A bank guarantee is in itself a complicated form of banking tool. It is a form of negotiable debt instrument which is issued by a bank to pay a sum of money to a beneficiary on behalf of its customer or the principal should the principal fail to perform his obligations or after the completion of a certain event. Depending on the obligation of the principal, a bank guarantee may differ from one another. Take for example, a performance bank guarantee. The bank will only indemnify the beneficiary if in case the principal fails to perform his obligations. Other examples are tender guarantee, advance payment guarantee and similar where the names are self-explanatory.
A bank guarantee has a tripartite structure comprising of the bank, the beneficiary and the principal. The principal and the beneficiary first enter into contract between themselves imposing certain obligations upon the principal, which is known as the underlying contract. The second contract is made between the bank and the beneficiary to indemnify the beneficiary with a sum of money if the principal fails to perform his obligations which the bank will later collect from the principal. This second contract is the bank guarantee in its most basic form. There is also a form of counter-guarantee which includes an additional bank which will not be discussed here.
Bank guarantees have some basic principles that guide how they should function. It is an irrevocable payment obligation by the bank usually upon first demand by the beneficiary. The beneficiary need only state that the principal failed to perform his obligations. The bank is not concerned with the contract between the beneficiary and the principal due to the principle of independence which states that a bank guarantee is completely separate and independent from the underlying contract. The documentary character of a bank guarantee obligates the bank to be concerned only with the documents required by such a guarantee which is usually specified in the guarantee itself. The ICC Uniform Rules for Demand Guarantees (URDG 758), which is the most widely accepted international source of bank guarantees, states in Article 15A that a demand under the guarantee shall be supported by such other documents as the guarantee specifies, and in event of a statement by the beneficiary indicating in what respect the applicant has breached its obligation under the underlying relationship. This statement may be in demand or in a separate signed document accompanying or identifying the demand.
Another principle, the doctrine of strict compliance, states that a demand and presentation made by the beneficiary must strictly comply with the terms, conditions and requirements of the guarantee. Under this principle, the bank is required to check whether the documents provided in a demand by the beneficiary strictly comply with the terms and conditions of the guarantee and if they do comply, the bank is obligated to pay the beneficiary. In light of all these principles, it can be said that the bank is under an obligation to pay the beneficiary upon his first demand, if such demand complies with the terms of the guarantee, without considering the underlying contract. But what happens in a case where the beneficiary fraudulently demands for payment but the documents still comply with the terms of the guarantee? Theoretically, the bank would be under an irrevocable obligation to pay even if it is aware of the fraud. However, there is another principle that would supersede all the previous ones. The Fraud Exception Rule to the independence principle allows the issuer of a Letter of Credit or a court to disrupt the payment of a demand guarantee when fraud is involved.
When the URDG 758 was drafted, the principle of fraud exception was intentionally left out so that individual jurisdictions would themselves address this issue through their own laws. Article 34 of the URDG 758 states that the governing law shall be the one which has been stated in the demand guarantee or that of the location of the guarantor. The reason behind doing this is that fraud is a complicated issue; there cannot be a general law to address fraud of every kind in every jurisdiction. Thus, the laws of individual countries need to address this issue themselves. The Banking and Financial Institutions Act (BAFIA) 2073 however, has failed to incorporate this principle. The only provisions in the BAFIA regarding bank guarantee are the ones that state which banks can issue such bank guarantees.
The Unified Directives Issued by Nepal Rastra Bank for Financial Institutions 2017 A.D. (2074) to some extent has dealt with this issue allowing banks to decide within seven days whether payment upon a bank guarantee should be made or not. However, as per the independence principle and the principle of strict compliance, it is not within the power of the bank to restrict payment if the documents comply with the terms of the guarantee. Nepali laws are either inadequate or do not conform with international norms and principles. As such, various issues arise repeatedly due to fraud in bank guarantees which the current laws are inadequate for. The use of such guarantees has considerably risen in the last few years in Nepal and although the courts do have the power to decide upon such cases, a suitable legislation would ease court procedures as well as simplify the use of bank guarantees. The previous BAFIA had also failed to incorporate this provision. With such high rise in the use of bank guarantees, a suitable legislation is a must if fraud in such guarantees is to be avoided.
Gandhi Pandit is a graduate of Columbia University, USA and has been recognised as a Senior Advocate by the Supreme Court of Nepal. He is the founding partner of Gandhi and Associates. Shahrukh Rai is an associate at G&A currently taking a leading role in developing the research department in the team.