CHARGING OF SECURITIES AND DOCUMENTATION

 

Security for bank advance has no doubt been reduced to secondary importance in the present context particularly for priority sector advances but it is still very important to influence the decision of banks in conventional advances. Reserve Bank of India has also stipulated certain quantitative restrictions on the banks' power to grant clean advances. Banks have prescribed their own formats for documentation for various types of advances and the borrowers in almost all the cases have to execute those documents without any choice. It would never be advantageous to know the general characteristics of securities, methods of their charging and documentation procedures adopted by the banks.

The securities may primarily be divided in two categories as under

 

q                   Primary security.

q                   Collateral security.

 

The assets created by the borrower from the credit facilities granted by the bank form the primary security for the bank advance as a matter of rule. The bank invariably obtains a charge over those assets. Similarly, other assets on which the advance is primarily based even if it is not created from the credit facilities granted by the bank will also be taken as primary security.

 

In some cases where primary security is not considered adequate or the charge on the security is open the bank may insist on an additional security to collaterally secure advances granted by it. Such securities are termed as collateral securities. Collateral security may either be tangible or third party guarantees may also be accepted.

 

Bank now grant need based advance after proper assessment and should not normally insist for collateral security in most of the cases.1bip matter needs to be discussed at die time of sanctioning of limits. Reserve Bank, of India has advised the banks not to obtain any collateral security in case of all priority sector advances upto Rs. 25,000. In other cases, it is left to the mutual agreement of the borrower with the bank.

 

BASIC CHARACTERISTICS OF SECURITIES AND CONCEPT OF MARGIN

 

The securities acceptable to banks either as primary or collateral must have certain, basic characteristics as under:

 

§                     Ascertainment of value. A security will be considered good and will be acceptable to the bank only if its value can be ascertained with a definite degree of correctness. Certain articles may be valuable but may not be accepted as security if the value cannot be ascertained such as paintings/antiques etc.

§                     Marketability. A good security must have a ready market. Raw materials, articles of necessity, other primary commodities are easily marketable and are considered good security. Semi‑finished goods may be more valuable than raw material for the borrower but may not be marketable at all and will thus be considered inferior to raw material in as much as its acceptance as a security is concerned.

§                     Stability in value. A good security should have a stable value over along period. If the value of a security fluctuates violently over a short period, it may not be considered a good security and may be accepted by the bank only after keeping a very high margin.

§                     Ascertainment of title and transferability. An asset can be accepted as security by the bank only when the title over that asset can be ascertained. Furthermore, the title should be easily transferable. The purpose of obtaining a security is to apply the sale proceeds of the security if the customer fails to repay the advance. But if the security is not easily transferable the very purpose of obtaining a security may be defeated. Immovable property located at a prime location may be very stable in value has a ready market and the value can also be ascertained but may still not be considered as a good security due to difficulty in ascertaining the title and elaborate legal process involved for effecting its sale through a court of law.

§                     Durability. The security accepted by the Bank must be durable. No bank advance is granted against perishable commodities.

§                     In case loan or advances to Muslims offering their property as primary or collateral security, it should be ensured, before accepting property as security that such property has not been alienated under the Muslim Law like 'waqf‑ul‑ulad' and/or 'Haq‑rnehr' in favour of their wives or for the benefit of their heirs since it will jeopardise the interest of the banker as lender.

§                     There are circumstances when securities given to the bank as security to cover the loan, have become void as against income tax dues/arrears of land revenues. To avoid such an unpleasant situation, the borrower should be asked to furnish income tax clearance certificate/clearance from local authorities.

§                     There are few other characteristics such as controllability of an asset as a security and securities having a yield which will enhance their value etc. which are critically analysed by the bank while accepting any security. The percentage of margin  which is kept by the bank as a cushion for any unforeseen drop in the value of security is directly linked to various characteristic as discussed above. Lower margin may be prescribed for those securities which have a stable value and easy marketability whereas higher margins are prescribed for those securities where fluctuations are wide. Margin fixed on raw material may be lower as compared to margin on stocks‑in‑process as the marketability has been effected in the latter case. The usual margin on advances against life policies is 10% on surrender value as compared to margin of 50% on shares. This is explained by the fact that life policies have a stable value which in fact increases with passage of time whereas share prices are subject to wide fluctuations.

