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Friday, September 14, 2012

Pledge - What a Banker Should Know

This is a common type of security against which commercial banks extend trade finance. It involves bailment of movable goods by the prospective loanees to the lending banker. The possession of the goods thereof rests with the lending banker till the loan is repaid, while the title to the goods remains with the borrower.

1. Bailment (Section 148)
As per Section 148 of the Indian Contract Act, a bailment is:
“The Delivery of goods by one person to another for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them.”
Mr. Ram delivers his car to M/s. Auto Garage for repairs.
Mr. Shyam lends his scooter to his friend Mr. Khan.
In these two transactions, you would observe that there are two persons: bailer and bailee.
A bailer is the one who delivers the goods (Ram, Shyam); and a bailee is the one to whom goods are delivered (M/s. Auto Garage, Mr. Khan).

The transaction is called bailment and it basically constitutes:
  • Delivery of movable goods
It is the delivery of a car to the garage or scooter to a friend and this delivery has the effect of putting the possession of said goods in the hands of the other person, i.e., bailee.
  • Delivery for some purpose
Ram delivers his car for repairs; however, the ownership still remains with Ram.
  • Goods to be returned
There is an implied agreement that once the car is repaired, it is to be returned to the owner.
  • Based upon a contract
This bailment arises out of a contract or is implied by law.

2. Pledge
As per Section 172 of the Indian Contract Act, a pledge is the bailment of goods as security for payment of a debt or performance of a promise.

M/s. Ramlal & Co. borrows Rs.10 lakhs from the Bank of India and keeps with the bank a stock of cloth worth Rs.15 lakhs as security for the payment of debt.

This transaction, known as pawn or pledge, involves:
Pawner or Pledger: the bailer – M/s. Ramlal & Co. who delivered the goods
Pawnee or Pledgee: the bailee – Bank of India who took delivery of the goods.

2.1. Creation of a Pledge
A pledge can be created, as mentioned above, by bailment of goods for the purpose of being held as a security for the payment of a debt or performance of a promise.

The bailment can only be of goods as per Section 2(7) of the Sale of Goods Act, 1930, i.e., every kind of movable property other than actionable claims and money; and includes stocks and shares, growing crops, grass and things attached to or forming part of the land, which are agreed to be severed before sale or under the contract of sale.

The delivery of goods for the purpose of bailment does not necessarily mean physical transfer of goods from the custody of the pledger to the pledgee. It could also be by doing anything which has the legal effect of putting the goods in the possession of the pledgee.

M/s. Ramlal & Co. keeps the goods in its own godown, but the Bank of India, the pledgee, takes ‘possession’ of the same by putting its own lock on the door of the said godown.

M/s. Ramlal & Co. keeps the goods in its own godown and puts its own lock on the door of the said godown, but passes on the keys to the bank.

M/s. Ramlal & Co. stores its goods in the godown of Warehousing Corporation and passes on the possession thereunder to the bank, the pledgee, by attornment. In other words, M/s. Ramlal & Co., the pledger, authorises the Warehousing Corporation to hold the goods on behalf of the
pledgee, the bank, and the Warehousing Corporation acknowledges to the pledgee that the goods are now held by them on the pledgee’s behalf and to its order.

M/s. Ramlal & Co. hands over a document of title to goods, such as a Railway Receipt, Lorry Receipt, Bill of Lading, etc., duly endorsed in favour of the pledgee, i.e., Bank of India.

2.2. Who can Create a Pledge?
A pledge can be created by the owner of the goods or by any person with the owner’s authority.

However, in certain circumstances, persons who are left with the possession of the goods by the owner may make a valid pledge, even without the owner’s authority:

Mercantile Agents
As per Section 178 of the Indian Contract Act, a mercantile agent, who is in possession of the goods or the documents of title to the goods with the consent of the owner and who has been entrusted the goods, can create the pledge in the ordinary course of the business in his capacity as a mercantile agent. The pledgee/pawnee should act in good faith and should not have, at the time of pledge, notice that the pledger/pawner has no authority to pledge.

Person in Possession under Voidable Contract
The pledge made by a person – who has obtained the goods by fraud, misrepresentation, undue influence, or coercion – would be binding on the true owner, if the pledge is made before the contract is rescinded, and the pawnee acts in good faith and without notice of the pawner’s defective title, creates a valid charge.

In the case of goods obtained by theft, there is no consent at all and hence the thief has no title whatsoever, not even voidable. Therefore, he cannot give a valid title to pawnee even if obtained in good faith/without notice of the theft.

Pledger Having Limited Interest
When a person pledges goods in which he has limited interest, the pledge is valid to the extent of that limited interest.

