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LEGAL AND REGULATORY ASPECTS OF BANKING 2nd Edition
INDIAN INSTITUTE OF BANKING & FINANCE
MACMILLAN 'THE ARCADE', WORLD TRADE CENTRE, CUFFE
PARADE MUMBAI400005
Established on 30th April 1928
MISSION

To develop professionally qualified and competent bankers

and financial professionals primarily through a process of
education, training, examination, consultancy/counselling and
continuing professional development programs.
VISION

To be the premier Institute for developing and nurturing

competent professionals in banking and finance field.
OBJECTIVES

To facilitate study of theory and practice of banking and

finance.

To test and certify attainment of competence in the

profession of banking and finance.

To collect, analyse and provide information needed by

professionals in banking and finance.

To promote continuous professional development.

To promote and undertake research relating to Operations,

Products, Instruments, Processes, etc., in banking and finance and
to encourage innovation and creativity among finance
professionals so that they could face competition and succeed.
COMMITTED TO PROFESSIONAL EXCELLENCE Website:
www.iibf.org.in

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LEGAL & REGULATORY ASPECTS OF BANKING
(For JAIIB/Diploma in Banking & Finance Examination)
2nd Edition
Indian Institute of Banking & Finance
MACMILLAN
© INDIAN INSTITUTE OF BANKING & FINANCE, MUMBAI,
2005, 2008
(This book has been published by Indian Institute of Banking &
Finance. Permission of the Institute is essential for reproduction of
any portion of this book. The views expressed herein are not
necessarily the views of the Institute.)
All rights reserved. No part of this publication may be reproduced
or transmitted, in any form or by any means, without permission.
Any person who does any unauthorised act in relation to this
publication may be liable to criminal prosecution and civil claims
for damages.
J-'im t'tlitiim. 2005 Second edition, 2008 Reprinted, 2008 2009
(twice)
MACMILLAN PUBLISHERS INDIA LIMITED
Delhi Bangalore Chennai Kolkata Mumbai Ahmedabad Bhopal
Chandigarh Coimbatore Cuttack Guwahati Hubli Hyderabad
Jaipur Lucknow Madurai Nagpur Patna Pune
Thiruvananthapuram Visakhapatnam
Companies and representatives throughout the world
ISBN 10:0230-63610-1 ISBN 13:978-0230-63610-1
Published by Rajiv Beri for Macmillan Publishers India Limited,
2/10 Ansari Road, Daryaganj, New Delhi 110 002
Printed by S.M. YOGAN at Macmillan India Press, Chennai 600

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041.
LEGAL & REGULATORY ASPECTS OF BANKING
Originally prepared by K.D. Zacharias (Module A), C.P.
Ravindranath (Module B), P.R. Kulkarni (Module C), B.
Gopalakrishnan (Module D) under the guidance of M.L. Chandak,
Advocate, High Court, Mumbai.
Revised and updated by K.D. Zacharias, Legal Adviser, RBI
(Module A), G.M. Ramamurthy, Legal Adviser, IDBI Ltd. (Modules
B, C and D)
This book is meant for educational and learning purposes. The
author(s) of the book has/have taken all reasonable care to ensure
that the contents of the book do not violate any existing copyright
or other intellectual property rights of any person in any manner
whatsoever. Jn the event the author(s) has/have been unable to
track any source and if any copyright has been inadvertently
infringed, please notify the publisher in writing for corrective
action.
FOREWORD
The world of banking and finance is changing very fast and banks
are leveraging knowledge and technology in offering newer services
to the customers. Banks and technology are evolving so rapidly that
bank staff must continually seek new skills that enable them not
only to respond to change, but also to build competence in
handling various queries raised by customers. Therefore, there is a
need for today's bank employees to keep themselves updated with a
new set of skills and knowledge.
The Institute, being the main provider of banking education,

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reviews the syllabus for its associate examinations viz.
JAIIB/CAIIB and various other examinations with the help of
Expert Groups from time to time to make the contents relevant and
contemporary in nature. The latest revision has been done by an
expert group under the Chairmanship of Prof. Y.K. Bhushan. This
book and the other two books mentioned below are the courseware
for JAIIB which aims to impart up-to-date knowledge in the field of
banking and finance and equip the bankers to face the emerging
challenges of today and tomorrow.
As there is a growing demand for qualified manpower in the
banking sector with accent on banking knowledge and skills,
together with technology-familiarity, customer-orientation and
hands-on application skills - which will substantially reduce the
training intervention at the bank level before/immediately after
they are employed - the institute has launched the Diploma in
Banking & Finance in 2007 for graduation-plus level candidates.
Candidates to the course will get extensive and detailed knowledge
on banking & finance and details of banking operations. The
Diploma is offered in the distance learning mode with a mix of
educational support services like provision of study kits, contact
classes, etc. The key features of the Diploma is that it aims at
exposing students to real-life banking environment and that it is
equivalent to JAIIB.
The JAIIB and the Diploma in Banking & Finance has three papers
viz.
1.

Principles & Practices of Banking

2.

Accounting & Finance for Bankers

3.

Legal & Regulatory Aspects of Banking

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This book, the courseware for the third paper on Legal &
Regulatory Aspects of Banking, deals with legal and regulatory
aspects that have a bearing on banking operations, and are woven
in to the units/chapters to make their relevance easily
understandable. Banking and business laws insofar as they relate
to day-to-day banking operations, have also been covered at
appropriate places. Case laws are included, wherever appropriate.
There are various newly enacted laws like Anti-money Laundering
Act, Right to Information Act, Information Technology Act, etc.,
which have significantly changed the way banking operations are
done, and these laws are explained in simple terms as needed to be
understood by a practicing banker.
The Institute had constituted teams consisting of eminent bankers
and academicians to prepare the reading material for all the
subjects as self-instructional study kits obviating the need for the
intervention of a teacher. This book represents the outcome of this
endeavour to bring out self-contained comprehensive
courseware/book on the subject. The Institute acknowledges with
gratitude the valuable services rendered by the authors in
preparing the courseware in a short period of time.
VI
The team, who developed the book, has made all efforts to cover
the entire syllabus prescribed for the subject. However, the
candidates could still refer to a few standard textbooks to
supplement this material which we are sure, will enhance the
professional competence of the candidates to still a higher degree.
We have no doubt that the study material will be found useful and

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will meet the needs of the candidates to prepare adequately for the
examinations. In addition, we are sure that these books will also be
useful to practitioners, academicians, and other interested readers.
We welcome suggestions for improvement of the book.
Mumbai 3-7-2008
R. Bhaskaran
Chief Executive Officer
RECOMMENDED READING
The Institute has prepared comprehensive courseware in the form
of study kits to facilitate preparation for the examination without
intervention of the teacher. An attempt has been made to cover
fully the syllabus prescribed for each module/subject and the
presentation of topics may not always be in the same sequence as
given in the syllabus.
Candidates are also expected to take note of all the latest
developments relating to the subject covered in the syllabus by
referring to Financial Papers, Economic Journals, Latest Books and
Publications in the subjects concerned.

