Guarantees and Performance Bonds

Payment obligations under commercial contracts are often secured by means of guarantees issued by banks, which guarantee the performance of the payment obligation by the buyer. For instance, if A and B enter into a contract whereby A agrees to sell B a ship for the price of $50 million, B's bank may issue to a payment guarantee to A to secure the payment of this amount from B. In the alternative, the contractual arrangements between A, B and the bank may be such that the bank issues a performance bond to A. However, there is a fundamental difference in the nature of the obligation assumed by the bank in the two cases.

If the bank issues a guarantee, the contractual arrangement between the parties is trilateral, whereby the bank undertakes a secondary obligation to guarantee that B will perform its contractual obligations to A. Therefore, any defences available to B are also available to the bank, and A must prove that B has invalidly failed to perform its contractual obligations. In such a case, depending on the nature of the guarantee, A can have recourse against the bank: (a) in damages, for a breach of the bank's obligation to ensure B's performance; or (b) requiring it to step into B's shoes and pay the amount owed by B on the satisfaction of any notice or demand requirements contained in the guarantee.

To the contrary, when the bank issues a performance bond, there are two independent bilateral arrangements in place: one between A and B, and the other between A and the bank. By virtue of the performance bond, the bank is obliged to pay A the secured amount if certain notice/demand conditions are satisfied, irrespective of whether any payment is due from B to A under the primary contractual arrangement.

Therefore, whether a given transaction involves a guarantee or a performance bond depends on the relative bargaining strengths of the parties, and the difference assumes great significance in cases where there is a dispute between A and B as to the existence of the primary payment obligation. It was one such case which was recently considered by the English High Court in Wuhan Guoyu v Emporiki Bank of Greece [2012] EWHC 1715 (Comm).

The facts of the case involved a shipbuilding contract, under which the buyer was to pay the consideration amount in instalments on the completion of certain activities in relation to the ship. The payment of these instalments was secured by means of a 'Payment Guarantee' which was Exhibit B to the primary contract, and was issued by the buyer's financing bank. The seller's bank had also issued a 'Refund Guarantee' to the buyer (Exhibit A), to secure repayment of the consideration amounts if the contract was rescinded or cancelled in accordance with its terms. Both these documents were referred to in the contract as 'irrevocable letters of guarantee'.

The buyer paid the first instalment, following which there was a dispute between the buyer and the seller as to whether the second instalment was due. The seller sought payment of the instalment from the bank notwithstanding this underlying dispute, thus calling upon the High Court to decide whether the 'Payment Guarantee' was a guarantee in the true sense, or in fact a performance a bond.

The Court began by clarifying that the question is one of construing the contract, and while previous cases could provide guidance as to the relevance of several factors, the identity of each document depended on its particular language and context. Based on a very useful survey of authorities (contained in paragraphs 32-54 of the report), the Court culled out the following principles which are relevant to determining the identity of a particular document:

• The labelling of the document as a 'guarantee' is not determinative, and neither is an elaboration of the commercial purpose of the document (e.g. 'to indemnify …')
• An undertaking to pay the on 'first written demand' and a provision that such demand is the only condition for payment indicates that the document is a performance bond
• The reasoning must start with the wording of the contract and the Court must not bring any pre-conceived notions to interpreting the document
• A key question is whether the condition for payment is the presentation of documents which assert certain facts, or the actual existence of the facts asserted
• A clause stating that the presentation of certain documents shall be 'conclusive evidence' indicates that the document may be a performance bond
• The issuance of the document in a banking context is material. In non-banking contexts, there is a strong presumption against it being a performance bond
• If the transaction is cross-jurisdictional, it may suggest that the parties would prefer to avoid a detailed proving of the merits of the underlying claim (and hence provide a performance bond)

On a detailed consideration of these factors, the Court concluded that the document in question was a guarantee and not a performance bond. While a detailed discussion of the conclusions would be out of place here, some interesting points emerging from the reasoning are:

• The fact that both the Payment Guarantee and the Refund Guarantee were referred to as 'irrevocable letters of guarantee' suggested that they had the same legal effect. The Refund Guarantee was undoubtedly a guarantee in legal terms (the contrary view would be commercially unreasonable), and therefore the Payment Guarantee was also likely a guarantee.
• The reference to the bank as the 'primary obligor' was not conclusive, since it begged the question of what the bank's primary obligation was. If the effect of the document was to create an obligation to guarantee and not to pay, then the reference to 'primary obligor' was not material.
• The bank's obligation arose if the buyer breached its obligations and then the seller issued a demand, which suggested that the breach a necessary precondition to payment. Although there is authority indicating that the use of such language ('if … when'; 'then') was not conclusive, when read in the context, the language here suggested that payment was condition on more than just the presentation of a demand notice.
• The fact that the bank was financing the buyer provided some commercial context to the bank's likely obligations. It was not a pure banking relationship, and the bank, in its capacity as the buyer's financer, was also likely to have an interest in the performance of the primary contract. While this was not a "particularly sure guide to the correct interpretation", it nevertheless refuted the seller's argument that the bank had no interest in the merits of the underlying transaction.

In sum, the decision provides a useful summary of the applicable principles in distinguishing between guarantees and performance bonds, and also is an example of their application to an interesting but not unusual set of facts.

Legality of Sale of NPAs Between Banks

Last week, the Supreme Court issued its ruling on whether non-performing assets/loans (NPAs) can be transferred between banks without the concurrence of the borrowers.

The case involved a transfer of NPAs (relating to the borrower, APS Star Industries Ltd.) from ICICI Bank to Kotak Mahindra Bank. The borrower was in liquidation. When the assignee Kotak Mahindra Bank sought before the Company Court to substitute its name as lender, the borrower objected on several grounds (including improper payment of stamp duty). The Company Court refused to recognize the assignee on account of improper presentation of the document of transfer. On appeal, a Division Bench of the Gujarat High Court upheld the Company Court’s decision, but on a different ground, i.e. that the assignment of debts by banks is not an activity permissible under the Banking Regulation Act, 1949 (BR Act).

On further appeal, the Supreme Court considered two issues:

1. Whether inter se transfer of debts between banks is an activity permissible under the BR Act?

2. Whether the assignee bank (Kotak Mahindra) is entitled to substitution in place of the original lender / assignor (ICICI Bank) in proceedings relating to liquidation of the borrower company?

On the first issue, the Court examined in detail the scheme and provisions of the BR Act and concluded that assignment of NPAs is within the purview of a bank’s permitted business activity:

- The Reserve Bank of India (RBI) can lay down parameters enabling banking companies to expand its business;

- Apart from accepting deposits and lending, the BR Act leaves ample scope for banks to venture into new businesses being subject to the control of RBI;

- Section 6(1)(n) of the BR Act “enables a banking company to do all things that are incidental or conducive to promotion or advancement of the business of the company”;

- The Guidelines on Purchase / Sale of Non Performing Financial Assets dated 13 July 2005 issued by the RBI allow banks to deal inter se in NPAs, which makes the activity a bona fide business. After going into the rationale for declaring a loan as an NPA, the court goes on to hold that the Guidelines “have been issued as a “restructuring measure” in order to avoid setbacks in the banking system”.

On the second issue, the Court distinguished between the transfer of (i) mere rights, which can be effected without concurrence of the borrower, and (ii) obligations, which requires a novation of the contract (thereby necessitating concurrence of the borrower):

- In the present case, it was found that the assignor is only transferring the rights under contract (which represent its assets);

- There is no transfer of obligations of the assignor towards the assignee, as they continue to be borne by the assignor;

- Hence the deed of assignment transferring the NPAs from ICICI Bank to Kotak Mahindra Bank is not unsustainable in law.

In addition, the court also ruled that the provisions of the SARFAESI Act, 2002 are not applicable to the case because that relates to a transfer of financial assets from banks to specific types of financial vehicles (such as securitization companies and asset reconstruction companies).

With its ruling on the limited questions before it, the Supreme Court remitted the matter to the Gujarat High Court for consideration of the other issues.

