The Hidden Pitfalls of Onerous Clauses in Bank Guarantees: What Indian Banks and Businesses Need to Know

In the realm of securing contracts with government departments, the requirement for a bank guarantee (BG) often brings to light a critical issue that often goes unaddressed: The imposition of onerous clauses.

The inclusion of such stringent terms can severely impact the contractor’s financial stability and increase the bank’s risk exposure. It’s essential for Indian bankers and entrepreneurs to be aware of these clauses to prevent potential pitfalls and avoid unforeseen liabilities.

In many cases, navigating these complex terms requires careful negotiation to ensure a fair balance between the interests of all parties involved. Understanding which clauses are non-negotiable and which can be discussed for exclusion is crucial.

This article aims to shed light on the implications of onerous clauses in bank guarantees, the importance of negotiating these terms effectively, and why a thorough understanding of these clauses is vital for both banks and businesses to protect their interests and avoid unnecessary complications.

These clauses can lead to significant financial, operational, or legal implications for the party bound by them.

The various onerous clauses that often arise in bank guarantees are explained as follows:

Auto Invocation Clause

This clause stipulates that the bank guarantee will automatically be invoked (i.e., payment will be made) upon the occurrence of certain events.

Example: Upon the failure of the contractor to complete the project by the agreed deadline of [Date], this bank guarantee shall be automatically invoked. The beneficiary is required to inform the bank in writing of the contractor's failure within [X] days from the agreed deadline. Upon receipt of this notice, the bank shall remit the guaranteed amount of [Amount] to the beneficiary within [Y] days, without requiring further proof of default or the submission of additional claims.

This can be risky for the applicant, as payment might be triggered by events outside of their control, and there might be limited opportunities to challenge or negotiate the payment before it is made.

Unconditional or Irrevocable Clause

Here the beneficiary is the sole judge in regard to invocation or enforcement of the bank guarantee which leaves the decision of invocation to the absolute discretion of that beneficiary. This clause obliges the bank to honor the guarantee regardless of whether the applicant disputes the claim or believes that the demand is unjustified. The bank cannot refuse payment once the demand is made, and the applicant has no right to contest or stop the payment once the guarantee is invoked.

The bank cannot refuse payment under any circumstances if the beneficiary makes a demand, regardless of whether the conditions of the underlying contract were met.

This may result into the issuer bank pays a large sum even if the actual default done by the applicant was of a lesser amount.

Auto Renewal Clause

These clauses extend the duration of the bank guarantee beyond the typical time frame, sometimes indefinitely, until the beneficiary is satisfied or releases the guarantee.

The clause often includes a notice period during which one of the parties can give written notice that they do not wish to renew the contract. If no such notice is given, the contract renews automatically.

This can result in the applicant having to maintain collateral or margin money with the bank for an extended period, affecting their liquidity and financial planning.

Fax/Email Invocation Clause

A fax/Email invocation clause allows the beneficiary of a bank guarantee to invoke (or demand payment under) the guarantee by simply sending a demand letter via fax/Email to the issuing bank. This means that no physical presence or original documentation may be required, and the invocation process can be completed quickly and remotely.

This ease of invocation can be burdensome for the applicant, as the bank might release payment without verifying the authenticity of the fax/Email or the legitimacy of the claim. The applicant may suffer financial loss if the bank honors a fraudulent or erroneous fax invocation.

The beneficiary may send the fax/Email to any branch of the bank than a trade branch and if the invocation is not attended by related officers in time resulting into delay or communication gap, the invocation may attract an interest payment from the date of fax/Email. ?

Invocation valid when written demand is posted whether received by the guarantor or not

This clause implies that the invocation of the bank guarantee is considered valid as soon as the beneficiary posts the written demand, regardless of whether the demand is actually received by the guarantor. The moment the beneficiary sends out the invocation letter (e.g., via post, courier, or another method), the bank is deemed liable, even if there are delays in the delivery of the letter or it gets lost in transit.

Normally, the invocation of a bank guarantee requires that the demand be properly received by the guarantor within a specified timeframe. However, under this clause, the act of sending the demand alone is enough to trigger the guarantee invocation.

If the invocation is deemed valid from the moment the demand is posted, the bank may be required to honor the guarantee from that point onward. If the bank delays payment because it did not receive the demand, interest may accrue on the amount due under the guarantee.

Assignment Clause

An Assignment Clause in a bank guarantee becomes onerous when it allows the beneficiary of the guarantee to transfer or assign the rights under the guarantee to another party without the consent of the guarantor (usually a bank). This significantly increases the risk and uncertainty for the guarantor, as it may find itself dealing with a new party, potentially with different interests, motivations or circumstances than the original beneficiary.

