Tuesday, January 24, 2023

INJUNCTION AGAINST INVOCATION OF BANK GUARANTEE PART- II

 



Injunction against invocation of bank guarantee

PART- II

The issue of encashing bank guarantee in the backdrop of disputes between parties is often a subject matter in the court dockets. The law has evolved in this regard over the year and generally, any fetter is not permitted to the encashment of bank guarantee. There are instances, however, when the restrain order against invocation of bank guarantee could be passed. In the present write up, endeavour shall be to reflect on the above issue. In fact, the present article is a sequel to earlier article where law relating to encashment of bank guarantee on merit i.e after trial was deliberated. However, unless, the issue of interim restrain against invocation of bank guarantee and parameter under which such order could be passed is also deliberated, a vital limb of the law shall remain unattended. Therefore, by way of the present write up it is endeavoured to analyze the law in respect of that and parameter under which interim injunction against invocation of bank guarantee could be passed and judicial precedents in this regard has accordingly been duly ventured on.



The Law and judicial precedents : Analysis

If a bank guarantee is invoked on fraudulent ground there may be a ground of interim injunction. Thus it follows that if a party seeks to encash bank guarantee, despite the pervasive fraud unleashed by it, then the same may tantamount to reaping advantage of their own wrong. Whether the same could be permitted is a question?

It will be apposite to cull out various precedents relating to the principles governing the bank guarantees and its encashment, and the parameter of probable challenges that are permitted to be raised against invocation thereof. 

As a general rule courts are loath to interfere with irrevocable documentary credits and obligations assumed by the banks, like Letters of Credit and Bank Guarantees, since internal and international Trade and Commerce runs on the faith of their efficacy. How well established and entrenched is the concept could be borne out from the scores of judicial decisions. In Hamzeh Malas & Sons Vs. British Imex Industries Limited, (1958) 1 All ER 262, it was held by the Queen’s bench that opening of a confirmed letter of credit constitutes a contract between the bank and the vendor of goods which imposes upon the banker an absolute obligation to pay, irrespective of any dispute between the parties, as to whether the goods are up to contract or not as an elaborate commercial system is built upon the footing that banker’s credit is of that character and it would be wrong for a court to interfere with the established practice.

In Centex India Ltd. Versus Vinmar Impex Inc, AIR 1986 SC 1924, it was held that a bank guarantee resembles and is analogous to a letter of credit and the same considerations apply to it, which apply to a letter of credit in the matter of its enforcement/ interference by courts. This decision is noted at the outset for the reason that letters of credit were in vogue earlier to the introduction of bank guarantees for commercial purposes and the principles governing letters of credit in the matter of interference by the courts were made applicable to bank guarantees as well.

        The Supreme Court in the case of Tarapore & Company v. V.O. Tractors Export, (1969) 2 SCR 920, while citing with  approval the aforesaid principle of Queens bench was pleased to lay down the following principles  :

(i)          an irrevocable letter of credit has a definite implication;

(ii)        letter of credit is a contract between the banker and the beneficiary and is  independent of and not qualified by the contract of sale or the underlying transaction; and

(iii)       letter of credit, being a mechanism of great importance in the international trade, its autonomy is entitled to protection. This being so courts do not interfere with their autonomy except in very exceptional circumstances.

 

        In yet another English decision in R.D. Harbottle (Mercantile) Limited Vs. National West Minister Bank Limited (1977) 3 W.L.R. 752, which is largely quoted by the courts  in the decisions involving letters of credit and bank guarantees, it was held as follows:- 

It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by the banks.  They are the life and blood of international commerce.  Such obligations are recorded as collateral to the underlying rights and obligations between the merchants at either end of the banking chain.  Except possibly in the clear cases of fraud of which the banks have notice the courts will leave the merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contract. The courts are not concerned with their difficulties to enforce such claims.  These are risks which the merchants take.  In this case, the plaintiffs took the risk of unconditional wording of the guarantees.  The machinery and commitments of banks are on a different level, they must be allowed to be honoured, free from interferences by the courts otherwise trade in international commerce could be irreparably damaged.” 

         The aforesaid observations of Kerr J. were cited with approval in Edward Owen Engineering Limited Vs. Barclays Bank International Ltd., (1978) 1 All ER 976 by Lord Denning, who observed that “a bank which gives a performance guarantee must honour that guarantee according to its terms.  It is not in the least concerned with the relations between the supplier and customer nor with the question whether the supplier is at default or not. The bank must according to its guarantee pay on demand, if so stipulated without proof of default.  The only exception is when there is a clear fraud of the beneficiary which the bank has notice.

         The Supreme Court in the case of United Commercial bank vs. Bank of India, (1981) 3 SCR 300, while relying upon various decision held that a letter of credit constitutes a contract between the beneficiary and the bank issuing the letter of credit and is independent of and unqualified by the underlying contract of sale.   In this regard it observed as follows:-

“The credit contract is independent of the sales contract on which it is based, unless the sales contract is in some measure incorporated…..The authorities are uniform to the effect that a letter of credit constitutes the sole contract with the banker, and the bank issuing the letter of credit has no concern with any question that may arise between the seller and the purchaser of the goods, for the purchase price of which the letter of credit was issued.”

