Hypothecation and Mortgage in Bank Lending: Charges and Section 58 TPA

Pledge works only where the bank can hold the goods. A manufacturer needs his raw material and a trader needs his stock, so Indian banking developed hypothecation, a charge on movables that leaves possession with the borrower. For immovable property the law supplies the mortgage, defined with unusual precision by the Transfer of Property Act. Both are charges without possession, and both therefore depend on registration and on the ability to enforce.

1. Hypothecation

• Not in the Contract Act: hypothecation is unknown to the Indian Contract Act and grew out of mercantile practice. Its principal statutory definition is in the SARFAESI Act, 2002.
• The definition (Section 2(1)(n), SARFAESI Act): a charge in or upon any movable property, existing or future, created by a borrower in favour of a secured creditor without delivery of possession of the movable property to such creditor, as security for financial assistance, and it includes a floating charge and the crystallisation of such charge into a fixed charge on movable property.
• The essential feature: no delivery of possession. The borrower keeps the goods, continues to deal with them, and the bank has an equitable charge rather than a special property.
• The deed of hypothecation: the security rests entirely on the contract, which typically contains a covenant to keep the goods insured and distinguishable, to submit periodical stock statements, to permit inspection, not to create any further charge, and to deliver possession on demand so that the bank may sell.
• Conversion into a pledge: the right to take possession on demand is what makes the security enforceable. Once the bank takes possession, the hypothecation is effectively converted into a pledge and the power of sale follows.
• The bank's risks: the goods may be sold in the ordinary course, removed, substituted, or charged again to another lender. The answers are periodical inspection, stock statements, registration of the charge and the exchange of information among lenders.
• Enforcement: by taking possession under the contract and selling; by suit; or, where the bank is a secured creditor and the account is a non-performing asset, under Section 13 of the SARFAESI Act without the intervention of a court.

Figure 1: Pledge and hypothecation compared

2. Fixed and Floating Charges

Figure 2: The life of a floating charge

• Fixed charge: attaches to specific, identified property from the moment it is created, and the borrower cannot deal with that property without the chargeholder's consent. A charge on an identified machine is a fixed charge.
• Floating charge: attaches to a changing class of assets, present and future, and permits the borrower to deal with them in the ordinary course of business until some event causes the charge to settle. Stock in trade and book debts are the usual subjects.
• Crystallisation: the floating charge fastens on the assets then in existence and becomes a fixed charge, on default, on the commencement of winding up, on the appointment of a receiver, on the borrower ceasing to carry on business, or on notice where the deed so provides.
• The weakness: until crystallisation the borrower may dispose of the assets, and a subsequent fixed charge created in the ordinary course may rank ahead of an earlier floating charge unless the deed contains a negative pledge of which the later chargeholder had notice.
• Priority in insolvency: in a winding up under the company law, preferential payments rank ahead of debts secured by a floating charge, and a floating charge also yields to fixed charges on the same property, which is a further reason why banks seek fixed charges wherever the asset permits it. In a liquidation under the Insolvency and Bankruptcy Code, the Section 53 waterfall governs instead.

3. Registration of Charges

• Companies (Section 77, Companies Act, 2013): every company creating a charge on its property must register the particulars with the Registrar of Companies within thirty days of creation, with power in the Registrar to allow further time on payment of additional fees within the limits the section prescribes.
• The consequence of failure: an unregistered charge is not taken into account by the liquidator or any creditor in a winding up or insolvency, so the bank is reduced to an unsecured creditor. The obligation is on the company, but the charge-holder may also register, which is why a bank always files itself rather than relying on the borrower.
• Satisfaction and inspection: satisfaction of a charge must be intimated, and the register of charges is open to inspection, which gives any later lender constructive notice of what is already charged.
• The central registry (Section 26B, SARFAESI Act): the Central Registry of Securitisation Asset Reconstruction and Security Interest of India records security interests created by any borrower, whether a company or not, which is what closes the gap left by the company law register for proprietorships and partnerships.
• Effect of central registration: registration operates as notice and determines priority among secured creditors, so a lender who does not search the registry before lending takes the risk of a prior charge.
• The Registration Act, 1908: a mortgage deed other than a mortgage by deposit of title deeds, where the principal money secured is one hundred rupees or upwards, requires compulsory registration.

