Analyzing the Contours of Pledge and Hypothecation

Introduction

Section 172 of the Indian Contract Act of 1872 defines a pledge. It’s a type of contract in which one party (Pledgor) gives another party (Pledgee) moveable goods as security in exchange for a payment. What’s important to remember here is that the pledgor is the one who delivers the security to the pledgee. Hypothecation, on the other hand, is a contract in which one party (the debtor) guarantees his moveable property to another (the creditor) in exchange for a payment. It’s worth noting that the debtor just pledges the security to the creditor in this case. The debtor makes no security delivery to the creditor.

Now that we’ve grasped the basic notion behind each of these concepts, let’s go deeper into them and see how they complement one another.

Pledge

Pledge is the bailment of goods as security for the payment of a debt or the fulfilment of a promise. In this scenario, the bailor is referred to as the pawnor. Pawnee is the term for the bailee. Due to the fact that a contract of pledge requires delivery of commodities to come into existence, it is apparent that pledge is likewise a sort of bailment as defined in the preceding section. If Raj borrows Rs. 1,00,000/- from Rohan and pledges his scooter as collateral, the contract between Raj and Rohan is a pledge contract, in which Raj is the pledgor and Rohan is the pledgee. A pledge is the transfer of possession of certain commodities from one person to another, to be kept by the latter as a security for the former’s execution of some duty to pay or perform, which must be recovered after the obligation is fulfilled.[1] Pledge is defined by the Supreme Court as –  “A bailment of personal property as a security for a debt or engagement is known as a pawn or pledge. A pawnor is a person who, as part of an engagement, provides something to the person to whom he is liable as security for the payment of his obligation or the fulfilment of his liability.”[2] There are three types of security that can be provided: lien, mortgage, and pledge.[3] In a pledge contract, one party pledges any good or the title of a good to the other as collateral for money advanced by the latter party. As a result, making a pledge is a must for receiving funds. Pledge can also be defined as the delivery of goods by a debtor to a creditor in exchange for a debt or any other contractual obligation, with the item supplied to the pledgor being returned when the debt money is repaid or the obligation is fulfilled.[4]

A legitimate contract of pledge includes the bailment of goods as security for the debt, as described by section 148[6] of the Act. There is no distinction between the Indian and English Common Law systems when it comes to the concept of pledge. The essence of the contract is one of security, with the security liable in the event of the debtor’s default.

Essentials of Pledge

  1. Delivery of the goods to be pledged – The basic prerequisite for a valid contract of pledge is the handover of possession of a good. In order for the contract to be fulfilled, the indicated chattel must be delivered in person. The property or other good pledged must be handed to the creditor, who in this situation is the Pawnee, the person to whom the pledge has been made, both actually and constructively.

The physical transfer of the good to the Pawnee is referred to as actual delivery, and the entire good is bailed to him. Pledge by way of constructive delivery, on the other hand, entails an indirect or symbolic delivery of the property or item. The distribution of the key to the warehouse containing the goods to be pledged to the Pawnee is the most common example of this principle. Delivery can also be made by attornment, which implies that if the commodities are in the custody of a third party, the pledgor can direct him to retain them on behalf of the pledgee. Also, for the purposes of a pledge, delivery of the title to the goods or property to be pledged would be equivalent to actual delivery.

The railway receipts issued by the railroads relating to the transfer of goods from Bombay to Okhla were pledged with the bank for a value of 20,000 in Morvi Mercantile Bank Limited vs. Union of India[5]. The products, however, were lost in route. The pledgee sued the railways for the realization of the security after failing to recover the debt from the pledgor. The Supreme Court ruled that the pledgor’s transfer of railway receipts to the pledgee counts as delivery of the items in question since it was a constructive delivery and the pledgee can sue the railways for the money owed. It’s worth noting that in circumstances of constructive delivery, the pledgor’s title in the goods should pass to the pledgee.

The Mysore High Court held in Syndicate Limited vs. Ramchandra Ganapathy Prabhu[6] that share certificates are not papers of title to goods, but rather things themselves. As a result, the pledgor’s transfer of share certificates to the pledgee constitutes real delivery of goods rather than constructive delivery.

