Hypothecation

Hypothecation is a legal arrangement in finance where a borrower pledges an asset as collateral for a loan while retaining ownership and possession of that asset. It provides security to the lender without transferring actual control of the property. If the borrower defaults, the lender has the right to seize and sell the asset to recover the outstanding dues.
This practice is common in vehicle loans, business financing, and mortgage lending, serving as a middle ground between unsecured loans and fully pledged assets.

Definition and concept

In simple terms, hypothecation means that a borrower uses an owned asset as security for a debt but continues to use and possess the asset during the loan period. The charge created on the asset is a floating charge, which becomes enforceable if the borrower fails to meet repayment obligations.
Unlike a pledge or mortgage, hypothecation does not transfer possession or ownership to the lender — only a right of claim in the event of default.

Legal framework

In India, hypothecation is governed by:

• The Indian Contract Act, 1872 (general principles of contract).
• The Transfer of Property Act, 1882 (for security interest concepts).
• The SARFAESI Act, 2002 (for enforcement by banks and financial institutions).
• The Companies Act, 2013 (for registration of charges created by companies).

A Deed of Hypothecation is executed between borrower and lender to specify:

• The asset(s) hypothecated.
• The amount borrowed.
• The rights and remedies available in case of default.

Key characteristics

1. Ownership: The borrower remains the legal owner of the asset.
2. Possession: The borrower keeps possession and continues to use the asset in normal business or personal operations.
3. Charge creation: A security interest (charge) is created in favour of the lender, typically registered with the appropriate authority in case of companies.
4. Floating charge: The charge usually remains floating, covering assets like stock, receivables, or movable property, until crystallised on default.
5. Right of enforcement: In case of non-payment, the lender can take possession and sell the asset to recover dues, following due process.

Example

A company obtains a loan of ₹50 lakh from a bank to finance its working capital and hypothecates its inventory and trade receivables as security.

• The company continues to use and sell its stock in day-to-day operations.
• If the company defaults, the bank can take control of the hypothecated assets (the stock or receivables) and liquidate them to recover its loan.

Similarly, when an individual takes a car loan, the vehicle is hypothecated to the bank — the borrower drives and owns it, but the registration certificate (RC) shows the lender’s hypothecation. Once the loan is repaid, the hypothecation is removed from the RC.

Types of assets commonly hypothecated

• Movable assets: Vehicles, equipment, machinery, furniture, inventory, and raw materials.
• Financial assets: Book debts, receivables, and securities.
• Current assets: Goods in trade, stock-in-process, finished goods, and other circulating capital.

Immovable property such as land and buildings cannot be hypothecated; they are typically mortgaged instead.

Rights and duties of parties

Borrower (Hypothecator):

• Must maintain the value and condition of the hypothecated asset.
• Cannot sell or dispose of the asset without the lender’s consent (except for trading stock).
• Must repay the loan as per agreement.

Lender (Hypothecatee):

• Has a legal claim over the hypothecated asset in case of default.
• Can enforce possession and sell the asset under applicable laws.
• Must return or release the charge once the loan is repaid in full.

Comparison with related terms

Advantages of hypothecation

For borrowers:

• Retain possession and use of the asset while obtaining credit.
• Flexibility to use the asset in business or daily activities.
• Generally lower interest rates compared to unsecured loans.

For lenders:

• Security interest provides assurance of repayment.
• Ability to recover dues through legal enforcement in case of default.

Risks and limitations

1. Default risk: If the borrower sells or misuses the hypothecated asset without consent, recovery can be difficult.
2. Valuation issues: The value of movable assets like stock may fluctuate, reducing collateral adequacy.
3. Monitoring burden: Lenders must regularly inspect and verify the existence and condition of assets.
4. Legal proceedings: Taking possession and selling assets require legal compliance, which can delay recovery.

Hypothecation vs. Charge Creation

When a company hypothecates assets to a lender, a charge is created that must be registered with the Registrar of Companies (ROC) under the Companies Act. This ensures transparency to other creditors and stakeholders that the asset is already encumbered.
The charge certificate issued by the ROC serves as legal proof of hypothecation.

Termination or release of hypothecation

Once the borrower repays the entire loan:

• The lender issues a No Objection Certificate (NOC) confirming repayment.
• The hypothecation is removed (de-hypothecated) from relevant records, such as the vehicle registration certificate or company charge register.
• The borrower regains full and unrestricted ownership of the asset.

Importance in financial systems

Hypothecation plays a key role in facilitating:

• Consumer credit: Vehicle and equipment financing.
• Business operations: Working capital loans secured by movable assets.
• Banking security management: Provides lenders with collateral without immobilising business assets.