Sanctity of bank guarantees is sacrosanct

S Kalyanasundaram | Updated on March 03, 2020

Only when there is a suspicion of fraud or there is some court injunction can the bank withhold payment

      It is reported that the Calcutta High Court had asked the Reserve Bank of India to consider ‘appropriate steps’ against Bank of Baroda, including cancelling its banking licence, for delaying to honour a bank guarantee. The case pertains to a bank guarantee issued to Indian Oil Corporation (IOC) at the request of Simplex Projects Ltd. IOC invoked the bank guarantee.

      It is also reported that Bank of Baroda, after seeking legal advice, decided to exercise its rights available under the law preferring to challenge the aforesaid orders passed by the Calcutta High Court before the Supreme Court of India.

      As full details are not available in public domain, one cannot ascertain whether the bank, while not honouring its commitment under the guarantee, envisages any fraudulent element.

      Terms of bank guarantees

      As per Section 126 of Indian Contract Act, contract of guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default. When a bank issues a guarantee at the request of its customer in favour of third parties, the bank is liable to discharge its obligation as per the terms of the guarantee issued.

      Apart from stipulations under Contract Act, the RBI’s instruction will be binding on the bank as the RBI is the banking regulator.

      RBI’s direction

      There are various guidelines issued by the RBI for guarantee issued by banks. Broadly, they include the following: The guarantee should be for a definite period and definite amount. Maximum period can be 10 years. The proposal should be analysed like any other fund-based financing, though the limit is a non-fund based one. The guarantee should be issued only for customers and after taking sufficient margin and security. Most importantly the guarantee should be honoured whenever invoked without any delay.

      Whenever any claim on guarantee is received, the bank has to just see whether the claim is in order, which means that is it actually invoked by the beneficiary only and is it within the time stipulated, and pay. There cannot be any delay on this. Only when there is a suspicion of fraud the bank can become cautious. Or there can be some court injunction directing the bank to withhold. On all other occasions the payment under the invoked guarantee should be forthwith.

      The RBI’s master circular dated July 1, 2013, gives the following direction in unambiguous terms: “2.5.1 Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur. An appropriate procedure for ensuring such immediate honouring of guarantees should be laid down so that there is no delay on the pretext that legal advice or approval of higher authorities is being obtained.

      “2.5.2 Delays on the part of banks in honouring the guarantees when invoked tend to erode the value of the bank guarantees, the sanctity of the scheme of guarantees and image of banks. It also provides an opportunity to the parties to take recourse to courts and obtain injunction orders.”

      The RBI had also informed that non-compliance of the instructions in regard to honouring commitments under invoked guarantees will be viewed by the RBI seriously and it will be constrained to take deterrent action against the banks.

      Supreme Court’s direction

      In the UP Co-op Federation Private Ltd versus Singh Consultants and Engineers Private Ltd (1988 IC SSC 174) case, the Supreme Court said: “We are, therefore, of the opinion that the correct position of law is that commitment of banks must be honoured free from interference by the courts and it is only in exceptional cases, that is, to say, in case of fraud or any case where irretrievable injustice would be done if bank guarantee is allowed to be encashed, the court should interfere.”

      The writer is a retired banker

      Published on March 02, 2020

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