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What Is a Bank Guarantee?

Understanding bank guarantees.

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What Is a Bank Guarantee? How They Work, Types, and Example

A bank guarantee is a financial backstop offered by a financial institution promising to cover a financial obligation if one party in a transaction fails to hold up their end of a contract. Generally used outside the United States, a bank guarantee enables the bank's client to acquire goods, buy equipment, or perform international trade. If the client fails to settle a debt or deliver promised goods, the bank will cover it.

Key Takeaways

• A bank guarantee is a promise by a financial institution to meet the liabilities of a business or individual if they don't fulfill their obligations in a contractual transaction.
• Bank guarantees are largely used outside the U.S. and are similar to American standby letters of credit.
• Bank guarantees are mostly seen in international business transactions, although they may also individuals may need a guarantee to rent property in some countries.
• Different types of guarantees include a performance bond guarantee, an advance payment guarantee, a warrantee bond guarantee, and a rental guarantee.

Investopedia / Joules Garcia

A bank guarantee is a promise by a lending institution to cover a loss if a business transaction doesn't unfold as planned. The buyer receives compensation if a party doesn't deliver goods or services as agreed or fulfill contractual obligations.

Non-U.S. financial institutions and intermediaries in countries such as Spain, the U.K., and elsewhere may more heavily rely on bank guarantees in commercial transactions. But sometimes, a bank guarantee may help an individual rent a property.

A bank guarantee may also be called a standby letter of credit or be referred to as a bond. Bank guarantees from a reputable institution can help you establish business relationships, increase your access to cash flow and capital, protect your business from losses , and set you up for international opportunities.

Another type of guarantee is the loan guarantee from the Export-Import Bank of the U.S. This guarantees creditworthy foreign buyers of financing for U.S. capital goods and services purchases. U.S. companies receive payment when the product is shipped from the U.S. to a foreign buyer.

The U.S. Securities and Exchange Commission (SEC) warns investors to be wary of secretive "high-yield" investments marketed as as a "Prime Bank" program or "Prime World Bank" financial instrument. These fraudulent investments may involve legitimate-sounding language such as "bank guarantee" or "standby letter of credit."

Examples of Bank Guarantees

Here are several kinds of bank guarantees that cover various risks, including:

• Performance bond guarantee : Serves as collateral for the buyer’s costs if services or goods are not provided as agreed in the contract.
• Advance payment guarantee: Acts as collateral for reimbursing the buyer's advance payment if the seller does not supply the specified goods per the contract.
• Warranty bond guarantee: Serves as collateral, ensuring ordered goods are delivered as agreed.
• Payment guarantee : Assures a seller the purchase price is paid on a set date.
• Rental guarantee: Serves as collateral for rental agreement payments.

For example, the World Bank offers a bank guarantee program for projects. These guarantees provide commercial lenders security against payment default or failure to meet performance obligations by governments.

What Are the Different Types of Bank Guarantees?

Two key types of bank guarantees include a tender bank guarantee (bid bond) and a performance guarantee. The tender bank guarantees to reimburse the buyer (who has already supplied some funding) if you, the supplier, don't sign a contract or fulfill conditions. Performance-based guarantees are for obligations laid out in a contract, such as particular tasks.

What Is the Financial Instrument for a Bank Guarantee?

The financial instrument used in a bank guarantee is called a banker's acceptance.

Do Banks in the U.S. Issue Bank Guarantees?

Banks in the U.S. often do not issue bank guarantees. Instead, they issue standby letters of credit serving the same purpose.

Guarantees help protect international trade relationships by mitigating risks if a contract falls through, suppliers don't perform according to a contract's terms, or a buyer won't pay for goods. While bank guarantees are not common in the U.S., you should be able to get a similar guarantee via a standby letter of credit.

Platinum Global Bridging Finance. " Bank Guarantee and Standby Letter of Credit ."

Santander. " Bank Guarantee ."

Lloyds Bank. " Bonds and Guarantees ."

OCBC Bank. " Understanding the Purpose and Benefits of a Banker's Guarantee ."

• EXIM. "Medium and Long-Term Loan Guarantee."

Investor.gov. "' Prime Bank' Investments ."

World Bank. " Guarantees Program ."

HSBC. " International Business Guarantees ."

HSBC. " Guarantees ."

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Bank Guarantees as Collateral of Construction Contracts

• February 10, 2021

A bank guarantee is a type of collateral in which the bank guarantees the fulfilment of an obligation by its client, i.e. the guarantee applicant, and assumes the obligation to pay if the guarantee applicant does not fulfil its contractual obligations to the guarantee beneficiary. The main purpose of issuing a bank guarantee is to provide security to the guarantee beneficiary, i.e. to regulate the relations between the parties if the obligations are not performed as stipulated by the Construction Contract.

It is interesting to note that the bank guarantee first appeared in the 1960s, specifically as a collateral for securing Construction Contracts when construction works of high value were contracted. However, today, the application of the bank guarantee is extremely wide, both in domestic and international trade. When it comes to higher value transactions, a bank guarantee will be the most common type of collateral.

Construction Contract is a type of services contract by which the contractor obliges to perform specified construction works or construct a building in accordance with a specific project, within the agreed time, while the employer undertakes to pay him a certain price. Construction Contract is one of the most complex contracts due to its economic value, the fact that the execution of construction works usually takes a longer period of time, as well as due to the complexity of the contracted works. Precisely because of these characteristics, this contract generates a high risk for both the contractor and the employer, given that in case of non-performance of the obligation of the other party, each of the parties may suffer significant damage.

