The Procedure of Bank Loan Against Shares

Cash capital is the lifeblood of every type of business. And bank loan is one of the greatest sources of cash capital. A bank may issue loans against shares. Let’s know detail about this share and the procedure of bank loan against shares.

There are generally two types of companies operating in our country, namely,

  1. Public Limited Company
  2. Private Limited company

A public Limited Company can issue different types of shares to the public in order to tap the savings of people with different habits and temperaments regarding the investment of their savings but the Private Limited Company cannot issue shares to the public.

The persons who subscribe to the shares of the company are called shareholders. Such share, like goods, is movable property. A shareholder of a public limited company has a right to transfer his share to which he pleases.

The shares, however, cannot be passed by delivery as a movable property but on the execution of the proper instrument of transfer and in the manner as provided in the Articles of the company. There are generally two types of shares issued by a public limited company.

  1. Equity or ordinary share
  2. Preference share
Bank loan against shares

Equity or ordinary shares

Equity shares (also known as ordinary shares) are those which carry no special rights in respect of the annual dividend and the return of capital if the company is wound up. They are not given any guarantee of dividend on their investment in the company. They are entitled to receive such dividends as are determined by the Board of Directors and approved at the Annual General Meeting of the company.

Dividend among equity shareholders of a company is distributed out of the net profits of the company, i.e., after all the fixed charges have been met and preference shareholders have been paid a fixed rate of dividend on their shareholders have been paid a fixed rate of dividend on their shares.

Equity shareholders have been called “residual claimants”. Equity shareholders are those who provide “venture or sponsor capital” for the company without insisting on any special conditions for the safety of their capital.

Preference shares

Preference shares of a company are those shares that carry certain preferential rights for its holders over those of equity shareholders. Preference shares carry a prescribed rate of dividend, which the company share has to pay before any dividend can be distributed to the equity shareholders.

Preference shares may be either cumulative or non-cumulative. In cumulative preference shares, the dividend due to them is to be paid every year. If there be no profit for a few years, the dividend due for those years on the cumulative preference shares will have to be paid out of the profits of the company in future years when the company will be in a position to pay the same. Till the dividend due on this kind of share is paid in full for the years, no dividend shares do not carry this privilege.

Their dividend depends upon the divisible profit of each separate year. If the fixed dividend for any year cannot be fully paid, it is not made up out of the subsequent year’s profit. Again, the preference shares may be redeemable or non-redeemable. The former are repaid after the period specified.

Shares of public limited companies are one of the popular types of security accepted by commercial banks:

Precaution to be taken by the banker

Advancing against stock exchange securities involves the important task of proper selection. All securities are not worth accepting. The bank must advance only against approved shares quoted on the stock exchange.

Those securities which are dealt in on the stock exchanges are known as quoted and those which are not dealt in on stock exchanges are known as unquoted securities.

Banks usually prepare a list of approved shares against which they may consider financing. The following precautions are taken in this rearward:

1. Selection of shares: The suitability of shares as security for bank advance depends upon their price stability and easy marketability which in turn depends upon the success of the enterprise which in turn depends upon the success of the enterprise which they represent. Bankers, therefore, accept only those shares which they approve aft ere through screening and examination of all aspects of the company’s working. Generally, a list of the approved securities is prepared after they are satisfied as regards the following:

  • The nature of the business of the company: The types of business activity, its importance in the national economy, its future prospects and the company is being managed by persons of proven competence, integrity, and honesty, the banker can take it a plus point for inclusion of the security in its approved list.
  • The quality of the management: The quality of security depends primarily upon the competence and caliber of management. If the company is being managed by persons of proven competence, integrity, and honesty, the banker can take it a plus point for the inclusion of the security in its approved list.
  • Past-working results: The pat performance of the company in terms of production, sales, profits, dividends, etc., can be a suitable basis for the performance of the company in the future. The various accounting ratios based on previous income statements and balance sheets will help the bank in ascertaining the financial position of the company.
  • Market trends in values of the shares of the company: The trends in the value of the shares of the company are indicators of the value of the company’s shares in the future. Securities cannot be taken at their face or nominal values; it is the market value which is the relevant factor, but sometimes market values may not be reliable; especially when they are abnormally high or low. In such cases the banker will be required to arrive at his own values by considering such variables as the present and the prospective yields, earning in competing firms, etc.
  • Company’s financial reputation and its policy regarding the building up of reserves.

2. Valuation of securities: After approving the securities offered by the customer, the banker should ascertain their present market prices. The valuation of securities dealt on the stock exchange can be done on the basis of stock exchange quotations published in the daily newspapers and financial periodicals. In the case of shares that are transacted very rarely. The banker should ask the secretary of the company to quote the price at which the last transaction took place.

