Charges on Securities against loan

Charges on Securities against loan

While extending credit, banker must secure his position. A wide range of securities e.g. Land, Building, Goods, Share Certificates, Life Policies, Fixed Deposit Receipts, Title Deeds etc. are accepted by banks as cover for a loan. Not only that the banker should insist on good securities proper charge should also be created on the securities in order to make them available as and when needed. Creation of charges on securities means making it available as a cover for an advance. Hence, the method of charging securities should be legal, perfect and complete. The important method of charging securities are as follows:

1. Lien

2. Pledge

3. Hypothecation

4. Mortgage

5. Assignment

1. Lien

A lien is the right of a person in the possession of goods. to retain them until debts due to him have been satisfied. A lien may be particular or general.

A particular lien is a right to retain the goods in respect of which the debt arises. Thus, a particular lien can be exercised by a person who has spent his time, labour and money on the goods retained e.g., a scooter repairer may retain the scooter till the repair charges are paid for or a tailor may retain a stitched suit to claim his stitching charges. A general lie” on the other hand arises out of the general dealings between two parties and covers any property that the one party may be holding for the other. Banker’s lien is a general lien.

Bankers, in the absence of a contract to the contrary, can exercise general lien and retain as security for a general balance of account, any goods bailed to them. So, no agreement is necessary to create the right of lien. However, for the exercise of such lien, the securities must have been received by the banker as a banker. Securities received for safe custody are not received by the banker as a banker. But bills and documents left for collection are part of banker’s ordinary business and he has a lien upon them. There is a lien upon bonds and coupons deposited for collection, and where the bonds are given by the customer himself for collection, the lien attaches only to the coupons so given for collection and not to the bonds.

The lien also extends to all securities held by the banker as cover for any specific loan, but left with him after the loan has been repaid.

Banker’s lien is more extensive than an ordinary lien. It has been called an implied pledge because it gives him the right of a pledgee, i.e. the right to sell by giving a reasonable notice, and no suit be filed for seeking the right of sale.

However, this right of lien cannot be availed of by the banker in the following circumstances:

1. Where the goods or securities have been deposited for a specific purpose.

2. Where the valuables are deposited in safe custody of the banker.

3. Where money is paid to meet specific bills accepted payable at the banker.

4. It does not also extend to the title deeds casually left at the bank. Similarly, no lien can be exercised in respect of documents or valuables left inadvertently with the banker, or on property which is placed in his bands with the object of covering an advance which is not granted.

5. No lien can be exercised in respect of trust accounts. But if the bank has no knowledge and it has not, during the currency of the account, received notice of the trust character of the funds, the lien can be exercised.

Banker’s Lien and the Limitation Act

The banker’s right of lien is not barred by the Law of Limitation. The effect of the Limitation Act us only to bar the remedy and not to discharge the debt. Consequently, it does not affect property over which the banker has a lien.

2. Pledge

Pledge may be defined as the bailment of goods as security for payment of a debt or performance of a promise. Bailment means the delivery of goods by one person to another for some purpose, under a contract that the goods shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them. The person, who delivers the goods, as security is called thc ‘pledgor’ and the person to whom the goods are so delivered is called the ‘pledgee’. The ownership remains with the pledgor. It is only a qualified property that passes to the pledgee. He acquires a special priority and lien which is not of ordinary nature and so long as his loan is not re aid no other creditor or ‘authority ‘ can take away the goods or its price.

 

Delivery Essential

A pledge is created only when the goods are delivered by the borrower to the lender or to someone on his behalf with the intention of their being treated as security against the advance. Delivery of goods may, however, be actual or constructive. It is constructive delIvery wllere the key of a godown in which the goods are kept or documents of title to the goods are delivered. Similarly, where the goods continue to remain in the borrower’s possession but are agreed to be held as a ‘bailee’ on behalf of the pledgee and subject to the pledgee’s order, it amounts to constructive delivery and tantatmounts to valid pledge.

Under English Law, however, the delivery of documents of title to goods (except a bill of lading) by the owner of the goods to the lender is not considered as a valid pledge.

Advantages of Pledge

To a banker, pledge is perhaps the most satisfactory mode of creating a charge on securities. It offers the following advantages :-

  1. The goods are in the possession of the bank and, therefore, in case the borrower makes a default in payment, they can be disposed of after a reasonable notice.
  2. Stocks cannot be manipulated as they are under the banker’s possession and control.
  3. In the case of insolvency of the borrower, bank can sell the goods and prove for the balance of the debt, if any.

