Securities for Banker’s Loans – CS Professional Study Material

Chapter 13 Securities for Banker’s Loans – CS Professional Banking Law and Practice Notes is designed strictly as per the latest syllabus and exam pattern.

Securities for Banker’s Loans – CS Professional Banking Law and Practice Study Material

Question 1.
Differentiate between ‘pledge’ and ‘hypothecation’. (Dec 2009, 3 marks)
Answer:
‘Pledge’ and ‘Hypothecation’
In pledge there is actual delivery of good by the pledger to the pledge for securing a debt, refers to pledging property as security or collateral for a debt without transfer of title or possession. Both apply to movable goods and commodities, movable machinery, etc.

However in case of hypothecation, the possession as well as ownership of security remains with the borrower. In case of pledge, possession assets is transferred from the pledger to the pledgee. In hypothecation, the banker has a right to inspect the security at any time. In case of pledge, the banker has a duty to take reasonable care of the goods as a man of ordinary prudence would do in case the goods were his own.

Question 2.
Differentiate between ‘pledge’ and ‘hypothecation’ of goods as security. Which mode of security would a banker prefer ? (June 2019, 6 marks)
Answer:
Difference between Pledge and Hypothecation
Pledge: Section 172 of Indian Contract Act, 1872 defines pledge, as a bailment of a debt or performance of a promise. In pledge, there is actual or constructive delivery of goods by the pledger to the pledgee for securing a debt. At times pledge may be created by a pledger handling over the key to a godown containing the goods or giving a documents to tittle to the goods duly endorsed in favour of the pledgee.

The nature of charge is fixed. The Contract Act gives the pledgee the right to sell the goods if the pledgor fails to repay the debts by giving reasonable notice. At the same time the pledgee has a duty to return the goods to the pledgor once the debt is repaid. The ownership of security is with borrower and possession is with bank till repayment of the loan. Bank has to take care of the security and return the same if loan is repaid. No registration of charge with ROC required. Limitation period is not applicable. Parties are – Pledger/Pawner (borrower) and Pledgee / Pawnee(Bank).

Hypothecation: Defined in SARFAESI Act 2002 (Section 2nd) as charge on movable property in favour of secured creditor without delivery of possession. Nature of charge is equitable. Hypothecation refers to pledging property as security or collateral for a debt without transfer of the tittle or possession.

By its very nature, nature banks run a high risk in hypothecation. Hence the facility is generally given to borrower whose integrity is beyond doubt. Sometimes the borrower may hypothecate the same stock to several banks and obtains multiple finance. Registration with ROC under Section 125 of Companies Act, 2013 is required. Limitation period is 3 years. Both possession and ownership is with borrower. Parties – Hypothecator (borrower) and Hypothecatee (bank).

As a banker pledge is more preferred as a security than the hypothecation. But practically in banking industry maximum advances are granted under hypothecation and very rarely the advances are granted under pledge. As a banker, pledge is more preferred as a security than hypothecation.

Question 3.
How does the mechanism of ‘letter of credit’ reduce payment risk in foreign trade? (June 2008, 5 marks)
Answer:
Commercial letter of credit are very helpful in international trade because the exporter and importer are not known to each other and if the former dispatches the goods to the latter and then raises an invoice the latter may either not accept it or may not pay it. Further, the goods may not be of the stipulated quantity/quality. Thus, the letter of credit reduces payment risk in foreign trade.

The exporter (seller) asks the importer (buyer) to establish a letter of credit in his favour so that the required goods could be shipped to the port of destination. The importer (buyer) in turn requests his banker to open a letter of credit in favour of the exporter (seller).

Question 4.
Attempt the following:
List out the parties involved in a ‘letter of credit’ and also state their roles and responsibilities. (Dec 2009, 5 marks)
Answer:
Parties involved in a Letter of Credit
Parties to Letter of Credit transaction are:
(a) Applicant or opener
(b) Opening bank or issuing bank
(c) Advising bank
(d) Issuing Bank & Confirming Bank
(e) Negotiating Bank
(f) Reimbursing Bank
(g) Beneficiary

Liabilities and responsibilities of parties are as under:
1. Applicant: Applicant should request to issue a LC and must state precisely the documents against which payment, acceptance or negotiation is to be made. The applicant shall be liable to indemnify the banks against all obligations and responsibilities imposed by foreign laws and uses. The applicant shall also be ultimately liable for the charges, which can not be collected from the instructed party.

2. Advising Bank: Once bank decides to advise the credit, it shall take reasonable care to check the apparent authenticity of the credit, which it advises. If the bank elects not to advise, it must so inform the issuing bank without delay.

3. Issuing Bank and Confirming Bank: Issuing Bank constitutes a definite undertaking to pay at sight (for sight payment) / at maturity date (for deterred payment) that the terms and conditions of the credit complied with. A confirmation of an irrevocable letter of credit constitutes a definite undertaking. It adds guarantee to the issuing bank. If a bank is not prepared to add its confirmation, the bank should inform to the issuing bank without delay.

4. Negotiating Bank: If the credit provides for negotiations then negotiating bank should pay against documents as per terms of credit, without recourse.

5. Reimbursing Bank: Issuing Bank will reimburse the funds to reimbursing bank on first demand and shall not require a certificate of compliance with the terms & conditions of the credit. Issuing bank will also be responsible for any loss of credit and charges.

