Charge Creation_banking Notes

7/23/2019 Charge Creation_banking Notes

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PledgeSection 172 of the Indian Contracts Act, 1872, defines pledge as bailment of goods as

securit for pament of a debt or performance of a promise! "he ban# $pledgee% enters into

an e&plicit contract of pledge 'ith the borro'er $pledgor%, under 'hich the securities are

deli(ered to the ban#! Such deli(er of possession can be actual or constructi(e! "hus, a

pledge implies $a% bailment of goods, and $b% that the ob)ecti(e of bailment is to hold goodsas securit for the pament of a debt or performance of a promise!

"he primar ad(antage of pledge is that the goods are in the possession of the ban# thus

pre(enting securit dilution b the borro'er! *o'e(er, the ban# 'ould find holding goods of

(arious borro'ers under pledge a cumbersome e&ercise, since the ban#, as the pledgee, has

to ta#e reasonable care of the goods and an loss has to be compensated to the borro'er!

"his entails higher monitoring and inspection costs for the ban#!

"he disad(antages cited abo(e, along 'ith the ris#s associated 'ith the nature of the goods

under pledge, ha(e rendered this tpe of securit unpopular!

Hypothecation

"his is one of the most popular methods of creating securit interest for ban#s, and is

characteristic of the ban#ing industr! Simpl defined, hpothecation is the mortgage of or

charge on mo(able assets! "he difficulties of holding the securit in the ban#s custod are

remo(ed in hpothecation, as the securit interest is created 'ithout transferring the

possession of assets to the ban#! In hpothecation, the securit remains in the possession

of the borro'er, and is charged in fa(or of the ban# through documents e&ecuted b the

borro'er! "he documents contain a clause that obligates the borro'er to gi(e possession of

the goods to the ban# on demand! +nce possession o(er the goods is relinuished b the

borro'er, hpothecation becomes similar to pledge!

*pothecation differs from mortgage in t'o 'as! -irst, mortgage is in respect of

immo(eable assets! Second, mortgage implies transfer of interest in the propert, 'hile

hpothecation represents a mere obligation to repa the debt, 'ithout transfer of interest!

"hough the cumbersome procedures under pledge are eliminated b the process of

hpothecation, the latter is more ris# for the ban#! Since the securities are in the

borro'ers possession, the borro'er can fail to gi(e possession to the ban# on demand, or

sell the securities 'ithout the ban#s #no'ledge, or borro' from another ban# on the

strength of the same securities! In this respect, ad(ances under hpothecation are as ris#

as unsecured or clean ad(ances!

"he ban# 'ill therefore ha(e to ta#e the follo'ing precautions!

Credit limits 'ith hpothecation should be sanctioned onl after ascertaining the

credit'orthiness and integrit of the borro'er!

+nl full paid stoc#s 'ill be hpothecated to the ban#!

"he ban# has the unrestricted right of inspection of stoc#s and the related boo#s

of the borro'er! Such inspection should be done periodicall to ensure that the

stoc#s under hpothecation pro(ide adeuate cushion for the ad(ances! In the

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process, the ban# should also eliminate slo' mo(ing and obsolete stoc#s 'hile

estimating securit co(erage!

Stoc#s should be full insured against fire and other ris#s as specified b the ban#!

"he borro'er should submit a statement of stoc#s at the periodicit of specified b

the ban#, based on 'hich the dra'ing po'er under the credit facilit 'ill be

determined! "he borro'er should also declare in the abo(e statement that the borro'er has

clear title to the stoc#s and that slo' mo(ing or obsolete stoc#s ha(e been

e&cluded!

"o pre(ent the borro'er hpothecating the same stoc#s to another lender, the

borro'er should displa in a prominent place in his premises.factor.godo'n the

fact that the stoc#s are hpothecated to the credit disbursing ban#!

If the borro'er is a limited compan incorporated under the Indian Companies Act,

the hpothecation should be registered 'ith the /egistrar of Companies under

Section 120 of the Companies Act, 10, 'ithin 34 das of signing the documents!

"o enforce its claim, it is essential for the ban# to ta#e possession of the

hpothecated propert on its o'n or through the court! If the ban# fails to ta#epossession and see#s a simple mone decree from the court, then the ban# is

presumed to ha(e relinuished its right as hpothecatee!

