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Pledge

Section 172 of the Indian Contracts Act, 1872, defines pledge as bailment of goods as
security for payment of a debt or performance of a promise. The bank (pledgee) enters into
an explicit contract of pledge with the borrower (pledgor), under which the securities are
delivered to the bank. Such delivery of possession can be actual or constructive. Thus, a
pledge implies (a) bailment of goods, and (b) that the objective of bailment is to hold goods
as security for the payment of a debt or performance of a promise.
The primary advantage of pledge is that the goods are in the possession of the bank thus
preventing security dilution by the borrower. However, the bank would find holding goods of
various borrowers under pledge a cumbersome exercise, since the bank, as the pledgee, has
to take reasonable care of the goods and any loss has to be compensated to the borrower.
This entails higher monitoring and inspection costs for the bank.
The disadvantages cited above, along with the risks associated with the nature of the goods
under pledge, have rendered this type of security unpopular.
Hypothecation
This is one of the most popular methods of creating security interest for banks, and is
characteristic of the banking industry. Simply defined, hypothecation is the mortgage of or
charge on movable assets. The difficulties of holding the security in the banks custody are
removed in hypothecation, as the security interest is created without transferring the
possession of assets to the bank. In hypothecation, the security remains in the possession
of the borrower, and is charged in favor of the bank through documents executed by the
borrower. The documents contain a clause that obligates the borrower to give possession of
the goods to the bank on demand. Once possession over the goods is relinquished by the
borrower, hypothecation becomes similar to pledge.
Hypothecation differs from mortgage in two ways. First, mortgage is in respect of
immoveable assets. Second, mortgage implies transfer of interest in the property, while
hypothecation represents a mere obligation to repay the debt, without transfer of interest.
Though the cumbersome procedures under pledge are eliminated by the process of
hypothecation, the latter is more risky for the bank. Since the securities are in the
borrowers possession, the borrower can fail to give possession to the bank on demand, or
sell the securities without the banks knowledge, or borrow from another bank on the
strength of the same securities. In this respect, advances under hypothecation are as risky
as unsecured or clean advances.
The bank will therefore have to take the following precautions.
Credit limits with hypothecation should be sanctioned only after ascertaining the
creditworthiness and integrity of the borrower.
Only fully paid stocks will be hypothecated to the bank.
The bank has the unrestricted right of inspection of stocks and the related books
of the borrower. Such inspection should be done periodically to ensure that the
stocks under hypothecation provide adequate cushion for the advances. In the

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process, the bank should also eliminate slow moving and obsolete stocks while
estimating security coverage.
Stocks should be fully insured against fire and other risks as specified by the bank.
The borrower should submit a statement of stocks at the periodicity of specified by
the bank, based on which the drawing power under the credit facility will be
determined.
The borrower should also declare in the above statement that the borrower has
clear title to the stocks and that slow moving or obsolete stocks have been
excluded.
To prevent the borrower hypothecating the same stocks to another lender, the
borrower should display in a prominent place in his premises/factory/godown the
fact that the stocks are hypothecated to the credit disbursing bank.
If the borrower is a limited company incorporated under the Indian Companies Act,
the hypothecation should be registered with the Registrar of Companies under
Section 125 of the Companies Act, 1956, within 30 days of signing the documents.
To enforce its claim, it is essential for the bank to take possession of the
hypothecated property on its own or through the court. If the bank fails to take
possession and seeks a simple money decree from the court, then the bank is
presumed to have relinquished its right as hypothecatee.

Assignment
Borrowers assign actionable claims to the bank. Section 130 of the Transfer of Property
Act, 1882, permits an assignment to anyone except a judge, legal practitioner or an officer
of the court of justice. Section 3 of the act defines actionable claim as a claim to any debt,
other than a debt secured by mortgage of immovable property or by hypothecation or
pledge of movable property, or to any beneficial interest in movable property not in the
possession, either actual or constructive, of the claimant, which the civil courts recognize as
affording ground for relief, whether such debt or beneficial interest be existing, accruing,
conditional or contingent.
What are the actionable claims a borrower can assign to a bank?

Book debts
Money due from government departments or semi-government organizations
Life insurance policies

Assignment takes two forms (a) legal assignment, and (b) equitable assignment. A legal
assignment, which is in writing by the assignor, constitutes an absolute transfer of the
actionable claim. The assignor also informs his debtors of the assignees interest, which is
followed up by the assignee seeking confirmation from the debtors of the balances
assigned. In the case of equitable assignment, the above conditions are absent.
The bank gets absolute right over the funds assigned to it. Once the borrower assigns his
claims to the bank, other creditors of the borrower cannot get priority over the bank in the
realization of their dues from the assigned debts.

