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This article has been written by Vidhya Sumra, pursuing the Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. This article has been edited by Ruchika Mohapatra (Associate, Lawsikho).

Introduction

We hear a lot of terms like hypothecation, mortgage, pledge, and so on when it comes to securities. Isn’t it a little disconcerting? Let’s look a little deeper to understand the hypothecation principle and essential clauses to draft the deed of hypothecation. 

When the assets are pledged or guaranteed as collateral to obtain a loan, it is known as hypothecation. The owner of the assets retains title, possession, and ownership rights, including money generated by the asset. If the terms of the agreement are not met then the lender has the right to seize the asset. In simple terms, a charge on the borrower’s moveable property is created in the favour of the creditor as a security to obtain financial assistance from the creditor. 

The term ‘Hypothecation’ is defined under Section 2 (n) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Hypothecation means, 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 crystallization of such charge into fixed charge on movable property.

For example, a rental property could be hypothecated as security for a bank-issued mortgage. The bank has no claim on rental income while the property is being held as collateral; but, if the landlord fails on the loan, the bank may seize the property. The most common kind of hypothecation is in mortgage loans. Although the borrower theoretically owns the home, however, once it is pledged as collateral, the lender has the right to seize it if the borrower fails to repay the loan amount. Hypothecation is not used with unsecured loans because there is no collateral to claim in the event of default. Hypothecation makes it easier to acquire a loan as the lender has security due to the collateral pledged by the borrower and the lender may be willing to provide a lower interest rate than on an unsecured loan.

Example of hypothecation

In the case of a vehicle or auto loan, the vehicle is in possession of the borrower, but it is hypothecated with the lender. If there is any default in repayment of the loan by the borrower, the lender takes possession of the vehicle after giving notice to the borrower and sells the same to recover the loan amount from the sale proceeds of the asset. Any remaining balance will be given to the borrower. Apart from automobiles, shares and receivables can also be hypothecated.

Pledge v. mortgage v. hypothecation

Even though pledge and hypothecation are both kinds of charges placed on movable goods, there are some distinctions between pledge, hypothecation, and mortgage. Let’s take a closer look at the distinctions to obtain a better understanding of these concepts.

Pledge v. hypothecation

In the event of a pledge, the asset is in the possession of the lender, and in the case of hypothecation, it remains with the borrower. The two common examples are the gold loan in the case of pledge and the auto loan in the case of hypothecation.  

Mortgage v. hypothecation

In both circumstances, the borrower retains possession. However, mortgages are often for immovable assets, whereas hypothecation is for movable assets. The home loan in the event of a mortgage and the vehicle loan in the case of hypothecation are two common instances.

BasisPledgeMortgageHypothecation
PossessionWith lenderWith borrowerWith borrower
For assetsAll assets generallyImmoveable assetsMoveable assets
ExampleGold loanHome loanAuto loan

Documentation

To capture the above hypothecation transactions, we execute the hypothecation deed. A hypothecation deed is a written document that is signed and typically sealed and contains a contract, legal transfer, or deal. In most cases, the act is one-sided. As a result, a hypothecation deed is a document that explains the hypothecation process.

Essential clauses in the hypothecation deed

Parties

There are usually two parties in the hypothecation deed. i.e. lender and the borrower. The lender is the person in whose favour the charge is created. Lenders are usually banks and financial institutions. For example, SBI Bank and Piramal Capital. The borrower is the person who borrows money and creates the charge in favour of the lender. 

Example

ABC Private Ltd., a company incorporated under Companies Act, 2013, bearing CIN # _______, having its registered office at [], by Mr.____________ authorised representative appointed vide Board Resolution dated _________, (hereinafter referred to as “
Borrower” which expression shall unless excluded by or repugnant to the context or meaning thereof, include their respective successors and assigns). 

AND

State Bank of India, a financial institution established under the __________, having its registered office at ___________, by Mr.________ authorised representative appointed vide Board Resolution dated ________, (hereinafter referred to as “Lender” which expression shall, unless excluded by or repugnant to the context or meaning thereof, include their respective successors and assigns).”

Grant of loan

This is an essential clause of the hypothecation deed. In this clause, details of the loans are provided like loan amount, term of the loan, rate of interest, repayment schedule are provided briefly. 

