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COMMERCIAL

 INSTRUMENTS:  BANK  GUARANTEE  AND  LETTER  OF  CREDIT  

SANKALP  JAIN*  

Abstract  
 
The  paper  examines  the  nature  and  scope  of  bank  guarantee  system  and  letter  of  credit  in  
India.  This  paper  is  a  doctrinal  study  which  covers  the  law  relating  to  the  bank  guarantees  
particularly   embodied   in   the   Indian   Contract   Act   1872,   highlights   the   economic   functions  
and   benefits   of   the   bank,   explains   the   various   types   of   guarantees   issued   by   the   banks   in  
India.   This   paper   further   discusses   the   nature,   scope,   details,   structure   and   troubles   of   a  
letter  of  credit.  It  highlights  the  imbalance  of  the  rights  and  duties  of  the  parties  in  a  letter  
of  credit  transaction  by  emphasising  deficiencies  in  the  letters  of  credit  system.  It  discusses  
how  the  risk  of  the  innocent  buyer  has  increased  and  very  often  the  buyer  is  paying  for  the  
goods   he   had   not   contracted   for   and   also   throws   light   on  the   independence   principle   and  
the  doctrine  of  documentary  compliance.    
 
BANK  GUARANTEE:  AN  INTRODUCTION  
 
A  bank  guarantee  is  a  commercial  document.  It  is  a  contract  between  the  issuing  bank  and  
the  beneficiary  in  whose  favour  the  guarantee  has  been  furnished.    It  is  an  act  of  trust  to  
facilitate   the   fine   flow   of   trade   and   commerce   in   internal   and   international   trade   or  
business.  Even  though  the  genesis  of  a  bank  guarantee  lies  in  the  primary  contract  between  
the   parties,   it   is   nevertheless,   autonomous   and   independent.   Though   the   bank   guarantee  
may  have  been  issued  by  the  Banker  at  the  instance  of  his  client,  it  is  a  contract  between  the  
banker  and  the  beneficiary  in  whose  favour  such  bank  guarantee  has  been  issued.  The  party  
at  whose  instance  the  guarantee  has  been  furnished  is,  in  a  way,  a  stranger  to  the  contract  
of   bank   guarantee.   In   a   bank   guarantee,   the   bank   binds   itself   to   pay   unconditionally   and  
unequivocally  without  protest  or  demur  or  performance  by  the  principal  debtor.1  The  bank  
issuing   the   guarantee   is   not   concerned   with   the   relationship   between   the   seller   and   the  
                                                                                                                         
*
 Email:  sankalp_jain11@yahoo.com  
1
 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  October  27,  2012).  

Electronic copy available at: http://ssrn.com/abstract=2460246


customer  nor  it  is  concerned  with  the  question  whether  the  seller  performed  its  contractual  
obligation   or   not.   The   bank   must   be   allowed   to   honour   its   commitments   in   a   bank  
guarantee,   otherwise,   the   trust   in   international   commerce   will   be   irreparably   damaged.  
Respectability   and   reliability   of   the   assured   mode   of   payment   through   bank   guarantees   is  
essential  for  the  growth  and  promotion  of  trade.  
 
In  Basant  Rlymers  Alwar  v.  State  Chemical  and  Pharmaceuticals  Corporation  of  India2  it  was  
held   that   banking   system   is   the   backbone   of   the   economy   and   it   is   necessary   that   there  
should  be  confidence  in  the  banking  system  itself.  If  the  bank  guarantees  are  not  encashable  
like   a   credit   note   or   if   there   is   an   impediment   in   encashing   the   bank   guarantee,   then   the  
whole  foundation  of  the  banking  system  will  collapse  and  the  people  will  lose  faith  in  it.  
 
TYPES  OF  BANK  GUARANTEE  
 
a) Tender  Guarantee  (also  called  Bid  Bond)  
b) Performance  Guarantee  
c) Advance  Payment  Guarantee  
d) Retention  Money  Guarantee  
e) Payment  Guarantee  
f) Facility  Guarantee  
g) Maintenance  Guarantee  
h) Customs  Guarantee  
i) Shipping  Guarantee  
 
DIFFERENCE  BETWEEN  A  BANK  GUARANTEE  AND  A  USUAL  GUARANTEE  
 
Section   126   of   Indian   Contract   Act,   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.  Section  
126   section   further   provides   that   the   person   who   gives   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”.   In   every   contract   of  
guarantee,  there  are  three  parties:  the  creditor,  the  principal  debtor,  and  the  surety.  Firstly,  
                                                                                                                         
2
 AIR  1986  Raj.  1:  1985  Raj  LW  23.  

Electronic copy available at: http://ssrn.com/abstract=2460246


the  principal  debtor  himself  makes  a  promise  in  favour  of  the  creditor  to  perform  a  promise,  
etc.  Secondly,  the  surety  undertakes  to  be  liable  towards  the  creditor  if  the  principal  debtor  
makes   a   default.   Thirdly,   the   principal   debtor   makes   an   implied   promise   that   in   case   the  
surety  has  to  discharge  liability  in  case  of  his  default,  he  shall  indemnify  the  surety  for  the  
same.  The  object  of  a  contract  of  guarantee  is  to  provide  additional  security  to  the  creditor  
in   the   form   of   a   promise   by   the   surety   to   fulfil   a   certain   obligation,   in   case   the   principal  
debtor   fails   to   do   that.   A   guarantee   is   an   accessory   contract   by   which   the   promisor  
undertakes  to  be  answerable  to  the  promisee  for  the  debt,  default  or  miscarriage  of  another  
person,  whose  primary  liability  to  the  promise  must  exist  or  be  contemplated.3  
 
Following  are  the  points  of  difference  between  a  Bank  Guarantee  and  a  Usual  Guarantee  
 
1. A   usual   guarantee   is   governed   by   Section   126   of   the   Indian   Contract   Act   while   a    
bank  guarantee  is  not  directly  governed  by  the  Contract  Act.    
 
