Modes of Charging Security

Key Topics

  • Lien
  • Pledge
  • Hypothecation
  • Mortgage
  • Assignment

In Summary

  • Lien: Lien means the right to retain the goods of the borrower until the debts are repaid.
  • Pledge: Pledge is the bailment of goods as security for payment of a debt. Only movable goods can be pledged.
  • Hypothecation: Hypothecation creates on equitable charge on movable property without possession. However, the hypothecation deed provides that the banker will have the right to take the goods hypothecated in its possession if the the need arises.
  • Mortgage: A mortgage is a conveyance of an interest in property (land or any immovable property) for securing a debt. A legal mortgage is created by a registered deed and gives the mortgagee the right of sale in case of default of the borrower.
  • Assignment: Assignment is transfer of ownership from one person/authority to another person/authority.
  • Set-off: Set-off means the total or partial merging of a claim of one person against another in a counter claim by the latter against the former.

1.0 Lien

Lien is the right of a creditor to retain the properties belonging to the debtor until debt due to him is repaid. Lien gives a person only a right to retain the possession of the goods and not the power to sell unless such a right is expressly conferred by statute or by custom or by usage. A banker’s lien is a general lien which is tantamount to an implied pledge. It confers upon the banker the right to sell the securities after serving reasonable notice to the borrower

1.1 Kinds of Lien

  • A particular lien applies to one transaction or certain transactions only.
  • General lien gives a right to a person to retain the goods not only in respect of a particular debt but also in respect of the general balance due form the owner of the goods to the person exercising the right of lien. It extends to all transactions.

1.2 Negative Lien

Negative Lien: In case of negative lien. The possession of the security is with the debtor himself, who promises not to create any charge over them until the loan is repaid.

1.3 Banker’s Lien

A banker’s lien is always a general lien. A banker has a right to exercise both kinds of lien. A banker’s lien is treated as an implied pledge: It must be noted that a banker’s lien is generally described as an implied pledge. It means that a lien not only gives a right to retain the goods but also gives a right to sell the securities and goods of the customer after giving a reasonable notice to him. When the customer does not take any steps to clear his arrears. This right of sale is normally available only in the case of pledge. That is why lien is regarded as an implied pledge.

2.0 Pledge:

Section 172 of contract Act, 1872, defines a pledge as, the ‘bailment of goods as security for payment of a debt or performance of a promise.” Only movable goods can be pledged. From the above definition we observe that,

  1. A pledge occurs when goods are delivered for getting advance,
  2. The goods pledged will be returned to the owner on repayment of the debt,
  3. The goods serve as security for the debt.

The person who transfers the goods is called pledger and to whom it is transferred is called the pledgee.

2.1 Essentials of pledge

2.1.1 Delivery of goods:

Delivery of goods is essential to complete a pledge. The delivery may be physical or symbolic. Physical delivery refers to physical transfer of goods from a pledger to the pledgee. Symbolic delivery requires no actual delivery of goods. But the possession of goods must be transferred to a pledgee. This may be done in any one of the ways:

  1. Delivery of the key of the warehouse in which the goods are stored.
  2. Delivery of the document of title to goods like bill of lading, Railway receipt, Warehouse warrant etc.
  3. Delivery of transferable warehouse warrant if the goods are kept in a public warehouse.

2.1.2 Transfer of ownership:

The ownership of goods remains with the pledger. The possession of the goods vests with pledgee till the loan is repaid.

2.1.3 Right in case of failure to repay:

If the pledger fails to repay within the stipulated time, pledgee may,

  1. sell the goods pledged after giving reasonable notice,
  2. File a civil suit against the pledger for the amount due,

File a suit for the sale of the goods pledged and the realization of money due to him. When the pledgee decides to exercise the right of sale, he must issue a clear, specific and reasonable notice.

2.2 Precaution and general guidelines for pledgee

  1. The godown must be in good condition and well-constructed.
  2. Godown must be effectively under Bank’s control.
  3. Name board of the bank should be placed outside and inside of the godown.
  4. Letter from the party for free accesses to the godown by bank personnel (Bank’s prescribed form) to be obtained.
  5. Letter of disclaimer from the owner of godown is to be obtained if the godown is rented one.
  6. Godown keeper and godown Chowkider are to be posted for receiving/ delivery and to ensure security of the goods.
  7. Insurance of godown is to be done against all risks. Bank clause should be inserted.
  8. Periodical Inspection by the authorized person of the bank (monthly/fortnightly) should be conducted.
  9. Value of stocks must be determined at landed cost/invoice cost/market price whichever is lower as per Head office guideline (circulars).
  10. Restricted item must not be accepted for pledge.
  11. Deliveries and rotations of the stocks is to be made as per existing rules/procedures and terms and conditions contained in the sanction advice.
  12. Market value of the goods pledged should be ascertained frequently in order to retain proper margin and allow withdrawals within drawing power. No upward revaluation without H.O. approval.
  13. Pledged goods must be stocked properly to facilitate counting and checking.
  14. Stock report card on each stock mentioning Nos. of bales, bags, cases etc. must be maintained.
  15. In case of chemicals, drugs and medicines the date of expiry should be written and technical personnel must be employed to ensure its quality.