 

         The aforesaid decisions were noticed and relied upon by the Supreme Court in U.P. Co-operative Federation Limited Vs. Singh Consultants and Engineering Pvt. Ltd. ,  AIR 1988 SC 174. In that case it was held that in order to restrain the operation of an irrevocable letter of credit or of a bank guarantee, there should be a serious dispute, a prima facie case of fraud and special equities in the form of preventing irretrievable injustice between the parties, otherwise their very purpose would be frustrated and the fabric of trading operations will get jeopardized. While holding so, their lordships made reference to history, progress and growth of the concept of letter of credit.  Elucidating the concept it was pointed out to the effect that:

(i)          The letter of credit was used in conjunction with the sale transactions between the parties, separated geographically over distances and was intended to facilitate the sale and purchase of goods between unfamiliar buyers and sellers.  It was difficult for the seller to rely upon the credit of the buyer and similarly it was equally difficult for the buyer to pay for the goods prior to their delivery.  In order to bridge the gap and to generate confidence in the parties to do business even with total strangers, mechanism of letter of credit was created; 

(ii)        In the case of such transactions when the seller presents a demand as per terms of the documents, the banks must pay if the documents are in order and the terms of credit are satisfied. To this absolute rule that the banks must honour the commitments, there are two exception in as much as in case there be fraud of the beneficiary and  special equities in the form of preventing irretrievable injustice between the parties, the bank could refuse the demand. 

 

         The Supreme Court to illustrate a case of fraud of the beneficiary of a bank guarantee in the above decision, referred to the American case of Sztejn Vs. J. Heney Schroder Banking Corporation (1941) 31 NYS 2d 631.  The facts of the case as noticed by the Supreme Court were that one Mr. Sztejn wanted to buy certain quantity of Bristles.  He entered into deal with a overseas seller to sell to him a particular quantity thereof.  The Respondent bank issued a letter of credit to the seller that provided that upon receipt of appropriate documents, the bank would pay for the shipment. It was discovered by Sztejn that the shipment did not consist of Bristles, but crates of worthless material.  He approached the bank which informed him that the letter of credit was an independent undertaking of the bank and it must pay to the seller, whereupon he sought an injunction from the Court.  The collecting bank which received the documents from the seller for collection applied for dismissing the buyer’s claim for injunction on the ground that there was no cause of action. It was a proceeding similar to a proceeding that is initiated by an application under Order VII Rule 11 CPC. The allegations were taken to be true and as they constituted fraud, the court issued injunction against the demand of letter of credit.  It was noticed by the Supreme Court in the same decision- UP Co-operative Federation (supra)] that it was perhaps, the first time that the said exception of fraud to the rule of absolute independence of the letter of credit was applied in aforesaid American case.  The exception of fraud created in the above case was codified in sections 5 – 114 of the US Uniform Commercial Code.  The Supreme Court also noticed that the exception was accepted by the courts in England as reflected in the following cases: 

i.       Hamzeh Malas & Sons Vs. British Imex Industries Ltd. (supra). 

ii.     R.D. Harbottle (Mercantile) Limited Vs. National West Minister Bank Limited (supra)

iii.             Edward Owen Engineering Limited Vs. Barclays Bank International Ltd. (supra) 

iv.             United City Merchants (Investments) Vs. Royal Bank of India (1982) 2 All. E.R. 720.   

         In the case of General Electric Technical Services Company Inc. Vs. Punj  Sons (P) Ltd., (1991) 4 SCC 230, where as per the stipulations in the three bank guarantees, the bank was required to pay on demand of the beneficiary without demur and  the beneficiary was to be the sole judge as regards the loss or damage caused to it due to the alleged breach of the other party to the underlying contract, the Supreme Court held that the right of a contractor to recover certain amount under running bills would have no relevance to the obligation of the bank to honour its commitment under the guarantees given by it. At this stage, it may be worthwhile to quote the exact observations of the court :