The risk of the contractor is reflected in the possibility of the employer failing to fulfil its obligation, i.e. failing to pay the agreed price after the completion of the works. On the other hand, the employer is exposed to the risk of the contractor not performing the works at all or not performing them in accordance with the regulations, standards of the construction profession or the contract. These circumstances encourage the parties, when signing the contract, to envision various types of collateral in order to protect their interests as much as possible, while anticipating the amount of potential damage they would suffer in case the other party fails to fulfil the contractual obligations.

Statutory and contractual liability of a contractor

Legislators have also recognized the above stated characteristics of Construction Contracts as well as the public interest which permeates construction as a business activity, hence they prescribe special rules regarding the liability of contractors. Accordingly, Law on Obligations provides special provisions relating to the liability of the contractor. Besides the fact that the rules on defects of the work provided for the Services Contract are correspondingly applied to the defects of the construction, the Law on Obligations particularly regulates the liability of the contractor for the solidity of the building within 10 years from submission and acceptance of works.

However, the provisions of the Law on Obligations do not always provide satisfactory security to the employers, which is why they regularly require contractors to provide them with additional collateral. When it comes to the performance of construction works of higher value, the parties most often opt for a bank guarantee as a collateral, especially when it comes to securing an advance payment (where the employer is more exposed as, at the moment of payment, he receives no counteraction or benefit).

In some cases, parties will prefer to arrange a bill of exchange as a collateral, given that the issuance of a bill of exchange is more suitable when the value of contracted works is not high, because in that case it is not economically justified to require the contractor to pay a high fee for the issuance of a bank guarantee.

Types of collaterals issued for securing a Construction Contract

Depending on the risk that the employer is trying to secure, there are the following types of guarantees:

• Advance payment guarantee;
• Performance guarantee; and
• Defect liability guarantee.

These three types of bank guarantees are most often contracted because they represent security against the risks to which the employers are most exposed, i.e. for which it has been shown that they are most often realized. Regularly, these guarantees are issued as unconditional and irrevocable first demand guarantees.

The employer may request to determine the credit rating of the bank that will issue the bank guarantee under the contract (typically, a credit rating corresponding to at least the level 3 of credit quality is required) or to choose a bank he finds acceptable. It is common for such guarantees to be issued as non-transferable, meaning that the transfer of these bank guarantees requires the consent of the parties and the issuing bank.

Advance payment guarantee

Advance payment guarantee is a bank guarantee by which the bank undertakes to pay a certain amount of money to the guarantee beneficiary, i.e. the employer, in case that the guarantee applicant, i.e. the contractor, does not fulfil the contractual obligation for which he received the advance payment. If the Construction Contract stipulates the obligation of the employer to pay a certain amount to the contractor before the commencement of the works, as an advance payment, the employer will usually want to secure such amount. This type of bank guarantee allows the employer to refund the advance payment in full in the event that the contractor does not fulfil its obligation at all, when he does not fulfil it satisfactorily, as well as when the advance payment is not used for a purpose specified by the Construction Contract.

The advance payment guarantee is usually granted for the amount of the agreed advance, but it can also be for a smaller amount. The employer will usually require that the period of validity of this guarantee be at least equal to the period specified for the performance of the agreement, i.e. until the final settlement of accounts.

Performance guarantee

By issuing a performance guarantee, the bank undertakes to pay a certain amount to the guarantee beneficiary, i.e. to the employer, if the contractor does not fulfil or improperly fulfils its contractual obligations. The guarantee amount can be determined in several ways, as follows:

• a fixed amount;
• a certain percentage (usually 5% or 10%) of the contracted value of works; or
• by determining the upper limit or maximum amount that the bank will be obliged to pay.

The shortest period of validity agreed for a performance guarantee is until the expiry of the time for the completion of contractual obligations i.e. performance of construction works, but it is often agreed that it is valid until the expiry of a certain period after this (e.g. the guarantee is valid for 30 days after the expiry of the deadline for the completion of construction) or it can be agreed that this guarantee is valid until the contractor issues a defect liability guarantee.

Defect liability guarantee

Defect liability guarantee is a type of bank guarantee by which the bank undertakes to the guarantee beneficiary, i.e. the employer, to pay possible claims if the performed works have defects that the contractor fails not eliminate at the request of the employer. Depending on the intentions of the parties and the value of the performed works, the guarantee period can last from 12 months up to 10 years. If the agreement stipulates mandatory issuance of a defect liability guarantee, and the contractor does not provide this guarantee, the employer has the right to collect a performance guarantee. Namely, these two types of bank guarantees are linked because it is usually agreed that the employer returns the performance guarantee to the contractor only after the contractor submits a defect liability guarantee during the guarantee period.

The guarantee amount is usually agreed in a certain percentage (typically 5% or 10%) of the agreed value of the works.

Having in mind the above, bank guarantee is always one of the most desirable and safest collaterals for the employer. Bank guarantees enable the employer a quick, easy and safe collection when the contractor does not fulfil the obligations he undertook under the Construction Contract. On the other hand, for the contractor, bank guarantees are an expensive collateral because of the price he has to pay to the issuing bank, which amounts to about 2-3% of the approved amount of the guarantee on an annual basis. However, for employers, no bank guarantee is a deal breaker when it comes to contracting performance of high value works.

