TAMIL NADU NATIONAL LAW SCHOOL

This Project on Contracts Submitted in Partial Fulfilment of B.A. LL.B (Hons.)

3rd Semester

TOPIC:
NATURE AND EXTENT OF BANK GUARANTEE.

SUBMITTED ON: 18TH NOVEMBER, 2014

SUBMITTED TO:
PROF.KGR
NISCHAY

ROLL NO

(80)

SUBMITTED BY:
KUMAR

Acknowledgement
At the outset, I thank the Almighty who gave me the strength to
accomplish the project with sheer hard work and honesty.
I take this opportunity to observe protocol to show my deep gratitude
to the revered Contracts Teacher Sunil Gladson, for his kind gesture in
allotting me such a dynamic and burning issue as research project. His
timely advice, direction and valuable assistance tremendously boosted
me during the making of this project.
Secondly, all this wouldnt have been possible without my friends who
sacrificed their precious time for guidance and helped me a lot in
completing this project without any drawbacks.

Hence I am forever

indebted and grateful to them.

Thirdly, I am very much thankful to the staff and administration of
TNNLS who provided valuable sources of information in the form of
library and database connections.
The successful creation of this project is due to the background work
and co-operation of many persons.

So I once again take this

opportunity and privilege to convey my deepest regards and thanks to

all those who was involved directly or indirectly in the making of this
project.

DECLARATION

I, Kumar Nischay hereby declare that the project work entitled

NATURE AND EXTENT OF BANK GUARANTEE. submitted to Tamil
Nadu National Law School; Tiruchirappalli, is the record of a bonafide
work done by me under the supervision and guidance of Prof. KGR,
Faculty of law of contracts, Tamil Nadu National Law School;
Tiruchirappalli.

KUMAR NISCHAY
ROLL

(80)

CERTIFICATE
This is to certify that the project entitled Nature And Extent of
Bank Gurantee submitted to Tamil Nadu National Law School in
partial fulfillment of the requirement of the award of the degree of B.A.
LL.B (Hons) done by Kumar Nischay {Law of Contract} under the
supervision and guidance of Mr. KGR (mentor) Under Graduate
Department of Tamil Nadu National Law School.

Place: Tiruchirappalli
Date: 18th November, 2014

KGR
(mentor)

List of cases.
1. United commercial Bank v Bank of India and others
2. Rawala construction co. V Union of India
3. National Telecom of India Ltd. v. Union of India
4. Daewoo Motors India Ltd. v. Union of India
5. Bank of Baroda v. Ruby Sales Corporation (Agency)
6. Punj Lioyd Ltd V. India Cements Ltd
7. Mula Sahakari Karkhana v. State Bank of India
8. Veer Prabhu mktg v .N.S.C.
9. Man Industries India Ltd., Indore v. N.V. Kharote
Engineers and Contractors, Pune
10. Hindustan Steelworks Corpn ltd v. Tarapore and co
11. A.C. Roy & co.v. Union of India
12. U.P. COOP Federation Ltd v. Singh Consultants and
Engineering ltd
13. General Electric Technical Co Inc v Punj Sons(P) Ltd

Table of contents

Chapter 1
Introduction.
Bank Guarantee means a comfort, which is being given by issuing
bank, to a party (Beneficiary in whose favour the guarantee is issued)
of losses or damages if the Client (on whose behalf the guarantee is
being issued) fails to complete or conform to the terms of agreement.
Bank Guarantee is a type of guarantee in which bank promises to repay
the liabilities of a debtor in the event the debtor is unable to 1. A bank
guarantee enables the customer (debtor) to acquire goods, buy
equipment, or draw down loans, and thereby expand business
activity2. A bank guarantee is a commercial instrument in the nature of
a contract, intended between two parties, to secure compliance with
the contract.3
Bank guarantee is a contract involving two parties i.e. the bank and the
beneficiary. The bank guarantee is financial instrument in which if the
beneficiary perceives that there has been a breach of contract by the
other party, he can encase the guarantee and avail of the amount
immediately, without having to undergo the hassles of litigation. As
ordinary guarantee is construed dependent on the main contract of
guarantee for enforcement of such guarantee it may lead to
unnecessary disputes and litigation. These disputes may have a
material effect on the guarantee, thereby blocking funds in litigation.
Hence, there was a need for an innovative instrument which would
1 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co.,
Delhi,1999,p. 425
2 Retrieved
from http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2BUrtCDb.
3 Retrieved from http://www.business-standard.com/india/news/how-bankguarantees.

