Guarantees and Letters of Credit

In one line

A bank guarantee is a promise by the bank to pay the beneficiary on demand whatever the underlying dispute, and a court will not stop it being paid except for proved fraud.

In the wording a student can write in an exam: a bank guarantee is an independent contract between the bank and the beneficiary, and in U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd., (1988) 1 SCC 174, the Supreme Court held that a court will not interdict the encashment of an unconditional bank guarantee except on proved fraud or where irretrievable injustice would follow; a letter of credit operates on the same principle of autonomy, the bank undertaking to pay against conforming documents irrespective of disputes about the goods.

Why the bank's own credit is worth selling

A seller who does not know the buyer will not part with goods, and a buyer who does not know the seller will not pay in advance. Each is asking the other to take a risk on a stranger.

A bank solves it by substituting its own credit. Everybody trusts the bank, so the bank promises to pay, and the parties deal with each other on the strength of that promise.

But the promise is only useful if it is reliable, and that is the key to this whole chapter. If the bank could refuse to pay whenever the buyer said the goods were defective, the beneficiary would be no better off than before, because he would be back to arguing with the buyer.

So the law makes the bank's undertaking autonomous. It is a separate contract between the bank and the beneficiary, and disputes on the underlying contract do not touch it. That is the doctrine of autonomy, and it is what makes guarantees and credits work.

The price of autonomy is that a dishonest beneficiary can be paid. The law accepts that cost, and confines the exception to fraud, because an exception any wider would destroy the instrument.

Guarantee in the Contract Act, and how a bank guarantee differs

Section 126 of the Indian Contract Act, 1872 defines a contract of guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default. There are three parties: the surety, the principal debtor and the creditor.

The ordinary surety's position under the Act. His liability is co-extensive with that of the principal debtor under section 128, unless otherwise provided. He is discharged by a variance in the terms of the contract without his consent under section 133, by a release or discharge of the principal debtor under section 134, by a composition, extension of time or promise not to sue under section 135, and where the creditor loses or parts with a security under section 141. On payment he is subrogated to the creditor's rights under section 140.