BANK GUARANTEE AND ITS LEGALITIES

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Meaning: A bank guarantee is a tripartite agreement between the banker, the beneficiary and the person or the customer, whereby an undertaking is given by the bank that it will pay the beneficiary a definite sum of money, or arrange the performance of the obligations of the client in the possible event of his default. 

Banks are generally approached because they have the financial capacity to meet such obligations.  It is primarily a sort of an absolute undertaking to pay the amount whenever demanded by the guarantee holder.

  • A bank guarantee contract is distinct and independent from the underlying contract that exists between the beneficiary and the creditor. i.e. the relationship status between the guarantee holder and the person on whose behalf the guarantee is given does not affect the bank guarantee contract. And this feature plays a pivotal role in regulating the liability of the banks in the event of default by the debtor.

  • Bank guarantee not only protects the creditor from the loss but it also gives the right to the creditor to claim debt in case of default without the lengthy process of litigation. It basically facilitates the free flow of the trade.


Bank Guarantees are guarantee basically given by Suppliers/Contractor’s Bank in favour of the Buyer/Principal:

  • As security against initial and stage payment made by the Buyer to the Supplier.

  • As security against performance of the contract.

  • Towards liquidated damages in exceptional cases of large value contracts etc.

  • Towards earnest money deposit.

Bank guarantee is also called ‘first demand’ or ‘on-demand’ guarantee because they are paid against the beneficiary’s first written demand for payment and no further documentation or proof of default is required.

 

Types of Bank Guarantee

  1. Advance Payment guarantee- It is mostly used in export and import business. However, with the advancement of business and trade, this guarantee has now been extended to domestic trade as well. This is mostly used by the buyers of goods to secure the advance payment made by them. Advance guarantee paid can be recovered as it is the primary obligation of the bank which is giving the guarantee.

  2. Payment Guarantee-  This is a more secure guarantee because collateral securities are given with this type of guarantee, in the event of default by the debtor the bank can recover the given amount from the collateral securities given by the debtor. In short, it binds the debtor to make the payment. 

Liability under Bank Guarantee

  • The amount of liability undertaken in a bank guarantee without any objection or dispute under the terms of guarantee is absolute and unequivocal.

  • As per Sec. 128 of the Indian Contract Act, 1872, the surety’s liability under the normal guarantee is co-extensive with that of the principal debtor i.e. the liability of the guarantee is to the same extent as that of the principal debtor. 

  • While in a bank guarantee the bank becomes liable when the conditions in the guarantee instruments are fulfilled without regard to the transaction between the beneficiary and the person for whose obligation the guarantee has been given i.e. the liability may arise even when such later person has not been in default, his actual liability under that transaction would be much less than the amount paid under the unconditional guarantee.

  • The bank guarantee can be imposed simply without scrutinizing into the nature of the transactions between the Bank and the customer that led to the furnishing of the bank guarantee.

  • The bank has to pay irrespective of any objections raised by the person at whose instance the guarantee has been given and cannot raise a contention regarding the breach by the principal debtor.

  • Also, any changes in a contract put in effect by one of the parties do not affect the liability under the guarantee. The bank may reject the bank guarantee if the beneficiary is not able to show that the all the required terms in the bank guarantee are fulfilled, in cases where all the requisites are fulfilled the bank has to make the payment.

Invocation of Bank Guarantee

A beneficiary can at any time invoke the bank guarantee, in such situation the bank has to only confirm that all the terms and conditions of the contract of the guarantee are satisfied after due examination. However, the invocation is based on the terms of the guarantee. 


Exceptions
Exceptions Payment under a bank guarantee may be refused of restrained: 

  1. Fraud- If it is prima facie evidence that a fraud has been committed by the beneficiary then the bank can put a stop against the encashment of bank guarantee. A mere allegation of fraud will not suffice the purpose of strong evidence to prove the same is a must.

Irretrievable harm or injustice- If the bank guarantee tends to harm or any way leads to injustice to one of the parties concerned then the creditor is not entitled to encash the bank guarantee, the harm must be genuine and immediate.

  1. Safeguards taken by banks: To reduce the risks to which the banks are exposed while furnishing bank guarantees on behalf of their clients, banks resort to the following to safeguard their interest.