The guarantor loses control over who it is guaranteeing. The original risk assessment was made based on the creditworthiness and relationship with the original beneficiary. However, once the guarantee is assigned, the guarantor may have to deal with a completely different party, potentially with higher risks.

The guarantor may also have to deal with unfamiliar legal or regulatory environments if the assignment involves a party in a different jurisdiction.

Example Scenario:

• A medium-sized Indian engineering firm (Principal Debtor) provides a bank guarantee from a local bank (Guarantor) in favour of a supplier (Original Beneficiary) as security for the purchase of high-value machinery.
• The guarantee includes an onerous assignment clause, allowing the supplier to assign the rights under the guarantee to any third party without the bank’s consent.
• The supplier, facing financial difficulties, decides to assign the rights under the bank guarantee to a third-party finance company (New Beneficiary) as part of a debt restructuring arrangement. The guarantor bank is not informed of the assignment until after it has taken place.
• The finance company, unfamiliar with the original transaction, aggressively pursues claims under the guarantee as part of its efforts to recover its investment. The finance company is also located in a different jurisdiction, creating legal and regulatory challenges for the bank.
• The bank, which originally assessed the risk based on its relationship with the supplier, now finds itself dealing with a party it knows nothing about. The bank may face higher claims and more aggressive enforcement efforts than it would have from the original supplier.

Guarantor confirms that there are no court/tribunal/regulatory order or bankruptcy administrative proceedings against him having impact on BG

This clause requires the guarantor to confirm that there are no ongoing legal, regulatory, or bankruptcy proceedings that could impact its ability to fulfill its obligations under the bank guarantee.

The clause typically implies a continuous obligation on the part of the guarantor, meaning that even after the guarantee is issued, if any such proceedings arise, the guarantor could face consequences, such as immediate invocation of the guarantee or legal actions from the beneficiary. If the guarantor faces any unexpected litigation, regulatory action, or bankruptcy proceedings, it could be considered in breach of this clause, which may trigger immediate liability under the guarantee.

Even if the proceedings are unrelated to the specific bank guarantee, their mere existence could impact the guarantor's obligations. The beneficiary may potentially early invoke the guarantee having any such news of regularity action in hand.

Honoring of BG despite court order

This clause mandates that the bank must honor the BG and make payments or perform its obligations under the guarantee even if a court order or legal directive is issued that might typically prevent or delay such action. It essentially overrides any legal or regulatory constraints that could otherwise affect the bank’s performance under the guarantee.

If a court issues an injunction or order that affects the BG (e.g., a freeze on payments or an order to halt all financial transactions), the bank must still honor the BG. This could put the bank in a difficult legal position, potentially leading to contempt of court or other legal consequences.

Example Scenario:

• A large multinational company (Beneficiary) receives a bank guarantee from an Indian bank (Guarantor) to secure a major construction project. The guarantee includes a clause stating that the bank must honor the BG despite any court orders.
• During the course of the project, a legal dispute arises between the construction company and its subcontractor. The subcontractor obtains a court order freezing the construction company’s assets, which includes a directive preventing the bank from making payments under the BG until the dispute is resolved.
• Despite the court order, the bank is required to honor the BG and make payments to the beneficiary (the multinational company) as per the terms of the guarantee.

Notwithstanding clause

The "Notwithstanding Clause" has a broader scope than the “Honour a BG despite court order” and may cover a range of conflicting issues beyond just court orders. It ensures that the guarantee remains effective despite various potential conflicts. This clause typically serves to protect the beneficiary by ensuring that the bank’s obligations under the guarantee are upheld regardless of other circumstances that might otherwise impact the enforceability of the guarantee.

Clause waiving suretyship rights of the guarantor – Waiver of rights under section 133, 135 and 141 of the Indian Contract Act.

Under the Indian Contract Act, 1872, certain rights and defenses are available to a guarantor. Waiving these rights means the guarantor cannot rely on them to contest claims or disputes related to the guarantee.

Section 133 – Discharge of Surety by Variance in Terms of Contract:

• Provision: This section states that a surety (guarantor) is discharged from liability if there is a material alteration or change in the terms of the contract without the surety’s consent.
• Waiver Implication: If this right is waived, the guarantor cannot claim discharge of liability due to changes in the terms of the underlying contract, even if such changes are made without the guarantor's consent.

Section 135 – Discharge of Surety by Release or Discharge of Principal Debtor:

• Provision: This section provides that a surety is discharged if the principal debtor is released or discharged from the debt, either by the creditor or by operation of law.
• Waiver Implication: If this right is waived, the guarantor remains liable even if the principal debtor is released or discharged from the debt, reducing the guarantor’s ability to escape liability based on the debtor’s release.

