DR.

RAM MANOHAR LOHIYA NATIONAL

LAW UNIVERSITY

!
CONTRACT - II
CONTRACT OF HYPOTHECATION WITH REFERENCE TO THE
PROVISIONS & CASE LAWS

Submitted to : Submitted by :
Dr. Visalakshi Vegesna Chaitanya
Associate Professor 170101047
( Law )


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 TABLE OF CONTENT

INTRODUCTION 3
HYPOTHECATION - AN EXTENDED PLEDGE 4
STATUS OF LENDER UNDER HYPOTHECATION 5
BANK’S RIGHT TO SEIZE THE HYPOTHECATED GOOD 5
PRIORITY OF HYPOTHECATION CHARGE 6
HYPOTHECATEE’S RIGHT OF PRIVATE SALE 8
Illegal Use of Hypothecated Asset - Bank’s Status 9
Hypothecation and Writ Remedy 10
Hypothecation and Criminal Breach of Trust 12
CONCLUSION 13

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 INTRODUCTION
Hypothecation is a right which a creditor has over a thing belonging to another, and which consists
in a power to cause it to be sold, in order to be paid his claim out of the proceeds.There are two
species of hypothecation, one called pledge, pignus, and the other properly denominated
hypothecation. Pledge is that species of hypothecation which is contracted by the delivery by the
debtor to the creditor of the thing hypothecated. Hypothecation, properly so called, is that which is
contracted without delivery of the thing hypothecated.

The risk of lending against hypothecation of goods is that since the lender does not obtain actual or
constructive possession of the goods, his measure of control over them is very limited with the
results that the borrower will probably have ample opportunity of dealing with them fraudulently.
This is not a very satisfactory position for the banker as he cannot have a preferential claim in the
event of insolvency of the borrower or in case of an attachment of goods by another creditor or if
the goods are pledged by the borrower to a third party who has no notice of hypothecation to the
banker.

The concept of hypothecation is not provided under the Indian Contract Act, 1872. Hypothecation is
neither governed by any statute nor is there any law governing it directly or indirectly. It has been in
mercantile usage since time immemorial. Therefore courts have to consider the cases involving
hypothecation purely on general conditions of contract as per the terms of hypothecation agreement.

The word "Hypothecation" is found under Section 3 of the Transfer of Property Act, 1882 under
"actionable claim". The interpretation clause of Section 3 does not define the term "hypothecation".

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 HYPOTHECATION - AN EXTENDED PLEDGE
In Bank of Maharashtra v Official Liquidator1, the Mysore (now Karnataka) High Court observed
as follows : "In the case of hypothecation or pledges of movable goods there is no doubt about the
creditor’s right to take possession, to retain possession and to sell the goods directly without the
intervention of court for the purpose of recovering his dues. The position in the regular pledge
completed by possession is undoubted and set out in the relevant sections of the Contract Act.
Hypothecation is only extended idea of pledge, the creditor permitting the debtor to retain
possession either on behalf of or in trust for himself.

In Sewakram v State Bank of India2, the Madhya Pradesh High Court held that hypothecation is an
extended idea of pledge. Therefore, if the creditor has permitted the debtor to retain possession the
debtor retains that possession either on behalf of or in the trust for the creditor. The hypothecatee is
supposed to be in legal possession and custody of the property though its physical possession is
with the debtor.

The Madhya Pradesh High Court in M/s. Tara Rerolling Mills & Five others v Punjab National
Bank3 held that so far as hypothecation is concerned, the possession remains with the hypothecator
but the hypothecatee has the right to get possession of the hypothecated property and sell it for
realisation of the debt secured by way of hypothecation. The goods hypothecated to the Bank are
covered by Section 176 of the Indian Contract Act, 1872. There can be no distinction between

"hypothecation" and "pledge" for application of Section 176 of the Contract Act.

