CONTRACTS II

NATIONAL LAW UNIVERSITY, ODISHA

PLEDGE AND HYPOTHECATION

UNDER THE GUIDANCE OF

MR. KANISHKA
ASSISTANT PROFESSOR (LAW)
NATIONAL LAW UNIVERSITY, ODISHA

THIS PROJECT IS AUTHORED BY-

YOGESH SINGH (2017/BA LLB/119)
ZODIKA KHIANGTA (2017/LLB 120)
ONAM JAIN (2017/LLB/121)
DIPESH SINGHAL (2016/ BA LLB/ 048)
 INTRODUCTION

A pledge is a contract between the borrower and the lender where the borrower offers an asset as
a security. the asset is delivered by the pledger to the pledgee. The lender will have legal possession
of the pledged asset, and has the right to sell when borrower is unable to fulfil the contract. the
lender, can cease and even sell the asset and the surplus shall be returned to the pledger.

Hypothecation is a charge that is created for assets that are moveable in nature, the asset remains
in the possession of the borrower. If the borrower is unable to make due payments on his loan
obligations, the lender first take action to possess the asset and then can sell off to recover the
losses.

The main similarity between the two terms is that both are related to borrowing funds from
financial institutions. The lender needs some financial assurance that the borrower will repay his
loan. If the borrower is unable to pay, the terms pledge and hypothecation come in. A pledge is a
contract where the borrower offers an asset as a security to the lender. The lender will have legal
possession and right to sell. Hypothecation is for moveable assets, which remains in the possession
of the borrower. When recovery is done, the lender will take possession

A pledge is a contract between the borrower and the lender where the borrower offers an asset as
a security to the lender. The lender will have legal possession of the pledged asset, and the lender
has the right to sell the asset in the event that the borrower is unable to meet his loan obligatio

RESEARCH METHODOLOGY

The present research is undertaken in descriptive nature with an analytical approach to the topic.
The study is essentially doctrinal study and has been conducted with relying on both primary and
secondary data. It has been examined in a holistic manner for the purpose of dissertation.
 PLEDGE

Pledge is a defined as “bailment of personal property as security for some debt or engagement”.
Under common law pledge is also related to Pawn as a synonymous, but as the time drastically
changed bailment of tangible objects in lieu of money is been termed as "Collateral Security", or
simply "Collateral", and meaning and scope of pledge is restricted only up to as a security for any
transaction or contract other than a standard borrowing of money, and specifically when the
primary object includes incorporeal chattels such as stocks, bonds, or choses in action.1

Pledge is the transfer by one person to another of the possession of certain goods to be held by the
latter as security for the performance by the former of some obligation to pay or perform, which
being performed, the pledge must be restored.2

POSSESSORY SECURITY

Possession is the essence of the contract of pledge, but without suitable written evidence the
pledgee will be entitled only to hold the goods until the pledger defaults. For the sake of liquidity
the banker normally reserves the right of sale, with or without reasonable notice, and the contract
is evidenced by the execution of a document setting out the facts and embodying, amongst other
things, a power of sale. It is prudent to ensure wherever possible that the pledge is completed
before any document is signed, thereby avoiding any suggestion of a contract of hypothecation
amounting to an agreement to create a pledge.

1 Bouvier’s Law Dictionary, 8th Edition, 1914, Vol III, p.2604

2
The Oxford Companion to Law by David M. Walker, 1980, p.963
 TRUST RECEIPTS

Customers who have obtained advances on the security of goods, or of documents of title
frequently cannot repay the amount borrowed until they return the goods. As possession of the
documents of title is essential to obtain the goods from the shipping company or warehouse -
keeper, bankers sometimes arrange to deliver the documents to the customer against his signature
to an instrument known as a Trust Receipt, by which the customer undertakes to hold the
documents or the goods, and any proceeds therefrom, as a Trustee for the banker, in whose name
the goods are insured and warehoused. He further undertakes to keep the transaction separate
from others to prevent the prejudicing of the bank’s security by the merging of the goods in his
general stock; or he may undertake to store the goods separately. The rule that the pledgee loses
his security if he loses possession seriously limits the usefulness of pledge as security. Therefore,
trust receipt is obtained from a customer of a banker where goods have been pledged as security
for an advance.