  • A Valid Contract – Even though a pledge contract falls under the category of Special contracts, it must contain all of the basic elements as defined by the Indian Contract Act of 1872 in order to be valid.
  • Right on the Pledge – Another important feature of a pledge is that the pawnee only has possessory rights over the pledge, not legal ones. The pawnee only has the special property, while the pledgor retains the general property. When the pledge is repaid, the unique rights are likewise returned to the pledgor.
  • Time of Delivery – In a pledge contract, the delivery of possession and the payment of money do not always have to happen at the same time. Even after an advance has been made, a promise can be made later. Blundell Leigh v Attenborough is a case in point for more discussion on this topic.[7]

The facts of the case are that A provided B some gems for the purpose of valuing them and determining how much credit she could get for them. B kept the jewel as a form of insurance in case he made any attempts toward her. This happened on November 1st, and B grabbed the jewels and promised them to C for 1000 pounds on the same day. On the promise of the jewels and a promissory note, B advanced 500 pounds to A at a later date. A perished as a result of this. B subsequently sued C for the return of the jewels, claiming that she simply provided them to him as a gratuitous bailment and that he had no right to do anything with them. He did not have possession of the commodities when he advanced money, thus it was not a commitment. When the case proceeded to court, the trial court ruled that the pledge between A and B was invalid since the jewels were not in B’s possession at the time of the pledge.

As a result, A had the right to reclaim the diamonds from C without having to pay any money. The Court of Appeals, however, overturned this verdict, ruling that the original distribution, albeit gratuitous, was a good and legitimate delivery. As a result, even though he didn’t have the jewels at the time of the pledge, it was still legitimate.

Rights and Duties of Pledgor and Pledgee

Right of retainer

Section 173 of the Act allows the pledgee to keep the security until the pledgor has paid off the total amount. The term ‘entire debt’ encompasses any accrued interest as well.

According to Section 174 of the Act, the pledgee cannot keep the security and force the pledgor to discharge an obligation for which the security was not promised, i.e., the pledgee can keep the security only until the debt discharged against it has been recovered.

Right to extraordinary expenses

According to Section 175 of the Act, if the pledgee has incurred any unusual expenses in order to preserve the security, he can sue the pledgor to collect those costs. The Act does not provide for a right to keep the items in order to recover such excessive costs.

Right to sell

According to Section 176 of the Act, if the pledger fails to comply with the pledge contract and creates a default there under, the pledgee has the right to sell the commodities held as security to satisfy the obligation, unless there is a contract to the contrary. However, the pledgee is required to provide the pledgor adequate notice of the transaction.

Right to redeem

According to Section 177, if the pledgor fails to comply with the pledge contract and makes a default there under, he may redeem the security by making the full amount at any moment before the pledgee sells it. The pledgor will also be responsible for any losses incurred by the pledgee as a result of the default in payment.

Pledge by Hypothecation

When things are pledged via hypothecation, they stay in the debtor’s possession even after the creditor has advanced payment. Although it is implied that the security has been delivered in this case, the debtor retains control of the security. For example, if Rahul borrows $1,000,000 from Ramesh and pledges his tractor as collateral, but Rahul keeps control of the tractor and uses it to plough the field on a daily basis, this is known as a pledge through hypothecation.

Reeves vs. Capper[8]was one of the first cases to establish the concept of commitment by hypothecation (1838). In this case, the captain of a ship had pledged his chronometer to the ship’s owner, but he kept control of the chronometer and utilised it during his voyage. Later, he pledged the chronometer to someone else. In light of the first vow, the question was whether the second pledge was still valid. The Court decided that the case at hand constituted a pledge through hypothecation, and that the ship owner had rights to the security even if the captain remained in possession of it. As a result, the second pledge was ruled invalid.

In Appa Rao vs. Salem Motors and Salem Radios[9], the plaintiff pledged motor cars to the defendant, but the plaintiff retained control of the vehicles and utilised them for demonstrative purposes. A pledge becomes hypothecation, according to the Madras High Court, when the items that are to be delivered as security remain in the ownership of the debtor rather than the creditor.