3. Creation of charge over the securities: There are two ways of creating a charge on stock exchange securities, viz.

  • By giving a legal title in favor of the banker.
  • By creating an equitable title

4. Legal Title: In the case of legal title the securities are transferred by the borrower to the bank when either the banker or his nominee is registered as a shareholder in the books of the company. From the bankers’ point of view transfer of legal title is very desirable but the borrower shows his reluctance to do so because of the following reasons:

  • The registration of transfer and re-transfer of the shares entails expenses that are payable by the borrower himself.
  • The reputation of the borrower is lowered down because the fact of charging security becomes public.
  • The borrower is deprived of voting and other rights attached to the securities for the period they stand in the name of the bank. In case the borrower was holding directorship of a company on the basis of these shares, he may lose that also.

5. Equitable Title: An equitable mortgage on shares is created when the customer deposits the relevant share or stock certificates with the bank with an intention to create a charge. The securities continue to stand in the borrower’s name in the company’s records. The equitable charge may be created by way of the following methods:

  • By memorandum of deposit: A mere deposit of shares is not enough. The banker must require a memorandum of deposit form the customer specifying the purpose of such a deposit to make the equitable mortgage effective. The memorandum also authorizes the banker to sell the securities, if the customer defaults in making a payment or in maintaining the required m aging as per terms of agreements. It also authorizes the banker to debit the customer’s account with the amount that the banker might have to pay towards payment of call on partly-paid hares deposited by the customer.
  • By bank transfer: The customer may be required to deposit with the bank together with blank transfer forms duly signed by him. In the case of bank transfer, the name of the transferee is not filled in the form. The advantage of such a transfer is that the bank may at any time fill its own name or that of any other person to whom it has sold the securities for recovering the loan. The bank or such other person can get legal title to the securities by sending the transfer form duly filled in together with securities to the company for registration.
  • By power of attorney: The bank may get executed form their customers in respect of securities deposited, special powers of attorney either in its own favor or in favor of its nominees. The power of attorney will empower the bank or its nominees to deal in the securities so deposited on behalf of the customers. The power of attorney will protect the banker form all possible risks.

Risks in case of an equitable charge

  • Existence of prior equitable title: An equitable charge becomes defective by a prior equitable charge or a subsequent legal charge.
  • Company’s right of lien: In case the articles give the company the right of lien on its shares, it will have an adverse effect on the banker’s right to equitable charge.
  • Absence of information to the bank: Since the borrower continues to be the registered holder of shares, he gets every information regarding the issue of bonus shares, company’s meetings, issue of right shares, etc. The borrower may get bonus shares and may sell them directly. Thus, the banker’s security is reduced.

Practice and procedure of bank loan against shares

1. Advances are granted normally against shares of public limited companies that are quoted on the stock exchange and are on the bank’s approved list. Banks favor quoted shares because of other ready marketability and easy valuation.

2. The prospective borrower must be the owner of the shares offered s security, and not as trustee for another.

3. Only the fully paid-up value of cumulative preference shares should be taken into consideration.

4. In every case, the share certificate must be accompanied by a transfer deed signed in blank duly witnessed. Two sets of blank transfer deeds should be taken. On one of the sets, the signatures of the borrower should be dated. If the signatures of the borrower are dated, complications arise if the bank has to sell them after some time. If the signatures are updated and the borrower dies. If the signatures are updated and the borrower dies, the company refuses to register the transfer. Hence, two sets are obtained to meet either situation.

5. The signature of the shareholder in the blank transfer deed should be obtained duly verified by the company under its official seal.

6. The company should be advised by a registered acknowledgment-due notice intimating the fact of the pledge of shares and that of the blank transfer deed held by the bank. It ensures three things; first, that the banker will secure priority over and future advances which the company may make to the holder; of the shares and, secondly, it prevents and fraudulent dealing with the shares on the part of the holder, thirdly, this will prevent the company from issuing duplicate share certificate to the borrower. A copy of the notice, postal acknowledgment-due notice, and the company’s acknowledgment should be attached to loan documents. The banker should send the notice to the company concerned in the following form:

I hereby give you notice that has deposited with us by way of pledge, share certificates for shares in your company standing in his name, particulars of which appear below, and has executed share certificates. Please make the necessary entry in your company’s record and acknowledge receipt of this

7. Mutilated and damaged share certificates, certificates containing unauthenticated alterations and cancellations as well as those which do not bear the company’s seal should not be accepted. No rubber stamp of the bank should be put on the share certificate or transfer deed. There should be no cutting or overwriting on the transfer deeds.

8. A customer is required to sign a memorandum of deposit when the shares are deposited. A mere deposit of the securities will give the banker an equitable title, but in order that there may be no ambiguity about the terms under which they are held, it is usual to take a memorandum of deposit duly stamped and signed by the customer.