Legally speaking, pledge does not warrant any written evidence. A banker usually obtains a letter
of pledge’ from the customer containing the list of documents of title to goods and also clauses to
the effect that-

1. the bank is to have pledge upon all goods delivered by the customer

2. the pledge be held as continuing security

3. right of sale to the banker on default by the pledger

4. goods be insured by the customer

5. customer to pay rents and warehousing expenses

6. banker not responsible for default of any broker engaged for selling the goods.
 PLEDGEE AS SECURED CREDITOR

The Supreme Court laid down a very enlightening decision about the pawnee’s status as secured
creditor and his priority of charge. In Bank of Bihar v The State of Bihar and other,3 the facts
were that the pledgor availed cash credit facility from the bank against the pledge of sugar bags.
The key of the godowns containing the sugar bags was with the bank. The Rationing Officer and
the District Magistrate broke open the godown and seized the sugar bags on account of arrears
of sugar cess from the pledgor under the Public Demands Recovery Act. The pledgee - bank
filed a suit for return of the sugar bags or recovery of the value.

GOODS CHARGED TO TWO BANKS

In Nadar Bank Ltd v Canara Bank Ltd4, the borrower pledged its go downs to two banks, with the
first bank the advance was termed as "open cash credit" and the borrower was bound to submit
periodical returns of stock to the bank. When they did not do so the clerk of the bank went to inspect
the go down, and found the doors locked with the locks of another bank, from whom the borrower
took the advance under "Key loan" system.”

The question arose as to the priority of the claim. The Madras High Court held that the judicial
relationship between the parties (first bank and the borrower) is that of the pledgor and pledgee,
though the “system was termed as "Open Cash Credit" in mercantile practice. The court observed
that in order to constitute a valid pledge it is essential that there must be
delivery of goods either actual or constructive. Constructive delivery will be adequate to create a
pledge and it applies to all cases where the pledger remains in possession of the goods under the
specific authority of the pledgee or for limited purposes. The condition that the prior consent of the

3 AIR 1971 SC 1210

4
AIR 1961 Madras 326
pledgee was necessary for the pledger to deal with the goods ensures the constructive possession
as well as the character of the pledge. There can be no hard and fast rule that the delivery of the
keys of the warehouse is essential to secure constructive possession. There cannot also be any rigid
delimitation of the purposes for which the pledger is permitted to retain the possession of the goods.
The essential test is not the purpose but whether the dominion over the goods pledged is retained
and the physical possession
or handling of the goods by the pledgor is under the delegated authority of the pledgee or is
independent. The court held that where the possession of the pledgee is not lost and possession
may be manual or constructive, a subsequent pledgee even without notice cannot obtain any
preference upon a rule of estoppels.”

PLEDGE OF SHARES

It is not necessary that” there should be the pledge duly filed in transfer form. It has been held in
Bengal Silks Mills Co. Ltd, In Reu5 that a transferee in the case of a transfer of shares in blank has
the right to fill in the particulars, including his own name as transferee and the date
of the transfer, even after the death of original transferor. The transfer so made will be a valid one
and the transferee will be entitled to have his name registered in the company’s register as the
holder of the shares.”

RIGHT TO SELL

Section 176 of the Indian Contract “Act, 1872 provides as follows : "If the pawnor makes default
in payment of the debt, or “performance, at the stipulated time of the promise, in respect of which
the goods were pledged, the pawnee may bring a suit against the pawnor upon the debt or promise,
and retain the goods pledged as a collateral security; or he may sell the thing pledged, on giving
the pawnor reasonable notice of sale. If the proceeds of such sale are less than the amount due in

5
(1942) 12 Comp. Cas. 206
respect of the debt or promise, the pawnor is still liable to pay the balance. If the proceeds of the
sale are greater than the amount so due”, the pawnee shall pay over the surplus” to the pawnor".

REASONABLE NOTICE OF SALE

“In Raja K.V.S. Sundara Narasayyamma Garu v Andhra Bank Ltd6, the Andhra Pradesh High Court
held that before exercising the power of sale the pawnee should give to the pledgor a reasonable
notice of sale. The provision of section 176 of the Indian Contract Act, 1872 is mandatory and
cannot be waived. The notice should be given notwithstanding any contract to the contrary. Thus
at the time of entering into the contract of pledge, the pawnor cannot agree to waive notice as it
would be inconsistent with the provisions of Section 176.”

