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Friday, September 21, 2012

Indemnity & Guarantee: What a Banker should Know

As per Section 124 of the Indian Contract Act, an indemnity is a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other person.

Banks often obtain indemnity bond whenever they issue a duplicate demand draft in lieu of the lost original or duplicate fixed deposit receipt, etc.

By virtue of obtaining such indemnity the bank is, in effect, obtaining an undertaking from the indemnifier i.e., the customer to indemnify the bank from any losses/damages incurred by the bank by virtue of its issuing a duplicate DD in lieu of original.

Here, the customer is called the ‘indemnifier’ and bank the ‘indemnity holder’.

An indemnity could be expressed or implied. An implied contract of indemnity can be inferred from the circumstances of the case or from the relationship of the parties.

1.1. Rights of the Indemnity Holder
An indemnity holder (Section 125) is entitled to recover from the promisor/indemnifier:

·     All damages which he might have paid in any suit etc. relating to the indemnity
·     All costs which he may be compelled to pay in such suits
·    All sums which he might have paid under the terms of any compromise of any such suits.

1.2. Commencement of Indemnifier’s Liability
The usually accepted perception is that upon incurring absolute liability, the indemnity holder has the right to call upon the indemnifier to save him from that liability and pay it off.

2. Guarantees
This is another type of contract, most commonly entered into between the bank and its borrower. In the ordinary course of banking business, the word ‘guarantee’ means obtention of sureties from third parties, guaranteeing repayment of loans availed by the principal debtor. Guarantees are often used as leverage against lax borrowers.

As per Section 126 of the Indian Contract Act, a contract of guarantee means “a contract to perform the promise or discharge the liability of a third person in case of his (third person’s) default.”

A contract of guarantee could be oral or written. It consists of three parties:
·        Surety – person giving guarantee
·        Principal debtor – the person in respect of whose default a guarantee is given
·        Creditor – the person to whom guarantee is given.

2.1. Essentials of a Valid Contract of Guarantee
A guarantee to be enforceable must be:
·      Lawful;
·      Of free consent – i.e., guarantee given out of free will; and
·     For a consideration – i.e., anything done, or any promise made, for the benefit of the principal debtor may be sufficient consideration to the surety for giving the guarantee (Section 127).

The principal debtor can be a minor.

3. Indemnity vs. Guarantee
A guarantee, though embedded in an indemnity, differs from indemnity in more than one way:

Number of contracts
Basically, it is a single contract between indemnifier and the indemnity holder
Consists of three contracts:
contract between creditor and principal debtor; creditor and guarantor; and borrower and
Nature of liability
Primary – i.e., the indemnifier makes good the losses to the indemnity holder
Secondary, since primary
liability rests with the
principal debtor in repaying
loan, the guarantor will be
asked to make it good
For the reimbursement of loss
For the security of creditor
Making of a request
Indemnifier offers indemnity on his own

Surety signs the guarantee at
the request of the principal
Right of parties
Indemnifier cannot sue third parties in his own name
Surety can proceed against the principal debtor upon
discharging the liability of the debtor
Parties’ interest
Indemnifier may have some interest of his own
Surety should have no other
interest in the transaction apart from his guarantee

4. Types of Guarantees
·     Continuing Guarantee:
A guarantee which extends to a series of transactions (Section 129)
·     Simple/Specific/Ordinary Guarantee:
A guarantee covering a single transaction

5. Nature of Surety’s Liability
Liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract (Section 128).

Ram guarantees to Bank of India the payment of the loan of Rs.10 lakhs availed by John, the principal debtor.

Here, Ram is liable not only for the principal but also for interest thereon plus charges etc. that are due on it.

In other words, the creditor can recover from the surety all sums, including interest, cost of litigation, etc. However, by a special contract, it may be made less than that of the principal debtor, but never greater. It is for this reason that a surety is at times called a “favoured debtor”.

The surety becomes liable immediately on the default of the principal debtor. The creditor is free to realise the debt, when it becomes due, either from the debtor or from the surety. Thus, it is
not necessary for the creditor to proceed against the debtor first.