The creditor has no direct right of seizure

In the case of a pledge via hypothecation, if the debtor fails to settle the debt, the creditor has no right to enter the debtor’s premises and confiscate the goods pledged as security. If the creditor wishes to use this power, he must first obtain consent from the debtor or obtain an order from a competent court.

The Madras High Court declared in Union of India vs. Shenthilanathan (1977) that in circumstances of pledge through hypothecation, the creditor does not have a direct right to seize the commodities if the debtor fails to satisfy the loan. The creditors only alternative is to go to a competent court and file a complaint for debt recovery and get a decree for the seizure of the security in question.

Pledge and its Distinctiveness

  • Pledge and Hypothecation – A hypothecation has been described as a type of pledge in which the possession is not delivered. As a result, the hypothecator retains custody of the things, along with all of his interests and rights to pleasure. It’s worth noting that, unlike a pledge, when the pledgee is in possession, in a hypothecation, the owner of the items acts as the hypothecatee’s agent. As a result, the primary distinction between pledge and hypothecation is transmission of possession. Nonetheless, similarly promise the hypothecatee to have the right to litigate and even sell the thing in order to repay the loan payment. In hypothecation, the genuine owner takes on the role of a bailee of commodities acting on behalf of the bailor, who is the hypothecatee in this situation. To put it another way, while a pledge involves the transfer of possession, a hypothecation entails the transfer of rights or interests, which are both too limiting.
  • Pledge and Lien – A pledge creates unique property in the pledged item, but a lien is only a personal right that the party is entitled to exercise in the event of non-payment. The distinction between the two derives from the parties’ respective rights. While a promise allows the pledgee to keep, litigate, and even sell the property of the good pledged, a lien merely allows the pledgee to keep the property. Lien can be thought of as the inverse of hypothecation in that the former involves the transfer of ownership while the latter needs the transfer of rights.
  • Pledge and Mortgage – A pledge is the transfer of custody of an item in exchange for a monetary sum or as a guarantee that an obligation will be met. A pledge grants the pledgee unique rights, such as the ability to seek remedies if the pledgee defaults. Other than these particular rights, however, the juristic or legal rights are also transmitted under a mortgage. That is to say, in the case of a pledge, the right of enjoyment is not transferred, whereas in the case of a mortgage, the right of enjoyment is passed to the mortgagee. Another contrast is that a mortgage contract does not necessitate the actual delivery of the commodities or things. Furthermore, although a contract of pledge only allows for the pledge of movable goods, a mortgage can include both moveable and immoveable property.

Hypothecation

Hypothecation is the process of offering an asset to a lender as a kind of collateral security. The borrower has possession of the property, which is owned by the lender. In the event that the borrower defaults, the lender has the authority to confiscate the asset under his ownership rights.

The transaction is hypothecation, according to Hart, when things are made accessible as security for a loan without transferring possession of the item to the lender. It is frequently done in the event of movable assets in order to create a charge against collateral for a loan. The borrower retains possession of the security in a hypothecated transaction. As a result, if the borrower defaults on payments, the lender must first seize the security (asset under hypothecation) and then sell it to recoup the debt

Hypothecation, on the other hand, is not defined in the Indian Contract Act of 1872, but it is defined in Section 2(1)(n) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SRFAESI) Act of 2002:

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 a security for financial assistance, including floating charge and crystallisation of such charge into fixed charge on movable property.” according to the definition.

The term “hypothecation” refers to the formation of a charge on any movable asset by the owner in order to obtain funds from a bank without surrendering ownership and possession to the lender. The borrower (owner) of goods borrows money against the security of assets, such as inventories, in this agreement.

Under this arrangement, the lender is the hypothecatee and the borrower is the hypothecator. The hypothecatee’s rights are determined by the hypothecation agreement between the two parties. If the hypothecator fails to pay the dues within the agreed-upon time frame, the hypothecatee may launch a lawsuit to recover the debt by selling the hypothecated asset.

