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Essential clauses of hypothecation and hypothecation deed

May 29, 2021
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This article is written by Saloni Maniyar pursuing Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

Introduction

What is hypothecation or hypothecation of assets?

Hypothecation or hypothecation of assets is generally said to have taken place when an asset is provided as collateral security to secure a loan in advance. This means that a borrower against the security offered as collateral is granted a loan/credit by the lender. In the case of hypothecation, the borrower or owner of the asset retains the title as well as ownership of the asset while the lender enjoys the possession. In the event of default, the lender is entitled to exercise his ownership rights and seize the asset to recover the defaulted amount of the loan or when the terms of the agreement are not adhered to by the borrower.

Hypothecation provides security to the lender against the loan advanced, due to security as collateral pledged by the borrower. Hypothecation usually arises in the case of movable property, for instance, hypothecation of any automobile, stocks, inventories, and bills receivable as collateral against loan advances. The rate of interest charged by the lender under hypothecation is lower due to the creation of security for the loan.

Although hypothecation is nowhere defined under the Indian Contract Act, 1872 however Section 2(1) (n) of Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 does define hypothecation where it means a charge created on any movable property by the borrower/owner, to raise funds from the lender, while retaining ownership over such property.

Through this article, an attempt is made to clearly understand the concept of hypothecation, as well as emphasis, is placed upon important clauses of hypothecation deed to avoid any later confusion and conflicts amongst parties.

Alternate asset for hypothecation

Hypothecation is also possible for stocks or investments which is known as margin lending wherein the buyer provides his existing shares as collateral security to a brokerage firm against the shares purchased on margin. Brokerage firms are entitled to sell these existing shares if the buyer is called upon for a margin call (wherein the value of the shares purchased diminishes below a certain specified limit or account value falls beyond a certain limit.

Benefits of hypothecation

Hypothecation is beneficial to the borrower in three ways:

  1. The first and most important advantage available to the borrower is that he can retain the title and ownership of the property as well as at the same time he can raise funds from the bank. This is helpful to a great extent to those individuals or companies who have just started out and are new in the business.
  2. Second important advantage that lies with the borrower is that the loan amount is charged with a lower interest rate. Reasons for this being, the lender has the right to take possession of the property in the event when the loan amount is not repaid on time or defaulted. This right of possession provides a sense of security to the lender that the amount shall be repaid as the loan is secured against security as well as there shall be a signed hypothecation deed between the parties.
  3. Third, the loan amount granted under hypothecation is usually small amounts. Businesses, as well as individuals, can take the benefit of this opportunity to raise funds and pay off easily.

Hypothecation deed and its purpose

Hypothecation deed is a legal document that establishes contractual relations between the lender and the borrower wherein the lender agrees to grant a loan amount to the borrower in return for movable asset provided as security as well as the lenders right to seize the possession of such security if the borrower defaults in repayment of the loan as per terms of the agreement.

Hypothecation deed builds terms and conditions upon which the borrower and lender agree to hypothecate movable assets against a loan amount. The deed defines every right and liability of the parties which can be enforced in an appropriate court of law.

Key elements of hypothecation deed

Before entering into a hypothecation agreement, having a clear understanding of important clauses in an agreement is vital. Although the procedure clearing a loan may seem cluster free, the agreement at times may turn out to be complex, as the agreement is usually drafted by a bank and therefore, it can be inferred that the bank would keep their interest at the top. 

Therefore, it is advisable for the borrower/customer to read through the entire agreement giving equal emphasis to each clause, and not consider this stage as mere signing formality and discard it completely.

Here are some of the important clauses of the hypothecation agreement that require a clear understanding.

Here, the clause shall discuss all the rights and liabilities of both the borrower and lender with respect to the loan amount advanced and security provided as collateral against the loan subject to terms and conditions of the agreement. 

For instances, the clause shall cover disbursement of the loan amount, manner and number of installments shall it be done, mode of disbursement, confirmation of loan amount received by the borrower, fulfillment of certain conditions prior to disbursement of the loan, clear title, and ownership of the property and other related obligations.

This clause shall define in detail what type of security is offered as collateral against the loan amount advanced. The property/properties upon which charge is created shall be defined as hypothecated properties or secured properties. The clause shall further include insurance charges, repairs, and maintenance costs, no disposing of that shall be borne and adhered to by the borrower.

Having this clause is essential and it is equally important to define this clause well wherein, the clause shall state that the borrower retains the title and ownership of hypothecated property as well as income generated from it while the lender enjoys the possession of such property. Further, the clause shall state that the lender shall have the right to seize such property in the event of default to repay the loan amount plus interest amount or under any other condition agreed by the parties under the agreement to recover the loan amount advanced to the borrower.

This clause is similar to every other repayment clause in a loan agreement. The parties under the agreement, agree on the time period within which the loan shall be repaid along with interest with agreed trenches. 

The clause shall further include the mode and manner in which the repayment shall be done by the borrower specifying details of it as well as an extension to the time period of repayment beyond the agreed time which shall be contingent upon parties to the agreement and circumstances of the situation.

Again this clause is identical to every interest clause in a loan agreement. This clause shall state that the applicable interest rate shall be paid upon the loan amount at regular intervals till the loan is actually repaid by the borrower. 

This clause further encapsulates the default interest rate which shall be higher than the normal interest rate payable by the borrower upon default in repayment of loan amount by agreed repayment date under the agreement. The borrower is liable to repay such default interest rate from the date of default of repayment till the loan amount is actually repaid.

This clause shall state the position of the lender as well as the manner in which the lender shall recover the loan amount advanced to the borrower in the event if the borrower is declared insolvent by a competent court or if any insolvency proceeding initiated against the borrower. The clause may further state the right of the lender to seize the possession of the hypothecated property to recover the loan amount under such circumstances being raised. 

This clause defines in detail all the assertions and assurances provided by the borrower and lender under the agreement. In addition to this, the clause shall further encapsulate, the parties under the agreement agree to provide all the required and necessary assistance to each other in order to perform their respective obligations and duties with due diligence.

This clause gives the right to the lender to amend the agreement in the event of default of repayment of the loan amount or under any other event by giving prior notice to the borrower regarding the same or without intimating the borrower which shall be contingent upon the situation and parties to the agreement.

Conclusion

Hypothecation is one of the many modes through which a borrower can raise funds by providing movable property as collateral security while retaining the title and ownership. This type of loan carries a lower interest rate due to the security provided to the lender. This can prove to be beneficial to small businesses or individuals new to business ventures requiring small amounts of loans.

The parties run into many risks while entering into such an agreement, for instance, the borrower may dispose of the hypothecated property without intimating the lender or the lender may amend few clauses of the agreement without informing the borrower; therefore, incorporating proper clauses in the agreement and understanding them thoroughly provides protection to parties to a large extent.

Reference


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