The fixation of margin may also depend on the credit worthiness of the borrower and in some cases even Reserve Bank may issue directives to the banks.

 

TYPES OF CHARGES

 

Security is obtained by the bank as an additional cover against default by the borrower in repayment of bank's dues. Charging of security means making such security available to the bank and involves certain formalities. Charging should be legal and perfect so that it is possible to realise the security if such a need arises. There are six different modes of charging a security as under:

 

§                       Pledge. Pledge is bailment of goods by the debtor to the creditor with an intention to create a charge thereon as security for the debt. It has a legal backing as per the Indian Contract Act, 1872 wherein the definition of pledge and bailment and also the rights and liabilities of all the parties to pledge have been clearly spelt out. Important conditions to be complied with for constitution of a valid pledge are:

§                       There should be bailment of goods which implies that goods should be delivered the debtor (pledger) to the creditor (pledgee). The delivery may nevertheless be actual physical delivery or constructive delivery as in case of documents of title to goods.

§                       The bailment must be by the debtor or on behalf of the debtor.

§                       The delivery of goods must be with an intention of the parties to create security for die debt or performance of a promise.

 

In pledge the ownership of the goods remain with the borrower whereas physical control over these goods will be exercised by the bank. The borrower has a right to get the goods returned to him after payment of debt created here against.

 

In case of default by die borrower the bank can sell  the goods after giving a reasonable notice of sale as required under Section 176 of the Indian Contract Act,1872. Notice must clearly indicate the intention of the pledgee to sell the security and is compulsory before the sale can be effected. If the bank realises more than its dues by such sale, the excess realised will have to be returned to the borrower. However, if there is any shortfall, die bank can proceed against the borrower in a court of law for recovery of the balance.

 

This mode of charge may be considered as an ideal one for the bank as it has full control over the security and can even realise it without any legal process merely by serving a notice on the borrower. The borrower however, is put to great disadvantage as he losses coned over the goods and the account involves operational difficulties. Generally the raw material or finished goods or stock in‑trade etc. not immediately required by the borrower may be offered to the bank for pledge.

 

The goods pledged to the bank may sometimes be required by the borrower for undertaking a small process. The documents of title to goods deposited with the bank in the pledge account may be required to take delivery from the port/ railway etc. In such situations the bank may temporarily part with the goods on the borrower signing a 'Trust Receipt'. The possession of goods legally remains with the bank and the borrower keeps those goods 'in trust' for the bank during that temporary period. This facility is sometimes given by the bank as a sub‑limit of pledge account for operational convenience.

 

§                     Hypothecation. Pledge takes away control over the goods from the borrower which may not be practicable as the borrower would require certain goods under his control to continue its manufacturing and/or trading activities.

An equitable charge in favour of the bank over the goods is created in such cases without parting with the  possession of the goods. A charge on a property for a debt where neither ownership nor possession is passed on to the creditor is known as ‘hypothecation charge’ Hypothecation agreements obtained by banks gener­ally have a clause under which hypothecation can be converted into a pledge at, a later date.

 

This form of charge is ideal from the point of view of the borrower as he is always in control of goods offered as security to die bank. In case of default by the borrower, the bank may take possession of goods and convert it to pledge only with the consent of the borrower notwithstanding any clause w this effect being included in the hypothecation agreement. The bank will have to move a court of law for taking physical possession of goods or their attachment before judgement.

 

Hypothecation charge extends to all the goods and moveable properties with the borrower as per the agreement of hypothecation and operations in these accounts are permitted on the basis of stock statement, submitted by the borrower periodically usually every month. Hypothecation may, however, be created as a fixed charge over a particular machinery/vehicle etc.

 

§         Assignment. Assignment means transfer of a right, property or debt by one person to another person. The person transferring the right is known as assignor and the person to whom the right is transferred is known as assignee. The assignment may be legal in which case the assignor must give a written notice of the assignment stating the name and address of the assignee to the debtor or may he equitable where no such notice is sent. This form of charge is generally adopted for charging of book debts, monies due from Government (supply bills) and life insurance policies etc. Banks generally go in for legal assignment and insist for obtaining an acknowledgement of assignment from the debtor.