Co-Owner in Possession
When there are several joint owners of goods, one of the co-owners in possession thereof with the consent of other co-owners may create a valid pledge of the goods.

By Seller after Sale and By Buyer before Sale
A seller, left in possession of the goods after sale, with the consent of the buyer, can create a valid pledge, subject to the condition that the pawnee acts in good faith and has no notice of the sale of the goods.

Similarly, a buyer, who obtains possession of the goods before sale, with the consent of the seller, can create a valid pledge, subject to the condition that the pawnee acts in good faith and has no notice of the lien of the seller over the goods.

2.3. Rights of the Pledgee
The rights of the pledgee include:

Right of Retainer (Section 173)
The pledgee can keep the goods pledged for Non-payment of
  • the debt or non-performance of the promise;
  • Interest on the debt; and
  • All expenses properly and necessarily incurred for the preservation of goods pledged.

Right of Retainer for Subsequent Advances (Section 174)
In the absence of a contract to the contrary, the pledgee cannot retain the goods for a debt or a promise other than the debt or promise for which they are pledged. But such a contract, in the absence of anything to the contrary, shall be presumed to exist in regard to subsequent advances made by the pawnee.

Right to Extraordinary Expenses (Section 175)
The pledgee can claim from the pledger any extraordinary or unexpected expenditure incurred by him for the preservation of goods pledged. But he has no right of lien over the goods pledged in respect of such extraordinary expenses; he can only sue to recover them.

Right to Sell the Goods (Section 176)
In case of any default in payment of debt or performance within the stipulated time by the pawner/pledger, the pledgee has two remedies open to him:

  • He may, if he so chooses, file a suit for the debt and retain the pledged goods as collateral security; or
  • He may sell the pledged goods after giving the pawner a reasonable notice of such sale.
Requirement of a reasonable notice is a statutory obligation and, therefore, cannot be excluded by a contract to the contrary.

If the sale proceeds are less than the amount due in respect of debt or promise, the pawner is still liable to pay the balance. On the other hand, if the proceeds of sale are greater than the amount so due, the pawnee shall pay the surplus to the pawner.

2.4. Rights of the Pledger
The rights of the pledger include:

Right to Redeem (Section 177)
Upon satisfaction of the debt or engagement, the pledge gets extinguished and the pledgee is bound to redeliver the goods to the pledger.

Even in cases where the time stipulated for payment of debt/promise has expired, the pledger can still redeem the goods before the pledge actually sells away the goods pledged by paying all the lawful dues of the pledgee. In such situations, the pledger is also liable to pay for the expenses regarding the sale or any other lawful expenses which may have arisen by reasons of his default in paying the debt within the proper time.

2.5. Enforcement of Pledgee’s Duties
The duties of the pawnee/pledgee are the rights of the pawner/pledgee. Therefore, the pawner has a right to enforce by suit the duties of the pawnee which include the following:

  • If the pawnee makes an unauthorised sale, the pawner can file a suit for the redemption of goods;
  • The pawner has a right to receive the pledged goods along with accretion, if any, on making the payment on the stipulated date.
 3. Lending Banker
The Lending Banker, by virtue of being the pledgee ends up with the responsibility for the safe keep of the pledged goods. To protect himself from a plausible litigation at a future date, the banker has to ensure that:
  • The contract of pledge is complete in all respects.
  • The title to the goods as pledgee is free from any legal flaws and continues to be so.
  • The quality, quantity, value, etc., of the goods pledged are verified and proper margins are stipulated and maintained, both at the time of accepting the goods for pledge and thereafter all through the loan period.
  • The full and effective control over all the goods lodged is exercised – put under proper lock and key and signboards displaying the bank’s interest on the pledged goods displayed prominently.
  • Proper care of the goods is taken in the same way as a man of ordinary prudence would take care of his own goods.
  • Proper insurance is bought against all the possible risks.
  • A letter of pledge signed by the borrower is taken (though not needed) which inter alia provides for:
    • the bank having a pledge upon all goods delivered by the customer or by his agent;
    • the bank holding the said pledged goods as a continuing security for the payment of all sums owed by the customer either solely or jointly with any other person;
    • the customer agreeing to repay all the monies secured by the pledge to the bank on demand, and in case of default, the bank having a right to sell the goods or any part thereof;
    • the customer agreeing to keep the goods fully insured/in the event of his failure, and the bank having the right to debit insurance premium etc. to the borrower’s account and obtain insurance;
    • the customer agreeing to pay all rent and other expenses of, and incidental to, warehousing of goods;
    • the customer agreeing to the fact that nothing in the agreement shall be construed as excluding the general lien of the bank for any balance due to the bank on any account; and
    • the customer agreeing to maintain the stipulated margins at all times.


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