The GETSCO has only sought to enforce the bank guarantee for the balance amount of Rs. 1,06, 12,500 on a complaint that Respondent-1, has failed to perform the contract as per the terms and conditions. The Bank has undertaken to pay this sum of money and it is a commitment of the Bank. The Bank must honour its commitment when demand is made. Indeed, the Bank was prepared to pay and has in fact issued the Cashier's order as per demand from GETSCO, but the Court has directed the Bank not to pay under the guarantee. The question is whether the Court was justified in restraining the Bank from paying to GETSCO under the bank guarantee at the instance of Respondent-1. The law as to the contractual obligations under the bank guarantee has been well settled in a catena of cases. Almost all such cases have been considered in a recent judgment of this Court in U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd., [1988] 1 SCC 174 wherein Sabyasachi Mukherji, J., as he then was, observed (at 189) 'that in order to restrain the operation either of irrevocable letter of credit or of confirmed letter of credit or of bank guarantee, there should be serious dispute and there should be good prima facie case of fraud and special equities in the form of preventing irretrievable injustice between the parties. Otherwise, the very purpose of bank guarantees would be negatived and the fabric of trading operations will get jeopardised'. It was further observed that 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 in case of irretrievable injustice, the Court should interfere. In the concurring opinion one of us (K. Jagannatha Shetty, J.) has observed that whether it is a traditional bond or performance guarantee, the obligation of the Bank appears to be the same. If the documentary credits are irrevocable and independent, the Bank must pay when demand is made. Since the Bank pledges its own credit involving its reputation, it has no defence except in the case of fraud. The Bank's obligations of course should not be extended to protest the unscrupulous party, that is, the party who is responsible for the fraud. But the banker must be sure of his ground before declining to pay. The nature of the fraud that the courts talk about is fraud of an "egregious nature as to vitiate the entire underlying transaction". It is fraud of the beneficiary, not the fraud of somebody else.

The High Court has observed that failure on the part of GETSCO to make a reference to mobilisation advance in the letter seeking encashment of the bank guarantee would tantamount to suppression of material facts, in the sense that the mobilisation advance was, under the contract to be recovered from the running bills. It was further observed that disclosure of such facts would have put the bank to further inquiry as to what was the amount covered by those bills and what was the corresponding amount of the mobilisation advance and to what extent the amount covered by the bank guarantee remained payable. In any event, the High Court said, that GETSCO could not demand full amount of the bank guarantee on 17 April 1989. It seems to us that the High Court has misconstrued the terms of the bank guarantee and the nature of the inter-se rights of the parties under the contract. The mobilisation advance is required to be recovered by GETSCO from the running bills submitted by the Respondent. If the full mobilisation advance has not been recovered, it would be to the advantage of the Respondent. Secondly, the Bank is not concerned with the outstanding amount payable by GETSCO under the running bills. The right to recover the amount under the running bills has no relevance to the liability of the Bank under the guarantee. The liability of the Bank remained intact irrespective of the recovery of mobilization advance or the non-payment under the running bills. The failure on the part of GETSCO to specify the remaining mobilisation advance in the letter for encashment of bank guarantee is of little consequence to the liability of the Bank under the guarantee. The demand by GETSCO is under the Bank guarantee and as per the terms thereof. The Bank has to pay and the Bank was willing to pay as per the undertaking. The Bank cannot be interdicted by the Court at the instance of Respondent-1 in the absence of fraud or special equities in the form of preventing irretrievable injustice between the parties. The High Court in the absence of prima facie case on such matters has committed an error in restraining the Bank from honouring its commitment under the bank guarantee.

Thus it is clear that notwithstanding the dispute between the beneficiary and the party at whose instance the bank guarantee is furnished, the bank is liable to discharge its liability in accordance with the terms of the bank guarantee, subject to the two exceptions recognised by the Supreme Court in its decision rendered in the case of UP Cooperative Federation (supra).

         In the State Trading Corporation of India Ltd. Vs. Jainsons Clothing Corporation and Anr., (1994) 6 SCC 597, the Supreme Court while referring to the decision in U.P .Coop federation Ltd. case and various other decisions held as follows:-             The grant of injunction is a discretionary power in equity jurisdiction. The contract of guarantee is a trilateral contract which the bank has undertaken to unconditionally and unequivocally abide by the terms of the contract. It is an act of trust with full faith to facilitate free flow of trade and commerce in internal or international trade or business. It creates an irrevocable obligation to perform the contract in terms thereof. On the occurrence of the events mentioned therein the bank guarantee becomes enforceable. The subsequent disputes in the performance of the contract does not give rise to a cause nor is the court justified on that basis, to issue an injunction from enforcing the contract, i.e., bank guarantee. The parties are not left with no remedy. In the event of the dispute in the main contract ends in the party's favour, he/it is entitled to damages or other consequential reliefs.”… 

“It is settled law that the court, before issuing the injunction under Order 39, Rules 1 and 2, CPC should prima facie be satisfied that there is triable issue strong prima facie case of fraud or irretrievable injury and balance of convenience is in favour of issuing injunction to prevent irremediable injury. The court should normally insist upon enforcement of the bank guarantee and the court should not interfere with the enforcement of the contract of guarantee unless there is a specific plea of fraud or special equities in favour of the plaintiff. He must necessarily plead and produce all the necessary evidence in proof of the fraud in execution-of the contract of the guarantee, but not the contract either of the original contract or any of the subsequent events that may happen as a ground for fraud.”