4. There is hardly any possibility of the same goods being charged with some other party if actual possession of the goods is taken by the banker.

Who may Pledge ?

Besides owner of the goods, any of the following persons may .create a valid pledge :

1. Mercantile agent who is in possession of goods or documents of title to goods, with the consent of the owner.

2. A person who has obtained possession of goods under a voidable contract and that contract bas not been rescinded at the time of the pledge.

3. A seller who continues to be in possession after sale, with the consent of the buyer.

4. A buyer in possession of the goods, with the consent of the seller, after agreement to sell but before completion of sale.

5. A pledgee may create a valid pledge by repledging the goods and the pledge is valid to the extent of his interest in the said

Rights of a Pledgee

If the pledgor fails to pay his debt or complete the performance, of obligation at the stipulated time, the pledgee can exercise any of the following rights :

1. bring a suit against the pledgor upon the default in redemption of the debt or performance of promise and retain possession of goods pledged as collateral security; or

2. sell the things pledged on giving the pledgor reasonable notice of sale.

In case, the goods pledged when sold do not fully meet the amount of the debt, the pledgee can proceed for the balance. If, on the other hand, there is any surplus, that has to be accounted for to the pledgor.

Before sale can be executed, a reasonable notice must be given to the pledgor so that;

(a) the pledgor may meet his obligation as a last chance.

(b) he can supervise the sale to see that it fetches the right price

Allahabad High court held that reasonable notice means a notice of intended sale of t security by the creditor within a certain date so as to afford an opportunity to the debtor to pay up the amount within the time entioned in the notice. Notice of sale is essential even where the agreement specifically excludes it.

However, the sale made by the pledgee. without giving a reasonable notice to the pledgor is not void, i.e., cannot be set aside. The pledgee will be liable to the pledgor for the damages.

In addition to the rights mentioned above, a pledgee has following rights:

1.It is the duty of the pledgor to disclose any defects or faults in the goods pledged which are within his knowledge. Similarly, if the goods are of an abnormal character say, explosives or fragile, the pledgee must be informed. In case the pledgor fails to inform such faults or abnormal character of the goods pledged, any damage as a result of non-disclosure shall have to be compensated by the pledgor.

2. The pledgee has a right to claim any damages suffered because of the defective title of the pledgor.

3. A pledgee’s rights are not limited to his interests in the pledged goods. In case of injury to the goods or their deprivation by a third party, he would have all such remedies that the owner of the goods would have against them.

4. A pledgee has a right to recover any extraordinary expenditure incurred for the preservation of the goods pledged.

 

Duties of a Pledgee

1. The pledgee is required to take as much care of the goods pledged to him as a person of ordinary prudence would, under similar circumstances, take of his own goods of a similar nature.

2. The pledgee must not put the goods to an unauthorized use.

3. The pledgee is bound to return the goods on payment of the debt.

4. Any accruals to the goods pledged belong to the pledgor and should be delivered accordingly. Thus, for example, if the security consists of equity shares and the company issues bonus shares to the equity shareholders, the bonus shares are the property of the pledgor and not the pledgee.

 

Rights and duties of a Pledgor

Rights

I. The pledgor has a right to claim back the security pledged on repayment of the debt with interest and other charges.

2. The pledgor has a right to receive a reasonable notice in case the pledgee intends to sell the goods and in case he does not receive the notice he bas a right to claim any damages that may result.

3. In case of sale, the pledgor is entitled to receive from the pledgee any surplus that may remain with him after the debt is completely paid off.

4. The pledgor has a right to claim any accruals to the goods pledged.

5. If any loss is caused to the goods because of mishandling or negligence on the part of the pledgee, the pledgor has a right to claim the same.

 

Duties

1. A pledgor must disclose to the pledgee any material faults or extraordinary risks in the goods to which the pledgee may be exposed.

2. A pledgor is responsible to meet any extraordinary expenditure incurred by the pledgee for the preservation of the goods.

