M J Antony: Guidelines on bank guarantees

OUT OF COURT

Except in case of fraud or irreparable injury to a party, bank guarantees should be honoured without fail.

The courts have conferred a certain sanctity to bank guarantees and letters of credit in the interest of business confidence. This has become more important now since trade and commerce have lost political and geographical borders. Over the years, the Supreme Court has laid down principles which facilitate the enforcement of bank guarantees and letters of credit in several of its judgements. Last week, it culled out six guidelines developed in important decisions in the past and set them forth in the judgement, Himadri Chemicals Industries Ltd vs Coal Tar Refining Company.

In this case, an Indian company and an Iranian one entered into a contract for the supply of goods after opening an irrevocable letter of credit. Disputes arose between them and the Indian company moved the Calcutta high court to stop the release of payment under the letter of credit before resolving the dispute. On this application for injunction under Section 9 of the Arbitration and Conciliation Act, the high court ordered status quo. The Iranian company moved the division bench which vacated the order. Therefore, the Indian company moved the Supreme Court. It dismissed the appeal, after laying down norms for passing injunction orders in financial matters.

One of the leading judgements on this issue is UP State Sugar Corporation vs Sumac International, delivered by the Supreme Court in 1996. In that decision, the court considered various earlier rulings and emphasised that the bank giving a guarantee was bound to honour it according to the terms of the contract, irrespective of any dispute raised by its customer. The courts should be slow in granting an order of injunction to restrain the realisation of a bank guarantee.

There are only two exceptions. Firstly, the bank should be convinced that a fraud has been committed which would vitiate the foundation of the guarantee. Secondly, the invocation of the guarantee would result in injustice of the kind which would make it impossible for the guarantor to reimburse himself.

In another judgement, the Supreme Court explained the first exception (UP Coop Federation Ltd vs Singh Consultants & Engineers, 1988). Quoting an English decision, the Supreme Court said: "The wholly exceptional case where an injunction may be granted is where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly be fraudulent. But the evidence must be clear both as to the fact of the fraud and as to the bank's knowledge. It would certainly not normally be sufficient that this rests on the uncorroborated statement of the customer, for irreparable damage can be done to a bank's credit in the relatively brief time which must elapse between the granting of such an injunction and an application by the bank to have it charged."

The second exception was elaborated in the Sumac judgement noted above. It cited an American case in which a US exporter had entered into an agreement with Iran and sought to terminate its liability regarding a letter of credit by an American bank in favour of an Iranian bank. When 52 Americans were taken hostage by the Iranian government, the US government blocked all Iranian assets under its jurisdiction. This was shown as an instance to explain the irretrievable injury which justified injunction. The exceptional circumstances which make it impossible for the guarantor to reimburse himself if he ultimately succeeds will have to be decisively established. A mere apprehension that the other party will not be able to pay is not enough.

Drawing on these basic principles, the Supreme Court set forth the following guidelines: While dealing with an application for injunction in the course of commercial dealings, and when an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realise such a bank guarantee in terms thereof, irrespective of any pending disputes relating to the terms of the contract. The bank is bound to honour it. The courts should be slow in granting injunction. The fraud should be of an egregious nature which would vitiate the very foundation of the bank guarantee and the beneficiary seeks to take advantage of the situation. Lastly, allowing encashment of the bank guarantee would result in irretrievable harm or injustice to one of the parties concerned.

There was an attempt last year to introduce more exceptions to the established rules in BSES Ltd vs Fenner India Ltd. However, the Supreme Court ruled out further liberalisation of the norms which have stood the test of time. Despite such firm stand, the power of money, or the lack of it, leads big firms to fight their battles up to the Supreme Court.