6. Beneficiary: A beneficiary can in no case avail himself of the contractual relationship existing between the banks or between the applicant and issuing bank.

Question 5.
Discuss the precautions which a banker should take while granting advances with special reference to the various types of securities that a banker takes to secure the advance. (Dec 2014, 10 marks)
Answer:
The banker has to secure the advance with adequate proportion of marketable and liquid securities to secure the advance and safeguard it from the unforeseen circumstances. For this purpose the banker is required to take certain precautions while granting loan against different types of securities.

1. Land and Real estate: Bankers were some years ago adverse to accept land as security. Finance granted for building would have to include land as security as the two cannot be separated at the time of sale. Further bankers normally insist on mortgage of land and building as collateral security for various obvious reasons such as:

1. Value always increases and thus the advance is sufficiently secured at all times.
2. The same cannot be shifted or misappropriated. With the setup Mortgage Repository provided by SARFAESI Act, the risk of the assets being fraudulently mortgaged to multiple lenders is also eliminated.

However, the banker is required to take precaution with reference to valuation of property, realize the securities, ascertainment of the title of the security, encumbrances on the property resulting out of occupation by third parties and various other acts such as rent control act, land ceiling act, etc.

2. Stocks, shares and debentures: These can be classified as listed or unlisted. Bankers normally grant loans or overdrafts against listed securities while they accept unlisted securities as additional collateral. The bankers should consider following while accepting stocks, shares and debentures as security.

1. Ascertain the value and monitor the same to calculate mark to market margin.
2. Credit periodic returns such as dividends and maturity value to the loan account.
3. Whether they are traded regularly or not.
4. Whether all the shares are fully paid up or not.
5. Whether the company whose shares etc. are given as security is having sound performance or not.

3. Goods as security: Almost all working capital advances are secured by hypothecation or pledge of goods. The goods could comprise of raw materials or work in progress of finished goods. The Bank should take precautions regarding following aspects:

1. Risk of deterioration and resulting reduction in value.
2. Risk of frauds as bulk quantities stored cannot be verified.
3. Price fluctuations as a result of changes in consumer preferences new advance products introduced in the market or changes in fashions etc.
4. Storage of goods on appropriation and the rent to be paid thereof for such storage.
5. Problems and cost associated with transportation at the time of appropriation as well as the time of sale.
6. Banker is required to ensure that the borrower has paid the warehouse rent to safeguard himself from warehouse keepers lien.

4. Book Debts: Usually Bankers grant cash credit limits against book debts. This is done because in many cases the buyers of the goods sold would not be able to accept bills and thus this is the only way the banker can finance the borrower for the credit sales. The banker must ensure that the book debts are not time bared. Usually the banker permits finance against book debts up to 6 months only.

However, when the book debts financed become more than 6 months old the drawing limit for the book debts is reduced. If the borrower is unable to pay for the same the account remains overdrawn. These debts due to various reasons or dispute may remain unpaid for more than 3 years. The banker should in such cases ensure that the borrower files suit against the debtors before they become time barred.

5. Insurance Policies: Insurance policies are seldom taken as principal security but are taken as co-lateral security. In advances like housing loans and personal loans where the credit rating of the borrower and his income and the ability to pay the installments are the main consideration for granting the advance, the bankers normally insist on a life insurance policy on the life of the borrower be taken and assigned to the bank. This ensures the payment of the loan on the death of the borrower. The main points that a banker has to consider are:

1. The assignment of the policy to be recorded with the insurance co. and on the policy.
2. The policy to be kept in the possession of the bank.
3. The bank would take an undertaking from the borrower that the premiums should be paid by the bank by debiting his account.
4. The Policy could be reducing sum policy where the sum assured and premium reduces as the loan is repaid.

6. Fixed Deposits as security: In order to make fixed deposits liquid the banks usually grant loans against the fixed deposits. Further the banks may ask the borrower to pledge his deposits with the bank as co-lateral security. While taking FDs as security the banker should:

1. Mark his lien on the deposits.
2. The deposits should be in the name of the borrower and in case they are in the name of a third party the deposit holder should be made a guarantor.
3. In case of deposits in joint names the holders should be joint borrowers.
4. If the FD is in the name of a minor a declaration should be taken from the guardian that the loan would be used for the benefit of the minor.

7. Supply bills as security: Supply bills which are accepted by the purchaser are taken as security for working capital finance. Here the banker depends on purchaser to make payment and the debt would devolve on the borrower only of the purchaser defaults. Sometimes the supplier requires that the bills are co-accepted by the purchaser’s banker. In such cases the banker accepting the bills acts as a guarantee and the bill discounting bank is assured of payment. This type of finance is common when Letter of credit is issued by a bank to the supplier.

Thus, in all cases the banker is required to consider the aspects related to marketability of securities, adequate margins, realization of the advance and proper documentation. Although securities play an important role in securing an advance and help in protecting the deposits of customers, the Banker and his ability to assess the customer and the loan requirement goes a long way in securing an advance and preventing the same from becoming Non Performing Asset.

