While lending money, the bank has to keep three principles in mind viz., liquidity, safety and profitability. In order to minimise risks in advancing money, banks usually insist on good security and would like to create a charge on the tangible assets of the borrower in favour of the bank. When a charge is created, the bank gets certain rights on the tangible assets. In case the borrower fails to repay the advance, the bank can recover its money by disposing of those assets in the market. The important methods of creating a charge are:
Let us now study them briefly.
Section 172 of the Indian Contract Act defines pledge as “a bailment of goods as security for payment of a debt or performance of a promise”. So, a pledge is a contract whereby a borrower delivers his movable property to the lender as a security for the loan on the understanding that the property pledged will be returned to the borrower on repayment of the debt. The borrower who pledges the property is called the ‘pledged’ or ‘pawner’ and the person with whom the property is pledged is known as ‘pledgee’ or ‘pawnee’. From the above, you must have understood that delivery of goods and return of goods are the two essential features of pledge. Delivery of goods may be either physical delivery or constructive (symbolic) delivery. When the pledgee puts his own lock on the godown or when the keys of the lock are handed over to the bank, it amounts to delivery of goods. Similarly, handing over the duly endorsed documents of title to goods like railway receipt, bill of lading, etc., amount to delivery of goods. While accepting a pledge as a charge, the bank should ensure that the contract is in writing to minimise the misunderstanding of the terms. The contract should be complete in all respects and should incorporate all the usual clauses of pledge. It is advisable for the bank to get a declaration from the borrower to the effect the goods deposited with the bank are left as a security for the advance. The bank should see that the borrower has a valid title to the property pledged. The bank should ensure that the goods are kept safely in the godown. It is desirable that the bank should ensure goods against theft, fire, riot, etc. You must remember that when goods are pledged, only the possession over the goods is given and not the ownership. The pledger or the borrower continues to be the owner of the property. If the borrower fails to repay the loan in time, the bank has a right to file a suit against the borrower for the recovery of the amount, and retain the goods as collateral security. But since this is a lengthy process, the banks are given the right to sell the pledged goods and recover their money. But before selling the goods, the bank must give a reasonable notice to the borrower about his intention to sell the goods. If the proceeds of sale are less than the amount due, the borrower is still liable to pay the balance. But if the proceeds of sale is in excess of the amount due, the bank has to pay the surplus amount to the borrower. In case the goods are sold without giving a reasonable notice to the borrower, the sale cannot be set aside, but the bank will become liable to the borrower for damages.
From the above, it must be clear to you that for securing a charge on the property, the method of pledging is very simple and therefore, it is very popular. It should also be noted that the right to retain the goods pledged is applicable only in case of a particular debt for which the goods are pledged. The bank has no right to retain the security, as security for other debts owned by the borrower.
Hypothecation is a mode of creating charge on goods or related document surrender of possession of goods. According to Prof. Herbert Hart, “Hypothecation is a legal transaction whereby goods may be made available as security for a debt without transferring either the property or the possession to the lender”. Hypothecation is resorted to such cases where transfer of possession of the property from the borrower to the creditor is either impracticable or inconvenient. For example, if the borrower wants to borrow on the security of motor vehicle, which is being used as a taxi, it shall not be advisable to pledge the vehicle with the bank, as it will deprive him of his livelihood. In the case of hypothecation, an equitable charge is created on the goods for the amount of debt but the hypothecated goods actually remain in the physical possession of the borrower. The borrower who hypothecates the goods is known as ‘hypothecator’ and the lender is termed as ‘hypothecatee’. Generally, hypothecation is done by the borrower by executing a document called a ‘letter of hypothecation’ in favour of the lender. In this letter it is stated that the said goods or property are at the order and disposition of the lender until the debt is cleared. It also empowers the lender to sell the hypothecated property in the event of default or repayment by the borrower.
As the hypothecated goods remain in the possession of the borrower, there is considerable scope for fraud. The same goods may be hypothecated with another person. It is a risky method no doubt. That is why this facility is granted to parties of unquestionable integrity and honesty. Even then the banker should obtain a declaration from the borrower to the effect that the goods are not hypothecated earlier with some other lender and that the borrower has a clear title to the property hypothecated. The bank should carry out regular inspection and physical verification of the hypothecated goods.
When immovable property like land and building is offered as security for debt, a charge is created thereon by means of a mortgage. A mortgage is the transfer of the interest in a specific immovable property by one person to another for the purpose of securing an advance of money. The transferor is called ‘mortgagor’ and the transferee is known as ‘mortgagee’. The advance of money in respect of which the mortgage is effected is called the ‘mortgage money’ and the instrument by which the mortgage is effected is called the ‘mortgage deed’. In a mortgage, the possession of the property need not always be transferred to the mortgagee. Usually, it remains with the mortgagor. Since the mortgagee gets the interest in the property, he has a right to sell of the property and recover his loan. When the borrower repays the amount of loan together with interest, the interest in the property is re-conveyed to the mortgagor.
While accepting a mortgage as a charge, the bank should ensure that the borrower has a valid title to the property and this can be done by examining the original title deeds. The bank must not part with the title deeds to the borrower when the mortgage is pending. If the advance against mortgage is given to a joint stock company, then the charge should be registered with the Registrar of Companies within 30 days of the creation of the charge. The mortgaged property should be inspected periodically to ensure that it is in good condition. If the property mortgaged is building, the bank should ensure that it is insured against fire, riot etc. There are several forms of mortgage. They are
- Simple mortgage
- Usufructuary mortgage
- English mortgage
- Mortgage by conditional sale
- Equitable mortgage or mortgage by deposit of title deeds
- Anomalous mortgage