         In Larsen and Tubro Ltd. Vs. Maharastra State Electricity Board, AIR 1996 SC 334, it was held to the effect that bank guarantee furnished by the bank being irrevocable and unconditional one and as the beneficiary was made the sole judge on the questions of breach of performance of the contract and the extent of loss and damages, injunction restraining the beneficiary from invoking the bank guarantee could not have been granted.

         In Hindustan Steel Works Construction Ltd. Vs. Tarapore and Co. and another, AIR 1996 SC 2268, the Supreme Court while quoting the  observations of Mukherji, J., recorded in para 34 of his lordships judgment rendered in UP Cooperative Federation case (supra), namely, “It is only in exceptional cases that is to say in case of fraud or in case of  irretrievable injustice be done, the Courts should interfere,” clarified that this being the ratio of the decision, fraud cannot be said to be the only exception.  Their Lordship went on to lay down that where the party approaching the Court is able to establish that in view of special equities in his favour, if injunction as requested is not granted, then he would suffer an irretrievable injustice, the court could and would interfere. It was further observed that the fraud which is recognized as an exception is the fraud by one of the parties to the under lying contract which has the effect of vitiating the entire underlying transaction. It was also observed that the demand by the beneficiary under the bank guarantee may become fraudulent, not because of any fraud committed by the beneficiary executing the underlying contract but it may become so because of subsequent events or circumstances. The court also observed that there is no good reason that the court should not restrain a person making such a fraudulent demand from enforcing a bank guarantee.  

         In Dwarikesh Sugar Industries Ltd. vs Prem Heavy Engineering Works Pvt. Ltd. & Anr.  (1997) 6 SCC 450, the Supreme Court held as follows:- 

21. Numerous decisions of this Court rendered over a span of a nearly two decades have laid down and reiterated the principles which the Court must apply while considering question whether to grant an injunction which has the effect of restraining the encashment of a bank guarantee.  We do not think it necessary to burden this judgment by referring to all of them.  Some of the most recent pronouncements on this point where the earlier decisions have been considered and reiterated are; Svenska Handelsbanken Vs. Indian Charge Chrome, (1994) 1 SCC 502; Larsen & Toubro Ltd. Vs. Maharashtra , (1995) 6 SCC 68; Hindustan Steel Workers Construction Ltd. Vs. G.S. Atwal & Co. ( Engineers ) (P). Ltd., (1995) 6 SCC 76 and U.P. State Sugar Corporation Ltd. Vs. Sumac International Ltd. (1997) 1 SCC 568.” 

The general principle which has been laid down by this court has been summarized in case of U.P. State Sugar Corporation as follows:- 

The law relating to invocation of such bank guarantee is by now well settled.  When in the course of commercial dealings an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realize such a bank guarantee in terms thereof irrespective of any pending dispute.  The  bank giving such guarantee is bound to honour it as per its terms irrespective of any dispute raised by its customer.  The very purpose of giving such a bank guarantee would otherwise be defeated. Courts should, therefore, be slow in granting an injunction to restrain the realisation of such a bank guarantee.  The Courts have carved out only two exceptions. A fraud in connection with such a bank guarantee would vitiate the very foundation of such a bank guarantee. Hence if there is such a fraud of which the beneficiary seeks to take advantage, he can be restrained from doing so. The second exception relates to cases where allowing the encashment of an unconditional bank guarantee would result in irretrievable harm or injustice to one of the parties concerned. Since in most cases payment of money under such a bank guarantee would adversely affect the bank and its customers at whose instance the guarantee is given the harm or injustice contemplated under this head must be of such an exceptional and irretrievable nature as would override the terms of guarantee and the adverse effect of such injunction on commercial dealings in the country.

Dealing with the question of fraud it has been held that fraud has to be an established fraud. The following observation of sir John Donaldson, M.R. in Bolivinter oil SA V. Chase Manhattan Bank (1984) 1 All ER 351, are apposite:

 

"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 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."

(emphasis supplied)

 

The aforesaid passage was approved and followed by this court in U.P. cooperative Federation Ltd. Vs. Singh consultants and Engineers (P) Ltd. [(1988) 1 SCC 174].

 

The second exception to the rule of granting injunction, i.e., the resulting of irretrievable injury, has to be such a circumstance which would make it impossible for the guarantor to reimburse himself, if he ultimately succeeds. This will have to be decisively established and it must be proved to the satisfaction of the Court that there would be no possibility whatsoever of the recovery of the amount from the beneficiary by way of restitution. …….

 

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29.    It is unfortunate that the High Court did not consider it necessary to refer to various judicial pronouncements of this Court in which the principles which have to be followed while examining an application for grant of interim relief have been clearly laid down. The observation of the High Court that reference to judicial decisions will not be of much importance was clear a method adopted by it in avoiding to follow and apply the law as laid down by this Court. Yet another serious error which was committed by the High Court, in the present case, was not to examine the terms of the bank guarantee and consider the letters of invocation which had been written by the appellant…………

 

“It is held that when a position, in law, is well settled as a result of judicial pronouncement of the Supreme Court, it would amount to judicial impropriety to say the least, for the subordinate courts including the High Courts to ignore the settled decisions and then to pass a judicial order which is clearly contrary to the settled legal position. Such judicial adventurism cannot be permitted and we strongly deprecate the tendency of the subordinate courts in not applying the settled principles and in passing whimsical orders which necessarily has the effect of granting wrongful and unwarranted relief to one of the parties. It is time that this tendency stops.”