2. An  ordinary  guarantee  is  a  tri-­‐partite  agreement  involving  the  surety,  the  debtor  and  
the   creditor   but   a   bank   guarantee   is   a   contract   involving   two   parties   i.e.   the   bank  
and  the  beneficiary.  
 
3. In   an   ordinary   guarantee,   the   contract   between   the   surety   and   the   creditor   arises   as  
a  subsidiary  to  the  contract  between  the  creditor  and  the  principal  debtor.  The  bank  
guarantee  is  independent  of  the  main  contract.  
 
4. In  an  ordinary  guarantee,  the  inter  se  disputes  between  the  debtor  and  the  creditor  
have   a   material   effect   upon   the   surety’s   liability   but   the   bank   guarantee   is  
independent  of  the  disputes,  arising  out  of  the  contract.  
 
5. An   ordinary   guarantee   does   not   have   any   time   limit   before   which   the   debt   has   to   be  
claimed.   Bank   guarantees   generally   have   a   specific   time   within   which   they   are  
functional.  
 
 

                                                                                                                         
3
 Halsbury’s  Laws  of  England,  “Guarantee  and  Indemnity”  (4th  edn.,  Reissue,  Vol.  20,  para  101).  
BENEFITS  OF  BANK  GUARANTEE  

Bank   guarantee   benefits   both   the   Government   as   well   as   the   private   sector.   For   the  
Government,  the  bank  guarantee:  
 
a) increases  the  rate  of  private  financing  for  key  sectors  such  as  infrastructure,  
b) provides  access  to  capital  markets  as  well  as  commercial  banks.  
c) Reduces  cost  of  private  financing  to  affordable  levels.  
d) Reduces  government  risk  explore  by  passing  commercial  risk  to  the  private  sector.  
 
For  private  sector,  the  bank  guarantee:  
 
a) Reduces  risk  of  private  transactions  in  emerging  countries.  
b) Mitigates  risks  that  the  private  sector  does  not  control.  
c) Opens  new  markets.  
d) Improves  project  sustainability.  
 
BANK  GUARANTEE  SYSTEM  IN  INDIA:  LEGAL  PERSPECTIVES  
 
In   England   there   is   no   statutory   law   governing   bank   guarantees.   The   English   courts     content  
state  that  the  banks  should  be  left  free  to  perform  their  obligations  under  the  agreements  
of  bank  guarantees.    However,  in  India,  the  courts  have  to  keep  in  view  the  provisions  of  the  
Indian  Contract  Act  applicable  to  bank  guarantees.  The  provisions  of  the  Act  have  to  be  read  
into  each  contract  of  bank  guarantee.    
 
Bank   guarantees   lead   to   invoking   the   payment   only   in   case   of   default   by   the   supplier/  
contractor.   Bank   guarantees,   therefore,   figure   as   contingent   liability   in   the   accounts   of   a  
bank  furnishing  it  and  the  supplier/contractor  on  whose  behalf  it  has  been  furnished.  Bank  
guarantees  should  be  unconditional  guarantees  by  the  bank  to  the  beneficiary  undertaking  
to  pay  the  sum  specified  in  the  guarantee  on  demand.  It  is  a  well  established  law  that  when  
a  bank  guarantee  is  given  by  bank  to  the  beneficiary,  a  contract  comes  into  being  between  
the   bank   and   the   beneficiary,   independent   of   the   main   contract   between   the   buyer  
/principal   and   the   supplier/contractor.   Thus,   two   contracts   and   three   parties   come   into  
existence   when   a   contract   is   entered   into   which   provides   for   bank   guarantees   being  
furnished.   A   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   buyer/principal   and  
the   supplier/contractor.   The   right   of   the   beneficiary   under   a   bank   guarantee   is   governed   by  
the  bank  guarantee  itself  and  not  by  the  terms  and  conditions  of  the  original  contract.  The  
bank  guarantee  is  a  contract  separate  from  the  original  contract.    
 
I   shall   now   sum   up   the   general   principles   as   evolved   from   the   decisions   of   the   Supreme  
Court  as  follows:  
 
1. A   bank   guarantee   is   ordinarily   a   bipartite   contract   between   the   issuing   bank   and   the  
beneficiary   quite   distinct   and   independent   of   the   underlying   contract,   the  
performance   of   which   it   seeks   to   secure.   To   that   extent,   it   can   be   said   to   give   rise   to  
a   cause   of   action   separate   from   that   of   underlying   contract.   If   the   document   of  
Guarantee  is  in  order,  the  Bank  giving  the  Guarantee  must  honour  the  same  to  make  
payment.  
 
2. The  commitments  of  the  banks  under  a  bank  guarantee  must  be  honoured  and  the  
court  should  not  interfere  by  granting  injunction  to  restrain  the  performance  of  the  
contractual   obligations   arising   out   of   bank   guarantee.   The   contract   of   guarantee   is   a  
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.  
 
