This article is written by Advocate Nishit Paul, pursuing M&A, Institutional Finance and Investments Laws(PE and VC transactions) from LawSikho. Here he discusses methods by which security is created against a debt.
In this system of competitive markets, a financial benefit by lending money adds high expectation of competition in the markets as well as developing private business and enterprises. Institutions are created specially to grant loans and perform the business of credit in the market which adds fuel to the economy. But this form of business of lending comes with the disadvantage that the debtor might default in payment of his debt and recovery of debt is a hefty task for which I will be discussing the methods by which a lender may secure his debt.
What is debt?
A debt is a money that is owned or bound by a person to repay to that person who provided it to the person in need. Debt in this sense becomes something which has an inert value of its own. For example, two friends Raju and Mohan have good terms with each other. Raju is having a tough time to start his business, he ask Mohan to provide him 10,000 rupees to pay for his expenses and promises him to repay him after 6 months because he believed he has a good sense of business Mohan gets the confidence that Raju may repay him his money. Here 10,000/ is value of debt which Raju is bound to pay back to Mohan.
Is debt an actionable claim?
Under Transfer of Property, act debt is classified as an actionable claim. An actionable claim is generally an instrument of debt, which can be claimed by action against the debtor. In the transaction of debt, there are two or more parties which are a debtor and a creditor. Section 3 of the Act defines:
“actionable claim” means a claim to any debt, other than a debt secured by mortgage of immovable property or by hypothecation or pledge of movable property, or to any beneficial interest in movable property not in the possession, either actual or constructive, of the claimant, which the civil courts recognize as affording grounds for relief, whether such debt or beneficial interest be existent, accruing, conditional or contingent;
The proviso above defines three ways by which a debt is secured :
1, Mortgage of immovable property
3. Pledge of movable property.
But in addition to above-mentioned methods, two more methods can be added to secure a debt.
4. By a blank cheque.
5. Bond and debentures.
1. Mortgage of immovable property.
By securing a debt by Mortgage, the debtor has to place his immovable property before the creditor. In a mortgage, if the debtor defaults in paying up his debt by stipulated time period as agreed by the creditor and the debtor, the creditor can take action against the debtor by selling off the mortgaged property.
The law related to mortgage is governed by the Transfer of Property Act,1886. Section 58 of the act defines a simple mortgage as :
A mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan an, an existing or future debt or the performance of an engagement which may give rise to pecuniary liability.
The mortgage is generally used by the banks in securing its loans. Banks in case of recovering it’s mortgaged loan takes the action under Section 13(4) SARFESI or by Recovery Suit application under S.19 of Recovery of Debts and Bankruptcy Act,1992.
Hypothecation is another way of securing a debt. In hypothecation, a ‘charge’ created on movable property of the debtor. In an agreement of Hypothecation, the movable property hypothecated is sold for recovery of the debt. Hypothecation is similar to that of mortgage with the only difference that mortgage is used for immovable property whereas movable property is used in hypothecation of security.
Hypothecation is defined under s.2(n) of SARFESI ACT :
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 crystallisation of such charge into fixed charge on the movable property;
Hypothecation is also generally used by the banks for securing its credit.
3. By Pledging of movable property.
In the contract of bailment, pledging is used for securing the payment of a debt or promise to pay to bay the Bailor. Pledge has been defined under Section 172 of Contracts act as:
The bailment of goods as security for payment of a debt or performance of a promise is called ‘pledge’. The bailor is in this case called the ‘pawnor’. The bailee is called ‘Pawnee’. —The bailment of goods as security for payment of a debt or performance of a promise is called ‘pledge’. The bailor is in this case called the ‘pawnor’. The bailee is called ‘Pawnee’.”
In short, the pledge can only be used for securing the payment in the contract of bailment. In case of default, the Bailee can sell off the goods bailed with him in default of payment of consideration from Bailor. Under Section 173 the Pawnee has the right to retain which is:
The Pawnee may retain the goods pledged, not only for payment of the debt or the performance of the promise, but for the interests of the debt, and all necessary expenses incurred by him in respect of the possession or for the preservation of the goods pledged.