PRINCIPLE OF "NEMO DAT QUOD NON HABET”

There is a general rule of common law that a man cannot give a better title to property than be
himself possesses. This is often expressed in the maxim "Nemo dat quod non habet". If, therefore,
a customer steals certain property and pledges it to his banker as security for a loan, the banker
although acting in perfect good faith without any knowledge of the theft - will usually obtain no
title thereto and will be obliged to return it to the person from whom it was stolen.

Section 411 of the Indian Penal Code, 1860, provides that whoever dishonestly receives or retains
any stolen property, knowing or having reason to believe the same to be stolen property, shall be
punished with imprisonment of either description for a term which may extend to three years, or
with fine, or with both. Dishonest intention is the ‘sine qua non’ of the offence under Section 411
of the Indian Penal Code. Unless and until there is dishonest reception or retention of any stolen
property the section is not attracted.”

6
AIR 1960 AP 273
 HYPOTHECATION

“Hypothecation is a right which a creditor has over a thing belonging to another, and which consists
in a power to cause it to be sold, in order to be paid his claim out of the proceeds. There are two
species of hypothecation, one called pledge, pignus, and the other properly
denominated hypothecation. Pledge is that species of hypothcation which is contracted by the
delivery by the debtor to the creditor of the thing hypothecated. Hypothecation, properly so called,
is that which is contracted without delivery of the thing hypothecated.”
H.L. Hart gives the following definition:
"Where property is charged with the amount of a debt, but neither ownership nor possession is
passed to the creditor, it is said to be hypothecated.”
The concept of hypothecation is not provided under the Indian Contract Act, 1872. Hypothecation
is neither governed by any statute nor is there any law governing it directly or indirectly. It has
been in mercantile usage since time immemorial. Therefore, courts have to consider the cases
involving hypothecation purely on general conditions of contract as per the terms of hypothecation
agreement.”
The word "Hypothecation" is found under Section 3 of the Transfer of Property Act, 1882 under
"actionable claim". The interpretation clause of Section 3 does not define the term "hypothecation"
.

HYPOTHECATION - AN EXTENDED PLEDGE

In Bank of Maharashtra v Official Liquidator7, the Mysore (now Karnataka) High Court observed
as follows :
In the case of hypothecation or pledges of movable goods there is no doubt about the creditor’s
right to take possession, to retain possession and to sell the goods directly without the intervention
of court for the purpose of recovering his dues. The position in the regular pledge completed by
possession is undoubted and set out in the relevant sections of the Contract Act. Hypothecation is

7
AIR 1969 Mysore 280
only extended idea of pledge, the creditor permitting the debtor to retain possession either on behalf
of or in trust for himself.”

STATUS OF LENDER UNDER HYPOTHECATION

In Union of India and another v Ct. Shenthilnathan and another8, the Madras High Court held that
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 favor 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.”

BANK’S RIGHT TO SEIZE THE HYPOTHECATED ASSET

In Lambersingh Mavasingh v Punjab National Bank9, the appellant filed the appeal before the
Gujarat High Court praying for time for payment of the amount of the loan availed for purchase of
the truck from the bank. The High Court rejected the prayer. The borrower submitted that the bank
had no right to recover the possession without recourse to the court. The question before the Court
was whether the clause in the hypothecation deed which enables the bank to recover possession of
the truck can be enforced or not. The High Court held that the loan is secured by the hypothecation
of truck and if such a clause for recapture of possession is provided in the agreement, it is lawful.
The High Court observed that the real course the borrower should have adopted was to approach
the bank to accept a reasonable amount in the light of the adverse circumstances which he had to

8
(1977) 2 MU 499
9
Unreported Judgment - Appeal from order No. 165 of 1987 - Gujarat High
Court
suffer. Instead of doing that, the borrower rushed to the court to preempt the bank from resorting
to a remedy which has been reserved to it under the agreement and dismissed the appeal.”

Hypothecation is an extended form of pledge. Pledge has been codified by the Indian Contract
Act. Sections 172 to 176 deal with pledge of goods. Under Section 172, a pledge is a bailment of
the goods as security for payment of a debt or performance of a promise. Section 172 entitles a
pawnee to retain the goods pledged as security for payment of a debt and under Section 175 he is
entitled to receive from the pawnor or the pledger any extra-ordinary expenses he incurs for the
preservation of the goods pledged with him. Section 176 deals with the rights of a pawnee
and provides that in case of default by the pawnor the pawnee has the right to sue upon the debt
and to retain the goods as collateral security and to sell the goods after reasonable notice of the
intended sale to the pawnor. Once the pawnee, by virtue of his right under Section 176 sells the
goods, the right of the pawnor to redeem them is extinguished. However, the pawnee is bound to
apply the sale proceeds towards satisfaction of the debt and pay the surplus, if any, to the pawnor.
So long the sale does not take place the pawnor is entitled to redeem the goods on payment of
the debt. Therefore, when a pawnee files a suit for recovery of debt, though he is entitled to retain
the goods, he is bound to return them on payment of the debt. The right to sue on the debt assumes
that he is in a position to re-deliver the goods on payment of the debt and, therefore, if he has put
himself in a position where he is not able to re-deliver the goods, he cannot obtain a decree.”