Question 6.
Answer the following question in brief:
State the types of letter of credit. (June 2015, 1 mark)
Answer:
Types of Letters of Credit

1. Revocable and Irrevocable letter of Credit
2. Confirmed letter of Credit
3. Back to Back letter of Credits
4. Transferable letter of Credit
5. Revolving Letter of Credit
6. Sight letter of Credit
7. Time letter of Credit

Question 7.
What is the period of limitation under the Limitation Act, 1963 in respect of following documents :
(i) Mortgage-foreclosure
(ii) Guarantee
(iii) Demand promissory note
(iv) Mortgage-possession of immoveable property
(v) Money payable for money lent. (June 2016, 5 marks)
Answer:

	Documents	Period of Limitation
(i)	Mortgage-foreclosure	Twelve years from the money (secured by the mortgage) become due.
(ii)	A Guarantee	Three years from the date of invocation of the guarantee.
(iii)	Demand Promissory Note	Three years from the date of Demand Promissory Note.
(iv)	A mortgage – possession of immovable property	Thirty years when the mortgagee becomes entitled to possession.
(v)	Money payable for money lent	Three years when the loan is made.

Question 8.
Comment on the following:
(i) Mortgage by deposit of title deeds is called English mortgage.
(ii) Assignment is a term associated with loan against life insurance policy.
(iii) In case of pledge, possession remains with the borrower.
(iv) Commercial papers are issued at par value. (Dec 2016, 2 marks each)
Answer:
(i) False: Mortgage by deposit of title deeds is called Equitable Mortgage,

(ii) True: A borrower may assign any of the following items to secure a loan viz., (i) book debts (ii) life insurance policies (iii) money due from Government department.

(iii) False: Pledge can be created only in the case of existing goods (and not on future goods) which are in the possession of- the pledger himself. It is for the physical presence of goods pledged.

(iv) False: Commercial papers are issued by companies with high credit ratings, in the form of promissory notes, at discount but repayable at par, to their holder at maturity.

Question 9.
Why letters of credit and letters of guarantee issued by banks on behalf of their customers not shown in the balance sheet as advances are reported separately as off balance sheet items? (Dec 2016, 5 marks)
Answer:

• Letter of Credits and Letter of Guarantees issued by banks on behalf of their customers are contingents which do not exist as on the date of balance sheet.
• There is no actual liability as the date of balance sheet but they may arise in future.
• Letter of credit is granted for future purchase of material expected to be received in due course of time and is not available physical in the unit premises.
• Unlike other items, which are classified as balance sheet items, the contingent liabilities are classified as off balance sheet items.
• The balance sheet items are parts of the balance sheet as historical items, whereas the contingent liabilities are future items.
• In case these items become payable, it would affect the liquidity position of the company.

Question 10.
Banks play an important role in facilitating international trade, as they enable the exporter and importer operating at different locations to receive and pay for the goods sold and bought. Describe in brief the instruments issued by banks which apart from facilitating payment towards the trade also facilitate grant of advance and storage facility for the goods to be exported. (June 2017, 5 marks)
Answer:
1. A Letter of Credit with a special clause which allows the beneficiary (exporter) to avail of pre-shipment advance (a type of export finance granted to an exporter, prior to the export of goods) for procuring, manufacturing and export of the goods is called Red Clause Letter of Credit. This special clause used to be printed (highlighted in red colour), hence it is called “Red Clause” credit.

The issuing bank undertakes to repay such advances, even if shipment does not take place. In case of a “Green Clause” credit, the exporter is entitled for an advance for storage (warehouse) facilities of goods. The advance would be granted only when the goods to be shipped have been warehoused, and against an undertaking by the exporter that the transportation documents would be delivered by an agreed date.

2. Rupee Export Credit (pre-shipment and post-shipment): Bank provides both pre and post shipment credit to the Indian exporters through Rupee Denominated Loans as well as foreign currency loans in India. Rupee Export Credit is available generally for a period of 180 days from the date of first disbursement. In deserving cases extension may be permitted within the guidelines of RBI.

3. Pre-shipment Credit in Foreign Currency (PCFC): Bank offers PCFC in the foreign currency to the exporters enabling them to fund their procurement, manufacturing/processing and packing requirements. PCFC is generally available for a period of 180 days from date of first disbursement. In deserving cases extension may be permitted within the guidelines of RBI.

4. Export Bill Rediscounting: Bank provides financing of export by way of discounting of export bills, as a post shipment finance to the exporters at competitive international rate of interest. This facility is available in four currencies i.e. US$, Pound Sterling, Euro and JPY.

5. Bank Guarantees: Bank, on behalf of exporter constituents, issues guarantees in favour of beneficiaries abroad. The guarantees may be Performance and Financial. For Indian exporters, guarantees are issued in compliance to RBI guidelines.

Question 11.
Which type of charge is more suitable in respect of each of the following security?
(i) Bank Deposits
(ii) Book Debts
(iii) Immovable Property
(iv) Movable Stock
(v) Plant and Machinery (Dec 2017, 5 marks)
Answer:
Suitability of type of charge:

Sr. No.	Security	Charge
(i)	Bank Deposits	Lien
(ii)	Book Debts	Assignment of Debts
(iii)	Immovable Property	Mortgage
(iv)	Movable Stock	Pledge
(v)	Plant & Machinery	Hypothecation

Question 12.
What precautions to be taken by the Bankers while issuing of Letter of Credit to their existing clients? (Dec 2018, 5 marks)
Answer:
Precautions to be taken by the Banks while issuing of Letter of Credit (LC) to it’s existing clients are as under:
(i) The LC application cum agreement form is adequately stamped as per respective State Stamp Duty Act/Laws.

