Law on Injunction of Bank Guarantee - The Blog of Daksh Pandit

Bank Guarantees are issued to secure performance of Contract by the Contractor and indemnify the Employer should the Contractor fail to perform the Contract within the stipulated period of time or commits a material breach of the terms of the Contract causing losses to the Employer in which event the Bank Guarantees issued by the Bank to the Employer, on behalf of the Contractor, can be encashed by the Employer to meet the losses. Bank Guarantees play a fundamental role in performance of construction contracts and operate as a foundational basis for entering into a construction Contracts.

Origins of Bank Guarantee

The concept of Bank Guarantees originated from Letter of Credit which came to be developed over decades of international trade. It was most commonly used in conjunction with sale of goods between geographically distant and unfamiliar buyer and seller. Due to the element of unfamiliarity, it was difficult to trust the creditworthiness or credential of an unknown customer/buyer. This is where the Banks stepped in to bridge the gap and facilitate the trade by issuing a letter of credit¹. Today, the Letter of Credit which was prevalent previously, has taken the form of Performance Bond, Bank Guarantee or a Performance Guarantee, all carrying the same meaning and function of securing payment of money in commercial dealings.

Usage of Bank Guarantee in Construction Projects

In Contracts awarded to private individuals by the Government, which involve huge expenditure, as, for example, construction contracts, Bank Guarantees are usually required to be furnished by the Contractor as “Advance” from time to time during the course of the contract as also to secure performance of the work entrusted under the contract. Such Guarantees are encashable in terms thereof on the lapse of the Contractor either in the performance of the work or in paying back the “Government Advance”, the Guarantee is invoked and the amount is recovered from the Bank².

Parties involved

The issuing party, the Bank.
The beneficiary, in whose favour the Bank Guarantee/letter of credit has been issued.

Bank Guarantee is an independent Contract and not qualified by the underlying Contract

The party, on whose behalf the Bank has issued the Bank Guarantee does not form part of the Contract between the beneficiary and the Bank. The law in this regard is no longer res integra that a Bank Guarantee is an independent contract between the bank and the beneficiary and the bank is always obliged to honour its guarantee as long as it is an unconditional and irrevocable one. The dispute between the beneficiary and the party at whose instance the bank has given the guarantee is immaterial and is of no consequence³. The Bank issuing or confirming a letter of credit is not concerned with the underlying contract between the buyer and seller⁴. The Bank is not in the least concerned with the relations between the supplier and the customer and nor with the performance of contractual obligations⁵. The beneficiary cannot be restrained from encashing the Bank Guarantee even if dispute between the beneficiary and the person at whose instance the bank guarantee was given by the Bank, had arisen in performance of the contract or execution of the works undertaken in furtherance thereof⁶. In the matter of invocation of Bank Guarantee or a Letter of Credit, it is not open for the Bank to rely upon the terms of the underlying contract between the parties⁷.

General Rule: Court cannot interfere in case of Unconditional Bank Guarantee except in exceptional circumstances

The general rule is that in case the Bank Guarantee is an unconditional one then the Banks must pay when the demand is made⁸. Whether the Bank Guarantee is towards security deposit or mobilization advance or working funds or for due performance of the contract, if the same is unconditional and if there is stipulation in the bank guarantee that the bank should pay on demand without a demur and that the beneficiary shall be the sole judge not only on the question of breach of contract but also with respect to the amount of loss or damages, the obligation of the bank would remain the same and that obligation has to be discharged in the manner provided in the Bank Guarantee⁹.

In the matter of General Electric Technical Services Co. Inc. vs Punj Sons (P) Ltd¹⁰; Larsen and Toubro Ltd. vs Maharashtra State Electricity Board¹¹; Hindustan Steel Works Construction Ltd. vs G.S. Atwal & Co. (Engineers) Pvt. Ltd¹² and Hindustan Steel Works Construction Ltd. vs Tarapore and Co. and Ors.¹³, the Bank Guarantees were unconditional and inter alia stipulated that the Bank had to pay on demand without demur and the Beneficiary was to be the sole judge as regards the loss or damage caused to it or whether the contractor committed breach of contract. The Supreme Court inter alia held that the Bank Guarantees being irrevocable and unconditional and as the beneficiary was made the sole judge on the question of breach of performance of the contract and the extent of loss or damages, an injunction restraining the beneficiary from invoking the bank guarantees could not have been granted. The Supreme Court has also observed that Courts should be slow in granting an injunction to restrain the realization of an unconditional Bank Guarantee¹⁴. If the Bank Guarantee furnished is an unconditional and irrevocable one, it is not open to the bank to raise any objection whatsoever to pay the amounts under the guarantee. The person in whose favour the guarantee is furnished by the bank cannot be prevented by way of an injunction from enforcing the guarantee on the pretext that the condition for enforcing the Bank Guarantee in terms of the agreement entered into between the parties has not been fulfilled¹⁵. In the matter of invocation of Bank Guarantee or a Letter of Credit, it is not open for the Bank to rely upon the terms of the underlying contract between the parties¹⁶.