Previously, hypothecation was seen as a pledge, with the lender entrusting possession of the security to the borrower. The borrower retains the right, title, and possession of the security in hypothecation, while the lender has a qualified interest in the security. The borrower agrees to transfer possession whenever it is required. When the security covered requires action or the borrower requires specific goods under his control to continue its manufacturing and/or trading activities, hypothecation is used. Because hypothecation serves as a security for present and future movable property, the charge is also known as a “Floating Charge.” This is the charge that poses the most risk to the lender. It is almost like an unsecured advance, given that neither the title or possession or right is under his control. The lender is totally reliant on the borrower’s promise to give over possession as necessary.

To address these challenges, banks must exercise extreme caution when dealing with assets that have been hypothecated. They can do so by verifying that the borrower uses a single bank for the facility or by examining periodic stock statements, among other things.

Hypothecation is a common component in consumer contracts involving mortgages — the debtor legally owns the house, but the creditor has the right to take ownership (and perhaps also possession) until the mortgage is paid off – but only if the debtor defaults on payments. If a consumer takes out a second loan secured against the value of his mortgage (commonly referred to as a “second mortgage”) for up to approximately the current value of the house minus outstanding repayments, the consumer is hypothecating the mortgage itself. The creditor can still seize the house, but the creditor is now responsible for the outstanding mortgage debt. Consumer items and business equipment are sometimes purchased on credit arrangements including hypothecation, in which the goods are legally owned by the borrower but can be seized by the creditor if necessary.

Parties in a Hypothecation Deed

Lender

Whose benefit does the charge accrue? Banks and other financial entities are the most common lenders. State Bank of India, HDFC Bank, ICICI Bank, and others are examples.

Borrower

Who initiates the charge in the lender’s favour? The person or business who receives financial help from the lender is known as the borrower.

Need for Hypothecation Deed

When a charge on moveable property must be made in such a way that the movable property remains in the borrower’s ownership even after the charge is created, then the parties will require a hypothecation deed. For example, if a person seeks a loan of INR 3 lakhs from the bank but does not own any immovable property or does not want to keep his immovable property as a security for the loan amount, he might place a charge on his mobile property, such as a vehicle, machinery, or furniture.

When are Hypothecation Agreements Used?

The hypothecation agreement is not a verbal agreement between the borrower and the lender. Rather, a document known as a hypothecation deed is used. A hypothecation agreement, also known as a hypothecation letter, specifies the details of the hypothecation and settles the parties’ rights and duties conclusively. In India, hypothecation is most commonly used to finance automobiles and motorcycles, as well as to purchase commercial real estate. When a debt is to be secured, hypothecation is frequently used, and the creditor requests collateral or security to help limit his risk. Hypothecation is also frequently employed in consumer and company finance, as well as the financial and investing industries.

Hypothecation in Investing

The most common application of hypothecation is in real estate investments. Commercial real estate investments may necessitate additional collateral from lenders. Because the loan payment is contingent on the success of a commercial firm, these types of investments and properties might be more risky. Depending on the perceived worth of the investment location or type of property, the lender may need larger monetary collateral. There are a number of reasons why you should form a hypothecation agreement rather than other types of agreements. The following are some of the reasons:

Reduction of down payment

Because the borrower is pledging a high-value item to guarantee his loan, rather than a standard mortgage, which employs loan-to-value ratios and credit score to screen a borrower, the amount of down payment that a borrower owes can be decreased by hypothecating an asset. As a result, borrowers who choose to hypothecate an asset to finance a loan may be eligible for lower down payments, making lending more accessible.

Retain the title

Borrowers can keep the title to their hypothecated assets, i.e. whole ownership rights. You don’t have to be concerned about a third party retaining the title to your asset if you are confident that you will be able to repay the loan.

Greater security for lenders.

Lenders benefit from hypothecation on high-risk loans, particularly commercial mortgages when the loan payment is contingent on the performance of a commercial enterprise.

Benefits of Hypothecation

The borrower has numerous advantages in this situation. Let’s take a look at each one individually —

Ownership: This is a far better alternative for someone who is just starting out in business or in their profession. Of course, there are some restrictions that must be adhered to, but one of the most significant benefits is ownership. As a borrower, you will be able to keep ownership of your movable property while also receiving loan assistance from the bank. The only stipulation is that you pay the bill on time.

