Banks grant advances (loans) against various forms of security. The type of security determines the bank's rights upon default. The primary forms are: pledge (movable goods), mortgage (immovable property), hypothecation (possession remains with borrower), lien (right to retain), and assignment (transfer of rights). Each has distinct legal requirements and enforcement mechanisms.
Legal Framework
| Provision | Subject |
|---|---|
| S.172 Indian Contract Act | Pledge defined |
| S.173 | Pledgee's right to retain |
| S.174 | Pledgee not to retain for debt/promise other than pledged |
| S.176 | Pledgee's right of sale on default |
| S.58 Transfer of Property Act | Mortgage defined |
| S.69 TP Act | Mortgagee's power of sale without court |
| S.2(2) SARFAESI Act | Security interest defined |
| S.38 Insurance Act | Assignment of life policies |
| S.27 Sale of Goods Act | Document of title to goods |
Types of Advances
| Type | Security | Possession | Key Statute |
|---|---|---|---|
| Clean advance | No security (unsecured) | N/A | Contract Act |
| Advance against pledge | Movable goods delivered | With bank | S.172-179 Contract Act |
| Advance against mortgage | Immovable property | With borrower | TP Act S.58 |
| Advance against hypothecation | Movable goods (not delivered) | With borrower | Contract + SARFAESI |
| Advance against assignment | Life policy, book debts | N/A (transfer of right) | Contract + Insurance Act |
| Advance against lien | Banker retains securities | With bank | S.171 Contract Act |
Pledge (S.172-179, Indian Contract Act)
Pledge = bailment of goods as security for payment of debt or performance of promise (S.172).
| Feature | Rule |
|---|---|
| Parties | Pledgor (borrower), Pledgee (bank) |
| Delivery | Actual or constructive delivery of goods to bank |
| Right to retain | S.173: pledgee may retain until debt paid + interest + expenses |
| Right of sale | S.176: on default, after reasonable notice, pledgee may sell |
| Surplus | S.176: after sale, surplus returned to pledgor |
| Deficiency | Pledgee can sue for balance |
| Pledge by non-owner | Valid if pledgor is agent (S.178), mercantile agent (S.178A), or factor |
Advances Against Specific Securities
1. Pledge of Goods
| Goods Type | Requirement | Risk for Bank |
|---|---|---|
| Raw materials | Actual possession in bank's godown or warehouse receipt | Deterioration, price fluctuation |
| Finished goods | Hypothecation more common; pledge needs possession | Storage costs, obsolescence |
| Gold/jewellery | Physical custody in bank vault | Valuation fluctuation |
2. Advances Against Land (Mortgage)
| Mortgage Type | S.58 TP Act | Bank's Right |
|---|---|---|
| Simple mortgage | S.58(b) | Right to sell through court |
| English mortgage | S.58(e) | Right to sell without court (if deed provides) |
| Equitable/deposit of title deeds | S.58(f) | Created by deposit of documents with intent to create security |
| Mortgage by conditional sale | S.58(c) | Ostensible sale with condition of re-transfer |
Why: Banks prefer equitable mortgage (deposit of title deeds) because it requires no registration (created orally by deposit with intent) and is cost-effective. However, post-2001, some states require registration even for equitable mortgages.
3. Advances Against Stocks and Shares
| Feature | Rule |
|---|---|
| Nature | Pledge of shares (delivery of share certificates + blank transfer deed) |
| Transfer | Requires delivery of certificates + signed transfer form |
| Listed shares | Marked value; margin maintained (LTV ratio) |
| Unlisted shares | Higher risk; lower margin accepted |
| Dematerialised shares | Pledge created through depository (NSDL/CDSL) |
| Right on default | Bank can sell shares in market after notice (S.176) |
| Risk | Price volatility; margin calls if value drops |
4. Advances Against Life Policies
| Feature | Rule |
|---|---|
| Nature | Assignment of policy (S.38 Insurance Act) |
| Transfer | Written assignment + notice to insurer |
| Surrender value | Bank lends up to 90% of surrender value |
| On death | Bank recovers loan from proceeds; surplus to nominee/heirs |
| On maturity | Bank recovers from maturity amount |
| Risk | Policy lapse if premiums unpaid; bank may pay premiums and add to debt |
| Registration | Notice to insurer is essential (S.38); without notice, insurer not bound |
5. Advances Against Documents of Title to Goods
| Document | Nature | Example |
|---|---|---|
| Bill of lading | Document of title (S.2(4) Sale of Goods Act) | Shipping document |
| Railway receipt | Deemed document of title by mercantile custom | Transport |
| Warehouse receipt/warrant | Evidence of goods stored | Godown keeper |
| Dock warrant | Evidence of goods at docks | Port authority |
Transfer of document of title = constructive delivery of goods. Bank holding a bill of lading has constructive possession of goods.
