Security Creation a tool of recourse lending: Project Finance

A. INTRODUCTION

Being a law student you must have come across the articles stating that XYZ law firm advised ABC Company for setting up its power plant worth thousands of crores of rupees. But have you ever thought what the lawyers do during the transaction, how lawyers come into the picture for a complete financial phenomena oh yes the process is called “Project Finance” and as the opening words suggest it’s a process of financing of projects, projects which are infrastructure based.

The process involves lengthy documentation and the terms and conditions of the documents directly flow from the sanction letters of lenders (banks or financial institutions). Thus the sanction letter is the bible in project finance documentation, and to draft the documents outlining the terms and conditions of the sanction letter with a legal backing is what our job is.

Before we begin with the process, I would like to brief my readers about the due diligence process, which forms part of almost every corporate transaction namely Project Finance, Merger & Acquisitions, Joint Ventures etc. the importance of due diligence is to ascertain the position of target company, it has become more important in transactions where high stakes are involved. A legal due diligence or corporate due diligence report details the corporate structure and commercial aspects such as authorized and paid up share capital, promoter’s details, profit and loss statement etc. whereas land due diligence (one of the unique features of recourse/secured financing) is used to ascertain the title and encumbrances over immovable property (land or built up property).

Despite the complexity inherent in the nature of the financing, some contend that every project financing can be fitted into the same basic structure and essentially has the same components. The two sets of documents are called financing documents and security documents, and jointly these are referred to as transaction documents.

Financing documents facilitate the flow of debt from lender to banker via account bank, which works on the instructions of the lenders. And to secure the repayment of debt, borrower is under mandate to create security in favour of lenders in the form of either pledge of shares, mortgage of immovable property, hypothecation of machinery, assignment of project documents/contracts and personal or corporate guarantees or all.

In this article our scope shall be limited to the definition of security, security creation by way of pledge, hypothecation and mortgage the similarities and difference between the modes of securities etc.

B. MEANING OF SECURITY

The term “security” is neither defined in the Contract Act, 1872 nor in Transfer of Property Act, 1882 or in any other statute time being in force. Thus any exclusive statutory definition with respect to the same is not readily available.

“Security” means and includes Protection; assurance; indemnification. The term is usually applied to an obligation, pledge, mortgage, deposit, lien, etc., given by a debtor in order to make sure the payment or performance of his debt, by furnishing the creditor with a resource to be used in case of failure in the principal obligation. The name is also sometimes given to one who becomes surety or guarantor for another. (Black’s Law Dictionary, 9th Edn.)

Features:

1. Security provides protection towards the repayment of the debt, loan or advance made.

2. It assures the repayment within the stipulated time.

3. It aims to indemnify the creditor towards the loan or advance made by him to debtor.

C. KINDS OF SECURITIES

i. Mortgage – Mortgage is the transfer of interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, an existing or future debt, or the performance of an engagement which may give rise to a pecuniary liability. [Section 58 of Transfer of Property Act, 1882]

Mortgage is defined as a conveyance of property, upon condition, as security for the payment of a debt or the performance of a duty, and to become void upon payment or performance according to the stipulated terms; also, the written instrument by which the conveyance is made or a State of being pledged; as, lands given in mortgage or to grant or convey, as property, for the security of a debt, or other engagement, upon a condition that if the debt or engagement shall be discharged according to the contract, the conveyance shall be void, otherwise to become absolute.

a. Simple Mortgage: A simple mortgage does not involve giving the possession of the mortgagor's property to the mortgagee. It is under mutual agreement that in case of non-payment by the mortgagee to the mortgagor within the specified time, the mortgagee can cause the mortgaged property to be sold in accordance with law and have the sale proceeds adjusted towards the payment of the mortgage money.

b. Mortgage by Conditional Sale: This type of mortgage entails the apparent sale of property by the mortgagor to the mortgagee on a conditional basis, that on default by mortgagor, the sale shall become absolute and complete. If the mortgagor repays his loan, the sale shall become null and void.

c. Usufructuary Mortgage: This type of mortgage, by an express or implied term gives possession to the lender and gives him rights to accrue the rents or income coming from that property as repayment for interest and mortgage money till the time repayment is complete. There is no time limit for payment of the mortgage money.

d. English Mortgage: The mortgagor transfers the mortgaged property to the mortgagee in entirety. However there is a condition that on complete repayment of the repayment money, he will re-transfer the property back to himself.

e. Reverse Mortgage: Reverse mortgage involves lending money to senior citizens against mortgage of their property (house) and there is no need of repaying the same. The loan is awarded as a lump sum amount or as monthly installments. In the event of death of the mortgagor, the property goes into the possession of the mortgagee.

f. Anomalous Mortgage: A mortgage that does not fall under the purview of any of the mortgage types is called an anomalous mortgage.

g. Mortgage by legal charge: In a mortgage by legal charge or technically "a charge by deed expressed to be by way of legal mortgage", the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it. In Pakistan, the mortgage by legal charge is most common way used by banks to secure the financing. It is also known as registered mortgage. After registration of legal charge, the bank's lien is recorded in the land register stating that the property is under mortgage and cannot be sold without obtaining an NOC (No Objection Certificate) from the bank.

h. Equitable mortgage: In an equitable mortgage the lender is secured by taking possession of all the original title documents of the property and by borrower's signing a Memorandum of Deposit of Title Deed (MODTD). This document is an undertaking by the borrower that he/she has deposited the title documents with the bank with his own wish and will, in order to secure the financing obtained from the bank.

ii. Pledge – The bailment of goods as security for payment of a debt or performance of a promise is called "pledge", and bailment is defined as the delivery of goods by one person to another for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them. [Section 172 & 148 of Indian Contract Act, 1872]

Pledge is transferring property as collateral for a debt. Usually the person pledging does not have control over the asset. In pledge the asset offered will be in the custody of lender (i.e., gold loan).But the lender cannot adjust the secured asset with the debt until the debt is due and giving prior notice to the borrower about the due.

iii. Hypothecation - "Hypothecation" means a charge created in or upon any movable property, existing or future, created by a borrower in favour of a secured creditor without delivery of possession of the movable property to such creditor, as a security for financial assistance and includes floating charge and crystallization of such charge into fixed charge on movable property. [Section 2 (n) of The Securitisation and Reconstruction of Financial Assets and enforcement of security interest act, 2002]

This is offering something as collateral for a debt. In hypothecation, the debtor usually does not have to turn over physical custody of the collateral although the lender is "hypothetically" in control of the collateral.

D. DIFFERENCE BETWEEN THE DIFFERENT KINDS OF SECURITIES:

Court’s Observations:

It was stated in this case that in hypothecation a general lien is created, but possession of the property is not transferred, whereas in case of a pledge a special interest and not special property is transferred to the pawnee who is impliedly authorized to sell the goods pledged in case of default in accordance with the provisions of the Contract Act. In case of mortgage, however, a general but limited property is transferred to the creditor, but the possession may or may not be transferred to the mortgagee. [Md. Sultan v. Firm Rampratap Kannyalal: AIR 1964 AP 201]

The distinction between pledge and hypothecation is, that in case of hypothecation the hypothecator can be in possession of the goods hypothecated and enjoy the same without causing any damage to the rights of the hypothecatee whereas in the case of pledge the possession of goods will be transferred to the pawnee and he will be in possession and the pawnor will not be able to enjoy the same as the possession has already been parted with. [State Bank of India vs. S.B. Shah Ali (Died) and Ors.: AIR 1995 AP 134]