Nature, Types & Forms of Securities – Mortgage, Pledge, Hypothecation, Set-Off: Priorities
Introduction:
Financial Institutions use different types and forms of Securities in order to safeguard their interest in the best possible way. It will not be wrong to assume that securities against finance facilities are the primary concern of any financial institution. Securities make sure that in case of bankruptcy or wilful default financial institutions should have an upper hand to sett-off their debt conveniently.
1) OBLIGATIONS AND SECURITIES:
Personal obligations and obligations supported by a security: Clean & Secured Advances.
a) Personal Securities such as Guarantees & indemnities.
b) Proprietary Securities such as Pledges, Mortgages etc.
2) Attributes of a Good Security:
a) Easily marketable with ready buyers.
b) Storage, management, & maintenance problems
c) Process to bring to sale or liquidate the security should not be difficult.
d) Valuation Issues. There should not be too heavy fluctuation of value, and it should be possible to form a good judgment regarding the value.
e) Ability to pass a good title and delivery.
f) Risk of third party interest.
3) Nature of property on which security is created:
a) Intangible Property e.g. goodwill, intellectual property, assignment of contractual rights.
b) Tangible movable property such as raw materials, finished goods, equipment, etc.
c) Immovable Property : Land, buildings, and rights attached to them.
d) Documents of title to properties: land & other properties.
4) Types of Securities:
a) Possessory Securities such as lien, pledge, mortgage with possession.
b) Non-Possessory Securities such as hypothecation, floating charges, mortgage without possession etc.
5) Exercise of security rights.
a) Power of Retention (lien) or Sale (pledge).
b) Securities carrying self help remedies, such as right of set-off, pledge, mortgage with power to sell etc.
c) Securities requiring judicial/institutional enforcement rights such as lien, mortgage sales through court.
d) Securities requiring third party consent for the perfection of realization e.g. assignment of debts or rights.
6) Nature of Proprietary Security Interest:
a) Charge: Personal promise that certain property would be made available to satisfy a claim.
b) Mortgage: Transfer of property to the secured person with the right to have the claim satisfied from that property.
7) Creation of Security:
a) Attachment: A security must be created between the contracting parties.
b) Perfection: A security must become binding on third parties, e.g., requirement of registration of Company’s securities with the Registrar of Companies.
8) Types of Securities:
a) Pledge:-
i) Possession of pledged goods with Pledgee.
ii) Possession : Actual, Constructive, Symbolic.
iii) Trust Receipts
iv) Scope of security interest covered by a pledge.
v) Power of sale after notice.
b) Hypothecation:
i) Possession of goods with hypothecator but security interest vesting in the hypothecatee.
ii) Inspection — Insurance — Margin — Restraint on Disposal.
c) Floating Charge:
Debtor’s freedom to deal with the charged asset, till event of “Crystallisation” takes place.
d) Lien:
Right to retain possession of the debtors property. Particular and general lien.
Distinction between lien, pledge, hypothecation, and a floating charge.
e) Set-Off:
i) Set-Off regarding accrued obligations.
ii) Set-Off regarding only debts.
iii) Set-Off regarding accounts held in the same capacity.
iv) Set-Off regarding current accounts.
v) Notice before exercising right of Set-Off.
vi) Letters of Set-Off obtained by banks.
9) Priorities & Pari-Passu Sharing of Security:
a) Ordinarily the person secured earlier in time prevails over the one later in time unless they agree to share on pari-passu basis, or agree to alter the priorities.
b) Single & Multiple Charges.
c) First Charge.
d) Second and Ranking Charges.
e) Joint Charge.
f) Pari-Passu Charges.
10) Certain Aspects of Multiple Charges on the same property:
a) Normal rules regarding priority of security interest
The normal rule is that the earlier security prevails over the subsequent security.
b) Subordination of security by agreement
Parties may by contract agree that security of one party shall be subordinate to the security of the other party. Such an agreement need not be reported to RJSC.
c) Pari passu charges by agreement
A senior security holder may agree with the junior security holder, that it shall share its security on a pari passu basis with the junior security holder. Such an agreement need not be reported to RJSC.
d) The effect of a pari passu charge on the prior charge holder
i) Where the assets on which more than one person hold a pari passu charge are sufficient to satisfy all claims there is no adverse effect on the interest of the bank that had obtained a charge first of all and had subsequently agreed to share it with others on a pari passu basis. However, where the assets are not sufficient to satisfy all claims, a single pool of funds would have to be created by realizing the security, and then all pari passu charge holders would share in the same ratably. In such a situation, the security of the prior security holder would stand diluted to the extent of the pari passu sharing.
ii) Where a first charge holder has agreed to pari passu sharing while the second ranking charge holder has not so agreed, an unusual situation emerges. The prior charge holder has first to realise his security to the extent of the unpaid secured amount and then share it with the pari-passu charge holders. The pari passu sharers bite into the “security cake” of the senior charge holder. In other words, the size of the cake remains unchanged, while the number of those who may eat it has increased. Any surplus from the proceeds of the realized security, after the security rights of the first charge holder have been satisfied, becomes available to the second charge holder (who had not agreed to pari passu sharing).
iii) Down the line, the emerging pattern would be that any surplus security proceeds shall, to the extent of those who had not agreed to pari passu sharing, become available exclusively for them while as far as those creditors are concerned who had agreed to pari passu sharing the proceeds would become part of a security pool to be shared by them in common.
e) The effect of a pari passu charge on intervening charge holders
As would emerge from the foregoing discussion, the agreement of a senior charge holder for pari passu sharing of the security with another ranking charge holder does not affect the rights of the intervening charge holders. In order to obtain priority over them, their NOC is always required.
f) Enhancement of the amount secured by way of security and its effect on intervening charge holders.
Enhancement of the amount secured by way of security, to the extent of the enhanced amount, ranks inferior to the charge of any intervening charge holders, unless an NOC has been obtained from such charge holders.
g) Financing for acquisition of future assets when there is a prior charge on future assets and the holder of that charge does not give an NOC
If a specific property is generated by the funds provided by a financier on the condition that the property so generated shall be the security of the financier alone then such property would be exclusive security of the financier despite an existing charge on future assets. However, it is necessary that the financier should obtain an agreement to that effect prior to the acquisition of the fresh property and the charge so created in case of a company is recorded with the RJSC within 21 days of its creation.
We hope that this discussion proves helpful in understanding the matter generally. However, if any action is to be taken, relating to this Article, please consult your professional advisors.