3. Where the pledgee has exercised his right of sale of goods, any shortfall has to be made good by the pledgor.

4. The pledgor is liable for any loss caused to the pledgee because of defects in his (pledgor’s) title the goods.

 

Banker as the Pledgee

A Banker when accepting goods under pledge should take a letter pledge from the customer to include the following declarations:

1. That the bank shall have a pledge upon all the goods and documents of title delivered to him by the customer or his agent.

2. That the goods are being pledged as a continuing security to cover the existing and future debt, i.e., the amount of the loan, interest and expenses.

3. That the customer shall keep the goods insured against fire.

4. That the customer shall not repledge or otherwise encumber any of the goods pledged till the continuance of this agreement.

5. That the customer undertakes to submit periodical statements of stocks and to allow at his cost inspection by the bank from time to time of the goods as well as the borrower’s records.

3. Hypothecation

Hypothecation means creating some claim in goods or related documents without transferring their possession to the lender. Hart describes hypothecation as a “charge against property for an amount of debt where neither ownership nor possession is passed to the creditor.” Holden says, hypothecation is “a legal transaction, whereby goods may be made available as security for a debt with- out transferring either the property or the possession to the lender.” Thus, in hypothecation, the goods remain in the possession of the borrower but, however, he binds himself under the hypothecation agreement to give possession of the goods to the creditor when called upon to do so.

The goods are charged under hypothecation particularly where pledge is either inconvenient or impracticable. For example, where the security offered is either raw-materials or work-in-progress. Under this arrangement, the borrower is allowed to use the stock, sell it and replenish it by new one. A floating charge is created over the movable assets of the borrower. Lord Macnaghten characterises hypothecation as “ambulatory and shifting in nature ; hovering over so to speak, floating with the property until some event occurs or some act is done which causes it to settle and fasten on the subject within its grasp.” As in hypothecation, the goods remain in the possession of the borrower, this facility should be granted only to parties of utmost honesty and proven integrity. Besides, a banker should take the following precautions:

1. The banker should obtain periodical statements of stock stating the figure of opening stock, purchases, safes and closing stock for the period covered by them. These stock statements must be signed by the authorized persons.

2. In case borrower is a joint stock company, the bank’s charge must be registered with the Registrar of Joint Stock Companies within a period of 30 days of the creation of the charge. In case it is not registered within this period, it becomes void against the liquidator and/or any other creditor of the company.

Where the company’s financial position does not justify the granting of an advance on hypothecation basis, it is sometimes reinforced by the personal guarantee of its directors. where they are persons of substantial means. Personal guarantee of directors is usually taken in the case of advances to private companies.

It is because, the relationship between private company and its directors is more personal than that in a public company.

3. The banker should ensure that the hypothecated stocks are fuJ1y insured against fire and other risks.

4. Periodical inspection of the stocks should be carried out to verify the correctness of the stock statements submitted by the borrower.

As the borrowers who are granted hypothecation facility are highly creditworthy, the inspecting officer must exercise consider-able discretion and tact in verifying the stocks and looking into their accounts. At the same time the banker’s interest must be looked after and any deterioration in the security must be duly reported so that appropriate action is taken in good time.

5. A name plate of the bank stating that the stocks are hypothecated to it, must be displayed at all conspicuous places in the premises where the stocks are kept. This is done to avoid the risk of a second charge being created on the same stocks.

Hypothecations of Book-Debts

Advances are sometimes granted on hypothecation basis against the security of book-debts. This mode of charging book-debts is more convenient than the assignment of book-debts. The charge on book-debts is taken by means of a hypothecation deed or agreement specially drafted for the purpose. The borrower is required to submit statements of the outstanding debts hypothecated to the bank from time to time as in the case of hypothecation against goods. The agreement and statements form the basis of the ad vance against the security of book-debts. The statements contain, inter-alia, the names and addresses of the borrower’s debtors, the mounts due from them arid the periods for which the debts have been outstanding.

Precautions

1. Bankers should not advance against debts which have remained outstanding for an unreasonably long period, say for over three (or sometimes six) months. The long unpaid debts should therefore be excluded while calculating the drawing limit.

2. Banks sometimes also assess the credit-worthiness of the debtors of the borrower, particularly when the amount of any debt, is large.

3. The borrower’s books should be inspected periodically and the correctness of the statements submitted by him verified.

4. Documents like D. P. note containing security letter etc. should be taken as is done in case of advances against goods.