(ii) The LC application is signed by an authorised signatory of the firm, company etc. The signature is to be verified by the processing officer to satisfy the genuineness.

(iii) The LC application is complete in all respects with clear and consistent instructions which correspond to the conditions/provisions of accompanying contract/indent/licence. In case of any variance the importer customer should be asked to obtain necessary modifications.

(iv) The beneficiary of the LC should not be importer himself or his nominee or his buying agent. Further, beneficiary should be either a manufacturer, supplier or shipper of the goods. Care should be taken with regard to method of payment where the beneficiary is in one country and shipment is authorised from a different country.

(v) The insurance policy/cover note provides coverage up to 110% of the invoice value, in the currency of invoice in the banks’ name and covers risks under Institute Cargo Clause “A”.

(vi) If the import is covered under licence, the importer must submit Exchange Control copy of the same.

(vii) The LCs to be advised through a bank specified by the opener provided we have prior arrangement with that bank.

(viii) Ability of the Applicant to retire the import bills on due date/presentation and/or availability of funded facilities to meet his import payment obligations including payment duties and taxes. It must be ensured that the applicant will be in a position to clear the goods by payment of duties.

(ix) Credit standing and capability of the supplier to ship the goods as per the requirements is to be assessed by the branches by obtaining a credit report from the overseas banker of the supplier/Credit rating agency for establishing import LCs of over specified limit.

(x) As the import LC is drawn in a freely convertible foreign currency, the importer is exposed to exchange risk.

Question 13.
What are the popular types of mortgages obtained by a banker? How the mortgage(s) is/are enforced by the bank ? Cite the relevant provisions of the Banking Regulation Act or of Code of Civil Procedure as applicable. (June 2019, 6 marks)
Answer:
Popular types of mortgage and their enforcement by the bank are under:

1. Mortgage by deposit of title deeds(Equitable Mortgage)
2. Simple mortgage
3. English mortgage

Enforcement of all these types of mortgages is by way of filing a suit for sale of mortgaged properties. The procedure for filing a suit for a sale is provided for in the Code of Civil Procedure, 1908. The Section 16(c) of the Civil Procedure Code provides that a suit for sale of mortgaged property shall be filed in the Court within whose jurisdiction the mortgaged property is situated.

Order 34 of the Civil Procedure Code provides for various things to be adhered to while filling suit for sale of mortgaged property. When a suit for sale is filed, the Court after hearing the parties passes a preliminary decree. Through the preliminary decree it directs the mortgagor to pay the mortgage debt within a certain period and in the event of his failure to pay the money due under the mortgage, the Court orders for sale of mortgaged properties by passing a final decree.

After passing of the final decree, the mortgagee with the help of the Court gets the mortgaged property sold in execution of the mortgage decree.

Question 14.
“Commercial Paper is an unsecured Money Market Instrument issued in the form of a Promissory Note introduced in the year 1990 to enable highly rated Corporates to borrow on short-term basis. It also serves as additional Money Market instrument for investment”. Explain in detail the latest terms and conditions of Reserve Bank of India in this regard. (Dec 2021, 12 marks)
Answer:
The Reserve Bank of India (RBI) introduced the Commercial Paper Directions, 2017 Directions on 10 August 2017. The primary purpose of the Directions is to regulate Commercial Papers (CPs) accepted as deposits by non-banking companies.

The Directions supersede previous directions such as the Non-Banking Companies (Acceptance of deposits through Commercial Paper) Directions 1989, which had been amended in 1996, 1998, 2000 and further in 2012 (2012 Guidelines).

Eligible Issuers:
(a) Companies and All India Financial Institutions (AIFIS) subject to following conditions:

1. The entity has been sanctioned working capital limit by bank/s or Financial Institutes; and
2. The account of the company/AIFI is classified as a Standard Asset by the financing bank/institution.

(b) Standalone Primary Dealers.

(c) Other entities such as co-operative societies/unions, government entities, trusts, limited liability partnerships and any other body corporate having presence in India with a net worth of ₹ 100 crore or higher with a net worth of ₹ 100 crore or higher subject to conditions under (a)(i) and (a) (ii) above.

(d) Any other entity specifically permitted by the Reserve Bank of India (RBI).

Eligible Investors: (individuals, banking companies, other corporate bodies registered/ incorporated in India and unincorporated bodies, Non residents and Fils (within limits by SEBI)

(a) All residents, and non-residents permitted to invest in CPs under Foreign Exchange Management Act (FEMA), 1999 are eligible; however, no person can invest in CPs issued by related parties.

(b) Investment by regulated financial sector entities will be subject to such conditions as the concerned regulator may impose.

Form of the instrument, mode of issuance, rating and documentation procedures:
Forms:
(a) CP should be issued in the form of a promissory note and held in a dematerialized form through any of the depositories approved by and registered with SEBI.
(b) CP should be issued in minimum denomination of ? 5 lakh and multiple of ? 1 lakh.
(c) CP may be issued at a discount to face value.
(d) No issuer shall have the issue of CP underwritten or co-accepted.
(e) Options (call / put) are not permitted on CP.