 

§         Mortgage. Mortgage is a mode of charge associated with immovable property. Immovable property has been defined by Section 3(26) of General Clauses Act, 1887 as under:

 

Immovable property shall include land, benefits to arise out of land and things attached to the earth or permanently fastened to anything attached to the earth".

 

Section 4 of General Clauses Act, 1887 further provides that the above definition of immovable property shall hold good under the Transfer of Property Act, 1882 as well.

 

Section 3 of Transfer of Property Act, 1882 provides that immovable property does not include standing timber, growing crops or grass. It also provides explanation to the term "attached to the earth" which means:

(a)        rooted in the earth, as in case of trees and shrubs,

(b)                imbedded in the earth, as in case of walls or buildings, or

(c)                attached to what is so imbedded for the permanent enjoyment of that to which it is attached.

 

A similar definition of immovable property has been given by Section 2(6) of the Registration Act, 1908 as under:

 

Immovable property' includes land, buildings, hereditary allowances, rights to ways, lights, ferries, fisheries or any other benefit to arise out of land and things attached to the earth or permanently fastened to anything which is attached to the earth but not standing timber, growing crops nor grass".

 

A point in case may arise in respect of machinery. Machinery which is not permanently attached to the earth and can be shifted to other place will not be considered as immovable property. But if a machinery is permanently attached  to the earth in, a manner that it cannot be removed from there, it shall be considered as immovable property.

 

Section 58 of 'Transfer of Property Act, 1882 defines mortgage’ as a transfer of an interest in a specific immovable property for the purpose of securing an existing or future debt. The person transferring the interest is known as 'mortgagor' and the person to whom the interest is transferred is known as 'mortgagee'. Indian law recognises six different types of mortgages out of which the two most acceptable form of mortgages are discussed hereunder :

 

§                     Mortgage by deposit of title deeds or equitable mortgage. Section 58(f) of the Transfer of Property Act, 1882 defines equitable mortgage as mortgage created by depositing title deeds of an immovable property to secure a debt, existing or future. Three basic conditions to constitute a valid equitable mortgage are

 

(i)         Delivery of title deeds (original) by the mortgagor to the bank.

(ii)        Existence of a debt, existing or future.

(iii)       Intention of the mortgagor to create a mortgage on that property to secure the debt.

 

No equitable mortgage can be created if any of the above three conditions' is not complied with.

 

This form of mortgage is very popular because it does not require finalisation of any mortgage deed and its subsequent registration which requires payment of heavy stamp duty. Mortgage is created simply by depositing the title deeds with the bank with an intention to create a security and no other agreement etc. is strictly required. Equitable mortgage can, however, be created only at places as notified by government in this regard.

 

§         Simple Mortgage. Section 58(b) of Transfer of Property Act, 1882 relates to simple mortgage in which the mortgagor personally binds himself to pay the debt and agrees that in the event of non‑payment by him, the mortgager may cause the mortgaged property to be sold and the proceeds of sale be applied in repayment of debt. The possession of mortgaged property, however, still remains with the mortgagor. The mortgagee does not have an absolute right to sell the property in case of default but has to seek intervention of the court.

 

A formal mortgage deed will have to be executed for creation of a simple mortgage which will also be required to be registered after payment of necessary stamp duty which is quite substantial and in all the cases will have to be borne by the borrower. All efforts should, therefore, be made to convince the bank to accept equitable mortgage. Simple mortgage may be resorted to only when equitable mortgage cannot be created as in cases where title deeds are not available,

 

In all forms of mortgages the mortgagor has a right of redemption on payment of the debt after it has become due. The mortgagor also has a right to inspect the documents of title to goods and make copies of or extracts from the title deeds which are in the custody of the bank.

 

§         Lien. Lien means the right of the creditor to retain the goods or securities of the debtor, which are in his possession until the debt due from the debtor is paid. It does not require any specific agreement to support this right. The lien may be general which confers the right to retain any goods for a general balance of account or it may be particular lien where goods can be retained by the creditor for a particular debt only. The person exercising general lien has only a right to retain the goods till the dues are paid and may not be able to sell those goods.

 

The right of the banks to general lien is however, considered on a different footing and banks have a general lien on all securities deposited with them as bankers by a customer, unless there be an express contract or circumstances that show an implied contract, inconsistent with lien. A banker’s lien is thus more than a general lien, it is an implied pledge. The bank, therefore, has a right to sell the goods in his possession after giving a reasonable notice. The lien can be exercised on bills and cheque deposited for collection, dividend warrants received by the banker as a mandatee from the customer, securities left with the banker after a particular loan has been paid. The bankers lien however, does not extend to:

 

(i)         Securities or valuables lying in the locker rented to the customer.

