Bank Guarantee

A Bank guarantee is a promise from a bank that the liabilities of a debtor will be met if the debtor fails to fulfill your contractual obligations. It is a promise from a bank or other lending institution that if a particular borrower defaults on a loan, the bank will cover the loss.

Contract of guarantee: As per Section 126 of the Indian Contract Act 1872, A “contract of guarantee” is a 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”. A guarantee may be either oral or written.

Guarantee Parties Involved: The parties to the contract of guarantee are:

1. Applicant: The principal debtor: The person at whose request the guarantee is executed.
2. Beneficiary: The person to whom the guarantee is given and who can enforce it in case of default.
3. Guarantor: The person who undertakes to discharge the obligations of the applicant in case of his default.

Thus, a contract of guarantee is a collateral contract, consequential to a main contract between the applicant and the beneficiary. Guarantee issued must be unconditional and for:

• Definite period
• Definite amount
• Definite purpose

Types of Bank Guarantees

Guarantee may be based on the location of beneficiary, Purpose, and Currency:

Inland: Issued within India in favour of beneficiary located in India for any contract or purpose originating within India.

Foreign: Issued in India in favour of beneficiary located in any other country in Foreign Currency.

As per the nature of the contract, Bank Guarantees are classified into three types;

• Financial Guarantee: Financial Guarantees are issued by a bank on behalf of a customer’s requirement to deposit a cash security or earnest money. Most Government departments insist that before the contract is awarded to the contractor, insist on an Earnest Money Deposit. Issued in respect of Excise / Custom duties and Octroi under dispute etc. Issued for liabilities towards tax, excise duties, customs duties etc. to Govt. authorities in relation of the specific transaction; Issued for covering payments for supplies/services favouring Oil Companies, SAIL, Railways etc.
• Performance Guarantee: Performance Guarantees are issued by the bank on behalf of its customer whereby the bank assures a third party, which the customer will perform the contract as per condition stipulated in the contract. These are issued on behalf of customer, who enters into contracts to do certain things on or before a given date. It involves a contractual obligation.
• Deferred Payment Guarantee: It is issued in favour of suppliers to guarantee payment of installments for capital goods purchased on deferred payment basis. Under this type of guarantee, the banker guarantees payment of instalment spread over a period. It required when goods or machinery are purchase on long term credit and payment is made through cheque or bills of different dates. In this case, generally the payment terms are as under:
• Advance payment of ten to fifteen percent of the value of goods is made by the borrower.
• Another ten to fifteen percent of the value of goods is paid on receipt of documents under letter of credit.
• The balance amount is paid in installments spread over a period of one to five years, which is secured by ‘Deferred Payment Guarantee’.

Bank issues guarantee of payment of installments on due date, in event of default by buyer. Following terms are mandatory for issuing a deferred payment guarantee.

1. The payment schedule of both the installment and interest,
2. The supply of goods by the seller to the buyer and the seller agreeing to postpone the payment of the price, this being the consideration of a guarantee,
3. The unconditional and irrevocable assurance of the bank that it would make payment on the invocation of the guarantee.

For example- Rs. 50 Lacs is the cost of the Machinery, Rs. 10 Lacs paid in advance, and a balance amount of Rs. 40 Lacs is repayable in 5 yearly installments. A guarantee is issued in case of default in payment of installment by the buyer.

4. Statutory Guarantee:These are guarantees issued by banks favoring Courts and other statutory authorities guaranteeing that the customer will honor his commitments imposed under law, failing which the bank will compensate to the extent of the amount guaranteed.

Invocation of Guarantee

Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur. An appropriate procedure for ensuring such immediate honouring of guarantees should be laid down so that there is no delay on the pretext that legal advice or approval of higher authorities is being obtained. The obligation of a banker, to honour his commitment on a guarantee given by him primarily, casts a duty on the bank to honour it irrespective of the dispute between the beneficiary and the debtor. Invocation has to be made by the same authority in whose favour the guarantee is issued. In case the payment is to be refused, controlling authorities’ permission must be obtained before refusal.

Guarantee Onerous Clause

Any provision in the guarantee which is likely to give rise to further pecuniary liability like interest or liability which is unlimited in terms of money as well as validity period is considered as an Onerous Clause:

• Auto Renewal / Extension.
• Jurisdiction clauses in different places.
• Where a time limit is specified for payment say 24 hours, 48 hours etc.
• Payment of interest on the invoked amount.

