Introduction
A bank guarantee is a financial promise made by a bank to ensure that one party in a transaction meets their obligations. If the party fails to fulfill their commitments—whether it’s paying for goods or completing a service—the bank steps in to cover the loss. This financial tool provides assurance and reduces risk, making it an essential part of modern business transactions, especially in international trade, where trust between parties is often a concern.
In international commerce, bank guarantees play a significant role by offering protection against uncertainties. When companies from different countries enter into business agreements, they face risks like differences in legal systems, currency fluctuations, and the possibility of non-payment or non-performance. A bank guarantee helps reduce these risks by ensuring that if one party defaults, the other party will still be compensated, making cross-border transactions smoother and safer.
There are two main types of bank guarantees: financial guarantees, which ensure that payments will be made, and performance guarantees, which ensure that a specific task or project will be completed. Both types give businesses the confidence to engage in large, complex deals, knowing that their investments are protected.
This blog will explore the concept of bank guarantees in detail, explaining what they are, how they work, and why they are critical in international commercial transactions. By understanding their role, businesses can better navigate the complexities of global trade.
What is Bank Guarantee?
A bank guarantee is a formal agreement where a bank promises to cover the financial obligations of its client if they fail to meet them. In simple terms, it acts as a financial safety net for the party receiving the guarantee (the beneficiary), ensuring they will be compensated if the other party (the applicant) defaults on the agreement.
Bank guarantee is nothing but the contract of guarantee and can be understand with the help of definition for contract of guarantee provided in the Indian Contract Act, 1872 (hereinafter to be referred as "Contract Act"). Section 126 of the Contract Act provides for the contract of guarantee, and it provides that, "A 'contract of guarantee' is a contract to perform the promise, or discharge the liability, of a third person in case of his default". It is clear from the definition of the Contract of Guarantee that it is a promise to perform or discharge the obligation of third person in case of his default. Element of default in guarantee is essential because only in case of default of the debtor, the guarantee came into picture.
There are three parties which are involved in the Contract of Guarantee namely, the "Principal Debtor", is the one on whose behalf the contract of guarantee is entered upon and whose liability sought to the discharged; "Surety" is the one who undertakes to discharge the liability of the Principal Debtor or perform the promise on his default; "Creditor" is the one for whose benefit the contract of guarantee is entered into. He is often referred to as "Beneficiary" in international commercial transactions.
Essentials of a Bank Guarantee
There are certain essentials, if fulfilled, can be said to be a contract of guarantee. The Supreme Court of India culled out certain essentials of Bank guarantee in case of Syndicate Bank v Vijay Kumar and those are;
- Concurrence of three parties is necessary
The court said that a contract of suretyship requires the contract of three parties i,e. the Principal Debtor, the Creditor and the Surety. The surety in the contract of Guarantee undertakes the obligation to pay on behalf of Principal Debtor at the request of Principal debtor.
2. Surety's distinct promise to be Answerable
The court said that in order to constitute the Guarantee, there must be a distinct promise on the part of surety to be answerable to the debt.
3. Primary Liability is that of Principal Debtor
The court said that in a contract of Guarantee, the primary liability to pay the debt is always that of the Principal Debtor. The Liability of the surety arises only in case of the default of the Principal Debtor.
Types of Bank Guarantee
Bank guarantees can be classified into different types based on their specific purpose and the nature of the underlying transaction. In international transactions, the question arises as to who has the responsibility of procuring the bank guarantee because, in international contracts of sale, there are two parties involved namely, the Seller and the Buyer unlike in a contract of guarantee where the parties are creditor, and Debtor.
Now in the case of a bank guarantee, the responsibility of procuring the bank guarantee depends on the type of bank guarantee and the type of risk that is to be covered. There are majorly two types of Bank guarantees according to the risk involved, namely Financial Bank Guarantee and Performance Bank Guarantee.
Financial Bank Guarantee
A Financial Bank Guarantee is a guarantee where the parties seek to secure the risk associated with the payment of the contract price. Since it is a payment-related bank guarantee and in the international contract of sale, the responsibility of the payment rests on the buyer, therefore it is the buyer who procures the Financial Bank Guarantee.
Performance Bank Guarantee
As the name suggests, a Performance Bank Guarantee is a guarantee that is related to the performance of the contract. In the international contract of sale, the responsibility for the performance of the contract rests with the Seller, therefore in the performance bank guarantee, the responsibility of procuring the Bank guarantee rests on the shoulders of the Seller.
In the case of Performance Bank Guarantee, although the performance of the contract is secured but it is to be noted that the bank is only liable for the encashment in terms of money and the bank is not obligated to perform the contract on behalf of Principal Debtor. The bank is only responsible to the tune of the amount agreed under the contract of bank guarantee. In international contracts of sale, in most cases the bank guarantee is performance bank guarantee.
What are the Issues associated with the Bank Guarantees?
In the case of a bank guarantee, the obligation of the bank to pay the agreed amount arises only in case of default by the principal debtor and not otherwise. The creditor or Beneficiary is the one who seeks the invocation of the Bank guarantee. In such a scenario, whenever the Beneficiary seeks the invocation of the bank guarantee, the principal debtor will always object and argue that there is no default on his part. Here the issues arise as to how the bank is going to decide whether the default has occurred and make the payment accordingly.
In the case of Delkon India Pvt Ltd v Bharat Heavy Electrical Ltd & Ors, there was a contract between Bharat Heavy Electricals Ltd (BHEL) and National Thermal Power Corporation Limited (NTPC) for setting up certain power plant. BHEL pursuant to the contract subcontracted with the Delkon India Pvt Ltd (Delkon). As part of the contract between BHEL and Delkon, delkon was required to procure a performance bank guarantee and Delkon procured it from the State Bank of India (Bank).
