A construction contract is often defined by price, financial terms, quality, and time of completion, wherein price is one of most dominating factors in determining success of the construction projects. In providing priced bids for building contracts, cost accounting, which calculates costs for later calculations and pricing decision-making plays a critical role. Based on contractual conditions, a construction company is required to provide a bank guarantee for the effective and timely project completion by securing its performance to the investors. However, the concerns surrounding bank guarantees receive little attention, and there is almost no literature on the subject. This article travels around the concept of bank guarantees, discusses its types, invocation in construction contracts and the legal development surrounding it. It also discusses the problems faced by courts in deciding whether in a given situation, bank guarantees can be invoked or not.
The bankability of construction projects comes into existence when third parties provide lending services. Among these services, bank guarantee (“BG”) is one of the most commonly used instrument that allows banks to ensure or guarantee payment in the event of non-performance in a commercial transaction by any of the contractual parties. The process of invoking BG involves three parties, namely the applicant, the beneficiary, and the bank. The beneficiary is entitled to realize the entire amount under the guarantee from the bank of the applicant in terms thereof regardless of any pending disagreement between the applicant and the beneficiary. BG is essentially a separate contract between the bank and the beneficiary; therefore, it binds both the parties to its terms and conditions. As a result, the invocation must be in conformity with the requirements of the guarantee, or else the it would be rendered invalid. However, problem arises when the beneficiaries try to encash these guarantees with malafide intentions. Vague boundaries between exceptions (fraud, special equities and irretrievable damage) to invocation adds to the dilemma. This article is an attempt to explain the concept of Bank Guarantees and how courts have time and again discussed about its invocation.
Law governing Bank Guarantees
The Indian Contract Act (“ICA”) of 1872 describes a contract of guarantee underSection 126 as a contract wherein a third party guarantees or discharges his liability in case if guarantor fails to perform his liability. A bank guarantee, on the other hand, is a one-sided legal contract in which a bank is the guarantor who agrees to pay a particular amount to the beneficiary if the debtor from the original contract becomes incapable of fulfilling his contractual liabilities. A bank guarantee (BG) is a contract between a bank and a beneficiary that is independent from the underlying contract between the beneficiary and the person for whom the BG is given.
When an agreement for the purchase of BGs is signed,two contracts and three parties are formed. When the guarantee is invoked, the bank will honour its commitment regardless of the person on whose behalf it was granted, and regardless of any disagreements that may have arisen between the lender and the beneficiary in the interim. This approach is based on the idea that a BG is designed for the protection of the beneficiary by empowering him to make an urgent demand of payment against the party who has refused to make a payment under the terms of the BG, and hence it cannot be constrained by their contractual obligations.
Kinds of BGs
The BGs can becategorised into different categories on the basis of the specific types of transactions, however in this article the authors have limited their scope totwo types of BGs which are unconditional and conditional bank guarantees. When an unconditional BG is used, it ensures that the beneficiary will be paid unconditionally and irrevocably on their first claim. Whereas, whn a conditional BG is used, the beneficiary must meet a specific criterion before invoking the guarantee. It is necessary to take heed of the text of the BG in order to ascertain the type guarantee. Regardless of the fact that certain guarantees contain the words ‘unconditionally and irrevocably’, sometimes they also contain a condition or an event in which the guarantee can be encashed. In these types of situations, the BG would be characterised as a conditional BG. As a consequence, the words used in the guarantee are important to determine its nature.
Invocation of Bank Guarantees
Whenever there is any default in payment by the applicant, the beneficiary can invoke BG by making a claim to the bank. The BG, however, must be used by the beneficiary within its validity period after which the Bank is relieved from its obligation. The invocation is initiated by writing a letter, which is addressed to the Bank, stating why the guarantee needs to be encashed by the beneficiary. In case if the BG is unconditional, the beneficiary is entitled to an unconditional payment on the first demand itself and this payment is irrevocable. However, if its conditional, then the beneficiary’s ability to exercise the guarantee and demand immediate payment is limited by the conditions mentioned therein. After meeting those conditions, the issuing bank becomesobligated to follow and uphold the provisions of the guarantee and the beneficiary cannot be prevented from encashing the guarantee. It can be said that a BG is abargain between the two parties, in which the banker is bound to pay the specified amount in question unconditionally.
