Performance Bank Guarantees: The Linchpin Of Commercial Transactions [Part-1]

This series of blog posts shall recount the law on evolution of performance bank guarantee in India. It shall cover the meaning of bank guarantee as distinguished from indemnity and letter of credit, and the legal framework governing performance bank guarantees in India in Part 1; the types of bank guarantees and character of such guarantees in Part 2; and finally, the exceptions and rules concerning invocation of bank guarantees in Part 3.Evolution And Legal Framework Performance bank guarantee is a specialized type of bank guarantee, operating as a contract to perform the promise or discharge the liability of a third person, in case of his default. It operates as a security for the promise or beneficiary of the contract and imposes an absolute obligation upon the bank to fulfill the terms of the contract. The fulfillment of the contract of guarantee is independent of the underlying contract. Banks operate as reliable paymasters for transactions. Such guarantees have the dual function of ensuring timely payment to the seller, and of the performance of the contract. In the modern times, bank guarantees have become the life-blood of trade and commerce and courts are circumspect in ensuring that no interference with the obligations assumed by the banks is there. Intervention by courts in the banks' obligation to honour its commitment would lead to "thrombosis" in the words of Donaldson L.J. (1981). In this article, the meaning of bank guarantee and its various types vis-à-vis indemnity and letters of credit is understood, after which the framework governing issue of bank guarantees in India, as given by the Reserve Bank of India is explained. Meaning of Bank Guarantee: §126 of the Indian Contract Act, 1872 defines a guarantee as a contract whereby the 'surety' (in this case, a bank) undertakes to discharge the liability of the 'principal debtor' against the 'creditor' in case of default by such 'principal debtor'. Since consideration is essential to ensure the validity of contracts (§10, Indian Contract Act, 1872), §127 further clarifies that mere benefit to the principal debtor acts as sufficient consideration. The contract of guarantee presupposes the existence of separate liability of the principal debtor and the surety's liability thus becomes secondary. Halsbury's Laws of England defines a guarantee as an accessory contract by which the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person, whose primary liability to the promisee must exist or be contemplated (5th Ed., ¶1013). Unless otherwise provided in the contract, the liability of the surety is co-extensive with that of the principal debtor, implying that the creditor need not exhaust his remedies against the principal debtor to make the surety liable (§128, Indian Contract Act, 1872). Variance of terms of contract without surety's consent, creditor compromising time, creditor's conduct impairing the surety's remedy etc lead to a discharge of the surety's liability (§§133-137 and §139, Indian Contract Act, 1872). Furthermore, the surety has rights in equity such as that of payment on performance which has been codified in §140 of the Indian Contract Act, 1872. Bank guarantees can be tailored to suit different needs and come in various forms covering a number of contingencies such as limited, continuing, payable on demand etc. Origin of the Term According to John H. Wigmore's study, credit conceptually presupposed a fairly organized society and did not exist in primitive societies. It is hypothesized by William H. Lloyd that with the development of family system, institution of suretyship emerged, with family members acting as collateral for another (p.42). This led to a system of credit and securities. Eventually, guarantee came to denote undertaking a secondary obligation to ensure performance in commercial transactions. Guarantee and suretyship are terms used interchangeably in Anglo-American legal systems and this is certainly the case in India where the 'guarantor' is termed as the 'surety'. Max Rodin notes that while 'guarantee' and 'surety' denote the same concept, the "pedigrees of the two words are of unequal dignity" (p.607). Guarantee, a low Latin garantia or garandia was used as a variant spelling of 'warantia' used in the sense of warranty for land and chattels, and only in the eighteenth century became popularly used in law and literature in the sense of a "special obligation" (pp.605-607). Au contrare, the term 'surety' derived from the Latin word securitas had been applied to the person making an engagement to answer for the performance of another, since at least the thirteenth century (p.608). While in Europe, the independent banker's guarantee was developed, there were regulatory hurdles in issuance of bank guarantees in the U.S. Hence, banks evolved the form of 'standby'...

Performance Bank Guarantees: The Linchpin Of Commercial Transactions [Part-1]

Ragini Agarwal

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