Banking on Force Majeure: Honouring Bank Guarantees in Times of a Pandemic

[Abhilash Agrawal is a legal officer at a private bank.

In this post, he writes about the conflicting opinions given by the Bombay and Delhi High Courts on whether banks can be restrained from honouring bank guarantees and letters of credit by citing Covid-19 and subsequent disruptions caused due to it as force majeure. While the Bombay High Court has categorically denied such relief to applicants, the Delhi High Court has taken the opposite position. Until the Supreme Court comes out with a ruling regarding this, he foresees different High Courts across the country picking sides in this debate, causing much confusion to the stakeholders]

“Banks deal with documents and not with goods, services or performance to which the documents may relate”

-Article 5 of the ICC Uniform Customs and Practice for Documentary Credits

The existence of commercial laws is predicated upon a need to supplement trust, or the lack thereof, between parties entering into contracts. Amongst the galaxy of examples which can be given to enforce this idea, bank guarantees stand out for their unconditional nature. Even in normal times, bank guarantees can be tricky, but Covid-19 presents some unique challenges which I discuss in this post.

Concept of Bank Guarantee and Letter of Credit

Let me begin by presenting the concept of bank guarantee in broad strokes. Party A contracts with Party B, but wants an assurance that if there is a failure in performance, the monetary loss incurred will be made good. Here, a bank comes into the picture. The applicant, in this case Party B, will contact its banker to issue a bank guarantee in favour of the beneficiary, in this case Party A, assuring payment of a certain pre-agreed amount(usually but not always the contract amount) upon demand by the beneficiary. According to a Reserve Bank of India (RBI) circular issued in this regard (at paragraph 5.1):“Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur.” Further, the circular states (at paragraph 5.7):“Non-compliance of the instructions in regard to honouring commitments under invoked guarantees will be viewed by Reserve Bank very seriously and Reserve Bank will be constrained to take deterrent action against the banks.” This is followed very strictly. Recently, a division bench of the Calcutta High Court directed the RBI to take appropriate action against Bank of Baroda, including “revoking its licence or authority to carry on with banking business, if necessary” for its failure to honour a bank guarantee in which the Indian Oil Corporation Limited was a beneficiary.

A similar instrument issued by a bank is a letter of credit, which is mostly given for international contracts and is more complex, since it involves another bank in the home country of the beneficiary called the advising bank. The repercussions of not honouring a letter of credit are seemingly higher. The law relating to letters of credit is voluntarily following the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (“UCP 600”). According to Articles 7 and 8 of UCP 600, if the stipulated documents are presented to the bank in what will constitute a complying presentation,^[1] they are bound to honour the letter of credit.[2]

Reinforcing the idea, the Supreme Court in U.P. Co-operative Federation Private Ltd. v. Singh Consultants and Engineers Private Ltd., (1998) 1 SCC 174, observed that “commitment of banks must be honoured free from interference by the courts and it is only in exceptional cases, that is, to say, in case of fraud or any case where irretrievable injustice would be done if bank guarantee is allowed to be encashed the court should interfere.”

Further, the Supreme Court observed that:

“the courts should, therefore, be slow in granting an injunction to restrain the realization of such a bank guarantee. The courts have carved out only two exceptions. (First) a case of Fraud… 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. [Emphasis mine]

Suffice it to say, banks honour their commitments under these two instruments post haste. After the payment, banks take the place of the beneficiary and attempt recovery from the applicant for the said amount.

Force Majeure and its Impact on Encashment

The present conundrum is due to the invocation of force majeure clauses as a result of Covid-19 and its debilitating impact on day to day business operations. An applicant is not able to service its end of the bargain, and the beneficiary is eager to invoke either the bank guarantee or the letter of credit, as the case maybe, to recover its due. Banks, as we have seen above, are more than willing to comply with the demand of the beneficiary. The fearful applicant seeks to thwart such an attempt by rushing to courts pleading force majeure and a prayer seeking direction that banks be stopped from making the said payments. Now the question is whether the pandemic and the resultant disruption it has caused can be considered a valid invocation of force majeure. This is, in short, the question that the High Courts of Bombay and Delhi faced in Standard Retail Private Limited v. G.S. Global Corp (8 April 2020) and Halliburton Offshore Services Inc. v. Vedanta Limited(20 April 2020) respectively.

Standard Retail Case (Bombay High Court’s Position)

The petitioners were seeking an intervention under Section 9 of the Arbitration and Conciliation Act, 1996 by the Court to restrain the bank in question from encashing the letter of credit on account of the contract having become “unenforceable” under section 56 of the Indian Contract Act owing to “frustration, impossibility and impracticality”. For the present discussion, the relevant facts to state here are that a party based in South Korea exported certain steel products to the party based in India. The party in India seemingly allegedly could not perform their part of the contract, and thus was seeking the said section 9 intervention.