3. The   issuing   bank   is   bound   to   observe   and   honour   the   terms   of   guarantee.   The  
beneficiary   of   a   bank   guarantee   cannot   be   restrained   from   invoking   the   bank  
guarantee  and  the  issuing  bank  cannot  be  injuncted  from  paying  over  the  proceeds  
of   the   bank   guarantee,   except   in   the   case   of   fraud   which   violates   the   entire  
underlying  transaction  or  in  a  case  where  irretrievable  injustice  would  be  caused  by  
the   invocation   or   the   encashment   of   the   bank   guarantee.   The   existence   of   any  
dispute   between   the   parties   to   the   contract   is   not   a   ground   for   issuing   an   injunction  
to  restrain  enforcement  of  bank  guarantee.  But  that  does  not  mean  that  the  parties  
to   the   underlying   contract   cannot   settle   a   dispute   with   respect   to   allegation   of  
breach  by  resorting  or  litigation  or  arbitration  as  stipulated  in  the  contract.    
 
THE  SCOPE  AND  LIMITS  OF  JUDICIAL  INTERFERENCE  
 
It   is   a   settled   law   that   a   contract   of   guarantee   is   a   complete   and   separate   contract   by   itself.  
The   law   regarding   enforcement   of   an   on   demand   bank   guarantee   is   very   clear.   If   the  
enforcement   is   in   terms   of   the   guarantee,   then   the   courts   must   not   interfere   with   the  
enforcement  of  bank  guarantee.  The  court  can  only  interfere  if  the  innovation  of  on  demand  
guarantee  is  in  accordance  with  its  terms  by  looking  at  terms  of  the  underlying  contract.    
 
The   courts   have   observed   in   numerous   cases   that   the   liability   of   the   bank   under   the  
guarantee   is   absolute   and   they   would   not   generally   interfere   with   the   contractual  
obligations  of  the  banker  by  issuing  any  injunction  against  the  payment  when  the  guarantee  
is  validity  invoked.  In  enunciating  the  general  principle  of  non-­‐intervention  by  the  courts  in  
respect   of   the   guarantees   and   letter   of   credit   the   courts   intend   that   trade   and   commerce  
should   function   smoothly   without   interference   from   the   judiciary.   The   existence   of   any  
dispute   between   the   parties   to   the   Contract   is   not   a   ground   for   issuing   an   injunction   to  
restrain   enforcement   of   Bank   Guarantee.   But   that   does   not   mean   that   the   parties   to   the  
underlying  contract  cannot  settle  a  dispute  with  respect  to  allegation  of  breach  by  resorting  
or  litigation  or  arbitration  as  stipulated  in  the  contract.  
 
EXCEPTIONS  
 
Payment  under  a  bank  guarantee  may  be  refused  or  restrained:  
 
1. Where   the   bank   knows   that   the   documents   presented   by   the   beneficiary  for   seeking  
enforcement  are  forged  or  fraudulent.4  
 
2. Where   a   fraud   by   one   of   the   parties   to   the   underlying   contract   has   been   established  
and  the  bank  has  notice  of  the  fraud.5  
 
                                                                                                                         
4
 (1984)  1  All  ER  351,  United  City  Merchants  (Investments)  Ltd.  v.  Royal  Bank  of  Canada  (1982)  2  All  ER  720.  
5
 Bolivinter  Oil  SA  v.  chase  Manhattan  Bank  (1984)  1  All  ER  351:  (1984)  1  WLR  392.
3. Where  a  case  of  apprehension  of  Irretrievable  Injustice  is  made  out.  
 
4. Where  the  guarantee  is  conditional  and  the  condition  has  not  been  complied  with.6  
 
5. Where  the  conditions  necessary  for  invoking  a  conditional  bank  guarantee  have  not  
arisen.7  
 
6. Where   the   purpose   for   which   a   conditional   guarantee   was   given   has   been  
accomplished.8  
 
7. Where  the  period  stipulated  for  innovation  of  the  guarantee  has  expired.9  
 
8. In   BSES   Ltd.   (Now   Reliance   Energy   Ltd.)   v.   Fanner   India   Ltd.  10  it   was   held   that   as   a  
general  rule  that  a  bank  guarantee  must  be  honoured  in  accordance  with  its  terms  
there  are  however,  two  exceptions:  
 
The   first   is   when   there   is   clear   fraud   of   which   the   bank   has   notice   and   a   fraud   of   the  
beneficiary  from  which  it  seeks  the  benefit.  The  fraud  must  be  of  an  egregious  nature  as  to  
vitiate  the  entire  underlying  transaction.    
 
The   second   exception   to   the   general   rule   of   non-­‐intervention   is   when   there   are   special  
equities   in   favour   of   injunction   such   as   when   irretrievable   injury   or   irretrievable   injustice  
would  occur  if  such  an  injunction  were  not  granted.  
 
