No minimum period for claims under bank guarantee

By Aditya Vikram Dua and Harshil Shubham, SNG & Partners
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Section 28 of the Indian Contract Act, 1872 (ICA), in its original form inter alia made all such contracts void that limited the time within which a party may enforce its rights under a contract by the usual legal proceedings in the ordinary tribunals. The courts interpreted the provision in a manner that an agreement which provides for the relinquishment of remedy to sue simultaneously with rights under the said agreement was not affected by section 28.

Aditya-Vikram-Dua-an-associate-at-SNG-&-Partners
Aditya Vikram Dua
SNG & Partners

The said section was amended in 1997 after the Law Commission of India’s recommendation in its 97th Report. The commission noted that what is affected by section 28 is an agreement relinquishing the remedy only i.e., where the time limit specified in the agreement is shorter than the period of limitation provided by law. The amendment had an unintended effect on bank guarantees. Banks apprehended that they could not limit their liabilities under the guarantees to a specified period, which meant that banks had to treat in their books their liability under the bank guarantee to the government as outstanding till the limitation period of 30 years, under the Limitation Act, 1963 (Limitation Act).

An expert committee constituted by the government was also of the view that owing to the amended section 28, it would be now difficult to sustain a prescriptive clause, howsoever worded, in a bank guarantee which limits the period of banks and financial institutions liability to a period lesser than the normal period of limitation.

Therefore, in 2013, the parliament added exception 3 to section 28 of ICA. The said exception stated that “this section shall not render illegal a contract in writing by which any bank or financial institution stipulates 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.” Banks interpreted the said exception in a manner that to make use of the benefit of the said exception, a minimum claim period of one year needs to be added in a bank guarantee on top of the guarantee period.

Harshil Shubham SNG & Partners
Harshil Shubham
SNG & Partners

In the recent case of Larsen & Toubro Limited v Punjab National Bank, the Delhi High Court has delved into the interpretation of section 28 of ICA, with special emphasis on exception 3. L&T contended in its writ petition that in the ordinary course of its business, it was required to furnish bank guarantees while bidding for contracts. However, PNB, based on an erroneous interpretation of section 28 of ICA, had stipulated a compulsory minimum claim period of 12 months for the guarantee, even though L&T required the guarantee for a shorter period. Such claim period provided for a grace period beyond the validity period of the guarantee, during which a demand could be made on the bank for a default which occurred during the validity period. Under the guarantee, the creditor could also enforce his right before a court of law within the validity period or claim period, in the event the bank failed to honour its commitment, as per exception 3 to section 28 of the ICA. In the absence of such a clause in the guarantee, the said period would be determined by the Limitation Act.

Punjab National Bank argued that a claim period in a bank guarantee whose duration was less than 12 months would render the claim period void, and increased the claim period under the guarantee to that prescribed under the Limitation Act. This was further based on the clarification provided by the Indian Bank Association (also a respondent).

The court has held in the matter that exception 3 deals exclusively with curtailment of the period for the creditor to institute proceedings before a court of law to enforce his rights (the enforcement period), which shall be not be less than 12 months. Further, in the absence of such a clause limiting the enforcement period to 12 months, the limitation period as set out under the Limitation Act shall be applicable (which is three years for private parties and 30 years for the government). However, it does not in any manner deal with the duration of claim period or mandate the stipulation of a claim period of at least 12 months in a bank guarantee.

This judgment will have far-reaching consequences as it provides significant relief both to banks and companies.

Aditya Vikram Dua (left) is a principal associate and Harshil Shubham is an associate at SNG & Partners

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