When a bank guarantee favouring Government and others actually discharges the issuer from liabilities?

Inasmuch as, the legal provisions governing Contract of Guarantee, the guarantees furnished by the banks in favour of Government Departments in the name of the President of India, has validity period of 30 years as per limitation act 1963.In the light of above section of limitation act, many readers are asking the questions whether the Government can enforce the rights under the Bank Guarantee within thirty years in spite of  ‘standardized notwithstanding clause which specifies that guarantee is valid up to…………’ mentioned  at the end of the guarantee bond. There are also questions on how long the banks can retain the margin money of the applicant if the original guarantee is not returned or notice of cancellation of guarantee received from the concerned Government department.

The Bank Guarantees are issued by all scheduled commercial banks in favour of Central Government Departments, in lieu of security deposits, etc. As regards to maturity, as a rule, bank guarantees are issued for shorter maturities and leave longer maturities to be guaranteed by other institutions. In any case, no bank guarantee normally has a maturity period of more than 10 years.

As per IBA specification bank guarantees were issued with the following clause at the end of the bond.

“Notwithstanding anything contained herein:

• Our liability under this guarantee shall not exceed Rs…….(Rupees)
• This bank guarantee shall be valid up to…….
• We are liable to pay the guarantee amount or any part thereof under the bank guarantee only and only if you serve upon us a written claim or demand on or before…..(date of expiry of the guarantee)”

Since section 128 of contract act allows the limited liability of the surety for specific amount or in respect of specific transaction or for that matter, for specific duration, it was common belief that the above clause in the guarantee would relieve and discharge the bank from the liability under the Guarantee on failure of the beneficiary of the guarantee filing the Demand/Claim with the bank on or before the expiry of the Claim period. However, as per amendment to Section 28 of the Indian Contract Act, 1872, which came into force with effect from 8th January 1997, the Bank was not absolved of its obligation to make payment under the Bank Guarantees but was bound and liable to pay the amounts referred to therein. The addition of Section 28(b) to section 28 of Indian Contract Acts provides that ‘every agreement which extinguishes the rights of any party thereto, or discharges any party thereto, from any liability, under or in respect of any contact on the expiry of a specified period so as to restrict any party from enforcing his rights, is void to that extent.’

Hence, Section 28(b) of the Contract Act entitled the beneficiary of the guarantee to enforce the guarantee till limitation period provided by Limitation Act. Under Limitation Acts, the Government departments can enforce their right within 30 years from the date of failure on the part of the Bank to pay the amount as per the Bank Guarantees and that, no part of the Bank Guarantee will extinguish the rights of the beneficiary or discharge the Bank from its liability under or in respect of any Bank Guarantees on the expiry of the period specified therein.

This new provision attached to section 28 in 1997 actually relinquishes the remedy subscribed in the agreement where the time-limit specified in the guarantee agreement is shorter than the period of limitation provided by law. The courts have, however, held that this section shall not come into operation when the contractual term spells out an extinction of the right of a party to sue or spells out the discharge of a party from all liability in respect of the claim.

To rectify the anomalous situation created by the above section, the government of India amended the contract act once again in 2013 by adding exception (iii) to section 28 of contract act. The exception (iii) to section 28 provides legitimacy to a term in a guarantee for extinguishment of the rights or discharge from any liability on the expiry of a specified period which is not less than one year from the date of occurring or non-occurring of a specified event.

The Supreme Court in an appeal of Union of India Vs Indusind Bank Ltd & others, (Sept 15, 2016)) while interpreting the discharge of liability clause observed that “It may only be noticed, in passing, that Parliament has to a large extent redressed any grievance that may arise qua bank guarantees in particular, by adding an exception (iii) by an amendment made to section 28 with effect from 18.1.2013. Since we are not directly concerned with this amendment, suffice it to say that stipulations like the present would pass muster after 2013 if the specified period is not less than one year from the date of occurring or non-occurring of a specified event for extinguishment or discharge of a party from liability.

This new provision 28(iii) now enables a bank or financial institution to limit the time within which a guarantee must be invoked by a beneficiary, in order for it to be honoured. RBI vide circular No.DBOD. No.Dir.BC.12/13.03.00/2013-14 July 1, 2013 advised the scheduled commercial banks that they should adopt the Model Form of Bank Guarantee Bond. The Apex Bank advised that the banks may incorporate a clause in the guarantee bond to that effect precisely in line with exception (iii) to section 28 of contract act. Since exception (iii) to section 28 is special law and would prevail over the provision of the Limitation Act, banks may not find it difficult in releasing the margin money held with them after expiry of specified claim period.

However, Banks should be careful in closing guarantees favouring the Director General of Supplies and Disposal(DGSD)DGSD, the Public Notice issued by the Customs Department. The tender form floated by BGs favouring the Director General of Supplies and Disposal(DGSD)DGSD, the Public Notice issued by the Customs Department stipulates, inter alia, that all BGs furnished by an importer should contain a self- renewal clause inbuilt in the guarantee itself. Hence, BGs issued in favour of DGSD and Customs Houses should invariably contain suitable clause for automatic extension of the guarantee period etc.

As per RBI guidelines, banks should mention in the guarantee bonds and their correspondence with the various State Governments, the names of the beneficiary departments and the purposes for which the guarantees are executed. This is necessary to facilitate prompt identification of the guarantees with the concerned departments. In regard to the guarantees furnished by the banks in favour of Government Departments in the name of the President of India, any correspondence thereon should be exchanged with the concerned ministries/ departments and not with the President of India.

Related article:

What is the time limit for enforcement of a bank guarantee?