Lower interest rate: Because the bank/financier has the possibility of keeping the movable property if the money isn’t paid on time, the interest rate is lower. The rationale for the decreased rates is due to two factors. To begin with, the option of owning the vehicle provides the lender with a sense of assurance that the money will be repaid. Second, because there is a documented hypothecation agreement between two parties, it is not an unsecured loan.

Small loans: Unlike a mortgage, this is only done for small loans. As a result, it’s simple to utilize and pay back. It’s a fantastic chance for a business owner, and it’s often used more than mortgage loans.

Alternate Asset for Hypothecation: It can also be done with stocks and investments. This is known as margin lending, and it is a frequent practice in stock trading. When a buyer buys stock on margin, he puts his current stock up as collateral with the brokerage business. If the buyer suffers a margin call, the brokerage company can sell these shares. When the value of securities purchased falls below a specific threshold or the account value falls below a given threshold, a margin call is issued.

Indian Laws Covering Hypothecation

Previously, hypothecation was not defined in Indian law for a long time, and it was based on practice and use. Hypothecation is now defined as “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 a security for financial assistance, and includes floating charge and crystallisation into fixed charge on movable property” under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI).

Formalities for Creation of Hypothecation

The security provider executes a “deed of hypothecation” on favour of the lender in hypothecation. The charge formed by the hypothecation deed is governed by the terms of the agreement, which spell out the powers and provisions that protect the lender’s interests. Hypothecation over a motor vehicle must be mentioned on the vehicle’s registration certificate.

The payment of necessary Stamp Duties as per rates in each state, as well as filing with the ROC in the case of corporations, are the other prerequisites for hypothecation. It is now mandatory to file creation, modification, or satisfaction of security interests in hypothecation of plant and machinery, stocks, book debts, and receivables after the formation of CERSAI (under SARFAESI), the Central Registry of Securitisation and Asset Construction and Security Interest of India.

How is Hypothecation Removed?

By paying out the entire loan, you can get rid of the hypothecation. You will receive a No Objection Certificate (NOC) from the bank. This paper will show that there are no outstanding debts. You can take the copies to the Regional Transport Authority and the insurance firm to get your registration and insurance changed to your name rather than the bank’s.

Difference between Hypothecation and Mortgage

Governing Laws

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 governs the notion of hypothecation in India. The Transfer of Property Act, 1882 governs the concept of a mortgage in India.

Definition

The term hypothecation is defined in Section 2(n) of The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 as “a charge on movable property created by the borrower in favour of the creditor as a security to obtain financial assistance from the creditor.”

The term mortgage is defined as the transfer of a specific interest in an immovable property to finance a debt under Section 58 of the Transfer of Property Act, 1882.

Parties

The parties involved in hypothecation are known as the lender and the borrower. The mortgagor (transferor) and the mortgagee are the persons engaged in a mortgage (transferee).

Deals with

Hypothecation is used to finance moveable property, whereas a mortgage is used to finance immovable property.

Instrument

The hypothecation deed or hypothecation agreement is the instrument by which the hypothecation takes effect, and in the event of a mortgage, it is the mortgage deed or mortgage agreement.

Ownership

When a loan is hypothecated, the lender gains ownership of the property. In the case of a mortgage, however, the mortgagor retains ownership.

Possession

Possession is with the borrower in the case of hypothecation. In the case of a mortgage, however, it is dependent on the type of mortgage.

Amount of loan

Because the mortgage is secured against the immovable property, the amount of loan secured by the borrower by hypothecating the movable property is often smaller than the amount of loan secured by the mortgagor.

Tenure

The time period for which the security is hypothecated is usually less than the time period for which real estate is mortgaged.

Difference between Hypothecation and Pledge

Governing Laws

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 governs the notion of hypothecation in India. The Indian Contract Act,1872 governs the concept of a commitment in India.