PAPER 3LEGAL&REGULATORY ASPECTS OF BANKING
Objectives: The candidates would be able to acquire knowledge in:

The legal & regulatory framework of the banking system and

The various laws and enactments affecting day-to-day

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banking operations
MODULE, A.-REGULATIONS &COMPLIANCE
• The questions in this section will be with reference to legal issues
and problems.
A.

Provisions of RBI Act 1935, Banking Regulation Act 1949,

Banking Companies [Acquisition and Transfer of Undertakings Act
1970 & 1980].
B. Government and RBIs Powers:
-

Opening of New Banks and Branch Licensing

-

Constitution of Board of Directors and their Rights

-

Banks Shareholders and their Rights

-

CRR/SLR Concepts

-

Cash/Currency Management

Winding Up - Amalgamation and Mergers

Powers to Control Advances - Selective Credit Control -

Monetary and Credit Policy

Audit and Inspection

Supervision and Control-Board for Financial Supervision -

Its Scope and Role

Disclosure of Accounts and Balance Sheets

Submission of Returns to RBI, etc.

Corporate Governance

MODULE B - LEGAL ASPECTS OF BANKING OPERATIONS

Case Laws on Responsibility of Paying/Collecting Banker

Indemnities/Guarantees

-

Scope and Application

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-

Obligations of a Banker

-

Precautions and Rights

Laws Relating to Bill Finance, LC and Deferred Payments

Laws Relating to Securities

Valuation of Securities - Modes of Charging Securities -

Lien, Pledge, Mortgage, Hypothecation,
etc.

Registration of Firms/Companies

Creation of Charge and Satisfaction of Charge

MODULE C - BANKING RELATED LAWS

Law of Limitation

Provisions of Bankers Book Evidence Act

Special Features of Recovery of Debts Due to Banks and

Financial Institutions Act, 1993

TDS and Service Tax

Banking Cash Transaction Tax

Asset Reconstruction Companies

The Securitisation and Reconstruction of Financial Assets

and Enforcement of Security Interest
Act, 2002

The Consumer Protection Act, 1986

Banking Ombudsman 2006

LokAdalats

Lender's Liability Act

MODULE D - COMMERCIAL LAWS WITH REFERENCE TO
BANKING OPERATIONS

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Indian Contract Act, 1872 (Indemnity, Guarantee, Bailment,

Pledge and Agency, etc.)

The Sale of Goods Act, 1930 (Sale and Agreement to Sell,

Definitions, Conditions and Warranties,
Express and Implied, Right of Unpaid Seller, etc.)

The Companies Act, 1956, Definition, Features of Company,

Types of Companies, Memorandum,
Articles of Association, Doctrines of Ultra Vires, Indoor
Management and Constructive Notice,
Membership of Company - Acquisition - Cessation, Rights and
Duties of Members and Register of
Members, Prospectus and Directors.

Indian Partnership Act, 1932, Definition and Types of

Partnership, Relation of Partners to One
Another-Relation of Partners to Third Parties, Minor Admitted to
the Benefits of Partnership,
Dissolution of Firm, Effect of Non-Registration

The Transfer of Property Act

Foreign Exchange Management Act, 2000

Prevention of Money Laundering Act, 2002

Right to Information Act, 2005

Information Technology Act, 2000

CONTENTS
Foreword

v

MODULE A - REGULATIONS AND COMPLIANCE
1.

Legal Framework of Regulation of Banks 3

2.

Control Over Organisation of Banks

15

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3.

Regulation of Banking Business

31

4.

Returns, Inspection, Winding Up 49

5.

Public Sector Banks and Co-operative Banks

65

MODULE B - LEGAL ASPECTS OF BANKING OPERATIONS
6.

Case Laws on Responsibility of Paying Bank

7.

Case Laws on Responsibility of Collecting Bank 93

8.

Indemnities 101

9.

Bank Guarantees

107

10.

Letters of Credit

119

11.

Deferred Payment Guarantee

131

12.

Laws Relating to Bill Finance

135

13.

Various Types of Securities 143

14.

Law Relating to Securities and Modes of Charging -1

155

15.

Law Relating to Securities and Modes of Charging - II 163

16.

Different Types of Borrowers

17.

Types of Credit Facilities

18.

Secured and Unsecured Loans, Registration of Firms,

Incorporation of Companies
19.

83

173

181
187

Registration and Satisfaction of Charges 197

MODULE C - BANKING RELATED LAWS
SECURITISATION AND RECONSTRUCTION OF FINANCIAL
ASSETS
AND ENFORCEMENT OF SECURITY INTEREST, 2002
(SARFAESI ACT)
20.

Introduction to SARFAESI Act, 2002

205

21.

Definitions at SARFAESI Act, 2002

209

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22.

Regulation of Securitisation and Reconstruction of Financial

Assets of
Banks and Financial Institutions 219
xii
23.

Enforcement of Security Interest

24.

Central Registry

25.

Offences and Penalties

26.

Miscellaneous Provisions

THE BANKING OMBUDSMAN SCHEME, 2006
27.

Purpose, Extent, Definitions, Establishment and Powers

28.

Procedure for Redressal of Grievances

RECOVERY OF DEBTS DUE TO BANKS AND FINANCIAL
INSTITUTIONS ACT, 1993 (DRTACT)
29.

Preliminary

30.

Establishment of Tribunal and Appellate Tribunal

31.

Jurisdiction, Powers and Authority of Tribunals

32.

Procedure of Tribunals

33.

Recovery of Debts Determined by Tribunal and

Miscellaneous Provisions
THE BANKERS' BOOKS EVIDENCE ACT, 1891
34.

The Bankers' Books Evidence Act, 1891

THE LEGAL SERVICES AUTHORITIES ACT, 1987
35.

LokAdalats

THE CONSUMER PROTECTION ACT, 1987
36.

Preliminary, Extent and Definitions

37.

Consumer Protection Councils

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38.

Consumer Disputes Redressal Agencies

THE LAW OF LIMITATION
39.

Limitations of Suits, Appeals and Applications

TAX LAWS
40.