Illustrations
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Pledge vs hypothecation (who keeps the goods): Gold loan from Muthoot Finance: You hand over your gold jewellery. Muthoot keeps it in their vault. This is PLEDGE possession transferred. If you default, Muthoot sells the gold after notice (S.176). Simple, fast. Car loan from HDFC Bank: You drive the car home. HDFC doesn't park it in their lot. This is HYPOTHECATION possession stays with you. If you default, HDFC must either get a court order or use SARFAESI to seize the car. Slower, riskier for the bank (you might sell the car to someone else before they can grab it).
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Equitable mortgage (the cheapest security): You need a Rs.50 lakh home loan from SBI. Instead of executing a registered mortgage deed (costs 1% stamp duty = Rs.50,000 + registration fee), you simply deposit your original property title deed with SBI, saying: "I'm depositing this as security for my loan." That's it an equitable mortgage is created under S.58(f) TP Act. No stamp duty, no registration, no lawyer fees. This is why 90% of home loans in India use equitable mortgage. SBI holds your title deed; you can't sell the property without getting the deed back from SBI first.
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Shares as security (the margin call nightmare): You pledge 10,000 shares of Reliance (market value Rs.25 lakh) with Axis Bank for a Rs.15 lakh loan (60% LTV Loan to Value). Next week, Reliance stock crashes 40%. Your shares are now worth Rs.15 lakh same as your loan. Axis Bank issues a "margin call": deposit more shares or repay part of the loan within 24 hours. If you can't, Axis sells your shares in the open market (S.176 right after notice). The bank doesn't wait for share value to recover it protects its own exposure first.
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Life policy assignment (the notice trap): You assign your LIC policy (sum assured Rs.25 lakh, surrender value Rs.8 lakh) to PNB for a Rs.7 lakh loan. You sign an assignment deed. But PNB forgets to send notice to LIC under S.38 Insurance Act. You die. LIC pays Rs.25 lakh to your nominee (wife) not to PNB. Why? Without notice, LIC is not bound by the assignment. PNB's security is worthless. The bank must now recover Rs.7 lakh from your estate through civil suit. Lesson: notice to the insurer is not optional it's the step that perfects the security.
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Document of title (constructive possession via paper): Tata Steel ships 500 tonnes of steel from Mumbai to Kolkata by rail. The railway receipt (RR) is a "document of title to goods" (Sale of Goods Act S.2(4)). Tata endorses the RR to Union Bank as security for a Rs.2 crore advance. Union Bank now has CONSTRUCTIVE POSSESSION of 500 tonnes of steel without physically touching a single tonne. Per Bank of Baroda v. Punjab National Bank (1944): delivery of the document = delivery of goods. If Tata defaults, Union Bank takes possession by presenting the RR at the railway godown.
Recall Check
- What distinguishes pledge from hypothecation?
- What is an equitable mortgage and why do banks prefer it?
- What must a bank do to perfect an assignment of a life insurance policy?
Key Cases
Lallan Prasad v. Rahmat Ali (1967) Lallan-Prasad-v-Rahmat-Ali-1967 Issue: Whether a pledgee can sell pledged goods without giving reasonable notice to the pledgor. Rule: S.176 mandates that the pledgee must give reasonable notice of intended sale; sale without notice is wrongful. Held: The pledgee's right to sell under S.176 is conditional on giving reasonable notice to the pledgor. Sale without notice renders the pledgee liable for wrongful conversion. "Reasonable notice" means sufficient time for the pledgor to redeem.