FOR MORE INFO CONTACT:

Dušan Vukadin

Amina Kajević

• advance payment guarantee , Bank guarantee , bank guarantees , Collateral Construction contracts , collaterals , construction contracts , defect liability guarantee , performance guarantee

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Bank Guarantee

An assurance to a beneficiary that the bank will uphold a contract if the applicant and counterparty to the contract are unable to do so

What is a Bank Guarantee?

A bank guarantee is an assurance that a bank provides to a contract between two external parties, a buyer and a seller, or in relation to the guarantee, an applicant and a beneficiary. The bank guarantee serves as a risk management tool for the beneficiary, as the bank assumes liability for completion of the contract should the buyer default on their debt or obligation.

Bank guarantees serve a key purpose for small businesses; the bank, through their due diligence of the applicant, provides credibility to them as a viable business partner for the beneficiary of the guarantee. In essence, the bank puts its seal of approval to the applicant’s creditworthiness, co-signing on behalf of the applicant as it relates to the specific contract the two external parties are undertaking.

• A bank guarantee is an assurance to a beneficiary that the bank will uphold a contract if the applicant and counterparty to the contract are unable to do so.
• Bank guarantees serve the purpose of facilitating business in situations that would otherwise be too risky for the beneficiary to engage.
• The underlying contracts to a bank guarantee can be both financial, such as loan repayment, or performance-based, such as a service provided by one party to another.

Types of Bank Guarantees

A bank guarantee is for a specific amount and a predetermined period of time. It clearly states the circumstances under which the guarantee is applicable to the contract. A bank guarantee can be either financial or performance-based in nature.

In a financial bank guarantee , the bank will guarantee that the buyer will repay the debts owed to the seller. Should the buyer fail to do so, the bank will assume the financial burden itself, for a small initial fee , which is charged from the buyer upon issuance of the guarantee.

For a performance-based guarantee , the beneficiary can seek reparations form the bank for non-performance of the obligation as laid out in the contract. Should the counterparty fail to deliver on the services as promised, the beneficiary will claim their resulting losses from non-performance to the guarantor – the bank.

For foreign bank guarantees , such as in international export situations, there may be a fourth party – a correspondent bank that operates in the country of domicile of the beneficiary.

Real-World Example

For a real-world example, consider a large agricultural equipment manufacturer. While the manufacturer may have vendors in many places, it is often best practice to have local vendors for key parts, both for accessibility and transportation cost reasons.

As such, they may wish to enter into a contract with a small metalworks shop that is located in the same industrial area. Due to the small vendor being relatively unknown, the large company will require the vendor to secure a bank guarantee before entering into a contract for $300,000 worth of machine parts. In such a case, the large company will be the beneficiary, and the small vendor will be the applicant.

Should the small vendor receive the bank guarantee, the large company will enter into a contract with the vendor. At this point, the company may pay the $300,000 in advance, with the understanding that the vendor is to deliver the agreed-upon parts in the following year. If the vendor is unable to do so, the agricultural equipment maker can claim the losses resulting from the vendor breaking the terms of the contract from the bank.

Through the bank guarantee, the large agricultural equipment manufacturer can shorten and simplify its supply chain without compromising its financial situation.

Advantages of Bank Guarantees

To the applicant:.

• Small companies can secure loans or conduct business that would otherwise not be possible due to the potential riskiness of the contract for their counterparty. It encourages business growth and entrepreneurial activity.
• The banks charge low fees for bank guarantees, normally a fraction of 1% of the overall transaction, for the assurance provided.

To the beneficiary:

• The beneficiary can enter the contract knowing due diligence’s been done on their counterparty.
• The bank guarantee adds creditworthiness to both the applicant and the contract.
• There is a risk reduction due to the bank’s assurance that they will cover the liabilities should the applicant default.
• There is an increase in confidence in the transaction as a whole.

Disadvantages of Bank Guarantees

• The involvement of a bank in the transaction can bog down the process and add an unnecessary layer of complexity and bureaucracy.
• When it comes to particularly risky or high-value transactions, the bank itself may require assurance on the part of the applicant in the form of collateral.

Bank Guarantees vs. Letters of Credit

For a bank guarantee, the primary debtor is the buyer or applicant. Only when the applicant defaults on its obligation, will the bank guarantee step into the transaction. Often, a delayed payment is not a trigger for a bank guarantee. Contrastingly, in the financial instrument termed as a letter of credit , the seller’s claim first goes to the bank.

Thus, a letter of credit offers more confidence that there will be prompt repayment, as the bank is involved in the transaction throughout the process. With a bank guarantee, there must be an inability to uphold the contract on the part of the applicant before the bank becomes involved.

Related Readings

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Corporate Guarantee
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Assignment of bank guarantee for bank finance

Nitin Agrawal (Chartered Accountant) (317 Points)

This is a question related to finance on which clarity is needed.

- Suppose there is large size contractor (X Ltd) who has got a work order for construction of govt building and also for execution of electrical commissioning in said building. 

- Said contractor company (X Ltd) need to buy various electrical items from open market for execution of the project. Lets assume said company has made tie up with one supplier (Y Ltd)  for supply of all electrical items. Y Ltd will also provide the after sales services for 2 years to main contractor X Ltd

- Due to large size order and shortage of working capital Y Ltd needs working capital assistance. However to get that assistance from its bank, Y ltd does not have sufficient security. Also in such huge project Y Ltd wants to involve X ltd financially either by way of advance or by way of financial security.

- X Ltd is having bank guarantee limits with various banks in sizable amount. 