Rating Requirement:
(a) Eligible issuers shall obtain credit rating for issuance of CPs from at least two CRAs (if the total CP issuance during a calendar year is ? 1,000 crore or more).registered with SEBI and should adopt the lower of the two ratings.
(b) The minimum credit rating for a CP should be ‘A3’ as per rating symbol and definition prescribed by SEBI.
(c) CRAs should take approval from RBI for the purpose of rating CPs.

Documentation Procedures:
Issuers, investors and Issuing and Paying Agents (IPAs) shall follow the standard procedures and documentation prescribed by Fixed Income Money Market and Derivatives Association of India (FIMMDA) as ‘Operational Guidelines on Cps’.

Secondary market trading and settlement of CP:
(a) All OTC trades in CP shall be reported within 15 minutes of the trade to the Financial Market Trade Reporting and Confirmation Platform (“F-TRAC”) of Clearcorp Dealing System (India) Ltd. (CDSL).
(b) The settlement cycle for OTC trades in CP shall be T+1.
(c) OTC trades in CP shall be settled through the clearing house of the National Stock Exchange (NSE), the Bombay Stock Exchange (BSE), the Metropolitan Stock Exchange of India Limited or any other mechanism approved by RBI.

Buyback of CP:
(a) The buyback of CP, in full or part, should be at prevailing market price.
(b) The buyback offer should be extended to all investors in the CP issue.
(c) The buyback offer may not be made before 60 days from the date of issue. (30 days as per FIMMDA rule of 24.2.20)
(d) CPs bought back shall stand extinguished.

Duties and Obligations:
The duties and obligations of the Issuer, Issuing and Paying Agent (IPA),
Credit Rating Agency (CRA) and Arrangers are set out below:

Issuer:
(a) Comply with the relevant requirements under these Directions.
(b) Appoint an IPA for issuance of CP.
(c) Ensure that the proceeds from CP issues should be used to finance only current assets and operating expenses. The end use must be explicitly disclosed in the offer document.
(d) Furnish the Board Resolution authorizing the company to borrow through issuance of CP to the IPA.
(e) Keep the bank (s) from whom it has outstanding credit facility (ies) informed of its market borrowings, including through CPs, latest by the date of borrowing.
(f) Arrange for crediting the CP to the Demat account of the investor with the depository through the IPA.
(g) Route all subscriptions/redemptions/payments through the IPA.
(h) Making minimum disclosures in the offer document.
(i) Submit a certificate from the CEO/CFO to the concerned IPAs on quarterly basis that CP proceeds are used for disclosed purposes, and certifying adherence to other conditions of the offer document.

Issuing and Paying Agent:
(a) Ensuring that the borrower is appropriately authorized to borrow through CPs.
(b) Verifying all the information disclosed in the offer document before issuance.
(c) Verify all documents submitted by the issuer are in order and issue a certificate to this effect.
(d) Make available the IPA certificate in electronic form on the website of the depositories for the CPs.
(e) Verify and hold certified copies of original documents in its custody.

Report the details of issuance of CP and instances of default on the F-TRAC platform by close of business hours, of the day of issuance or default as the case may be.
Credit Rating Agency:
(a) Credit Rating Agency (CRA) should act responsibly in rating CP issuances and continuously monitor the rating assigned to an issue and revisions, if any, to the rating and disseminate to public through their publications and website.
(b) Advise the concerned IPA about the ratings of the CP and any subsequent change in the ratings, on the date of rating or change in rating.

Non-applicability of Certain Other Directions:
Nothing contained in the Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998 shall apply to the raising of funds by issuance of CP, by any NBFC in accordance with these directions.

Question 15.
While discounting “Trade Bills” by the Banks, the Quality of such bills is to be checked. Explain the various factors to determine the Quality of Trade Bills. (June 2022, 3 marks)

Question 16.
Aditya mortgages his land with Bhanu Bank. The bank constructed its branch office on that site. After 5 years, Aditya repaid the loan and asked the bank to hand over the site. What can the bank do? Advise. (June 2008, 4 marks)
Answer:
Mortgage involves transfer of some interest in property and not its ownership. Interest may relate to the right of enjoying gains/income out of the property, right to sell the property (on default) right to appoint receiver (on default) or any such right. In the given case, Bhanu Bank has to give both land and building to Mr. Aditya once the loan is repaid.

Question 17.
Nav Chetan bank has given a hypothecation advance against inventory to Rajani Enterprises. In a periodical checking, the stocks are found short by the bank. The bank allows more finance to make good the shortage. Is the bank’s action correct? Give reasons for your answer. (June 2009, 4 marks)
Answer:
Bank’s action is not correct. The Bank should have asked the borrower to make good the security and on his failure, should initiate recovery action against M/s Rajani Enterprises.

Question 18.
Read the following comprehension and answer the questions that follow: (Dec 2016)

BANK GUARANTEE
The liability of the bank under a guarantee depends on two fundamental criteria, viz., the amount guaranteed and the period of guarantee. These two factors have to be specifically stated since in the absence of any one or both of these factors the bank’s liability could be unlimited, either in the amount guaranteed or the period during the guarantee.

The banker should also obtain counter guarantee from his customer on whose behalf he has given the guarantee, so that in case he is required to pay the guarantee he can fall back on the counter guarantee to claim the amount paid by him.

