A Critique on the Implications of Counter-Guarantee vis-à-vis Bank Guarantee and Letter of Credit

By Samrudh Kopparam [1]

ABSTRACT

With the emergence of the COVID-19 pandemic, the entire world went into lockdowns which immensely impacted the global economy. To recuperate from this impact and ‘rebuild’ the global economy, global cooperation, collaboration, and international trade is of the essence. At times like these, transactional security becomes pivotal to bring in foreign investment and integrate a sense of financial security and stability. Consequently, innovative financial and negotiable instruments become rampant. Thus, it becomes crucial to understand the implications of such sources of finance. This paper will critically analyse Bank Guarantees and Letters of Credit when a provision of counter-guarantee is provided. We aim to understand the elevated scope of these financial and negotiable instruments, implications of such instruments, and lastly, the inadequacy that arises to conclude by substantiating the necessity of a counter-guarantee.

Keywords: Counter-Guarantee, Bank Guarantee, Independence, Fraud, Irretrievable Injustice.

INTRODUCTION

In the aftermath of the COVID-19 pandemic, the entire world is facing a severe economic and financial gnaw. India remains indifferent to these consequences and is riddled with a massive unemployment crisis, alongside a contracting G.D.P. In pursuance of ‘rebuilding’ the country’s economy, other than focusing on value-added products and augmenting domestic manufacturing, the government would seek to engage in foreign collaboration and increase its international trade. In these harsh and volatile business conditions wherein international transactions are often carried out with parties apart, barriers of language, and diverse interpretations, innovative instruments are utilized to provide payment security and airtight guarantee. Thus, it becomes essential to understand the implications of reliable sources of financing to protect and reduce the risks in business transactions.

Through this paper, we analyse the provision of ‘counter-guarantee in two such innovative instruments, i.e., bank guarantee and letter of credit. The former is considered the ‘life-blood of domestic and international trade. The bank binds itself to pay unequivocally without demur to the beneficiary. [2] Despite being nascent in its applicability, the latter has crept into day-to-day international transactions as it carries an immediate legal effect and is necessary with the increased complexity of trade. [3] The provision of a counter-guarantee plays a critical role in expanding the scope of the aforementioned instruments. This paper critically analyses the extent of the scope and parties’ legal position in a counter-guarantee in Chapter I. We aim to understand Chapter II’s ‘common’ implications that arise from this increase of scope. Lastly, we juxtapose the common inadequacies derived from both the instruments in Chapter III to conclude by substantiating our claim that a counter-guarantee is necessary for the contemporary context to reduce the risks in business transactions.

LEGAL POSITION OF PARTIES IN A COUNTER-GUARANTEE

To weigh down the parties’ legal position in a counter-guarantee vis-à-vis bank guarantee, let us first briefly examine the working of a bank guarantee. Essentially, a contract of guarantee is governed under section 126 (“S.126”) of the Indian Contract Act, 1872 [4] to provide security to the creditor in the form of a promise by the surety in case of default by the principal debtor. [5] Bank guarantees work on this principle; however, they become inherently peculiar as it is to a certain degree an absolute undertaking to pay the amount whenever demanded by the guarantee-holder without due assertion on their relationship. Subsequently, making it the backbone of international commerce and attracting litigation due to abusive or unfair callings. [6] In this regard, a ‘counter- guarantee provision is instituted for the protection of the original guarantor. When a counter- guarantee is integrated into a bank guarantee, a four-party arrangement arises that gives effect to two back-to-back demand guarantees involving two different banking or financial institutions. [7] A bank (usually referred to as ‘counter guarantor’) instructs a second bank (the ‘guarantor’) to issue a demand guarantee in favour of a ‘beneficiary.’ The second bank is guaranteed compensation against the counter-guarantor its payment to the beneficiary under its demand guarantee. Later, the guarantor provides a demand guarantee in the beneficiary’s favour and pays the beneficiary upon receipt of a compliant demand. [8] To simplify the process, a counter-guarantee is an independent undertaking by a bank (counter-guarantor) in the country of the principal debtor in favour of a local bank (guarantor) in the beneficiary’s country. It is important to note that the beneficiary himself does not receive the guarantee ‘directly.’ Rather, the local bank guarantees payment on first demand.