- X Ltd agrees to give a bank guarantee in favor of banker of Y Ltd against which Y Ltd can avail working capital from its banker. Said bank guarantee will have assignment clause in favor of banker of Y ltd and also would be invocation at the open of banker of Y ltd at the incident of default by Y Ltd in repayment of debt of working capital.

- Question is 1) Whether RBI permits assignment of Bank Guarantee's in such way for raising funds? 2) Whether said kind of practice is prevailing in market with any bank? 3) Whether said BGs would be enforceable by lender at the time of default?

Kindly suggest.

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Dhirajlal Rambhia (SEO Sai Gr. Hosp.) (174620 Points) --> Replied 24 June 2023

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Bank guarantees in practice

The construction industry is high risk and disputes and insolvencies are common. As a result parties to a construction project typically seek to secure the counterparty’s contractual obligations by a variety of means, most frequently a bank guarantee. Principals often regard these instruments as the gold standard of security for its “cash-like” quality. This status stems from its unconditional nature which means that, if called on by the principal, the bank must unconditionally and on demand pay cash to the equivalent amount stated in that guarantee – irrespective of the terms of, or proof of breach of, the underlying construction contract.

But – what actually is a “bank guarantee” and, are they really “as good as cash”?

What is a bank guarantee?

What is frequently called a “bank guarantee” is in fact an unconditional performance bond given by a bank. The use of the term “guarantee” to describe such bonds has been deemed misleading by Courts. [i] This is because a guarantee, strictly speaking, is a contract of suretyship – where the guarantor (the “surety”) takes on a secondary obligation to which it is held only after the liability of the contractor is established.

Usually, an unconditional performance bond or undertaking from a bank (“bank guarantee”) or an insurance company (“insurance bond”) can be called upon by the principal without requiring proof of the contractor’s breach of the construction contract. In this case, the liability of the institution issuing such a bond is primary, and the bond is said to operate autonomously from the construction contract (however, as seen below, this is becoming less so with the erosion of the “autonomy principle”).

Set out below are common characteristics distinguishing an unconditional bond (either a “bank guarantee” or “insurance bond”) from a conditional undertaking or bond (“surety bond”, “contract of surety” or “guarantee”).

When can a bank guarantee be called on?

If a bond is unconditional, and intended to be cash equivalent, it can (subject to the below exceptions) be called on by the beneficiary upon written demand to the issuing institution, without regard to the underlying construction contract. This is what is known as the “autonomy principle.”

The beneficiary need only have a bona fide claim of a breach of contract. [ii]

Traditionally, Courts have been reluctant to interfere with the autonomy principle as the parties (often sophisticated commercial entities) have agreed to the unconditional nature of the security. Any such interference not only undermines the intention of the contracting parties, but also diminishes the commercial worth of these forms of security.

Here the intended purpose of the security comes into play.

It is common for security under a construction contract to serve a dual purpose, being:

• to secure the contractor’s performance of the contract / provide security against the contractor becoming insolvent
• to give the principal access to funds it claims notwithstanding a dispute with the contractor is on foot. Here, the security is called a “risk allocation device” as it is used to allocate the risk between the parties as to who will be out of pocket during a dispute under the contract.

Courts are more likely to uphold the autonomy principle where the parties have agreed that the security is also a risk allocation device. [iii] To allow an injunction to restrain a call on a guarantee that is intended to act as a risk allocation device would defeat the purpose of that security: i.e. that the principal will have access to funds during a dispute between the parties.

In complex transactions involving multiple parties and multiple security instruments, the intended purpose of a particular bond can be critical to a beneficiary’s right to call on that bond – as seen in the recent case of Kawasaki Heavy Industries Ltd v Laing O’Rourke Australia Construction Pty Ltd [2017] NSWCA 291 ( Kawasaki ) (see our recent case note here ).

Exceptions to the autonomy principle

There are exceptions to the rule, and the three exceptions to the autonomy principle are:

• fraud by the principal
• unconscionable conduct by the principal (under section 20 of the Australian Consumer Law)
• an ‘underlying contract exception’.

Due to the commercial nature of performance bonds, the bar is set high for both fraud and unconscionability. For example, an element of predatory behaviour must be proven to establish unconscionable conduct. [iv] In a commercial context, disparity in bargaining power or use of superior bargaining power to achieve a legitimate commercial interest will not necessarily amount unconscionable conduct. [v]

Not surprisingly, the underlying contract exception is the most frequently argued exception. It is also the most contentious, as it provides the greatest opportunity for the erosion of the autonomy principle.

The underlying contract exception

This exception arises where a contractor asserts that the principal is attempting to call on the bond beyond the circumstances in which a call is permitted under the underlying contract, and applies for an injunction to prevent such a call.

For the exception to be established by a Court, there must be “clear words” in the underlying contract that limit the principal’s rights to call on the performance bond. [vi] However, the necessary “clear words” are often difficult to distinguish. [vii]

If established, the Court will then examine the terms of the underlying construction contract to determine whether the principal rightfully called on the bond in accordance with those terms.

An obligation on the principal to provide notice to the contractor prior to a call on security is an example of a term that may exist in the underlying contract, which if found to be expressed in “clear words”, could restrict a principal’s unconditional right to call on that security. This can be difficult to reconcile with the autonomous nature of an unconditional bond, especially if the terms of the unconditional bond itself expressly exclude any obligation on the principal to provide notice to the contractor prior to a call on the bond.