5. As an additional safeguard, a power of attorney in favour of the bank for collection of debts should be obtained from the borrower.

4. Mortgage

Mortgage may be defined as “the transfer of an interest in specific immovable property for the purposes of securing the payment of money advanced or to be advanced by way of loan, an existing or future debt, or the performance of an engagement which may give rise to a pecuniary liability. The transferor is called the mortgagor and the transferee the mortgagee. The instrument (if any), by which the transfer is effected is called a mortgage-deed.

Mortgages are advances against immovable properties. Immovable property includes land, benefits that arise out of land and things attached to the earth like trees, buildings and fixed machinery. Machinery that is not fixed, i.e. not permanently attached to the earth and can be shifted from one place to another is not an immovable property. Moreover, the immovable property to be mortgaged must be specific, that is capable of being clearly described. It may also be noted that the term immovable property does not include grass or standing crop.

Legal and Equitable Mortgages

A mortgagor can transfer either a legal interest or an equitable interest in the property mortgaged. Accordingly, mortgage that is created is a legal mortgage or an equitable mortgage.

Legal Mortgage

A legal mortgage may be defined as the creation by demand of a legal estate or interest in land, as security for the payment of money due or to become due, in favour of the person who takes the security subject to the mortgagor’s right to have the estate so created extinguished on repayment of the loan with interest. The person (borrower) who gives the security is called the mortgagor and the lender is called the mortgagee. It should be noted that a mortgagee given as security for a debt is not a sale of the property. The mortgagor has the right to have the mortgage redeemed upon repayment of the moneys advanced, together with interest and any cost and charges properly incurred by the mortgage in order to protect, preserve or enforce his security. A legal mortgage must be by deed.

Equitable Mortgage

An equitable mortgage is created by an agreement, express or implied, that an equitable interest in the property shall pass to the mortgagee as security for a debt due or to become due. An equitable mortgage is effected by deposit of the deeds or document of title. The legal title to the property is not passed on to the mortgagee, but the mortgagor undertakes, through a memorandum of deposit; to execute a legal mortgage in case he fails to pay the debt in time. Equitable mortgages accompanied by the deposit of title deeds do not require registration.

Difference between Legal and Equitable Mortgage

From the above discussion of the two types of mortgages, the following points of differences may be noted:

1. In case of a legal mortgage, the mortgagor transfers the legal title to the mortgaged property in favour of the mortgagee by a deed; whereas in case of an equitable mortgage, the mortgagor transfers the documents of title to the mortgaged property to the mortgagee, though he agrees to transfer legal title on his failure to pay the mortgage money.

2. Equitable mortgages accompanied by the deposit of title deeds do not require registration and hence save a lot of money, formality and botheration. Legal mortgages, on the other hand, have to undergo all the legal complications, and are thus quite expensive in terms of time as well as money.

Relative Merits as a security against advance

An equitable mortgage bas the following advantages over a legal mortgage:

1. It is easily and inexpensively acquired, as no stamp duty and registration charges are payable.

2. The mortgagor’s credit does not suffer, as in the absence of registration, nobody knows the transaction except the mortgagee.

3. The mortgagee gets the same right in case of an equitable mortgage as are conferred in case of a simple mortgage. ‘

Risks in Equitable Mortgages

When a banker makes advances against an equitable mortgage, there are several considerations which may prejudice the value of the equitable mortgage as a security. These are

1. The equitable title may be affected by the legal mortgage, if any. If a legal mortgage has been executed prior to the banker’s .equitable charge and remains undischarged, the legal mortgagee being in possession of the legal estate will rank before the banker as equitable mortgagee. But where. the legal mortgagee is a party to the creation of such an equitable charge (either being a party to the fraud or being guilty of gross negligence, e.g. failure to take possession of title deeds), the equitable mortgagee would have priority over the prior legal mortgagee.

2. The principal risk run by a banker as equitable mortgagee is that the borrower may subsequently execute a legal mortgage in favour of another party. If a person lends upon a legal mortgage without either a sight of the deeds or a reasonable explanation of their disappearance, he will get a charge prior to the equitable mortgagee.

3. Even amongst equitable mortgagees, if the first equitable mortgagee has, through negligence, failed to obtain possession of the title deeds, he will be postponed to a second equitable mortgagee who has the deeds, and who advanced money without notice of the “prior equitable charge. Transfer of Property Act reads, “where through the fraud, misrepresentation or gross neglect of a prior mortgagee another person has been induced to advance money on the security of the already mortgaged property, the prior mortgagee shall be postponed to the subsequent mortgagee.”