2.3 Accepting goods for pledge

Before accepting the goods for pledge, banker should be satisfied that proposed pledge goods contain the attributes of a good security.

2.4 In the matter of pledge banks may be cheated in one or more of the following manners:

  • Pledge of spurious goods.
  • Inflating the value of goods.
  • Pledging the goods to more than one bank by using various entrances to the godowns.
  • Fraudulent removal of goods with the connivance / due to the negligence of the bank’s staff.
  • Pledge of goods belonging to a third party.

2.5 Attributes of a good Tangible security

  1. Marketability
  2. Easy ascertainment of value
  3. Stability of value
  4. Storability
  5. Cost and labor of supervision
  6. Transportability
  7. Durability
  8. Ascertainment of title
  9. Easy transfer of title
  10. Absence of contingent liability.
  11. Yield

2.6 Documents required for Pledge:

  • Demand promissory note.
  • Agreement for pledge.
  • Letter of continuity.
  • Letter of arrangement
  • Insurance policy covering all risks.
  • Invoice of goods pledged (for imported goods).
  • Latest stock report.
  • Letter of disclaimer
  • Other documents as per sanction letter.

3.0 Hypothecation:

Hypothecation creates on equitable charge on movable property without possession. The mortgage of movable property for securing loan is called Hypothecation. In other words, in case of hypothecation, a charge over movable properties like goods, raw materials, goods in progress is created. Hypothecation is a charge against property for an amount of debt where neither ownership nor possession is passed to the creditor. Though the borrower is in actual physical possession, the constructive possession remains with the Bank as per the deed of hypothecation. The borrower holds the possession not in his own right as the owner of the goods but as the agent of the Bank. Being only an equitable charge on movable property without possession, hypothecation facility is risky as clean advances.  So it is granted only to parties of undoubted means with the highest integrity. Moreover, bankers insist upon for giving some sort of collateral securities.

3.1 Features of Hypothecation:

  • Charge against a property for an amount of debt,
  • Goods remains in the possession of the borrower,
  • Borrower binds himself to give possession of the hypothecated goods to the Bank when called upon to do so.
  • It is a floating charge.
  • It is rather precarious.

Being only an equitable charge on movable property without possession, hypothecation facility is risky as clean advances. So it is granted only to parties of undoubted means with the highest integrity.

 3.2 Precaution and general guidelines for Hypothecation:

As goods under hypothecation remains in the possession of the borrower, extra care has to be exercised to see that the bank’s security is complete, adequate, safe and available at times when required. The banker should take the following precautions:

  1. He must get stock statements periodically which contain a declaration by the borrower regarding his title to goods and correctness of the quality, quantity etc.
  2. On the basis of the statement, he should inspect the stock and books of accounts of the borrower.
  3. An undertaking from the debtor in writing, stating that he has not hypothecated the same goods to any other bank must be obtained.
  4. The banker should get a letter of hypothecation containing several clauses to protect his interest under all circumstances.
  5. The banker should insist on the borrower insuring the goods against the risks. He should also get it endorsed and assigned in his favour.
  6. A board reading “Stock Hypothecated to X Bank” should be displayed in the place where the goods are stored.

3.3 In case of hypothecation bank may be cheated in the following ways:

  • The borrower declares wrongly the capacity of the storing place.
  • A false platform between the loose stocks is erected.
  • The borrower creates a hollow square in the middle of stocks. Kind of fraud is generally committed by the borrowers who have either built-up confidence with the bank or where the branch managers and other officials at the branch office have been got around by such borrowers.
  • Often the borrower with intention to cheat the bank resorts to dumping deteriorated/obsolete stocks in between the good stocks.
  • The borrower mixes inferior quality liquids or water with good liquids and commits fraud. The device is generally adopted by parties dealing in chemicals or oils.
  • The borrower stores stocks of different qualities in the godown and cheats the bank. In such cases borrowers store goods of qualities different from these declared in lodgment memos.