Limitation Period for Invocation of Bank Guarantees
The Indian Limitation Act, 1963 provides for the time period to invoke a BG. It is usually 3 years in all cases but if the beneficiary is a governmental organisation, then it would be 30 years. Previously, BGs used to have a clause that it should be claimed within 6 months before its expiry otherwise the bank would be relieved from its obligation to provide the guaranteed amount. However, in 1996 an amendment took place in the Indian Contract Act which provided that any clause that restricts bank’s from fulfilling their obligations, including the one invoked after the validity, would be illegal. The beneficiary can take recourse from the Limitation Act in filing a case against the bank. Hence, the bank is required to get a certificate from the beneficiary cancelling the invocation and if it’s not obtained then it should retain the security of the applicant and his cash margin till the expiry of the limitation period. However, if the bank retains the guaranteed amount for no reasonable grounds, then the beneficiary can pursue taking a legal action against the bank.
Stay on Invocation of Bank Guarantees
Giving someone complete discretion can sometimes lead to abuse of power, culminating in corrupt and illegal behaviour. An excellent example of this is when a beneficiary is aware of his substandard goods and is not entitled to payment, but yet invokes BG for monetary advantage. As a result, specific conditions for invoking unconditional BGs are required in order to define the scope and application of unconditional BGs. In India, there are essentially two exceptions to the injunction on invocation of unconditional BG:
- Fraud of such a magnitude that it taints the entire underlying transaction, and the bank is aware of it.
- Special equities in the form of avoidingirretrievable injustice between the parties.
Irretrievable injustice/damage is sometimes treated asthird exception when the damage that will be sustained by the party against whom BG will be invoked, will be of such a nature that it will be impossible for him to recover it. However, it’s difficult to draw distinct lines between special equities and irretrievable damage.
Bank Guarantees in Construction Contracts
Since a bank guarantee is essentially a promissory note on a loan ensuring that if the borrowerdefaults on the loan, the bank will cover the defaulted amount, it has become an important provision In the construction contracts for persuading several companies to collaborate on long-term contracts and projects. It acts like a work assurance clause which is necessary for a project or enterprise to move to the next stage. All parties are assured in the worst-case situations of non-payment because of the bank’s backing.
The bank guarantee firstappeared in the 1960s as a kind of collateral for securing Construction Contracts when large-scale construction projects were being contracted. The bank guarantee is now widely used in both domestic and international trade because it a typical security for higher-value transactions.
A construction contract is aservice agreement wherein the contractor agrees to complete specified construction projects or construct a structure in conformity with the terms of the agreement within a set timeline, in exchange for the employer agreeing to pay him a fixed amount. The fact that construction work typically takes a longer length of time to complete, and given the complexity of the contractual work, the construction contract is one of the most complicated contracts. Because of these attributes, it carries a high risk for both the contractor and the employer, as non-performance of the other party’s obligations could result in considerable loss for both the parties.
The contractor’s risk is embodied in the likelihood of the employer’s inability to meet its obligations, such as avoiding paying the agreed fee when the construction is finished. But from the other end, the employer faces the risk of the contractor failing to complete the work or failing to do so in conformity with the norms, requirements, and the specifications. These conditions drive the parties to consider different sorts of collateral before entering into the contract in order to safeguard their interests as much as possible while forecasting the amount of potential damage they might sustain if the other party fails to meet the terms of the contract.
Similarly, the constructer also undertakes long-term projects which engage vendors andsubcontractors. The construction company usually oversees the overall project as it specializes in framing the structure but it subcontracts with other companies to outsource ancillary work related to furniture, pipe fittings, electricity, etc. these outsourcing is generally done on credit by obtaining loans because the former is paid only after completion of the entire work. It puts them in a lot of risk if the other party refuses to pay these construction companies. In circumstances like this, which are common these days, having a bank guarantee in the main contract reduces the risk to both the ancillary companies and the construction companies because they will be assured of payment from their respective contractors. The fundamental goal of issuing a bank guarantee is in fact is to give security to the beneficiary, i.e. to govern the parties’ relationships even if the liabilities under the construction contract are not relieved.
Challenges faced by courts in invoking BGs
The legality of relying on bank guarantees has always been a point of disagreement between the parties to business agreements. While the courts in India have generally held that when a bank guarantee is invoked, the courts should not intervene because this would negate the purpose of such guarantees in commercial transactions. However, legal decisions against the use of bank guarantees, even in exceptional circumstances, abound. It is well established that the courts cannot prevent the invocation of an unconditional bank guarantee unless there is fraud that would jeopardise the very objective for which the bank guarantee was given, or if the disbursement of the guaranteed amount would cause damage which is irreparable in nature. It is for this reason, seeking stay orders against the invocation of the bank guarantee used to be a tall order.