Box: Praveen Kumar and Another v s. Sri Balaji Onion Co. & Others [I (2006) BC 117]
Facts of the Case
M/S Balaji Onion Co, Respondent, was transacting business with M/S Vijaya Traders. In this connection, M/S Vijaya Traders, a proprietary concern represented by Ms. Vijaya Lakshmi issued several cheques to M/S Balaji Onion Co towards the amounts payable for certain transactions. These cheques drawn on Syndicate Bank, Malakpet, Hyderabad, which were presented for payment were returned with an endorsement “account closed”. M/S Balaji Onion Co served the statutory notice under Sec 138 (b) of Negotiable Instruments Act, 1881, demanding payment of cheques, which were dishonoured by the drawee bank. Apart from serving the above notice to the Principal Borrower, M/S Balaji Onion Co served another similar notice to Mr. Praveen Kumar (Petitioner) and others who stood as sureties for M/S Vijaya Traders. The Magistrate of the trial court took cognizance of the cases under Sec 138 of the Act against M/S Vijay Traders and also Mr. Praveen Kumar and other sureties. Mr. Praveen Kumar and other sureties filed the present petition in High Court seeking the quashing of the proceedings against them.

·    Can a surety for credit transactions be made liable for punishment under Sec 138 of the Negotiable Instruments Act, 1881, on the ground of dishonour of cheques drawn by the principal borrower in favour of the creditor?
·    Is the principle of co-extensive liability of surety with the borrower applicable in   the above case?
·    Can the vicarious liability stipulated under Sec 141 of the Negotiable Instruments Act, 1881 for persons connected to the company be applied to the above case?

The drawer of the cheque alone would be liable for the offences under Section 138 of the Negotiable Instruments Act. There was no vicarious liability for surety for an offence under Sec 138 of the Act. Hence, the continuance of proceedings against the Petitioner would be an abuse of the process of law and the proceedings against the Petitioner were quashed.

Case Notes
·    Sec 138 of the Negotiable Instruments Act being a penal provision should be put to strict interpretation. The Section is applicable to the parties of the Negotiable Instruments only, viz, drawer, drawee and payee.
·     The drawer of the cheque alone can be charged for the offence of dishonour under Sec 138.
·    The dishonoured cheque is deemed an evidence of default of debt and recourse against surety to be obtained only in the civil court by the aggrieved creditor.
·     Section 141 has no relevance, as the drawer is a sole proprietrix.

Source: The Icfai Journal of Banking Law, Vol. IV, No. 3, 2006.

6. Rights and Liabilities of Sureties
A contract of guarantee entails a surety with certain rights against the principal debtor, creditor, and co-sureties.

6.1. Rights against a Principal Debtor
When a guaranteed debt becomes due and the default of the principal debtor to perform a guaranteed duty takes place, the surety, upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the debtor. In other words, in every contract of guarantee, there is an implied promise by the principal debtor to indemnify the surety, whereby the surety acquires a right to recover from the principal debtor whatever sum he has
rightfully paid under the guarantee (Section 145).

6.2. Rights against Creditor
       i.  A surety is entitled to the benefit of every security which the creditor had against the principal debtor at the time when the contract of suretyship was entered into.
     ii.  Secondly, if the creditor loses or parts with such security without the consent of the surety, the surety is discharged to the extent of the value of security lost or released. (Section 141).

6.3. Rights against Co-Sureties (Sections 146 and 147)
i.   When a debt is guaranteed by two or more sureties, they are called co-sureties. Such co-sureties are liable to contribute equally towards the debt they have jointly guaranteed;
ii.  If one of the sureties pays the debt in full, he can recover from the other the excess of what he has paid above his share.

6.4. Rights and Liabilities of Co-Sureties
The co-sureties have rights and obligations among themselves as follows:
i.   A release by the creditor of one of the co-sureties does not discharge others from the liability to the creditor. Secondly, it does not free the so released surety from his responsibility to the other sureties (Section 138).
ii.  Co-sureties bound in different sums are liable to pay equally as far as the limits of their respective obligations permit (Section 147).

7. Discharge of Surety from Liability
The liability of a surety under a contract of guarantee comes to an end under any one of the following circumstances:
·      Revocation by Notice
A guarantor can revoke his liability by serving a revocation notice. In specific guarantee, the guarantor cannot revoke if the liability has already been incurred. In the case of continuing guarantee, a revocation notice issued by the guarantor terminates his liability as regards all future transactions, i.e. he is liable only for all transactions entered prior to the date of the notice (Section 130).

·     Revocation by Death
In the case of continuing guarantees, death of a surety discharges him from all his liabilities as regards transactions undertaken after his death.

·    Variation in Terms of Contract
Any variance in the terms of contract between the principal debtor and the creditor made without the surety’s consent discharges the surety from the transactions subsequent to the variance (Section 133). Such variations must materially alter the position of the surety. Some of such alterations which would tantamount to his discharge are given below. 
Lending Bankers are to pay the utmost attention to these provisions, while handling their credit portfolio, or else they run the risk of losing their sureties.