Later on, BHEL seeks the invocation of the bank guarantee on the failure of Delkon to meet the deadlines and accordingly issues the Letter of Invocation. There was a dispute resolution clause in the contract which provides for Arbitration as the mode of dispute resolution. Accordingly, the Delkon initiated the arbitration proceedings arguing that there was no default.
The court in this case said that a bank guarantee is an independent contract whereby the bank undertakes to abide by its terms, and it cannot be affected by the dispute between the parties to the underlying transaction. It creates an irrevocable obligation on the bank to perform the contract. Therefore, the court should be slow in granting the injunction to restrain the realisation of the bank guarantee and only in exceptional cases like, a) a case of fraud and b) allowing an encashment would result in the irretrievable harm to one of the parties concerned, then the court may intervene.
Further in Itek Corporation v First National Bank of Boston, the American district court explained the term "irretrievable harm". In this case there was contract between Itek corporation situated in America and the Govt of Iran whereby Itek was required to deliver certain optical equipment to the Govt of Iran. The underlying contract between the party, Itek was required to procure a bank guarantee from the Iranian Bank (Bank Melli). Itek was also required to procure a standy Letter of Credit in favour of Bank as a measure of security because it is a foreign bank guarantee. The contract provides that in case of any dispute the appropriate forum to be the Iranian Court and the law to be Law of Iran.
Later on, the relation between both countries deteriorated and due to political turmoil American Govt impose complete ban on export licenses. Eventually there were certain relaxation with respect to the Letter of Credit transaction but the export ban was still there. Now, Itek is unable to deliver the equipment to Iran and anticipating invoking of standy Letter of Credit by the Bank, seek injunction from the court to restrain payment to Bank Melli.
The court in this case explain irretrievable harm and said that the question whether the plaintiff is likely to suffer irreparable injury may be cast in term of whether the plaintiff has any legal remedy available that is adequate to compensate it for its injuries. Therefore, in the present case as there was a complete export ban, Itek is unable to export the equipment. As the appropriate forum is Iranian court which is rendered impossible becuase of the turmoil in relation between the two countries therefore Itek cannot get the remedy and will incur an irreparable harm to the plaintiff.
Role of Bank Guarantee in International Commerce
The role of a bank guarantee in international transactions is vital, as it provides financial security and trust between parties engaged in cross-border business. International transactions often involve significant risks due to unfamiliarity between the parties, different legal frameworks, and potential currency fluctuations. A bank guarantee acts as a protective mechanism that mitigates these risks and ensures smooth execution of agreements.
- Risk Mitigation
A bank guarantee reduces the risk of financial loss for both buyers and sellers. For the seller, it assures that they will receive payment even if the buyer defaults on their contractual obligations. For the buyer, it guarantees that if an advance payment is made, the goods or services will be delivered as per the contract. This is particularly useful in large or long-term contracts where there is a time gap between delivery and payment.
2. Building Trust
When businesses from different countries engage in trade, trust may be limited due to the lack of direct knowledge of each other’s credibility or performance. A bank guarantee bridges this trust gap. Since a reputable financial institution backs the guarantee, both parties feel secure that the transaction will be completed or compensated in case of failure.
3. Facilitating Larger Contracts
International transactions, especially those involving infrastructure, energy, or manufacturing, often involve large amounts of money. A bank guarantee allows companies to enter such large-scale contracts with confidence. Sellers are assured that the buyer has financial backing, while buyers feel secure knowing the seller is committed to performance.
4. Ensuring Performance
In addition to guaranteeing payments, performance guarantees ensure that the seller or service provider will meet their obligations, whether it’s completing a construction project or delivering goods on time. If the seller fails to deliver, the buyer is compensated, reducing potential losses and delays.
5. Enhancing Creditworthiness
A bank guarantee enhances the credibility of both parties involved in the transaction. For the applicant (usually the buyer), obtaining a guarantee from their bank demonstrates financial reliability and commitment to fulfilling their obligations. For the beneficiary (usually the seller), the bank guarantee serves as a layer of protection, ensuring they will be compensated in case of non-performance.
Conclusion
Bank guarantees play a crucial role in facilitating international commercial transactions by providing security and trust between parties from different countries. They reduce the risks inherent in cross-border trade, ensuring that both parties fulfill their contractual obligations. By offering financial protection, bank guarantees help businesses confidently engage in international deals, promoting global trade and economic growth.
Bank guarantees offer two main types of security: financial and performance. They are particularly useful in industries where trust and reliability are critical, such as construction, manufacturing, and large-scale infrastructure projects. With a bank guarantee in place, buyers and sellers can safeguard themselves against potential losses if one party fails to meet their obligations.
As international trade continues to grow, bank guarantees provide stability and assurance in a constantly changing global market. Companies looking to expand their operations across borders can rely on these guarantees to protect their interests, ensuring smoother and more secure transactions. These guarantees not only protect businesses but also enhance the efficiency and reliability of global trade, making them an indispensable part of modern commerce.
Frequently Asked Question
Question: Does the Bank issue the Bank Guarantee?
Yes, as the name suggests, it is a bank guarantee, and in international commercial transactions, banks issue the Bank guarantee.
Question: What is a Foreign Bank Guarantee?
A foreign bank guarantee is a type of bank guarantee where the bank of another jurisdiction is involved, and the guarantee is issued by the foreign bank.
Question: How can a Bank guarantee help your business?
The bank guarantee is an instrument by which either the payment of the contract price or the performance of the contract is secured. The bank is involved in the transaction thereby a greater security is there if either party default in the contractual obligations.