ELUCIDATINGTHELEGAL POSITION OF THE FOUR-PARTY AGREEMENT

From the aforementioned discussion, it can be established that the ‘real’ guarantor remains the banks and financial institutions of the beneficiary’s jurisdiction (the ‘reissuing bank’). [9] In contrast, the bank in the applicant’s jurisdiction plays the role of a counter-guarantor. In this manner, a guaranteed contract relationship is constituted, as the beneficiary is reimbursed based on the underlying transaction by the primary guarantee. When we closely examine the relationship between the counter-guarantor and the guarantor, there emerge two inter-linked. However, independent relationships – one of an agency relationship and another bearing qualities of an ‘indemnity.’ In the former case, the guarantor acts in a dual capacity while instructing the issuance of a guarantee. [10] I.e., as a principal between himself and the beneficiary and as an ‘agent’ between himself and the counter-guarantor. This contended in Bank Melli Iran v. Barclays Bank. [11] The confirming bank acted as a principal towards the beneficiary while acting as an agent towards the counter-guarantor. The conundrum was resolved by denoting this relationship as a ‘mandate’ accorded by the International Chamber of Commerce (I.C.C.) uniform rules on-demand guarantee. [12] In the latter case, a counter-guarantee like a primary guarantee takes effect on its terms. This was duly laid down in the landmark judgment of Mitsubishi v. Gulf Bank., [13] wherein It was maintained that the counter-guarantee is independent not only of the underlying contract between the beneficiary and the principal but also of the primary guarantee. Thus, if the counter-guarantor undertakes to reimburse the guarantee without receiving a complying demand, it would give rise to a contract of indemnity as defined under S.124 [14] of the Indian Contract Act, 1872.

It is also important to note that apart from the underlying contract, there are three significant relationships involved in a four-party transaction, i.e., between the beneficiary and the guarantor, the principal and the counter-guarantor, and the counter-guarantor and the guarantor. Additionally, we shall draw comparisons of these relationships vis-à-vis the Letter of Credit to advance a coherent discourse in Chapter III. Firstly, a Letter of Credit is a financial instrument that acts as a promissory note, i.e., it guarantees a buyer or borrower’s payment to a beneficiary on time and in full. [15] In this regard, the first relationship between the beneficiary and the guarantor is similar to that between the beneficiary of actual credit and the confirming bank (‘guarantor’), which adds confirmation to the Letter of Credit at the beneficiary’s desire. [16] The second relationship between the principal debtor and the counter-guarantor resembles an applicant for a standby credit and the issuer. This can be examined through the case of Re. Twist Cap, Inc.; [17] wherein it was held that when the applicant secures a standby credit, an indirect preference will occur to benefit the unsecured beneficiary. Thus, the principal party’s insolvency risk is shifted to the issuer. [18] Lastly, to understand the legal position and relationship between the guarantor and the counter-guarantor, we shall examine the case of Turkiye Is Bankasi A.S. v. Bank of China. [19] Due to the similarity of the object in primary and counter-guarantee, it was held that they are to be governed by the same law system. However, it imposed severe implications. [20] Those are discussed in Chapter II. Illuminating on this relationship, firstly, we observe that although it was widely acknowledged that the appropriate law of a demand guarantee was unaffected by the governing law of the underlying contract, [21] the case here was unique because the counter-guarantee was inextricably linked with the primary guarantee. Secondly, according to the doctrine of infection in a commercial context, the court shall assume that the same law shall govern even the guarantees. This has been reaffirmed in the case of National Building Co. v. A.M Rasool Co., [22]. Furthermore, taking aid of the Broken Hill case [23].