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Bankers Lien
This is one of the most important rights of the lending bank. Lien is the right of the bank
to retain the securities given by the borrower until the debt due is fully repaid.
Lien is of two kinds general lien and particular lien. Section 171 of the Indian Contracts
Act, 1972, confers the right of general lien on the bank, stated as Bankers may, in the
absence of a contract to the contrary, retain as a security for a general balance of account,
any goods bailed to them. In the case of a particular lien, specific securities are earmarked
for a specific debt. Once the debt is satisfied, the lien ceases to have effect. Example of a
particular lien is that marked on a fixed deposit against which a loan has been taken. Once
the loan is repaid, the fixed deposit becomes unencumbered.
The distinguishing features of the bankers right of general lien are:
The general lien can be exercised by the bank only on all the goods and securities
entrusted to it in its capacity as banker and in the absence of a contract
inconsistent with the right of lien. Circumstances under which the banker cannot
exercise the right of general lien are one of the following.
o The goods and securities have been entrusted to the banker as a trustee or
an agent of the customer.
o The goods and securities have been entrusted for a specific purpose.
A bankers lien is tantamount to an implied pledge. It confers upon the bank the
right to sell the goods and securities in case the borrower defaults. Since this right
resembles a pledge, the lien is called an implied pledge. The bank can sell the
securities to realize its dues after giving proper notice to the borrower.
The right of lien is conferred by the Indian Contract Act, and therefore, tacitly
understood by both banker and borrower. However, as a precaution, banks take a
letter of lien from the borrowers acknowledging the right of lien over securities for
existing as well as future loans.
The right of lien extends to securities and goods belonging solely to the borrower
and does not include securities owned jointly with others.
If no contract to the contrary exists, the bank can exercise its lien over the
securities remaining even after the loan, for which they were pledged, are repaid by
the borrower. The bank can also exercise its general lien in respect of a customers
obligation as a guarantor, and retain the security offered by him for a loan granted
on a personal basis, even after the loan has been fully repaid.
The following are the exceptions to the right of general lien.

Goods entrusted for safe custody: A customers documents, ornaments and other
valuables deposited with the bank for safe custody or as trustee, is a contract
inconsistent with the right of lien.
Securities earmarked for a specific purpose: Customers may sometimes entrust the
bank with shares or bills of exchange, meant for a specific purpose, say, for sale or
for honoring another liability, which contract is inconsistent with the right of lien.

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Sometimes, the bankers general lien may be replaced by a particular lien due to
certain special circumstances. The right of the banker is interpreted by what is
written by the banker in respect of the security rather than the printed word.
The bank has no lien over securities left with the bank by oversight or negligence
by the borrower.
The bank cannot exercise right of lien over securities given to the bank as
collateral for a loan, before such loan is actually granted or disbursed.
The banks right of lien extends only to securities and goods and not to money
deposited with the bank, or the borrowers credit balances. In the latter case, the
bank can exercise its rights of set off.

Mortgage
Section 58 of the Transfer of Property Act, 1882, defines a mortgage as the transfer of
interest in specific immovable property for the purpose of securing the payment of money
advanced or to be advanced by way of loan, on existing or future debt or the performance
of an engagement, which may give rise to a pecuniary liability.
The transferor of the property is the mortgagor. The entity to whom the transfer takes
place is the mortgagee. The document through which mortgage takes effect is the
mortgage deed.
From the definition, it follows that there are two important ingredients to a mortgage
(a) The transfer of interest in the mortgaged asset, and (b) the transfer is to create a
security for the amount paid or to be paid by the bank as loan.
The following points about mortgage are to be noted:

Transfer of interest differs from sale where there is a transfer of ownership.


Transfer of interest implies that only some rights of the owner are transferred,
and some are retained with the owner. For example, the right of redemption of
mortgaged property is retained with the owner. Once the amount due to the bank
(principal and interest) is repaid, the interest in the property is restored to the
owner. Similarly, the bank, as the mortgagee, does not become the absolute owner
due the transfer of interest, but only has the right to recover its dues from selling
the mortgaged property.
Every co-owner or joint owner of the property is entitled to mortgage his share of
the property.
The mortgaged property should be specific, and identified by features such as
location, size, boundaries, and distinguishing features.
Transfer of property in discharge of a debt is not a mortgage. Transfer of interest
in the property should be to secure an existing or future loan, or to ensure the
performance of an obligation which results in monetary obligation.
It is not necessary that the actual possession of the property be transferred to the
bank.