 

         In Federal Bank Ltd. Vs. V.M. Jog Engineering Ltd. and Ors. (2001) 1 SCC 663, the Supreme Court taking stock of the various judgments observed as under:- 

“55.  In several judgments of this Court, it has been held that courts are not to grant injunction to restrain encashment of bank guarantees or letter of credit. Two exceptions have been mentioned- (i), Fraud, and (ii) Irretrievable damage. If the plaintiff is prima facie able to establish that the case comes within these two exceptions, temporary injunction, under order 39 rule 1 CPC can be issued. It has also been held that the contract of bank guarantee or the letter of credit is independent of the main contract between the seller and the buyer.  This is also clear from Article 3 and 4 of UCP (1983 Revision).  In case of an irrevocable bank guarantee or letter of credit the buyer cannot obtain injunction against the banker on the ground that there was a breach of the contract by the seller.  The bank is to honour the demand for encashment if the seller prima facie complies with the terms of the bank guarantee or the letter of credit, namely, if the seller produces the documents enumerated in the bank guarantee or the letter of credit.  If the bank is satisfied on the face of the documents that they are in conformity with the list of documents mentioned in the bank guarantee or the letter of credit and there is no discrepancy, it is bound to honour the demand of the seller for encashment.  While doing so it must take reasonable care.  It is not permissible for the bank to refuse payment on the ground that the buyer is claiming that there is a breach of contract.  Nor can the bank try to decide this question of breach at that stage and refuse payment to the seller.  Its obligation under the documents having nothing to do with any dispute as to breach of contract between the seller and the buyer.  As to its knowledge of fraud or forgery, we shall presently deal with it.”

         The Supreme Court in the aforesaid case also referred to the following observations in the case of Sztejn v. J. Heney Schroder Banking Corpn. (1941) 31 NYS 2d. 631.

 

“where the seller's fraud has been called to the bank's attention before the drafts and documents have been presented for payment, the principle of the independence of the bank's obligation under the Letter of Credit should not be extended to protect the unscrupulous seller. …..

 

“……No hardship will be caused by permitting the bank to refuse payment where fraud is claimed, where merchandise is not merely inferior in the quality but consists of worthless rubbish, where the draft and the accompanying document are in the hands of one who stands in the same position as the fraudulent seller, where the bank has been given notice of fraud before being presented with the drafts and documents for payment, and where the bank itself does not wish to pay pending an adjudication of the rights and obligations of the other parties.”

 

         In BSES Ltd. (Now Reliance Energy Ltd.) Vs. Fenner India Ltd. and Anr. (2006) 2 SCC 728, it was reiterated that there are two exceptions to the general rule that the bank must pay according to the tenor of the guarantee: “when there is a clear fraud of beneficiary from which it seeks to benefit and the bank has notice of the fraud; and the second exception is when there are special equities in favour of injunction such as when irretrievable injury and injustice would occur if such an injunction were not granted.”

In the case of Samwoh Asphalt Premix Pte. Ltd. Vs. Sum Cheong Piling Pte. Ltd. (2002) 1 SLR 1, wherein the Singapore Court has gone so far as to say that the unconscionable calling of a bank guarantee was an exception independent of fraud.  The Supreme Court, while repelling the aforesaid contention advanced on behalf of one of the Respondents, refused to accept the proposition of law laid down in the aforesaid judgment of the Singapore court in the face of the law laid down in U.P. Coop. federation (supra) and numerous other judgments. It was also observed that whatever may be the law as to the encashment of the bank guarantees in other jurisdictions, when the law in India is clear, settled and without any deviation whatsoever, there is no occasion to rely upon the foreign case law. 

28.    In Hindustan Construction Company Ltd. Vs. State of Bihar, AIR 1999 SC 3710, it was held that a bank guarantee is the common mode of securing payment of money in commercial dealings as a beneficiary under the guarantee is entitled to realise the whole of the amount under the guarantee in terms thereof irrespective of any pending dispute between the person on whose behalf the guarantee was given and the beneficiary.

         In Reliance Salt Ltd. Vs. Cosmos Enterprises & Anr, (2006) 13 SCC 599, it was held that “breach of contract by reason of supply of inferior quality tea or salt or delay in supply or a short supply may render a party responsible for damages for commission of breach of contract, but breach of contract alone does not lead to a conclusion that a fraud had been committed thereby…..”. It was also held by the Supreme Court that fraud which vitiates the contract must have a nexus with conduct of the parties prior to entering into the contract but these observations are contrary to the decision rendered by two judge bench in Hindustan Steel Works Constructions Ltd. Vs. Tarapore and Company (supra).  