This usually states that advance is to be continuing one and the details of security held, terms upon which the securities will be handed over and undertaking to maintain the value of the security at the stated level, etc.

The bank should also obtain in the memorandum the power of selling the securities in case the borrower defaults in making payment. It is essential that the banker exercises this right of sale after giving a notice demanding payment within a reasonable period.

9. Mandates addressed to the company whose shares are accepted as security, should be taken for realization of dividends on the shares, which are pledged and forwarded to the companies.

10. In all advances against stock exchange securities, the banker should see that he has a substantial margin to protect the bank against any unforeseen fall in the market prices.

11. The bank should not make any advance against a large block of shares of one single company, especially is the borrower has any controlling interest in the company.

12. Shares standing in the name of third parties should not, as a rule, be taken as securities. If the shares in the name of a third party are accepted as security, the banker should insist on the following:

  • The third-party must sign the transfer form in the presence of an official of the bank or a party well known to the bank.
  • A letter of renunciation should be taken from such a party who authorizes the borrower to pledge the shares and also gives up his rights in favor of the borrower.
  • The blank transfer forms must be sufficient in number if the number of shares is large so that they can be transferred conveniently.

13. The shares of the private limited companies offer no real security because, firstly, due to restrictions on the transfer of such shares, these have limited local market and, secondly, it is very difficult to ascertain their actual market value as these are not quoted on the stock exchange.

Before pledging such shares, a resolution of the Board of Directors should be3 obtained sanctioning the transfer of such shares, because the Articles of Association of the private limited company sometimes place restrictions on the free transfer of shares. As such, these shares must be got properly transferred in the borrower’s name before these are accepted as security.

14. No advance can be made by a bank against shares kept with it as a safe custody article.

15. It should be ensured that the bank does not hold shares in any company of an amount exceeding 30 percent of the total paid-up capital of that company or, 30% of the bank’s own paid-up capital and reserves, whichever is lower, as required in terms of Section 23(2) of the Banking Companies Ordinance, 1962.

16. Partly paid-up shares are generally not accepted as security as they carry a contingent liability in respect of the unpaid amount on the shares, which the bank may be called upon to pay in the event of the borrower’s inability to pay the calls made. If the bank does not pay the outstanding call on-demand, the partly paid shares which form the bank’s security are liable to be forfeited.

In case the advance is given against partly paid-up shares, the banker must obtain a declaration in writing from the borrower that he would pay the calls promptly. By way of precaution, the banker must reserve the right to pay the calls in case of default by the borrower, in which case he should also obtain the right to debit the borrower’s account.

Advance against letters of allotment of shares

Advance against “Letters of Allotment” should not, ordinarily, be entertained. These letters indicate that a certain number of shares have been allotted by the company to the person concerned and can be exchanged for share certificates in due course.

The letters sometimes carry over unpaid liability for the calls to be made and cannot, therefore, in such a case, enjoy a status better than of partly paid shares against which banks do not normally lend.

But when accepted as security, bankers should ascertain the amount of liability in respect of money that is still unpaid. It is always advisable to obtain from the borrower an authority to pay on his behalf and y subsequent call made by the company respect those shares and to charge the same to his account.

He should also get the letter of renunciation attached with the allotment letter, duly signed by the borrower so that in case of need the shares can be transferred in the name of the banker or be sold.

Forced sale

In case the bank decides to close the account by selling the securities, due notice should be given to the borrower. A lawyer’s notice would be preferable. The securities should be sold after the expiry of the notice.

It would be better if the bank obtains authority from the borrower to sell them. It should, however, be carefully noted that the bank should sell only so much of the securities that would be required to adjust the debit balance in the account.

The sale should be arranged through a respectable broker only, and the party kept informed in writing of the sale of the securities from time to time. It may also be advisable to sell the securities at a place where there is a recognized stock exchange.

After the should be returned to the borrower unless the bank can, under an agreement, exercise its lien thereon in respect of any other indebtedness.

Documents need for bank loan against shares

  1. Application for advance
  2. demand promissory Notes
  3. Letter of continuity (in case of overdraft account)
  4. Letter of General Lien
  5. Original share scripts with blank transfer deeds signed by the shared holder duly witnessed but updated 9 if the shares are not transferred in the name of the bank).
  6. Letter of guarantee (if the share stands in the name of persons other than borrower)
  7. An irrevocable letter of mandate in duplicate for collection of dividends, bonus, etc. addressed to relative companies by the shareholder (a copy thereof should be sent to the company concerned under cover of a forwarding letter).
  8. Notice of pledge by the shareholder to the related companies.
  9. Declaration regarding ownership and title.
  10. In case of renewal of documents in addition to the full set of documents, a Letter of Acknowledgement of Debt should be obtained.

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