The Hon’ble Supreme Court of India, however, appears to have made a paradigm change in its recent decision inGangotri Enterprises v. Union of India, wherein it stated that facts of the case are the determining factor in deciding whether stay can be granted or not while invoking a BG. The Supreme Court declared that while the proposition laid forth in cases involving the encashment of bank guarantees cannot be disputed, it will not be applied in every case. The Supreme Court overturned an Allahabad High Court decision that refused to impose an injunction against the beneficiary party’s invocation of a bank guarantee, holding that the law laid out in the case ofUnion of India v. Raman Iron Foundry is applied in this case. In some aspects, the Supreme Court has augmented the line of authority of decisions against beneficiary invocation of bank guarantee, such asHindustan Construction Co. Ltd. v. State of Bihar, wherein the court concluded with the proposition that a BG can be invoked after adhering to the terms and conditions mentioned therein.
This decision of Gangotri Enterprises would undoubtedly be handy for litigants and concerning parties, especially contractors performing under government projects where the government authorities used to exercise unconstrained power while encashing BGs provided by the contractor. The prevalent idea that bank guarantees can be honoured regardless of any dispute involving the contractor and the government has been overturned by this decision.
Another challenge that recently surfaced is that of invocation of BGs during lockdowns wherein the work is stayed owing to the imposition of nationwide lockdown due to COVID 19. The Delhi High Court was the first court to observe inM/s Halliburton Offshore Services Inc.(“Halliburton”) v. Vedanta Limited and Anr. (“Vedanta”) that the nation-wide lockdown was in the nature of force majeure as it was unexpected, beyond anyone’s control and incapable of any prediction. The court decided that an ad-interim order, preventing the invocation or encashment of the bank guarantees, would be appropriate. The court stated that where special equities are present, it has the authority to enjoin the invocation or encashment of a bank guarantee in a specific set of facts and circumstances. In this case, it was held that special equities existed therefore it would be appropriate to injunct Vedanta from invoking the bank guarantees until the lockdown is lifted.
However, the Bombay High Courtin Standard Retail Pvt. Ltd. (“Standard Retail”) v. M/s. G. S. Global Corp & Ors. (“GS Global”) declined to hold the BG’s encashment because GS Global had already performed their part of the contract by exporting the products from South Korea way before the lockdown was declared. The court flatly rejected the Standard Retail’s failure to perform its part of the contract owing to the lockdown and the ensuing losses As a result, it was established that the lockdown is for a limited period and that the lockdown will not be able to save Standard Retail from its contractual responsibilities.
The courts are taking a cautious approach due to these unusual circumstances that have arrived to the courts recently. They become more wary in cases where parties have attempted to invoke COVID-19 as a rationale for failing to complete their obligations despite having been given sufficient time before the crisis would possibly hit the economy. Furthermore, the courts are well cognizant of the repercussions of COVID-19 on the entire country, and it is therefore all the more important that they strive to mitigate any substantial harm or loss made to the parties while fulfilling their contractual obligations. In these circumstances, it should be noted that sometimes courts issue ad-interim orders in cases where time is crucial to the contract, however this approach cannot be used in cases where performance is of essence.
Given the above-mentioned, a bank guarantee is often one of the most preferred and secure forms of collateral for an employer. When the contractor fails to fulfil his obligations under the Construction Contract, bank guarantees allow the employer to obtain the guaranteed amount quickly, easily, and safely. Bank guarantees for the contractors, similarly, can be a good option in availing ancillary services on credit and in securing payment from the beneficiary. It is a tool that is beneficial for any party who invokes it because the bank is obligated to render its duty once the request is made despite existence of any dispute between the parties. Although, challenge arises when the purpose of invocation gets coloured by greed, however the same has always been cautiously dealt by courts after examining the facts of the case. Therefore, it can be said that in today’s commercial world, BGs have proven to be a major boon.
About the Authors
Ms. Shuchi Sejwar is the Principal Associate at Hammurabi & Solomon, New Delhi.
Ms. Vidhi Saxena is a 4th Year Law Student from National Law Institute University (NLIU), Bhopal.
Managing Editor: Naman Anand
Editors-in-Chief: Jhalak Srivastav and Akanksha Goel
Senior Editor: Muskaan Singh
Associate Editor: Vidhi Saxena
Junior Editor: Harshita Tyagi
Preferred Method of Citation
Shuchi Sejwar and Vidhi Saxena, “Bank Guarantees and their Injunctions in Construction Contracts” (IJPIEL, 11 April 2022)