This article is authored by Akash Krishnan, from ICFAI Law School, Hyderabad. It discusses in detail the concepts of pledge and hypothecation and how the concept of hypothecation is an extended arm of the concept of the pledge.
Pledge has been defined under Section 172 of the Indian Contract Act, 1872. It is a form of contract wherein a party (pledger) delivers movable goods as security to another party (pledgee) in exchange for some payment. What is important to note herein is that the security in question is delivered by the pledger to the pledgee. On the other hand, hypothecation is a contract wherein a party (the debtor) pledges his movable goods to another party (the creditor) in exchange for some payment. What is important to note herein is that the debtor only pledges the security to the creditor. There is no delivery of security by the debtor to the creditor.
Now that we have understood the basic idea behind both these concepts, let us try and understand these concepts in detail and the manner in which these two concepts complement each other.
Section 172 of the Indian Contract Act defines Pledge as the bailment of goods as security for payment of a debt or performance of a promise. It is also referred to as a special kind of bailment. The person who pledges the goods as security is called the ‘Pledger’ and the person to whom such goods are pledged is called the ‘Pledgee’. For example, if Rahul borrows ₹1,00,000/- from Ramesh and pledges his scooter as the security for repayment, the contract between Rahul and Ramesh is a contract of Pledge, wherein Rahul is the pledger and Ramesh is the pledgee.
In Lallan Prasad vs. Rehmat Ali (1967), the Supreme Court observed that a pledge is a special form of bailment wherein the pledger pledges his personal property to the pledgee as a security, in exchange for a debt. The Court further held that any form of movable property can be the subject matter of pledge.
There are two essential ingredients of a valid pledge. These ingredients are discussed in detail below.
Essential ingredients of a valid pledge
Delivery of possession
Delivery of possession means that the security in question should be actually or constructively delivered to the pledgee. If there is no actual or constructive delivery of security at the time of the creation of debt, then the contract cannot be deemed as a contract of pledge. Actual delivery means that the security is physically handed over to the pledgee. On the other hand, constructive delivery means where the title in the security is transferred to the pledgee but the goods are not transferred physically into his possession. For example, if the key to a godown where the security is stored is given to the pledgee, it would be deemed as constructive delivery.
In Morvi Mercantile Bank Limited vs. Union of India (1965), the railway receipts issued by the railways regarding the transfer of goods from Bombay to Okhla were pledged with the bank for a sum of ₹20,000. However, the goods were lost in transit. On failing to recover the debt from the pledger, the pledgee filed a suit against the railways for the realisation of the security. The Supreme Court held that the delivery of railway receipts by the pledger to the pledgee will be deemed as delivery of the goods involved because it was a constructive delivery and the pledgee can recover the due sum from the railways. What is pertinent to note is that in cases of constructive delivery, the title in goods should pass from the pledger to the pledgee.
In Syndicate Limited vs. Ramchandra Ganapathy Prabhu (1968), the Mysore High Court observed that share certificates are not documents of title of the goods, but themselves constitute as goods. Thus, the delivery of share certificates to the pledgee by the pledger amounts to the actual delivery of goods and not constructive delivery.
In pursuance of a contract
It is necessary that the delivery of security and the receipt of payment in exchange for such delivery is done in pursuance of a contract. However, it is not necessary that the delivery of goods and the receipt of payment should go hand in hand. Delivery of security can be done before the receipt of payment as well.
In Blundell Leigh vs. Attenborough (1921), the plaintiff had delivered a ring to a jeweller and requested him to value the ring for the purpose of a pledge. The jeweller instead pledged the ring for 1000 euros with a pawnbroker and then paid the plaintiff 500 euros in exchange for the ring as security. The jeweller died during the tenure of the pledge. Plaintiff repaid the pledge amount and on coming to know the actual scenario, sued the defendant for releasing the security. The Court held that even though the delivery of security was made by the plaintiff to the jeweller before the money was advanced by the jeweller, a valid contract of the pledge was created and the money was advanced by the jeweller in pursuance of that contract itself. Since the defendant had advanced money in good faith, the legal representatives of the jeweller were made to repay the due amount to the defendant and the defendant was ordered to release the security in favour of the plaintiff.
Rights and duties of pledger and pledgee
Right of retainer
Section 173 of the Act empowers the pledgee to retain the security till the entire debt has been discharged by the pledger. The term ‘entire debt’ also includes any interest that has been generated.
Section 174 of the Act states that the pledgee cannot hold on to the security and compel the pledger to discharge some other debt for which such security was not pledged, i.e., particular security can be retained by the pledgee only till the debt discharged against it has been recovered.
Right to extraordinary expenses
Section 175 of the Act states that if any extraordinary expense has been incurred by the pledgee to preserve the security, he can sue the pledger to recover the same. A right to retain the goods for recovery of such extraordinary expenses has not been provided under the Act.
Right to sell
Section 176 of the Act states that if the pledger fails to comply with the contract of pledge and makes a default thereunder, then subject to a contract to the contrary, the pledgee has the right to sell the goods held as security to satisfy the debt. However, a duty is cast upon the pledgee to give the pledger a reasonable notice of such sale.