Therefore, as long as the Bank Guarantee has the following features-

It is unconditional,
Payable on demand without demur,
The Beneficiary is made the sole judge on the question of breach of contract.

In the aforementioned circumstances, the Bank would be obligated to pay the Bank Guarantee without any interference from the Court, except only in exceptional circumstances as discussed herein below.

Exceptional Circumstances

In a consistent line of precedents, starting from U.P. Cooperative Federation Ltd. vs Singh Consultants & Engineers (P) Ltd¹⁷ the Supreme Court has held that there are only two exceptional cases in which the invocation of a Bank Guarantee can be restrained by the Court, viz-

Fraud
Special equities, such as irretrievable injury or irretrievable injustice which would occur if injunction is not granted.

The aforesaid two conditions must be pleaded and prima facie established by strong evidence as a triable issue¹⁸.

Principles for grant or refusal for invocation of bank guarantee

In Himadari Chemicals Industries Ltd. vs Coal Tar Refining Company¹⁹ the Supreme Court, after going through a conspectus of case of laws laying down the position of law on the issue, laid down the following principles which ought to be kept in mind while adjudicating a case pertaining to injunction on invocation of Bank Guarantee-

While dealing with an application for injunction in the course of commercial dealings, and when an unconditional Bank Guarantee or Letter of Credit is given or accepted, the Beneficiary is entitled to realize such Bank Guarantee or a Letter of Credit in terms thereof irrespective of any pending disputes relating to the terms of the contract.
The Bank giving such guarantee is bound to honour it as per its terms irrespective of any dispute raised by its customer.
The courts should be slow in granting an order of injunction to restrain the realization of a Bank Guarantee or a Letter of Credit.
Since the Bank Guarantee or a Letter of Credit is an independent and a separate contract and is absolute in nature, the existence of any dispute between the parties to the contract is not a ground for issuing an order of injunction to restrain enforcement of Bank Guarantees or Letter of Credit.
Fraud of an egregious nature which would vitiate the very foundation of such a Bank Guarantee or Letter of Credit and the Beneficiary seeks to take advantage of the situation.
Allowing encashment of an unconditional Bank Guarantee or a Letter of Credit would result in irretrievable harm or injustice to one of the parties concerned.

Fraud

It is settled principle of law that fraud has to be pleaded with the necessary particulars²⁰ and a mere pleading qua fraud without the necessary details will not bring the case under the exception of fraud. The nature of Fraud must be of an egregious nature as to vitiate the entire underlying transaction. It is fraud of the beneficiary, not the fraud of somebody else. If the Bank detects with minimal investigation the fraudulent action of the seller, the payment could be refused²¹. The Supreme Court in the matter of Singh Consultants (supra) while discussing “fraud” vis-à-vis a case of Bank Guarantee, quoted with approval the following observations made in the case of Bolivinter Oil SA vs Chase Manhattan Bank–

“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 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 discharged.”

In Vinitec Electronics Pvt. Ltd vs HCL Infosystems Ltd.²², the Supreme Court observed that the allegation with regard to the alleged breach of a contract by the respondent is not a plea of fraud of an egregious nature so as to vitiate the entire transaction. In case of confirmed Bank Guarantee/irrevocable letter of credit, it cannot be interfered with unless there is fraud and irretrievable injustice involved in the case and fraud has to be an established fraud²³.