Definition

Section 2(n) of The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 defines hypothecation. Section 172 of the Indian Contract Act, 1872 defines the term pledge as “the bailment of goods such as gold as a security for the execution of a promise or the payment of a debt.

Parties

The parties involved in hypothecation are known as the lender and the borrower. The pawnor (bailor) and the pawnee are the parties involved in a pledge (bailee).

Possession of security

The borrower retains possession of the security in the event of hypothecation. A promise, on the other hand, transfers ownership of the security from the pawnor to the pawnee. The film producer obtained a loan and committed to supply the final prints of the picture when they were completed in the case of Chief Controlling Revenue… vs. Sudarsanam Picture, Madras. The court ruled that it was a pledge because the property’s possession was not transferred at the time of the arrangement.

Instrument

The hypothecation deed of the hypothecation agreement, and in the case of pledge, the Contract of pledge or pledge agreement, is the instrument through which the hypothecation takes effect.

Scope

Because hypothecation is the species of the pledge, the scope of a pledge is broader than that of hypothecation. When the borrower fails to pay the lender’s dues according to the hypothecation deed, the charge of hypothecation is transformed to a pledge, and the lender gains pawnee rights.

Similarities between Pledge and Hypothecation

Preferential right to recovery

The Madras High Court held in Rehaboth Traders, By Partner R. vs. Canara Bank[10] that in circumstances of hypothecation, the creditor has a special and preferential right to recover the debt from the security. The creditor is treated as a secured creditor in this case, and his claim to recover takes priority over all other creditors.

The Supreme Court declared in Bank of Bihar vs. State of Bihar[11] that the bank, as the pledgee, has priority over all other creditors over the security pledged with it. As a result, it can be seen that the pledgee/creditor is given a preferential right to recover the debt from the security in both circumstances.

Right over the goods

The Madras High Court held in Rehaboth Traders By Partner R. vs. Canara Bank (1998) that the debtor must guarantee that the value of the items pledged as security does not deteriorate due to his own negligence in circumstances of pledge by hypothecation. The debtor must provide the creditor with regular reports on the status and upkeep of the security. It was also noted that the creditor has first claim to the security and that the debtor is just acting as the creditor’s agent in holding the security.

The Andhra Pradesh High Court held in Kamili Sarojini vs. Indian Bank[12] that the pledgor has the authority to keep the security in his custody till the obligation is settled. Before the obligation is fully paid, the pledgor has no right to exercise any rights over the security or sell it.

As a result, regardless of whether the pledgee/creditor is in possession of the security or not, the pledgee/creditor has the right to the items supplied as security in both circumstances.

Right to sell

The Mysore High Court held in Sree Yellamma Cotton Woollen & Silk Mills and Co. Ltd. vs. Official Liquidator[13] that in cases of pledge by hypothecation, the creditor has the right to sell the goods pledged as security if the debtor fails to comply with the contract’s terms, provided that such a right has been granted to the creditor under the contract of pledge by hypothecation.

The Jharkhand High Court ruled in S.N. Choubey vs. Central Coalfields Limited[14] that in circumstances of pledge, the pledgee has two rights for the redemption of the due obligation. He has two options: one, he can sue the pledgor for the debt’s recovery and keep the security in his possession until a decree is issued, and second, he can sell the goods held as security after providing the pledgee due notice of the proposed sale.

As a result, it can be shown that the pledgee/creditor has the right to sell the items to recover the obligation in both circumstances.

Case Laws

1.     Union of India & Anr v. CT. Shentilnathan & Anr [(1978) 48 Com Cas 640]:

The Division Bench of the Madras High Court held as:

“Hypothecation of goods is a concept which is not expressly provided in the law of contracts, but is accepted in the law merchant by long usage and practice. Hypothecation is not a pledge and there is no transfer of interest or property in the goods by the hypothecator to the hypothecatee. It only creates a notional and equitable charge in favour of the hypothecatee and the right of the hypothecatee is only to sue on the debt and proceed in execution against the hypothecated goods, if they are available. The only right, which the hypothecatee got under hypothecation, was a right to seek for the sale of the hypothecated goods after a money decree on the debt. This Madras High Court decision classifies the hypothecatee as unsecured creditor”.