LETTER  OF  CREDIT:  AN  INTRODUCTION  
 
A   letter   of   credit   is   a   promise   to   pay. 11  While   the   letter   of   credit   has   been   in   use   for  
centuries,   the   modern   letter   of   credit   is   so   far   different   as   to   be   practically   a   new  

                                                                                                                         
6
 Banwari   Lal   Radhe   Mohan   v.   Punjab   State   Co-­‐op   Supply   and   Marketing   Federation   Ltd.   AIR   1982   Del   357  
Banerjee  and  Banerjee  v  Hindustan  Steel  Works.  
7
 Basic  Tele  Services  Ltd.  v.  Union  of  India  AIR  2000  Del  1  (bank  guarantee  given  to  cover  withdrawal  of  bid  by  a  
bidden  during  period  of  validity  of  bid  could  not  be  invoked  where  the  bidder  never  withdraw  the  bid.  Kirloskar  
Pnlumatic  Co.  Ltd.  v.  National  Thermal  Power  Corpn  Ltd.  AIR  1987  Bom.  308.  
8
 Larsen  and  Toubro  Ltd.  v.  Muharasthra  State  Electricity  Board  AIR  1996  SC,  334  (1995)  6  SCC  68.  
9
 Makharia  Bros  v.  State  of  Nagaland  AIR  1999  SC,  3466  (2000)  10  SCC  503.  
10
 AIR  2006  SC  1148;  (2006)  130  Comp  Cas  8  (SC).    
instrument.12  The  use  of  new  forms,  together  with  the  more  varied  and  complex  situations  
in  which  they  occur  at  present,  has  given  rise  to  many  new  legal  problems.  The  early  letter  
of   credit   was   usually   given   by   a   principal   to   his   agent,   for   use   in   purchasing   goods   abroad.13  
The  reasons  for  this  were  twofold.  In  the  first  place,  the  international  worldwide  banks  of  
to-­‐day  did  not  exist.  In  addition,  the  firms  doing  international  trade  were  so  few  and  so  well-­‐
known,   that   the   promise   contained   in   their   own   letter   of   credit   was   considered   sufficient  
security   for   the   sale   of   goods   on   credit,   and   the   functions   of   the   letter   were   chiefly   to  
authenticate  the  power  of  the  agent.14  It  was  generally  addressed  to  a  correspondent  bank  
on  which  the  drafts  were  to  be  drawn  and  requested  the  bank  to  pay  such  drafts  as  were  
drawn   by   the   agent.15  With   the   rising   importance   and   increasing   complexity   of   this   trade  
and   the   entrance   of   new   firms   into   the   field,   the   letter   of   credit   became   a   necessity   and  
took  on  other  aspects.    
 
As  a  result  of  this  development,  the  law  has  been  faced  with  a  new  set  of  legal  problems,  
solutions   of   which   has   become   more   and   more   imperative   with   the   increasing   use   of   the  
letter  of  credit.  
 
1. The  performance  of  conditions  under  the  letter  of  credit;    
 
2. The  legal  relation  between  the  letter  of  credit,  the  sales  contract  in  performance  of  
which   the   credit   is   procured   and   the   agreement   to   indemnify   the   bank   that   is   signed  
by  the  buyer  in  order  to  procure  the  credit;  and  
 
3. The  legal  basis  of  the  right  of  a  beneficiary  to  recover  under  an  irrevocable  letter  of  
credit.16    
 
 

                                                                                                                                                                                                                                                                                                                                                                                         
11
 Justin   Pritchart,   “Letter   of   Credit-­‐   How   Letters   of   Credit   Work”   available   at:  
http://banking.about.com/od/businessbanking/a/letterofcredit.htm  (visited  on  August  30,  2012).  
12
 Herman   N.   Finkelstein   “Performance   of   conditions   under   a   letter   of   credit”   25   Colum.   L.   Rev.   724   (1925)  
available  at:  http:/heinonline,org  (visited  on  August  27,  2012).  
13
 Ibid.  
14
 Ibid.  
15
 Ibid  
16  Ibid.  
Their   purpose   is   to   insure   to   a   seller   payment   of   a   definite   amount   upon   presentation   of  
documents.  The  bank  deals  only  with  documents.  It  has  nothing  to  do  with  the  quality  of  the  
merchandise.   Disputes   as   to   the   merchandise   shipped   may   arise   and   be   litigated   later  
between  vendor  and  vendee  but  they  may  not  impede  acceptance  of  drafts  and  payment  by  
the   issuing   bank   when   the   proper   documents   are   presented.   The   bank   was   absolutely  
bound  to  make  payment  under  the  letter  even  if  it  had  known  or  had  reason  to  believe  that  
the  sugar  was  not  of  the  quality  contracted  for.  17  
 
NATURE  AND  FUNCTION  OF  LETTER  OF  CREDIT  
 
A  letter  of  credit  is  neither  a  negotiable  instrument  nor  a  guaranty.  The  letter  of  credit  has  
an   immediate   legal   effect.   Unlike   the   guaranty   letter,   which   promises   to   answer   for   the  
debt,  default  or  miscarriage  of  another,  the  issuer  of  a  letter  of  credit  is  primarily  liable  upon  
it.   The   beneficiary   does   not   need   to   look   anywhere   else   than   to   the   issuer   for   the  
performance.   This   letter   of   credit   authorizes   the   beneficiary   to   whom   it   is   addressed   to  
advance  money  or  furnish  goods  or  to  enter  into  some  obligation  based  fully  upon  the  credit  
of  the  writer  of  the  letter.  Common  to  every  letter  of  credit  transaction  is  the  contract  that  
exists  between  the  buyer  and  the  seller,  the  buyer  and  his  bank,  and  the  bank  and  the  seller.  
18
 The   issuing   bank   replaces   the   bank's   customer   as   the   payee.   Letters   of   credit   used   in  
international   transactions   are   governed   by   the   International   Chamber   of   Commerce  
Uniform  Customs  and  Practice  for  Documentary  Credits  (UCP).    
 
