Banker's Lien and Pledge under the Contract Act: Securities for Advances

Security does not make a bad loan good, but it decides how much of a bad loan is lost. Indian banking uses four devices to take security over property: lien, pledge, hypothecation and mortgage. They differ in one respect above all, which is whether the bank takes possession and whether the property is movable. This note deals with the two that depend on possession, and with the principles by which a banker decides whether a security is worth taking at all.

1. Why Security Is Taken

• The second way out: the primary source of repayment is the borrower's cash flow. Security is what the bank falls back on when that fails, and it limits the loss given default rather than preventing the default.
• Discipline: a borrower with his own assets at risk behaves more carefully than one with nothing to lose. Security aligns the borrower's interest with the bank's.
• Priority: a secured creditor stands outside the insolvency process to the extent of his security, or is paid ahead of unsecured creditors, so security determines where the bank stands in the queue.
• Primary and collateral: primary security is the asset created or financed by the advance itself, such as the stocks financed by a cash credit or the machine bought with a term loan. Collateral security is additional property charged to reinforce it.
• Personal and impersonal: impersonal security is property charged to the bank; personal security is the promise of a third person, as a guarantor. The first gives a proprietary right; the second gives only a claim against another pocket.
• Clean advances: some advances are taken without security at all, on the strength of the borrower's standing. Section 20 of the Banking Regulation Act restricts loans and advances, secured or not, to directors and their concerns, and banks fix their limits on unsecured exposure through board approved policies.

2. What Makes a Good Security

Figure 1: The attributes a banker looks for

• Marketability: there must be a buyer when the bank wants to sell. A specialised machine with one possible purchaser is poor security however much it cost.
• Ascertainable value: the value must be capable of being fixed without dispute, which is why listed securities and standard commodities are preferred to goodwill or a half finished building.
• Stability of value: a value that does not swing with season, fashion or sentiment. The margin the bank keeps is the measure of how unstable it expects the value to be.
• Transferable title: the bank must be able to pass a good title to a buyer, free from prior charges, disputes and statutory attachments. Title investigation is therefore part of taking security, not a formality after it.
• Durability: goods that perish, or that become obsolete faster than the loan is repaid, are falling security.
• Simplicity of charge: a security whose charge is easy to create, to register and above all to enforce. A legally perfect charge that takes eight years to realise is of limited value.
• Absence of liability: the security should carry no obligation with it, such as partly paid shares on which calls may be made, or property subject to a statutory dues charge.

Figure 2: The four modes of charge, by possession and by kind of property

3. Lien

• Particular lien (Section 170): where the bailee has, in accordance with the purpose of the bailment, rendered any service involving the exercise of labour or skill in respect of the goods bailed, he may, in the absence of a contract to the contrary, retain those goods until he receives due remuneration. It is confined to the particular goods and the charges on them.
• General lien (Section 171): bankers, factors, wharfingers, attorneys of a High Court and policy-brokers may, in the absence of a contract to the contrary, retain as security for a general balance of account, any goods bailed to them.
• An implied pledge: the banker's lien is treated as an implied pledge, so the bank may not merely retain the goods but may, after giving reasonable notice, sell them and apply the proceeds. This is what distinguishes it from an ordinary lien, which gives only a right of retention.
• What it requires: lawful possession obtained in the capacity of a banker, property not held for a special purpose inconsistent with the lien, a balance due, and no contract to the contrary.
• What it does not reach: property held for safe custody or for a specific purpose, property that came to the bank by accident, the property of a third person, the contents of a locker, and money held as a trustee.
• Negative lien: an undertaking by the borrower not to create any charge on specified assets without the bank's consent. It is not a lien at all, confers no proprietary interest, and gives only a contractual claim if broken.

4. Pledge

• It is a bailment: so delivery of the goods is essential. Delivery may be actual, as where goods are placed in the bank's godown, or constructive, as where the key of the godown is handed over, the warehouseman is instructed to hold for the bank, or a document of title such as a warehouse receipt or railway receipt is endorsed and delivered.
• General property stays with the pawnor: the pawnee acquires a special property in the goods, that is a right to retain and in default to sell. Ownership remains with the pawnor until sale.
• Retainer (Section 173): the pawnee may retain the goods not only for payment of the debt, but also for the interest on it and all necessary expenses incurred in respect of the possession or preservation of the goods.
• Not for other debts (Section 174): in the absence of a contract to that effect, the pawnee may not retain the goods for any debt other than that for which they were pledged. Such a contract is presumed in respect of subsequent advances made by the pawnee.
• Extraordinary expenses (Section 175): the pawnee is entitled to receive from the pawnor extraordinary expenses incurred for the preservation of the goods, but may not retain the goods for them.
• On default (Section 176): the pawnee may bring a suit against the pawnor upon the debt and retain the goods as collateral security; or he may sell the thing pledged, on giving the pawnor reasonable notice of the sale. If the proceeds are less than the amount due, the pawnor remains liable for the balance; if greater, the pawnee must pay over the surplus.
• Notice is mandatory: a sale without reasonable notice is wrongful, and the pawnor may recover the goods or damages. Unlike several neighbouring sections, Section 176 is not expressed to be subject to a contract to the contrary, and the requirement is generally treated as one the parties cannot dispense with, because it protects the pawnor's right to redeem.
• Redemption (Section 177): where a time is stipulated and the pawnor defaults, he may redeem the goods at any subsequent time before the actual sale, on payment of the debt and of any expenses arising from his default.