4. Mortgage

• The elements: a transfer of an interest, not of ownership; in specific immovable property; for the purpose of securing money advanced or to be advanced, an existing or future debt, or an engagement giving rise to a pecuniary liability.
• The mode (Section 59): every mortgage other than a mortgage by deposit of title deeds, where the principal money secured is one hundred rupees or upwards, can be effected only by a registered instrument signed by the mortgagor and attested by at least two witnesses.
• Redemption (Section 60): at any time after the principal money has become due, the mortgagor has a right, on payment, to require the mortgagee to deliver the mortgage deed, to deliver possession where he holds it, and to retransfer the property. A term preventing redemption is a clog and is void, on the principle once a mortgage always a mortgage.
• Remedies: foreclosure or sale under Section 67, suit for sale where the mortgage is simple or English, and a power of sale without the intervention of the court under Section 69 where the conditions of that section are met.
• Priority (Section 48): where a person creates successive rights over the same property, and they cannot all exist together, each later created right is subject to the rights previously created, so prior in time is prior in right unless registration or notice alters the position.

The six kinds

• Simple mortgage (Section 58(b)): the mortgagor binds himself personally to pay and agrees that on default the mortgagee shall have a right to cause the property to be sold by a decree of court. No possession is delivered.
• Mortgage by conditional sale (Section 58(c)): an ostensible sale with a condition that on default it shall become absolute, or that on payment the sale shall become void and the buyer shall retransfer. The condition must be embodied in the same document. The remedy is foreclosure.
• Usufructuary mortgage (Section 58(d)): possession is delivered, and the mortgagee retains the rents and profits in lieu of interest or in payment of the principal. There is no personal covenant and the mortgagee cannot sue for sale or foreclosure.
• English mortgage (Section 58(e)): the mortgagor binds himself to repay on a certain date and transfers the property absolutely to the mortgagee, subject to a proviso for retransfer on payment. The remedy is sale, and Section 69 may give a power of sale without the court.
• Mortgage by deposit of title deeds (Section 58(f)): where a person delivers to a creditor documents of title to immovable property with intent to create a security, in a notified town. It requires no registration and no written instrument, which is why banks use it more than any other form. It is commonly called an equitable mortgage.
• Anomalous mortgage (Section 58(g)): a mortgage that is none of the above, governed by the terms of the contract and by such of the Act's provisions as are consistent with it.

5. Questions Arising

Is a hypothecation a pledge in disguise?

No, and the difference is possession. A pledge is a bailment, giving the pawnee a special property in the goods and a statutory power of sale on notice. A hypothecation gives only an equitable charge resting on the contract, with no property in the goods and no automatic power of sale. The two converge only when the bank exercises its contractual right to take possession, at which point the security becomes enforceable in the same way as a pledge.

Why do banks register charges with both CERSAI and the Registrar of Companies?

Because the two registers do different work. Section 77 of the Companies Act covers charges created by companies only, and failure to register makes the charge unenforceable against the liquidator. The central registry under Section 26B of the SARFAESI Act covers security interests created by any borrower, including proprietorships and partnerships, and fixes priority among secured creditors. A bank lending to a company against immovable property files in both, and searches both before lending.

6. Quick Revision

7. Frequently Asked Questions

What is hypothecation?

A charge in or upon movable property, existing or future, created by a borrower in favour of a secured creditor without delivery of possession, as security for financial assistance, including a floating charge and its crystallisation into a fixed charge. The definition is in Section 2(1)(n) of the SARFAESI Act, 2002; the Indian Contract Act does not deal with it.

What is the difference between a fixed and a floating charge?

A fixed charge attaches to specific identified property from the moment of creation, and the borrower cannot deal with it. A floating charge attaches to a changing class of assets and allows the borrower to deal with them in the ordinary course of business until it crystallises, on default, winding up, the appointment of a receiver, cessation of business or notice, whereupon it fastens on the assets then held.

What are the six kinds of mortgage under Section 58?

Simple (personal covenant, sale by decree); mortgage by conditional sale (ostensible sale, remedy foreclosure); usufructuary (possession delivered, rents and profits taken); English (absolute transfer with a proviso for retransfer); mortgage by deposit of title deeds in a notified town; and anomalous, which is any mortgage that is none of the other five.

Why is a mortgage by deposit of title deeds so widely used?

Because it requires no registered instrument and no written document at all. It is created by the delivery of documents of title with intent to create a security, in a notified town, which makes it quick and inexpensive. A memorandum may record the deposit, but if it is drafted so as to create the mortgage rather than merely evidence a deposit already made, it becomes a mortgage deed requiring registration and stamp duty.

What happens if a company's charge is not registered?

The charge is not taken into account by the liquidator or any creditor in a winding up or insolvency, so the bank falls to the position of an unsecured creditor. Section 77 of the Companies Act, 2013 requires registration within thirty days of creation, with limited extension on additional fees, and permits the charge-holder itself to register, which is why a bank files rather than relying on the borrower.

8. Related Topics and Provisions

• Securities for advances: lien and pledge
• Principles of bank lending and credit facilities
• Guarantee and indemnity in bank lending
• Non-performing assets and the recovery statutes
• The SARFAESI Act and enforcement of security interest