PARTIES  TO  LETTER  OF  CREDIT  
 
Following  persons  are  generally  parties  to  a  letter  of  credit:  
 
1. Beneficiary:  The  exporter  of  goods  in  whose  favour  the  L/C  has  been  established.  
 
2. Customer/importer:  The  person  we  intends  to  import  the  goods  and  instructs  bank  
to  established  Letter  of  Credit.  

                                                                                                                         
17
“  Letters  of  Credit”  14  Bus.  L.J.  408  July-­‐December  1929  available  at  :  http://heinonline.org  (visited  on  August  
27,  2012).  
18
 Alphonse   M.   Squillante,   “Letter   of   Credit:   A   Discourse   Part   11”   84   Com.   L.J.   426   1979   available   at:  
http://heinonline.org  (visited  on  August  27,  2012).  
 
3. Issuing  Bank:  The  banker  in  the  importers  Country  who  opened  the  L/C.  
 
4. Correspondent  Bank  or  Advising  Bank:  The  banker  in  the  exporters  country,  who  is  
authorised  by  the  issuing  bank  to  advise  the  beneficiary  of  the  credit  and  to  effect  
such   payment   or   to   accept   and   pay   such   bills   of   exchange   or   to   negotiate   against  
stipulated  documents  and  on  compliance  of  stipulated  terms  and  condition  specified  
by  the  importer  on  the  exporter.  
 
5. Confirming   Bank:   The   banker   in   the   exporters   (beneficiary)   country,   who   at   the  
desire   of   the   beneficiary   adds   confirmation   to   the   letter   of   Credit   so   that   beneficiary  
can   get   payment   without   recourse   from   the   confirming   bank.   The   confirming   bank  
may  be  correspondent  bank  itself  or  some  other  bank.  
 
TYPES  OF  LETTER  OF  CREDIT    
 
Generally  following  types  of  Letter  of  Credit  are  in  operation:  
 
• Revocable  or  Irrevocable  Letters  of  Credit.  
• Confirmed  Credit.  
• Transferable  Credit.  
• With  or  without  Recourse  Credit.  
• Revolving  Letter  of  Credit.  
• Transit  Credit.  
• Back  to  Back  Credit.  
•  The  Sight  Credit.  
• The  Credit  available  against  Time  Draft  (Usance  Credit).  
• The  Deferred  Payment  Credit.  
 
ELEMENTS  OF  A  LETTER  OF  CREDIT  
 
• A  payment  undertaking  given  by  a  bank  (issuing  bank).  

• On  behalf  of  a  buyer  (applicant).  


• To  pay  a  seller  (beneficiary)  for  a  given  amount  of  money.  
• On  presentation  of  specified  documents  representing  the  supply  of  goods.  
• Within  specified  time  limits.  
• Documents  must  conform  to  terms  and  conditions  set  out  in  the  letter  of  credit.  
• Documents  to  be  presented  at  a  specified  place.    
 
LETTER  OF  CREDIT  Vs.  BANK  GUARANTEE  
 
A  bank  guarantee  and  a  letter  of  credit  are  similar  in  many  ways  but  they  are  two  different  
things.   Letters   of   credit   ensures   that   a   transaction   proceeds   as   planned   while   bank  
guarantees  reduce  the  loss  if  the  transaction  doesn't  go  as  planned.  A  letter  of  credit  is  an  
obligation   taken   on   by   a   bank   to   make   a   payment   once   certain   criteria   are   met.   Once   these  
terms   are   completed   and   confirmed,   the   bank   will   transfer   the   funds.   This   ensures   the  
payment   will   be   made   as   long   as   the   services   are   performed.   For   example,   a   letter   of   credit  
can  be  used  in  the  delivery  of  goods  or  the  completion  of  a  service.  The  seller  may  request  
that   the   buyer   obtain   a   letter   of   credit   before   the   transaction   occurs.   The   buyer   would  
purchase   this   letter   of   credit   from   a   bank   and   forward   it   to   the   seller's   bank.   This   letter  
would  substitute  the  bank's  credit  for  that  of  its  client,  ensuring  correct  and  timely  payment.  
 
A  bank  guarantee  might  be  used  when  a  buyer  obtains  goods  from  a  seller  then  runs  into  
cash   flow   difficulties   and   can't   pay   the   seller.   The   bank   guarantee   would   pay   an   agreed-­‐
upon  sum  to  the  seller.  Similarly,  if  the  supplier  was  unable  to  provide  the  goods,  the  bank  
would   then   pay   the   purchaser   the   agreed-­‐upon   sum.   The   bank   guarantee   acts   as   a   safety  
measure  for  the  opposing  party  in  the  transaction.  A  guaranty  is  a  promise  to  answer  for  the  
debt,   default   or   miscarriage   of   another.   A   guarantor   is   making   himself   liable   for   the  
performance  of  some  obligation  which  is  owed  by  another  person  who  in  the  first  instance  
is   liable   for   the   payment   or   the   performance.   A   guaranty   is   in   essence   an   insurance   or  
security  device  and  not  one  by  which  a  transaction  is  financed.  
 
