Hypothecation: What a Banker Should Know?

Mortgaged securities, pledges and guarantees, etc., are incidentally covered or governed by a single piece of legislation, i.e., mortgages by the Transfer of Property Act, and pledge and guarantees by the Indian Contract Act. But, in the case of hypothecation, there is no such specific piece of legislation which deals with the subject, and hence different courts are known to interpret the rights under hypothecation differently. Yet, hypothecation is, perhaps, the commonest form of security obtained by the banks.

The reasons for the popularity of hypothecation are many. For instance, a trader cannot run his business without the actual possession of the goods. Similarly, a manufacturer of television sets cannot undertake manufacturing unless he has the necessary raw materials at his disposal, and in the same way he cannot supply the television sets to the retailers unless he possesses the manufactured sets. In view of these constraints, borrowers feel comfortable in creating the charge of hypothecation on the stock in trade. This enables the trader to keep possession of assets with himself and at the same time offer it as a security for availing working capital. And banks, in their anxiety to have one or the other kind of security for the monies lent to the businesses, accept the proposition. Thus, hypothecation has become the commonest tool for the businesses to borrow and for banks to lend.

1. Hypothecation—Defined

As mentioned above, there is no identifiable central law that governs hypothecation, and so, it is very difficult to give a precise definition of the same.

Watson Law Lexicon defines hypothecation as “An act of pledging the property or thing without parting with the possession of the pledged property or thing to the pledgee.” It means hypothecation is nothing but a pledge without possession.

However, bankers do not treat hypothecation as a pledge without possession. Going by the usage that hypothecation has been put to, we may define hypothecation thus:

Hypothecation is a legal transaction, whereby, goods may be made available as security for a debt without transferring either the property or the possession thereof to the lender. It is an equitable charge created on the goods, and is governed by general principles of the Contract Act.

A still better comprehension of the term “hypothecation” may be attempted through the logic of exclusion i.e., seeing what it is not and thereby comprehending what it could be.

1.1. Hypothecation vs. Pledge

·    “In hypothecation, the possession of the property is retained by the owner and certain rights in that movable property are transferred to the person in whose favour the property is hypothecated. But, in a pledge, the possession of goods also passes to the pledgee by way of security though the possession may be constructive” (AIR 1988, A.P. 18=(1987) to Andhra Law Times 360 in the case of State of A.P. and another vs. Andhra Bank Ltd.).

·    In hypothecation, constructive delivery is in favour of the bank, whereas delivery of goods is a sine qua non in pledge. In terms of a court observation, in hypothecation, “The goods strictly speaking are not under lock and key of the bank but are allowed to be kept at the factory or the premises of the borrower without any lock and key of the bank as such, but are supposed to be under the constructive possession of the bank by virtue of the deed of hypothecation, which obliges the borrower to submit regular return to the bank indicating the increase and decrease in the value of the said goods to enable the bank from time to time to determine the drawing power of the borrower with regard to it…. In a sense, the borrower in the case of hypothecated goods has actual physical possession of the goods as agent, as it were, of the bank and in that limited sense, hypothecated goods are also not only constructively but actually in the possession of the bank.” (M/s. Gopal Singh Hira Singh vs. Punjab National Bank AIR 1976, Delhi, 115).

    In  a pledge, the bank can sell the goods outright and file a suit to recover the balance; whereas in the case of hypothecation, goods can only be sold if possession is gained with the consent of the borrower, and a suit can be filed for recovering the balance or goods can be sold only through the intervention of the court. However, there are conflicting court decisions in this regard.

1.2. Hypothecation vs. Mortgage

·   In mortgage, there is an intention to transfer interest in the property to the mortgagee; whereas in the case of hypothecation no such attempt is made except to create a charge on the movables.

·     In the case of mortgage, enforceability of security must be through the intervention of court; whereas in the case of hypothecation, since there is an equitable charge on the property and movables, the creditor (as held in some decided cases by various courts) is entitled to take possession of the goods and cause the sale of goods.

