Fraud and Bank Guarantees

Often, it so happens in the commercial world that a contract between two parties requires one to provide a performance guarantee to the other. Accordingly, the party provides a bank guarantee; but the guarantee itself is expressed to be “unconditional” and “irrevocable”. The understanding of the parties is that the guarantee will be utilized and encashed if and only if a breach is committed. Some dispute arises between the parties; and a breach is alleged (and perhaps, vehemently denied). Can one party now be restrained from encashing the guarantee by the other?

In general, it is settled law that an injunction cannot be obtained against the encashment of a bank guarantee if, on its terms, that guarantee is unconditional. The only exceptions are fraud and special equities/irretrievable injury. The logic behind this is that the guarantee must be enforced on its own terms; and if the guarantee is stated to be ‘unconditional’ other instruments/documents should not be used in order to imply any conditions on the encashment of the guarantee.

In one of the more recent decisions on the point, Vinitec Electronics Pvt. Ltd. v. HCL Infosystems Ltd, the Supreme Court noted:

“11. The law relating to invocation of bank guarantees is by now well settled by a catena of decisions of this Court. The bank guarantees which provided that they are payable by the guarantor on demand is considered to be an unconditional bank guarantee. When in the course of commercial dealings, unconditional guarantees have been given or accepted the beneficiary is entitled to realise such a bank guarantee in terms thereof irrespective of any pending disputes…

“12. When in the course of commercial dealings an unconditional bank guarantee is given or accepted, the beneficiary is entitled to realise such a bank guarantee in terms thereof irrespective of any pending disputes. The bank giving such a guarantee is bound to honour it as per its terms irrespective of any dispute raised by its customer. The very purpose of giving such a bank guarantee would otherwise be defeated. The courts should, therefore, be slow in granting an injunction to restrain the realisation of such a bank guarantee. The courts have carved out only two exceptions. A fraud in connection with such a bank guarantee would vitiate the very foundation of such a bank guarantee. Hence, if there is such a fraud of which the beneficiary seeks to take advantage, he can be restrained from doing so. The second exception relates to cases where allowing the encashment of an unconditional bank guarantee would result in irretrievable harm or injustice to one of the parties concerned. Since in most cases payment of money under such a bank guarantee would adversely affect the bank and its customer at whose instance the guarantee is given, the harm or injustice contemplated under this head must be of such an exceptional and irretrievable nature as would override the terms of the guarantee and the adverse effect of such an injunction on commercial dealings in the country. The two grounds are not necessarily connected, though both may coexist in some cases…”

This position of law has been consistently maintained by the Supreme Court. Yet, the scope of the ‘fraud’ exception continues to be controversial. What exactly constitutes a ‘fraud in connection with the bank guarantee’? Assume that the contract between the parties expressly states that the guarantee can only be invoked if there is non-performance. The recitals of the guarantee make reference to the contract between the parties. Further, the facts are such that a default by one party X is occasioned only by the default of the other Y (say, where X has to transfer possession of land to Y; Y has to construct a building on that land – X refuses to hand over possession). Can the invocation of the bank guarantee in such cases be held a ‘fraud’; thereby entitling one to restrain encashment? Can ‘X’ in this example successfully restrain Y from encashing the bank guarantee?

Must there be a fraud in the creation of the guarantee; such that the guarantee itself can be entirely avoided? Or is it enough if there is some dishonesty in the invocation of the guarantee? The Supreme Court has offered no clear answer to the question of what is meant by ‘fraud’ in this connection (except stating that the fraud must be of an “egregious” nature – BSES v. Fenner). However, a recent decision of a Division Bench of the Bombay High Court – Maytas Infra v. Utility Energytech – suggests that the threshold for fraud is extremely high. The Court stated:

“Recitals in the preamble do not control operative part of the deed. In the present case, the operative part may be making a mere reference to the bank undertaking pecuniary responsibility of the appellants to the first respondent for due performance of the contract and for payment of any money but that part or clause does not mean that the parent contract is to be read into the obligations of the bank to make payment of money in favour of the EPC contractor/ first respondent…”

The Court went on to suggest that the fact that a party in encashing a guarantee is violating the underlying contract between the parties with complete impunity would not be sufficient for establishing ‘fraud’. It is to be hoped that when a matter comes up before the Supreme Court, a less rigid viewpoint is taken. The question can perhaps be settled by allowing Courts to look at the conduct of the parties in individual cases and deciding on the basis of equitable considerations. At the very least, there appears to be some need for clarity as to what ‘fraud’ is and what can be considered as ‘irretrievable injury’ in this regard.