It  is  true  that  a  letter  of  credit  will  serve  as  a  guaranty,  but  even  if  it  has  that  effect,  it  is  not  
a  guaranty.  The  law  surrounding  the  guaranty  arises  because  the  guarantor  promises  to  act  
for  the  debt,  default,  or  miscarriage  of  another.  That  would  make  the  guarantor  secondarily  
obligated  to  the  oblige  should  the  primary  obligor  fail  in  his  performance  to  the  obligee.  The  
bank  that  issues  a  credit  is  a  principal,  not  an  agent  of  the  parties  to  the  underlying  contract  
and   thereby   assumes   primary   duties   independent   of   the   contract   between   the   buyer   and  
the   seller.   On   the   other   hand,   a   contract   of   guaranty   is   not   a   primary   one,   because   any  
rights  and  obligations  which  the  guarantor  is  liable  for  must  first  be  determined  by  a  factual  
account   of   those   rights,   and   duties   which   arise   out   of   the   underlying   contract   are   not  
material.  19    
 
A  letter  of  credit  is  neither  a  negotiable  instrument  nor  a  guaranty.20  The  letter  of  credit  has  
an   immediate   legal   effect.   Unlike   the   guaranty   letter,   which   promises   to   answer   for   the  
debt,  default  or  miscarriage  of  another,  the  issuer  of  a  letter  of  credit  is  primarily  liable  upon  
it.   The   beneficiary   does   not   need   to   look   anywhere   else   than   to   the   issuer   for   the  
performance.   This   letter   of   credit   authorizes   the   beneficiary   to   whom   it   is   addressed   to  
advance  money  or  furnish  goods  or  to  enter  into  some  obligation  based  fully  upon  the  credit  
of   the   writer   of   the   letter.  21  The   letter   of   credit   is   the   third   in   a   trilogy   in   independent  
contracts.    
 
OBTAINING  A  LETTER  OF  CREDIT    
 
The   letter   of   credit   is   a   tripartite   transaction.   The   buyer   is   the   customer   of   the   bank   that  
issues   a   credit.   The   beneficiary   is   the   seller   of   the   goods   to   the   buyer   who   receives   the  
benefit  of  that  credit.  The  letter  of  credit  itself  is  a  substitution  of  the  bank's  credit  for  that  
of   the   buyer.   The   bank   is   the   issuer   of   the   credit.   These   transactions,   although   related   to  
one   another   are   considered   to   be   three   separate   contract   transactions.   The   seller  
(beneficiary)   of   the   goods   and   the   buyer   (customer)   enter   into   a   contract   for   the   sale   of  
goods.   The   customer   (buyer)   goes   to   the   bank   (issuer)   to   get   money   to   pay   for   the   goods  
represented  in  contract  one.  The  bank  (issuer)  issues  a  letter  of  credit  to  cover  the  amount  
of   money   needed   for   the   performance   of   the   underlying   contract   with   the   seller-­‐contract  
                                                                                                                         
19
 Alphonse   M.   Squillante,   “Letter   of   Credit:   A   Discourse   Part   VIII”   85   Com.   L.J.   220   1980,   available   at   :  
http://heinonline.org  (visited  on  August  27,  2012).  
20
 Bank  of  N.C.  v.  Rock  Island  Bank,  570  F.2d  202,  23  UCCRS  715  (7th  Cir.).  N.B.:  Some  confusion  exists  between  
a  letter  of  credit  and  a  guaranty.  Essentially  a  letter  of  credit  and  a  letter  of  guaranty  are  grounded  in  contract,  
but   the   comment   to   UCC   §5-­‐101   calls   the   confusion   "unfortunate   excursions   into   the   law   of   guaranty."   It  
would  seem  that  in  spite  of  some  judicial  opinion  to  the  contra,  these  two  areas  of  law  are  not  to  be  treated  as  
one  and  the  same.  
21
Alphonse   M.   Squillante,   “Letter   of   Credit:   A   Discourse”   84   Com.   L.J.   372   1979   available   at   :  
http://heinonline.org  (visited  on  August  27,  2012).
two.   Once   the   letter   of   credit   is   issued   by   the   issuer   (bank)   to   the   beneficiary   (seller),   the  
bank's  liability  is  absolute  if  the  beneficiary  performs  as  required  by  the  terms  of  the  letter  
of  credit-­‐contract  three.22  The  letter  of  credit  is  a  distinct  and  separate  transaction  from  the  
underlying  contract  (contract  between  seller  and  buyer).  All  parties  deal  in  documents  and  
not   in   goods.   The   issuing   bank   is   not   liable   for   performance   of   the   underlying   contract  
between   the   buyer   and   seller.   The   issuing   bank's   obligation   to   the   buyer-­‐applicant   is   to  
examine   all   documents   to   insure   that   they   are   in   compliance   with   the   terms   and   conditions  
of   the   credit.   To   get   the   payment,   it   is   for   the   beneficiary   to   provide   all   the   required  
documents.   If   the   seller-­‐beneficiary   conforms   to   the   letter   of   credit,   the   seller   must   be   paid  
by  the  bank.  
 
A  typical  documentary  letter-­‐of-­‐credit  transaction  might  involve  the  following  events:    
 
United  States  customer  A  desires  to  purchase  a  shipment  of  wine  from  French  seller  B.  B,  
desiring  prompt  payment  and  unsure  of  A's  creditworthiness,  requires  A  either  to  pay  cash  
in  advance  of  shipment  or  to  establish  a  letter  of  credit.  A,  not  willing  to  pay  for  the  wine  
until  he  knows  it  has  been  shipped,  opts  for  payment  by  a  letter  of  credit.  A  goes  to  his  bank  
and   asks   it   to   issue   a   letter   of   credit   for   B's   benefit,   to   be   paid   upon   presentation   of   a   bill   of  
lading.  
 