Fighting back with a no injunction clause – fruitful or futile?

One way principals have attempted to thwart a contractor from successfully obtaining an injunction restraining a call on a security is by including a “no injunction clause” in the underlying contract.

If Courts are more willing to look behind an unconditional bond to the terms of the underlying contract to determine whether an underlying contract exception exists, then it is thought that more weight will also be given to an express intention of the parties from precluding the contractor seeking an injunction from restraining a call?

However, the case law on “no injunction clauses” appears unsettled. Some Courts have held that a no injunction clause is invalid as it is an ouster of the Court’s jurisdiction. [viii] Indeed, it is a long standing principle that parties cannot contract out of the Court’s jurisdiction, or preclude a Court from granting a remedy at law. [ix]

However, some recent decisions have cast doubt on this position. In Anaconda Operations Pty Ltd v Fluor Daniel Pty Ltd [1999] VSCA 214, the Court held “It matters not that it may be argued that the latter part of this provision is bad as ousting the jurisdiction of the Courts. The important thing is that both parts of it show an intention that the owner is to be at liberty to call on the security at any time”. [x] Further, the Western Australian Court of Appeal held that if a no injunction clause is unenforceable as an ouster of the jurisdiction of the Court, it is nevertheless permissible to take it into account in construing whether the parties intended the principal to have unfettered recourse to the security.

Therefore, where the parties have expressly agreed that the contractor will not injunct a principal’s right to have recourse to security, Courts appear to struggle to reconcile that intention with an award of an injunction on the basis of a finding that the “no injunction” clause is invalid.

Practical take outs

The underlying contract

• Whether you are the principal or contractor, always carefully consider the wording of any clause relating to security
• Principal’s should:
• reflect the intended purpose of the security is in the contract. If it is intended to act as a risk allocation device, clearly state that the principal may have recourse to it, pending the resolution of a dispute between the parties
• consider including a “no injunction / obstruction clause” – however these may be held to be invalid as ousting the Court’s jurisdiction. It may survive if:
• the intention of the clause is to preclude a contractor from restraining a call where the principal has a bona fide claim to the security and the purpose of the security is to act as a “risk allocation device”. A “no injunction clause” that seeks to completely defeat access to the Courts, or preclude a party from seeking other kinds of remedy (such as damages) is likely to be invalid. [xii]
• the terms of the underlying contract, and the bond itself, are consistent and unequivocal with regards to the security being an autonomous, unconditional form of security which the principal may have recourse to for a bona fide claim
• the clause also contains less prohibitive restrictions on the contractor which may survive if the “no injunction” part of the clause is severed from the clause e.g. the contractor must not hinder or obstruct the principal’s right to recourse of the security. [xiii]
• ensure that there are no contradictory conditions or restrictions on the principal’s recourse to security in the underlying contract e.g. notice provisions
• always go for an unconditional performance bond by a bank or reputable insurance company over any other kind of security
• include a clause that the form of security must be on terms approved by the principal, or include an approved pro forma bond as an attachment to the contract.

Reviewing the terms of an unconditional performance bond If you are a principal:

• make sure it includes the words: unconditional and on demand
• make sure it is from a bank or a reputable insurance company
• include an assignability clause
• resist an expiry date, but if one is needed ensure it is suitably in the future (well past the likely date of final completion)
• carefully check all details are correct and are consistent with the terms of the underlying contract (party names, ACN’s, the amount of the bond and any notice provisions)
• execute as a deed to avoid any issues of consideration.

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Bank Guarantees In India

Contributor.

In the modern business environment, characterised by  spatial distance and  inability of the parties to a commercial transaction in performing a realistic assessment of the creditworthiness of a business partner, there is often a need for the use of instruments that secure payments. 1 “ Bank Guarantee ” is a commercial instrument that has emerged as a contemporary solution  for securing payment of money in a commercial dealing.

The Indian Contract Act (ICA), 1872 defines a “contract of guarantee” as a contract to perform the promise, or discharge the liability, of a third person in case of his default. 2 Similarly, bank guarantee (hereinafter referred to as “ BG ”) can be defined as a unilateral legal contract  in which a bank (guarantor) undertakes an obligation to guarantee to pay the beneficiary a certain amount of money specified in the guarantee if the debtor from the original contract does not fulfil his contractual obligations.

An Independent Contract

As per law  a BG  is an “independent contract” between the bank and the beneficiary, separate from the underlying contract between the beneficiary and the person (debtor) at whose instance the BG is given. 3 Thus, two contracts and three parties come into existence when a contract is entered into which provides for BGs being furnished. 4 The bank has to honour its undertaking when the guarantee is invoked, without reference to the party on whose behalf it has been issued, notwithstanding any disputes or disagreements that might have arisen in the mean time between the debtor and the beneficiary. 5 The doctrinal basis for this principle is that a BG is intended to secure the beneficiary by allowing it to immediately claim from a party in terms of the BG and therefore it cannot be qualified by the contract on performance of the obligations.

Types of Bank Guarantee

According to specific purposes, BGs are categorized into various types. Some of them are as follows.

On the basis of issuance:

A direct BG is one where a bank is asked to provide a guarantee by its account holder, in favour of the beneficiary. Direct BG does not rely on the existence, validity and enforceability of the main obligation.

• Indirect BG

When a second bank issues a BG in return for an already issued BG, it is termed as an Indirect BG. In such scenarios, if the second bank suffers losses when a claim is made against a guarantee, the issuing bank will make sure that it compensates all the losses.