The court inferred beyond reasonable doubt that the parties intended the counter-guarantee to be governed by the same law as the primary guarantee. This inference was drawn by observing that the guarantor took no greater risk than the solvency of the counter-guarantor, and the reimbursement was reissued to the same liability. [24] Another vital precedent was set in Bank of Baroda v. Vysya Bank [25] which held that if the same law system did not govern the contract between the counter-guarantor and guarantor, it would lead to inconsistencies. Consequently, the applicable law of the counter-guarantee is the law of the guarantee, thereby preserving the independence principle.

IMPLICATIONS OF A COUNTER-GUARANTEE

Now that the relationship between the parties and their legal liability has been established, we can understand the common implications posed by a counter-guarantee provision.

A. Distortion of the Independence Principle in Counter-Guarantee

By analysing the relationship between the parties in a four-party arrangement, we can observe that each party is correlated to such an extent that the existence is only possible through the existence of another. [26] However, according to the autonomy or independence principle, each contracting party is independent and has commercial obligations. This can be observed in a recent judgment by the Delhi High Court. It was held that a counter-guarantee is an independent contract, separate from its underlying transaction. [27] Firstly, it was examined that the standard ‘independence’ principle that applies to the relationship between the guarantee and the underlying contract cannot be concretely adopted to the relationship between the counter-guarantee and the guarantee because the guarantor bears duties derived from a mandate, [28] i.e., the counter-guarantee and the guarantee are restricted by their respective context and do not need to coincide with each other. Furthermore, independence is also manifested in the context of expiry. This has been duly upheld in the case of Helm Dungemittel GMBH v. S.T.C. India, Ltd. [29]. The court opinionated that the expiration of the letter of guarantee does not automatically lead to the expiration of the counter- guarantee. The inconsistency arises with the court’s contention of viewing the parties to be applicable under the same law. This aspect was raised in BHEL v. Electricity Generation Inc. [30] The court opinionated that if the letter of guarantee stipulates an arbitration clause while the counter- guarantee does not, the dispute based on the letter of guarantee shall be subject to arbitration jurisdiction and the dispute based on the counter-guarantee the court jurisdiction. Therefore, imposing conflicted ramifications vis-à-vis exclusive territorial jurisdiction in commercial contracts.

Narrow Scope of Judicial Intervention in Enforcing a Counter-Guarantee

There is immense stress on ‘independence’ to counter-guarantee as it performs the role of risk distribution to achieve its purpose. Firstly, there is a shift in the burden of litigation, and the beneficiary can immediately have the necessary funds by submitting a complying demand. [31] Secondly, it shifts the burden of proof and the risk of currency fluctuation. Most importantly, it shifts the form of litigation in an international transaction. Therefore, to achieve an equitable relationship, there must be minimal external interference to the agreement. The Supreme Court also laid this in United Commercial Bank v Bank of India. [32] That courts should not interfere executively in such contracts since doing so may cause delays and disrupt the transaction process. However, there are certain exceptions wherein such intervention becomes necessary, i.e., fraud and irretrievable injustice cases. In Texmaco Ltd. v. State Bank of India, [33] the Court held that in the presence of “fraus omnia corrumpit,” i.e., fraud corrupts everything, the bank does not have to make payments payment where a fraudulent beneficiary presents documents. Indian Courts, however, impose a high standard of proof in granting such injunctions. [34] Through this approach, a twin- fold objective is achieved; firstly, it discourages the principal from making false claims about the presence of fraud and maintains the efficacy of the demand guarantee as a financial instrument. [35] The scope of the fraud rule was discussed in Vinitec Electronics Pvt. v. H.C.L. Infosystems Ltd, [36] wherein the Supreme Court remarked that the bank could pursue redressal when it is apparent that the documents produced by the beneficiary for pursuing enforceability is fraudulent or unlawfully obtained, and where the ‘fraud’ occurs in the underlying transaction by either party. [37] Furthermore, in the case of Ross Exports v Tartan Infomark Ltd., [38] it was held that the standard of proof is dependent on the facts in their entirety, and it is essential for the ‘fraud’ to vitiate the underlying transaction entirely.

