ABSTRACT
This research paper will develop an understanding of the bank guarantees in high-value transactions, and this research will look at the implications of bank guarantees within the legal framework of India. Further highlights the intervention of the judiciary in the matters of bank guarantees, the role of bank guarantees in facilitating trade and commerce, and the effect of high-value transactions on the competitive market. Through an examination of specific case studies of fraudulent loan guarantees involving Vijay Mallya and Nirav Modi, the study will also clarify the intricacies and difficulties associated with bank guarantees in India. Additionally, this research will also provide a valuable insight into the regulatory dimensions of bank guarantees. And the concepts of surety bonds, which can be used as an alternative to bank guarantees for fair and transparent business practices in India.
INTRODUCTION
The Bank guarantee is not a funding credit facility which is similar to the contract of guarantee defined under section 126 of Indian Contract Act, 1872. This is the contract between the banker, the creditor, and the debtor, wherein the bank promises to take the responsibility to pay off the debts of the creditor in the event of default made by the Debtor. The contract of Bank guarantees is not governed by the Indian Contract Act, only in the case of fraud and misrepresentation, court intervenes in the matters of the bank guarantees. And as per section 126 of the Indian Contract Act, 1872, the “contract of guarantee,” which states that the third person is introduced in this contract as a guarantor to perform a promise or discharge the liability of the principal debtor towards the creditor. There can be both oral and written guarantees. But in bank guarantees there are only written agreements.
Generally, bank guarantees are classified into two types: conditional bank guarantees and unconditional bank guarantees. An unconditional bank guarantee makes the bank liable to pay off the debts in case of default, without the need for any proof of default, whereas a conditional bank guarantee requires the creditor to provide the proof of default.
In the case of “State Trading Co. Of India Ltd. Vs. Janson’s Clothing Corporation,” the Supreme Court defines the bank guarantee by stating that a bank guarantee is a trilateral contract in which the bank must unequivocally abide by the terms of the contract, which help in the free flow of trade in domestic or international trade. Bank guarantees play a crucial role in commercial transactions, encompassing construction projects, international trade, real estate transactions, and procurement contracts, all falling under the purview of the Indian Contract Act. They provide a degree of protection, assurance, and credibility to the parties engaged in the contractual obligations by reducing the financial risks.
And the Court cannot interfere in the matters of the bank guarantee, the exceptions to this rule are when there is a clear case of fraud, irretrievable injustice, or special equities. Cases such as Vijay Mallya, Nirav Modi, and many others, involve substantial financial commitments and complex contractual arrangements that may result in non-performing assets that affect the economy and can have a huge impact on the competitive market. And there may be situations where bank guarantees can refuse to be invoked due to financial distress, due to which the contracting party may not be left with any adequate legal remedy to recover the damages. Although bank guarantee is for the securities of the creditor but in certain exceptions, the creditor can’t exercise his rights, in the case of fraud by the creditor and irretrievable injury, in these situations’ banks can refuse to invoke bank guarantee.
JUDICIAL INTERVENTION IN THE BANK GUARANTEES
The courts or the state cannot interfere in the contract of bank guarantees because the bank undertaking consideration towards the creditor is unconditional and absolute. The whole point of the bank guarantee is to avoid any long judicial or legal proceedings and allow individuals to recover their debts through bank guarantees so that the transaction process is not harmed and to protect the interests of the parties. In many cases, such as “United Commercial Bank vs. Bank of India [1981],” the Supreme Court ruled that courts need not intervene in unconditional bank guarantees; they can only intervene in cases of fraud and irretrievable harm. And, in the case of “Tarapore and Cooperation vs. Tractor Exports [1970],” the Supreme Court stated that the contract formed between the bank and the creditor is totally different from the original contracts; that’s why there is no need for the intervention of the courts in bank guarantees.
BANK GUARANTEE PROCESS AND ELIGIBILITY CRITERIA
Any organisation or person who has a good financial background or record can apply for bank guarantee, but, before approving bank guarantee, certain procedures needs to be followed, which are regulated by the RBI [Reserve Bank of India], the bank will analyse the creditworthiness, due diligence, liquidity, banking history, purpose, validity, specific amount, written documentation between the bank and the customer, “credit rating information services of India limited” [CRISIL], “credit information bureau [India] limited” [CIBIL] rating for the application, The bank charges fees for the bank guarantee, which is determined by several factors, including the risk that the bank took on for the specific transaction. The bank may also charge application, document, and handling fees. Bank guarantee is given against the collateral securities – bank deposits, FDs; these securities charged by the bank have a 100% value of the bank guarantee. After all these the application of guarantee goes through the approval process and once the banking officials are satisfied with the criteria and conditions are fulfilled, the bank issues the guarantee in favour of the beneficiary.