The Pawnee also has the right where the pawnor has defaulted as under Section .176. which is :
If the pawnor makes default in payment of the debt, or performance; at the stipulated time or 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 the sale.
This form of security is used to secure gold loans where the debtor fails to repay his debt, the pledged gold is sold in repayment of his debt
4. By a Blank Cheque or through dishonour of Cheque.
This is the most common form of lending which creates security against a debt. Cheque bounce is a criminal offence and action can be taken against the debtor under Section 138 of the Negotiable Instruments Act,1876 (NIA) for which a punishment of imprisonment for 1 month and a fine of the amount defaulted plus costs. The general concept of this kind of security is that the debtor in consideration of money owned a criminal action can be taken against him. This is a mostly common way of securing debt as it is generally used by small and medium business owners in day to day transaction in the market. This form of debt securing is not regulated by any law but has its legal foundations NIA act and that too from Dishonor of Cheque.
Law Governing Dishonor
A cheque is Negotiable Instrument governs by The Negotiable Instrument Act, 1881. A cheque has been defined in Section 6 of NI ACT, which is defined as :
A “cheque” is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand and it includes the electronic image of a truncated cheque and a cheque in the electronic form.
The Law governing the Dishonor of Cheque is provided in The NI Act under Chapter XIX from Section 138 to 148A. The cognizance of dishonor of cheque is taken my Judicial Magistrate First Class which has the jurisdiction in the trial of this offence.
Who generally prefer this kind of Security against debt.
This kind of security is generally preferred by the small business or a local (non-regulated) creditor in securing their business activities. Cheque plays a vital role in a commercial transaction, thus its dishonour amounts to criminal liability.
5. Bond and debentures.
Bonds are another method for securing a debt. Bonds are governed by the Indian Contract Act, whereby the issuer of bond secure its payment of any money lend and if, in default, bond-holder has to pay for the damages to the issuer. To secure payment by bond they are generally used by the corporate financial organization known as debentures.
Debenture has been defined under section 2(30) in Companies Act, 2013 which describes it as:
”debenture” includes debenture stock, bonds or any other instrument of a company evidencing a debt, constituting a charge on the asses of the company or not’
Bonds or Debentures are instruments of investment by which an investor invest a sum of money which is a promise to pay back by the issuer the principal debt amount and with interest on which will be paid to the debenture holder. Various organization or corporate bodies or government issues bonds as debentures in the market. It is a form of a loan which the organization promise to pay back in a stipulated period of time to the holders of the instrument.
Bonds and debentures also known as capital market or money market instruments. These Instruments are used by big corporate firms or by Government to raise capital in running day to day expenses. Bonds can be classified into three kinds.
2.Indian G-sec bonds.
These bonds are issued by a corporate entity to raise money from the market. They are generally considered high-risk bonds because if the business of the corporate entity fails then it becomes hard for the entity to pay back to its bondholders. Thus, whenever a corporate entity distributes its profits they first payback to the bondholder of the company. The Company issues bonds with various time periods known as Short term Bond or Long term Bond. The default of IL&FS is paying back is one of the major examples in corporate bonds.
Indian Government Bonds
Government bonds or G-sec Bonds are another instruments debt with are issued by the government for raising capital from the market. G-sec Bonds are issued by RBI annually through its yearly calendar for issuing of bonds (https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=16413#1). Government raises money from the market to finance its projects and other activities. G-Sec bond has its tenure from 5 years to 40 years having a coupon rate (interest rate) on face value of the instrument paid half-yearly to the holder.
Treasury Bills (T-Bills) are another method by which the Government can raise money to finance its short term money obligations. The T-Bills are short term money market instrument in comes in three tenors 91 day, 182 day and 364 day and zero coupon bonds it can be bought in discount and sold in face value.
In the business of lending, securing ones debt through various means builds the confidence in the market and the willingness of the debtor from not being defaulted in his payment. If debtor gets defaulted in payment in his money the various laws empower the creditor to act in such a way to secure his amount and this would help better shape the economy.