In this blog post, Ashok K. K. Vasudevan, the Managing Director at Festo Global Production Centre, India and a student pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, describes why lenders insist on the need for security before providing a loan.
What is Debt Finance? (1), (3)
When a company decides to raise capital for its business, it can choose the routes of either raising equity investment by issuing convertible securities or obtaining loans from financial institutions or lenders. In simplest of terms, debt financing is borrowing of money without giving up the business ownership. This may be a more preferred route opted by business owners who have sufficient cash flows to repay interests and principal amounts borrowed without diluting their ownership control. The financial institutions that lend money to businesses do so by providing different types of credit facilities and sanctioning loans. The commonly extended credit facilities by the banks are a letter of credits, cash credits and overdraft facilities. A letter of credit is a form of guarantee of payment to an outsider (exporter of goods) with respect to an import transaction made by a resident / client of the bank. The cash credits and overdraft facilities are short-term credit facilities extended by banks to its important clientele, aiding them in their smooth operations of their day-to-day business.
Loans are provided by banks and other financial institutions to the businesses for different purposes such as for providing working capital, purchasing of any capital equipment, for a specific project or for any other specific business transactions.
In the Indian market, there have been a number of alternative credit providers. These have been primarily non-banking financial companies (NBFCs), micro-finance institutions (MFIs) and international financial institutions. Amongst these three, NBFCs are the most prominent as they are exempt from a number of lending restrictions which are otherwise applicable to banks. NBFCs are usually not involved in very large financing transactions as they are limited to the funding available to them when compared to banks, but continue to be regulated by the Reserve Bank of India. The weaker sections of societies are catered to by the Microfinance institutions, who offer very low-ticket short-term credits. The Indian market also has the presence of international financial institutions such as the World Bank Group; however, their lending range is limited primarily due to their preference for lending in niche areas. 
One of the key developments in the Indian loan market has been an initiative by the Reserve Bank of India in addressing the issue of non-performing assets in the Indian banking system and the reformation of bankruptcy laws in the country. When a foreign entity lends to an Indian entity, it is termed as an External Commercial Borrowing (ECB), and such lendings are regulated by the Reserve Bank of India. The recognised classes of foreign lenders include international banks and financial institutions, international capital markets, export credit agencies, equipment suppliers, foreign collaborators and foreign equity holders. For ECBs, any type of security can be offered as collateral, but upon enforcement of a mortgage on immovable properties, the assets can be sold only to Indian residents
Why do lenders insist on security while agreeing to provide a loan?
(2) (3)
When a bank offers a loan to a borrower, it would demand a security over an asset for the loan. This is because in the event of insolvency filed by the borrower and he/she is not able to repay the loan, the lending bank can then take over the said asset offered as security by the borrower and then sell the asset to use the proceeds of the sale of the asset to cover the losses. Based on the circumstances, the lending bank would have the option of taking security over specific assets of the borrower or all of the assets of the borrower.
Every bank would have its own policy for granting loans, which is approved by its own Board. According to the Banking Codes and Standards Board of India (BCSBI), the individual loan policies framed by any bank should follow the guidelines issued by the Reserve Bank of India. It is expected of the banks to make their decisions on lending, based on a careful and prudent assessment of the financial status and capacity to repay the loan by the borrower/applicant.
The common forms of security over assets are as follows:
(1) Real Estate
The term real estate includes land, buildings or structures erected on the land, any structure attached permanently to the land and any rights attached to the land. Security over real estate is created by way of mortgage which is governed primarily by the Transfer of Property Act 1882. The common forms of mortgage in India are (i) English Mortgage and (ii) Equitable Mortgage. An English mortgage (or a registered mortgage) is whereby the mortgaged property is transferred absolutely to the mortgagee with the condition that the mortgaged property will be reconvened to the mortgagor on the discharge of the debt. An equitable mortgage is created by depositing the title deeds with the mortgagee with an intention to create security for repayment of debt.
(2) Tangible Movable Property
The tangible movable property includes plant and machinery, raw materials for production, inventoried stocks, vehicles, aircraft, ships and furniture and other movable assets. In India, the common forms of security on tangible movable property in India are Mortgage and Hypothecation.
(3) Financial Instruments
The financial instruments include shares, debentures and bonds, government securities and mutual fund certificates. On financial instruments, the most prevalent form of security is the pledge. A pledge agreement is entered into between the pledger and pledgee to create and record the pledge. There is usually a power of attorney (PoA) issued by the pledger in favour of the pledgee for dealing with the financial instruments during the occurrence of a default.
(4) Claims and Receivables
Claims and Receivables include trade receivables, proceeds of insurance, cash flows and also rights under a contract. The common forms of security over claims and receivables are Mortgage, Hypothecation and Assignment of receivable subject to restrictions as specified in the contract.
(5) Cash Deposits
For cash deposits, the prevalent common forms of security creation are English mortgage and Hypothecation.
(6) Intellectual Property
Intellectual property includes patents, copyrights, trademarks and design rights. For Intellectual property, the security rights could be created by any of the following ways, namely, (i) Assignment or (ii) Hypothecation or (iii) Mortgage.
Conclusion
To summarise, in terms of offering security, the common ways are in the forms of a mortgage over immovable properties, hypothecation of movable properties which includes fixed and current assets or a pledge over shares. There is a stipulation that creation of all types of securities over the assets of any company requires registration of the charge to be done with the Registrar of Companies within thirty days of creation of the charge. If this timeframe of thirty days is not adhered to, then in the event of the company going into liquidation, the charge will not be considered.
In the case of mortgages, it is mandatory that the registration of mortgaging of immovable properties with the concerned local Sub-Registrar of Assurances within the designated area where the mortgaged property is located, be done within four months of the creation of the security. Unless the registration process is completed, the mortgage cannot be enforced, which, however, is not mandatory in certain states, if the mortgage is done in the form of equitable mortgage, effected by the deposit of title deeds. In the case of pledging of shares, the pledge can only become effective after completion of the filing of a Pledge Creation Form with the depository, if the shares are in dematerialised form. Even though there are no significant costs involved for form filings with the Registrar of Companies with a very small amount being charged as a fee, in the case of mortgages, there is payment of stamp duty payable to the government at the time of execution of any instrument and post-execution registration fees. These payment rates vary from state to state wherein there is a cap on such fees in some states whilst in others, the fee is charged as a percentage of the amount of debt being secured without a cap/upper limit.
References:
- Subject notes on course for Diploma in Entrepreneurship Administration and Business Laws – National University of Juridical Sciences, Kolkata (1)
- http://uk.practicallaw.com/9-504-4730#a533416 (“PLC – Lending and taking security in India: overview”) (2)
- http://www.chambersandcom/guide/practice-guides/location/270/8077/2249-200 (“India-Law&Practice – Ibanking & Finance 2016 – Chambers and Partners”) (3)