enable the guarantee to serve its original purpose i.e. providing a form
of security.
Bank guarantee is also similar to Letter of Credit as it is discussed
below.
1.3 Letter of Credit and bank guarantee
A letter of credit is a binding document which buyers can request from
the bank as a guarantee that payment for goods purchased will be
transferred to the seller. The letter serves as a reassuring letter that
the seller will receive payment due to him. The payment will only occur
once the seller presents the necessary shipping documents to the
bank. This will serve as confirmation that shipment of the goods to the
buyer was completed in the given time frame. A letter of credit can
also be defined as an obligation given to a bank so that criteria can be
followed before payment is made. As soon as the terms from both
parties have been confirmed and completed, it is now the banks role
to transfer the funds. A letter of credit ensures payment for performed
services4.
A letter of credit can be used upon the completion of a service or
delivery of goods. Before the transaction occurs, the seller can send a
request to the bank to obtain a letter of credit. The buyer will purchase
the letter of credit from the bank and forward it to his sellers bank. As
such, the letter will act as a replacement or substitute for the credit of
the client, so that correct and timely payment is assured.
A bank guarantee can be used if a buyer obtains goods or services
from a seller and then encounters cash flow difficulties. As a result, he
is unable to pay his seller in time. A bank guarantee is suitable in such
instances because it would pay an agreed-upon amount to the seller.
Alternatively, if the seller is unable to provide the goods, a bank will
4 Rupnarayan Bose, Bank Guarantee and Letter of Credit, Economic Law Journal,
University of Chicago Press 12 1995, p.76

pay his buyer the agreed-upon sum. For any side of the transaction,
the bank guarantee serves as an extra safety measure.
Because of these two facilities individuals are able to participate in
international trade with customers around the world. Because of these
options, the risks are lessened. It also helps build the mutual trust
between the two parties involved in the trade.
In this project I have answered the question of the need of bank
guarantee and enforcement of Bank guarantee. As bank Guarantee is
independent of the main contract so it is no interference of courts but
there are exceptional cases in which bank guarantee is enforced
through courts, which is mentioned in this project. We have discussed
in detail the nature of bank guarantee laid down by courts in various
landmark judgments.

Chapter 2
Need for Bank Guarantee
Bank guarantee is used to reduce many business transactions risks. It
is a reliable security instrument in both international and domestic
trade. Many genuine business requirements like obtaining goods,
purchasing machinery can be fulfilled even when the enterprise does
not have enough money. It enables to use bank's creditworthiness to
facilitate many genuine business transactions. It provides immediate
funds to the business in the form of payment guarantees. It gives us
ample time to make our payments in case of deferred payment
guarantees. It is a quality security instrument which ensures a healthy
business transaction and provides better negotiable terms and
conditions to the buyer and seller5.
There are various kinds of bank guarantee which are used in different
situations which are discussed as follows:
5 Retrieved from www.eagletraders.com

1. Tender bond is bank guarantee which is used in the export

business for project tenders. They are short term guarantees. Its
purpose is to secure any claims by the party inviting the tender
on the tenderer in the event of withdrawal of the bid before its
expiry date or if the bid is modified unilaterally. It is also used if
the tenderer, upon being awarded the contract, refuses to sign
the contract or provide further guarantees on request.
2. There is another type of Bank Guarantee, the
Payment

Advance

Guarantees which is used in the import-export

business and also in domestic commercial business, trade and

industry. The Performance Bond Guarantees used to secure any
claims by the buyer on a seller arising from default in delivery or
performance of the terms of a contract e.g. construction,
assembly, execution. It is used in import-export businesses as
well as in domestic commercial business, trade and industry. The
terms of the guarantee are until the contract has been fulfilled. 6
3. The Bank Guarantee for Warranty Obligations is type of
bank guarantee used in the import-export business and in
domestic commercial business, trade and industry, where it is
more often a surety. Its purpose is to secure any claims by the
buyer on the seller due to possible defects appearing after
delivery. In the construction trade, the guarantee for warranty
obligation in the form of a simple guarantee or a joint and several
guarantee is known as a building (or works) contractor's
guarantee.
4. The Payment

