01 January 0001

Agreement in Restraint of Legal Proceedings – Is your Bank Guarantee valid?

by Sudish Sharma

The original text of Section 28 of the Indian Contract Act, 1872, which voids agreements made (or containing clauses) in restraint of legal proceedings, has been subject to many amendments over the years. In fact, in 1997, the original Section 28 was replaced with a new one, after taking into consideration the recommendations given in the 97th Report of the Law Commission of India. The changes brought by the 1997 amendment caused much displeasure amongst the banking and financial institutions, as the amendment restricted them from including clauses, for example in a bank guarantee (or similar agreement), which extinguish the rights of a party to bring a claim against them.

An attempt to resolve this was made in 2013, when, by the Banking Laws (Amendment) Act, 2012, Exception 3 to Section 28, was introduced as a saving clause for a guarantee agreement of a bank or a financial institution. But a relook at this 2013 amendment, though aimed at protecting banks and financial institutions, shows that instead of resolving the issues, it may add conditions which many banks and financial institutions should be worried about. This article aims to examine such issues and conditions in greater detail.

Rules of Limitation and Prescription

As per Section 28, agreements by which a party is restricted absolutely from enforcing his rights under or in respect of a contract [Section 28(a)], or which extinguish the rights of a party from any liability in respect of a contract [Section 28(b)], are void to that extent.

Prior to the 1997 amendment, Section 28 only contained a provision holding those agreements void which restrict the rules of limitation [Section 28 (a)]. However, in 1997, the Section was amended to hold those agreements void which allowed parties to invent their own rules of prescription [Section 28 (b)]. Not only did this amendment seek to nullify the effect of various High Court and Supreme Court decisions (in which prescriptive clauses were held to be valid), the amendment also caused undue hardship to banking and financial institutions, which made prescriptive terms in contracts like bank guarantees, where the rights of a party to make a claim against the bank would extinguish at the end of a prescribed period.

Exception 3 to Section 28 was, therefore, introduced to safeguard banks and financial institutions. This Exception provided 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.

Thus, in effect, this Exception not only allowed banks and financial institutions to invent their own rules of prescription, but also allowed the banks from keeping their guarantee instruments open and valid till the expiry of period of limitation under the Indian Limitation Act, 1963. Thus, legally, banks and financial institutions could include prescriptive clauses in their guarantee instruments where the rights of a party to make a claim against the bank would be extinguished at the expiry of a time period, irrespective of the fact that such extinguishment of right was before the period prescribed in the Limitation Act.

The conundrum of minimum period

In the press release issued by the Press Information Bureau after the 2013 amendment, the Government justified the amendment as being brought pursuant to the recommendations of the Indian Banks’ Association (“IBA”), Reserve Bank of India and Industry Associations and “to bring finality to redemption of such guarantees”.

Howsoever noble the intention of the amendment may have been, it seems to have caused an unintended problem. A close reading of the Exception shows that though it allows the extinguishment of rights of a party to make a claim under a bank guarantee at the end of a specified period, it also states that such specified period should not be less than one year from the date of occurring or non-occurring of a specified event.

A plain reading of this would imply that every bank guarantee would have to be kept open for at least a year from when it is executed, and where the “specified event” (let us suppose such “specified event” is the breach of an agreement under which such bank guarantee has been given) occurs on the date on which the bank guarantee is made. Commercially, this seems unviable and impractical!

This time limit of one year was included in the 2013 amendment after considering recommendations made by the Andhyarujina Committee Report of 1999. The Indian Banks’ Association also endorsed this in the statement released by them in the “Review of the activities of the Association during 2004-05”. Surprisingly, the IBA as well as the framers of the amendment failed to envisage a situation where bank guarantees are to be given for a period of less than one year. In such a case, would such bank guarantee be void?

In practice, there may be contracts where the term of the contact is, for example, six months and a Performance Bank Guarantee is given for this period. Ideally, a party would not want to bear bank charges for keeping the bank guarantee alive for a period of one year where the contract itself has been performed in six months. In such a case, would extinguishment of rights of a party to make a claim against the bank after a period of six months be invalid as per Section 28?

Moreover, this period of one year is to be calculated “from the date of occurring or non-occurring of a specified event”. In case breach of the main contract is the “specified event”, and the breach happens on the last day of validity of the bank guarantee, in such a case, would the bank guarantee have to be kept alive for another one year? Exception 28, and its circuitous interpretation, seems to suggest so!

Need for another amendment?

The intent of Section 28 is to ensure that the rights and the remedies available to a party cannot be barred or extinguished by an agreement. However, despite its tumultuous amendment history, the impracticality of time limit created by Exception 3 may force the Government to re-think and bring another amendment to Section 28. If this is not done, an action brought against a bank for extinguishing rights of a party under a bank guarantee before a period of one year may allow the Courts to term such bank guarantees as void.

In the meantime, however, banks and financial institutions should protect themselves and ensure that their bank guarantees are so worded that they do not directly extinguish the right of a party, at least not before one year of a “specified event”. To an extent, the “notwithstanding clause” template released by the IBA in response to the 1997 amendment could be used by banks. This notwithstanding clause provided that the right of a party to make a claim on the bank would arise only if the claim is served on the bank within a certain period.

A liberal interpretation of this clause would show that it is neither prescriptive nor extinguishing any rights. This does not, however, provide a blanket safeguard to banks and financial institutions and the bank guarantees issued by them are always open to judicial scrutiny. Ideally, what is required is another legislative amendment to clarify Section 28 and make it more commercially viable. We just hope the legislature, in all its wisdom, brings such an amendment at the earliest!

[The authors are Executive Partner and Principal Associate, respectively, in Lakshmikumaran & Sridharan Attorneys, New Delhi]

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