A  bill  of  lading  can  only  be  obtained  by  delivery  of  the  wine  to  a  shipper  and  consigning  it  as  
the   seller   requires.   Upon   shipment   of   the   wine,   B   or   a   collecting   bank   presents   a   draft"  
drawn  under  the  letter  of  credit  and  the  bill  of  lading  to  the  issuing  bank  for  payment.  The  
issuing  bank  pays  B.  
 
STATUTE/RULES/REGULATIONS  GOVERNING  LETTER  OF  CREDIT  IN  INDIA  
 
In   India,   all   transactions   that   include   foreign   exchange   are   regulated   by   the   Foreign  
Exchange   Management   Act   (FEMA),   1999.   FEMA   has   been   enacted   to   facilitate   external  
trade  and  payments  and  to  promote  the  orderly  development  and  maintenance  of  foreign  
exchange   market.   According   to   the   Act,   the   term   'foreign   exchange'   means   "foreign  
currency   and   includes   letters   of   credit.   The   Reserve   Bank   of   India   (RBI)   has   been   assigned  
                                                                                                                         
22  Ibid.
the  function  of  administering  the  various  provisions  of  the  Act.23  If  we  consider  international  
regulation  governing  letter  of  credit,  the  UCP  600  are  the  latest  rules  that  govern  letters  of  
credit   transactions   worldwide.   UCP   (Uniform   Customs   and   Practice   for   Documentary  
Credits)   is   prepared   by   International   Chamber   of   Commerce’s   (ICC).   Currently   majority   of  
letters  of  credit  issued  everyday  is  subject  to  latest  version  of  the  UCP.  They  are  now  applied  
by  the  banks  in  nearly  all  countries  including  India.24  
 
THE  UNIFICATION  AND  HARMONIZATION  OF  LETTER  OF  CREDIT  LAW  
 
In   some   fields,   harmony   between   different   systems   is   not   vital   but   not   so   in   the   letter   of  
credit  instruments.  Essentially  international,  they  would  be  adversely  affected  by  a  serious  
divergence  between  municipal  law  and  international  law.  In  the  course  of  time,  a  number  of  
practices,   expressions   and   terms   have   evolved   between   banks   dealing   with   documentary  
credits.   To   ensure   uniformity   of   interpretation   in   international   trade,   the   International  
Chambers   of   Commerce   in   Paris   has   worked   out   the   “Uniform   Customs   and   Practice   for  
Documentary  Credit”.  These  have  been  revised  and  brought  up  to  date  several  times  in  the  
past.  The  latest  in  the  line  of  revisions  is  the  UCP  600  (UCP  500  w.e.f.  January  1,  1994)  which  
updates  and  consolidates  the  previous  UCP  400.    
 
DEFICIENCIES  IN  THE  LETTERS  OF  CREDIT  
 
It  exhibits  a  lack  of  justice  and  equity  in  its  operation  and  in  addition,  on  those  areas  which  
render  the  system  particularly  vulnerable  to  fraudulent  activities.  Fraud  is  a  persistent  thorn  
in   the   side   of   international   commerce.   Apart   from   its   primary   purpose,   i.e.   of   establishing  
The  letter  of  credit  system  is  established,  with  its  primary  purpose  of  generating  profit  for  
banks,   to   facilitate   international   commerce.   It   is   not   designed   to   prevent   fraud.   As  
fraudsters  have  become  more  sophisticated,  there  has  been  a  trend  for  the  number  and  size  
of  letter  of  credit  frauds  to  increase,  and  this  has  become  more  marked  since  2001.  

                                                                                                                         
23
 “Is   there   any   specific   statute/rules/regulations   in   India   governing   letter   of   credit?”   available   at:  
http://www.linkedin.com/answers/law-­‐legal/corporate-­‐law/finance-­‐securities-­‐law/LAW_COR_FSL/1012375-­‐
60840417  (visited  on  October  26,  2012).  
Singh  
24
 Gulab   A.   “Letter   of   Credit   Vs   Bank   Guarantee”   available   at:    
http://gulabsingh.wordpress.com/2009/01/18/letter-­‐of-­‐credit-­‐vs-­‐bank-­‐guarantee/   (visited   on   October   21,  
2012).  
CONCLUSION  
 
Guarantee   is   an   undertaking   to   be   collaterally   responsible   for   the   debt,   default   or  
miscarriage  of  another.  In  banking  context,  it  is  an  undertaking  given  by  the  guarantor  to  the  
banker   accepting   responsibility   for   the   debt   of   the   principal   debtor   if   he   defaults.   Bank  
guarantees   should   be   unconditional   guarantees   by   the   bank   to   beneficiary   undertaking   to  
pay  the  sum  specified  in  the  guarantee  on  demand  and  without  demur.  In  bank  guarantee  
the   bank   binds   itself   to   pay   unconditionally   and   unequivocally   without   protest   or  
performance   of   the   principal   debtor.   A   bank   guarantee   is   an   independent   and   distinct  
contract  between  bank  and  the  beneficiary,  and  is  not  qualified  by  the  underline  transaction  
and   the   primary   contract   between   the   people   at   whose   instance   the   bank   guarantee   is  
given.  When  bank  gives  absolute  and  unconditional  guarantee  then  the  courts  cannot  issue  
an   injunction   restraining   the   bank   for   the   payment.   The   main   difference   between   the  
ordinary   guarantee   and   the   bank   guarantee   is   that   in   ordinary   guarantee   the   contract  
between   the   surety   and   the   creditor   arise   as   a   subsidiary   to   the   contract   between   the  
creditor  and  the  principal  debtor  but  the  bank  guarantee  is  an  independent  contract  from  
the  principal  contract.  
 
