The Delhi High Court in the case of Larsen & Toubro Limited vs. Punjab National Bank1 recently pronounced an important judgement clarifying the duration of a claim period in a bank guarantee. The issues raised in this case pertain to the scope of Section 28 of the Indian Contract Act, 1872 ("Act"). This Section renders void an agreement that is in restraint of legal proceedings. However, there are three exceptions to the Section, one of them relating to guarantee agreements of a bank or financial institution. This 'Exception 3' was carefully analyzed in the judgement, and the honorable judge held that the Section does not provide for a minimum claim period of 12 months.
At the outset, it is essential to understand the terms generally contained in a bank guarantee. The validity period of a bank guarantee is determined by the principal debtor and the creditor, and it expires on a mutually agreed upon date. The creditor can invoke the bank guarantee if the principal debtor defaults during this period. A grace period provided to the creditor to call upon the bank for a default that occurred during the validity period of the bank guarantee is the claim period. The stipulation of a claim period in a bank guarantee is not compulsory. Further, the time within which a creditor can approach an appropriate court, after demanding enforcement of the bank guarantee is the enforcement period. The Court, in this case, determined whether Exception 3 is applicable to the claim period or enforcement period of a bank guarantee.
Exception 3 to Section 28 of the Act reads as follows:
"Saving of a guarantee agreement of a bank or a financial institution.
This section shall not render illegal a contract in writing by which any bank or financial institution stipulate a term in a guarantee or any agreement making a provision for guarantee for extinguishment of the rights or discharge of any party thereto from any liability under or in respect of such guarantee or agreement on the expiry of a specified period which is not less than one year from the date of occurring or non-occurring of a specified event for extinguishment or discharge of such party from the said liability."2
The second respondent in the case, the Indian Banks Association ("IBA") had issued two circulars dated February 10th, 2017 and December 5th, 2018 addressed to banks. The first circular stated that "it would be open to the banks to stipulate as condition precedent that if a claim is not lodged before a stipulated time, the bank guarantee shall be revoked or terminated but the stipulated date cannot be less than one year in any event." The second circular provided that if a bank issues a claim period of less than one year on top of the guarantee period, then it would not have the benefit of Exception 3 and the period of limitation as per the Limitation Act, 1963 would apply. This period is 30 years in case of Government being the beneficiary and 3 years for private parties. The IBA contended that this view of minimum claim period of 1 year was endorsed by the Ministry of Finance and the Department of Financial Services in consultation with the Reserve Bank of India in communications3 made to the IBA. It is relevant to note that the ambiguity in the claim period created by these communications, complicated the process of issuing bank guarantees for parties.
This writ petition was filed by Larsen & Toubro ("L&T") aggrieved by two communications made by Punjab National Bank ("PNB") which mandated a claim period of 12 months for its bank guarantee and the aforementioned circulars. Reiterating IBA's view, PNB's communication also stated that if the claim period stipulated was less than 12 months, a 3 year period as per the Limitation Act, 1963 would apply.
L&T contended that PNB had misinterpreted the Section and the petitioner should not be liable to maintain a collateral and bear commission charges during the extended claim period of 1 year. It was also alleged that this interpretation affects the ability of L&T to do business and violates its fundamental right under Article 19(1)(g) of the Indian Constitution.
The Court delved into the historical background of Section 28 to understand the legislative intent of the Section. Before Exception 3 to Section 28 was inserted in 2013, the Law Commission in its 97th Report dated March 31st, 1984 interpreted the impugned provision. The Commission noted that there is a distinction between 'remedy' and 'right' and a clause barring a remedy is void, whereas, extinguishing rights is valid. This distinction was subsequently done away with in 2013. The Commission recommended an amendment to the Section to render invalid clauses that extinguish rights accruing from an agreement on the expiration of a certain period. Such an amendment was made to the provision in 1997. However, pursuant to this, banks expressed concerns over the applicability of the Limitation Act to bank guarantees. Banks were required to maintain their bank guarantee obligations for 30 years in the case of Government and 3 years for private parties. These concerns were addressed by the insertion of Exception 3 that reduced the period to 1 year. Thus, upon examining the amendments to the provision the Court noted that "Exception 3 to Section 28 of the Contract Act deals with the rights of a creditor to enforce his rights under the bank guarantee after happening of a specified event."
PNB placed reliance on the judgement of the Supreme Court in Union of India vs. Indusind Bank4 and averred that this case supported its plea. The Court clarified that, this judgement cannot be relied upon since the clauses in question dealt with the enforcement period i.e. curtailment of the limitation period and not the claim period of a bank guarantee.
Further, the Court observed that "it is clear that Exception 3 to Section 28 of the Contract Act deals with the curtailment of the period for the creditor to approach the court/tribunal to enforce his rights. It does not in any manner deal with the claim period within which the beneficiary is entitled to lodge his claim with the bank/guarantor." Moreover, it was noted that PNB accepted this interpretation in its counter-affidavit while making statements to the effect that the Exception deals with the period within which the beneficiary is to approach an appropriate court to raise its claim.
The Court concluded that PNB is erroneously of the view that a claim period of 12 months in the bank guarantee is mandatory. However, Section 28 of the Act does not deal with the claim period. It was held that "it deals with right of the creditor to enforce his rights under the bank guarantee in case of refusal by the guarantor to pay before an appropriate court." Thus, the period envisaged under the Section is the enforcement period of a bank guarantee. It is pertinent to note that, such an enforcement period according to the Section, should not be less than 1 year. Therefore, the Court vitiated the two communications5 issued by PNB and relevant circulars6 of the IBA that support the erroneous interpretation(to the extent they reproduce this interpretation).
1. W.P.(C) 7677/2019
2. Exception 3 to Section 28, Indian Contract Act, 1972
3. Letters dated 23.04.2019 and 21.05.2019
4. 2016(9) SCC 720
5. Communications issued by PNB on 18.08.2018 and 28.03.2019
6. Circulars issued by Indian Banks Association on 10.02.2017 and 05.12.2018
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Ms Ashima Obhan
Obhan & Associates
N - 94, Second Floor
Tel: 114 020 0200
Fax: 114 020 0299
© Mondaq Ltd, 2021 - Tel. +44 (0)20 8544 8300 - http://www.mondaq.com, source Business Briefing