1AIR 1969 Mysore 280

21990 (2) All India Banking Law Judgments 173

31998 (4) All India Banking Law Judgments 275

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 STATUS OF LENDER UNDER
HYPOTHECATION
In Union of India and another v Ct. Shenthilnathan and another4 , the Madras High Court held that
hypothecation of goods is a concept which is not expressly provided in the law of contracts, but is
accepted in the law merchant by long usage and practice. Hypothecation is not a pledge and there is
no transfer of interest or property in the goods by the hypothecator to the hypothecatee. It only
creates a notional and equitable charge in favour of the hypothecatee and the right of the
hypothecatee is only to sue on the debt and proceed in execution against the hypothecated goods, if
they are available. The only right which the hypothecatee got under hypothecation was a right to
seek for the sale of the hypothecated goods after a money decree on the debt. This Madras High
Court decision classifies the hypothecatee as unsecured creditor.

BANK’S RIGHT TO SEIZE THE

HYPOTHECATED GOOD
In Lambersingh Mavasingh v Punjab National Bank5, the appellant filed the appeal before the
Gujarat High Court praying for time for payment of the amount of the loan availed for purchase of
the truck from the bank. The High Court rejected the prayer. The borrower submitted that the bank
had no right to recover the possession without recourse to the court. The question before the Court
was whether the clause in the hypothecation deed which enables the bank to recover possession of
the truck can be enforced or not. The High Court held that the loan is secured by the hypothecation
of truck and if such a clause for recapture of possession is provided in the agreement, it is lawful.
The High Court observed that the real course the borrower should have adopted was to approach the
bank to accept a reasonable amount in the light of the adverse circumstances which he had to suffer.
Instead of doing that, the borrower rushed to the court to pre - empt the bank from resorting to a
remedy which has been reserved to it under the agreement and dismissed the appeal.

4(1977) 2 MU 499

5Unreported Judgment - Appeal from order No. 165 of 1987 - Gujarat High Court

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 PRIORITY OF HYPOTHECATION CHARGE
In Union of India and another v Ct. Shenthilnathan and another6, the facts were that the plaintiff
was lending moneys to the third defendant from time to time on the basis of a deed executed by the
latter in August 1960 hypothecating his camera and certain other articles. In February 1963, the
camera was attached and taken possession of by the District Revenue Authorities in the course of
proceedings against the third defendant for recovery of arrears of Income Tax for the assessment
year 1958 - 59. The plaintiff filed a claim petition for release of the camera to him to enable him to
preserve it for the realisation of the dues under the hypothecation bond. Upon rejection of the
petition by the Sub - ordinate Judge, Salem, the plaintiff filed a suit against the Government of India
(first defendant) and the Salem District Collector (Second defendant) seeking a declaration that the
camera was not liable to be attached by the defendants in the tax recovery proceedings, in view of
the plaintiffs prior charge over it. The trial court gave judgment for the plaintiff and the Government
appealed. The appeal was allowed by the Madras High Court. The Court held that the right of the
hypothecatee is that of a bare money creditor with the ancillary right to proceed against the
hypothecated goods after obtaining a decree in a court of law. Thus, a hypothecation is a right in a
creditor over a thing belonging to another and which consists in the power in him to cause the goods
to be sold in order that his debt might be paid to him from the sale proceeds.

The best that can be claimed by the plaintiff is an equitable charge. He could work out the equitable
charge only after obtaining a decree on the private debt. After obtaining the decree, he should seek
execution as against the goods under the hypothecation deed if available with the hypothecator at or
about the time when he seeks execution. The tax dues are public debt and were not a debt which
arose in the course of commercial dealings between the citizen and the State. As between public
debt payable to the State and a private debt payable to a citizen, the former has priority. Under the
circumstances, the State Authorities are capable of attaching the camera for recovery of Income -
Tax arrears and they have a priority in the sense that they are entitled to recover the tax dues from
out of the sale proceeds of the camera.