The force majeure clause in the said contract envisaged a situation whereby the seller only would be allowed to invoke it, if such event had a serious effect on the ability of the seller to manufacture and deliver the goods. Given this, the nature of the dispute is bereft of any element of force majeure and becomes a normal commercial dispute between the parties, something that the bank (and the Court for that matter) is unconcerned with as regards the encashment of the letter of credit. This is a fact-reliant ratio and does not contribute to the overall jurisprudence. I seek to focus on the more general observations made by the Court in the context of the ongoing Covid-19 pandemic and its eligibility for being invoked under force majeure. These observations were:

• for the invocation of any force majeure clause, it is important to establish absolute impossibility of performance;
  
  
• if there are no restrictions on the movement of the said goods under the contract, the same cannot be said to be impossible to perform;
  
  
• even if there were temporary restrictions due to the ongoing lockdown in India, the said lockdown would be for a limited period only and cannot per se come to the rescue of the Petitioners so as to resile from its contractual obligations with the Respondent No. 1 of making payments. [Emphasis mine]
  

In short, according to the Bombay High Court, Covid-19 and the subsequent lockdown imposed due to it will not constitute force majeure, and thus will not be grounds to invoke section 56 of the Indian Contract Act to wriggle out of commitments under a contract.

Vedanta Case (Delhi High Court’s Position)

The relevant factual matrix is quite similar to the above case. Pursuant to an international tender floated by the respondent, the petitioners were awarded a contract to develop three oil wells. What follows is a predictable story: the contract in question was not performed, the respondent sought to enforce the bank guarantees and the petitioners filed a section 9 intervention seeking to restrain encashment of the said bank guarantee. Allowing the petition, the Delhi High Court issued an interim stay on the encashment accepting the argument of impossibility of performance and that Covid-19 presented special equities^[3] in the form of preventing irretrievable injustice between the parties. This follows the sixth principle laid down by the Supreme Court for the invocation and encashment of bank guarantees in Himadri Chemicals Industries Ltd v. Coal Tar Refining Co.,(2007) 8 SCC 110: allowing encashment of an unconditional bank guarantee or a letter of credit would result in irretrievable harm or injustice to one of the parties concerned.

The High Court has held in the present case that “in view of the sudden and emergent imposition of lockdown, the interests of justice would justify an ad interim injunction, restraining invocation or encashment of the aforesaid eight bank guarantees” (paragraph 27). Justice C Hari Shankar predicated his opinion on the fact that since the “imposition of the lockdown was by way of a sudden and emergent measure, of which no advance knowledge could be credited to the petitioner – or, indeed, to anyone else… the petitioner’s activities had to suddenly discontinue on 22nd March, 2020, and have not been able to resume ever since.” (paragraph 22)

In short, according to the Delhi High Court, Covid-19 and the subsequent lockdown imposed due to it will constitute force majeure and that the special equities of the present situation provides stable ground for restraining banks from encashing bank guarantees. The Delhi High Court has recently passed a similar order restraining Indian Oil Corporation Ltd. from encashing Punj Lloyd’s bank guarantee.^[4]

Conclusion

As High Court judgments, their writ runs only till the extent of the jurisdiction of their respective High Courts. Courts in the rest of the country can only derive persuasive value from these judgments when coming out with their own decisions. It is pertinent to mention at this juncture that both the judgments were given by single judge benches. Also, as observed in the Vedanta Case through a Supreme Court obiter: “every case has to be decided with reference to the facts of the case involved therein.”^[5]

Most commercial activities have been adversely impacted since the imposition of the lockdown in the country, and performance of contracts has become unviable in many sectors, at least for the time being. The party not being able to perform its part of the contract cannot be considered to be at fault, but neither can the party suffering on account of such non-performance. Banks will not be inclined to defer bank guarantees or letters of credit claims on their own, considering the lack of clarity on the issue presented by the two judgments above.

In my opinion, the approach adopted by the Delhi High Court in the Vedanta and Punj Lloyd cases is the correct way forward. They are interim reliefs that will be reviewed once the lockdown is lifted and the aggrieved parties are given an opportunity to perform their part of the contract. In this way, the bank guarantee is kept in a suspended state and a moratorium (of sorts) is provided over their invocation.  Given the gravity of the situation, and until the Supreme Court finally decides on the matter, the RBI should come out with a circular in this matter and clarify the scope of discretion banks can (and should) employ.

– Abhilash Agrawal

---

^[1] What may constitute as “Complying Presentation” is given under Article 15 of UCP 600.

[2]Interestingly, Article 36 of UCP 600 provides for force majeure. But that pertains more to disruptions caused to banking operations and is not relevant for our discussion here.

^[3] The term ‘special equities’ was borrowed by the High Court from the recent Supreme Court judgment in the case of Standard Chartered Bank Ltd. v. Heavy Engineering Corporation Ltd (2019 SCC Online SC 1638).

^[4] Ashwani Mehra v. Indian Oil Corporation Ltd. (17 April 2020) Order can be accessed here.

^[5]The High Court noted observations from the Supreme Court’s judgment in Gangotri Enterprises Ltd v. Union of India, (2016) 11 SCC 720.