Example

“Grant of Loan 

  1. It is hereby agreed between the Borrower and the Lender that the loan is being granted to the Borrower by the Lender at the interest rate of 12% per annum (“Interest Rate”).
  2. The Borrower shall repay the complete loan amount with the Interest Rate to the Lender by ____________. 
  3. In the event that the Borrower fails to repay the loan amount by __________, the Lender shall have the complete right to sell the two loading vehicles (described in detail in the Schedule A of this Agreement). 
  4. The Lender shall serve 30 days’ notice to the Borrower to rectify his default failing which the Lender shall have complete right to sell the two loading vehicles.”

Hypothecation of assets

This clause is the operating clause of the agreement and it states the main function of the agreement i.e. hypothecation of the assets. Under this clause, we mention the details of the properties, which are hypothecated by the borrowers to the lenders. 

Example

“Hypothecation of Assets:

Pursuant to the Loan Agreement and in consideration of the Lender having lent and advance the Loan to the Borrower for the purposes and subject to terms and conditions set out in the Loan Agreement, it is agreed and declared that as security for the timely and satisfactory repayment and performance of the Secured Obligations, the two loading vehicles of the Borrower will stand hypothecated (“Hypothecated Properties”) to the Lender in the manner set out below.

The Lender undertakes not to release the charge over the Hypothecated Properties till the entire Secured Obligations are paid by the Borrower under the Loan Agreement.”

Covenants and undertaking

Covenants and undertakings are pledges or promises made by the borrower and sometimes other obligors to the lender or security providers to execute or to perform or not to perform specified activities mutually agreed between the parties. For eg. Covenant to repay the loan amount on time, charge the securities, owner of the assets, etc. 

Example

Covenant and Undertaking

The Borrower has made the representations and warranties in accordance with Clause 16 of the Loan Agreement, which is deemed to be incorporated herein by reference and made a part of this Deed as if such representations and warranties were set forth in full herein.

In addition, to supplement the representations and warranties made by the Borrower in Clause 0 above, the Borrower represents and warrants to the Lender that:

[List of covenants and undertakings to be added]

Title and ownership

This is also another essential clause of the hypothecation deed where we mention that the borrower who has pledged or hypothecated the assets to the lender to secure the loan is the owner of the hypothecated properties. 

Example

“Title and Ownership

It is agreed between the Parties that the Borrower shall remain as the sole owner of the Hypothecated Properties to the Lender. It is also agreed between the Parties that upon repayment of the Loan, the Borrower shall be freed and discharged from all liabilities and obligations of the Lender in respect of the Hypothecated Properties.”

Enforcement of securities

This is a very important clause from the lender’s side. In case of any event of default from the borrower, the lender will have the right to cease the hypothecated properties given as a security to the lender. The lender after giving written notice to the borrower can enforce all or any part of the security created under the hypothecation deed. 

Example

“Enforcement of Security: 

Upon the occurrence of an Event of Default, the Lender may after giving a written notice to the Borrower in the manner contemplated in the Loan Agreement, enforce all or any part of the Security Interest created hereunder and may, inter alia: 

  • Use the Hypothecated Properties to make payment towards the Outstanding Amounts;
  • bring, take, arrange, defend, settle, compromise, submit to arbitration and discontinue any actions, suits or proceedings whatsoever whether civil or criminal in relation to the Hypothecated Properties ;
  • manage and use any or all of the Hypothecated Properties and exercise and do (or permit any nominee of it to exercise and do) all such rights and things as the Lender would be capable of exercising or doing if it were the absolute beneficial owner of the Hypothecated Properties;
  • instruct any insurance company to make payments of any insurance proceeds to the Lender; 
  • take all such other action expressly or impliedly permitted under this Deed or as an attorney of the Borrower or under Applicable Law.”

In hypothecation deed, other clauses like dispute resolution clause, obligations of the parties, representations and warranties of the parties, amendment, relationship of the parties, assignments and miscellaneous which are standard clauses that are imperative to all kinds of agreement irrespective of their purpose.

Conclusion

Hypothecation is a method by which a borrower can raise funds by hypothecating the security (movable) as collateral while still being able to use it because the borrower retains possession. This type of loan is issued by a bank or financer at a cheaper rate than an unsecured loan since it gives the lender a sense of security. 

The lender has a risk since the borrower may sell the hypothecated asset without the lender’s knowledge; however, periodic checks and appropriate clauses in this deed can safeguard both the borrower and the lender to a significant extent.

References


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