In State ofAndhra Pradesh and another v Andhra Bank Ltd and others7 , a bank granted cash credit
advance against hypothecation of stock in the godown of the Sugar Mill under the open credit

6(1977) 2 MLJ 499

7AIR 1988 AP 18

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system. The Tahsildar attached the sugar in the godown hypothecated to the bank for recovery of
dues towards sugar cane purchase tax to the State under the provisions of the Andhra Pradesh
Sugarcane (Regulation and Purchase) Act, 1961. The stocks were sold and the amount realised was
deposited. The Bank filed a suit claiming that the Bank is entitled to preferential first charge and
lien based on the hypothecation of the stocks to recover the suit amount. The State, being simple
money creditors (on account of tax recovery) is entitled to any surplus that may be left. The Andhra
Pradesh High Court held that the concept of hypothecation is recognised in the civil courts and it
has become "law in force" in the country within the meaning of Article 372 (1) of the Constitution
of India as laid down by the Supreme Court in Builders Supply Corporation v Union of India38.
The rules of common law relating to substantive rights have been recognised, adopted and enforced
by judicial decisions. That being so, to say that secured creditor does not get any lien over the
property hypothecated will amount to negativing his right as a secured creditor. In view of these
principles, the doctrine of "Priority of Crown debts" is not applicable as against the secured debt
and therefore the bank’s (hypothecatee) claim has to be satisfied first. In Canara Bank v Asst.
Commissioner (Commercial Taxes), Madras8 , the Commercial Taxes Dept of Tamil Nadu attached
the movables of the borrower on account of the Sales Tax dues. The movables were already
hypothecated to the Bank for certain credit facilities availed by the borrower. The Bank filed a writ
of mandamus before the Madras High Court seeking a direction to the Taxation Authorities not to
sell the property as the bank has the first charge over the property by virtue of the hypothecation in
its favour. The High Court held that the hypothecation in favour of the Bank is not a secured debt.
Therefore the Bank’s charge as hypothecatee could not be treated in preference to the government
dues that can be recovered as a prior charge if the goods hypothecated are available for being

proceeded against and attached for tax arrears.

81989 (1) All India Banking Law Judgments 258

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HYPOTHECATEE’S RIGHT OF PRIVATE SALE
In Re S.Y.C. W & S. Mills9 , the Mysore High Court (now Karnataka High Court) held that in
hypothecation or pledge of movables, there is no doubt about the creditor’s right to take possession,
to retain possession and to sell the goods directly without the intervention of court for the purpose
of recovering his dues. Hypothecation is only extended idea of pledge, the creditor permitting the
debtor to retain possession either on behalf of or in trust for himself (the creditor). Hence so far as
movables actually covered by the hypothecation deeds are concerned, there can be no doubt that the
bank is entitled to retain possession and also to exercise the right of private sale.

In Syndicate Bank v Official Liquidator10 , the Delhi High Court held that hypothecation creates a
special property in the goods in favour of the hypothecatee. In the case of hypothecation, possession
remains with the hypothecator but the hypothecatee has the right to take possession of the
hypothecated property and to sell it for the realisation of the debt secured by hypothecation. It is
open to the bank to take possession of the hypothecated property on its own or through the court. It
is also open to the bank to enforce the security by the suit.

The Andhra Pradesh High Court in State Bank of India v S.B. Shah Ali (Died) and others11 held that
where there is a mere charge in hypothecation agreement, the hypothecatee has to approach the
court and seek intervention of the court for obtaining money decree and for bringing the
hypothecated goods for sale through the court. When there is any specific clause in the
hypothecation agreement empowering the hypothecatee to take possession of the goods and to sell
the same, in the event of default in payment, as per the said terms the hypothecatee can proceed
ahead without intervention of the court. It cannot be said that the hypothecatee has to approach the
court even though the deed provides for taking possession in case of default of the hypothecator. If
there is any violation of the terms of the deed it will not bar the hypothecator to approach the court

and seek proper relief.

9AIR 1969 Mysore 280

10AIR 1985 Delhi 256

111994 (3) ALT 332 (D.B) 


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 ILLEGAL USE OF HYPOTHECATED ASSET -
BANK’S STATUS
A loan was advanced by the bank for purchase of a truck which was hypothecated to the bank. On
default in making repayment, the bank brought a suit against the borrowers for recovery of the loan.
During the pendency of the suit, the said truck was seized by the Range Forest Officer for violation
of forest laws. An application was moved by the bank for attachment before judgment of the truck.
An order of attachment before judgment was granted.

