Contract of Guarantee

This article aims to analyze the contract of guarantee and its enforceability in Pakistan. It also sheds light on the dispute between a principal debtor and creditor which leads to the issue of encashment of bank guarantees or performance guarantees. Moreover, it demonstrates established principles pertaining to the contract of guarantee within the judicial sphere.

Ordinarily, there are two parties to a contract where one party is willing to give something for a consideration to another party with consensus ad idem. But unlike simple contracts, a contract of guarantee is a tripartite contract which involves three parties namely, surety, principal debtor and the creditor. In a contract of guarantee, there are two contracts:

  • the Principal Contract between the principal debtor and the creditor; and
  • the Secondary Contract between the creditor and the surety.

It has been established that the contract of guarantee is not a contract that is collateral to the contract of the principal debtor, but is an independent contract.

Liability of surety is secondary and arises when a principal debtor fails to perform commitments under the Principal Contract. It can be said that surety only plays a third-party role to confirm, support or supplement an obligation between the principal debtor and creditor. Surety can also be described as an assurance to the creditor that if the principal debtor fails to pay, the guarantor or surety would repay the debt.[1]

The Supreme Court of Pakistan in Shipyard K Damen International v. Karachi Shipyard and Engineering Works Ltd,[2] relying on Halsbury’s Laws of England, Fourth Edition, Volume 2, page 101, defined a contract of guarantee in the following words:

“A guarantee is an accessory contract whereby the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person whose primary liability to the promise must exist or to be contemplated.”

Accordingly, under the contract of guarantee, one person contracts with another to pay some debt or perform some act or duty owed by the principal debtor who nevertheless remains primarily liable for such payment or performance. Enforcement of the contract of guarantee depends upon the default of the principal debtor.

There is no special law applicable to independent guarantees in Pakistan. However, Chapter VIII of the Contract Act, 1872 deals with the contract of guarantee. Section 126 reads:

“A contract of guarantee is a contract to perform the promise, or discharge the liability of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’; and the person to whom the guarantee is given is called the ‘creditor.’ A guarantee may be either oral or written.”

The following essential ingredients are indispensable for a contract to fall under Section 126 of the Contract Act:

  • dedicated commitment;
  • absolute undertaking;
  • unambiguous assurance;
  • unconditional willingness;
  • definite certainty;
  • compliance without objection;
  • sacred obligation; and
  • defined responsibility[3] on behalf of the surety to comply henceforth with the guarantee on failure of the principal debtor.

It is clear that a guarantee once given cannot be avoided, except on grounds of fraud or misrepresentation.

The important role that a contract of guarantee plays has been described in the case of Doha Bank Limited v. Pangrio Sugar Mills Limited.[4] According to Para no. 23 of the judgment:

“Indeed, all secured financial dealings and business transactions such as execution of a bank guarantee etc. are based on a commercial morality and mutual trust and confidence which should not be shaken by taking a turn much against the terms of guarantee itself. The bank guarantee is a tripartite contract of guarantee between the bank, the beneficiary and the person at whose instance the bank issues such guarantees; the banker is not supposed to question the nature of accounts or liabilities between two parties… that in order to restrain the operation of, inter alia, a bank guarantee there should be a serious dispute and there should be a good prima facie case of fraud, and special equities in the form of preventing the irretrievable injustice otherwise the very purpose of Bank Guarantees would be negative and the fabric of trading operations would be jeopardized.”

It has been long established that the contract of guarantee, in whatever form, is an independent contract, the performance of which will not be contingent upon the principal contract (between the creditor and the principal debtor), unless the contract provides otherwise. The question of whether a contract of guarantee is contingent upon the principal/underlying contract has been dealt with in the case of Husein Industries LTD. Through authorized representative v. Sui Southern Gas Company LTD through Managing Director and 2 others[5] in which emphasis has been laid on the principle that a contract of guarantee is an independent contract between the surety and the creditor. The relevant portion of the judgment is reproduced below:

“It is settled law that a bank guarantee, a ‘guarantee’ within the meaning of section 126 of the Contract Act, 1872, is an independent contract between the surety (bank) and creditor (beneficiary of the guarantee), and as such the bank guarantee is to be construed on its own terms independent of the underlying contract between the creditor and the principal debtor, and irrespective of claims pending inter se the creditor and principal debtor. Accordingly, the nature and language of that independent contract, namely the bank guarantee, assume great importance.”

The liability of the surety is co-extensive with that of the principal debtor, unless otherwise provided by the contract.[6] Simply put, where in a contract of guarantee, no provision, either express or implied, has been made between the parties to the effect that the liability of the surety will not be co-extensive with that of the principal debtor, the liability of the surety arises immediately on the failure of the principal debtors to perform their obligation.