Bank of Baroda v. Punjab National Bank (1944) Bank-of-Baroda-v-Punjab-National-Bank-1944 Issue: Whether delivery of documents of title to goods (railway receipts) to a bank creates a valid pledge. Rule: Delivery of a document of title to goods constitutes constructive delivery of the goods themselves; a valid pledge is created. Held: When railway receipts are endorsed and delivered to a bank as security for an advance, a valid pledge of the goods represented by those receipts is created. The bank acquires the same rights as if the physical goods were delivered.
Distinctions
| Aspect | Pledge | Hypothecation | Mortgage |
|---|---|---|---|
| Property type | Movable goods | Movable goods | Immovable property |
| Possession | Transferred to bank | Remains with borrower | Remains with borrower (except English mortgage) |
| Creation | Delivery of goods (S.172) | Agreement (no delivery) | Deed + registration (TP Act) |
| Right of sale on default | S.176 (after notice) | Only through court/SARFAESI | Through court or S.69 TP Act or SARFAESI |
| Registration | No registration needed | Registered with ROC for companies (S.77 Companies Act) | Registration mandatory (Registration Act) |
| Example | Gold loan, shares pledged | Car loan, stock-in-trade | Home loan, property loan |
| Statute | S.172-179 Contract Act | Contract Act + SARFAESI | TP Act + SARFAESI |
Flashcards
Q: What is pledge under S.172? A: Bailment of goods as security for payment of a debt or performance of a promise. Requires delivery of possession from pledgor to pledgee (bank).
Q: What is the pledgee's right on default under S.176? A: After giving reasonable notice to the pledgor, the pledgee may sell the pledged goods. Surplus goes to pledgor; deficiency can be recovered by suit.
Q: What is an equitable mortgage? A: Mortgage created by deposit of title deeds of immovable property with the lender, with intent to create security. No written deed required in most states (S.58(f) TP Act).
Q: How is a pledge of shares created in dematerialised form? A: Through the depository system (NSDL/CDSL). The pledgor's demat account is debited and a pledge is marked in favour of the bank's demat account.
Q: What must a bank do to perfect assignment of a life policy? A: Written assignment + notice to the insurer (S.38, Insurance Act). Without notice, the insurer is not bound by the assignment.
Q: What is constructive delivery in the context of pledge? A: Delivery of documents of title to goods (bill of lading, railway receipt, warehouse receipt) to the bank. This equals delivery of the goods themselves.
Q: What distinguishes hypothecation from pledge? A: In hypothecation, possession remains with the borrower. In pledge, possession is transferred to the bank. This makes enforcement harder in hypothecation (requires court/SARFAESI).
Exam Scenario
A borrower pledges 100 bags of rice with Beta Bank against a loan of Rs.5,00,000. The borrower defaults. Without giving notice, Beta Bank sells the rice in an auction for Rs.4,00,000. The borrower sues for wrongful sale. Advise.
Under S.176, the pledgee's (Beta Bank's) right to sell on default is conditional upon giving reasonable notice to the pledgor of the bank's intention to sell. Per Lallan Prasad v. Rahmat Ali (1967), sale without reasonable notice is wrongful. "Reasonable notice" means sufficient time for the borrower to arrange repayment and redeem the pledge.
Beta Bank sold without notice. The sale is wrongful. The borrower can claim damages for conversion (value of goods at time of conversion minus the debt). However, since the borrower was in default, the bank's right to sell per se is valid; only the process was defective. The court may: (a) treat the sale as valid but award damages for procedural irregularity, or (b) declare the sale voidable at borrower's option.
The bank is entitled to recover the loan (Rs.5,00,000) but must account for the rice at fair market value (not forced auction price). If market value exceeds Rs.5,00,000, the bank owes the surplus to the borrower. If below, the bank can sue for the deficiency. The procedural defect (no notice) exposes the bank to damages but does not extinguish the underlying debt.