The Latest Blow For Infrastructure Projects — A Shortage Of Bank Guarantees

Infrastructure projects, already struggling with a host of issues ranging from availability of finance to execution delays, have another problem on their hands.

Lenders who, until about a year ago, were willing to provide bank guarantees for projects under implementation, have slowly pulled away from the product since the start of this year.

According to three private sector bankers, lenders have been staying away from issuing bank guarantees to companies in the engineering, procurement and construction sector due to uncertainty about the period over which claims can be raised against the guarantee issued. The bankers spoke on condition of anonymity.

The inability to secure guarantees, in turn, is hurting the ability of EPC firms to secure projects, adding to the stress in the sector.

The Source Of The Trouble

Typically when a bank issues a guarantee to a borrower, it sets a ‘claim period’ after the guarantee ends. Any invocation of the guarantee must happen before the claim period expires. If a claim is raised within this period and the bank refuses to honour the guarantee, the counter-party can litigate against such a decision.

Confusion over the claim period of a bank guarantee started with an advisory from the Indian Banks’ Association in December 2018. In its advisory, the IBA said that banks could include a 12-month claim period, after the guarantee period ends, to avoid litigation in courts.

Earlier, banks used to set a three-month claim period.

If a bank guarantee is issued with a claim period of one year on top of the guarantee period, then such guarantee will have the benefit of Exception 3 to Section 28 of the Indian Contract Act. In other words, the bank issuing such guarantee will not be liable under such guarantee to the beneficiary after the expiry of such claim period of one year, regardless of period of limitation under the Limitation Act, 1963.

IBA Advisory, December 2018

BloombergQuint has reviewed a copy of the IBA advisory.

The advisory, itself, came in response to a 2016 judgment by the Supreme Court. It followed requests by bankers to the IBA to standardise industry practice with regards to the claim period set for bank guarantees issued.

The 2016 case was originally filed by the government against IndusInd Bank in April 1999. It pertained to guarantees issued by the bank to three cotton exporters in 1997, where the government invoked the guarantees after the three-month claim period on them ended.

In September 2016, a two-judge bench of the apex court passed a judgment stating that under the amended Indian Contract Law, IndusInd Bank would have had to pay out the liability. According to the amended act, if a guarantee has a claim period of one year and above, then any claim raised beyond that period would not need to be paid out.

However, since the Indian Contract Law was amended in 2013 and the IndusInd Bank guarantees were issued much earlier, the bank won the case and was not required to pay out the liability.

It may only be noticed, in passing, that Parliament has to a large extent redressed any grievance that may arise qua bank guarantees in particular, by adding an exception (iii) by an amendment made to Section 28 in 2012 with effect from 18.1.2013. Since we are not directly concerned with this amendment, suffice it to say 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.

Supreme Court judgement in Union of India v/s IndusInd Bank case, September 2016

Confusion Reigns

While IndusInd escaped any liability, confusion has reigned since in the industry, magnified by the IBA’s advisory.

Ajay Shaw, partner at DSK Legal, said the confusion stems from an interpretation of the judgment. According to Shaw’s understanding of the Supreme Court judgment, if a bank issues a guarantee wherein the contract clearly defines the period of eligible claims as one year, they would be in the clear.

There are other practical problems beyond the interpretation.

A bank guarantee cannot be extinguished till the issuer receives the physical guarantee back, the private sector bankers quoted above said. Government agencies, which act as counterparties, often tend to delay this beyond the claim period and then raise a claim. If the banks cite an expired claim period, these government agencies promptly approach the court and seek legal intervention, the bankers said.

It is easier for private banks to not issue bank guarantees, than work through a tedious legal battle with the government over the validity of the claim, said one of the bankers quoted above.

The amount involved in the guarantee also does not earn any large income, apart from the commission that the banks charge for issuing it. As a result, private lenders are preferring to stay away from the business.

Adding To The Pain

According to Vish Iyer, a management consultant who works with corporate borrowers, the reluctance to issue bank guarantees has made it tougher for EPC companies to do business

Since the IBA released its advisory, even those banks that are willing to issue guarantees have raised the claim period to 12 months from three months for many borrowers, which has resulted in the borrowers having to pay higher commissions to banks. For example, to get a two-year guarantee from a bank, the borrower would have earlier had to pay commissions for 27 months. Now that period has been extended, the commissions needs to be paid for 36-months, which adds to the cost for the borrower.

EPC companies, which are already reeling under stress are finding this cost excessive, said Iyer.

According to the Reserve Bank of India’s Trends and Progress In Banking report, private banks had issued guarantees worth Rs 3.84 lakh crore as of March 2018, as compared with Rs 3.4 lakh crore a year ago. For three consecutive financial years before 2016-17, fresh issue of bank guarantees have remained flat at around Rs 3.2 lakh crore, previous reports of the RBI showed. Data for 2018-19 and beyond is not available.