Special Equity

The second exceptional circumstance in which the invocation of Bank Guarantee could be restrained is Special Equity which is akin to irreparable injustice or irretrievable injury. The Supreme Court in a judgment rendered by a three-judge bench in the matter of Svenska Handelsbanken vs M/s Indian Charge Chrome and Ors.²⁴ observed that irretrievable injury must be of the kind which was the subject matter in the case of Itek Corpn. v. The First National Bank of Boston²⁵. In that case an exporter in USA entered into an agreement with the Imperial Government of Iran and sought an order terminating its liability on stand by letter of credit issued by an American Bank in favour of an Iranian Bank as part of the Contract. The relief was sought on account of the situation created after the Iranian revolution when the American Government cancelled the export licenses in relation to Iran and the Iranian Government had forcibly taken 52 American citizens as hostages. The US Government had blocked all Iranian assets under the jurisdiction of United States and had cancelled the export Contract. The Court in that case upheld the contention of the exporter that any claim for damages against the purchaser if decreed by the American Courts would not be executable in Iran under these circumstances and realization of the bank guarantee/letters of credit would cause irreparable harm to the Plaintiff/exporter.

Therefore, to avail this exception, exceptional circumstances, which make it impossible for the guarantor to reimburse himself if he ultimately succeeds, will have to be decisively established²⁶. The Supreme Court and High Courts have consistently referred to the Itek case (supra) with respect to irretrievable injury vis-à-vis Bank Guarantee²⁷. In Hindustan Steel Construction vs Tarapore (supra) the Contractor sought injunction on the ground of special equities by stating that there is a serious dispute on the question as to who has committed breach of contract and there is an arbitration proceeding pending between the parties for adjudication of the dispute. The Supreme Court however, held that the aforesaid factors do not fall under the exception of special equity. In Umaxe Projects Private Limited vs Air Force Naval Housing Board²⁸, the Delhi High Court observed that merely because invocation of Bank Guarantee would cause financial distress to the Petitioner, cannot be a ground to invoke the exception of irreparable injury.

In National Construction Co. Ltd. vs National Hydro Electric Power Corporation Ltd.²⁹, the Delhi High Court restrained the invocation of Bank Guarantee by recording the following special equities in favour of the Petitioner-

Petitioner has Arbitral Awards with respect to the project in his favour wherein counter claims of the Respondent have been dismissed.
The Bank Guarantees given during the contract cannot be said to have been given in perpetuity even for the period after the completion of the project and adjudication of claims/counter claims between the parties.
Even if the Respondent succeeds in his challenge to Award under Section 34, it has to resort to fresh arbitration proceedings with regard to the counter claims.
There is no prima facie case made out in light of the Awards passed in favour of the Petitioner.
There is no stay by Section 34 court on the operation of Award.
As per the provisions of the contract, the Bank Guarantee ought to be returned to the Contractor within 14 days of issuance of Defects Liability Certificate.

Pending adjudication of Dispute between the parties before Court/Arbitral Tribunal is not a ground for restraining invocation of Bank Guarantee

In Ansal Engg. Projects Ltd. vs Tehri Hydro Development Corpn. Ltd.³⁰, plea was raised by the Petitioner that unless the amount due and payable is determined by a competent court or tribunal, by mere invocation of bank guarantee pleading that the amount is due and payable by the Petitioner, which was disputed, cannot be held to be due and payable in a case. The Supreme Court relied upon Hindustan Steel Works Construction vs G.S. Atwal (supra) in which despite pendency of the Arbitration proceedings with respect to the payable amount, the Supreme Court allowed encashment of Bank Guarantee. The Supreme Court in Ansal Engg. (supra) emphasized upon Bank Guarantee being an independent contract between the Bank and the Beneficiary and further clarified that the encashment of Bank Guarantee does not depend on the result of the dispute between the person on whose behalf the Bank Guarantee was given by the bank and the beneficiary. The aforementioned two decisions were quoted with approval by Delhi High Court in the matter of Suzlon Energy Ltd. vs Zemira Renewable Energy Ltd. and Ors.³¹ wherein the parties had raised disputes regarding the completion of the work under the Agreements as well as the amounts outstanding against each other. However, the Delhi High Court held that that disputes on the merits of the respective claims raised by the parties cannot be a ground to interfere and restrain the invocation of Bank Guarantee.

Conclusion

The Supreme Court has authoritatively held vide various judgments that a Bank Guarantee is an independent contract between the Beneficiary and the Bank which is strictly governed by the terms of the Bank Guarantee and not by the underlying Contract between the parties. The Courts, as a matter of rule, will refuse to restrain the invocation of Bank Guarantee except only in two exceptional circumstances viz. Fraud and Special Equity which is akin to irretrievable injury or injustice which has to be adjudicated from the facts and circumstances of each case on the basis of principles discussed hereinabove.

By Daksh Pandit