Assignment

5orro'ers assign actionable claims to the ban#! Section 134 of the "ransfer of Propert

Act, 1882, permits an assignment to anone e&cept a )udge, legal practitioner or an officer

of the court of )ustice! Section 3 of the act defines actionable claim as a claim to an debt,

other than a debt secured b mortgage of immo(able propert or b hpothecation or

pledge of mo(able propert, or to an beneficial interest in mo(able propert not in the

possession, either actual or constructi(e, of the claimant, 'hich the ci(il courts recogni6e as

affording ground for relief, 'hether such debt or beneficial interest be e&isting, accruing,conditional or contingent!

hat are the actionable claims a borro'er can assign to a ban#

5oo# debts

9one due from go(ernment departments or semi:go(ernment organi6ations

;ife insurance policies

Assignment ta#es t'o forms < $a% legal assignment, and $b% euitable assignment! A legal

assignment, 'hich is in 'riting b the assignor, constitutes an absolute transfer of theactionable claim! "he assignor also informs his debtors of the assignees interest, 'hich is

follo'ed up b the assignee see#ing confirmation from the debtors of the balances

assigned! In the case of euitable assignment, the abo(e conditions are absent!

"he ban# gets absolute right o(er the funds assigned to it! +nce the borro'er assigns his

claims to the ban#, other creditors of the borro'er cannot get priorit o(er the ban# in the

reali6ation of their dues from the assigned debts!

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Bankers Lien

"his is one of the most important rights of the lending ban#! ;ien is the right of the ban#

to retain the securities gi(en b the borro'er until the debt due is full repaid!

;ien is of t'o #inds < general lien and particular lien! Section 171 of the Indian Contracts

Act, 172, confers the right of general lien on the ban#, stated as 5an#ers== ma, in theabsence of a contract to the contrar, retain as a securit for a general balance of account,

an goods bailed to them! In the case of a particular lien, specific securities are earmar#ed

for a specific debt! +nce the debt is satisfied, the lien ceases to ha(e effect! >&ample of a

particular lien is that mar#ed on a fi&ed deposit against 'hich a loan has been ta#en! +nce

the loan is repaid, the fi&ed deposit becomes unencumbered!

"he distinguishing features of the ban#ers right of general lien are?

"he general lien can be e&ercised b the ban# onl on all the goods and securities

entrusted to it in its capacit as @ban#er and in the absence of a contract

inconsistent 'ith the right of lien! Circumstances under 'hich the ban#er cannot

e&ercise the right of general lien are one of the follo'ing!o "he goods and securities ha(e been entrusted to the ban#er as a trustee or

an agent of the customer!

o "he goods and securities ha(e been entrusted for a specific purpose!

A ban#ers lien is tantamount to an implied pledge! It confers upon the ban# the

right to sell the goods and securities in case the borro'er defaults! Since this right

resembles a pledge, the lien is called an implied pledge! "he ban# can sell the

securities to reali6e its dues after gi(ing proper notice to the borro'er!

"he right of lien is conferred b the Indian Contract Act, and therefore, tacitl

understood b both ban#er and borro'er! *o'e(er, as a precaution, ban#s ta#e a

letter of lien from the borro'ers ac#no'ledging the right of lien o(er securities for

e&isting as 'ell as future loans! "he right of lien e&tends to securities and goods belonging solel to the borro'er

and does not include securities o'ned )ointl 'ith others!

If no contract to the contrar e&ists, the ban# can e&ercise its lien o(er the

securities remaining e(en after the loan, for 'hich the 'ere pledged, are repaid b

the borro'er! "he ban# can also e&ercise its general lien in respect of a customers

obligation as a guarantor, and retain the securit offered b him for a loan granted

on a personal basis, e(en after the loan has been full repaid!

"he follo'ing are the e&ceptions to the right of general lien!

Boods entrusted for safe custod? A customers documents, ornaments and other(aluables deposited 'ith the ban# for safe custod or as trustee, is a contract

inconsistent 'ith the right of lien!