Amount guaranteed
When the bank issues a guarantee, the first and foremost consideration that should weigh in a banker’s mind is the amount of guarantee he is called upon to issue. In the guarantee agreement, the amount has to be specifically stated, both in figures and words.

While stating the amount that the bank would guarantee to pay, care should be taken to state whether the amount is inclusive of all interest, charges, taxes and other levies. This is important to avoid unnecessary disputes regarding liability of the bank. On invocation, the bank is liable to pay whole amount bf the guarantee, unless an earlier case of fraud has been brought to its notice.

One more point deserves to be considered here with reference to guarantee i.e., right of general lien becoming that of particular lien. Banker’s right of general lien is displaced by circumstances which show an implied agreement being inconsistent with the right of general lien. I

n Vijay Kumar v. M/s. Jullundur Body Builders, Delhi and Others [A.I.R. 1981, Delhi 126], the Syndicate Bank furnished a bank guarantee for ₹ 90,000 on behalf of its customer. The customer deposited with it as security, two fixed deposit receipts., duly discharged, with a covering letter stating that the said deposits would remain with the bank so long as any amount was due to the bank from the customer.

Bank made an entry on the reverse of receipt as “Lien to BG 11 /80”. When the bank guarantee was discharged, the bank claimed its right of general lien on the fixed deposit receipt, which was opposed on the ground that the entry on the reverse of the letter resulted in the right of a particular lien, i.e., only in respect of bank guarantee.

The Delhi High Court rejected the claim of the bank and held that the letter of the customer was on the usual printed form while the words written by the officer of the bank on the reverse of the deposit receipt were specific and explicit. They are the controlling words, which unambiguously tell us what was in the minds of the parties at the time. Thus, the written word prevail over the printed ‘word’. The right of the banker was deemed to be that of particular lien rather than of general lien.

Period of guarantee
Banks always specify the period for which their guarantee subsists and an additional period during which a claim has to be made on the bank to make payment. The former period during which the guarantee subsists is called the ‘validity period’ and the latter, the ‘claim period’. If any default has been committed by the debtor (i.e., the bank’s customer), it should be within the validity period. It is, thus, necessary as a matter of great caution that this period be specified to the exact date, for example, “this guarantee is valid up to 31^st December, 2017”.

Once this outer limit for the bank to guarantee a default of the debtor is fixed then the creditor can make a claim only if the default has occurred within this period; and for any default other than this period, bank cannot be held liable. Once a default is made then the surety has to make a claim on the bank to make good the loss within the claim period.

Claim period in a guarantee
In a guarantee, it is necessary to provide for a period slightly longer than the validity period for the beneficiary to make a claim. The claim period is usually a few months more than the validity period of the guarantee. Since if the debtor was to commit a default on the last day of the validity period, then the beneficiary can at the earliest invoke the same only on the next day.

Taking into account the time to communicate the invocation, etc., the claim period should at least be 15 to 30 days more than the validity period. For example, if the validity period of the guarantee is up to 31^st December, 2017, then the claim period would normally be up to 31^st January, 2018.

Amendment to Section 28 of the Indian Contract Act, 1872 and its effect on bank guarantee

Prior to the amendment of Section 28 of the Indian Contract Act, 1872, most bank guarantees had a standard clause at the end of their guarantee agreements. As per this clause, the beneficiary was required to enforce his claims within a period of 3 to 6 months, failing which the bank’s liability was extinguished and hence, the rights of the beneficiary.

The above clause was necessitated due to the fact that in absence of it, government departments and municipal bodies need to file a suit against the bank under bank guarantee within a period of 30 years after making claim. The bank would, therefore, be required to carry forward this liability for a long period and thereby required to make provision for the same in the balance sheet. Added to this, the customer’s cash margin and security would have to be retained either till the guarantee is returned by the beneficiary or till the expiration of the period of limitation.

Though this clause had been challenged before various High Courts, the High Courts have held such clauses in the bank guarantees to be valid and not violative of Section 28 of the Indian Contract Act, 1872.

However, from 1st January, 1997, Section 28 of the Indian Contract Act, 1872 has been amended due to which the standard limitation clauses in the bank guarantees through which the banks extinguished their liability has been declared illegal.

As such, at present if a beneficiary was to invoke the guarantee within the claim period, for a default committed by the debtor during the validity period then in case the bank did not make payment, the beneficiary can sue the bank within normal period as provided in the Limitation Act, 1963. This period under the Limitation Act, 1963 is 30 years in case the beneficiary is a government department or municipal body and 3 years in all other cases.

Therefore, it is prudent to insist that the bank guarantee be returned after the claim period, duly cancelled by the beneficiary or a certificate be obtained from the beneficiary that there are no claims under the guarantee; till such time the cash margin and the security of the debtor (customer) has to be retained.

Counter guarantee and other security
Though a bank guarantee is a contingent liability, it is always prudent for a banker to secure this contingent liability in case it is enforced. This can be done by obtaining a counter guarantee-cc/m-indemnity executed by the customer in favour of the bank.

The counter guarantee-cum-indemnity should be carefully drafted to ensure that in case the banks were to make payment on behalf of the customer then the customer in turn should not only make good the amount paid by the bank to the creditor but also any expenses connected therewith including cost of the attorney, any interest on the delayed payment, taxes and other levies.