On the basis of the conditions specified in the guarantee:

• Unconditional BG

Unconditional BGs ensure the payment to the beneficiary “unconditionally and irrevocably” on beneficiary's first demand upon invoking the guarantee. 6 Thus, the beneficiary becomes the sole judge of the performance of the  contract and the bank cannot question the judgment or ask question/evidence in that regard. The demand of the beneficiary shall be final and conclusive in that regard.

• Conditional BG

Where the BG has certain conditions, which need to be fulfilled in order for the absolute invocation of guarantee by the beneficiary, such BGs are termed as  conditional BGs. The language of the guarantee plays a vital role in determining which kind of guarantee is it. Some guarantees though mention the words “unconditionally and irrevocably,” they qualify such expressions with a condition or a situation upon occurring of which the underlying guarantee becomes encashable. In such circumstance, the BG in question would be categorised as a  conditional BG. 7

On the basis of the type of performance by the bank as per the guarantee:

• Financial BG

A financial BG assures that money will be repaid if the party ( debtor) does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of  a project, the bank will make the payment.

• Advance Payment BG

This guarantee signifies an obligation  on the part of the bank to return advance payment if, after receiving an advance, the party ( debtor) does not perform its contractual commitments.

• Deferred Payment BG

Deferred  payment BG is offered to the beneficiary for a deferred period or for a certain time period. Under this guarantee, payment is usually made in instalments by the bank for failure in the completion of contractual obligations by the debtor.

• Performance/Contract Execution BG

This guarantee  assures  timely delivery of goods or performance of services according to a contract. Monetary  compensation of will be made by the bank  in case of any delay in performance of services or operation of the contract.

Invocation of Bank Guarantees

The beneficiary needs to invoke the BG on or before the expiry date of the guarantee, and in accordance with the contract/terms of the guarantee. 8 The issuing bank is bound to observe and honour the terms of the guarantee and therefore, the beneficiary of a BG cannot be restrained from invoking the BG. 9 If a bank does not receive any claim on or before the validity period mentioned in the terms of the guarantee, the   bank will be discharged from its liability.

It is pertinent to note that Unconditional BGs ensure the payment to the beneficiary “unconditionally and irrevocably” on beneficiary's first demand upon invoking the guarantee, 10 while in case of Conditional BGs, the beneficiary does not have an unfettered right to invoke that guarantee and demand immediate payment thereof. 11 BGs can be invoked by the beneficiary irrespective of pending disputes between him and the debtor. 12 Moreover, a BG constitutes a bargain between the two parties,  in which the banker creditor is unconditionally required to pay the amount in question. 13

Limitation Period for Invocation of Bank Guarantees

Under the Indian Limitation Act, 1963, the period for invoking the BG is 30 years, if the beneficiary is government Department or Municipal Corporation and 3 years in all other cases. Prior to the amendment made by the Contract (Amendment) Act, 1996 in the ICA, 14 BGs used to have a clause that “…unless the claim under this bank guarantee is made within six months from the expiry of the bank guarantees, the liability of the bank will be extinguished under the guarantee…”. After the amendment, if a beneficiary of a BG invokes the guarantee with the claim period, for a default committed by the debtor during the validity period, then the bank will not make payment, the beneficiary may file suit against the bank within the period mentioned in the Limitation Act, 1963 and any clause restricting the bank's liability will be illegal and void ab initio. Therefore, the bank should obtain the bank guarantee duly cancelled by the beneficiary or a certificate from the beneficiary that there is no claim under the guarantee. If the guarantee, duly cancelled or certificate is not obtained from the beneficiary, the bank should retain the security of the debtor and cash margin till the expiry of the limitation period under the Limitation Act, 1963. 15

Stay on Invocation of Bank Guarantees

 There are instances when giving absolute discretion to someone can lead to misuse of power resulting in corrupt and illicit practices.  For instance, when a a beneficiary is aware of his faulty goods and is not entitled to payment,  but still invokes BG with the mala-fide intentions for monetary gains is a case in point. Therefore, in order to define an ambit of independence and the scope of Unconditional BGs, it is essential to have certain parameters towards invocation of BGs.  The courts 16 in India have narrowed down two exceptions where injunction on invocation of unconditional BG can be granted:

• Fraud 17 of an egregious nature as to vitiate the entire underlying transaction, of which the bank has notice.
• Special equities 18 in the form of preventing irretrievable injustice 19 between the parties.

Egregious Fraud

An injunction against encashment of BG can be issued when there is clear fraud on the part of a beneficiary, which the bank notices. 20 The fraud must be as to vitiate the whole transaction 21 and vague and indefinite allegations made do not satisfy the requirement in law constituting any fraud much less than the fraud of an egregious nature. 22 It is apposite to state here that a demand by the beneficiary under the BG may become fraudulent not because of any fraud committed by the beneficiary while executing the underlying contract but it may become so because of subsequent events or circumstances. 23

Special Equities in the Form of Preventing Irretrievable Injustice

“Special Equities ”has been considered as a prima facie ground that would prevent irretrievable injustice between the parties. 24 While the courts have not ventured to define or even describe the term “Special Equities”, 25 every case has to be decided with reference to the facts of the case involved therein. 26 However, special equities might entitle the party to an injunction restraining the performance of BG. 27 The  courts have often opined that allowing encashment of an unconditional BG would result in irretrievable harm or injustice to one of the parties concerned; 28 however, to avail of the exception of irreparable harm or injury, the party seeking relief would necessarily have to show exceptional circumstances, which would make it impossible for the guarantor to reimburse himself in the event of succeeding in the main dispute. In other words, a case of irretrievable injury and/or irreparable harm would have to be made out clearly. 29

Key Guidelines for Bank Guarantee by the Reserve Bank of India (RBI)

The RBI has, over the years, developed rules and regulations around BGs, in order to befit the contemporary requirements of the business environment. Some of the key guidelines 30 are as follows:

No BG should normally have a maturity of more than 10 years.