Ajay Shah’s Blog has a nice summary and analysis of the judgment, while this discussion on CNBC-TV18 also examines the impact of the decision on the securitization markets. As these demonstrate, in view of the Supreme Court’s limited mandate, it can be said to have merely covered the tip of the iceberg when it comes to the plethora of issues that arise from securitization of financial assets. More issues can be expected to be addressed through the future course the matter is likely to take.

Although securitization has acquired popularity in the Indian markets for over a decade now, the legal regime has been founded on age-old principles of law laid down in legislation such as the Transfer of Property Act, 1882, and the law relating to stamp duty and registration. While these laws do provide solid fundamentals in terms of legal concepts within which modern financial practices such as securitization can be worked, the judiciary has been presented with limited circumstances to interpret these legislation in the modern context. The opportunity that the current batch of cases presents the judiciary may well help clear the air on some of the issues.

Finally, when the SARFAESI Act was enacted in 2002, there was great expectation that such a law would create a modern framework to carry out securitization transactions. However, with its limited application (recognized by the Supreme Court in this latest decision), one cannot afford to turn a blind eye towards pre-existing law on transfer of financial assets.

Security for External Commercial Borrowings: Liberalised Regime

The Reserve Bank of India (RBI) has announced a series of measures to liberalise the regime for Indian borrowers to create security in favour of lenders in case of external commercial borrowings (ECBs). Now, borrowers are only required to obtain the ‘no-objection’ from the authorized dealers (AD) rather than to obtain the prior approval of the RBI for certain types of security (as was the practice until now).

The relevant Circular issued by the RBI yesterday notes:

“3. As a measure of rationalization of the existing procedures, it has been decided to allow AD Category – I banks to convey ‘no objection’ under the Foreign Exchange Management Act (FEMA), 1999 for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees in favour of overseas lender / security trustee, to secure the ECB to be raised by the borrower.

4. Before according ‘no objection’ under FEMA, 1999, AD Category – I banks may ensure and satisfy themselves that (i) the underlying ECB is strictly in compliance with the extant ECB guidelines, (ii) there exists a security clause in the Loan Agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee, (iii) the loan agreement has been signed by both the lender and the borrowers, and (iv) the borrower has obtained Loan Registratoin Number (LRN) from the Reserve Bank.”

The Impending FCCB Conundrum

Foreign currency convertible bonds (FCCBs) have been issued by Indian companies, whereby investors have the option to convert these debt instruments into equity. Such conversion would normally occur when the market price of equity shares at the time of conversion is higher than the conversion price. But, with the markets now moving in the wrong direction, it is unlikely that the FCCB holders will exercise their conversion options. That means they will likely redeem the FCCBs, which partake the nature of repayment of debt. An event less expected by Indian borrowers, this would not only impose huge financial burden on Indian borrowers (who have to raise the cash to meet their obligations), but could also result in various accounting and other related issues.

These aspects have been covered in detail in this column by Rajrishi Singhal in the Economic Times.

(For more on FCCBs, and how they are different from Foreign Currency Exchangeable Bonds (FCEBs), please see this earlier post)

Update – July 10, 2008: See also this column in the Hindu Business Line

External Commercial Borrowings Liberalised

In August 2007, the Government tightened its policies on external commercial borrowings (ECBs). However, subsequently, in view of the changed economic scenario in the country, it has decided to liberalise its policies on ECBs. In a circular issued yesterday, the Reserve Bank of India (RBI) now allows borrowers in the infrastructure sector to borrow up to US$ 100 million for permissible end uses under the approval route. In case of other borrowers, the existing limit of US$ 20 million for permissible end uses under the approval route has been enhanced to US$ 50 million. The allowable interest rates have also been increased.

This move would allow better scope Indian corporate to raise foreign currency borrowings as ECBs were largely curtailed since August 2007 until now. Livemint has a brief report on the possible effects of this liberalization.

Update – June 3, 2008: By way of another notification issued on June 2, 2008, the RBI has allowed borrowers in the services sector, viz. hotels, hospitals and software companies to avail of ECBs up to US$ 100 million, per financial year, for the purposes of import of capital goods under the automatic route.