The Forest Department passed orders for confiscation of the vehicle. Apprehending sale of
the.vehicle by the Forest Department, the Bank again applied for an order against sale or disposal of
the truck. This application was dismissed. Against that order, the Bank filed an appeal before the
Madhya Pradesh High Court. The High Court in the case titled "'Bank of Baroda v Sitaram and
others12 held that hypothecation of the truck does not mean that the owner of the truck or the person
responsible for its running is absolved of the liabilities under any other law. If the truck is utilised
for transporting the contraband and is rendered liable for confiscation, it is no defence that it was
hypothecated to a nationalised bank. The Forest Department officials had nothing to do with the
transaction the Bank had with the borrowers. If the truck is found to be liable to be confiscated
under law, the officers of the Forest Department are within their rights to confiscate the same. In
such a case, the bank would lose its security but this cannot be helped.

12(1995) 82 Comp. Cas. 435

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 HYPOTHECATION AND WRIT REMEDY
The Madras High Court decided a case titled "Sukra Shoe Fabric v United Commercial Bank’13 in
respect of the hypothecator’s (borrower) right to file a writ before the High Court questioning the
hypothecatee - bank’s act in locking and sealing the factory premises containing the hypothecated
machinery.

The petitioner - firm was granted certain credit facilities by the respondent bank against
hypothecation of machinery. On default by the borrower in making repayment within the stipulated
time, the officers of the bank along with an Inspector of Police entered the factory premises, locked
and sealed the premises after taking an inventory of the machinery. A writ petition was filed by the
petitioner - borrower for the issue of writ of mandamus to direct the bank to remove the lock and
seal applied to the factory premises and deliver the possession of the same back to the petitioner.
The petitioner contended that the bank had no right either in law or under the hypothecation
agreement to enter the premises and lock and seal the same.

The bank contended that it exercised the powers reserved under clause 4 (j) of the Hypothecation
Deed and seized the goods by means of locking and sealing the premises. The Police Inspector,
though present, did not enter the premises. The bank raised a preliminary objection that writ petition
under Article 226 of the Constitution of India is not maintainable since the rights of the parties are
governed by a non - statutory contract and the remedy of the borrower is Only to file a civil suit.

The High Court observed that the hypothecatee is a nationalised bank and an authority under Article
12 of the Constitution of India. It owes a public duty to its customers as well as to the borrowers. It
has been held by the Supreme Court in Shri Anadi Mukta Satguru Shree Muktajee Vandasjiswami
Suvama Jayanti Mahotsav Smarak Trust v V.R. Rudani14 that mandamus can issue against any
person provided that the court is satisfied that such a person owes a duty to the public at large. The
bank falls within this category.

The High Court rejected the first contention that the writ petition is not maintainable. The only
other question is whether the respondent - bank has any authority of law to enter the premises, lock

13(1992) 73 Comp. Cas. 179

14AIR 1989 SC 1607


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and seal the same. Hypothecation agreement will not enable the creditor to enter the premises, lock
and seal the same without recourse to law.

The High Court further observed as follows on the bank’s act in locking and sealing the factory
premises :

"When the factory was actually working, the officers of the respondent - bank along with the police
have gate - crashed into the factory and purported to lock and seal the premises. If a nationalised
bank can take the law into its own hands, how can the courts criticise and find fault with others?.
The rights given to a creditor under a hypothecation agreement can be exercised only by
approaching the court of law, and not by taking the law into its own hands. If we recognise such a
power in a nationalised bank, then every other State Financial Corporation and Government
Company will be emboldened to follow the same procedure. It will tantamount to bidding good -
bye to the rule of law. There are sufficient remedies available to the creditor - bank. Even in case
there is an imminent danger of the debtor secreting the properties or depleting the securities, it is not
uncommon for civil courts to issue temporary orders of attachment as well as appointment of
commissioners to safeguard the interests of the deserving creditors.

Under what provision of law the police accompanied the bank officials when they purported to
enforce a term of the hypothecation deed? More often than not, the public complain that the police
do not lend their support in urgent cases where there is a threat to life, liberty and property of a
citizen. While so, it is rather strange that the police should have accompanied the officers of the
respondent - bank when they are allegedly enforcing a term of the hypothecation deed. The said
action of the respondent bank is totally unauthorised and arbitrary".