Right to redeem
Section 177 states that if the pledger fails to comply with the contract of pledge and makes a default thereunder, he may at any time before the actual sale of the security by the pledgee, redeem the security by making the full payment. The pledger will also have to bear the costs for any loss suffered by the pledgee due to the default in payment.
Pledge by hypothecation
When goods are pledged via hypothecation, the goods remain in the custody of the debtor even after the payment is advanced by the creditor. Herein, it is deemed that the delivery of security has taken place, but actually, the possession of the security remains with the debtor. For example, if Rahul borrows ₹1,00,000/- from Ramesh and pledges his tractor as the security for repayment, but Rahul continues to remain in possession of the tractor and uses it on a day-to-day basis to plough the field, it is called a pledge by hypothecation.
One of the first cases wherein the concept of pledge by hypothecation was laid down was Reeves vs. Capper (1838). In this case, the captain of a ship had pledged his chronometer with the owner of the ship, but he continued to remain in possession of the chronometer and used it during his voyage. He then later pledged the chronometer to another person. The question for consideration was whether the second pledge was valid in light of the first pledge. The Court held that the instant case was a case of pledge by hypothecation and even though the captain remained in possession of the security, the shipowner had the rights over the security. Therefore, the second pledge was deemed to be invalid.
In Appa Rao vs. Salem Motors and Salem Radios (1955), motor vehicles were pledged by the plaintiff to the defendant but the possession of the vehicles remained with the plaintiff and he used the same for demonstration purposes. The Madras High Court held that a pledge becomes hypothecation when the goods that are to be delivered as security remain in the possession of the debtor instead of the creditor.
The creditor has no direct right of seizure
In case of a pledge by hypothecation, if the debtor defaults in the repayment of the debt, there is no right vested with the creditor to enter the premises of the debtor to seize the goods held as security. If the creditor wants to exercise this power, he either has to seek permission from the debtor or get an order from a competent court in this regard.
In Union of India vs. Shenthilanathan (1977), the Madras High Court held that in cases of pledge by hypothecation, the creditor does not have a direct right to seize the goods on the failure of the debtor to repay the debt. The only option available with the creditor is to approach a competent court and file a suit for recovery of the debt and obtain a decree for the seizure of the security involved.
Similarities between pledge and hypothecation
Preferential right to recovery
In Rehaboth Traders, By Partner R. vs. Canara Bank (1998), the Madras High Court observed that in cases of hypothecation, a special and preferential right is conferred upon the creditor to recover the debt from the security. The creditor herein is treated as a secured creditor and his right to recover has precedence over all other creditors.
In Bank of Bihar vs. State of Bihar (1971), the Supreme Court held that the bank, i.e., the pledgee has a preferential right over the security pledged with it over all other creditors.
Therefore, it can be observed that in both cases, a preferential right to recover the debt from the security is given to the pledgee/creditor.
Right over the goods
In Rehaboth Traders By Partner R. vs. Canara Bank (1998), the Madras High Court had observed that, in cases of pledge by hypothecation, the debtor has to ensure that the value of the goods pledged as security does not depreciate due to his own negligence. The debtor has to submit regular reports as to the condition/maintenance of the security to the creditor. It was further observed that the creditor has the first right over the security and that the debtor is only holding the security as an agent of the creditor.
In Kamili Sarojini vs. Indian Bank (2008), The Andhra Pradesh High Court had observed that the pledger is empowered to retain the security in his possession until the debt has been repaid by the pledger. The pledger cannot exercise any right over the said security or sell the said security before the debt has been discharged in full.
Therefore, it can be observed that in both cases, the pledgee/creditor has the right over the goods that are delivered as security irrespective of whether or not he is in possession of the security.
Right to sell
In Sree Yellamma Cotton Woollen & Silk Mills and Co. Ltd. vs. Official Liquidator (1969), the Mysore High Court observed that in cases of pledge by hypothecation, the creditor has the right to sell the goods that are pledged as security if the debtor fails to comply with the terms of the contract, provided such a right has been granted to the creditor under the contract of pledge by hypothecation.
In S.N. Choubey vs. Central Coalfields Limited (2001), the Jharkhand High Court observed that in cases of pledge, there are two rights that are vested with the pledgee for the redemption of the due debt. Firstly, he may sue the pledger for recovery of the debt and retain the security in his possession until a decree has been passed and secondly, he may sell the goods held as security after giving the pledgee a reasonable notice of the intended sale.
Therefore, it can be observed that in both cases, the pledgee/creditor has the right to sell the goods for recovery of the debt.
Based on the aforesaid discussion, one can conclude that the sole point of difference between pledge and hypothecation is that in pledge, there is a physical or constructive delivery of the goods to the pledgee but in hypothecation, there is no delivery of goods to the creditor. Apart from this small difference, the rights and duties of the parties under both these concepts are similar and thus, it can be said that the concept of hypothecation is just an extended arm of the concept of the pledge.
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