Pledge by a person who is not the owner

• Mercantile agent (Section 178): a pledge by a mercantile agent who is, with the consent of the owner, in possession of goods or documents of title, is valid as if he were expressly authorised, provided the pawnee acts in good faith and has no notice that the pawnor had no authority.
• Voidable contract (Section 178A): where the pawnor obtained possession under a contract voidable under Section 19 or 19A but not rescinded at the time of the pledge, the pawnee acquires a good title provided he acts in good faith and without notice of the defect.
• Limited interest (Section 179): where a person pledges goods in which he has only a limited interest, the pledge is valid to the extent of that interest.
• Why these matter to a bank: a bank taking a pledge of goods from a trader is often dealing with someone who is not the ultimate owner, and these sections determine whether the pledge is good against the true owner.

5. What Banks Pledge

• Goods and commodities: held in the bank's own godown or in a warehouse under its control, with a godown keeper employed or a collateral manager appointed, periodical inspection and insurance in the bank's name.
• Documents of title to goods: a railway receipt, bill of lading, warehouse receipt, dock warrant or delivery order, endorsed and delivered to the bank. Possession of the document is treated as possession of the goods.
• Electronic warehouse receipts: issued by warehouses registered with the Warehousing Development and Regulatory Authority and held in a repository, which has made agricultural pledge finance practicable at scale.
• Securities: shares, bonds and units. Since dematerialisation, a pledge of securities is created under the Depositories Act, 1996 and the regulations made under it, by recording the pledge in the depository's records, which replaces physical delivery.
• Life policies and term deposits: strictly these are assigned or made the subject of a lien rather than pledged, since they are actionable claims rather than goods.
• The practical weakness: a pledge requires the bank to hold and guard the goods, which is expensive and impractical for a manufacturer who must use his raw material. That is why most Indian working capital security is taken by hypothecation instead.

6. Questions Arising

Can a bank sell pledged goods without notice if the contract allows it?

Generally not. Section 176 requires reasonable notice of the sale, and the requirement is treated as mandatory rather than as a term the parties may vary, because it exists to preserve the pawnor's statutory right to redeem under Section 177 at any time before the actual sale. A clause purporting to waive notice is therefore unlikely to validate a sale made without it, and the pawnee who sells in breach is liable for the loss.

Does the bank become the owner of pledged goods?

No. A pledge is a bailment, so the pawnee acquires only a special property, a right to retain and on default to sell. The general property, that is ownership, remains with the pawnor until a valid sale passes it to the buyer. That is why any surplus on sale belongs to the pawnor and any shortfall remains recoverable from him.

7. Quick Revision

8. Frequently Asked Questions

What is a pledge?

Under Section 172 of the Indian Contract Act, 1872, the bailment of goods as security for payment of a debt or performance of a promise. The bailor is the pawnor and the bailee the pawnee. Because it is a bailment, delivery of possession is essential, though delivery may be constructive, as by handing over the key of a godown or endorsing a document of title.

What are the rights of a pawnee if the pawnor defaults?

Under Section 176 he may either bring a suit on the debt and retain the goods as collateral security, or sell the goods on giving the pawnor reasonable notice of the sale. If the proceeds fall short, the pawnor remains liable for the balance; if they exceed the debt, the pawnee must pay over the surplus.

What is the difference between a lien and a pledge?

A lien arises by operation of law over goods that happen to be in the holder's possession, and in the banker's case secures the general balance of account under Section 171. A pledge arises from a contract of bailment under which the goods are delivered in order to secure a particular debt. The banker's lien is unusual in being treated as an implied pledge, so that it carries a power of sale.

Is a pledge by someone who is not the owner valid?

It can be. Section 178 validates a pledge by a mercantile agent in possession with the owner's consent, where the pawnee acts in good faith and without notice; Section 178A validates a pledge by one who obtained the goods under a voidable contract not yet rescinded; and Section 179 makes a pledge by a person with a limited interest valid to the extent of that interest.

Why do banks prefer hypothecation to pledge for working capital?

Because a pledge requires delivery of possession, and a manufacturer or trader must keep using his raw material and stock. Holding and guarding the goods is also expensive for the bank. Hypothecation creates a charge without delivery, so the borrower keeps and deals with the goods while the bank holds a security interest in them, which is why it is the normal form of working capital security in India.

What is the difference between primary and collateral security?

Primary security is the asset created or financed by the advance itself, such as the stocks financed by a cash credit or the machine bought with a term loan. Collateral security is additional property charged to reinforce it, often belonging to a third person. The distinction matters because the primary security falls in value for the very reason the borrower has defaulted, which is why collateral is taken at all.

Can a bank take a pledge of shares held in dematerialised form?

Yes, but not by delivery. Since dematerialisation there is nothing physical to hand over, so a pledge of securities is created under the Depositories Act, 1996 and the regulations made under it by recording the pledge in the depository's records against the beneficial owner's account. The entry performs the function that delivery performs in an ordinary pledge, and the pledgee's rights on default are governed by the regulations together with Section 176 of the Contract Act.

9. Related Topics and Provisions

• Principles of bank lending and credit facilities
• Hypothecation and mortgage
• Guarantee and indemnity in bank lending
• Rights of a banker: lien, set-off and appropriation
• Non-performing assets and the recovery statutes