Guarantees are used in the import-export

business or in any circumstance where payment of an obligation

needs to be guaranteed. It is used to secure any claims by the
seller on the buyer for payment of the contract price by the
agreed date. The payment guarantee is often used instead of a
documentary credit upon delivery against open account. 7 The
use of this guarantee is to secure any claims by the lender on the
6 Retrieved from www.nordea.ru

borrower due to a credit (loan, etc.) not being repaid in

accordance with the terms of the lending contract. The amount of
the guarantee is the amount of the credit or loan, and it usually
includes a margin to cover accrued interest and incidental
expenses. The term of the guarantee is until the expiration date
of the loan plus a few days (e.g. 15 days).
These are often abstract guarantees in favour of a foreign or domestic
lending bank e.g. letter of indemnity for Missing Bill of Lading. This
guarantee is specifically used for importers when the bill of lading is
missing. Its purpose is to secure any claims by the shipping
line/shipping company on (i) the buyer resulting from the goods
arriving from overseas being released without the original bill of lading
being presented (e.g. due to postal delays or even loss) or (ii) the
supplier due to issuance of a replacement bill of lading (original
misplaced or lost).8
Attributes of Guarantees as Security an unsupported guarantee is
a very simple security to take - no registration is involved and no
complications concerning

proof

of

title

arise.

A guarantee can easily and immediately be enforced by court action.

As with any other security given by a third party (collateral security), it
can be ignored when claiming against the principal debtor. As several
parties can guarantee a loan, it is useful security where the principal
debtor is unable to provide security but offers a viable business loan
proposition.

7 Retrieved from www.universalwealthcreation.com

8 Agasha Mugasha, The Law of Letters of Credit and Bank Guarantees, Central Law
Publisher, Allahabad, 2003, p. 137

Chapter 3
Nature of bank guarantee
The nature of bank guarantee is discussed in various judgments of
Supreme Court and High courts. In case of United commercial Bank
v Bank of India and others 9 SUPREME COURT laid down ... a bank
guarantee is very much like a letter of credit. The courts will do their
utmost to enforce it according to its terms. They will not, in the
ordinary course of things, interfere by way of injunction to prevent its
due implementation.10 It was also said in this case if the seller has
complied with terms of letter of credit, however, there is an absolute
obligation upon a banker to pay irrespective of any dispute there may
be between the buyer and the seller as to whether the goods are upto
contract or not
In case of Rawala construction co. V Union of India 11 SC laid down
the bank guarantee constitutes an agreement between bank and the
government under which there is an absolute obligation of the bank to
make payment to the government merely on the demand of the
government. The bank is prohibited under the guarantee from raising
any objection.

12

Contractual obligation in bank guarantee.

Bank Guarantee is important as it enables the debtor to acquire
goods, buy equipment, or draw down loans, and thereby expand
9 AIR 1981 SC 1426
10 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co.,
Delhi,1999,p. 425
11 AIR 1997 Delhi 205
12 M.A.Sujan, Law relating to Building Contracts, Universal Law Publishing Co.,
Delhi,1999,p. 425

business activity. So there is need for law to govern the Bank

Guarantee. The concept of Bank Guarantee has evolved out from the
Indian Contact Act, 1872 and various judicial pronouncements. A Bank
Guarantee is a contract between the issuing Bank and the beneficiary
in whose favour the Guarantee has been furnished. Though the Bank
Guarantee may have been issued by the Banker at the instance of his
client, as far as the Bank Guarantee is concerned, it is a contract
between the Banker and the Beneficiary in whose favour the Bank
Guarantee has been issued13.
3.1 Statutory Provisions
Section 126 of the Indian Contract Act, 1872 provides Contract of
Guarantee, surety, principal debtor and creditor A contract of
Guarantee is a contract to perform that promise, or discharge the
liability of a third person in case of his default. The person who keeps
the Guarantee is called the surety, the person in respect of whose
default the Guarantee is given is called the principal debtor and the
person to whom the Guarantee is given is called the creditor. A
Guarantee may be either oral or written.14
And Section 127 provides for Consideration for Guarantee
Anything done, or any promise made for the benefit of the principal
debtor may be a sufficient consideration to the surety for giving the
Guarantee.15
So,