(ii)        Securities deposited upon a particular trust.

(iii)       Securities deposited to secure a specific loan.

(iv)       Securities left with the banks after an advance against them has been adjusted.

(v)        Securities left inadvertently with the bank.

 

No specific letter of lien agreement is necessary as the banks enjoy the right of lien under the Contract Act. However, in some cases the bank may obtain a specific letter of lien so that the borrower is not able to contend later that the securities were deposited by him for a specific purpose inconsistent with the lien.

 

Negative Lien

 

The borrower may sometime be having non‑encumbered assets which are not charged to the bank as security. The borrower is thus free to deal with these assets and may even sell them if he so desires. To restrict this right of the borrower, bank may sometimes request him to give an undertaking to the effect that he will neither create any encumbrance on these assets nor sell them without the previous permission of the bank so long as the advance continues. This type of an undertaking obtained by the bank is known as 'Negative Lien'. Negative lien is in the form of a personal assurance or undertaking which has binding effect but confers no right on the bank to proceed against the property itself and thus creates no encumbrance or charge on the property.

 

§                     Set Off. Set off is the right of combining of accounts between a debtor and a creditor so as to arrive at a net balance payable to one or the other. Set off in relation to bank means his right to apply the credit balance in customer's account towards liquidation of debit balance in another account of the customer provided both the accounts are maintained by him in the same capacity. The right may not be considered as absolute and the bank may be required to give a notice for exercising his right of set off. The right of set off can be applied by the bank only if the following conditions are met:

(a)        The liability of the borrower is for a sum which is certain,

(b)        The repayment of debt is due, and

(c)        Both the accounts are held by the customer in the same capacity.

 

The right of set off should, however, not be exercised arbitrarily and a notice for combining the accounts must invariably be served by the bank on the customer.

 

DIFFERENT TYPES OF BORROWERS/EXECUTION OF DOCUMENTS

 

Banks generally grant advance to persons having legal capacity to enter into a contract. Minors/lunatics/drunken persons etc. who cannot enter into a valid contract may not be favoured as borrowers and no credit facilities may be sanctioned to such persons.

 

The borrowers may have different constitution conferring on themselves various legal rights and responsibilities and banks as creditors will be interested to know the exact constitution of the borrower. Banks may also require additional undertakings information in some cases. This information is very essential for the banks while getting the documents executed from the borrowers. The documents can be executed only by the persons who can validly bind the borrower. The position regarding obtaining of undertaking/information may differ from bank to bank. Chart given on the next page gives details of various types of borrowers, the additional undertakings required by banks and the persons who are authorised to execute the documents which is based upon the common practice of most of the banks.

 

 

S.NO.   Constitution of               Additional papers required                      Persons authorised to execute the document

            Borrower

1.         Individual

                        ----

Individual in his personal capacity

2.         Joint

 

                        ----

All the borrowers in their personal capacity binding themselves jointly and severally.

 

3.         Sole                 

            Proprie­torship   

Declaration regarding his sole interest in the business.                         

Sole proprietor in his capacity as sole proprietor. He is, however, personally liable for all the dealings and obligations in the name of business.

 

4.         Joint Hindu

            Family 

1. Letter of Joint Hindu Family giving   details of all the male members including minors                           

2.  Declaration to the effect that      the advances will be utilised only for the family business to be signed

     by Karta & all other major coparceners.

All documents to be signed by Karta of HUF and all major coparceners in their capacity as Karta & coparceners and also in their individual capacity.

                                                    

5.         Trusts  

1.  Copy of trust deed.              

2.  Legal opinion regarding the power       of trustee to borrow.             

All the trustees in their representative capacity or as per trust deed and supported by the legal opinion.

 

6.         Partner­ship firm

1. Copy of partnership deed.

2. Declaration from all partners to                   inform the bank of any change in constitution.

 

 

All partners in their representative capacity i.e. as partner and also in their individual capacity.