30.    It is also well settled that the Terms of the bank guarantee must be fulfilled before its invocation. In M/s Harprasad and Co. Vs. Sudharshan Steel Mills, AIR 1980 Delhi 174, it was held that under the bank guarantee absolute liability would arise only on the terms of the bank guarantee being fulfilled. It will be appropriate to quote the following paragraphs from the decision:  

“In this connection we may point out that the Punjab National Bank in this case, as every other bank issuing a bank guarantee, has a duty to perform. The bank must not, take up the position that it would be willing to pay the amount of the bank guarantee on a mere demand simply because its customer who has got the bank guarantee issued in favor of the other party to the contract has already secured the bank against any loss that may be caused by the recovery of the amount of the bank guarantee from the bank by the other party in the contract. The bank has itself a duty to satisfy itself that the demand by the beneficiary under the bank guarantee is made in accordance with the terms of the bank guarantee. For instance, if in the present case the appellant has simply called upon the bank to pay the money under the bank guarantee, such a notice in writing is not in accordance with the terms of the bank guarantee. It is the duty of the bank to satisfy itself that the demand is made on the ground that in the judgment of the appellant Respondent No. 1 has failed to fulfill any of the obligations under the contract. Further, the bank has to see that the judgment is exercised in respect of some definite obligation to be performed by Respondent under the contract. It is not sufficient for the appellant merely to reiterate parrot-like words of the bank guarantee. The statement by the appellant in the notice in writing that Respondent No. 1 has failed 'to carry out and fulfill any of the obligations assumed under the said contract' would simply be unintelligible 'Any of the obligations' are meaningless words unless and until a reference is made to some particular obligation to which Respondent No. 1 has failed to carry out in the judgment of the appellant. The duty of the appellant in making the demand on the bank is like the duty of the plaintiff to disclose the cause of action in the plaint. Just as a plaint is liable to be rejected for non-disclosure of the cause of action, a demand by the beneficiary of the bank guarantee is liable to be rejected by the bank if it does not state the facts showing that the conditions of the bank guarantee have been fulfilled. Just as the allegations in the plaint have to be assumed to be true at the stage of plaint is to be entertained, similarly the allegations in the demand would have to be assumed to be true by the bank provided that the proper allegations are made just as a proper pleadings has to be made in the plaint. The bank is not to enquire into the truth of the allegations just as the court is not to enquire into the truth of the pleadings at the stage of the filing of the plaint………

The argument of the appellant that the liability of the bank is absolute even without showing whether the appellant has stated in the notice in writing that in its judgment Respondent No. 1 has failed to fulfill an obligation under the contract after describing some particular obligation there under would amount to saying that the effect of the bank guarantee is to deliver the amount of money secured by the bank guarantee to the beneficiary. This is not so, until the terms of the bank guarantee are fulfilled the amount is not placed into the pockets of the beneficiary. It still remains with the bank. It is no use for the beneficiary to say that the amount under the bank guarantee is payable to the beneficiary on demand if the demand must be preceded by a proper statement in the demand notice. ” 

         In Explore Computers Pvt. Ltd. Vs. CALS Ltd. & Anr. 131 (2006) DLT 477, it was held that the bank is obliged to verify that the cause of action for invoking the bank guarantee has been made out as per the letter of invocation.  It was further held that the bank, however, is not required to go into the merits of the controversy. 

         In V.V. Gupta Vs. New Delhi Municipal Council & Anr., 129 (2006) DLT. 771, it was held that if invocation of bank guarantee is not in terms of the bank guarantee then the injunction can be granted restraining the encashment of the bank guarantee. 

         In Hindustan Construction Company Ltd.  Vs. State of Bihar & Anr. (supra), it was also held that  invocation  must be in accordance with the terms of the bank guarantee or else the invocation itself would be void. In this regard it was observed as under:- 

What is important, therefore, is that the bank guarantee should  be in unequivocal terms, unconditional and recite that the amount would be paid without demur or objection irrespective of any dispute that might have much granted or might being pending between the beneficiary under the bank guarantee or the person on whose behalf the guarantee was furnished.  The terms of the bank guarantee are, therefore, extremely material.  Since the bank guarantee represents an independent contract between the bank and the beneficiary, both the parties would bound by the terms thereof.   The invocation, therefore, will have to be in accordance with the terms of bank guarantee, or else, that invocation itself would be bad.” 

         In National Highways Authority of India Vs. Karnataka Enterprises & Anr. (2003) 7 SCC 410, it was held that a contract of guarantee is a complete and separate contract by itself.  The law regarding enforcement of on demand bank guarantee is very clear.  If the enforcement is in terms of the guarantee then courts must not interfere with the enforcement of bank guarantee.  The courts can only interfere with the invocation is against the terms of the guarantee or if there is any fraud.  Courts cannot restrain the enforcement of on demand guarantee by looking at the terms of the underlying contract. 

