Hypothecation is a charge created on property or goods for the amount of the debt. All about advance against hypothecation of stock in trade are described below:
Herbert L. A. Hart describes hypothecation as a “charge against property for an amount of debt where neither ownership nor possession is passed to the creditor”.
In hypothecation, the ownership and possession of the goods remain with the borrower but the goods are equitably charged to the bank. The borrower, in the case of a hypothecation facility, will have to sign a hypothecation agreement whereby he binds himself to give the possession of the goods to the lender when called upon to do so.
This agreement contains a clause that provides that the bank can take possession of the goods without recourse to court proceedings. The charge of hypothecation is, in that case, converted into that of a pledge and the banker or hypothecate enjoys the powers and rights of a pledge. This is done by taking an inventory of goods taken into possession.
The inventory is taken in presence of independent witnesses besides the borrower. In practice, it is very difficult to take possession of the goods if the borrower is bent upon creating mischief.
Hypothecation is a floating charge on the borrower’s assets at present and in the future. The advantage of creating a floating charge is that the borrower is free to deal with the property in the course of his manufacturing and trading activity until the crystallization of the charge in the event of its enforcement by the banker.
Upon such crystallization the charge attaches specifically to any of the assets even if the description of each of the assets may have undergone a transformation; for example, raw materials held have been charged to stock-in-process or finished goods or debtors.
The position of the banker is hypothecation is not very safe. The banker must lose his right over the goods hypothecated under the following circumstances:
1. If the borrower, in possession of goods, sells them to a bonafide purchaser for value without notice of hypothecation, the purchaser gets ad good title to the goods and the hypothecate cannot proceed against them.
2. If the hypothecator, in possession of goods, makes a valid pledge of goods and the pledge has no notice of the hypothecation, ht claim of ht hypothecate will be postponed to that of the pledge.
3. An official receiver/assignee or an execution creditor attaching the goods.
As in hypothecation, the goods or movables remain in the possession of the borrowers, the facilities should be granted only to those parties whose financial stability and commercial integrity are beyond doubt.
Such advances are more or less clean advances and require extra caution on the part of bankers. For this purpose, effective supervision over the good and the position of the borrowers is absolutely necessary.
The banks prefer to sanction hypothecation advances to limited companies because the charge by way of hypothecation in the case of a limited company is compulsorily required to be registered under Section 159 of the Companies Act 1994 and it is constructive notice to the public. There is no such protection available to a banker in the case of individuals and firms.
When a hypothecation advance is made to a company, it is necessary to get a memorandum in the prescribed form signed by the company. The memorandum should be submitted to the Registrar, Joint Stock Companies within 21 days of its execution along with the documents and the prescribed fees.
The Registrar will register the charge in his books and issue a certificate to that effect. In case of any modification of the terms of the charge, the same procedure stated has to be followed regarding the registration of ht modification under the prescribed form. When the debt is paid off and the charge satisfied, a memorandum of satisfaction will have to be similarly registered.
Non-registration of a charge in the case of a company is fraught with serious consequences; as such charge will become void against the liquidator and/or any creditor of the company.
Hypothecation is a convenient device to create a charge over the movable assets in circumstances in which transfer of possession is either inconvenient or impracticable. Hypothecation facility is, therefore, considered favorably in the case of manufacturing concerns and factories where the raw materials are required every day or every now and then for production.
Because the bank staff is unable to control such changes, the system of pledge letters and delivery orders will not be convenient in such cases.
This facility is normally desired by small traders and businessmen who cannot offer their stock for pledge because of constant fluctuation but can only offer hypothecation of the stock in their shops etc.
They may, however, offer mortgages of immovable property belonging to them or a third party as collateral security or guarantee of a third person acceptable to the bank. The banker should take the following precautions and checks while advancing against the hypothecation of stocks.
Table of Contents
Practice and procedure of advance against hypothecation of stock in trade
Procedure 1
The first stock statement must be obtained at the time of execution of the documents and verified by the bank, and the same is generally attached to the hypothecation document.
The stock statement usually contains a declaration by the borrowers regarding their clear title to the goods and the correctness of the quality, quantity, and valuation thereof.
The declaration made in the stock statement is the basis of the hypothecation advance, binding the party to repay the advance taken on the stock declared.