Income Tax, Banking Cash, Transaction Tax, Fringe Benefit

Tax and Service Tax
231 241 245 249
255 259
267 271 275 279 285
293 299
303 311 315
327 331
MODULE D - COMMERCIAL LAWS WITH REFERENCE TO
BANKING OPERATIONS
41.

Meaning and Essentials of a Contract

42.

Contracts of Indemnity

43.

Contracts of Guarantee

44.

Contract of Bailment

45.

Contract of Pledge

46.

Contract of Agency

47.

Meaning and Essentials of a Contract of Sale

48.

Conditions and Warranties

341 345 347 353 357 359 365 369

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XIII
49.

Unpaid Seller

50.

Definition, Meaning and Nature of Partnership

51.

Relations of Partners to One Another

52.

Relations of Partners to Third Parties

53.

Minor Admitted to the Benefits of Partnership

54.

Dissolution of a Firm

55.

Effect of Non-Registration

56.

Definition and Features of a Company

57.

Types of Companies

58.

Memorandum of Association and Articles of Association

59.

Doctrines of Ultra Vires/Constructive Notice/Indoor

Management
60.

Membership

61.

Prospectus

62.

Directors

63.

Foreign Exchange Management Act, 1999

64.

Transfer of Property Act, 1882

65.

The Right to Information Act, 2005

66.

Right to Information and Obligations of Public Authorities

67.

The Prevention of Money Laundering Act, 2002

68.

Information Technology Act, 2000

Bibliography
373 377 381 385 389 393 397 399 405 411 415 419 425 429 437 443
453 457 463 469 475

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MODULE-A REGULATIONS AND COMPLIANCE
Unit 1. Legal Framework of Regulation of Banks
Unit 2. Control over Organisation of Banks
Unit 3. Regulation of Banking Business
Unit 4. Returns, Inspection, Winding Up
Unit 5. Public Sector Banks and Co-operative Banks

Unit 1 LEGAL FRAMEWORK OF REGULATION OF
BANKS
STRUCTURE
1.0

Objectives

1.1

Introduction

1.2

Business of Banking

1.3

Constitution of Banks

1.4

Reserve Bank of India Act, 1934

1.5

Banking Regulation Act, 1949

1.6

Reserve Bank as Central Bank and Regulator of Banks

1.7

Government as a Regulator of Banks

1.8

Control Over Co-operative Banks

1.9

Regulation by Other Authorities

1.10

Let Us Sum Up

1.11

Keywords

1.12

Check Your Progress

1.13

Answer to 'Check Your Progress'

1.14

Terminal Questions

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1.0

OBJECTIVES

The objectives of this Unit are to understand:

the definition and nature of the business of banking;

the constitution of different types of banks;

the regulatory scheme of the RBI Act and the BR Act;

the role of the Reserve Bank and the Central Government as

regulators; and

the special position of public sector banks and co-operative

banks.
1.1

INTRODUCTION

Banking in India is mainly governed by the Banking Regulation
Act, 1949 and the Reserve Bank of India Act, 1934. The Reserve
Bank of India and the Government of India exercise control over
banks from the opening of banks to their winding up by virtue of
the powers conferred under these statutes.
All the regulatory provisions are not uniformly applicable to all
banks. The applicability of the provisions of these Acts to a bank
depends on its constitution; that is, whether it is a statutory
corporation, a banking company or a co-operative society. In this
unit, we look at the definition of banking, the constitution of
different types of banks and applicability of regulatory laws, the
general framework of the regulatory laws and the role of regulators
namely, the Reserve Bank of India and the government.

1.2

BUSINESS OF BANKING

i. Definition of Banking: Banking is defined in Section 5(b) of the
Banking Regulation Act as the acceptance of deposits of money
from the public for the purpose of lending or investment. Such

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deposits may be repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise. Thus, a bank
must perform two essential functions: i) acceptance of public
deposits, and ii) lending or investment of such deposits. The
deposits may be repayable on demand or for a period of time as
agreed by the banker and the customer. In terms of the definition,
the banker can accept "deposits" of money and not anything else.
Further, accepting deposits from the "public" implies that a banker
accepts deposits from anyone who offers money for such purpose.
However, a banker can refuse to open account for undesirable
persons and further, the opening of accounts is subject to certain
conditions like proper introduction and identification.
The "Know Your Customer" guidelines issued by the Reserve Bank
require banks to follow certain customer identification procedure
for opening of accounts for protecting the banks from frauds, etc.,
and also for monitoring transactions of a suspicious nature for the
purpose of reporting to appropriate authorities for taking antimoney laundering measurers and combating financing of
terrorism.
There is no exhaustive definition of "banking" in Common Law of
England. However, the usual characteristics of banking as
identified by Lord Denning MR in United Dominions Trust Ltd. vs
Kirkwood ([1966] 1 All ER 968 at 975) are:
(a)

the conduct of current accounts;

(b)

the payment of cheques; and

(c)

the collection of cheques for customers.

These characteristics are not equivalent to a definition, and these
are also not the only characteristics. (See, Paget's Law of Banking,

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12th Edn., pp. 107 to 109)
ii. Deposits Withdrawable by Cheque: Under Section 49A of the
Banking Regulation Act, no organisation other than a bank is
authorised to accept deposits withdrawable by cheque. The Savings
Bank
Scheme run by the government, a Primary credit society and any
other person or firm notified by the government are exempted
from this prohibition.
iii. Acceptance of Deposits by Non-banking Entities: There are also
non-banking companies, firms and other unincorporated
associations of persons and individuals who accept deposits from
the public. Acceptance of deposits by non-banking financial
companies is regulated by the Reserve Bank under the NonBanking Financial Companies Acceptance of Public Deposits
(Reserve Bank) Directions, 1998 and other directions issued by it
under Chapter IIIB of the Reserve Bank of India Act. Other
companies are regulated by the Central Government under the
Companies (Acceptance of Deposit) Rules, 1975 issued under
Section 58A of the Companies Act, 1956. Individuals, firms and
other unincorporated associations of persons whose business
includes the business of a financial institution or whose principal
business is acceptance of deposits, is prohibited under Section 45S
of the RBI Act (as amended in 1997) from accepting deposits from
the public, except relatives. This prohibition does not apply to
acceptance of deposits by those who are mainly engaged in
manufacturing or trading.
iv. Licence for Banking: In India, it is necessary to have a licence