Despite all these strict guidelines the banks do not adhere to the guidelines, due to which the facilities provided by the bank laps and results in the misuse and fraudulent activities.
FRAUDULENT CASES OF BANK GUARANTEE
There are many cases in India where banks did not follow the regulatory guidelines necessary for the contract of bank guarantees, which lead to the situation of fraudulent activities such as the Vijay Mallya case.
Vijay Mallya, who was the former chairman of Kingfisher Airlines, was accused of misusing bank guarantees. Approx. 17 banks, such as the State Bank of India, Bank of India, Bank of Baroda, Punjab National Bank, and many others had extended term between 2009 and 2012 on bank guarantees, personal guarantees, corporate guarantees by United Breweries [UB] holdings, and guarantees of listing companies, which were part of Airline. And the bank gave the bank guarantees involving loans guarantee for high-value transactions when the airline’s business was not in a condition to repay its dues, and many banks declared him bankrupt and stopped providing him with further loan guarantees, but by using his influential position, he continued to take them from other banks. Even airlines were not paying salaries and taxes due to greater losses. In all these cases, banks were giving loans, guarantees to Vijay Mallya.
The assets attached as securities for bank guarantees were deemed worthless. The total value of Kingfisher airline assets shown in the write-down value was much higher than its actual value. The write-off value was $395 crore, but the actual value was $186.12 crore.
Even the personal guarantees, corporate guarantees, and other guarantees that were supposed to provide securities or pay bank debts were deemed worthless.
The purposes specified by Vijay Mallya for loans and bank guarantees, were other than those specified in the agreement.
And in the case of Nirav Modi, the fraudulent bank guarantee of Punjab National Bank was involved in obtaining fraudulent letters of credit and undertakings [LOCs] and [LOUs]. LOCs and LOUs are kinds of bank guarantees that were used by Nirav Modi to obtain credit from overseas Indian branches. The fraud was disclosed when the Punjab National Bank found out about the unauthorised transactions made by Nirav Modi to finance his business. And later, it was also discovered that bank officials issued these letters of credit without following proper regulations, authorizations, or collators. And there are many other cases where banks acted negligently and, considering the reputation of these people, granted them bank guarantees or loan guarantees without proper checks and balances.
All these factors clearly show the noncompliance with regulatory guidelines and due diligence norms by the banks for providing bank guarantees or loans. The bank provided credit facilities without proper checks and balances and without adequate collateral or securities. Due to all these fraudulent cases, non-performing assets are increasing day by day. Non-performing assets affect operational efficacy, which affects the profitability, liquidity, and solvency of banks.
EFFECTS OF NON PERFORMING ASSETS ON ECONOMY
Due to improper credit appraisals, business failures, and no recovery of debts, banks face non performing asset situations. Which impacts economic growth, financial stability, credit availability, capital fights, reduced foreign investment, current depreciation, and further economic challenges such as: Higher non-performing assets will weaken the financial stability of the banks and other financial institutions. Banks won’t have sufficient funds for the other developing industries, and funds are the main requirement for such projects. Insufficient funds for these developing industries will affect economic growth.
Due to the limited availability of funds, banks will be forced to increase interest rates. Which restricts farmers and new startup businesses from leading loans, and the high interest rate also makes it difficult for these groups to pay off their debts.
Due to an imbalance in the financial market or in future investments, there is a rise in the situation of unemployment in society.
Due to non-performing assets, resources are diverted from the productive sector as the government starts using essential services and infrastructure.
And fiscal resources are also diverted towards resolving the problems in the banking sector. Otherwise, those resources could be used for welfare programmes and other productive investment projects.
As we know, the banking system is considered the backbone of a country’s economy. If bank guarantees are not encashable, due to non performing asset situations, the whole system of bank guarantees will collapse, and people will lose faith over time.
COMPETITIVE MARKET IS AFFECTED
High-value transactions involve large corporations, which may reduce competition in the market because they will create dominant players with certain market powers.
These transactions will also restrict the entry of domestic players or new competitors into the market. They may lack financial resources, and the market may restrict them from competing with the dominant or established players.
This transaction will also affect the price, as it may increase due to reduced competition and decrease due to economies of scale and efficiency gains.
