves be unconscionable."^[11]

This high threshold was visible in the ruling of Tactic Engineering v. Sato Kogya.^[12] The court, in this case, held that the back charges claimed by the beneficiary could not be said to be abusive or excessive enough to establish that the bloating of numbers was 'unconscionable'. After looking at the evidence holistically, the court rejected Tactic's case on the ground of lack of a 'strong prima facie case'.

Considering the aforementioned cases, the parties must be mindful that the Singapore courts will not likely interfere with payment obligations under performance bonds.

India

The case law in India suggests two established grounds for restraining payment under performance bonds- "egregious fraud" at the time of execution of the contract; and "special equities" such that encashment would lead to irreparable injury. However, the recent case of Standard Chartered Bank v. Heavy Engineering Corporation establishes an additional ground of "irretrievable injustice".^[13] In other cases, such as U.P. Co-operative Federation Ltd v. Singh Consultants,^[14] it seems that the 'irretrievable injustice' is not a separate ground but an overarching consequence of 'fraud' or 'special equities' which must be avoided.

In any case, it is generally established that Indian courts are also slow to interfere with the guarantee payments unless there is strong evidence of the aforementioned factors. The courts in India, in the case of U.P. Co-operative Federation that trust in commerce would be 'irreparably damaged' should the court not restrict its interference with encashment of bank guarantees. Similarly, it was held in Dwarikesh Sugar Industries by the Supreme Court of India that the courts cannot be liberal in granting such injunctions. Like the UK Courts, the Indian courts have also treated this interference as an "exceptional case".^[15]

Another similarity to the UK jurisprudence is that the Indian courts also treat the letters of credit and bank guarantees to be similar instruments. The relevant case law is Himadri Chemical Industries, where the same principles were deemed to apply to both of these instruments.^[16]

The "Egregious Fraud" Ground

Unlike the English standard of 'clear fraud', the Himadri Chemicals case in India established the use of an aggravated standard of 'egregious fraud'. As laid down in this case, any actionable fraud in this context would mean one which vitiates the foundation of bank guarantee, and the beneficiary would be taking advantage of the situation. Moreover, it is vital that bank has knowledge of the fraud. Further, the evidence to establish fraud must be clear, and a mere assertion without strong corroborative evidence does not suffice.

In the case of Mercator Oil v. ONGC, it was clarified that the nature of the fraud must be egregious enough to vitiate the entire transaction. The word 'egregious' was defined to mean extraordinary, conspicuous, or flagrant bad conduct. Thus, the fraud must be so noticeable that it destroys the very foundation of the contract.

The "Special Equities" Ground

The ground of 'special equities' is vague and depends on the facts and circumstances of each case. In the case of Vinitec Electronics Pvt. Ltd v. HCL Infosystems Limited, it was clarified that irretrievable injustice and injury are related to special equities ground. While the judgment does not equate the two, there is a reason to believe that irretrievable injury forms a part of the 'special equities' ground.

The Indian courts have further relied on the famous US case of Itek Corporation v. The First National Bank of Boston to establish the nature of irretrievable injury and injustice. In that case, hostilities had broken out between US and Iran. Accordingly, the court held that if the American corporation was successful in obtaining a decree against the Iranian entity, it would be impossible to enforce the same. This situation, it was noted, amounted to 'special equities' and thus merited interference with the bank guarantee. The situation of civil unrest in Yemen also merited a similar finding in the recent case of Transrail Lighting Limited v. Public Electricity Corporation Republic of Yemen.^[17]

Lastly, the court in Hindustan Steel and Construction Ltd. v. Tarapore & Co. held that the irreparable harm should not be speculative but genuine.

The Autonomy Principle In India

It is also now clear that the disputes between parties relating to the termination of the underlying contract cannot impact the bank guarantee's invocation. Similar to other jurisdictions, the Indian cases of Ansal Engineering Projects^[18] and Himadri Chemicals Industries^[19] establish the 'autonomy principle'. These cases held that the beneficiary cannot be restrained even if there is a dispute between the beneficiary and the contractor unless these two grounds have been established. The reasoning behind such a decision is that the bank guarantee is a distinct and separate contract between the beneficiary and the bank; it is thus not qualified by the validity of the underlying transaction and contract. Reading otherwise would open possibilities of bankers arguing unconditional guarantees to be conditional ones.^[20] This principle has also been upheld in Hindustan Construction Co. Ltd. v. State of Bihar.^[21]

More recently, a very liberal application of this principle was seen in the Bharat Aluminum Company case, where encashment was allowed even though the corporate debtor was in a moratorium period. The rationale followed was that the identity and contracts of the guarantor and debtor were distinct and autonomous of each other.

Australia

As held in the case of Uber Builders v. MIPA, the beneficiary may be retained from seeking recourse from a bank guarantee when he is acting either 'fraudulently' or 'unconscionably'. Thus, the grounds in Australia are similar to the grounds in Singapore.

The Ground Of 'Fraud'

Much like other jurisdictions, the ground of fraud has been long established in the Australian jurisprudence. In the cases such as Wood Hall v. Pipeline Authority^[22] and Bolivinter Oil SA v. Chase Manhattan Bank NA,^[23] it has been established that a beneficiary will not be restrained unless there is a 'clear case of fraud' that the bank is clearly aware of. The evidence, as to both the fact of fraud and the knowledge of the bank, must be clear.

The Ground Of 'Unconscionability'

In the case of Olex Focas,^[24] unconscionability was said to connote circumstances in which the beneficiary attempts to call on guarantees without a belief that he was entitled to do so, or with the positive belief about the absence of such a right or entitlement. In Logue v. Shoalhaven Shire Council, it was established that insistence on rights where the circumstances make the same harsh or oppressive will amount to 'unconscionable' conduct.^[25] It was also held that unconscionable conduct involves a situation that invokes intervention of a court that, from the beginning, regards itself as a court of conscience.

The court in Uber upheld that even upon unconscionable conduct, the autonomy principle may be relevant to a claim for injunctive relief. Accordingly, the high threshold of unconscionability is easily established in the Australian cases as well.

While the jurisprudence of interference with bank guarantees' invocation is developing, sight must not be lost that the question of whether there has been a breach of contract and thus, whether there is an event to trigger the demand on bank guarantee, remains in the realm of the arbitral tribunal's power. Accordingly, there is an interesting interplay between proceedings in the local court granting injunctions pending any final rulings before arbitral tribunals.

The parties must consider that besides the high threshold of the required factors, compliance with the requirements of the demand under a bond may also be a fertile ground for challenge. The bonds, although on-demand, may still prescribe formal conditions of content or form of demand that are required to be satisfied for a valid demand to be made.^[26] The parties may also set a time limit on the period within which the demand can be made upon becoming aware of the breach, as demonstrated in the Oval case.^[27] Keeping the pitfalls in mind, parties must be careful while negotiating the scope of the demand according to their respective interests.

The author is a student at W.B. National University of Juridical Sciences, Kolkata.Views are personal.