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from the Reserve Bank under Section 22 of the Banking Regulation
Act for commencing or carrying on the business of banking. Every
banking company has to use the word "bank" as part of its name
(See, Section 7 of the Act) and no company other than a banking
company can use the words "bank", "banker", "banking" as part of
its name. Further, no firm, individual or group of individuals is
permitted to use the words "bank", "banking" or "banking
company" as a part of the name or for the purpose of business.
Subsidiaries of banks and association of banks in certain cases as
also Primary Credit Societies are exempted from this restriction.
v. Permitted Business: Although, traditionally, the main business of
banks is acceptance of deposits and lending, the banks have now
spread their wings far and wide into many allied and even
unrelated activities. The forms of business permissible under
Section 6(1) of the Banking Regulation Act, apart from banking
business, are summarised below:
(a)

(i) Borrowing, raising or taking up of money;

(ii) Lending or advancing of money either upon security or without
security;
(iii) Drawing, making, accepting, discounting, buying, selling,
collecting and dealing in bills of exchange, hundis, promissory
notes, coupons, drafts, bills of lading, railway receipts, warrants,
debentures, certificates, scrips and other instruments and
securities whether transferable or negotiable or not;
(iv) Granting and issuing of letters of credit, travellers' cheques and
circular notes;
(v) Buying, selling and dealing in bullion and specie;
(vi) Buying and selling of foreign exchange including foreign bank

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notes;
(vii) Acquiring, holding, issuing on commission, underwriting and
dealing in stock, funds, shares, debentures, debenture stock,
bonds, obligations, securities and investments of all kinds;
(viii) Purchasing and selling of bonds, scrips and other forms of
securities on behalf of constituents or others;
(ix) Negotiating of loans and advances;
(x) Receiving of all kinds of bonds, scrips or valuables on deposit or
for safe custody or otherwise;
(xi) Providing of safe deposit vaults; and
(xii) Collecting and transmitting of money and securities.
(c)

Contracting for public and private loans and negotiating and

issuing the same.
(d)

Insure, guarantee, underwrite, participate in managing and

carrying out any issue of state, municipal or other loans or of
shares, stock, debentures or debenture stock of companies and
lend money for the purpose of any such issue.
(e)

Carry on and transact every kind of guarantee and

indemnity business.
(f)

Manage, sell and realise any property which may come into

its possession in satisfaction of any of its claims.
(g)

Acquire, hold and deal with any property or any right, title

or interest in any such property which may form the security for
any loan or advance.
(h) Undertake and execute trusts.
(i) Undertake the administration of estates as executor, trustee or
otherwise.

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(j) Establish, support and aid associations, institutions, funds,
trusts, etc., for the benefit of its present or ex-employees; grant
money for charitable purposes,
(k) Acquire, construct and maintain any building for its own
purpose.
(L) Sell, improve, manage, develop, exchange, lease, mortgage,
dispose of or turn into account or otherwise deal with all or any
part of the business of any person or company, when such business
is of a nature described in Section 6.
(m) Acquire and undertake the whole or any part of the business of
any person or company, when such business is of a nature
described in Section 6.
(n) Do all such things which are incidental or conducive to the
promotion or advancement of the business of the company,
(o) Do any other business specified by the Central Government as
the lawful business of a banking company. The Central
Government has accordingly specified leasing and factoring as
permissible business for banks.
vi. Prohibited Business: Section 8 of the Banking Regulation Act
prohibits a banking company from engaging directly or indirectly
in trading activities and undertaking trading risks. Buying or
selling or bartering of goods directly or indirectly is prohibited.
However, this is without prejudice to the business permitted under
Section 6(1) of the Act. Accordingly, a bank can realise the
securities given to it or held by it for a loan, if need arises for the
realisation of the amount lent. It can also buy or sell or barter for
others in connection with: (i) bills of exchange received for
collection or negotiation, and (ii) undertaking the administration of

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estates as executor, trustee, etc. Goods for the purpose of this
Section means every kind of moveable property, other than
actionable claims, stocks, shares, money, bullion and specie and all
instruments referred to in Clause (a) of sub-Section (1) of Section
6.
As regards immoveable properties, Section 9 prohibits a banking
company from holding such property, howsoever acquired, except
as is required for its own use, for a period exceeding seven years
from the acquisition of the property. The Reserve Bank may extend
this period by another five years, if it is satisfied that such
extension would be in the interest of the depositors of the banking
company. The banking company shall be required to dispose of
such property within the permitted period.
1.3 CONSTITUTION OF BANKS
i. Banks in India fall under one of the following categories:
(a)

Body corporate constituted under a special statute;

(b)

Company registered under the Companies Act, 1956 or a

foreign company;
(c)

Co-operative society registered under a central or state

enactment on co-operative societies.
ii. Public Sector Banks: The public sector banks including
nationalised banks, State Bank of India and its associates
(subsidiaries) and the Regional Rural Banks fall in the first
category. By the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 and the Banking Companies (Acquisition
and Transfer of Undertakings) Act, 1980 the Central Government
nationalised (took over the business undertakings) of certain

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banking companies and vested them in newly created statutory
bodies (corresponding new banks) constituted under Section 3 of
the 1970/1980 Act. The State Bank of India was constituted under
the State Bank of India Act, 1955 and the six associate/subsidiary
banks were constituted under the State Bank (Subsidiary Banks)
Act, 1959 or other statutes (See Para 5.2.6). The regional rural
banks are constituted under the Regional Rural Banks Act, 1976.
These banks are governed by the statutes creating them as also
some of the provisions of the Banking Regulation Act and the
Reserve Bank of India Act. The details are discussed in Unit 5.
iii. Banking Companies: A banking company, as defined in Section
5(c) of the Banking Regulation Act is a company which transacts
the business of banking. Such company may be a company
constituted under Section 3 of the Companies Act or a foreign
company within the meaning of Section 591 of that Act. All the
private sector banks are banking companies. These banks are
governed by the Companies Act, 1956 in respect of their
constitution and by the Banking Regulation Act and the RBI Act
with regard to their business of banking.
iv. Co-operative Banks: A co-operative bank is a co-operative
society registered or deemed to have been registered under any
Central Act for the time being in force relating to the multi-state
co-operative societies, or any other central or state law relating to
co-operative societies for the time being in force. If a co-operative
bank is operating in more than one state, the Central Act applies.
In other cases, the state laws apply. The Banking Laws (Application
to Co-operative Societies) Act, 1965 extended certain provisions of
the Banking Regulation Act and the Reserve Bank of India Act to