Section 141 – Discharge of Surety by Revocation of Continuing Guarantee:

• Provision: This section allows a surety to revoke a continuing guarantee as to future transactions, meaning the guarantor can stop being liable for future transactions once they give notice of revocation.
• Waiver Implication: If this right is waived, the guarantor cannot revoke the guarantee for future transactions, meaning they remain liable for ongoing or future transactions covered by the guarantee.

Waiver of Subrogation Rights

Subrogation is a legal right that allows one party (in this case, the bank) to assume the legal rights of another party (the beneficiary) after paying a debt or fulfilling an obligation on their behalf. After the bank pays the beneficiary under a bank guarantee, it normally has the right to seek reimbursement from the applicant, as it has fulfilled the applicant’s obligation.

A Waiver of Subrogation Rights by the guarantor in a bank guarantee (BG) is an onerous clause that prevents the guarantor (typically the bank) from stepping into the shoes of the beneficiary to recover any losses from the applicant (the party for whom the guarantee was issued) after the bank has made a payment under the guarantee. This clause limits the bank’s rights to seek reimbursement from the applicant, even after fulfilling its obligation to pay the beneficiary.

The Guarantor becomes liable as principal debtor/obliged under the contractor

In a typical bank guarantee, the guarantor (usually a bank) provides a secondary obligation, meaning it only becomes liable if the principal debtor (the party for whom the guarantee is issued) fails to fulfill its obligations. However, under this clause, the guarantor assumes the same level of liability as the principal debtor, making the bank directly responsible for fulfilling the obligations under the contract, irrespective of the principal debtor's actions.

In a standard guarantee, the guarantor's liability is secondary. The guarantor only becomes liable if the principal debtor defaults. The guarantor is not directly responsible for performing the underlying obligation but only for compensating the beneficiary if the principal debtor fails.

The bank may have to pay or perform under the contract without waiting for the principal debtor to default or without requiring proof that the principal debtor has failed to meet its obligations.

Let’s explore a practical example to illustrate the implications of this clause:

• A large Indian infrastructure company (Principal Debtor) enters into a contract to build a power plant for a government agency (Beneficiary).
• As security for the contract, the infrastructure company provides a bank guarantee from an Indian bank (Guarantor). The guarantee includes the clause stating that the guarantor (the bank) becomes liable as the principal debtor under the contract.
• Midway through the project, the infrastructure company faces financial difficulties and is unable to complete the construction of the power plant. Normally, the government agency would first seek to enforce the contract against the infrastructure company, and only after proving default would it invoke the bank guarantee for compensation.
• Under the onerous clause, the government agency can immediately turn to the bank and demand that it fulfill the obligations under the contract, as if the bank were the contractor itself. The agency does not need to pursue the infrastructure company or prove its default before seeking relief from the bank.
• The bank may now be responsible not just for paying a sum of money but for ensuring that the power plant is completed. This could involve significant financial outlay, project management, and even the hiring of another contractor to finish the project.

Governing law of the BG to be law other than local laws/Indian Laws/Laws which are deemed favorable to the bank and the jurisdiction of the court settle the dispute are the courts/tribunals other than the local courts/Indian Courts/ Laws which are deemed favorable to the bank.

When the governing law is set to a foreign jurisdiction (e.g., English law, U.S. law), it can create complexities for the parties involved, particularly if they are unfamiliar with that legal system. If the courts are located in a country where the legal system is perceived as favorable to the bank (e.g., based on precedent, bank-friendly regulations), this can further disadvantage the applicant or beneficiary.

Disputes may need to be litigated or arbitrated in foreign jurisdictions, leading to higher legal costs, travel expenses, and other associated costs.

Conclusion

The importance of understanding onerous clauses in bank guarantees cannot be overstated, especially for entrepreneurs and public sector banks. For entrepreneurs, these clauses can significantly impact cash flow, operational continuity, and even the survival of the business. A lack of awareness or oversight in negotiating these terms can expose them to unexpected liabilities, potentially derailing their ventures. Entrepreneurs must take the time to understand the implications of these clauses, seek expert advice, and actively negotiate terms to protect their interests.

For public sector banks, the stakes are even higher. With inherent vulnerabilities stemming from larger portfolios and a broader mandate, the risk of overlooking these onerous terms can lead to significant financial exposure and reputational damage. Unlike private banks, which may have more stringent risk management practices, public sector banks must ensure that their teams are thoroughly educated on these clauses. Rigorous due diligence and internal controls are essential to mitigating the risk of costly disputes and defaults.

In essence, both entrepreneurs and public sector banks must recognize the critical role that these clauses play in shaping the outcome of business transactions. Proactive management, continuous education, and a strong focus on risk mitigation will go a long way in preventing the negative consequences that can arise from the ignorance or oversight of these onerous clauses in bank guarantees.