a Contract of

Guarantee is a Tripartite Agreement which

contemplates the Principal Debtor, the Creditor or Beneficiary and the

Surety. A Contract of Guarantee may be said to be an Accessory
13 Alok Ray, Enforcement of Bank Guarantee: Limits of Courts Interference,
Economic Law Journal, University of Chicago Press 12 1995, p.76
14 Indian contract Act, 1872
15 Indian contract Act, 1872

Contract i.e., a contract of accessory nature, being always ancillary and

subsidiary to some other contract or liability on which it is founded and
without the support of which it must fail. By this Contract, the Promisor
undertakes to be the answerable person, whose primary liability to the
Promisee must exist or be contemplated. 16 But it is not necessary or a
Sine qua non, that the principal debtor must expressly be a party to the
document or Guarantee, as it is adequate, if the principal debtor is a
party by implication. A careful reading of Section 126 and 127 of the
Contract Act would clearly indicate that the primary idea of a surety
ship is an undertaking to indemnify the debtor in case he does not fulfil
his promise, the contract of Guarantee, being thus, a contract to
indemnify.
A bank guarantee is not directly governed by Sec. 126. Bank
guarantee is a contract involving two parties i.e. the bank and the
beneficiary. In an ordinary guarantee, the contract between the surety
and the creditor arises as a subsidiary to the contract between the
creditor and the principal debtor. The bank guarantee is independent of
the main contract. In an ordinary guarantee, the inter se disputes
between the debtor and the creditor have a material effect upon the
surety's liability. However, the bank guarantee is independent of the
disputes, arising ex contractu (arising out of the contract). An ordinary
guarantee does not have any time limit before which the debt has to
be claimed. Bank guarantees generally have a specific time within
which they are functional17.

16 H.S. Pathak, Indian Contract Act, Lexis Nexis, Delhi,2011,p.47

17 R.L.Meena, Law of Contract, Universal Law Publishing Co., Delhi, 2008, p.319

Chapter 4
Judicial interpretation of legal obligation arising of Bank
Guarantee
Bank guarantee is a guarantee from a lending institution ensuring that
the liabilities of a debtor will be met. In other words, if the debtor fails
to settle a debt, the bank will cover it 18. The guarantor incurs
secondary liability, that is, the guarantor becomes liable only if the
principal debtor fails to pay. If the principal debtor's liability to the
bank is void, the guarantor will not be liable. A guarantee must be
evidenced by a written note or memorandum signed by the guarantors
or their agent.
unenforceable.

Without such written evidence, a guarantee is

Bank guarantees are, of course, always written

contracts. An indemnity imposes direct or primary liability to pay and

need not be evidenced in writing.
4.1 Invocation of Bank Guarantee
If an agreement of bank guarantee requires fulfilment of certain
conditions or requirements necessary for the invocation of the bank
guarantee, the guarantee can be invoked if those conditions are
fulfilled.
In National Telecom of India Ltd. v. Union of India 19, there was a
bank guarantee in favour of the government in respect of supplies to
be made by the contractor as per the purchase order. As per the
guarantee agreement, the amount was payable without any demur and
on demand.
To invoke the bank guarantee it has to be shown that there was
existence of one of the two conditions:18 Retrieved
from, http://www.investopedia.com/terms/b/bankguarantee.asp#ixzz2Av86oUM
L
19 AIR 2001 Delhi 236

a)

That there failure on the part of the contractor to perform the

contract, and

b)