It is to take care of all the above payments that the counter guarantee also includes an indemnity aspect. The counter guarantee should also include a clause that it would remain in force till the guarantee given by the bank subsists, viz., till the bank is duly discharged by the beneficiary or a certificate to this effect is issued by the beneficiary.

Though the counter guarantee-cum- indemnity is taken as security for every guarantee issued by the bank, its value would depend on the financial standing of the person/company giving the counter guarantee. Hence, it is preferable that keeping in mind the financial worth of the counter guarantor, necessary security in the form of fixed deposits, mortgage, etc. be obtained or the existing charge of the debtor be extended to cover the guarantee.

Payment under bank guarantee
Before making payment, a banker has to ensure that the invocation of the guarantee has been properly done failing which he may not have any recourse against the debtor. The banker should also see that no order of injunction has been passed by any court of law prohibiting the bank from making payment. In case a banker makes payment inspite of there being an order by a competent court in which the bank is a party, then the bank will be answerable for contempt of court.

Questions —
(a) Banks issue different types of guarantees on behalf of their customers. Briefly explain the nature of each type of bank guarantee. (10 marks)
(b) State in brief the precautions to be taken by the banks — (i) while issuing a bank guarantee; and (ii) before making payment under the bank guarantee. (10 marks)
(c) What requirements a banker should ensure in deciding whether the invocation made is proper in case of payment under a bank guarantee? (5 marks)
(d) While issuing a guarantee the bank omits to mention the amount and period of the guarantee. Can the bank still be held liable? What would be the extent of liability? (5 marks)
(e) What is ‘validity period’ and ‘claim period’ in a bank guarantee? (5 marks)
(f) Can the bank in a guarantee issued by it restrict the claim period so as to avoid its liability? Discuss. (5 marks)
(g) What is a counter guarantee and when is it obtained? (5 marks)
(h) What is an order of injunction? (5 marks)
Answer:
(a) Guarantees issued by banks are mainly Financial Guarantee, Performance Guarantee and Deferred Payment Guarantee.
(i) Financial Guarantee

• The banker issues guarantee in favour of a government department against caution deposit or earnest money to be deposited by bank’s client.
• At the request of the customer, in lieu of a caution deposit or earnest money, the banker issues a guarantee in favour of the government department.
• This is an example of a Financial Guarantee.
• This type of guarantee helps the bank’s customer to bid for the contract without depositing actual money.
• In case, the contractor does not take up the awarded contract, then the government department would invoke the guarantee and claim the money from the bank.

(ii) Performance Guarantee
Under performance guarantee, the bank as guarantor guarantees the beneficiary that in case the applicant does not perform to the satisfaction of the beneficiary, within the validity period (including the claim period if any) of the guarantee, the beneficiary can invoke the guarantee and the banker has to honor his commitment and pay the amount mentioned in the guarantee.

(iii) Deferred Payment Guarantee

• Under this type of guarantee, the banker guarantees payment of installments spread over a period of time.
• This type of guarantee is required when goods or machinery is purchased by a customer on credit and the payment is to be made in installments on specified dates as per schedule drawn in the contract agreed upon.

For example: Mr. A purchases a machinery on a long-term credit basis and agrees to pay the cost in installments on specified dates as pre-scheduled over a period of time. In terms of the contract of sale, Mr. B (the seller) draws Bills of Exchange on the customer for different maturities. These bills are to be accepted by Mr. A. The banker (guarantor) guarantees payment of these bills of exchange on the due date. In the event of default by Mr. A, the banker need to honor the claim to the seller (beneficiary). Again this has a time limit for the claim.

(b) Precautions to be taken by banks :
(i)

• While issuing a bank guarantee: It has to be ensured that the amount guaranteed and the period of the guarantee is specially mentioned in the guarantee.
• These two are important factors to be clearly mentioned in the guarantee issued by the banker, otherwise the bank’s liability could be unlimited.
• The bank should obtain a counter guarantee from the customer on whose behalf guarantee is issued, because this helps in claiming the guarantee from the beneficiary who is originally liable for it.
• This is to doubly insure the fund parted with by the bank and it also provides a legal tool to claim it, if not paid.
• At the time of issuing the guarantee, the amount to be paid under the guarantee should clearly state whether the amount is inclusive of all interest charges, taxes and other levies to avoid disputes regarding the liability of the bank.

(ii) Before making payment under the bank guarantee: The bank while making the payment under a guarantee has to ensure that the invocation is proper and that the person invoking the guarantee has the authority to invoke the guarantee. This should be clarified in the contract-agreement.

(c) In case of invocation, the banker is required to ensure that:
(a) The invocation is well within the claim period.

(b) The amount claimed by way of invocation is not in excess of what is guaranteed.
The authority invoking the guarantee has the powers to do so. In the case of Government Departments, the authority to invoke bank guarantee is usually placed in a position by way of delegation and allocation of authority. It is the duty of the banker is to ensure about the authority invoking the bank guarantee.

(d) The liability of the bank under a guarantee depends on:

1. the amount of the guarantee and
2. the period of the guarantee.

These two are important factors to be clearly mentioned in the guarantee issued by the banker, otherwise the bank’s liability could be unlimited.

Note: Pursuant to the amendment to Section 28 of the Indian Contract Act, 1872, the limitation period on a contract of guarantee cannot be restricted to less than the period provided under the limitation Act. As such if the guarantee is invoked in time the beneficiary can sue the bank within 30 years in case the beneficiary is a government or municipal body or 3 years in all others cases.