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the co-operative banking sector. After the Supreme Court held in
Apex Co¬operative Bank's case (AI R 2004 SC 141) that multi-state
co-operative societies cannot be licensed as co-operative banks, the
Banking Regulation (Amendment) and Miscellaneous Provisions
Act, 2004 was enacted to permit licensing of multi-state cooperative banks. A "multi-state co¬operative bank" under this Act
means a multi-state co-operative society which is a primary cooperative bank.
1.4 RESERVE BANK OF INDIA ACT, 1934
i. The Reserve Bank of India Act, 1934 was enacted to constitute
the Reserve Bank of India: (i) to regulate the issue of bank notes,
(ii) for keeping reserves for securing monetary stability in India,
and (iii) to operate the currency and credit system of the country to
its advantage. The Act came into force on 6th March 1934. The Act
has been amended from time to time to meet the demands of
changing times. The last amendment to the Act was effected by the
RBI (Amendment) Act, 2006.
ii. The Act deals with the constitution, powers and functions of the
Reserve Bank. It does not directly deal with regulation of the
banking system except for Section 42, which provides for cash
reserves of scheduled banks to be kept with the Reserve Bank, with
a view to regulating the credit system and ensuring monetary
stability. Further, Section 18 of the Act provides for direct discount
of bills of exchange and promissory notes when a special occasion
arises, making it necessary or expedient for the purpose of
regulating credit in the interests of trade, industry and agriculture.
The Act, in short, deals with:
(i) incorporation, capital, management and business of the bank:

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(ii) the central banking functions like issue of bank notes, monetary
control, acting as banker to government and banks, lender of last
resort;
(iii) collection and furnishing of credit information;
(iv) acceptance of deposits by non-banking financial institutions;
(v) general provisions regarding reserve fund, credit funds,
publication of bank rate, audit and accounts; and
(vi) penalties for violation of the provisions of the Act or the
directions issued thereunder.

1.5

BANKING REGULATION ACT, 1949

i. The Banking Regulation Act, 1949 was enacted to consolidate and
amend the law relating to banking and to provide for a suitable
framework for regulating the banking companies. Initially, the Act
provided for regulation of banking companies only, but in 1965 the
Act was amended to cover co-operative banks as well with certain
modifications (See, Section 56). However, the Act, as provided in
Section 3, does not apply to primary agricultural credit societies
and co-operative land mortgage banks. The provisions of the Act
are applicable to banking companies in addition to other laws
which are applicable to such companies, unless otherwise
specifically provided in the Act. Thus, Companies Act, 1956 which
deals with the incorporation and working of companies is
applicable to banking companies except where special provisions
are made in the Banking Regulation Act in that regard.
ii. The Act regulates entry into banking business by licensing as
provided in Section 22 thereof. The Act also puts restrictions on the
shareholding, directorship, voting rights and other aspects of

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banking companies. There are several provisions in the Act
regulating the business of banking such as restriction on loans and
advances, rates of interest to be charged, requirement as to cash
reserve and maintenance of percentage of assets, etc. There are
provisions regarding audit and inspection and submission of
balance sheets and accounts. The Act provides for control over the
management of banking companies and also deals with the
procedure for winding up of the business of the banks and
penalties for violation of its provisions. In short, the Act deals with:
(a)

regulation business of banking companies;

(b)

control over the management of banking companies;

(c)

suspension and winding up of banking business; and

(d)

penalties for violation of the provisions of the Act.

1.6

RESERVE BANK AS CENTRAL BANK AND REGULATOR

OF BANKS
i. The Reserve Bank was constituted under Section 3 of the Reserve
Bank of India Act, 1934 for taking over the management of
currency from the Central Government and carrying on the
business of banking in accordance with the provisions of the Act.
Originally, under the RBI Act, the Bank had the responsibility of:
(a)

regulating the issue of bank notes;

(b)

keeping of reserves for ensuring monetary stability; and

(c)

generally to operate the currency and credit system of the

country to its advantage.
ii. The Reserve Bank is a body corporate having perpetual
succession and common seal and shall sue and be sued in its name.
The whole capital of the bank is held by the Central Government.
The Bank has its central office in Mumbai and offices in Mumbai,

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Kolkata, Delhi and Chennai, and branches at most of the state
capitals and some other cities.
iii. The bank functions under the general superintendence and
directions of the Central Board of
Directors. The bank has to abide by the directions given by the
Central Government in public interest after consultation with the
Governor of the bank. The board shall consist of a Governor and
not more than four Deputy Governors to be appointed by Central
Government and other directors nominated by the Central
Government. Apart from the Central Board, the bank has also local
boards situated at Mumbai, Kolkata, Delhi and Chennai, which
perform any duty delegated to them by the Central Board. The
Governor has the power of general superintendence and direction
of the affairs of the bank and exercise all powers of the bank unless
otherwise provided in the regulations made by the Central Board.
The Deputy Governors, Executive Directors and other officers in
different grades assist the Governor in the discharge of the Bank's
functions.
iv. The Reserve Bank is the sole authority for issue and
management of currency in India under Section 22 of the RBI Act.
The bank may issue notes of different denominations from Rs. 2 to
Rs. 10,000 as the Central Government may decide on the
recommendations of the Central Board of the bank. Such notes
shall be legal tender at any place in India.
v. The bank is the banker to the Central Government under Section
20 of the Act, and accordingly it is obligatory to undertake banking
business for the Central Government. In the case of state

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governments, their banking business is undertaken by the bank
based on agreements as provided in Section 21 A. Bank provides
ways and means of advances to the Central and state governments.
These are temporary advances to meet immediate needs when
there is interval between expenditure and flow of revenue.
vi. The role of the bank as regulator of banking sector is mainly by
virtue of the provisions of the Banking Regulation Act, 1949. In
exercise of the powers under that Act the bank regulates the entry
into banking business by licensing, exercises control over
shareholding and voting rights of shareholders, exercises controls
over the managerial persons, and regulates the business of banks.
The bank also inspects banks and exercises supervisory powers,
and may issue directions from time to time in public interest and in
the interest of the banking system with respect to interest rates,
lending limits, investments and various other matters.
vii. The major powers of the Reserve Bank in the different roles as
regulator and supervisor can be summed up as under:
(a)

power to licence;

(b)

power of appointment and removal of banking

boards/personnel;
(c)

power to regulate the business of banks;

(d)

power to give directions;

(e)

power to inspect and supervise banks;

(f)

power regarding audit of banks;

(g)

power to collect, collate and furnish credit information;

(h) power relating to moratorium, amalgamation and winding up;
and (i) power to impose penalties.
1.7 GOVERNMENT AS A REGULATOR OF BANKS

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i. The Reserve Bank is the primary regulator of banks. But the
Central Government has also been conferred extensive powers
under the RBI Act and BR Act either directly or indirectly over the
banks.
ii. The government holds the entire capital of the Reserve Bank and
appoints the Governor and the
mr.mhe.rs nf the Central Rmrd nnri Vns the power to
remove them. The government has also the
--•j i
10
necessary in public interest after consultation with the Governor.
Thus, the government can exercise control over banks by
influencing decision-making by the Reserve Bank and has also got
appellate authority in respect of several matters in which the
Reserve Bank has been conferred the power to decide at the first
instance. Thus, under the Banking Regulation Act appeal lies with
the Central Government on removal of managerial personnel under
Sections 10B and 36AA of the BR Act. Similarly, there are also
provisions for appeal in respect of cancellation of banking licence
(under Section 22) and refusal of certificate regarding floating
charge on assets (Section 14A).
iii. The government has the power to suspend the operations of the
Banking Regulation Act or to give exemption from any of the
provisions of the Act on the representation/recommendation of the
Reserve Bank under Sections 4 and 53 of the Act, respectively. The
government has also the power to notify other forms of business
which a bank may undertake under Section 6(1 )(o) of the Act.