The courts may also intervene in the encashment of guarantee when there is a prima facie irretrievable harm or injustice to one of the parties. The fundamental requirement in this regard is that the ensuing irretrievable harm or injustice must be such that the guarantor cannot indemnify themselves. It must also be demonstrated to the court’s satisfaction that the amount could not be recovered from the recipient through restitution. [39] Furthermore, the Apex Court in U.P. State Sugar Corp. v. Sumac International [40] Held that the extent of the irretrievable nature should transcend the fundamental stipulations of the guarantee and adversely affect the commercial agreement. The exception plays a significant role when the parties to contract restrained by an internal adjudicative mechanism (like arbitration) attempt to frustrate the adjudication results to encash the guarantee. This intervention to over-arch the adjudication procedure with a ‘mala fide’ motive to inflict injury to the opposing party draws the exception of irretrievable injustice.

ANALYZING THE INADEQUACIES OF A COUNTER-GUARANTEE

After analysing the broad implications of a counter-guarantee provision common to Bank Guarantees and Letters of Credit, we observe quite a few common inadequacies. Unlike other economically advanced countries, India does not follow the I.C.C. Uniform Rules for Demand Guarantee (URDG) [41] i.e., a set of voluntary contractual rules standardizing international banking transactions. The URDG 758, in particular, regularizes the banking practice on-demand guarantees and counter-guarantees. [42] This inconsistency may lead to conflicts due to the difference in ‘rules’ and governing laws between the parties. For instance, I.C.C. regulations hold that the counter-guarantee terminates three years after the issuing date when time is not of the essence or not explicitly mentioned. On the other hand, in India, the guarantees are governed by the Limitation Act, 1963. [43] In cases wherein the government is the beneficiary, the expiry date extends to 30 years. Another inadequacy that has sparked controversy is the impact of the Doctrine of Strict Compliance within these instruments. [44] The counter-guarantors obligation against the guarantor is to pay only against an excellent conforming demand, i.e., there arises no payment if the documents presented do not conform to the text of the bank guarantee. As the Indian regime does not follow the ICC URDG, the ‘degree of compliance’ has remained ambiguous, asserting a more significant ‘duty of care upon the guarantor. [45] This arises as if no strict review is conducted when the guarantor makes payment upon the request to the beneficiary, the beneficiary may file malicious claims, which will bring irretrievable damage to the applicant. [46] Thus, we can contend that the courts, when adjudicating these cases, must take an open-minded approach and review if ‘substantial’ compliance is met.

Another fallacy in the counter-guarantee provision is the inability to combat shell companies. [47] It has been observed that after encashment of the guarantee, these companies would initiate insolvency proceedings and set off their contractual obligations. [48] Furthermore, the Reserve Bank of India’s (R.B.I.) recent master circular allows such corporations to beguile themselves into a false sense of security by commencing insolvency procedures. [49] This further contradicts the “Rule of Gibbs” established in Anthony Gibbs v. La Société Industrielle. [50] The Gibbs rule is widely known for its legal application in safeguarding creditors’ rights in transnational dealings and comfort the local lenders in a counter-guarantee. The Rule holds that foreign insolvency proceedings cannot merely discharge a debt governed by law. Thus, such a reform exacerbates the issues of ‘set-off’ clauses and perpetuates the inequitable relationship between the parties.

CONCLUSION

The primary objective of these innovative instruments is to give security for the due performance of the underlying commercial transaction. However, through this paper, we have observed the myriad lacunae present that can deter the purpose and tip the scales of an equitable relationship. To overcome the inadequacies and international transactions are carried out smoothly, India must adopt a uniform regime like the first-world countries. This would guarantee minimal jurisdictional tussle during disputes, forum shopping, abuse of interpretative contrariety, and contravention of foundational legal principles.