• Unsecure Guarantees

The restriction of 20% on unsecured guarantees has been withdrawn (w.e.f.17.6.2004) by the RBI and bank boards have been given the freedom to fix their own policies on their unsecured exposures.

• Precautions for averting frauds

Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. Moreover,  banks should, while forwarding guarantees, caution the beneficiaries that they should, verify the genuineness of the guarantee with the issuing bank.

• Inter-institutional Guarantees

Banks may issue guarantees favouring other banks/  financial institutions/other lending agencies for the loans extended by the latter, subject to the condition that the guaranteeing bank should assume a funded exposure of at least 10% of the exposure guaranteed.

• Payment of Invoked Guarantee

Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur.

BGs have proved to be a huge advantage in  a modern business setting. BGs are individual contracts between the bank and the creditor, and are independent of the underlying contract between the beneficiary and the person at whose instance the bank guarantee is given.  However, courts may analyse facts of a matter and may intervene and grant  stay on invocation of such bank guarantees under certain conditions (Egregious Fraud, Irretrievable Harm/Injustice and Special Equities); this is done to prevent miscarriage of justice or to not let one party take  advantage of a legal loophole.

1 Mirjana Knezevic and Aleksandar Lukic (2016). The importance of bank guarantees in modern business (business environment in Serbia). Investment Management and Financial Innovations , 13(3-1), 215-221.

2 The Indian Contract Act 1872, Section 126.

3 Delhi Lotteries v. Rajesh Aggarwal, AIR 1998 Del 332.

4 Mohd Yasin Wani & Rais Ahmad Qazi, “A Legal Perspective of Bank Guarantee System in India” available at: ijrcm.org.in/download.php?name=ijrcm-1-vol-3 (visited on June 20, 2021).

6 Vinitec Electronics Pvt. Ltd. v. HCL Infosystems Ltd., (2008) 1 SCC 544; see also Adani Agri Fresh Ltd. v. Mahaboob Sharif (2016) 14 SCC 517; see alsoMahatma Gandhi Sahakra Sakkare Karkhane v. National Heavy Engg. Coop. Ltd. and Ors. AIR 2007 SC 2716; see alsoGujarat Maritime Board v. L&T Infrastructure Development Projects Ltd., (2016) 10 SCC 46.

7 Hindustan Construction Co. Ltd. v. State of Bihar and Ors. (1999) 8 SCC 436; see also Jacsons Veeners & Panels Pvt. Ltd. v. State Bank of Travancore & Anr . , (2009) SCC OnLine Ker 4210.

9 Hugglunds Drives AB v. National Heavy Engineering Co-Op. Ltd., AIR 2002 Bom 305.

10 Supra note 7.

11 Supra note 8.

12 Bank of Baroda v. Ruby Sales Corporation Agency, AIR 2001 Del 285.

13 UP State Sugar Corporation v. Sumac International Ltd., (1997) 1 SCC 568.

14 The Indian Contract Act 1872, Section 20.

15 Supra note 5.

16 Hindustan Steelworks Corp. Ltd. v. Tarapore and Co., (1996) 5 SCC 34.; see also Svenska Handelsbanken v. M/s. Indian Charge Chrome, (1994) 1 SCC 502.

17 UPCOF v. Singh Consultants and Engineers (1988) 1 SCC 174.

18 Standard Chartered Bank v. Heavy Engineering Co. and Anr., 2019 SCC OnLine SC 1638; see also Texmaco Limited v. State Bank of India, AIR 1979 Cal 44.

19 Himadri Chemicals Industries Ltd. v. Coal Tar Refining Co., (2007) 8 SCC 110.

20 Supra note 14.

21 Supra note 17; see alsoRigoss Exports International (P) Ltd. v. Tartan Infomark Ltd (AIR 2001 Delhi 285).

22 Supra note 7.

23 Mercator Oil & Gas Limited v Oil & Natural Gas Corporation Limited, 2019 SCC OnLine Bom 1378.

24 Supra note 18.

25 Cosy (India) Ltd. v. Vijaya Bank and Ors, (1991) 1 Cal LJ 39.

26 Gangotri Enterprises Ltd v. U.O.I., (2016) 11 SCC 720.

27 Supra note 19.

28 Supra note 20.

29 Supra note 14.

30 Reserve Bank of India,Master Circular - Guarantees and Co-acceptances, RBI/2009-10/70 DBOD. No. Dir. BC. 14 /13.03.00/2009-10 (2009) https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=5130 (last accessed on June 24, 2021).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Sanctions on Russia: what about your contracts?

As you will know, an unprecedented sanctions regime has been imposed by the UK, EU and US in response to Russia’s actions concerning Ukraine.  But what issues could arise for your contracts with Russian or Ukrainian parties or where your supply route relies on those countries? Can you avoid those contracts?

