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A bank guarantee is a commercial instrument in the nature of a contract, intended between two
parties, to secure compliance with the contract. In simple terms, a bank guarantee is defined as
an accessory contract, whereby the promisor undertakes to be answerable to the promisee for the
debt, default or miscarriage of another person, whose primary liability to the promisee must exist
or be contemplated.

Section 126 of the Indian Contract Act, 1872 defines a contract of guarantee as contract to
perform the promise, or discharge the liability, of a third person in case of his default. The person
who gives the guarantee is called the "surety", the person in respect of whose default the
guarantee is given is called the "principal debtor", and the person to whom the guarantee is given
is called the "creditor".

According to section 127 of Indian Contract Act, 1872, anything done, or any promise made, for
the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the
guarantee. It is not necessary that the consideration should be received by the surety.
Consideration between the principal debtor and the creditor is a good consideration for the
guarantee given by the surety.

According to Section 128 of Indian Contract Act, Suretys liability is co-extensive with that of
the principal debtor. However a surety may limit or restrict his liability by contract. It is the
choice of the creditor to recover the amount either from the principal debtor or from the surety.
The liability, though co-extensive is separate.

Bank guarantees are given by banks or financial institutions.

Liabilities of guarantor:

The extent and nature of the liabilities of a surety or guarantor will depend on the words of the
contract of guarantee. Some guarantees are limited for a fixed amount. Some guarantees are for
an unlimited amount. Whatever is alleged as being guaranteed, the court will interpret the
contract of guarantee strictly and a surety will not be liable beyond the precise terms of his or her

Sometimes there may be two or more persons who enter into a contract of guarantee. The
liabilities of the sureties or guarantors are in most cases joint and several. This means that when
there is a default by the principal debtor, the creditor is free to take action either against one or
both of the sureties.

Rights of guarantor:

As soon as the surety or guarantor has paid to the creditor what is due to the creditor under the
contract of guarantee, he is entitled to "step into the shoes" of the creditor and avail himself to all
the rights possessed by the creditor in respect of the debt, default or miscarriages to which the
guarantee relates. Thus upon payment, the surety or guarantor has a right to the benefit of all the
securities which the creditor has received from the principal debtor.

Position of invocation of Bank guarantees in law:

The invocation of a bank guarantee by the beneficiary can be restrained by an injunction under
the Civil Procedure Code, 1908, or the Specific Relief Act, 1963 or Arbitration & Conciliation
Act, 1996. However, the normal considerations, which apply in granting an injunction, will not
apply in cases of a bank guarantee. The courts follow a very strict approach in granting any
injunctions against encashment of Bank guarantees.

If the bank guarantee is unconditional, arbitration proceedings would in no way affect the
enforcement of the guarantee. This is because an unconditional bank guarantee is independent of
the main contract which refers disputes to arbitration.

However, if the bank guarantee includes a clause to the effect that it could not be invoked prior
to the decision of the arbitrators, such a bank guarantee, which is conditional, cannot be invoked
and an injunction can be granted.

In by the Supreme Court UP State Sugar Corporation versus Sumac International Ltd. SCC
568, 1997 it was held by the Honble Supreme Court that whenever an irrevocable and
unconditional bank guarantee to be paid without demur, is invoked, the bank is bound to honour
the guarantee irrespective of any dispute raised by the customers with notable exceptions of
fraud and irretrievable injustice.

The bank guarantee is an innovative financial instrument whereby, if the beneficiary perceives
that there has been a breach of contract by the other party, he can encash the guarantee and avail
of the amount immediately, without having to undergo the hassles of litigation. It enables the
customer (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand
business activity. It also facilitates the mode of payment. Bank Guarantee has dual aspect. It is
not merely a contract between the bank and the beneficiary of the guarantee. It is also a security
given to the beneficiary by a third party. Bank should not interfere with the dispute related to the
encashment of bank guarantee. As far as possible the dispute should be solved by Arbitrators.
Commitment of banks must be honoured free from interference by the courts. It is only an in
exceptional case that is to say in case of fraud or in case of irretrievable injustice, that the court
should interfere. Thus in commercial transactions bank guarantees achieve relevance.

Richa Sharma

Forwarded by
Rashmi Verma
Senior Manager/ Law