That the amount claimed was by way of loss or damage to the

government due to the breach of contract.
If the contractor fails to supply the goods against purchase order, in
spite of extension of time, and the government writes to the Bank to
claim compensation stating that the same has arisen due to nonperformance of the contract by the contractor, the guarantee, in such a
case, has been properly invoked in accordance with the terms of the
contract.
It was further held in the case that if there is a breach of contract in the
judgment of the beneficiary of the contract, the bank has a obligation
to pay the amount covered under the bank guarantee on demand by
the beneficiary without raising any objection. The bank is not to judge
that whether there is breach of contract or not.
In Daewoo Motors India Ltd. v. Union of India 20, the Appellant
Company agreeing to fulfill export obligation had obtained various
import licenses from the government after furnishing bank guarantee
in that regard. There was a term in the bank guarantee that made the
President under guarantee would be conclusive. Such guarantee was
held to be absolute and equivocal, hence invocation of guarantee on
failure to fulfill export obligation was held not arbitrary and its
encashment could not be resisted by the bank.
In Bank of Baroda v. Ruby Sales Corporation (Agency) 21, one of
the parties demanded for discharging Bank guarantee by producing
proper documents. No proceedings had been initiated by party for
alleged breach of agreement against other party. Bank was not
20 AIR 2003 SC 1786
21 AIR 2006 Guj. 251

concerned with dispute between parties. Unless it was a case of fraud,

bank was bound to discharge bank guarantee. Plea that there was
negligence on the part of bank in discharging bank guarantee though it
was informed not to make payment was rejected by the Gujarat High
Court. Action of Bank in discharging Bank Guarantee was not improper.
Again in, Punj Lioyd Ltd V. India Cements Ltd 22, supply of cement
by defendants to plaintiff for its project, the plaintiff had furnished Bank
guarantees for ensuring timely payments.
In Mula Sahakari Karkhana v. State Bank of India 23, document
was supplied between the plaintiff and the bank and the supplier of the
goods was not a party to it. The document and the intention of the
parties was clear covering comprehensive claim of plaintiff to the
extent of Rs. 3,40,000/- . The guarantor was invoked within the
prescribed time. Since there was no dispute between the plaintiff and
the supplier as also there being no fraud or misrepresentation involved,
the Bank was held bound to honour the guarantee.
4.2 Injunction against Invocation of Bank Guarantee
Where the is a very strong prima facie case of element of fraud in
connection with the invocation of bank guarantee, the party giving the
bank guarantee can lawfully seek injunction against the invocation of
bank guarantee. This was held in Veer Prabhu mktg v .N.S.C.24 but
there was no finding of fraudulent injunction against encashment of
bank guarantee cannot be granted.

22 AIR 2005 Del. 389

23 AIR 2005 Bom. 385
24 A.I.R. 2006 Cal. 301

In Man Industries India Ltd., Indore v. N.V. Kharote Engineers

and Contractors, Pune,25 there was a contract for supply of goods
by the company to the contractor. Dispute arose between parties
regarding outstanding amount. Bank guarantee executed at the
instance of contractor in favour of company was unconditional. It was
not dependent on extent of goods supplied. Condition was stipulated in
bank guarantee that it could become en-cashable in the event of
default of payment. No prima facie case for injunction was made out by
contractor. No irretrievable injustice would be caused to him. Balance
of convenience was also not in his favour. Injunction against
encashment of bank guarantee was refused as there was no finding of
fraud recorded.
4.3 Important Case Laws and Their Rulings
In Hindustan Steelworks Corpn ltd v. Tarapore and co.: The
Supereme court laid down the law in terms of following propositions:
1.

A bank guarantee is an independent and distinct contract between

the bank and the beneficiary and is not qualified by the underlying
transaction aand the primary contract between the person at whose
instance the bank guarantee is given aand the beneficiary.

2.

In the case of an unconditional bank guarantee the nature of the

obligation of the bank is absolute and not dependent upon any dispute
or proceeding between the party at whose instance the bank
guarantee is given and the beneficiary.

3.

