A 6-minute read by Manasvini Vyas, an NLU-O graduate currently practicing in Mumbai
On 28 July 2021, the Delhi High Court in the case of Larsen & Toubro Limited vs. Punjab National Bank passed a landmark ruling clarifying the scope of exception 3 of section 28 of the Indian Contract Act 1872 (ICA). The order passed by a Single Judge Bench has set aside the circulars issued by the Indian Banking Association (IBA) that recommended an unalterable claim period of 12 months for bank guarantees.
Before delving further into the judgment, it is imperative to analyse the background against which the judgment holds significance.
Bank Guarantees (BG) are independent contracts that confer upon the beneficiary the right to claim performance from the bank in case of default by the principal borrower. On default, the beneficiary can invoke the guarantee by making a claim within the lifetime of the BG i.e. the “validity period”. This period is mutually determined by the creditor and the principal debtor and it expires on a decided date. Often, a BG provides for an additional grace period over and above the validity period for making a claim before the bank, which is known as the “claim period”. Stipulating a claim period is not a mandatory requirement and inclusion of the same depends solely on the discretion of the contracting parties. If the bank defaults in honouring its obligations, the beneficiary is entitled to approach the court of law and the period within which the beneficiary is permitted to enforce their rights from the date of default is called the “enforcement period”.
The enforcement period is prescribed under the Limitation Act 1963 (Limitation Act) and any agreement that limits the time within which a party may enforce its rights is hit by section 28 of the ICA. According to the provision, an agreement is void
- if it absolutely restricts a party from enforcing their rights under a contract or if it limits the time within which a party can enforce their contractual rights, or
- if it extinguishes the contractual rights of a party or it discharges a party from any contractual liability on the expiry of a prescribed period such that the rights cannot be enforced beyond it.
exception 3 appended to the provision states that if a contract for bank guarantee stipulates a term for extinguishment of rights or discharge of liability on the expiry of a given period, such a clause would not be void provided the said period is not less than one year from the date of the specified event.
History behind Exception 3
Prior to 1997, the courts created a distinction between ‘remedy’ and ‘right’ and an agreement which barred a remedy to sue beyond the prescribed time period was void under section 28 but an agreement which relinquished rights under the contract was held to be valid. The Law Commission, in its 97th Report dated 31 March 1984, observed that such a distinction was not practical and it gave a dominant party the power to limit the period of remedy by limiting the period of relinquishment of rights because if rights didn’t exist, the remedy would also be extinguished. Consequently, clause (b) was added to section 28.
As a result of this amendment, banks were concerned that they could no longer limit their obligations under the BGs and would be required to maintain their BGs for 30 years in case of government contracts and 3 years for private contracts pursuant to the Limitation Act. It was feared that the high cost of maintaining BGs would severely affect the banks’ ability to issue fresh guarantees. In order to assuage the concerns of the banking sector, exception 3 was added to section 28 by way of the Banking Law (Amendment) Act, 2012 (The 2013 Amendment) on the recommendations of Sh. T.R. Andhyarujina Committee.
The aftermath of the 2013 Amendment
Post the 2013 amendment, there was confusion whether the exception dealt with the claim period or the enforcement period. The IBA was of the view that the exception concerned the claim period and therefore it issued circulars recommending banks to stipulate a minimum claim period of 12 months in BGs. It was further believed that if the banks stipulate a claim period of less than 12 months, they will lose the benefit under exception 3 and the period specified under the Limitation Act would be applicable.
The confusion was further compounded after the Supreme Court’s observations in the case of Union of India & Anr. vs. M/s Indusind Bank Ltd. & Anr. (2016). Here, the Apex Court was concerned with an issue concerning section 28 as it stood before the 1997 amendment. In this case, the BG stipulated an invocation period of three months beyond the validity period, however, the BG was invoked after the expiry of three months. The Court held that since the clause did not provide for a time limit for lodging a claim before the court, the same will not be hit by section 28. Further, in its obiter, the Court noted that:
“… Stipulations like the present would pass muster after 2013 if the specified period is not less than one year from the date of occurring or non-occurring of a specified event for extinguishment or discharge of a party from liability.”
In this case, the Court was dealing with the time period for filing a claim with the bank and not the period for enforcing the guarantee before the courts. Therefore, when it mentioned “stipulations like the present would pass muster after 2013”, it seemed that the Court had interpreted exception 3 to mean that it provided for a mandatory claim period of minimum one year, thereby, worsening the already unsettled position with respect to exception 3.
Notably, a BG is a costly affair for the borrower as it has to maintain margin money/collateral security in support of the guarantee and has to pay commission charges at regular intervals. In such a scenario, a mandatory claim period of 12 months poses a financial burden on the borrower. Not only is the borrower forced into paying commissions for an additional period of one year, but funds locked in as margin money results in increasing the working capital requirements. A 12 month claim period would be even more commercially unviable in cases of short-term guarantees. For example, a BG with an original validity period of six months would be required to be kept open for a period of 18 months! In view of this, critics of exception 3 sought another amendment to section 28 to rectify the anomaly.
The decision in Larsen & Toubro Limited vs. Punjab National BankIn this case, L&T had filed a writ petition against PNB, IBA and the RBI before the Delhi High Court challenging their interpretation of exception 3. As noted above, IBA, in its circulars dated 10 February 2017 and 5 December 2018, had recommended a minimum claim period of 12 months for BGs. It was also stated that, in the absence of such a clause, limitation period as per the Limitation Act would be applicable.
L&T challenged this clause on the grounds that the extended claim period grossly affected its ability to sign new contracts and affected its fundamental right under Article 19(1)(g) of the Constitution of India to carry on business. It was also contended that a claim period is contractually agreed term between the borrower and the creditor and it may or may not be present in BGs. After scrutinising the tumultuous amendment history of section 28, the Court concluded that exception 3 provides for enforcement period and not a claim period. In coming to this conclusion, the Court observed that exception 3 curtails the limitation period within which the beneficiary can approach the appropriate forum for enforcing its rights. [SS3] The said provision, in no way, limits the period for filing a claim with the bank and the same is to be contractually agreed between the creditor and the debtor. Therefore, IBA’s interpretation that exception 3 dealt with a claim period does not hold ground. The Court also distinguished the obiter in the case of IndusInd with the present case and stated that “the judgement cannot be relied upon since the clauses in question dealt with the enforcement period i.e. curtailment of the limitation period and not the claim period of a bank guarantee”.
The 2013 amendment, though well intended, had thrown open a can of worms. BGs, which should ensure smooth flow of cash in business, were rendered ineffective by the weight of exception 3. The confusion surrounding the provision often stood in the way of claims under guarantees and severely affected the ease of doing business in India. In view of this, the judgment of Delhi High Court is a welcome move as the parties can now choose to incorporate a claim period that suits their needs, thereby, significantly bringing down the cost of maintaining the guarantee.
Shakoor Gany v. Hinde &Co (AIR 1932 Bom. 330); Kerala Electrical & Allied Engineering Co.Ltd. v. Canara Bank & Others (AIR 1980 Ker 151)