4.0 Mortgage

  • The transferor is called a ‘mortgagor’, the transferee a ‘mortgagee’, the principal money and interest of which payment is secured for the time being are called ‘mortgage money’, and the instrument (if any) by which the transfer is effected is called a ‘mortgage deed’.
  • A mortgage is a method of creating charge on immovable properties like land and building.
  • Section 58 of the Transfer of Property Act 1882, define a mortgage as follows: “A mortgage is the transfer of an interest in specific immovable property for the purpose 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.”

4.1 Characteristics of a Mortgage:

In terms of the definition, the following are the characteristics of a mortgage:

  1. A mortgage can be effected only on immovable property. Immovable property includes land, benefits that arise out of land and things attached to earth like trees, buildings and machinery. But a machine which is not permanently fixed to the earth and is shift able from one place to another is not considered to be immovable property.
  2. A mortgage is the transfer of an interest in the specific immovable property. This means the owner transfers some of his rights only to the mortgagee. For example, the right to redeem the property mortgaged.
  3. The object of transfer of interest in the property must be to secure a loan or performance of a contract which results in monetary obligation. Transfer of property for purposes other than the above will not amount to mortgage. For example, a property transferred to Liquidate prior debt will not constitute a mortgage.
  4. The property to be mortgaged must be a specific one, i.e., it can be identified by its size, location, boundaries etc.
  5. The actual possession of the mortgaged property is generally with the mortgager.
  6. The interest in the mortgaged property is re-conveyed to the mortgager on repayment of the loan with interest due on.
  7. In case, the mortgager fails to repay the loan, the mortgagee gets the right to recover the debt out of the sale proceeds of the mortgaged property.

4.2 Forms of Mortgages

Section 58 of the transfer of Property Act enumerates six kinds of mortgages:

  1. Simple mortgage.
  2. Mortgage by conditional sale.
  3. Usufructuary mortgage.
  4. English mortgage.
  5. Mortgage Ly deposit of title deeds.
  6. Anomalous mortgage.

4.3 Rights of Mortgager

  1. Rights of Redemption
  2. Accession to Mortgaged Property:
  3. Right to Transfer to Third Party
  4. Right to Inspection and Production of Documents

4.4 Rights of Mortgagee

  1. Right to sue for mortgage money:
  2. Right of sale:
  3. Right of foreclosure:
  4. Right of accession to property:
  5. Right of possession:

4.5 Sub-Mortgage

A sub-mortgage is created when the mortgagee gives the mortgaged property as security for advance. The mortgaged security is the property of the mortgagee and so he has the right to re-mortgage for securing loans. The sub-mortgagee is placed in the position of the original mortgagee and entitled to receive the mortgage money, sue for the property and realise, the security. Therefore, a sub-mortgage is also known as ‘mortgage of mortgagee.’

5.0 Assignment

  • Assignment means transfer of any existing or future right, property or debt by one person to another person.
  • The person who assigns the property is called assignor and the person to whom it is transferred is called assignee.
  • Usually assignment are made of actionable claims such as book debts, insurance claims etc.
  • In banking business, a borrower may assign to the banker

i) The book debts,
ii) Money due from government department
iii) Insurance policies

5.1 Type of Assignment

Assignment may be two types

  1. Legal Assignment: A legal Assignment is an absolute transfer of actionable claim. It must be in writing signed by the assignor. The assignor informs his debtor in writing intimating the assignee’s names and address. The assignee also gives a notice to the debtor and seeks a confirmation of the balance due.
  2. Equitable assignment: An equitable assignment is one which does not fulfill all the above requirement.

In case of legal assignment, the assignee can sue in his own name. A legal assignee can also give a good discharge for the debt without the concurrence of the assignor.

Types of Security & Modes/Ways of charging security

Types of Security Modes of Charging security
Immovable Security:

Land, Building, Apartments, Factory Building, Heavy Machinery etc.

 Mortgages.
Movable security:

Goods (Inventory) e.g. Raw materials, Work-in-progress and finished goods, Machineries, vehicles.

 Hypothecation,

Pledge.
Financial obligations (Instruments):

FDR, ICB Unit Certificates, Wage earner development Bonds, Shares etc.

 Lien, Set-off
Actionable Claim:

Book Debt (Accounts Receivable), Supply Bill (Contract bill), Life Insurance Policy etc.

 Assignment
Title to Goods:

Shipping Documents, Commercial Invoice, Transport Documents (Bill of Lading, Truck Receipt, Railway receipt), Insurance documents and Other documents.

 Lien