(e)

• Banks always specify the period for which their guarantee subsists and an additional period during which a claim has to be made on the bank to make payment.
• The former period during which the guarantee subsists is called the validity period and latter, the claim period.
• If any default has been committed by the debtor (i.e. the bank’s customer) it should be within the validity period.
• The bank should specifically indicate the period for which the guarantee is valid.
• The guarantee should also indicate the claim period, usually beyond the validity period. Invocation should have been made within the validity period.
• The claim period is usually a few months beyond the validity period of the guarantee and it is preferred to mention the exact period and time of grace.

(f)

• With effect from 1^st January, 1987, Section 28 of Indian Contract Act had been amended.
• As a result of which the standard limitation clauses in the bank guarantees by which the banks extinguished their liability have been declared illegal.
• As such, at present, if a beneficiary is to invoke the guarantee within the claim period, for a default committed by the debtor during the validity period, then in case the bank does not make any payment, the beneficiary can sue the bank within the normal period as provided in the Limitation Act, 1963.
• This period under the Limitation Act is 30 years in case the beneficiary is a Government Department or Municipal Body and 3 years in all other cases.

(g)

• The bank while issuing a guarantee has to obtain counter guarantee from its customer and if necessary additional security and collateral to protect the bank in case it is required to pay under the guarantee.
• Though a bank guarantee is a contingent liability it is always prudent for a banker to secure this contingent liability in case it is enforced.
• This can be done by obtaining a counter guarantee cum indemnity executed by the customer in favour of the bank.
• The counter guarantee cum indemnity should be carefully drafted to ensure that in case the bank is to make payment on behalf of the customer, then the customer in turn should not only make good the amounts paid by the bank to the creditor but also any expenses connected therewith including costs of attorney, any interest on delayed payment, taxes and other levies. It is to take care of all the payments.
• The counter guarantee also includes an indemnity aspect.
• The counter guarantee should also include a clause that it would remain in force till the guarantee given by the bank subsists viz., till the bank is duly discharged by the beneficiary or a certificate to this effect is issued by the beneficiary.

(h)

• An injunction is an order issued by a Court that forces the defendant – a person, a company, corporation or government entity – to do something or stop doing something, depending on what the plaintiff is requesting.
• In relatively rare cases, the Court may issue a mandatory injunction, compelling a person, company, or government unit to take affirmative action in carrying out a specified action.

Question 19.
M/s Party & Company was sanctioned a Cash Credit Facility of ₹ 4 lakh from M/ s XYZ Bank against pledge of goods and personal guarantee of Mr. A who is not a partner in the firm. The bank subsequently recalled the advance and demanded repayment of the amount both from the borrowing firm and guarantor. As there was no response, the Bank sold the pledged stocks by public auction for ₹ 2,70,000 and filed a suit against the borrowing firm and the guarantor for the balance amount due in the cash credit account. Mr. A denies his liability on the ground that the pledged stocks were sold without his knowledge or consent and in doing so, the bank has prejudiced his right as guarantor. How will you deal with the situation? (Dec 2021, 5 marks)
Answer:
The right to sell conferred by Section 176 of the Contract Act, 1872 arises only if the pawner (pledgor) makes default in payment of the debt or performance of the promise at the stipulated time. Even when no period is fixed for the repayment of debt, or the performance of the promise, the pawnee (pledgee), to entitle him to exercise the power of sale conferred by this section must prove:

1. That he had made demand for the payment of the debt,
2. That the pawner had made a default, and
3. He had given due notice of sale as required by this section.

In the present case the conditions (1 & 2) stand fulfilled. The contention of the guarantor is that the pledged goods were sold without due notice to him and the pawner. In case the right of sale is improperly exercised, the pawner is entitled for damages caused thereby.

Here the pledged stock was sold in a public auction. Therefore, the damages in this case will be difficult to prove.

Question 20.
What do you mean by hypothecation? Differentiate between hypothecation and pledge.
Answer:
The term “Hypothecation’ means a charge created on any movable asset/property, for a loan borrowed by the owner of goods/movable assets (existing or future) without transferring, either the property or the possession to the lender.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security interest Act,2002 (SARFAESI Act) defines hypothecation thus: “hypothecation means a charge in or upon any movableproperty, 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 of such charge into fixed charge on movable property”.

Hypothecation – important features:

1. The charge hypothecation is applicable to movable assets.
2. The ownership and possession are held by the borrower of the assets (security).
3. The document (hypothecation agreement) provides for a covenant, whereby the borrower agrees to give possession of the goods (movable assets) when called upon to do so by the creditor. Upon taking over the possession of goods, the charge is treated as pledge.

Difference between Hypothecation and Pledge

HYPOTHECATION	PLEDGE
A. Applicable to movable goods/assets	Applicable to movable goods/assets
B. Ownership remains with the borrower	Ownership remains with the borrower
C. Possession remains with the borrower	Possession is held by the lender
D. Defined under SARFAESI Act	Defined under Indian Contract Act
E. Legal document is hypothecation Agreement	Legal document is deed of pledge
F. In case the borrower is a Limited Company registra­tion of charge with ROC is a must	In case the borrower is a Limited Company, registration of charge with ROC is not applicable