Performance bond and performance guarantee

Supreme Court in United Commercial Bank case, (1981) 3 SCR 300 . There A.P. Sen, J. speaking for the Court, said (pages 323 and 324):

The rule is well established that a bank issuing or confirming a letter of credit is not concerned with the underlying contract between the buyer and seller. Duties of a bank under a letter of credit are created by the document itself, but in any case it has the power and is subject to the limitations which are given or imposed by it, in the absence of the appropriate provisions in the letter of credit.

It is somewhat unfortunate that the High Court should have granted a temporary injunction, as it has been done in this case, to restrain the appellant from making a recall of the amount of ` 85,84,456 from the Bank of India in terms of the letter of guarantee or indemnity executed by it. The courts usually refrain from granting injunction to restrain the performance of the contractual obligations arising out of a letter of credit or a bank guarantee between one bank and another. If such temporary injunctions were to be granted in a transaction between a banker and a banker, restraining a bank from recalling the amount due when payment is made under reserve to another bank or in terms of the letter of guarantee or credit executed by it, the whole banking system in the country would fail.

In view of the banker’s obligation under an irrevocable letter of credit to pay, his buyer-customer cannot instruct him not to pay.

In Centax (India) Ltd., AIR1986 SC 1924 , Supreme Court again speaking through A.P. Sen, J. following the decision in the United Commercial Bank case said:

We do not see why the same principles should not apply to a banker’s letter of indemnity.

It is true that both the decisions of this Court dealt with a contract to sell specific commodities or a transaction of sale of goods with an irrevocable letter of credit. But in modern commercial transactions, various devices are used to ensure performance by the contracting parties. The traditional letter of credit has taken a new meaning. In business circles, standby letters of credit are also used. Performance bond and guarantee bond are also the devices increasingly adopted in transactions. The Courts have treated such documents as analogous to letter of credit.

A case involving the obligations under a performance guarantee was considered by the Court of Appeal in Edward Owen Engineering Ltd. v. Barclay’s Bank International Ltd. (1978) 1 All E.R. 976. The facts in that case are these: English sellers entered into a contract to supply and erect glass-houses in Libya. The Libyan buyers were to open an irrevocable letter of credit in favour of the sellers. The sellers told their English bank to give a performance guarantee. The English bank instructed a Libyan bank to issue a performance bond in favour of the buyers for a certain sum and gave their guarantee payable on demand without proof or conditions to cover that sum. The Libyan bank issued a bond accordingly. The sellers received no confirmed letter of credit and refused to proceed with the contract. The sellers obtained in interim injunction to prevent the English bank from paying on the guarantee. On appeal Lord Denning M.R. said:

So as on takes instance after instance these performance guarantees are virtually promissory notes payable on demand. So long as the Libyan customers make an honest demand, the banks are bound to pay and the banks will rarely, if ever, be in a position to know whether the demand is honest or not. At any rate they will not be able to prove it to be dishonest. So these will have to pay.

And said:

All this leads to the conclusion that the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relations between the supplier and the customer: nor with question whether the supplier has performed his contractual obligation or not; nor with the question whether supplier is in default or not. The bank must pay according to its guarantees, on demand if so stipulated, without proof or conditions. The only exception is when there is a clear fraud of which the bank has noticed.

Whether it is a traditional letter of credit or a new device like performance bond or performance guarantee, the obligation of banks appears to be the same. If the documentary credits are irrevocable and independent, the banks must pay when demand is made. Since the bank pledges its own credit involving its reputation, it has no defence except in the case of fraud. The bank’s obligations of course should not be extended to protect the unscrupulous seller, that is the seller who is responsible for the fraud. But, the banker must be sure of his ground before declining to pay. The nature of the fraud that the Courts talk about is fraud of an “egregious nature as to vitiate the entire underlying transaction”. It is fraud of the beneficiary, not the fraud of somebody else. If the bank detects with a minimal investigation the fraudulent action of the seller, the payment could be refused. The bank cannot be compelled to honour the credit in such cases. But it may be very difficult for the bank to take a decision on the alleged fraudulent action. In such cases, it would be proper for the bank to ask the buyer to approach the Court for an injunction. [JT 1987 (4) SC 406 : (1987) 2 SCALE 1149 : (1988) 1 SCC 174 : (1988) 1 SCR 1124]