2.     M/s Tara Rerolling Mills & Five others v. Punjab National Bank [1998 (4) All India Banking Law Judgments 275]:

The Madhya Pradesh High Court held that, in the case of hypothecation, the hypothecator retains possession, but the hypothecatee has the right to take control of the hypothecated property and sell it to pay off the obligation secured by hypothecation. Section 176 of the Indian Contract Act, 1872, applies to the items hypothecated to the Bank. For the purposes of applying Section 176 of the Contract Act, there can be no distinction between “hypothecation” and “pledge.”

Hypothecation is no different from from Pledge: A Justification

Hypothecation Defined

Hypothecation is not a legal concept, but it has long been utilised in the mercantile world. In either the Contract Act or the Sale of Goods Act, there is no provision for Hypothecation. It is not governed by any law or statute. As a result, courts must decide hypothecation matters only on the general principles of the contract as set forth in the hypothecation agreement.

The term “hypothecation” is defined as a charge on any movable property payable in the future created by a debtor in favour of a secured creditor without relinquishing control of the property to that creditor as financial security in the SARFESI Act, 2002.

Hypothecation is the use of items as security for a debt without actually transferring ownership or custody of the goods to the creditor (hypothecatee). The debtor (hypothecator) retains control of the items in this case. If the owner of the goods fails to pay the debt within a certain time frame, the creditor retains all rights to collect the debt, including the ability to sell the security goods.

Hypothecation is defined by Halsbury’s Laws of England as a pledge of goods without an immediate change of possession. Also allows the creditor the right to seize the goods if the debt is not paid within the agreed-upon time frame, and it empowers the owner of the commodities to discharge the debt, releasing the hypothecated goods from the obligation.

Pledge Defined

The conveyance of commodities by the owner (Pawnor) to the creditor (Pawnee) by providing a security that when the dues are paid, the goods will be returned or disposed of according to the owner’s instructions is defined by Section 172 of the Indian Contract Act[v] (Pawnor). Actual or constructive delivery of goods is possible. A pawnee simply has the right to hold the things; he or she does not have the right to enjoy them. The terms of the pledge contract govern his actions.

Pledge is a type of hypothecation. Although hypothecation does not give the creditor possession or title, it does generate a charge.

Charge Defined

The term “charge” is defined as a mechanism to generate security that is enforceable in a court of law under Section 100 of the Transfer of Property Act [vii]. There is no transfer of property or interest; rather, a right to be paid out of the agreed-upon property is created. Though the term “charge” is defined in this act in terms of immovable property, it can be used to describe the general meaning of the term “charge,” which can be used to both moveable and immovable property. The fee for movable property does not have to be in writing.

Relation Between Charge, Hypothecation And Pledge

When a borrower fails to pay his or her debts to the creditor within the agreed-upon time frame, the charge of hypothecation is changed to a pledge, and the creditor gains pawnee rights.

Similarity between Pledge and Hypothecation

Hypothecation and Pledge have many similarities between them. Some of them are illustrated here:

In the case of Rehaboth Traders by Partner R. Vs. Canara Bank, it was decided that in a Hypothecation, the Bank (hypothecatee) is recognised as a secured creditor with a preferential right to recover over the other creditors. In The Bank of Bihar v. The State of Bihar and Others– it was determined that in a Pledge, no other creditor of the pawnor has the authority to take away the goods as long as the Bank’s claim is not paid, implying that the Pawnee is a secured creditor with priority over other creditors. As a result, it can be stated that both a pledge and a hypothecation secure the pawnee/hypothecatee and grant them priority rights over the pawnor/other hypothecator’s creditors. Subject to the rules of the Hypothecation, the debtor is allowed to utilise the commodities for commercial purposes, but must provide frequent reports to the creditor and maintain a certain value for the goods if the deed requires it.