There   is   no   doubt   that   documentary   credits   are   the   most   common   way   of   payment   for  
international  sales.  English  judges  have  referred  to  documentary  credits  as  “the  life  blood  of  
international   trade”.   This   interpretation   well   establishes   the   importance   of   documentary  
credit   for   international   trade.   It   seems   that   documentary   credits   will   preserve   their  
popularity   until   a   better   system   is   developed.   Indeed,   the   documentary   credit   system   has  
some  points  that  should  be  improved  and  adjusted  according  to  new  technology  and  new  
commercial   concepts.   Revisions   of   UCP   have   been   very   useful   in   achieving   this   idea.  
However   there   has   been   no   improvement,   in   respect   of   one,   maybe   the   most   important  
problem:  fraud.  UCP  500  is  silent  on  this  issue.  Case  law  has  considered  the  issue  but  has  
not  provided  a  precise  manner  to  follow  or  a  proper  solution  to  apply.  
 
 
 
 
REFERENCES  
 
BOOKS  

1. A.C.   Moitra,   “Law   of   Contract   and   specific   relief   Act”(   Universal   Law   publishing   Co.  
Pvt.  Ltd.  2005  Ed.,  2006  reprint).  

2. A.  Singh,  “Law  of  contract”  (Eastern  Book  Company,  Lucknow,  2002  Ed.).  

3. A.    Singh,  “Principles  of  Mercantile  law”(  Eastern  Book  Company,  Lucknow,  2006  Ed.).  
 
4. Halsbury’s   Laws   of   England,   “Guarantee   and   Indemnity”   (4th   Ed.   reissue,   Vol.   20,  
para  101).  
 
5. M.A.   Mir.,   “The   law   relating   to   bank   guarantees   in   India”   (Universal   Book   Traders,  
1992  Ed.).  
 
6. M.L.   Tannan,   Tannan’s   Banking   law   and   practice   in   India.   (Wadhwa   and   Company,  
New  Delhi,  2005  Ed.).  

7. M.L.   Tannan,   Tannan’s   Banking   Law   And   Practice   (Wadhwa   and   Company,   New  
Delhi,  21st  edn.,  2010).  

8. P.N.   Varshney,   Banking   Law   And   Practice   (Sultan   Chand   and   Sons   Educational  
Publishers,  New  Delhi,  21st  edn.,  2005).  
 
9. Pollock  &  Mulla,  “Mulla  on  Indian  contract  and  specific  relief  act”  (2006  Ed.).  
 
10. R.K.  Gupta,  “Banking  law  and  practice”  (Modern  Law  Publications,  2004  Ed.).  
 
ARTICLES  &  WEB  SOURCES  
 
1. Alphonse  M.  Squillante,  “Letter  of  Credit:  A  Discourse  Part  11”  84  Com.  L.J.  426  1979  
available  at  :  http://heinonline.org  (visited  on  August  27,  2012).  
 
2. Dr.   Alok   Ray,   “Enforcement   of   Bank   Guarantee:Limits   of   Court’s   Interference”  
available   at:   http://www.icai.org/resource_file/11510p836-­‐840.pdf   (   visted   on   10th  
October,  2012).  
 
3. Handerson   Wade,   “Bank   guarantee   explained”   available   at:     http:ezinerticles.com  
(visted  on  21-­‐10-­‐2012).  
 
4. Herman  N.  Finkelstein  “Performance  of  conditions  under  a  letter  of  credit”  25  Colum.  
L.  Rev.  724  1925  available  at:  http:/heinonline,org  (visited  on  August  27,  2012).  
 
5. Jessy   Ramachandran,   “Bank   guarantee”   available   at:   http://www.american-­‐
charomical.com  (Visited  on  10-­‐10-­‐2012).  
 
6. Justin   Pritchart,   “Letter   of   Credit   -­‐   How   Letters   of   Credit   Work”   available   at:  
http://banking.about.com/od/businessbanking/a/letterofcredit.htm   (visited   on  
August  30,  2012).  
 
7. Letters   of   Credit”   14   Bus.   L.J.   408   July-­‐December   1929   available   at   :  
 http://heinonline.org  (visited  on  August  27,  2012).  
 
8. 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  October  27,  2012).  
 
9. Pollock  &  Mulla,  Mulla  on  Indian  Contract  and  Specific  Relief  Act  (2006  Ed.).  
 
10. Prakash,   Faq   on   Bank   Guarantee.   http://www.calclubindia.com.   6th   Dec,   2009.  
(Visited  on  12-­‐10-­‐2012).  
 
11. Rajesh,   “Bank   guarantee”   available   at:   http://www.calclubindia.com,   27th  
September,  2012.  (Visited  on  14-­‐10-­‐2012).  
 
12. www.linkedin.com/answers/law-­‐legal/corporate-­‐law/finance-­‐securities-­‐
law/LAW_COR_FSL/1012375-­‐60840417  (visited  on  October  26,  2012).  

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