Recently, the Delhi High Court held that banks cannot force debtors to have a compulsory claim period of 1 year under the contract of Bank Guarantee. This is a significant development in interpreting exception 3 to section 28 of the Indian Contract Act (hereinafter ‘ICA’) under the Bank Guarantee laws in India.
While holding so, the High Court stated that the circulars issued by the Indian Banks Association (hereinafter ‘IBA’) advising its member banks to have a mandatory claim period of 1 year in Bank Guarantee are vitiated in the backdrop of exception 3 to section 28 of the ICA1.
One of the largest construction companies in India, Larsen & Toubro Ltd., filed the writ petition challenging the misinterpretation of exception 3 to section 28 of the ICA (hereinafter “exception 3”) by the respondent Bank and sought a writ of certiorari against the erroneous interpretation of said exception in circulars dated 10.02.2017 & 05.12.2018 by the IBA (impleaded as Respondent No.2). By way of these circulars, the IBA had advised its member banks that it would be open for the banks to fix a condition precedent under the contract of guarantee that if the claim is not lodged before a stipulated time, the Bank Guarantee shall be revoked or terminated but such time cannot be less than one year in any event. The IBA further advised that if the bank issues Bank Guarantee with a claim period of less than one year then such a Bank Guarantee would not have the benefit of exception 3 and would stand exposed to the period of limitation under the Limitation Act, 19632.
It was contended by the petitioner that under a misinterpretation of exception 3, the Bank insisted that the “claim period” (a contractually agreed grace period beyond the validity period of Bank Guarantee to make a demand to the bank against a default which had occurred during the validity period) should be not less than 1 year. The petitioner argued that exception 3 statutorily governs the enforcement period under which the creditor can enforce his accrued rights before a competent court of law pursuant to a demand being made by him within the validity period or the claim period. Therefore, it was the case of the petitioner that the banks cannot force the debtor and creditor to stipulate a claim period to be not less than 1 year.
The respondents asserted that exception 3 entitles the banks to insist on a claim period of one year in the Bank Guarantee. They also relied on the judgment of the Supreme Court in Union of India v. IndusInd Bank3 where the court dealt with the question of retrospectivity of section 28(b) of ICA (inserted by way of an amendment in the year 1997). While holding that the said section 28(b) being a substantive/ remedial law will operate prospectively, the Supreme Court also observed the stipulations in Bank Guarantee. The court observed that clauses such as “unless a demand or claim under guarantee is made within 3 months from the date of expiry of the guarantee, all the rights of the beneficiary shall be forfeited and the bank shall be relieved and discharged from all liabilities” in Bank Guarantee would pass the muster after addition of exception 3 in the year 2013 if the specified period is not less than one year. The respondent heavily relied upon the aforesaid obiter dictum of the Supreme Court and contended that the banks have a right to insist on a claim period of 1 year in the Bank Guarantee.
The Single Judge of Delhi High Court rejected the contention of the respondent Bank and held that it is an erroneous view that they are legally entitled to stipulate a claim period of 12 months in the Bank Guarantee failing which the clause shall be void under section 28 of ICA. The High Court noted that section 28 of ICA stipulates that every agreement by which “any party is restricted absolutely from enforcing its rights under any contract or which limits the time within which the right can be enforced, or which extinguishes the right of any party or discharges any party from any liability on expiry of a specified period to restrict any party from enforcing his rights” is void. The said section essentially prevents any party to the contract to create the law of limitation as well as the law of prescription of their own.
The court also noted the historical background for adding exception 3 i.e., a report of the expert committee constituted for recommending changes in the legal framework concerning the banking system headed by former Solicitor General T.R. Andhyarujina on 15.02.1999. The Committee observed that in view of section 28, banks would not be able to limit their liabilities under the Bank Guarantees to a specified period and thus recommended that a reasonable period should be provided to the creditor to enforce its rights under the Guarantee before a court. The Committee believed that a period of one year would be reasonable for banks and financial institutions.
Accordingly, exception 3, a special proviso has been promulgated for banks to allow them to stipulate a term in a guarantee for extinguishment of the right of the creditor to approach the court for enforcement of its rights under Bank Guarantee upon expiry of the specified period which cannot be less than one year. Therefore, by way of an exception to the main section 28 of ICA which declares every agreement in restraint to legal proceedings as void, the banks can stipulate a term in guarantee and extinguish the right of creditors or discharge its liability on expiry of a specified period to be less than one year. In this way, the banks are entitled to effectively extinguish the right of creditors to enforce a legal proceeding before a court. The exception very fairly puts at rest the fears and apprehensions of the banks which in absence of such an exception would be required to carry their Bank Guarantee commitments for a long period in accordance with the period of limitation as specified under the Limitation Act, 1963 i.e., for 3 years in case the beneficiary is a private entity and 30 years in case the beneficiary is a governmental organisation. The High Court has rightly held that exception 3 deals with the curtailment of the period for the creditor to approach the court to enforce his rights and does not in any manner deal with the claim period within which the beneficiary is entitled to lodge his claim with the bank/ guarantor.
The High Court also rejected the reliance of the respondent upon the judgment of the Supreme Court in IndusInd Bank (supra) and held that the said judgment was not dealing with the claim period i.e., the grace period beyond the validity of the Bank Guarantee to make a demand on the bank for a default which had occurred during the validity period. Hence, the High Court allowed the writ petition filed by Larsen and Toubro Ltd. and struck the misinterpretation by the respondent as well as the circulars issued by the IBA to the extent it reproduces erroneous interpretations of exception 3.
The judgment has come as a relief to debtors and creditors under the contracts of Bank Guarantee as now the parties can agree to have a claim period of less than 1 year and banks will have no right to demand otherwise. Consequently, the debtors will not be required to make a payment towards commission charges for a long claim period and will also not be liable to maintain the collateral security for supporting the claim period.
1. W.P.(C) No. 7677 of 2019 titled “Larsen and Toubro Ltd. & Another versus Punjab National Bank and Another” decided on 28.07.2021. Section 28 of the Indian Contract Act reads as follows:
Agreements in restraint of legal proceedings, void.- Every agreement,-
(a) by which any party thereto is restricted absolutely from enforcing his rights under or in respect of any contract, by the usual legal proceedings in the ordinary tribunals, or which limits the time within which he may thus enforce his rights, or
(b) which extinguishes the rights of any party thereto, or discharges any party thereto from any liability, under or in respect of any contract on the expiry of a specified period so as to restrict any party from enforcing his rights,
is void to that extent.
Exception 3 reads as follows:
Saving of a guarantee agreement of a bank or a financial institution. This section shall not render illegal a contract 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. which would be 30 years in a case when the Government is the beneficiary and 3 years when some other party is the beneficiary under contract of Bank Guarantee
Exception 3 to Section 28 of the Indian Contract Act deals with the enforcement period and not with the claim period under the contract of Bank Guarantee. The Delhi High Court settled this position in a recent judgment and struck down the contrary interpretation by the banks. Authored by @Manisha Singh & @Nisha Sharma, this article analyses the rationale for the court’s holding on the issue.