It was held in Rehaboth Traders By Partner R. Vs. Canara Bank that delivering the keys to a warehouse is not required to gain constructive possession because possession is irrelevant. Instead, what matters is control over the things, and the debtor/hypothecator (owner) is an agent of the hypothecatee (the creditor), with the debtor having only delegated authority over the goods subject to the hypothecatee’s rights. That is, the debtor is an agent of the hypothecatee, even though he is in possession of the goods. Until the obligation is paid, the hypothecatee holds indirect but ultimate control over the goods. As stated in Section 173, the Pawnee has the right to keep the items until the debt, interest, and fees incurred by him are paid. As a result, until the loan is paid off, the items are under the jurisdiction of the creditor (Pawnee). As a result, Hypothecation is a variation of Pledge that permits the creditor to have indirect control over the security items rather than the direct authority granted by Pledge.

It was held in the case of Shri Yellamma Cotton Wollen & Silk Mills and Co. Ltd., Bank of Maharashtra Ltd. Pune, vs. Official Liquidator that the creditor has the right to sell the items under hypothecation. On failure or breach of the provisions of Hypothecation by the debtor, he can take possession of items and sell them without the need for court intervention, but only if the creditor has been given such authority under the Hypothecation agreement. When the Pawnor fails to pay the dues within the stipulated length of time, the Pawnee has a right under Section 176 of the Act. It gives the Pawnee the option to sue the Pawnee and keep the items as collateral, or it gives the Pawnee the option to sell the things after giving sufficient notice of the sale. Thus, in both hypothecation and pledge, if the debtor defaults or breaches the terms of the hypothecation/pledge agreement, the creditor has the right to sell the goods to recover the debt or satisfy the contract’s terms.

Conclusion

Following the above reasoning, we may conclude that the main difference between Hypothecation and Pledge is that under Hypothecation, the owner retains control of the commodities. Pledge, on the other hand, transfers ownership of the item to the creditor. As a result, while a pledge involves the transfer of possession of commodities, a hypothecation entails the transfer of interests according to the terms of the agreement.

As can be seen, both a pledge and a hypothecation produce a charge and give debt security to the creditor. Both allow the creditor the ability to seize and sell goods in order to collect the debt. Both confer final sovereignty over the goods on the creditor. The role of the hypothecator (debtor/owner) in Hypothecation is similar to that of a bailee acting on the Hypothecatee’s orders (the creditor).

Therefore, hypothecation is nearly equivalent with pledge and has the same legal impact. As a result, the comparison between Hypothecation and Pledge is well justified. It is also possible to argue that hypothecation is merely an extension of the pledge notion.


[1] David M. Walker, The Oxford Companion To Law, 1980, p.963.

[2] Lallan Prasad v. Rahmat Ali, AIR 1967 SC 1322

[3] H.K. Saharay, Dutt on Contract, 11th ed., 2013, p.873.

[4] F.E. Perry & G. Klien, Dictionary of Banking, 3rd ed., 1988, p.240

[5] The Morvi Mercantile Bank Ltd. and Anr. v. Union of India 1965 AIR 1954

[6] Canara Industrial and Banking Syndicate Ltd. v/s V. Ramachandra Ganapathy Prabhu AIR 1968 Kant 133

[7] Blundell Leigh v. Attenborough [1921] 1 KB 382

[8] Reeves v. Capper (1838) 132 ER 1957

[9] Appa Rao v. Salem Motors and Salem Radios and Electricals AIR 1955 Mad 505

[10] Rehaboth Traders, By Partner R. … vs Canara Bank And 2 Ors 1997 (2) CTC 494

[11] Bank Of Bihar vs State Of Bihar & Ors 1971 AIR 1210

[12] Smt. Kamili Sarojini vs Indian Bank, Avanigadda Branch AIR 2008 AP 71

[13] Sree Yellamma Cotton, Woollen and Silk Mills Co. Ltd. and Bank of Maharashtra V. Official Liquidator, Court Buildings AIR 1969 Kant 280

[14] S.N. Choubey vs Central Coalfields Ltd. And Ors 2001 (49) BLJR 653

Author

  • a1e06b401c9db5e53ae81c6b433981a9?s=80&d=mm&r=g

    Nitesh is from Prayagraj, Uttar Pradesh and is a second year law student at National Law Institute University Bhopal.

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