Proportionality: A New Special Equities Exception Against Invocation of Bank Guarantees

[Rhythm Buaria is an Advocate based in New Delhi]

In an appeal under section 37 of the Arbitration and Conciliation Act, 1996 (“Arbitration Act”), a Division Bench of the High Court of Delhi in Hindustan Construction Co. Ltd. v. National Hydro Electric Power Corporation Ltd., held that proportionality constitutes a special equities exception against invocation or encashment of unconditional bank guarantees. Before delving into an analysis of this case, it would be expedient to discuss the law governing the grant of injunctions against invocation or encashment of bank guarantees. 

Injunctions against invocation or encashment of bank guarantees

It is settled law that courts should be slow to grant injunctions against invocation of bank guarantees primarily because: (i) the contract of bank guarantee is an independent contract between the banker and the creditor and therefore operates independent of any disputes that may have arisen between the creditor and the principal debtor; and (ii) commitment of banks must be honored as far as possible without the interference of courts; else trust in commerce would be irreparably damaged (see Standard Chartered Bank v. Heavy Engineering Corporation Ltd. and U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd.).

The grounds on which, however, the court may grant an injunction against invocation of a bank guarantee are: (i) egregious fraud relating to the bank guarantee; and (ii) special equities, i.e., circumstances which may lead to irretrievable injustice. The principal debtor, however, needs to make a specific plea in this regard and, moreover, is required to prima facie establish by strong evidence that there is a triable issue (see Ansal Engineering Projects Ltd. v. Tehri Hydro Development Corporation Ltd. and Standard Chartered Bank).

In cases in which the principal debtor seeks an injunction on the ground of fraud in relation to the bank guarantee, the principal debtor is required to show that the fraud committed had vitiated the very foundation of the bank guarantee and that the fraud would inure to the benefit of the creditor alone. In Svenska Handelsbanken v. M/s Indian Charge Chrome, the Supreme Court held that an injunction may also be granted if it can be shown that the bank (guarantor) itself had knowledge that the demand for payment of the bank guarantee was fraudulent.

An injunction may also be sought on the ground that special equities of the following kind exist: (i) irretrievable injury of any kind may be caused to the principal debtor; or (ii)  that it would be impossible for the principal debtor to be reimbursed at a later stage if found entitled to the money (see Hindustan Construction and Himadri Chemicals Industries Ltd. v. Coal Tar Refining Co.).

While the above-stated principles were laid down by courts in civil cases where temporary injunctions were sought under Order XXXIX Rules 1 & 2 of the Code of Civil Procedure, 1908, the same principles are and have been made applicable to section 9 petitions filed under the Arbitration Act seeking similar relief (see Saw Pipes Limited v. Gas Authority of India Limited, (1999) 78 DLT 12).

Hindustan Construction

The appeal in Hindustan Construction arose from denial of an injunction under section 9 of the Arbitration Act restraining National Hydro Electric Power Corporation Ltd. (“National Hydro”) from invoking any or all bank guarantees amounting to INR 243.16 crores. In this case, Hindustan Construction Co. Ltd. (“Hindustan Construction”) was awarded a turnkey project for a 330 MW hydro-electric power plant on the Kishangaga river by National Hydro. In pursuance of the contract entered into between the parties, Hindustan Construction was required to furnish bank guarantees of varying amounts, 48 of which were invoked by National Hydro in June, 2020. 

Hindustan Construction sought a stay on the encashment of these guarantees, which was denied by a Single Judge of the High Court. In appeal, Hindustan Construction argued that the Single Judge had, inter alia, wrongly rejected the principle of proportionality in view of the specific facts of the case which were that at the time of invocation of the bank guarantees, the cost of balance work to be completed was INR 56 crores for which National Hydro had sought invocation of bank guarantees worth INR 214 crores. It was also argued that Hindustan Construction had been put under severe financial pressure not only on account of invocation of the bank guarantees but also the failure of National Hydro to pay INR 163.55 crores under an arbitral award in its favor. 

Dismissing Hindustan Construction’s arguments on a perusal of the material on record, the Division Bench found that it could not be conclusively said that only work for the amount of INR 56 crores remained to be executed by Hindustan Construction. In view of this and surrounding circumstances like other pending civil works to be undertaken by Hindustan Construction, its request to National Hydro to inject money into the project, etc., the Division Bench held that the bank guarantees were rightly invoked by National Hydro. 

The Division Bench also did not find any merit in Hindustan Construction’s arguments that National Hydro had invoked the bank guarantees with fraudulent intent or there existed special equities causing irretrievable injury (as understood in the traditional sense) in favor of Hindustan Construction.

However, the Division Bench laid down the proposition that proportionality could be included as an exception of special equities. It also devolved a two pronged test for its application, namely,  a party seeking stay on invocation or encashment of a bank guarantee would be required to show that: i) the crystallized liability is significantly lower than the value of the bank guarantee furnished; and ii) the contract is a concluded one.

The problems with the test of proportionality

While the inclusion of proportionality as a special equity case may appear to be fair, the test laid down to apply it has some infirmities. 

Section 9 of the Arbitration Act provides for interim measures by court. Therefore, any view taken by a court on the facts of a matter in a section 9 petition are required to be only prima facie in nature unless they are admitted positions. In cases where these facts (of crystallized liability and conclusion of contract) are disputed, the court would not be in a position to conclusively determine the claims of the guarantor since it would not have the benefit of parties’ evidence which would be led only in the arbitration proceedings. Therefore, the courts should be cautious in applying this test since it would require a conclusive determination of facts which are best left to be ascertained through a trial before the arbitrator.

Another shortcoming of the test is the wide discretion given to the courts to ascertain (without any parameters) what the crystallized liability being ‘significantly lower’ than the value of bank guarantee means: Would it mean the crystallized liability should be one-tenth, or one-twentieth of the bank guarantee amount? There is therefore scope for uncertainty and the approach which would yield more precise determination would be that invocation of a bank guarantee in all cases should be in proportion to the crystallized liability. 

Furthermore, a prima facie view of the applicability of this test suggests that it would fly in the face of the settled positions of law. An injunction on encashment of bank guarantee ought not to be granted if the only loss that may be caused to the principal debtor is loss of money which can be recouped in terms of the final arbitral award or in cases where the only claim of the principal debtor is that encashment of the bank guarantee would entail financial hardship to the guarantor (see Bharat Heavy Electricals Ltd. v. Indian Overseas BankO.N.G.C. Ltd. v. Jagson Intl. Ltd., and Forcast v. Steel Authority of India Limited). The proportionality test is premised in the fact that a balance of some kind needs to be struck since the principal debtor may suffer loss of money. However, as pointed out above, an exception has already been carved out in law where a court ought to grant an injunction against invocation of the bank guarantee if in all likelihood the loss of money would not be recouped by a final award or judgment in favor of the principal debtor. 

The proportionality exception in itself also fails to consider the settled legal principles that a contract of guarantee is an independent contract and that the courts should be circumspect in interfering with commercial instruments which form the edifice of free trade and commerce. In view of the above, it is appears that the test of proportionality needs to be considered more thoroughly before it is applied in future cases. 

– Rhythm Buaria

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