The commitment by banks must be honoured free from interference

by the court and it is only in exceptional cases, that is to say, in case of
fraud, or in a case where irretrievable injustice would be done if bank
guarantee is allowed to be encashed, that the court would interfere.
Some litigation in connection with the bank or demand guarantees is
generated by the fact that there can be abusive or unfair callings,
25 AIR 2005 Bom. 311

which is to a large extent due to the independent nature of both

documentary credits and unconditional on demand guarantees.
The beneficiarys right to payment is absolute or almost absolute.
In A.C. Roy & co.v. Union of India 26, it was held that the person
claiming the guarantee must establish that conditions for invoking the
guarantee do exist. In another case of National Telecom of India ltd v.
Union of India27 the government was required to show at least one or
two conditions for invoking guarantee, i.e. either that the amount had
become due because of loss caused by breach or that the amount was
being forfeited by reason of the contractors failure to perform his
commitment.
The Supreme Court in case of U.P. COOP Federation Ltd v. Singh
Consultants and Engineering ltd28, the bank that the operation of a
bank guarantees should be stayed only in cases of serious dispute,
fraud or special equities.
In an another milestone case, General Electric Technical Co Inc v
Punj Sons(P) Ltd.29 The SC dealt with a case of bank guarantee given
for securing mobilization advance, it was held that the right of a
contractor to recover certain amounts under running bills would have
no relevance to the liability of the bank under the guarantee given by
it.
A bank guarantee is a sort of an absolute undertaking to pay the
amount whenever demanded by the guarantee-holder. It has nothing to
do with the state of relations between the guarantee-holder and the
26AIR 1995 Cal 246
27 AIR 2001Del 236
28 1988 1 SCC 174
29 1991 4 SCC 230

person on whose behalf the guarantee was given. While ordinary

guarantees are linked to and dependent on the underlying transaction,
a bank guarantee is an arrangement where the guarantee is
independent of the underlying transaction.

Chapter 5
Conclusion
Bank guarantees are simple, flexible and effective guarantee and play
a major role in the promotion of national and international trade. A
bank guarantee operates by way of a contract or agreement in which
the bank itself stands as guarantor to a particular advance made by a
creditor to a debtor, independent of the underlying contract and the
primary contract of the person at whose instance the bank guarantee
is given. It is extremely important to note that the enforcement of the
guarantee is actually dependent on the terms of the contract subsisting
between the bank and the beneficiary and is generally not interfered in
by the Courts.
The bank guarantee is an innovative financial instrument whereby, if
the beneficiary perceives that there has been a breach of contract by
the other party, he can encash the guarantee and avail of the amount
immediately, without having to undergo the hassles of litigation. It
enables the debtor to acquire goods, buy equipment, or draw down
loans, and thereby expand business activity. It also facilitates the mode
of payment.
Bank Guarantee has dual aspect. It is not merely a contract between
the bank and the beneficiary of the guarantee. It is also a security
given to the beneficiary by a third party. Bank should not interfere with
the dispute related to the encashment of bank guarantee. As far as
possible the dispute should be solved by Arbitrators. Commitment of
banks must be honoured free from interference by the courts. It is only
an in exceptional case that is to say in case of fraud or in case of
irretrievable injustice, that the court should interfere.
commercial

transactions

bank

guarantees

achieve

Thus

in

relevance.

Beneficiaries or the creditors may charge a rate of penal interest in the

event of delayed payment of the due amount. Hence, it is imperative

that banks remain cautious, when signing a contract of guarantee with

the beneficiary, which may contain provisions pertaining to the
payment of penal interest in the event of delay in payment on default
of the principal debtor.

Chapter 6
Bibliography.
Books:
1.

Bangia, R.K. Contract II. Allahabad Law Agency, Faridabad,2010

2.

Jain, J.D. Indian Contract Act. Faridabad: Allahabad Law Agency

3.

Kapoor, S.K., Contract -II, Central law Agency, Allahabad, 2007

4.

Meena, R.L., Law of Contract, Universal Law Publishing Co., Delhi,

2008

5.

Pathak, H.S., Indian Contract Act, Lexis Nexis, Delhi,2011

6.

Singh, Avtar. Law of Contract and Specific Relief. New Delhi: Eastern
Book Company.

7.

Sujan, M.A., Law relating to Building Contracts, Universal Law

Publishing Co., Delhi,1999
Bare Act
Indian Contracts Act, 1872

Websites
1.

www.business-standard.com

2.

www.eagletraders.com

3.

www.investopedia.com

4.

www.universalwealthcreation.com