The implications have been analysed throughout this paper to further our claim that the counter- guarantee provision is necessary. However, to make it truly effective, we recommend ‘regulatory’ measures for smoother functioning. Firstly, to mitigate the risks of being abused by ‘shell companies,’ a counter-guarantee may be provided after duly assessing the client’s financial standing and past transactional record vis-a-vis such guarantees. After evaluating the same, they may lay down maximum monetary limits up to which they shall ‘indemnify’ or guarantee the beneficiary, consequently reducing transactional risks and propensity to guarantee. Secondly, to adhere to the documentary compliance, there shall be a higher standard of due diligence during the issuance of a guarantee that two signatures must attest in triplicate copies. [51] Lastly, it has been observed that the independence principle tips the scales by giving security to the beneficiary by the bank, but no such provision is available for the buyer (principal); thus, the scope of judicial intervention must be made lucid to achieve a genuinely equitable relationship.

[1] 3rd Semester, Jindal Global Law School, Sonepat.

[2] Turkic, M., Bank demand guarantee and standby letter of credit as collaterals in international trading operations, 4 INTERNATIONAL JOURNAL OF MANAGEMENT, I.T. AND ENGINEERING 272, 274 (2014).

[3] Id. 272.

[4] Indian Contract Act, 1872, No. 9, Acts of Parliament, 1872, § 126.

[5] Sankalp     Jain,     “Commercial  Instruments:  Bank Guarantee  and  Letter  of  Credit,”  SSRN   (2014).

[6] Ashok Luhar, Letter of Credit and Bank guarantee- Which is More Cost-Effective in Selected Indian Industries, 3 JOURNAL OF RESEARCH IN MANAGEMENT & TECHNOLOGY 19, 24 (2014).

[7] 3 DR. AVTAR SINGH, CONTRACTS & SPECIFIC RELIEF 606-984 (12th Ed, 2020).

[8] Thomson           Reuters,           “Glossary-           Counter             Guarantee,”  U.K. PRACTICAL  LAW.

[9] Mohd. Yasin Wani & Rais Ahmed Khasi, A Legal Perspective of Bank Guarantee System in India, 3 INTERNATIONAL JOURNAL OF RESEARCH IN COMMERCE & MANAGEMENT 163, 165 (2012).

[10] Chung-Hsin Hsu, The Independence of Demand Guarantees, Performance Bonds and Standby Letters of Credit, 1 NTU L. REV. 1 15, 32(2006).

[11] Bank Melli Iran v. Barclays Bank Ltd., [1951] 2 Lloyd’s Rep. 367 (U.K.).

[12] Chung-Hsin Hsu, The Independence of Demand Guarantees, Performance Bonds and Standby Letters of Credit, 1 NTU L. REV. 1 18, 32(2006).

[13] Mitsubishi Heavy Industries Ltd. v. Gulf Bank K.S.C., [1996] EWCA Civ 1281 (U.K.).

[14] Indian Contract Act, 1872, § 124.

[15] He Bo, Legal Issues in Independent Guarantee Businesses in International Trade, 6 CHINA LEGAL SCI. 143, 151 (2018).

[16] Chung-Hsin Hsu, The Independence of Demand Guarantees, Performance Bonds and Standby Letters of Credit, 1 NTU L. REV. 1 29, 32(2006).

[17] Re. Twist Cap, 1 B.R. 284 (Bankr. M.D. Fla. 1979) (U.S.A.).

[18] It is important to note that the Issuing bank resides in the Applicant’s country.

[19] Turkiye Is Bankasi As v Bank of China, [1997] EWCA Civ 2649 (UK).

[20] The implications discussed in Chapter II relate to the ‘Independence Principle’ or the Autonomy Principle. The Autonomy Principle holds that each contracting party is independent and undertakes its commercial obligation governed by mutually accepted law.

[21] James J Mayers, et al., Illustrative Forms of Performance Guarantee and Counter Guarantee Security for International Construction Projects, 20 INT’L BUS. LAW. 243, 253 (1992).

[22] National Building Construction Corporation Limited v. A.M. Rasool Construction and Engineering Services Pvt. Ltd., 2012 S.C.C. OnLine Del 1455 (India).

[23] The Broken Hill Proprietary Co. Ltd. & Anr v. The Valuer-General of New South Wales, [1969] WLR 379.

[24] Dr. Athira P.S, et al., A Critical Appraisal of the Role of Bank Guarantees in Transnational Sales – An Indian Perspective, Ph.D. Dist. NUALS, 35, 93 (2020).