You may be able to take advantage of a force majeure clause if your contract contains one.  A force majeure clause provides for a party to the contract to be excused from performance of their obligations under the contract should a specified event occur which is beyond the party’s control.  Should your contract contain such a clause which covers the events in Ukraine then you may be able to avoid your obligations in circumstances where your inability to perform, caused by the imposition of sanctions and/or the war, are inevitably beyond your control.  You need to bear in mind that your counter-party may also have the benefit of any force majeure clause in your contract.

Interpretation of force majeure clauses

The meaning and effect of a force majeure clause depends entirely on its wording: the question is whether the Court would interpret it to cover the event in question.  The wording of the clause and ultimately its interpretation by a Court will also determine whether the clause, if it covers the event in question, allows a party to cancel the contract, be excused from performance of part or all of its obligations under the contract or be entitled to suspend performance or claim an extension of time for performance.

When interpreting the words of any force majeure clause the Courts will seek to determine objectively what the parties using the words in the clause meant when they made the contract, giving the words their natural and ordinary meaning.  Evidence of what the parties themselves actually subjectively intended is not relevant.  The Court will interpret the words of the contract in the context of the other relevant provisions of the contract, the overall purpose of the provision and the facts and circumstances known to the parties at the time of the contract. 

The Court will not however interpret a contract to relieve a party from a bad bargain: accordingly if your force majeure clause does not, applying the above rules of interpretation, cover the circumstances which you face, then the Court will not where clear language is used allow you to escape your contractual obligations on the basis of the force majeure clause.  When the contract uses unambiguous language, the Courts will apply it.  It is only when the words used are ambiguous that the Court may apply a meaning which makes the most business common sense. 

War and sanctions – are they covered?

It may be that your force majeure clause includes reference to “war” but it could well be considered relevant that in the current situation, there has been no declaration of war by Russia and a question arises as to whether such wording would be sufficient when the broader words “conflict” or “hostilities” would have been available.  Much may depend on the definition given to the word “war” in the contract. 

The imposition of economic sanctions is an even trickier issue: it may be less likely that sanctions are specifically included as a force majeure event but even if they are, the definition of sanctions in the contract and the impact which the sanctions has had on the parties will be key when determining whether a force majeure clause can safely be relied upon. 

If sanctions are not specifically mentioned as a force majeure event, a wide definition of “war”, “hostilities” or “conflict” – which could cover the consequences of such war, hostilities or conflict – may assist.  Of course, your counter-party will be quick to consider whether your inability to perform is actually a consequence of the conflict and seek to argue that your inability to perform is caused by a separate event. 

Consideration will also need to be given to whether your contract includes an “act of government” as a force majeure event and the extent of the definition of this event in the contract. 

Disruption to your supply chain may also be either specifically covered or covered by more general force majeure language commonly found in contracts. 

If your contract does not contain a force majeure clause or your clause is too constrained to be of assistance, all may not be lost since the legal doctrine of frustration or the defence of illegality may assist you.

Illegality and frustration

In the absence of a force majeure clause, the doctrine of frustration or the defence of illegality may be available. 

A contract is frustrated whenever the law recognises that without default of either party a contractual obligation has become incapable of being performed because the circumstances in which performance is called for would render it a thing radically different from that which was undertaken in the contract. 

An English law-governed contract is discharged if its performance becomes illegal under English law provided that the illegality clearly prohibits performance.  If performance is illegal in any specific case, the Court itself may of its own volition – and without the defendant pleading the defence of illegality - refuse a remedy to the counter-party suing in respect of any non-performance since this is a public policy issue.  

Each case would however fall to be considered on its own facts and the availability of the doctrine of frustration or the defence of illegality to assist in any given case is dependent not on the interpretation of the contractual words but on the application of an extensive body of case-law. 

No claims provisions

As with many EU sanctions regimes, the EU’s Russian sanctions contain so-called ‘no claims’ provisions, which protect a party who refuses to perform a contract on the basis that they may breach EU sanctions from claims that they might otherwise face. This prohibits designated parties and, as regards some of the restrictions, any Russian person (whether designated or otherwise) from bringing claims in connection with the performance of a contract or transaction, which has been affected by the EU’s sanctions. The UK’s Russian sanctions regime does not contain these provisions. This is an area of divergence that may be significant depending on the construction of the contract.

You should check any insurances on which claims could arise (including trade credit, travel, property etc.) to see whether they contain sanctions clauses. Typically insurance policies will contain a provision that will suspend cover and payment of existing claims where that cover or claim would be impacted by sanctions. Sometimes the policy will allow insurers to cancel cover on notice.

The UK Government and EU have introduced specific sanctions prohibiting the provision of any insurance for aviation and space goods and technology to a person connected with Russia or for use in Russia. Any insurer of such insurance has to cease to insure such risks as from 28 March 2022. It is possible that other sectors may also be targeted.

You may be able to escape liability for a failure to perform arising out of the imposition of sanctions and/or generally the current conflict in Ukraine by relying on a force majeure clause but careful consideration needs to be given to how a Court is likely to interpret what that clause covers before any reliance is placed on it: wrongful reliance could lead to a liability in damages for repudiatory breach of the contract.

Usually a force majeure clause will provide the most certainty to a party but if it is not sufficiently widely drafted, is badly drafted or you don’t have one, it is important not to forget to consider whether you could be assisted by the doctrine of frustration or the defence of illegality.

We are happy to assist with any queries which you may have.  Please contact  Anthony Lennox if you have any insurance queries; or Chris Bryant if you have any questions about the applicability of sanctions or the sanctions regime generally.

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