Securities earmar#ed for a specific purpose? Customers ma sometimes entrust the

ban# 'ith shares or bills of e&change, meant for a specific purpose, sa, for sale or

for honoring another liabilit, 'hich contract is inconsistent 'ith the right of lien!

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Sometimes, the ban#ers general lien ma be replaced b a particular lien due to

certain special circumstances! "he right of the ban#er is interpreted b 'hat is

'ritten b the ban#er in respect of the securit rather than the printed 'ord!

"he ban# has no lien o(er securities left 'ith the ban# b o(ersight or negligence

b the borro'er!

"he ban# cannot e&ercise right of lien o(er securities gi(en to the ban# ascollateral for a loan, before such loan is actuall granted or disbursed!

"he ban#s right of lien e&tends onl to securities and goods and not to mone

deposited 'ith the ban#, or the borro'ers credit balances! In the latter case, the

ban# can e&ercise its rights of set off!

Mortgage

Section 08 of the "ransfer of Propert Act, 1882, defines a mortgage as the transfer of

interest in specific immo(able propert for the purpose of securing the pament of mone

ad(anced or to be ad(anced b 'a of loan, on e&isting or future debt or the performance

of an engagement, 'hich ma gi(e rise to a pecuniar liabilit!

"he transferor of the propert is the mortgagor! "he entit to 'hom the transfer ta#es

place is the mortgagee! "he document through 'hich mortgage ta#es effect is the

mortgage deed!

-rom the definition, it follo's that there are t'o important ingredients to a mortgage (er co:o'ner or )oint o'ner of the propert is entitled to mortgage his share of

the propert!

"he mortgaged propert should be specific, and identified b features such as

location, si6e, boundaries, and distinguishing features! "ransfer of propert in discharge of a debt is not a mortgage! "ransfer of interest

in the propert should be to secure an e&isting or future loan, or to ensure the

performance of an obligation 'hich results in monetar obligation!

It is not necessar that the actual possession of the propert be transferred to the

ban#!

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"he "ransfer of Propert Act recogni6es si& tpes of mortgages! "he are as follo's?

Simple 9ortgage? In this tpe of mortgage, the ban# is not in possession of the

propert, but registration is mandator irrespecti(e of the amount of loan for 'hich

the propert is the securit! -urther, the ban# is not entitled to an income out of

rents or profits of the mortgaged propert, and the ban# cannot sell the propertfor reco(ering its dues 'ithout the permission of the court!

9ortgage b 'a of conditional sale? 5an#s do not prefer this tpe of mortgage

since there is no personal co(enant for debt ser(ice, and the ban# cannot loo# to

other assets of the mortgagor if there is a shortfall in securit co(erage! nder

this transaction, there is an ostensible $not real% sale of the mortgaged propert to

the ban#! If the debt is not repaid on due date, the ban# can approach the court for

foreclosure, 'hich implies causing the borro'er to lose his right of redemption of

the propert!

sufructuar mortgage? 5an#s do not prefer this mode of mortgage, because, as in

the earlier case, there is no personal co(enant on the borro'er for debt ser(ice!

*o'e(er, the ban# is in legal possession of the propert, b 'hich it can recei(erent and profits from the propert and appropriate them to the debt paable b the

borro'er! If the borro'er fails to redeem the propert 'ithin 34 ears through the

court, the ban# becomes the absolute o'ner!

>nglish mortgage? "here is an absolute transfer of propert to the ban#, 'ith the

pro(ision the full repament of the debt 'ill entitle the borro'er to redeem the

propert! In case of securit shortfall, the ban# can loo# to the personal assets of

the borro'er for full liuidation of its dues!

>uitable mortgage or mortgage b deposit of title deeds? "his is b far the most

preferred tpe of mortgage b ban#s in India! "hough this mortgage can be

effected onl in the to'ns notified b the go(ernment, the territorial restriction is

applicable not to the location of the propert, but 'here the title deeds aredeli(ered b the borro'er to the ban#! "itle deeds are documents or instruments

that enable the o'ner of the propert to en)o the right to peaceful and absolute

possession of the propert described in the documents! "o create this mortgage,

the o'ner or )oint o'ners of the propert should personall deposit the original title

deeds 'ith the ban# at the notified centers, 'ith the intention of creating a

securit for the loan ta#en from the ban#! "here are no registration or stamp

charges in(ol(ed and creation of the mortgage is least time consuming! "he ris#s for

the ban# could arise in respect of the authenticit of the documents, and the

borro'ers standing in respect of the propert! -or e&ample, if the borro'er

mortgages the propert for 'hich he holds the original title deeds as trustee, the

claim of the beneficiar under trust 'ill pre(ail o(er an euitable mortgage! "heban# should also conduct a phsical inspection of the propert and (erif the

authenticit of factors li#e the boundaries, and mar#et (alue before accepting the

securit!