 

  • Limits & Margins: Banks lay down maximum monetary limits up-to which they would furnish guarantees and open letters of credit at any point of time. The limits and margins fixed are based on many factors such as the financial standing, extent to which the account has been maintained by customers satisfactorily, the volume of transactions, past track record of the Counter client in-respect of such guarantees etc. The percentage of margin ranges from ten to fifty percent of the bank guarantee. The margin money is released once the principal debtor has fulfilled its obligation towards the bank. The limits and margins are reviewed and are re-fixed periodically depending upon the changes in the environment

  • Counter Guarantee: Apart from fixing limits and taking margin money as security. Bank also opts for counter-guarantee. Bank invariably obtains the counter-guarantee from the principal debtor before giving the guarantee, after this the bank debits the client’s accounts when the invocation of bank guarantee is done by the creditor in order to proceed legally against the client in case of default by him to repay the amount.

  • Limitation Period: The limitation period for enforcing the bank guarantee is three years from the date on which the letter of guarantee was executed. Recovery procedure initiated after three years is liable to be quashed.  It should be noted that till the time the account is alive i.e. it is not settled nor there is any refusal by the guarantors to carry out the obligations, the limitation period does not start.


Bank Guarantee and International Business

The bank guarantee is a unilateral legal transaction by which a bank as a guarantor undertakes an obligation to guarantee to pay the beneficiary a certain amount of money specified in the guarantee if certain terms and conditions are fulfilled, or if the debtor from the original contract does not fulfil his/her contractual obligations or if the obligations are fulfilled improperly. In international business, sellers are usually unaware of the financial situation of the customer and the results of his/her operations thus, there is always certain amount of risk present in the sales contract especially when it comes to the shipment of good without securing its payment.
In such events, bank guarantee brings down or eliminates the risk because the bank which gives the guarantee is also directly responsible towards the seller, i.e. the seller is assured that in case of any default the bank will pay the amount. Thus bank guarantee is an independent legal transaction, this feature of bank guarantee gave it an impetus in matters of international trade so today we can hardly imagine and conclude any serious contract with a foreign partner without its fulfilment being provided through a bank guarantee.

Bank guarantee has an upper hand when compared with the other means of personal security, because of its abstractness. Lack of accessory in bank guarantee provides for broader protection of economic interests of the creditors. Bank guarantee occurs as an institution that significantly influences the improvement of international economic relations. 

With bank guarantees, companies from the less developed countries enjoy a great deal on the competitiveness of their offerings in international affairs, because with their acceptance contractual partners are not placed in a less advantageous position in terms of risk of realization of their claims. Bank guarantees have, thus, creating a higher level of security for creditors and has also significantly affected the stabilization of relations in the international market. In the modern scenario where there is a huge distrust among the participants of the global business scenario, contracts or deals should be done with well-known and reliable business entities and bank guarantee is only backing this concept to great extent.
 

NOTE: As per RBI in terms of Regulation 4 of the Foreign Exchange Management (Guarantees) Regulations, 2000 notified by Notification no. FEMA.8/2000-RB dated May 3, 2000. Authorized Dealer banks are allowed to give guarantees in certain cases, as stated therein.

 

  1. Issue of Bank Guarantee in favour of Foreign Airlines/IATA: The Indian agents of foreign airline companies, who are members of International Air Transport Association (IATA), is required to furnish bank guarantees in favour of foreign airline companies/IATA, in connection with their ticketing business. This being one of the standard requirement of the business, Authorized Dealer banks in their ordinary course of business have the power to issue guarantees in favour of the foreign airline companies/IATA on behalf of Indian agents of foreign airline companies, who are members of IATA, in connection with their ticketing business.

  2. Issue of Bank Guarantee on behalf of Service Importers: In order to liberalize the procedure regarding the import of services, it was decided by the RBI to increase the limit for issue of guarantee by AD Category-I Banks from USD 100,000 to USD 500,000 i.e. Category-I banks cannot issue guarantee exceeding USD 500,000 in favour of a non-resident service provider on the behalf of a resident service importer, given that The Authorized Dealer Category-I Bank:

 

  • Is satisfied with the bonafide nature of the transaction.

  • Ensures submission of documentary evidence for import of services in the normal course.

  • And the guarantee is to secure a direct contractual liability arising out of a contract between a resident and a non-resident.

However, in the case of a Public Sector Company or a Department/ Undertaking of the Government of India/ State Governments, approval is required from the Ministry of Finance, Government of India for the issue of guarantee for an amount exceeding USD 100,000 (USD One hundred thousand).

  1. Invocation of guarantee: In case of invocation of the guarantee, the Authorized Dealer bank should send a detailed report to the Chief General Manager-in-Charge, Foreign Exchange Department, External Payments Division(EPD), Reserve Bank of India, Central Office, Mumbai 400 001, explaining the circumstances leading to the invocation of the guarantee.