It is obvious from the foregoing that in the case of hypothecation the title in the goods remains with the customer; the de jure and de facto possession continues to remain with the borrower and the creditor has merely a right to recover his dues, if need be, by the sale of the security. It is also held that, if the customer sells the hypothecated goods the bank can trace his claim to the proceeds, since it has an equitable and enforceable charge over the movables hypothecated.

1.3. Who can Hypothecate Goods as Security

It can be by anyone – an individual, partnership firm, company and so on. However, in the case of individuals and partnerships, the risks are too great since it is difficult to notify the bank’s charge effectively to the external world at large.

In the case of companies, by virtue of registration of charges with ROC which is mandatory, a constructive notice to the world at large is possible.

1.4. What can be Hypothecated

In the light of experience of the banks, any or all of the following can be hypothecated:

• Existing stock of movable goods;
• Goods that are not in the debtor’s immediate possession or control. E.g., Goods in transit;
• Goods which are not in existence at the time the security is given. E.g., Agricultural crops, implements yet to be fabricated and supplied, etc.;
• Goods which are in the manufacturing process;
• Immovable machinery and plant; and
• Present and future debts.

1.5. Rights and Liabilities of Hypothecator

The borrower, who has hypothecated the goods as security to the lending banker, as in vogue, is entitled to:

• Possession of the goods;
• Trade with the goods, i.e., to sell or to dispose of otherwise;
• Appropriate the proceeds for keeping the business in motion, i.e., to acquire fresh stocks, purchase raw material, undertake processing activities, meet other operating expenses contingent to the business, etc.

However, by virtue of his creating an equitable charge by executing a deed of hypothecation favouring the lending banker, the borrower is obligated to:

• Furnish details of the stocks held by him and the value thereunder from time to time;
• Realise the sale proceeds of the stock disposed of and account for the same by way of fresh acquisitions, investments in the processing, depositing in the loan account, etc.;
• Maintain the stocks at the promised levels to the lending banker at all times;
• Insure the stocks against all risks; and
• Protect the goods from all possible risks.

1.6. Rights and Responsibilities of Hypothecatee

To repeat again, hypothecation is not covered by any single piece of legislation that facilitates identification of rights and responsibilities of a hypothecatee. But, based on various court judgements, the following may be identified as available rights of a hypothecatee.

1.6.1. Selling the Hypothecated Goods

In the matter of Shri Yellamma Cotton Wollen & Silk Mills and Co. Ltd., Bank of Maharashtra Ltd., Pune, vs. Official Liquidator, AIR 1969 – Mysore 280=1970; 40 Company Cases 460 – the Mysore High Court passed a verdict on the matter of authority of the Bank to sell the hypothecated goods:

“In the case of hypothecation or pledge of movable goods, there is no doubt about the creditor’s right to take possession, to retain possession and to sell the goods directly without the intervention of the court for the purpose of recovering his dues. The position in the case of regular pledge completed by possession is undoubted and set out in the relevant sections of the Contract Act. Hypothecation is only an extended idea of pledge, the creditor permitting the debtor to retain possession either on behalf of or in trust for himself (Creditor)”.

“Hence, so far as the movables actually covered by the hypothecation deeds are concerned, there can be no doubt the Bank is entitled to retain possession and also exercise the right of private sale.”

1.6.2. Forcible Possession of Goods

The agreement of Hypothecation obtained by banks usually contains a clause empowering them to take possession of hypothecated goods and to sell them without any legal sanction on the occurrence of certain specified events. In practice, this is, however, a difficult power to be exercised since the goods are always in the possession of the borrower. If the possession is not given voluntarily, obviously it is not lawful for the lender to take possession of the goods forcibly, though such a power is included in the document. Such a forcible act would amount to breach of peace, wrongful entry, wrongful restraint, trespass, etc., and the borrower can file a criminal complaint against the lending bank that resorts to forcible possession. Incidentally, an agreement permitting the commission of such an act is an offence in itself, and is, therefore, unlawful and not enforceable in a court.

Nevertheless, it is in the interest of the lending bank to take possession of such hypothecated goods once the borrower defaults, as, otherwise, they may lose whatever salvage value they had. So this needs to be attended to with all care, concern and tact.