7.1. Variation in Terms of Contract that Discharges a Surety
Variation in the terms of contract between principal debtor and creditor (Section 133)

“Any variance made without the surety’s consent in the terms of the contract between the principal debtor and creditor, discharges the surety as to transactions subsequent to the variance.”

The underlying principle is that a guarantor should not be made liable beyond the terms of the contract when he gave the guarantee.

The normal guarantee forms of banks contain a clause that the surety consents for any variation that may be made without reference to him. Now the question is whether the surety can give consent in advance. Some of the latest court findings (Canara Bank vs. Gokuldas Shenoy, 1991) observe that such advance obtention of a surety’s consent is valid and binding on the other sureties.

Release or discharge of principal debtor by creditor (Section 134)

“The surety is discharged by any contract between the creditor and the principal debtor by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor.”

The mere failure of the creditor to enforce a security or file a suit against the principal debtor does not amount to release of the principal debtor and, therefore, would not relieve the guarantor. Section 137 of the Indian Contract Act states that “mere forbearance on the part of the creditor to sue the principal debtor or to enforce any other remedy against him does not, in the absence of any provision in the guarantee to the contrary, discharge the surety.”

The Supreme Court observed in the Bombay Dyeing and Manufacturing Company vs. State of Bombay AIR, 1958, SC 328 that the creditor is entitled to recover the debt from the surety even though the suit against a principal debtor is time-barred.

Creditors compounding with or giving time to or agreeing not to sue principal debtor (Section 135)
“A contract between the creditor and the principal debtor, by which the creditor makes a composition with or promises to give time to, or not to sue, the principal debtor, discharges the surety, unless the surety assents to such contracts.”
Such discharge is available only when the creditor makes a contract with the principal debtor by which more time is given without the knowledge or consent of the surety; then the surety stands discharged. Secondly, if the contract of guarantee excludes the application of this provision explicitly or impliedly, the surety cannot claim discharge on the ground of releasing or giving time to or composition with the principal debtor.

Creditor’s acts or omissions inconsistent with or impairing the remedy of the surety (Section 139)
“If the creditor does any act which is inconsistent with the rights of surety or omits to do any act which his duty to the surety requires him to do, in the eventual remedy of surety himself against the principal debtor is thereby impaired, the surety is discharged.”

The decided cases have almost established a principle that mere passive inaction of the creditor, say, not taking possession of the hypothecated goods before filing a civil suit etc., does not amount to negligence and thereby discharge the surety from his liability. The question of omission would arise in law only when there is duty.

Loss of or parting with securities by the creditor (Section 141)
A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not. And, if the creditor loses or without consent of the surety parts with such securities, the surety is discharged to the extent of the value of the security.

Loan is granted against hypothecation of a truck plus third party guarantee. Suppose, the bank releases its charge on the truck without the knowledge of surety, then the surety stands discharged to the extent of the value of the released vehicle.

8. Invalid Guarantees
A contract of guarantee is invalid in the following cases:
·    Misrepresentation (Section 142): A guarantee obtained by means of misrepresentation made by the creditor;
·    Concealment (Section 143): A guarantee obtained by maintaining silence as to material circumstances; and
·   Failure of co-surety to join (Section 144): A guarantee obtained from one person (Ram), stating that it shall not come into effect until another person (Isaac) also joins the guarantee as a co-surety, does not create any liability against the first person (Ram) if the second person (Isaac) does not join as a co-surety.

9. Guarantees Given by Banks
Besides obtaining guarantees on behalf of their borrowers, banks also issue guarantees on behalf of their customers, guaranteeing the performance or promise made by them to the beneficiary. Issuing of guarantees has almost become a favoured business of bankers as there is no outlay of funds at the issuing stage. Secondly, it also enables them to earn good income by way of guarantee commission plus deposits as cash margins for the guarantees. Guarantees are usually issued by the Banks in the following forms:

9.1 Financial Guarantee
A clause for acceptance of a bank guarantee in lieu of cash deposit or earnest money for due performance of a contractual obligation is common in contract agreements. In such situations, banks, through their guarantees, undertake to pay the amount fixed for cash deposit or earnest money unconditionally without demur and on demand in writing by the beneficiary of the guarantee. In order to protect themselves, banks while issuing such guarantees insert suitable clauses in the guarantee deed that define:
·        A definite period for continuance of the guarantee;
·        The maximum amount to which the bank is liable;
·        A specific date within which the guarantee should be invoked; and
·        The date beyond which no claims will be entertained by the bank.