4. Again, if a person makes a binding agreement to sell some property, and before conveyance hands over the deeds to his banker as security for an advance, the banker’s equitable charge may be postponed to the purchaser’s prior equitable interest, even if the banker had no knowledge of the sale and although he has possession of the title-deeds.

On the basis of the above discussion it may be said that although certain risks are associated with equitable mortgages, the advantages far outweigh them. Besides, the risks are such that they tan be avoided if necessary precautions are taken by the banker. The following are the chief precautions to be observed by a banker in this connection:

1. He should hold title deeds and get them examined by the mortgagor’s solicitors. .

2. He should obtain a formal memorandum of deposit showing why the deeds were deposited.

3. If any suspicious circumstances prevail, due enquiries must be made.

Although equitable mortgages are preferred to legal mortgages, in case of customers whose integrity has never been in question, the facility is available only in the towns of Calcutta, Madras and Bombay. However, equitable mortgage of property situated at any place, other than Calcutta, Bombay and Madras, can be created if the title deeds thereof are deposited in any of the aforesaid cities or other places notified from time to time by any State Government in its Official Gazette.

Forms of Mortgages

Transfer of Property Act, recognizes the following six forms of mortgages:

1. Simple Mortgage

2. English Mortgage

3. Mortgage by Conditional Sale

4. Usufructuary Mortgage

5. Mortgage by deposit of title deeds or Equitable Mortgage

6. Anomalous Mortgage

Rights of Mortgagee

1. Right to sue for mortgage-money: under simple mortgage or wherever expressly so agreed the mortgagee has a right to file a suit in a court of law for the mortgage-money.

2. Right of Sale. In case of simple, equitable and English mortgage, the mortgagee can cause through the court, the mortgaged properties to be sold in case of default by the mortgagor in repayment of the mortgage-money. Transfer of Properties Act, however, confers upon the mortgagee right of sale without the intervention of the court under certain circumstances.

3.Right of possession to any accession to mortgaged property. If any accession (addition) is made to the mortgaged property, the mortgagee, in the absence of a contract to the contrary is entitled to the possession of such accession for the purposes of security. For instance, if a person mortgages a plot of land and later erects a building on it, for the purposes of security, the mortgagee is entitled to the plot as well as the building.

4. Right of foreclosure. In case of mortgage by conditional sale, usufructuary mortgage or anomalous mortgage, a mortgagee may sue for foreclosure, i.e.. may obtain a decree from the court debarring the mortgagor of his right to redeem the property.

Rights of mortgagor

1. Right of redemption. The mortgagor has a right to redeem the property on payment of the mortgage money including interest and other charges. This right of redemption may however be extinguished by an act of parties or by decree of a court.

2. Additions to mortgaged property .In the absence of a contract to the contrary, any additions to the mortgaged property voluntarily carried out by the mortgagee shall, upon redemption, belong to the mortgagor.

3. Right to make copies of or extracts from the title deeds. The mortgagor has a right to inspection and make copies of or extracts from the title deeds in the custody of the mortgagee.

5. Assignment

Assignment means transfer of an existing or future right, property or a debt by one person to another person. The transferor is known as the assignee and the transferee as assignee. Usually assignments are made of actionable claims e.g. book debts, insurance claims etc.

Assignment may be :

(i) Legal, or (ii) Equitable

A legal assignment is one where :

  1. Assignment deed is in writing duly signed by the assignor,
  2. the transfer of actionable claim is absolute, and
  3. the assignee informs the assignor’s debtor about the assignment and also gets the balance confirmed from him.

An equitable assignment is one which does not fulfil all the above requirements. For example, where a debtor, issues an order in favour of his creditor, on his debtor asking him to pay such funds to his creditor, it will result in creation of an equitable charge of the creditor over such funds.

On assignment of property the assignee gets absolute control over it and no other creditors of the debtor can have priority over the assignee’s claim.

Note : Actionable claim means “a claim to any debt other than secured by mortgage of immovable property or 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 grounds for relief, whether such debt or beneficial interest be existent, accruing, conditional or contingent. (Transfer o of Property Act).

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