1.6.3. Removing and Storing of the Goods

The next question, after having taken possession of the goods, is where to store them. Unless the agreement permits, storing of goods within the borrower’s premises but under bank’s lock and key may not be lawful. The obvious alternative is to remove and store the goods elsewhere. Now, if it is a manufacturing unit, the task of removing the raw materials, goods in the manufacturing process, and so on and again storing it in hired premises is not an easy one. Incidentally, no attempt should be made to lock up the entire factory or other premises for taking possession of hypothecated assets as such an act is liable for damages for wrongful closure of the factory. At times, there could be disputes owing to the intervention of factory workers, which again demands circumspection.

Taking an inventory of the items, preferably in the presence of borrowers, and if possible valuation thereof is of paramount importance while taking possession of the goods. Further, to obviate future litigations or allegations being raised by the borrowers, banks should give a notice to the borrower demanding his presence at the time of taking inventory.

1.6.4. Realisation of the Hypothecated Machinery

Hypothecation of movable machinery and plant is frequently done along with equitable mortgage or as an independent security. Enforcement of such securities poses problems since a question often arises whether the machinery is, in fact, movable or immovable. It can be sold separately if only the machinery is movable.

Secondly, even if it is movable, its realisable value may get eroded once annexed from the other fixed machinery.

1.6.5. Realisation of Book Debts

Since the debtors are numerous and spread across the country, realisation of this security is very difficult despite the bank being a constituted attorney to recover and realise book debts of the borrower. It is also not uncommon to find that book debts, which have already been paid, are continued to be shown as receivables by the borrower.

The bank’s difficulties in realising the book debts multiply when the borrower company is in liquidation and the official liquidator has taken possession of all the books of account of the company.

1.6.6. Notice of Payment and Sale in Default

Once the goods come under the bank’s possession, it should issue the borrower a final notice for the payment of the amount due in the account and sale on default. Thereafter, it is preferable to dispose of the goods through public auction or by inviting tenders.

There is always the likelihood that the borrower may contend that the price realised is not sufficient and may even threaten to sue the bank for damages for wrongful sale or sale at an undervaluation or throw-away prices. However, despite this risk, taking possession of hypothecated goods and disposal of the same through public auction would have a definite deterring effect on the erring borrowers. Besides, such sale before filing a civil suit also reduces the incidence of court fees and other expenses relating to the filing of the suit.