9.2 Performance Guarantee
It may be defined as a “guarantee under which the bank (issuer) undertakes to pay on first demand a certain amount of money to the beneficiary when the latter makes a demand to this effect”. It is an autonomous and voluntary undertaking by the issuing bank to pay merely on demand by the beneficiary without any proof or fulfillment of any other conditions. Its purpose is to indemnify the beneficiary against non-performance or faulty performance of a contract made between the beneficiary and the party on whose account the guarantee is issued.

The risk inherent in agreeing to such an unconditional performance guarantee is that as soon as the beneficiary calls for the payment—it may even be an unfair demand—the bank would have no redressal mechanism available to it except to honour the claim. Therefore, banks have to exercise the utmost care while issuing performance guarantees.

9.3 Deferred Payment Guarantee
At times, the customers may purchase capital goods on deferred payment terms, i.e., cost payable in 5-6 quarterly/half-yearly instalments. In such situations, the seller of machinery asks the buyer to provide a bank guarantee. Then, the buyer acquiring the goods under deferred payment scheme, requests his banker to give a guarantee for the payment of the deferred value.

In a deferred payment guarantee, the issuing bank guarantees the payment of the stipulated instalments at stipulated intervals by the purchaser of machinery. In the case of the purchaser’s failure to pay the instalment on the due date, the bank will be called upon to pay the same to the seller, which the bank arranges for.

Such guarantees are incorporated with necessary clauses to define the maximum financial liability of the bank and the scope for reduction of the liability to the extent of payments, if any, made by the buyer.

10. Banker’s Liability under the Bank Guarantees
All bank guarantees are, no doubt, at the instance of the clients. However, bank guarantees are considered bilateral contracts between the banker and the party in whose favour the guarantee is issued by virtue of the banks undertaking to fulfil their obligations on demand and without demur. For all practical purposes, the party at whose instance the guarantee has been furnished remains a stranger to the contract of bank guarantee.

The net effect of such understanding is that the person, in whose favour the guarantee has been issued, has a right to ask the bank to fulfil its obligations as per the terms of bank guarantee. In other words, it means that the bank guarantee issued in favour of the beneficiary stands independent of other connected transactions, viz. contract between the beneficiary and the customer and the contract between the issuing bank and its customer, i.e., at whose instance the guarantee has been issued. It is also independent of any claim/counterclaim between the beneficiary and the bank’s customer. Thus, once the terms and conditions of the bank guarantee are fulfilled, the liability of the bank becomes absolute and unconditional.

11. How Banks Secure Themselves
Banks, while issuing such guarantees, insulate themselves by obtaining adequate security in the following ways:
·        Cash margin in the form of deposits with a suitable letter of appropriation;
·        Hypothecation/pledge of machinery/goods covered under the guarantee;
·        Mortgage of property; and
·        Counter guarantee from the customer.
Secondly, the banks usually insert a limitation clause in the guarantees issued by them as shown below:
“Notwithstanding anything contained herein above, our liability under this guarantee is restricted to Rs.............. and this guarantee is valid upto ......................... We shall be released and discharged from all liabilities hereunder unless a written claim for payment under this guarantee is lodged on us within one month from the date of expiry of guarantee i.e. on or before.................. irrespective of whether or not the original guarantee is returned to us.”
Thirdly, they draft the counter guarantee deed executed by the customer in such a way that it inter alia provides for:
·   Indemnifying the bank from any loss, damage, liability and obligation undertaken or any payments made in connection with the guarantee;
·  Reimbursement of all amounts paid under the guarantee with interest and other charges;
·   Freedom to the bank to pay the amount of guarantee on demand by the beneficiary  without reference to the customer;
·   Customer not raising any contest against payments made to beneficiary, under the  plea that there is a dispute between himself and the beneficiary of the guarantee;
·   Right of the bank to debit the amount paid under guarantee to any of the accounts maintained by the customer;
·    Not revoking the counter guarantee during the continuation of guarantee issued by the bank;
·    Recovering commission till the liability under the guarantee is extinguished either by payment or cancellation;
·     Bringing back the guarantee duly cancelled from the beneficiary; and
·     Bringing in additional security as and when called for by the bank.

Banks also ensure that the draft of the guarantee to be issued is authenticated by the customer so as to avoid scope for future litigation or disputes regarding payments, etc., and preserve it as an important document.

Upon the expiry of the guarantee, it is essential to get the original guarantee deed returned by the beneficiary. It is desirable for the banks to actively follow up with the beneficiary/customer for returning the original guarantee, and only on receipt of the original guarantee, the reversal of liability should be effected.

Whenever a guarantee is invoked by the beneficiary, the bank should acknowledge without delay, and, if the amount is to be paid without demur on demand, it should be remitted to the beneficiary under advice to the customer. The customer should then be called upon to pay the amount to the bank.



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