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Rule-making powers under Sections 52 and 45Y are vested in the
Central Government. There are also other provisions under which
the Central Government exercises powers as under:
(a)

Approval for formation of subsidiary for certain business

under Section 19;
(b)

Notification with reference to accounts and balance sheet

under Section 29;
(c)

Issue of direction for inspection of banks under Section 35;

(d)

Power to acquire undertakings of banks (Section 36AE);

(e)

Appointment of court liquidator;

(f)

Suspension of business and amalgamation of banks under

Section 45.
The above provisions confer wide powers on the Central
Government to regulate banks. These are in addition to the powers
conferred on the government as majority shareholder or full owner
of public sector banks under the statutes constituting them.
1.8 CONTROL OVER CO-OPERATIVE BANKS
i. A co-operative bank is a co-operative society engaged in the
business of banking and may be a primary Co-operative bank, a
district central co-operative bank or a state co-operative bank.
Co¬operative banks operating in one state only are registered
under the State co-operative Societies Act concerned. The
formation of such banks as well as their management and control
over personnel is regulated by the co-operative law of the state. The
Registrar of co-operative societies under the Co-operative Societies
Act exercises a wide range of powers on co-operative societies from
registration to winding up.
ii. In the case of co-operative banks operating in more than one

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state, the Multi-State Co-operative Societies Act, 2002 is
applicable. In that case, the Registrar appointed by the Central
Government takes the place of the Registrar appointed by the State
Government in other cases.
iii. With the introduction of Section 56 in the Banking Regulation
Act, 1949 with effect from 1965, co¬operative banks have come
under the regulatory purview of the Reserve Bank. While the
formation and management of co-operative societies operating in
one state only (including those conducting banking business) are
under the control of the State Government, licensing and
regulation of banking business rests with the Reserve Bank. Thus,
there is dual control of State Governments and the Reserve Bank
over these banks.
IV. In the case of co-operative banks which are registered under the
Deposit Insurance and Credit Guarantee Corporation Act, the
Reserve Bank has the power to order their winding up. The
circumstances in which Reserve Bank may require winding up are
mentioned in Section 13D of the Act.
11
1.9

REGULATION BY OTHER AUTHORITIES

i. Banks may be subject to the control of other regulatory agencies
in the conduct of their business. For instance, a banking company
will be subject to the control of the authorities under the
Companies Act in respect of company matters. Similarly, a bank is
answerable to labour authorities in respect of the terms and
conditions of service of its workmen, opening and closing of its
premises, engagement of contract labour, etc. Banks are also liable

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to pay income tax like cash transaction tax, service tax, etc., and
other taxes and have to follow the rules and regulations in that
regard.
ii. As provided in Section 6 of the Banking Regulation Act, banks
may undertake certain non-banking business in addition to the
business of banking. In that regard also, banks may be subject to
the regulatory control of other agencies. For instance, in the case of
dealings in securities like shares and debentures, banks are subject
to regulation by the Securities Exchange Board of India under the
Securities Contract (Regulation) Act, 1956 read with the Securities
and Exchange Board of India Act, 1992. If the Bank desires to raise
capital through public issue, it has to comply with SEBI guidelines.
In case of Insurance Business - by IRDA and in case of Mutual
Fund Business -RBI, SEBI.
The study herein is, however, largely confined to the regulation of
banks by the Reserve Bank and the Central Government under the
Reserve Bank of India Act and the Banking Regulation Act.
1.10

LET US SUM UP

1.

Banking means acceptance of deposits of money from the

public for lending or investment. Such
deposits may be repayable on demand or may be for a period of
time as agreed to, by the banker
and the customer, and may be repayable by cheque, draft or
otherwise. Apart from banking, banks
are authorised to carry on other business as specified in Section 6
of the Banking Regulation Act.
Banks are, however, prohibited from undertaking any trading
activities.

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2.

Banks are constituted as companies registered under the

Companies Act, 1956, statutory corporations
constituted under Special Statutes or Co-operative societies
registered under the Central or State
Co-operative Societies Acts. The extent of applicability of the
regulatory provisions under the
Banking Regulation Act and the Reserve Bank of India Act to a
bank depends on the constitution of
the bank.
3.

Reserve Bank of India is the central bank of the country and

the primary regulator for the banking
sector. The government has direct and indirect control over banks.
It can exercise indirect control
through the Reserve Bank and also act directly in appeals arising
from decisions of the Reserve
Bank under the various provisions of the Banking Regulation Act.
In public sector banks like the
State Bank of India and its subsidiaries, nationalised banks and the
regional rural banks, 50% or
more of their shares are held by the Central Government. Central
Government has substantial
control over the management of these banks. Only certain
provisions of the BR Act are applicable
to these banks as indicated in that Act. Co-operative banks
operating in one state only are registered
under the State Co-operative Societies Act and are subject to the
control of the State Government
as also the Reserve Bank. In the case of non-banking business of

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the banks, they are subject to
control by other regulatory agencies.
1.11

KEYWORDS

Banking; Banking Company; Body Corporate; Co-operative Bank;
Nationalised Bank; Regional Rural Bank; Public Sector Bank.
12
1.12 CHECK YOUR PROGRESS
A. 1. State whether the following statements are True or False.
(i) A public sector bank is a body corporate created under a special
statute.
(ii) A banking company is registered under the Banking Regulation
Act.
(iii) Co-operative banks are registered under the Multi-State Cooperative Societies Act or a
State Co-operative Societies Act.
(iv) Subsidiaries of the State Bank are companies registered under
the Companies Act. (v) Accepting deposits for safe custody would
fall within the definition of "banking".
2. Fill in the gaps choosing the answers from the brackets.
(i) Reserve Bank was constituted under (BR Act, RBI Act,
Companies Act)
(ii) A Regional Rural Bank is