Anomalous mortgage? A mortgage that does not fall into an of the categories

discussed abo(e is an anomalous mortgage! Such mortgages can also be combinations

of t'o tpes of mortgages, such as, a combination of simple and usufructuar

mortgages, depending on the custom and local usage!

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Charge

"his is a 'ord that can commonl be used to describe an form of securit for debt,

'hether the borro'er is an indi(idual, partnership firm, pri(ate or public limited compan or

the go(ernment!

9ore specificall, charges registered under the Companies Act, 10, include rigorouspro(isions, and can generall be classified into a fi&ed charge and a floating charge!

A fi&ed charge $not to be confused 'ith fi&ed assets% is a specific charge o(er

designated properties of the compan! It gi(es the ban# the right to sell the assets and

appropriate the sale (alue to the debt due from the compan!

A floating charge $a% floats o(er the present and future propert of the compan

$including those under fi&ed charge% and is not attached to an specific asset or assetsD $b%

does not restrict the compan from selling the assets under charge or assigning them as

securit for loans from other partiesD and $c% could crstalline into a fi&ed charge upon the

happening of an e(ent or contingenc, such as liuidation of the compan! It is important tonote that 'hen the floating charge becomes fi&ed, it constitutes a charge on all properties

and assets belonging to the compan, and gains seniorit o(er all subseuent fi&ed charges,

unsecured creditors and mone ad(anced to the liuidator!

It is, therefore, e(ident that, in order for the ban# to be the senior creditor, it 'ill ha(e to

ensure seniorit in claims o(er the ban#s assets as 'ell! "his purpose is achie(ed b

registering the ban#s charge 'ith the /egistrar of Companies under Section 120 of the

Companies Act, 10! Such registration of charge 'ill ha(e to be done 'ithin 34 das of

e&ecution of the loan agreement, and can be e&tended up to 4 das 'ith a penal pro(ision!

hat are the conseuences of non:registration of charge b the ban# In the e(ent of thecompan going into liuidation, the ban#s debt, other'ise ran#ed senior to all other

creditors claims, 'ill no' be treated as unsecured, and 'ill ran# lo' as an unsecured

creditor at the time of settlement of claims! It is to be noted that in spite of non:

registration of charge, the ban#s debt is reco(erable and the securities are enforceable, as

long as the compan is a going concern! "he ban# gets ran#ed as an unsecured creditor onl

in case of compan liuidation! A more serious conseuence 'ould be 'hen a )unior creditor

mo(es up to senior position at the time of enforcement of securities, merel b (irtue of

ha(ing filed its charge 'ith the registrar of companies before the senior creditor did! "his

is in accordance 'ith the pro(isions contained in Section 12, 'hich clarifies that notice of

charge registered b the ban# under Section 120 'ill be rec#oned from the date of

registration and not from the date of creation of the charge! It is also mandator thate(er time there is a change in the loan agreement, a modification charge is filed 'ith the

registrar of companies 'ithin 34 das of such modification ta#ing effect!

"he ban# should also (erif prior fi&ed and floating charges on the assets charged to it b

the borro'ing compan before specifing the securit ban#ing in its loan agreement! -or

e&ample, if the borro'ing compan had made a debenture issue, secured b floating charge

on all the compans assets, 'ith a specific clause prohibiting creation of an charge senior

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to ran#ing on par 'ith debenture holders, then the ban# cannot gain a senior creditor

position in spite of registering its charge on time! If the ban# still finds lending to this

compan profitable, it should stipulate suitable co(enants that 'ould compensate for a li#el

shortfall in securit bac#ing for its ad(ances to the compan!

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Charge Creation_banking Notes

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