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The Transfer of Property Act recognizes six types of mortgages. They are as follows:

Simple Mortgage: In this type of mortgage, the bank is not in possession of the
property, but registration is mandatory irrespective of the amount of loan for which
the property is the security. Further, the bank is not entitled to any income out of
rents or profits of the mortgaged property, and the bank cannot sell the property
for recovering its dues without the permission of the court.
Mortgage by way of conditional sale: Banks do not prefer this type of mortgage
since there is no personal covenant for debt service, and the bank cannot look to
other assets of the mortgagor if there is a shortfall in security coverage. Under
this transaction, there is an ostensible (not real) sale of the mortgaged property to
the bank. If the debt is not repaid on due date, the bank can approach the court for
foreclosure, which implies causing the borrower to lose his right of redemption of
the property.
Usufructuary mortgage: Banks do not prefer this mode of mortgage, because, as in
the earlier case, there is no personal covenant on the borrower for debt service.
However, the bank is in legal possession of the property, by which it can receive
rent and profits from the property and appropriate them to the debt payable by the
borrower. If the borrower fails to redeem the property within 30 years through the
court, the bank becomes the absolute owner.
English mortgage: There is an absolute transfer of property to the bank, with the
provision the full repayment of the debt will entitle the borrower to redeem the
property. In case of security shortfall, the bank can look to the personal assets of
the borrower for full liquidation of its dues.
Equitable mortgage or mortgage by deposit of title deeds: This is by far the most
preferred type of mortgage by banks in India. Though this mortgage can be
effected only in the towns notified by the government, the territorial restriction is
applicable not to the location of the property, but where the title deeds are
delivered by the borrower to the bank. Title deeds are documents or instruments
that enable the owner of the property to enjoy the right to peaceful and absolute
possession of the property described in the documents. To create this mortgage,
the owner or joint owners of the property should personally deposit the original title
deeds with the bank at the notified centers, with the intention of creating a
security for the loan taken from the bank. There are no registration or stamp
charges involved and creation of the mortgage is least time consuming. The risks for
the bank could arise in respect of the authenticity of the documents, and the
borrowers standing in respect of the property. For example, if the borrower
mortgages the property for which he holds the original title deeds as trustee, the
claim of the beneficiary under trust will prevail over any equitable mortgage. The
bank should also conduct a physical inspection of the property and verify the
authenticity of factors like the boundaries, and market value before accepting the
security.
Anomalous mortgage: A mortgage that does not fall into any of the categories
discussed above is an anomalous mortgage. Such mortgages can also be combinations
of two types of mortgages, such as, a combination of simple and usufructuary
mortgages, depending on the custom and local usage.

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Charge
This is a word that can commonly be used to describe any form of security for debt,
whether the borrower is an individual, partnership firm, private or public limited company or
the government.
More specifically, charges registered under the Companies Act, 1956, include rigorous
provisions, and can generally be classified into a fixed charge and a floating charge.
A fixed charge (not to be confused with fixed assets) is a specific charge over
designated properties of the company. It gives the bank the right to sell the assets and
appropriate the sale value to the debt due from the company.
A floating charge (a) floats over the present and future property of the company
(including those under fixed charge) and is not attached to any specific asset or assets; (b)
does not restrict the company from selling the assets under charge or assigning them as
security for loans from other parties; and (c) could crystalline into a fixed charge upon the
happening of an event or contingency, such as liquidation of the company. It is important to
note that when the floating charge becomes fixed, it constitutes a charge on all properties
and assets belonging to the company, and gains seniority over all subsequent fixed charges,
unsecured creditors and money advanced to the liquidator.
It is, therefore, evident that, in order for the bank to be the senior creditor, it will have to
ensure seniority in claims over the banks assets as well. This purpose is achieved by
registering the banks charge with the Registrar of Companies under Section 125 of the
Companies Act, 1956. Such registration of charge will have to be done within 30 days of
execution of the loan agreement, and can be extended up to 60 days with a penal provision.
What are the consequences of non-registration of charge by the bank? In the event of the
company going into liquidation, the banks debt, otherwise ranked senior to all other
creditors claims, will now be treated as unsecured, and will rank low as an unsecured
creditor at the time of settlement of claims. It is to be noted that in spite of nonregistration of charge, the banks debt is recoverable and the securities are enforceable, as
long as the company is a going concern. The bank gets ranked as an unsecured creditor only
in case of company liquidation. A more serious consequence would be when a junior creditor
moves up to senior position at the time of enforcement of securities, merely by virtue of
having filed its charge with the registrar of companies before the senior creditor did. This
is in accordance with the provisions contained in Section 126, which clarifies that notice of
charge registered by the bank under Section 125 will be reckoned from the date of
registration and not from the date of creation of the charge. It is also mandatory that
every time there is a change in the loan agreement, a modification charge is filed with the
registrar of companies within 30 days of such modification taking effect.
The bank should also verify prior fixed and floating charges on the assets charged to it by
the borrowing company before specifying the security banking in its loan agreement. For
example, if the borrowing company had made a debenture issue, secured by floating charge
on all the companys assets, with a specific clause prohibiting creation of any charge senior

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to ranking on par with debenture holders, then the bank cannot gain a senior creditor
position in spite of registering its charge on time. If the bank still finds lending to this
company profitable, it should stipulate suitable covenants that would compensate for a likely
shortfall in security backing for its advances to the company.

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