[25] Bank of Baroda v. ING Vysya Bank Ltd., 2014 S.C.C. OnLine Kar 12699 (India).

[26] Grace Longwa Kayembe, The Fraud Exception in Bank Guarantee, Master’s thesis, University of Cape Town 17, 79 (2014).

[27] L&S Attorneys, “Counter-guarantee is an independent contract, separate from its underlying contract,” LAKSHMIKUMARAN & SRIDHARAN ATTORNEYS (2017).

[28] Chung-Hsin Hsu, The Independence of Demand Guarantees, Performance Bonds and Standby Letters of Credit, 1 NTU L. REV. 1 19, 32(2006).

[29] State Trading Corporation of India Ltd. v. Helm Dungemittel GMBH, 2016 SCC OnLine Del 4455 (India).

[30] Bharat Heavy Electricals Limited v. Electricity Generation Incorporation, 2017 S.C.C. OnLine Del 11256 (India).

[31] Dr. Athira P.S, et al., A Critical Appraisal of the Role of Bank Guarantees in Transnational Sales – An Indian Perspective, Ph.D. Dist. NUALS 25, 93 (2020).

[32] United Commercial Bank vs. Bank of India and Others, 1981 S.C.R. (3) 300 (India).

[33] Texmaco Ltd. v. State Bank of India, 1978 S.C.C. OnLine Cal 140.

[34]          Akshay       Anurag,       “Bank        Guarantee        and        Judicial       Intervention,”        MANUPATRA (2018).

[35] Grace Longwa Kayembe, The Fraud Exception in Bank Guarantee, Master’s thesis, University of Cape Town 52, 79 (2014).

[36] Vitec Electronics (P) Ltd. v. HCL Infosystems Ltd., (2008) 1 SCC 544 (India).

[37] Dr. Athira P.S, et al., A Critical Appraisal of the Role of Bank Guarantees in Transnational Sales – An Indian Perspective, Ph.D. Dist. NUALS 49, 93 (2020).

[38] Ross Exports International (P) Ltd. v. Tartan Infomark Ltd., 2002 S.C.C. OnLine Del 91 (India).

[39] Rada Postolache, The Banking Counter-Guarantee- Juridical Regime, 4 EIRP PROCEEDINGS 64, 76 (2010).

[40] U.P. State Sugar Corpn. v. Sumac International Ltd., (1997) 1 SCC 568 (India).

[41] Uniform Rules for Demand Guarantees, International Chambers of Commerce (I.C.C.) Publication No. 758 (2010).

[42] Mohd. Yasin Wani & Rais Ahmed Khasi, A Legal Perspective of Bank Guarantee System in India, 3 INTERNATIONAL JOURNAL OF RESEARCH IN COMMERCE & MANAGEMENT 164, 165 (2012).

[43] The Limitation Act, 1963, No. 36, Acts of Parliament, 1963.

[44] Michelle Kelly-Louw, The Doctrine of Strict Compliance in the context of demand guarantees. 1 COMPARATIVE AND INTERNATIONAL LAW JOURNAL OF SOUTHERN AFRICA 85, 129 (2016).

[45] Id. 90.

[46] Id. 96.

[47] Shell firms do not engage in active commercial activities. However, they are set up to fulfill specific corporate goals such as minimizing tax liabilities, protecting a corporation from legal ramifications, etc.

[48] Linklaters,       No   side-stepping   the    rule  in Gibbs,   THE   LINKLATERS     BLOG   (2020).

[49] Devendra Mehta, An urgent need for a cross-border insolvency framework, THE ECONOMIC TIMES (2020).

[50] Antony Gibbs & Sons v. La Societe Industrielle Et Commerciale Des Metaux, 25 Q.B.D. 399 (UK).

[51] Dr. Athira P.S, et al., A Critical Appraisal of the Role of Bank Guarantees in Transnational Sales – An Indian Perspective, Ph.D. Dist. NUALS 65, 93 (2020).

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