As against pledge of goods, the transfer of legal title in the goods in the case of a hypothecation,
the rights of the lender and the borrower are strictly governed by the terms and conditions of the
hypothecation agreement executed by the parties. No assumptions can be drawn in such a case.
Hypothecation is resorted to mostly by banks and other financial institutions for securing their
long-term and medium-term loans and limits of working capital, bill discounting, letters of credit
and guarantees to limited companies, partnerships etc. Alongwith the hypothecation agreements,
the loaning institutions including banks have a plethora of other documents executed
by the borrowing companies e.g. demand promissory note, collateral personal guarantees of
managing directors, directors and other persons having substantial interest in the borrowing
entities, second charge on fixed assets like land and building and plant and machinery permanently
attached to land by legal or equitable mortgage and so on and so forth.”
Hypothecation agreements usually cover moveable machinery, equipment, stocks of finished
and semi-finished goods, raw materials, consumable stores, present and future available in
factories and go downs of the borrower and also enroot to the borrower's factories and book debts.
While these items as moveable assets, remain in the possession of the borrower and he has absolute
right to convert them, sell them and deal with them in any manner the borrower likes in the course
of his business, the legal title vests in the lending institution by virtue of the hypothecation
agreement. Pledge, which is regulated by the Indian Contract
Act, 1872, as stated above, technically speaking, cannot exist without bailment or possessio
n. Though not accompanied by delivery of possession, the validity of hypothecation of moveable’s
has been recognized in India and it has sometimes been enforced even against a bona fide purchaser
without notice. Since such hypothecation is not governed by the transfer of property act. Since
such hypothecation is not governed by the Transfer of Property Act, 1882 or the Indian Contract
Act and even the Sale of Goods Act, 1930, the Court is thrown back upon principles of equity and
justice.

PRIORITY OF HYPOTHECATION CHARGE

In Canara Bank v Asst. Commissioner (Commercial Taxes), Madras10, the Commercial Taxes
Dept of Tamil Nadu attached the movables of the borrower on account of the Sales Tax dues. The
movables were already hypothecated to the Bank for certain credit facilities availed by the
borrower. The Bank filed a writ of mandamus before the Madras High Court seeking a direction
to the Taxation Authorities not to sell the property as the bank has the first charge over the property
by virtue of the hypothecation in its favour. The High Court held that the hypothecation in favour
of the Bank is not a secured debt. Therefore the Bank’s charge as hypothecatee could not be treated
in preference to the government dues that can be recovered as a prior charge if the goods
hypothecated are available for being proceeded against and attached for tax arrears.”

10
1989 (1) All India Banking Law Judgments 258
 HYPOTHECATEE’S RIGHT OF PRIVATE SALE

In Re S.Y.C. W & S. Mills11, the Mysore High Court (now Karnataka High Court) held that in
hypothecation or pledge of movables, there is no doubt about the creditor’s right to take possession,
to retain possession and to sell the goods directly without the intervention of court for the purpose
of recovering his dues. Hypothecation is only extended idea of pledge, the creditor permitting the
debtor to retain possession either on behalf of or in trust for himself (the creditor). Hence so far as
movables actually covered by the hypothecation deeds are concerned, there can be no doubt that
the bank is entitled to retain possession and also to exercise the right of private sale.”