The essence of a contract of guarantee is that the guarantor agrees to discharge the liability of the debtor if the latter fails to perform his obligation. The liability of the guarantor has to be construed in accordance with the terms and conditions of the guarantee. Normally, the liability of the guarantor depends on the language of the guarantee, as has been held in the case titled United Bank Limited v. Pakistan Industrial Credit and Investment Corporation Ltd and another in the following words:

“The liability of the guarantor depends on the language of the guarantee. The terms of the guarantee would demonstrate how far the guarantor has bound itself to indemnify the creditor.”

A recent case, Adamjee Polycraft Limited v. National Investment Trust Limited[7] is also important in determining the liability of surety in a contract of guarantee. According to this case, the liability of surety is always considered to be co-extensive with that of the principal debtor while guarantors are jointly and severally liable to pay the outstanding amount to the creditor unless the contents of the contract provide otherwise. The case also explains that liability of the surety immediately arises after failure on part of the principal debtor to pay out the legally due liability against him while the creditor in this regard is legally entitled to proceed in case of default of principal debtor against the surety/guarantee, as per the terms of the contract. Determining the liabilities of the guarantors/sureties’ technicalities, unless insurmountable, may not be taken into consideration.

It is important to bear in mind that if the liability of the surety arises only upon the occurrence of a contingency which has been agreed to in the contract of guarantee, then the surety is not liable unless that contingency has actually happened.[8]

The guarantee provided by the surety to the creditor is either in the form of a bank guarantee or performance guarantee. In the former case, a bank promises that the liabilities of a principal debtor will be met if he does not fulfil the contractual obligation. A performance guarantee kicks in if services or goods are not provided to the creditor by the principal debtor as per the covenants mentioned in the contract.

A contract of guarantee may be unconditional or conditional. The guarantee is said to be absolute when the guarantor has agreed to discharge his liability unconditionally or irrespective of a dispute between the parties. It has been held in a recent judgment of the Supreme Court in Atif Mehmood Kiyani and another v. Messrs Sukh Chayn Private Limited, Royal Plaza, Blue Area, Islamabad and another[9] that,

 “A bank or insurance guarantee that contains a categorical undertaking and impose absolute obligation on the guarantor, i.e., the bank or the insurance company, to pay the agreed amount, irrespective of any dispute which may arise between the parties regarding breach of the contract for which performance the one party furnishes the guarantee to the other, is an independent contract; therefore, the guarantor must discharge its obligations under the contract of guarantee as per the terms thereof, independent of the dispute as to performance of the primary contract between the parties.”

The absoluteness of a contract comes from the language of a contract of guarantee. If a surety agrees unconditionally or irrevocably to discharge its obligation on demand by the creditor that the principal debtor has failed to perform his obligation under the underlying contract, then it is the duty of the surety to pay the amount guaranteed by the principal debtor to the creditor irrespective of the fact that a dispute has arisen between the parties. Para No. 5 of the judgment in Messrs National Construction LTD v. Aiwan-e-Iqbal Authority[10] is crucial in understanding the obligation of guarantors:

“…the bank guarantees furnished by the appellants contain categorical undertaking and impose absolute obligations on the bank to pay the amount, irrespective of any dispute which may arise between the parties regarding the breach of contract. In our view the Courts must give effect to the covenants of the bank guarantee, the performance guarantees, for the smooth performance of the contracts. Those guarantees are independent contracts and the bank authorities must construe them, independent of the primary contracts.”

On the contrary, a conditional guarantee may be dependent on the performance of a condition by a party within the terms of the guarantee. If, under a contract of guarantee, a condition has been imposed as to its enforcement, then the enforcement of the contract of guarantee will depend upon that condition. The contract of guarantee is conditional in the sense that sufficient proof has to be shown by the creditor regarding default of the principal debtor and damage suffered by the creditor before the surety is obliged to make any payment under the bond. A recent judgment of the Islamabad High Court in Montage Design Build v. The Republic of Tajikistan[11] is noteworthy in understanding the difference between a conditional and unconditional guarantee. The relevant portion of the judgment is reproduced below:

“Depending on the intention of the parties, a Bank or Insurance guarantee may be either ‘conditional’ or ‘unconditional. A conditional guarantee can only be invoked on fulfilment of the condition(s) stipulated therein e.g., proof of a breach or default. On the other hand, in case of an ‘unconditional’ guarantee, the guarantor i.e., the Bank or an Insurance Company is under an obligation to honour its commitment by making the payment on demand, regardless of a dispute between the parties arising out of or connected with the underlying agreement/contract.”

As a result, guarantees, conditional or unconditional, will primarily depend on the intention of the parties to a contact of guarantee.