Thereafter, these statements are obtained from the borrower weekly/fortnightly/monthly according to the rapidity with which the stocks are turned over.
These statements are to be certified as true as per books of account of the borrower and signed by him.
Procedure 2
The stocks are entered and valued as in the case of the pledge in the stock register and, after allowing the stipulated margin, drawing power is worked out.
Procedure 3
Periodical inspection of stock should be carried out by the Manager/authorized officer at least once a month to verify the correctness of the stock statement, submitted by the borrower.
Procedure 4
Stocks should be fully insured against fire and burglary and other risks in joint names with the bank clause.
Procedure 5
The real collateral security in a hypothecation advance is a mortgage of immovable property of double the value of advance belonging to the borrower or to the guarantor as collateral and the guarantee of a third party acceptable to the bank.
The document got executed by the guarantor should provide a continuing guarantee. Under Section 130 of the Contract Act. A continuing guarantee can be terminated by the surety so as to future transactions by notice.
Hence, if a guarantor serves the bank with a notice to revoke the guarantee the account should be stopped and no further debit should be passed to the account, because all subsequent debits will be fresh loans not covered by the guarantee and all credits will go to reduce the guarantor’s liability.
Under Section 131 of the Contract Act, the death of a surety operates, in the absence of a contract to the contrary, as a revocation of a continuing guarantee as regards future transactions. The same consequences follow with the death of the guarantor as in the case of a notice from the guarantor revoking his guarantee.
The agreement of guarantee should, therefore, be drafted in such a way that protects the interest of the bank. If the limit is reduced, it is however necessary to advise the borrower and the guarantor.
When the limit is increased, the documents for the additional limit need to be obtained with a letter that they are in supplement to the original agreement.
Procedure 6
The bank will seize the goods hypothecated to the bank according to the terms and conditions of the hypothecation agreement under the following circumstances. If possible, the bank is to obtain the consent of the borrower to the bank’s taking possession of the hypothecated stock.
- In case any suit is filed against the borrower by the other creditor.
- In case there is any doubt regarding the solvency of the borrower.
- In case the bank believes that the borrower intends to dispose of the stock otherwise than according to the terms of hypothecation.
- In case the borrower dies or becomes insolvent.
Procedure 7
Bank’s name boards inserting ‘Goods under hypothecation to……Bank’ should be prominently displayed inside the business premises/godown to obviate the possibility of the same goods being hypothecated to another bank.
Affixing the bank’s board will also avoid a possible attempt being made by the Receiver in the event of the borrower’s insolvency to treat the borrower as the “reputed owner” of the hypothecated goods.
Hypothecation of stocks-in-transit
The banker’s deed of hypothecation also encompasses stocks that are in transit between the point of procurement and the godown. While it is not harmful to extend a hypothecation charge on such an asset, a banker should not permit any drawings against such stocks in the Cash Credit (Hypothecation) account since they are subject to the right of stoppage in transit by an unpaid vendor under Sale of Goods Act.
It is therefore customary for a banker to exclude all stocks in transit that may have been declared by a borrower in his stock statement before allowing drawings in the Cash Credit (Hypothecation) account.
Default
In case of default in a hypothecation advance, the banker should carry out an inspection of the hypothecated stocks and prepare a detailed report of the stocks. He should take the stocks into his possession with the consent of the borrower. The hypothecation agreement signed by the borrower contains a clause authorizing the banker to convert hypothecation into a pledge.
It is advisable to get a document of pledge signed by the borrower after the goods are taken in the bank’s possession. Thereafter, if considered expedient, the advance should be recalled by giving a legal notice to the borrower and the goods sold.
Where the borrower does not co-operate in giving voluntary possession of stocks, and the application has to be made to the Court for the appointment of a Receiver to take charge of stocks or for attachment of the goods before judgment.
These steps have to be taken expeditiously, particularly when the borrower is a partnership firm or a proprietary concern, as in such a case, the bank’s charge of hypothecation has not been registered under the law.
It should be noted that hypothecation advance is allowed by banks to borrowers only for their working capital and not for any capital investment.
Documents Required for advance against hypothecation of stock In trade
- Demand Promissory Note
- Letter of Continuity
- Deed of Hypothecation
- Letter of Guarantee
- Mortgage of Property
- Certificate for registration of charges (in case of companies)
- Latest stock statement.
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