(a body corporate created under

a special statute, a co¬
operative society, a company)
(Reserve Bank, Registrar of Companies,
(iii) Banking companies are licensed by

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Company Law Board)
(iv) Business which a banking company may undertake other than
banking is as stipulated by
(Reserve Bank, BR Act, RBI Act)
(v) BR Act was enacted for (regulating banking companies,
creating Reserve Bank,
regulating acceptance of deposits from public)
B. 1
State whether the following statements are True or False, (i)
Central Government can give direction to the Reserve Bank, (ii) All
kinds of business of banks is regulated only by the Reserve Bank,
(iii) Central Government is the primary regulator of banks, (iv)
State governments have no control over co-operative banks. (v) On
cancellation of licence of any bank, an appeal lies with Central
Government.
Fill in the gaps choosing the answers from the brackets.
(State Co¬
operative Societies Act, Multi-State Co-operative Societies Act, RBI
Act)
Government can exempt a bank from the provisions of BR Act
(on the
recommendation of RBI, whenever the government is satisfied, if
requested by a bank)
exercises the central banking function in India. (State Bank,
Central Bank of
(ii) (iii)
(i) Co-operative banks operating in different states are registered
under

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(Reserve Bank,
India, Reserve Bank)
(iv) Company matters of a banking company are regulated by
(Controller
Authorities under the Companies Act, SEBI) (v) Trading in shares
and securities by banks is subject to regulation by .
of Capital Issues, SEBI, Company Law Board)
1.13 ANSWERS TO 'CHECK YOUR PROGRESS'
A.

1. (i) True; (ii) False; (iii) True; (iv) False; (v) False.

2. (i) RBI Act

(ii) a body corporate created under a special

statute
(iii)

Reserve Bank

(iv) BRAct

(v)

for regulating banking companies.

B.

1. (i) True; (ii) False; (iii) False; (iv) False; (v) True.

2. (i) Multi-State Co-operative Societies Act
(ii) On recommendation of RBI (iii) Reserve Bank
13
(iv) Authorities under the Companies Act (v) SEBI.
1.14 TERMINAL QUESTIONS
Fill in the gaps choosing the answers from the brackets. 1. One of
the essential characteristics of banking is _
(lending to traders; investment in
_. (body corporate
securities; acceptance of deposits from the public) 2. Banking
companies operating in India are constituted in the form of.

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constituted under a special statute; company registered under the
Companies Act, 1956 or a foreign company; society registered
under the Societies Registration Act)
3.

Companies Act applies to banking companies

_.

(notwithstanding the provisions of the
Banking Regulation Act; insofar as its provisions are not
inconsistent with the provisions of the Banking Regulation Act;
only in relation to registration and winding up)
4.

Under the Reserve Bank of India Act, Reserve Bank

regulates acceptance of deposits by
(all companies; non-banking financial companies; nonbanking non-financial
companies)
_. (to the extent as provided in the state laws
5.

BR Act is applicable to co-operative banks

on co-operative societies; in a modified form as provided in Section
56 thereof; at par with commercial banks)
6.

"Corresponding new banks" means

(new banks

[nationalised banks] constituted under
the Banking Companies [Acquisition and Transfer of
Undertakings] Act, 1970 and the Banking Companies [Acquisition
and Transfer of Undertakings] Act, 1980; new generation banking
companies registered under the Companies Act; a new bank
formed by amalgamation of two banking companies)
7.

Central Government may give directions to the Reserve

Bank when considered necessary in
public interest only after consulting

(the Governor of Reserve

Bank; the Central

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Board of the Reserve Bank; the Finance Commission)
8.

A co-operative society registered under the Multi-State Co-

operative Societies Act

(is

prohibited from undertaking banking business; can be declared as
a state co-operative bank; can undertake banking business as a
primary co-operative bank)
9. A multi-state co-operative bank means a multi-state co-operative
society which is a
(primary co-operative bank; central co-operative bank; state cooperative bank) 10. For the purposes of the BR Act, a "co-operative
society" means a society registered or deemed to
have been registered under (any Central Act for the time being in
force relating to the
multi-state co-operative societies only; any state law relating to cooperative societies for the time being in force only; any Central Act
for the time being in force relating to the multi-state co¬operative
societies or any other central or state law relating to co-operative
societies for the time being in force)

UNIT
2
CONTROL OVER ORGANISATION OF BANKS

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STRUCTURE
2.0

Objectives

2.1

Introduction

2.2

Licensing of Banking Companies

2.3

Branch Licensing

2.4

Paid-up Capital and Reserves

2.5

Shareholding in Banking Companies

2.6

Subsidiaries of Banking Companies

2.7

Board of Directors

2.8

Chairman of Banking Company

2.9

Appointment of Additional Directors

2.10

Restrictions on Employment

2.11

Control Over Management

2.12

Corporate Governance

2.13

Directors and Corporate Governance

2.14

Let Us Sum Up

2.15

Keywords

2.16

Check Your Progress

2.17

Answers to 'Check Your Progress'

2.18

Terminal Questions

16
2.0

OBJECTIVES

The objectives of this unit are to understand the laws that govern
banking companies, in respect of:

Licensing and branch licensing

Paid up capital and reserves

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Shareholding and rights of shareholders

Formation of subsidiaries and holding of shares of other

companies

Constitution and regulation of board of directors

Exercise of control by the Reserve Bank and the

Government over the appointment and removal of
chairmen, managerial and other personnel

Corporate governance

2.1

INTRODUCTION

The Banking Regulation Act provides for regulation of the
organisation of banking companies. To start with, there are
restrictions at the entry point, by way of licensing and then the
requirement of permission for opening or shifting of branches.
There are further regulations over the paid-up capital and reserves,
shareholder's rights, constitution of the board of directors,
appointment of chairman and formation of subsidiaries. Apart
from the above, there are also controls over the managerial and
other personnel, including the power to remove unsuitable persons
and to appoint suitable persons. In this unit, we study various
provisions of the Banking Regulation Act, providing for controls
over the organisation and management of banking companies.
2.2

LICENSING OF BANKING COMPANIES

i. License Requirement from RBI: To commence or carry on, the
banking business in India, a company requires a licence from the
Reserve Bank under Section 22 of the Banking Regulation Act,
1949. Commencing or carrying on a banking business without a
licence is prohibited. When the Act came into force, the banking
companies, which were then in existence were required to apply for