A dispute arises between the creditor, principal debtor and surety pertaining to the encashment of a guarantee usually when a principal debtor has sought an injunction from the courts restraining the surety from encashing a performance guarantee on the premise that the creditor has breached the Principal/Underlying Contract. In this regard, general practice demonstrates that the courts seem reluctant to grant an injunction when the surety undertakes, unconditionally or categorically, to encash a performance bond upon failure on part of the principal debtor to perform the agreed act. As discussed above, the language of the contract of guarantee plays a crucial role in understanding the liability of the surety. The non-interference of courts while dealing with an unconditional guarantee has been elaborated in the aforementioned judgment, the relevant portion of which is reproduced below:

“It is, therefore, obvious that a Bank or insurance Guarantee is an independent contract and its autonomy is to be protected. As a rule, courts do not interfere with the autonomy of an unconditional and irrevocable guarantee, except in certain exceptional circumstances. The two exceptional circumstances are, fraud and irretrievable injustice or injury. It is not sufficient to raise or allege the plea of fraud, rather a prima facie case has to be made out to demonstrate an established fraud, both of the fact and the knowledge of the Bank or Insurance Company.”

According to this case, courts ought not to interfere with the obligations undertaken by a bank or insurance company under an irrevocable or unconditional bank guarantee or performance bond. The only two exceptions that can be made to the established principle are when either a fraud has been committed by a principal debtor of which the bank has prior knowledge or when there is an apprehension of irretrievable injustice or injury which may be faced by the principal debtor upon the encashment of a bank/performance guarantee. The courts can only use their discretionary powers to grant injunction if the principal debtor has established a case.

The Supreme Court of India, in numerous judgments, has also addressed the issue of granting an injunctive order relating to the encashment of guarantees. In U.P. Cooperation Federation Ltd v. Sindh Consultants and Engineers (P) Ltd[12] the court observed the following:

“On the basis of these principles I reiterate that commitments of banks must be honoured free from interference by the courts. Otherwise, trust in commerce internal or international would be irreparably damaged. It is only in exceptional cases that is to say in case of fraud or in case of irretrievable injustice be done, the court should interfere.”

The courts can only grant an injunction on the grounds that its refusal will cause irreparable loss or harm to be suffered by the principal debtor since an adequate remedy to compensate for injuries may not available to the principal debtor.

The criteria set forth regarding a plea of fraud in the context of granting an injunction has been aptly articulated in the opinion of Sir John Donaldson, M.R in Bolivinter Oil SA v. Chase Manhattan Bank and another[13] in the following words:

“The wholly exceptional case where an injunction may be granted is where it is proved that the bank knows that any demand for payment already made or which may thereafter be made will clearly be fraudulent. But the evidence must clear, both as to the fact of fraud and as to the bank’s knowledge. It would certainly not normally be sufficient that this rests on the uncorroborated statement of the customer, for irreparable damage can be done to a bank’s credit in the relatively brief time which must elapse between the granting of an injunction and an application by the bank to have it discharged.”

Accordingly, for the principal debtor to stay the encashment of guarantees in whatever form, the principal debtor has to establish the case in terms of balance of convenience and irreparable loss coupled with the fraud committed by the creditor of which the bank has prior notice. It is only then, in exceptional cases, that the court can use its discretion to restrain the surety from encashing bank or performance guarantees. For Pakistan to prosper, the courts must ensure, among other things, that the contract pertaining to guarantees be enforced in letter and spirit and as per the language of the contract so that the trust of foreign investment companies as well as local companies is maintained while they invest their money in Pakistan.


References

[1] Gold Link Insurance Company Ltd V. Petroleum (Special) Trust Fund (2008) LPELR-4211(CA)
[2] PLD 2003 Supreme Court 191
[3] Ibid
[4] 2003 CLD 661
[5] PLD 2020 Sindh 551
[6] Section 128 of the Contract Act, 1872
[7] 2017 CLD 380 Karachi
[8] AIR 1948 Nag.123, ILR 1947 Nag 643
[9] 2021 SCMR 1446, Para No. 5
[10] PLD 1994 Supreme Court 311, Para 5
[11] 2005 CLD 8 [Islamabad]
[12] (1998) 1 Supreme Court cases 174
[13] (1984) 1 A11 ER 351

The views expressed in this article are those of the author and do not necessarily represent the views of CourtingTheLaw.com or any other organization with which he might be associated.

Muhammad Usman Jamil

Author: Muhammad Usman Jamil

The writer is a lawyer based in Lahore and currently serves as an associate at Surridge and Beecheno. He has remained a core member of a law school mooting team and participated in numerous international and national moot court competitions including the Philip C. Jessup International Law Moot Court Competition.

2 comments

Leave a Reply

*

This site uses Akismet to reduce spam. Learn how your comment data is processed.