SURETY BONDS VS BANK GUARANTEE
The concept of Surety bonds can be used as an alternative to bank guarantees. The financial minister, Nirmala Sitharaman, in the union budget 2022–23, proposed the idea of the surety bond. Surety bonds are an agreement made by the party that takes full responsibility to pay the financial debts and obligations that might be caused by any default. The main aim of both surety bonds and bank guarantees is to protect the party from any loss they might suffer due to default or non-performance of contractual obligations. But surety bonds are issued by specialised insurance institutions known as sureties. Surety bonds can be used as an alternative to bank guarantees. Surety bonds comply with state laws and regulations or are governed by the government pertaining to a specific business licence or meeting the terms of a construction contract. Whereas a bank guarantee is an independent institution and is liable for the financial risk of the contract, a surety is liable for any performance risk proposed by the principal. The payment made by the surety bonds is completely different from the bank guarantee; the surety company is paying for the bonds, but the principal debtor is still liable for the debt.
Surety bonds can act as a game changer, as they may be explored in contracts entered between private parties. Surety bonds have already been tried and tested in various jurisdictions, such as the United States, Australia, the Philippines, and many other countries. Surety bonds also help small businesses by providing a guarantee to their customers that they will not suffer any debt. Surety bonds are cheaper as compared to bank guarantees because they have lower base rates and no line fees. Surety bonds also act as a dispute resolution mechanism between the principal and the obligated surety bonds, can help in providing a solution, and ensure that the project moves forward without any delays. By that time, the demand for surety bonds is increasing as an innovative financial instrument. Surety bonds are also being favoured in developed countries. For example, in the United States, the “Miller Act, 1935” requires contractors to provide payment and perform bonds in relation with the construction, alternation or for public works. That’s why various groups recommend surety bonds as better than bank guarantees.
SUGGESTIONS
The guidelines set by the RBI for issuing bank guarantee is too strict which only allows the repudiated cooperation to take advantage of bank guarantees, but at same time restricts other businesses to take advantage of the bank guarantee.
Need for internal check and balances, because while domestic institutions take precautions against the fraud, still fraudulent acts. That’s why there is a need to take precautions for both international and national trade.
Need for adequate protection of the parties involved in the contract of bank guarantee, by providing more clarity on the judicial interventions so that the interest of the creditor and bank is protected in the case of default.
CONCLUSION
The bank guarantees play an important role in the business sector as well as in flourishing national and international trade. The bank guarantees are independent institutions that restrict any kind of judicial interference. The Supreme Court judgments also state that there will be no legal interference in the contract of bank guarantees, but there are some exceptions to this, such as in cases of fraud and irretrievable injury, where the court can interfere. The RBI sets the regulatory guideline for the bank guarantees, but due to banks negligent act leads to fraudulent activities, due to which whole economy suffers from losses, NPAs (non-performing assets), economic growth is affected, financial stress, and poor groups such as farmers suffer the most because due to the high interest rate, they are not able to take loans and pay the debts, effects international trade, also these high-value transactions affect the competitive market. The dominant player of the market restricts the developing business or small business to enter in the market. Which decreases the competition in both national and international market, but largely in domestic market. To avoid such a situation banks should strictly follow the guidelines and should not give bank guarantees based on the reputation of the person. And lastly, this paper talks about an alternative. The Surety bonds can act as an alternative to bank guarantees. As Surety bonds are considered more effective than bank guarantees. There are many reasons for it, but one of the main reasons is that surety bonds are governed by the government or by the state laws, whereas bank guarantees is an independent institution that restricts any kind of interference by the state. The surety bonds are trailed-and-tested by the other jurisdictions, such as the United States of America, Philippines and many others, these groups have appreciated the concept of surety bonds. The finance minister Nirmala Sitharaman of India also proposed this idea of surety bonds in the union budgets. The aim of both bank guarantees and surety bonds is to protect the interest of the creditor in the case of default. Bank guarantees play an important role in domestic, national, and international trade, but they are not properly regulated, and guidelines set up by RBI is way too strict which only allows high profiled investors and business to enjoy the facility of bank guarantees, all this needs to be re regulated so that fraudulent cases can be reduced, whereas surety bonds are well regulated and tried and tested by developed and developing countries. So, surety bonds can be used as an alternative to bank guarantees.
CITATION –
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SUBMITTED BY – DHRUVI JINDAL
COLLEGE – JINDAL GLOBAL LAW SCHOOL