M J Antony: Sanctity of bank guarantees

OUT OF COURT

The Supreme Court rules out further liberalisation of the norms laid down by it.

Though the Supreme Court has held in several recent cases that there could not be injunctions against the enforcement of bank guarantees, petitions for such orders are very frequent. There are courts which pass such orders too easily. Moreover, new grounds are being invented to get injunctions in such instances. Such exercises affect business confidence and end up in debilitating litigation. The Supreme Court spoke against such attempts in a judgement delivered earlier this month in BSES Ltd vs Fenner India Ltd.

The two well-known circumstances when injunctions could be passed are first, when there is a clear fraud of which the bank has notice and a fraud of the beneficiary from which it seeks to benefit. The fraud must be of an egregious nature that vitiates the entire underlying transaction. The second situation is when there are "special equities" in favour of injunction, such as when irretrievable injury or injustice would follow if such injunction was not granted. However, in the present case, new exceptions were sought to be introduced. The court did not allow it and strictly stood by the law laid down by it in the matter of bank guarantees.

In this case, Godavari Sugars Ltd awarded a contract for a captive power plant to BSES Ltd (now Reliance Energy Ltd). The latter, in turn, awarded a part of that work to Fenner India Ltd. As required by the terms and conditions, Fenner submitted four bank guarantees from the State Bank of India. They were unconditional, irrevocable bank guarantees. The amounts guaranteed were payable with or without any reason in writing from BSES, without protest or proof of satisfaction and without reference to Fenner, irrespective of any dispute between the two parties regarding the contract.

Disputes arose between the companies and Fenner moved a petition under the Arbitration and Conciliation Act before a district magistrate, seeking a declaration that BSES was not entitled to invoke the bank guarantees. It also sought an interim injunction against the encashing of the bank guarantees. The district magistrate refused to grant the injunction as it felt that it was not a case where irretrievable injustice would be done by enforcement of the bank guarantees. Nor did it find any prima facie case of fraud. The dispute was then taken to the Madras High Court. It set aside the order of the district magistrate and granted injunction orders. Therefore, the issue was taken to the Supreme Court.

So far the view taken by the Supreme Court was that a bank guarantee was an independent contract between the bank and the beneficiary. Irrespective of the dispute between the parties, the bank was obliged to honour its guarantee, as long as the guarantee was unconditional and irrevocable. The leading case on this point is UP Cooperative Federation Ltd vs Singh Consultants and Engineers (1988). That judgement of the Supreme Court emphasised that a bank guarantee must be honoured in accordance with its terms as the bank, which gave the guarantee, was not concerned with the question whether any of them had failed in their contractual obligations or not. The bank must pay according to the tenor of its guarantee, on demand, without proof or condition. The two exceptions to the rule, as stated above, are fraud of an egregious nature and irretrievable injustice.

Since the facts of the case did not fit into either of these exceptions, a few new exceptions were sought to be carved out, showing some English and Singapore judgements. In the Singapore judgement of 2002 (Samwoh Asphalt Premix Ltd vs Sum Cheong Piling Ltd), it had been held that calling a performance guarantee for an "oblique purpose" was not permissible. If it is used as a bargaining chip, as a deterrent or in an "abusive manner", the court would pass an injunction. These exceptions are apart from the common one of fraud. However, the Supreme Court refused to introduce these foreign concepts into the Indian law. It stood by the principles laid down in the UP Cooperative Federation judgement.

It applied those rules to the facts of the case and set aside the Madras High Court judgement.

An earlier judgement of the court, General Electric Technical Services Company Inc vs Punj Sons (1991), stated the reasons for taking such a view. It said: "The bank must honour the bank guarantee free from interference by the courts. Otherwise, trust in commerce, internal and international, would be irreparably damaged. It is only in exceptional cases, that is to say, in case of fraud or irretrievable injustice, the court should interfere. The nature of the fraud that the courts talk about is fraud of an egregious nature so as to vitiate the entire underlying transaction." Reiteration of this principle in the BSES case will go a long way to settle recurring disputes over encashment of bank guarantees. The banks, the industry and the courts should now be strict in following the law laid down by the Supreme Court and further liberalisation of the rules should not be allowed.