7.         Limited Companies

1. Articles and Memorandum Association

2. Copy of Certificate of   incorporation.

3.Copy of Certificate of commencement of  business (only in case of public limited companies)

4.Copy of Board Resolution empowering the company to borrow from the bank and also authorising managing director/       directors/other officers to execute the documents as required by the bank.

5.Copy of the resolution of general body meeting of the company under Section 293 (1) (D) authorising the company to borrow in excess of its own paid up capital and free reserve.

6.Declaration from the company that borrowings will remain within the powers conferred on it as in (5) above

 

Documents to be signed by authorised persons in terms of board resolution in their representative capacity. The common seal of die company is also required to be affixed wherever necessary.

The charge created by the company over its assets will also require registration under Section 125 of Companies Act, 1956.

 

                                                           

DOCUMENTATION

 

Banks have their own standard forms for promissory notes and other documents and no deviations are normally permitted. The borrowers are expected to execute these documents as required by the bank. Banks also do not generally give copies of these documents to the borrower which sometimes creates difficulty when these documents become subject matter of a legal dispute. The following points must be kept in mind while executing the documents as required by the Bank.

 

Precautions while executing loan documents

 

The following are the precautions, in nutshell, which should be taken care of both by the borrower as well as banker, at the time of preparation, execution and registration of loan documents etc.:

 

(a)        Person, executing the loan documents must be competent to enter into a contract i.e., he or she should have contractual capacity. Thus, minor, insolvent person, lunatic etc. are not competent persons to execute documents.

(b)        The loan documents should bear proper type of stamps i.e. adhesive, embossed etc. Further value of stamp duty should be adequate, keeping in view the laws of the State in which the documents are executed. The Non‑Judicial Stamp papers, if used, should bear the date, prior to its execution and also the date should not be earlier than six months. The text of the agreement may be written on the Stamp papers itself and plain papers (additional sheets) may be used, if required in addition to Stamp papers.

(c)        No column of the loan documents should be left blank. While executing the documents, the borrower must sign in full and in the same flow in which his signatures are available in the bank. The cuttings & over writings must be avoided and if at all, they become unavoidable, they should be authenticated by the borrowers by signing in full.

(d)        Sometimes the borrower does not understand the language of the loan documents. In such a case, a separate letter, in the language of the borrower should he taken from him stating that the contents of the loan documents have been well understood by him, including the terms and conditions of the loan sanctioned. The letter should be got witnessed by another person.

(e)        In the case of an illiterate borrower who puts his thumb impression on the loan documents, the bank official in whose presence the documents are executed, should give a certificate on a separate paper that the contents have been fully explained to the borrower in a language which he speaks and understands. This certificate should be got witnessed by independent persons.

(f)        Similarly, in case of a blind person, such a certificate should be obtained from lawyer or notary public in whose presence the borrower executes documents.

(g)        In case the borrowers reside at different places, the loan documents should he got executed through the branches of the bank situated at those stations, after properly verifying the identity of the borrowers. As

regards stamp duty, it should be according to the state which attracts highest value of stamp duty. The borrowers while signing the documents must put date and place of execution after their signatures.

(h)        In the case of a partnership firm where a minor is admitted as partner to the benefits of partnership, he should not be allowed to execute any loan document. This is so because a creditor i.e. lending banker cannot proceed against the minor in person. However, minor's share in the firm can be proceeded against, as the major partners of the firm have executed loan documents, thereby binding each other by their act of execution. After the minor attains majority and elects to remain as partner in the firm, the bank should proceed to obtain an undertaking from him stating that he (minor attaining majority) stands fully liable for the dues of the bank against the partnership firm.

(i)         Sometimes loan documents are executed by the holder of power of Attorney on behalf of a trading concern, partnership firm, Hindu undivided family (HUF), company, individual etc. In such a case, a notice should be sent to the principal, stating that the attorney has executed the documents on their behalf. A certified copy of Power of Attorney should be kept along with main loan documents. And also the letter/confirmation received from the principal in this regard, in response to the notice should be preserved.

(j)         The borrowers must obtain a copy of the sanction and ensure that documents only for those facilities which are sanctioned in their favour are executed.          

(k)                All the documents must be completely filled in before their execution.

(l)                  The guarantee form should be executed if so agreed and stipulated as a term of sanction.

(m)       Copies of all the documents executed must be obtained and kept on record for any future reference.