The Madras High Court allowing the writ petition, directed the respondent bank to remove the lock
and seal applied to the petitioner’s factory and to deliver the possession of the factory premises

along with the goods and articles to the petitioner.

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 HYPOTHECATION AND CRIMINAL BREACH
OF TRUST
The Supreme Court in Central Bureau ofInvestigation v Duncan Agro Industries Ltd15 held that
when the debtor hypothecates his goods to the bank by way of security, there is no entrustment of
the goods by the debtor to the banker. If there is any contravention of the terms of the contract it
will be a mere breach of contract making the debtor liable for damages under the civil law. There
will be no occasion for committing any offence of criminal breach of trust by the borrower in the
case of hypothecation.

Observations of the Supreme Court are as follows :

"The expression" entrusted with property" "or with any dominion over the property" has been used
in a wide sense in section 405 of the Indian Penal Code, 1860. Such expression includes all cases in
which goods are entrusted, that is, voluntarily handed over for a specific purpose and dishonestly
disposed of in violation of law. The expression "entrusted" appearing in section 405 of the Indian
Penal Code, 1860, is not necessarily a term of law. It has wide and different implications in different
contexts. It is, however, necessary that the ownership or beneficial interest in the ownership of the
property entrusted in respect of which offence is alleged to have been committed must be in some
person other than the accused and the latter must hold it on account of some person or in some ways
for his benefit. The expression "trust" in section 405 of the Indian Panel Code, 1860, is a
comprehensive expression and has been used to denote various kinds of relationship like that of the
trustee and beneficiary, bailor and bailee, master and servant, pledgor and pledgee. When some
goods are hypothecated by a person to another person, the ownership of the goods still remains with
the person who has hypothecated such goods. The property in respect of which criminal breach of
trust can be committed must necessarily be the property of some person other than the accused or
the beneficial interest or ownership of it must be in other person and the offender must hold the
property in trust for such other person or for his benefit. In a case of pledge, the pledged article
belongs to some other person but the same is kept in trust by the pledgee. In the instant case, a
floating charge was made on the goods by way of security to cover up credit facility. In such case
for disposing of the goods covering the security against credit facility the offence of criminal breach

of trust is not committed".

15(1996) 87 Comp. Cas. 849

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 CONCLUSION
Hypothecation means offering an asset as a collateral security to the lender whereby the ownership
lies with a lender and the possession is enjoyed by the borrower. In a case of default by the
borrower, the lender can exercise his ownership rights to seize the asset. It is usually done in a case
of movable assets, for creating the charge against collateral for the loan given. Under
hypothecation, the possession of the security remains with the borrower itself. Hence, if the
borrower defaults on payments, the lender would have to first take possession of the security (asset
under hypothecation) and then sell the asset to recover dues.In the case of vehicle loans, the vehicle
remains with the borrower but the same is hypothecated to the bank/ financier. If there is any default
by the borrower, the bank takes possession of the vehicle after giving notice and then sells the same.
The loan account is credited with the sales proceeds of the asset to recover the dues towards the
principal amount and interest amount. Any balance left thereafter shall be given back to the
borrower. Apart from vehicles, hypothecation can be done for stocks and bills receivables.Though
pledge seems similar to hypothecation as both are types of charge created on movable assets; there
lie some differences between pledge, hypothecation, and mortgage. Let us look at the differences to
get a better idea of these terms.The possession of the asset remains with the lender in case of a
pledge; while it remains with the borrower in case of hypothecation. Common examples include the
gold loan in case of pledge and vehicle loan in case of hypothecation.The possession remains with
the borrower in both these cases, however, mortgages are usually for non-movable assets while
hypothecation is for movable assets. Common examples include home loan in case of mortgage and
vehicle loan in case of hypothecation.It can also be done for investments / stocks. This is a common
practice in stock trading, better known as, margin lending. In such a case, the buyer, buying shares
on margin, places his existing shares as collateral with the brokerage firm. These shares can be sold
by the brokerage firm if the buyer faces the margin call. A margin call is received when the value of
securities bought decreases more than a certain limit or the account value reduces beyond a certain
limit.

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