         The Supreme Court in Federal Bank vs. V.M. Jog Eng. Ltd. and Ors. (supra) also laid down that the banks while dealing with the demand for encashment of a bank guarantee must satisfy itself that the bank guarantee has been invoked in accordance with the terms thereof. It also referred to uniform customs and practices for documentary credits formulated by the international chamber of commerce with a view to emphasize the duty and obligation of the bank to apply reasonable care to ascertain whether on the face of the letter of invocation, the banks credit has been invoked in terms and conditions thereof. In this regard, it was observed as follows:

Summary of the principles that flow from the aforesaid judicial pronouncements:

         The following principles emerge from the decisions cited above:-

a.   Irrevocable and unconditional bank guarantee constitutes a contract between the bank and the beneficiary, which is separate and independent of and unqualified by the underlying contract between the person at whose instance the bank guarantee is furnished and the beneficiary thereof. 

b.   Bank Guarantee must be invoked in terms thereof. The terms of the bank guarantee are material and both the parties, namely, the bank and the beneficiary are bound by them. This being so, the bank is required to honour the demand for encashment of a bank guarantee only if the beneficiary complies with the terms of the bank guarantee.  The bank has a duty to satisfy itself that the demand by the beneficiary under the bank guarantee is made in accordance with the terms of the bank guarantee.  In case the invocation is not in accordance with the terms of the bank guarantee, that invocation itself would be void.  Even under the Uniform Customs and Practices for documentary credits (for short UCP), formulated by the International Chamber of Commerce, it is provided that the bank must examine all the documents with reasonable care to ascertain that they appear on their face to be in accordance with the terms and conditions of the credit.  The invocation is to be rejected, if it does not state the facts showing that the conditions of the bank guarantee have been fulfilled.

c.   Where the irrevocable and unconditional bank guarantee is invoked in terms thereof the bank is under an obligation to honour its commitment irrespective of the pending disputes between the parties emanating from the underlying transaction. However, there are exceptions to the rule on the basis of which the invocation of bank guarantee may not be entertained by the bank or encashment thereof be injuncted by a court.

Exceptions:-

(i)          Prima-facie established fraud of the beneficiary of an egregious nature so as to vitiate the entire underlying transaction. 

       Explanation

(a)        The bank’s and courts obligation to entertain invocation of bank guarantee, cannot be extended to protect an unscrupulous party, who is responsible for the fraud as fraud unravels all but prima facie evidence of fraud must be clear.

(b)  The bank must have knowledge of fraud in case it refuses to honour the invocation of the bank guarantee. In Federal Bank Ltd. Vs. V.M. Jog Engineering Ltd. (supra), the Supreme Court after taking stock of various judgements held that “not only must fraud be clearly proved but as far as bank is concerned, it must also prove that it had knowledge of the fraud.” In other words, in a case the party, at whose instance the bank furnishes the guarantee, does not inform the bank about the fraud of the beneficiary and the bank in ignorance thereof entertains the invocation of the bank guarantee and encashes the same, the bank cannot be faulted and made liable to him for refund or restitution of the amount realised under the bank guarantee. A party that fails to give notice of fraud of the beneficiary to the bank, loses his right to complain against the bank for accepting the invocation. It is the risk which the party takes for his said failure.  In a nutshell, it may be stated that where the bank is urged not to entertain invocation, it must have notice of fraud. It is however, different where matter is before the court under section 9 of Arbitration & Conciliation Act, 1996 or before an arbitrator in proceedings under Section 17 thereof and court or the arbitral tribunal, as the case may be has to take a view in the matter regarding the allegation of fraud of the beneficiary. It is in the former contingency and context that the bank must have notice of fraud, in case it is to refuse invocation. In the latter contingency of an arbitration between the parties to the underlying contract, where the justifiability and legality of invocation of bank guarantee is in question, the party who challenges invocation must prima-facie prove fraud of the beneficiary. In such proceedings the bank has no role to play as the bank not being a signatory to the arbitration agreement, cannot be a party to such proceedings. The Supreme Court in Federal Bank Ltd. Vs. V.M. Jog Engineering Ltd. (supra) also relied upon the decision in the case of United Trading Corp. S.A. Vs. Allied Arab Bank, 1985 (2) Loyds Rep. 554, wherein it was stated that there must be proof of knowledge of fraud on the part of the bank at any time before payment is released. Therefore the person at whose instance bank guarantee is furnished can give proof of the fraud of the beneficiary to the bank before payment is released pursuant to invocation of bank guarantee by him. In the instant case the Hon’ble High Court passed the interim order restraining the bank from encashing the bank guarantee, before referring the matter for arbitration, which must have posted the bank with knowledge of the proceedings.   