HYPOTHECATION AND CRIMINAL BREACH OF TRUST

In Punjab National Bank v Anand Kumar12, the facts were that the respondents have opened an
account with the petitioner - bank. Cash credit facility was given to them. The respondents have
hypothecated goods with petitioner - bank. On 26.9.1983 manager of the petitioner - bank
inspected the factory premises of the respondents and the bank godown situated therein and found
that goods hypothecated with the bank had been removed by the respondents to the extent of 3760
quintals and the goods placed there were found short to a large extent. The petitioner’s Manager,
therefore, made a complaint to the S.H.O. Hissar for registration of a case. The case was registered
against the respondents. After investigation, the police concluded that there was no evidence that
the respondents have committed any offence with regard to the pledged goods. However, the police
found the respondents to be guilty of the offences punishable under sections 420 (cheating and
dishonestly inducing delivery of property) and 406 (punishment for criminal breach of trust) of the
Indian Panel Code and the police put up a challan against them. Learned Chief Judicial Magistrate
found that offence under sections 420 / 406 of the Indian Penal Code was not made out.”

11
AIR 1969 Mysore 280
12
2000 ISJ (Banking) 385
 HYPOTHECATION AND NATURAL JUSTICE

In Sri Rama Machinery Corpn. Ltd v Standard Chartered Bank, Madras13 before the Madras High
Court, The observations of the Madras High Court in the case are as follows:
"In Penumbra of Natural Justice by Tapash Gan Choudhaiy, at page, the circumstances under
which principles of natural justice could be excluded are also stated, which read thus,
"It is well established both in England and in India that where a right to a prior notice and an
opportunity to be heard before an order is passed would obstruct the taking of prompt action, such
a right can be excluded. Thus, the rule may be discarded in an emergent situation where immediate
action brooks no delay to prevent some imminent danger or injury or hazard to paramount public
interests.”

HYPOTHECATION AND WRIT REMEDY

The Madras High Court decided a case titled "Sukra Shoe Fabric v United Commercial Bank”14
in respect of the hypothecator’s (borrower) right to file a writ before the High Court questioning
the hypotheeatee - bank’s act in locking and sealing the factory premises containing the
hypothecated machinery .The petitioner - firm was granted certain credit facilities by the
respondent bank against hypothecation of machinery. On default by the borrower in making
repayment within the stipulated time, the officers of the bank along with an Inspector of Police
entered the factory premises, locked and sealed the premises after taking an inventory of the
machinery. A writ petition was filed by the petitioner - borrower for the issue of writ of mandamus
to direct the bank to remove the lock and seal applied to the factory premises and deliver the
possession of the same back to the petitioner. The petitioner contended that the bank had no right
either in law or under the hypothecation agreement to enter the premises and lock and seal the
same.”

13
AIR 1999 Madras 137
14
(1992) 73 Comp. Cas. 179
The bank contended that it exercised the powers reserved under clause 4 (j) of the Hypothecation
Deed and seized the goods by means of locking and sealing the premises. The Police Inspector,
though present, did not enter the premises. The bank raised a preliminary objection that writ
petition under Article 226 of the Constitution of India is not maintainable since the rights of the
parties are governed by a non - statutory contract and the remedy of the borrower is Only to file a
civil suit.””

The High Court observed that the hypothecatee is a nationalized bank and an authority under
Article 12 of the Constitution of India. It owes a public duty to its customers as well as to the
borrowers.”
 Conclusion

Pledge is used when the lender (pledgee) takes actual possession of assets (i.e. certificates, goods).
Such securities or goods are movable securities. In this case the pledgee retains the possession of
the goods until the pledger (i.e. borrower) repays the entire debt amount. In case there is default
by the borrower, the pledgee has a right to sell the goods in his possession and adjust its proceeds
towards the amount due (i.e. principal and interest amount). Some examples of pledge are Gold
/Jewelry Loans, Advance against goods, /stock, Advances against National Saving Certificates etc.

Hypothecation is used for creating charge against the security of movable assets, but here the
possession of the security remains with the borrower itself. Thus, in case of default by the
borrower, the lender (i.e. to whom the goods / security have been hypothecated) will have to first
take possession of the security and then sell the same. The best example of this type of arrangement
are Car Loans. In this case Car / Vehicle remains with the borrower but the same is hypothecated
to the bank / financer. In case the borrower, defaults, banks take possession of the vehicle after
giving notice and then sell the same and credit the proceeds to the loan account.

The common of the two terms is that the subject matter is a movable asset. Similarly, the two ways
are used in borrowing funds from the bank or financial institution. Collateral security act as an
assurance to the lender that the borrower will repay the debt or, if the borrower fails to pay the
outstanding dues the lender can forfeit the goods and dispose it off.

CDSFKSFNLSDNCVSDFLDJBFKSNDFKNSLNFSNDKLLDKNFKNDFKNDFFF