Application: The branch should obtain a request letter for the issue of a guarantee which contains the following:

• Authority to –adjust margin money, appropriate principal or collateral securities on default & recover all charges in respect of the issue of guarantee.
• The customer also accepts the responsibility to get back the original guarantee.

Guarantee Limitation Clause

All guarantees must carry limitation clauses invariably. As per RBI guidelines in 2014 minimum claim period to be mentioned in the BG is one-year Limitation clause as to time and amount. The following paragraph must be mentioned at the end of each guarantee:

“Notwithstanding anything contained herein above our liability under this guarantee is restricted to Rs. ——- (Rs. —————) and this guarantee is valid up to ————and we shall be released and discharged from all liabilities hereunder unless a written claim for payment under this guarantee lodged on us within ——- months from the date of expiry of this guarantee i. e. on or before ————- irrespective of whether or not the original guarantee is returned to us.”

Guarantee Confirmation Clause

All guarantees must contain the following clause in the forwarding letter of the guarantee: 

“The confirmation of this bank guarantee is available with our controlling office. The beneficiary in his own interest should obtain such confirmation from the controlling office at the following address………”

Expired Guarantee

Expired BGs are those BGs, that are outstanding in the Branch Books and attract risk weight, hence expired BGs should be canceled. The Bank should get back the original guarantee after the expiry of the guarantee. If the original guarantee has not been received back for cancellation, confirmation from the beneficiary should be obtained. The Branch should send a registered A/D letter to the beneficiary.  A copy of the letter should be sent to the customer also. If the expired guarantee or advice of cancellation is not received within one month from the date of the letter, the guarantee should be treated as canceled and entries should be reversed.

Limitation period in a guarantee

Section 28 of the Indian Contract Act 1872 pertaining to limitation clause of the guarantee has been amended w.e.f. 08.01.97. Due to this amendment, even when the period of liability is specified in the guarantee, the beneficiary can enforce his remedies till the limitation period is alive i.e. 30 years where the beneficiary is Govt. and 3 years in other cases from the stipulated expiry date / invocation, whichever is earlier.

Precaution to be taken while issuance of bank guarantee: Letter requesting for guarantee should be taken each time a guarantee is issued. Guarantees should be serially numbered. Guarantees should be signed by two officers, if the amount of BG is over Rs. 50,0000. The name, designation and code no. of the officers signing the guarantee should be incorporated. Guarantee must be issued after proper stamping of the paper as per State Stamp Act of the issuing state.

Bank Guarantee beyond 10 years: In terms of RBI circular dated July 1, 2008 on Guarantees, no bank guarantee should normally have a maturity of more than 10 years. In view of the changed scenario of the banking industry where banks extend long-term loans for periods longer than 10 years for various projects, RBI decided (April 22, 2009) to allow banks to issue guarantees for periods beyond 10 years under a policy-approved by their Board of Directors.

INDEMNITY CONTRACT

The dictionary meaning of the word Indemnity means ‘security or protection against a loss or other financial burden’. As per Section 124 of the Indian Contract Act 1872 the definition of the Indemnity is as follows. ‘A contract by which one party promises to save the other from loss caused to him by the contract of the promisor himself, or by the conduct of any other person, is called a “contract of indemnity”. The right of indemnity-holder is defined in Section 124 of the Indian Contract Act 1872.

An indemnity is an obligation by a person (indemnitor) to provide compensation for a particular loss suffered by another person (indemnitee). The concept of indemnity is based on a contractual agreement made between two parties, in which one party agrees to pay for potential losses or damages caused by the other party. The indemnifier is the sole person liable. Liability arises only on the occurrence of a loss.

The difference between an Indemnity Contract and a Guarantee Contract

Indemnity Contract – Use and Application in Bank

Letters of indemnity are used during various types of banking transactions. Indemnity taken by bank to protect the bank from any loss or damage and for cost incurred. Indemnity contracts are stamped as per stamp act. Some of the important uses of Indemnity contracts in banks are as under:

• In case of loss of Demand Draft, Travellers Cheque etc and to issue a fresh one.
• During issue of duplicate TDR, FDR, Pay order etc.
• When the valuable items are presented to the recipient prior to a bill of lading.
• In case of deceased account claim payment etc.