(c)     The Supreme Court has not accepted the proposition of law laid down by Singapore Court in the case of Samwoh Asphalt (supra) that injunction ought to be granted when a performance guarantee is invoked for an oblique purpose using it as an bargaining chip and as a deterrent.  It also refused to go as far as the Singapore Court which held that unconscionable calling of a bank guarantee was an exception independent of fraud.  Therefore, in India the invocation of bank guarantee cannot be restrained on the ground on which the Singapore Court interfered.

(d)    There is a conflict on the question at what stage the demand by the beneficiary under the bank guarantee may become fraudulent.  In Hindustan Steel Works Pvt. Ltd. Vs. Tarapur & Co., (1996) SC 2268 Supra, it was held that demand by the beneficiary under the bank guarantee may become fraudulent not because of any fraud committed by the beneficiary executing the underlying contract but it may become so because of subsequent events or circumstances.  It was also held that there was no good reason why the court should not restrain a person making such a fraudulent demand from enforcing a bank guarantee. In State Trading Corporation of India Ltd. Vs. Jainsons Clothing Corporation & Ors., (1994) 6 SCC 597 (supra), the Supreme Court observed to the effect that the party must necessarily plead and produce all the necessary evidence in proof of fraud, in execution of the contract of guarantee, but not the contract either of the original transaction or any of the subsequent events that may happen, as a ground for fraud.  In other words it means that fraud in execution of the contract of guarantee can be considered as an exception to the rule and not the fraud which is practiced at the time of execution of the original contract or at a point of time subsequent to the execution of the contract of guarantee.  In Reliance Salt Ltd. Vs. Cosmos Enterprises & Anr. ,(2006) 13 SCC 599, it has been stated that fraud which vitiates the contract must have a nexus with conduct of party prior to entering into the contract. 

In view of the conflicting observations of the Supreme Court, there is no clarity on the question whether the restraint order can be issued for the fraud committed by the beneficiary before or subsequent to the execution of the bank guarantee or underlying contract. It appears that the principle laid down by the Supreme Court in Hindustan Steel Works Pvt. Ltd. Vs. Tarapur & Co., AIR 1996 SC 2268, namely, the demand of the beneficiary may become fraudulent not because of fraud committed by the beneficiary executing the underlying contract but it may become so because of the subsequent supervening events, needs be adopted as fraud of the beneficiary cannot be overlooked at any stage and point of time. It is in keeping with the principles of fair play and justice not to allow a party to reap the benefit of his fraudulent act or to take advantage of it. The aforesaid decision in Hindustan steel was not noticed in Reliance Salt Ltd. Vs. Cosmos Enterprises & Anr. ,(2006) 13 SCC 599.

(ii)        Where the party approaching the court is able to prima-facie establish that in view of special equities existing in his favour, if injunction is not granted, he would suffer an irretrievable harm or injustice, the invocation of bank guarantee could be and would be interfered with.

Explanation

Irretrievable injury must be such as would make it impossible for the person on whose behalf the bank guarantee is furnished to reimburse himself if he ultimately succeeds against the beneficiary at the end of the trial. It must be prima-facie established that there would be no possibility of recovery of the amount from the beneficiary by way of restitution. The impossibility of restitution ought to be in the nature of impossibility which was demonstrated in the case of Itek Corporation Vs. First National Bank of Boston, 566 Fed. Supp 120. In that case an exporter in USA entered into an agreement with the Imperial Government of Iran. It brought an action for an order terminating its liability under the Letter of Credit issued by an American Bank in favour of an Iranian Bank as part of the contract. The action was sought in view of the situation created after the Iranian revolution as a result of which the American Government cancelled the export licenses for export of goods to Iran. The relations between the two countries had soured to such an extent that Iranian Government forcibly took 52 American citizens as hostages.  The Government of United States blocked all Iranian assets under its jurisdiction and also cancelled the export contracts. In these circumstances the US Supreme Court upheld the contention of the exporter that any claim for damages against the purchaser in the event of being decreed by the American Courts, would not be executable in Iran. In these circumstances, it was held that realisation of bank guarantee/letter of credit would cause irreparable harm to the exporter.

                   CONCLUSION

The conclusion that emanates from the aforesaid discussion are as under:-

General Rule: The courts normally do not go behind the    allegations made in the demand for realisation of a bank guarantee and loathe to interfere at that stage but where the demand/invocation falls in any of the following three exceptions, the general rule yields and the party at whose instance the bank guarantee is furnished is entitled to the grant of an order restraining the enforcement of the bank guarantee:

First Exception: Where fraud of the beneficiary is prima-facie established.

Second Exception:  Where party at whose instance the bank guarantee is furnished, is able to show that special equities exist in his favour and in case injunction is not granted, he will suffer an irretrievable injury.

Third Exception : Where the beneficiary has invoked the bank guarantee without fulfilling and satisfying the terms of the bank guarantee.

The aforesaid principles are self contained and self explained and no further elucidation may be necessary.

                                           --------

Anil K Khaware

Founder & Senior Associate

Societylawandjustice.com

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