Box: State Bank of India vs. Monarch Cyber Solutions Ltd & Others [IV (2005) BC 204 (DRAT/DRT)] Facts of the Case The 1st Defendant Company was dealing with Software and Hardware items such as computers, printers, furniture, fittings, etc. The 1st Defendant Company availed a loan from State Bank of India. Defendants 2 to 4 stood as guarantors and Defendants 5 to 7 offered corporate guarantee for the money borrowed by 1st Defendant Company. Since the 1st Defendant Company failed to discharge the loan, the Appellant Bank filed the OA. Defendants 1, 5, 6, and 7 remained ex parte. Defendant No. 2 filed a written statement in which defendant No. 2 admitted to borrowing from the Bank and that Defendants 2 to 4, who were the Directors of the Company, stood as guarantors for repayment of the loan amounts. It was also admitted that Defendants No. 5 to 7 were body corporate and they also stood as guarantors for the loan sanctioned to Defendant No. 1 Company. Defendants No. 3 and 4 filed a separate written statement but similar to Defendant No. 2’s written statement. The DRT appointed a Receiver who took charge of all the movable property of the 1st Defendant Company and realized Rs.4,06,000 through sale. The only defense by the Defendants was that the sale was not properly made. The defendants contended that the property was worth more than Rs.40,00,000. The contention of the Appellant Bank was that Defendants 2 to 4 stood as guarantors not only as directors but also in their individual capacity by virtue of clause 7 of the guarantee agreement. It was contended by the Appellant that Defendants 5 to 7 had also given a corporate guarantee and the agreement executed by them also incorporated clause 7 which read the same as clause 7 of the agreement executed by Defendants 2 to 4. According to the Appellant, the guarantors bound themselves in Clause 7 of the agreement that they would not claim benefit under section 140 and 141 of the Indian Contract Act. The Appellant Bank further stated that the Defendant Company shifted some of the property, such as computers and printers, held by it to Bangalore without its permission. The Appellant Bank submitted that it filed an application for the appointment of Receiver for movable property in order to stop the Defendants from disposing of the property and defeat the claim. DRT accepted the Defendant’s contention that the properties were not sold for proper value. It further observed that the sale was conducted without giving proper notice to Defendants No. 2, 3 and 4. Therefore, it was held in the OA that Defendants 2 to 7 were discharged as guarantors and only Defendant No. 1 was liable to pay the claim under the OA. An appeal was preferred before DRAT. Issues The only issue before the DRAT was whether the orders passed by DRT stating that the Respondents got discharged since the property hypothecated for security got impaired due to the action of Appellant Bank is proper or not. Held The DRAT, while setting aside the orders passed by DRT, observed that the surety can agree to waive his right available to him under various provisions contained in Chapter VIII of the Indian Contract Act, 1872. However, such a waiver is available to the extent permissible under Sec 133 r/w Sec 128 of the Indian Contract Act, 1872 only. The guarantors waived their right under clause 7 of the agreement and therefore could not claim that since the value of the property hypothecated got impaired, they were discharged from the liability. Further the guarantors failed to provide sufficient proof to establish their contention. It was also observed that the DRT was empowered to appoint a Receiver under Sec 19 (18) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 and such an appointment was in order. Further, the Respondents did not challenge the appointment. Therefore, it was not open for the Respondents to contend that the sale of the property would discharge them from their liability. Case Notes According to Sec 128 of the Indian Contract Act, the liability of the surety is coextensive with that of the principal debtor unless it is otherwise provided by the contract. Thus, the liability of surety is subject to the terms of the contract as may be arrived at by the parties to the contract. The words “unless otherwise provided by the terms of the contract” will also have a bearing on the provisions laid down under Chapter VII of the Indian Contract Act, 1872, which enable the surety to give up the rights available to him under sections 133 to 139 and 141. Source: The Icfai Journal of Banking Law, Vol. IV, No. 2, 2006.

1.7. Hypothecation vs. Surety

As mentioned above, hypothecated goods by virtue of being in the hands of the borrower are prone to be sold by the borrower and the proceeds not appropriated towards the debt. Now the question is whether the surety gets discharged to the extent of the security thus lost or parted with or without the consent of the surety under Section 141 of the Contract Act.

No definite answer can be arrived at for such questions. Since the rights and obligations of a hypothecator and the hypothecatee are  nowhere defined precisely, courts have so far taken different stances, which, at times, are quite opposite, regarding the rights and obligations of various parties under hypothecation.

In the matter of Karnataka Bank Ltd. vs. Gajanan Shankarrao Kulkarni and another (AIR 1977 Karnataka 14) it was held that a mere passive inactivity or passive negligence on the part of the creditor in failing to realise the debt from the security is not sufficient in itself to discharge a surety, as the surety can himself avoid the consequences of such passivity by paying the debt and getting subrogated to the rights of the creditor. In the absence of a contract to the contrary, a creditor is not under obligation to active diligence for the protection of the surety so long as the surety himself remains inactive.

However, an opposite view was taken in the case of State Bank of India vs. Quality Bread Factory and Other (AIR 1983 Punjab & Haryana 244). It was held that it is immaterial whether the goods are under lock and key of the bank as pledgee or under hypothecation of the bank, for in both the cases, the bank is having constructive possession as hypothecatee or pledgee. Hence, the surety stands discharged to the extent of the value of the security lost or parted, without the consent of the surety, more so, since the Indian Contract Act does not specify that this principle applies only to a pledge.

In another case viz., Bank of India vs. Yogeshwar Kant Wadhera and Others (AIR 1987 Punjab & Haryana 176), the court overruled the above judgement and held that a surety in case of hypothecation is not entitled to invoke the provisions of Section 141 of the Indian Contract Act, for the simple reason that if the goods are not in the possession of the hypothecatee, there is no question of his losing or parting with the same, and it would be wrong to say that the goods are in constructive possession of the creditor bank because it has no effective control over them, and by hypothecation, only equitable charge is created and nothing more.

