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Bank Guarantees And Burden Of Exception III

The industries have started reeling under pressure due this overburden of changed legal stance and badly looking rescue by the new government by making the required changes in the law, may be introduction of Exception IV to give some respite.

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Construction industry is one of the important driving forces behind India’s growth. Its size is estimated to reach USD 1 trillion by year 2025 and projected to become third largest construction market globally by year 2030. The industry encompasses real estate and infrastructure sectors. It is the third largest employment generator after agriculture and manufacturing and expected to take no.1 position by year 2025. The sector is poised for buoyant growth due to country’s need for development of infrastructure projects and real estate. It is estimated that about investment of USD 650 billion will be required for development of urban infrastructure over the next 20 years period. The real estate market is also expected to reach USD 180 billion by 2020. 

The focus of the government on infrastructure development, affordable housing, smart cities, metro rails etc. combined with implementation of revolutionary reforms of RERA, REIT and GST have made domestic and international business sentiments positive about the Indian construction sector. This scenario reflects a bright future for construction industry in India. 

The construction and infrastructure (C&I) sector formed 40% of the gross bank credit (March 2019) to the industries by scheduled commercials banks (SCB). As per RBI data (2018) the outstanding Bank Guarantees (BG) given for borrowers by SCBs in India were Rs.11.25 trillions. This reflects huge off balance sheet banking business opportunities available in India. The focus of government on development of infrastructure and civil amenities in the country clearly indicates that banks having a robust structure of taking off-balance exposures will get good business opportunity. Also, banks generally issue BGs by taking some margin money from applicant and which ranges from Nil to 25 per cent depending on credit strength of borrower. Hence, off balance sheet exposures also support garnering of large scale term deposits business to banks.

C&I sector requires huge bank guarantee limits. With the impetus on infrastructure sector growth, there will be accelerated need for BG limits by construction companies. The BG needs starts right from the tender stage. Various kinds of BGs include Bid Bond, Earnest Money Deposit, Performance, Mobilization/Advance Payment, Retention etc. While the Bid Bond/EMD BGs range from 1 per cent to 5 per cent of contract value, the other BGs range from 5 per cent to 10 per cent. The tenor of Bid Bond / EMD BG ranges from 3 months to 1 year while the tenor of other BGs range from 2 years to 7 years and sometimes higher also depending on specific nature of the contract. 

BGs have Validity Period and Expiry Period stipulated in the BG drafts. The beneficiary can claim for the act/default occurred on or before the Validity Date but within the Claim Expiry period. Generally, both these dates are different and Expiry Date ends one to twelve months after the validity period. However, there is no such compulsion to keep both dates different and depending on the applicant and beneficiary’s understanding banks have been  issuing BGs keeping both the dates same also or as otherwise requested by applicant and acceptable to beneficiary. 

Most of the SCBs in India issue BGs comprising Indian Bank Association (IBA) recommended clauses. The recommended clauses also include the ‘Notwithstanding’ clause (NWC) stipulated at the end of the BG draft. This clause mentions bank’s liability under the BG, validity of the BG (date), liability to pay BG amount if written claim or demand is made before the expiry of the BG. The NWC fixes the period to make a claim against the BG.

The Limitation Act 1963 of India prescribes the maximum time limit within which aggrieved party can approach courts for redress or justice by way of suit, appeal or application. The Act prescribes time limit of 3 years for private parties and 30 years for all suits to be instituted by government departments/agencies. Therefore, the BGs issued by banks favouring government department in the name of President of India has validity of 30 years for filing claims. 

Normally, after the Expiry Period as stipulated in the BG, if the BG is not invoked within the Expiry Period and original BG is not returned, banks send registered letters to beneficiary for returning the original BG. If no response is received then BG is cancelled and margin money provided by applicant is released.  

The section 28 of Indian Contract Act prohibits parties to substitute any other time period against the period as prescribed under Limitation Act. Banks considered that the stipulated NWC clause in BG would protect their interest against the Sec. 28 of Indian Contract Act, and they would be released from their obligation after the expiry period as stipulated under NWC in the BG. However, the Sec. 28(b) of Indian Contract Act (Amendment Jan 08, 1997) entitles the beneficiaries for filing their claim within the time period as prescribed under the Limitation Act and makes NWC as void to the extent not in compliance with the Limitation Act provisions. In court cases, it has been ruled that restrictive clauses in BG requiring beneficiary to enforce claim within the period as stipulated in BG was violation of Sec. 28. Supreme Court has considered that fixing a time period within which a claim can be lodged (NWC Clause) is different than limiting the period within which claims can be lodged through suits within the limitation period as per Limitation Act.

This has led banks apprehensive about extinguishment of their liability in BG after the end of Expiry Date despite the stipulation of NWC and when no claim/invocation is received by Expiry Date. To resolve this conflicting issue, on the recommendations of RBI, IBA, and industry associations, and to bring finality to the redemption of BGs, Government of India amended the Contract Act by adding Exception (III) to the Section 28 of Contract Act from January 18, 2013.     

The Exception III stipulates that this section shall not render illegal a contract in 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.

This exception has enabled banks and FIs to limit the period for making a claim upto one year by incorporation of suitable clause in the BGs.

Due to the above developments, now banks in India have started practice of stipulating minimum claim expiry period of one year in all the BGs. But, as one may notice, there are practical business cases (say Bid Bond/ EMDs) where the required BG tenor (Validity and Claim Expiry Date) is less than one year. Keeping minimum claim period of one year will increase the cost (BG commissions) for the contractors and give unnecessary upperhand to the beneficiary. The funds will remain locked under margin money for longer tenor and result in increasing working capital requirements. BG line limit will also remain blocked for unwanted reasons. 

Imagine EMDs which generally have tenor of maximum six months will now be issued for a tenor of eighteen months (six months plus one year of claim period). A contractor having EMD BG limits of Rs.100 crore could bid for projects worth Rs.4000 crore (assuming 5 per cent EMD requirement) in a year if EMD BG tenor was only upto six months since he was able to rotate BGs upto average 2 times. However, under the new rule of minimum claim expiry period of one year, he will now require BG limit of Rs.200 crore for bidding the same Rs.4000 crore of projects. Assuming BG commission of 1% p.a. all inclusive, his BG cost will also unnecessarily increase from Rs.1 crore to hopping Rs.3 crore for bidding the same Rs.4000 crore worth projects. Tying up for any additional BG limits is a herculean task for EPC players in the present banking scenario where banks are averse to taking additional exposures. 

Construction and infrastructure is one set of heavy users of bank guarantee limits however BGs lines are general need of all the other industries also. Therefore, the peculiar change of minimum one year claim period for taking benefits of Exception III is adversely affecting all the other industries also.

When the country is focusing on Ease of Doing business, construction and infrastructure projects are key to turbo-charge the economy, and industries are in need for positive support from govt. with radical reforms, in such scenario, stipulation of having minimum claim period of one year under Exception III in BGs does not make a sensible business case. It seems that while drafting Exception III, the practical scenario of BGs requiring less than one year tenor could not be envisaged. The industries have started reeling under pressure due this overburden of changed legal stance and badly looking rescue by the new government by making the required changes in the law, may be introduction of Exception IV to give some respite.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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Kapil Vaghela

Author is working as AGM in PSB and has banking experience of more than 17 years. He has extensively worked in Corporate Banking involving Working Capital Finance, Project Finance, Debt Syndication, Carbon Credit Business, NPA Management etc. His qualifications include MSc (IT), CFA. He is a Certified Associate of IIB&F.

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