2. Precautions to be Taken by Lending Banker

Since the law relating to hypothecation is quite unclear and much is dependent on how the courts interpret individual cases from time to time, the lending bankers need to be extremely careful in managing the hypothecation security for many reasons.

·   Goods are basically in the possession of the borrower – hence it can depreciate and can get disposed of by the borrower with no appropriation towards the loan outstanding. Hence, constant monitoring is a must in managing hypothecated security.

·    

     The hypothecator enjoys the comfort of disposing of the goods that has demand while storing non-movers, i.e., goods having no demand/market, in the godown as stock hypothecated to the lending banker. Such an act affords only an illusory value to the lending banker, and hence, banks should always try to separate the chaff from the wheat.

• The banker should ensure that the value of hypothecated goods is at cost but not inclusive of profit.  
• Since the price of the same goods keeps changing from time to time, the banker should constantly monitor to ensure that the goods are valued at ruling cost/market price or cost price, whichever is less.
• The banker should also ensure that the hypothecated goods are paid for, i.e., not obtained on credit terms, as the seller continues to have his right on such goods. Technically speaking, the borrower can create charge even on unpaid stocks/stocks obtained on credit but it amounts to “double financing”. It also encourages “over trading” which is against the prudential norms of lending. Over and above this, such financing against unpaid stocks makes the bank pari passu with the other creditor for goods. Secondly, it also needs to be verified that the goods are not obtained under the Guarantee/LC facilities granted by the bank itself, for it results in double financing.
• Banks should ensure that the entire stock hypothecated to the bank is properly insured against fire and other risks. It is also to be ensured that the “banks clause” notifying the interest of the bank in the good insured is inserted in the policy, so that the insurance company pays the claim to the bank directly and not to the borrower, and gets valid discharge.
• The bank should display its name plate indicating to the world at large that the goods in the premises are under an equitable charge with the bank.
• In the case of company accounts, the hypothecatee should ensure that the hypothecation charge on the goods is registered with the Registrar of Companies, with the full description of the goods under his charge. Even then, there is the risk of the hypothecatee’s charge becoming invalid under Section 534 of the Companies Act, 1956. For example, when the company is being wound up, a floating charge created within twelve months of the commencement of the winding up shall, unless it is proved that the company after the creation of the charge was solvent, be invalid, except to the amount of any cash paid to the company at the time of, or subsequent to, the creation and in consideration for the charge together with interest.

All the disadvantages listed above, no doubt, make hypothecation charge a security of poor value. Nevertheless, many of these weaknesses can be managed with proper monitoring and constant evaluation. And, hypothecation being the commonest form of security accepted in the banking circles, there is no way out for the banks except to accept such risks and manage them through proper monitoring tools.

Summary

Hypothecation is one of the commonest modes of security creation in banks. There is, however, no specific law by which the rights and liabilities of the hypothecator and hypothecatee are defined. Hypothecation is governed by the general principles of the Contract Act. Therefore, the courts interpret the obligations under hypothecation in different ways.

Hypothecation is basically an equitable charge created by the borrower over his goods as security for the loan being availed from a banker. The goods could be in existence or come into existence, or book debts. Since the possession of goods is always with the borrower, the material value of the security is always doubtful unless the borrower is a man of honesty. It thus casts an additional responsibility on banks of monitoring the goods and ensuring that the security is available.

The hypothecatee has a right to take possession of the goods charged and dispose them of for realizing the value and appropriating the same towards the loan balances. But, in practice, this is a very difficult proposition, unless the customer voluntarily gives up possession. It is desirable to take an inventory of goods in the presence of the borrower and give him a notice before disposing of the goods.

Hypothecation has got very many disadvantages for the simple reason that the very possession of goods always remains with the borrower. However, since hypothecation is one of the most convenient and commonest modes of security creation by a borrower, the banks have no option but to accept it and manage it skillfully.