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licence within six months from the commencement of the Act. But,
such banking companies were permitted to continue business,
unless and until their applications for licence were rejected by the
Reserve Bank. The requirement of licence was meant to ensure the
continuance of only those banks, which were established and
operating on sound lines and to prevent indiscriminate formation
of banking companies.
ii. Discretion of Reserve Bank: The granting of licence by the
Reserve Bank may be subject to such conditions as the RBI may
think fit in each case. As held by the Gujarat High Court in
Shivabhai vs RBI, Ahmedabad (AIR 1986 Guj 19), Reserve Bank
has the discretion to grant or refuse the licence and when such
decision based on relevant, material and germane considerations,
the decision cannot be assailed. Only if the decision is based on
extraneous considerations or is perverse, the court will intervene.
It is open to the RBI to consider the defects or improvements
revealed in an inspection held under Section 35 of the BR Act while
disposing of an application for licence. (See, Sajjan Bank Pvt. Ltd.
vs RBI, AI R 1961 Mad 8). The refusal of licence to a company
would make it ineligible to undertake banking business, but it
would still be open to the company to carry on other business like
money lending.
iii. Conditions to be Satisfied: Before granting a licence under
Section 22, Reserve Bank may have to be satisfied by an inspection
of the books of the banking company or otherwise in respect of the
fnllnwintr matters17

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(a)

Whether the company is or will be in a position to pay its

present and future depositors in full
as their claims accrue;
(b)

Whether the affairs of the company are being conducted or

likely to be conducted in a manner
detrimental to the interests of its present and future depositors;
(c)

Whether the general character of proposed management of

the company will not be prejudicial
to public interest or the interest of depositors;
(d)

Whether the company has an adequate capital structure and

earning prospects;
(e)

Whether public interest will be served by grant of licence to

the company;
(f)

Whether considering the banking facilities available in the

proposed area of operation, the
potential scope for expansion of business by banks already in
existence in that area and
other relevant factors, the grant of licence would be prejudicial to
the operation and consolidation
of banking system, consistent with monetary stability and
economic growth;
(g)

The fulfilment of any other condition which the Reserve

Bank considers relevant in public
interest or in the interest of depositors.
Although Section 11 of BR Act specifies the minimum capital and
reserves requirements of a banking company, the Reserve Bank can
stipulate a higher requirement of capital for licensing a banking

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company as under Section 22 the Reserve Bank has to be satisfied
that the company has an adequate capital structure and earning
prospects.
iv. Foreign Banks: In the case of companies incorporated outside
India applying for a licence, apart from the conditions specified in
the case of domestic companies, three additional conditions have
been stipulated for consideration by the Reserve Bank. These are:
(a)

Whether carrying on of banking business by the company in

India will be in public interest;
(b)

Whether the government or the law of the country, in which

the company is incorporated
discriminates in any way against banking companies registered in
India;
(c)

Whether the company complies with provisions of the BR

Act, as applicable to foreign
companies.
v. Local Area Banks: The Reserve Bank has recognised the concept
of local area banks and licensed a few(four) such banks. These are
banking companies operating only in a limited geographical area.
The licence issued to these banks would restrict their operations to
the specified local area to ensure adequate banking services in that
area.
vi. Cancellation of Licence: Sub-Section (4) of Section 22 of the
Banking Regulation Act authorises the Reserve Bank to cancel the
licence granted to any banking company. The cancellation of
licence may be on any one or more of the following grounds:
(a)

The company ceases to carry on banking business in India;

(b)

The company at any time fails to comply with any of the

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conditions imposed under the subSection (1) of Section 22 of Banking Regulation Act;
(c)

The company does not fulfil at any time, any of the

conditions referred to in the sub-Section(3)
or 3(A) of Section 22 of Banking Regulation Act.
Before cancellation of a licence for non-compliance with any of the
conditions as above, the company has to be given an opportunity
for taking necessary steps for complying with or fulfilling the
conditions. However, in cases where the Reserve Bank is of the
opinion that delay will be prejudicial to the interests of depositors
or the public, the requirement of opportunity can be dispensed
with. As observed by the Madras High Court in Sajjan Bank Pyt.
Ltd. vs RBI (AIR 1961 Mad. 8), the Reserve Bank has a wide range
of administrative discretion under the Act, which it is competent to
exercise, and it cannot be said that there is an excessive delegation
of power. A banking company, whose licence is cancelled, can
appeal to the Central Government within a
;

i _r

t/\ J r-.
18
2.3 BRANCH LICENSING
i. Apart from the requirement of licence for commencing or
carrying on banking business, banks have to obtain the prior
permission of Reserve Bank for opening a new place of business or
changing location of the existing place of business. Under Section
23 of the Banking Regulation Act, 'Place of business' for this
purpose includes any sub-office, pay office, sub-pay office or any

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place at which deposits are received, cheques cashed or moneys
lent. However, changing the location of an existing place of
business within the same city, town or village would not need such
permission. These restrictions also apply to foreign branches of
banking companies incorporated in India. Opening of a temporary
place of business up to one month for purpose of affording banking
facilities for any exhibition, mela, conference or like occasion is
exempt. However, the temporary branch has to be within the limits
of the city; town or village where there is an existing branch or in
the environs thereof. The present guidelines from RBI provide that
Banks should submit their request for new branches,
administrative offices, ATMs once in a year for consideration of
RBI as against the earlier practice of making individual
applications for each and every branch. When approved, the
permission would be valid for a period of one year before which the
branches/ offices should be operationalised.
ii. For granting permission under Section 23, the Reserve Bank
may require to be satisfied of the following:
(a)

Financial condition and history of the bank;

(b)

General character of its management;

(c)

Adequacy of capital structure and earning prospects;

(d)

Public interest.

This may be done by an inspection of the bank under Section 35 or
otherwise.
While granting permission for opening or shifting a branch, the
Reserve Bank may impose any conditions which it thinks fit
necessary. If any bank fails to comply with such conditions, the
permission may be revoked after giving an opportunity to the bank

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to show cause.
iii. In the case of regional rural banks, the applications for
permission have to be routed through the National Bank
(NABARD), and the national bank has to offer its comments on
merits to the Reserve Bank.
2.4 PAID-UP CAPITAL AND RESERVES
Section 11 of the Banking Regulation Act provides for certain
minimum requirements as to paid-up capital and reserves of
banking companies. Any company wanting to commence banking
business has to comply with these requirements. The amounts
stipulated have reference to the places of business. 'Place of
business' for this purpose means any office, sub-office, sub-pay
office and any place at which deposits are received, cheques cashed
or moneys lent. In the case of any dispute regarding computation
of paid-up capital and reserves of any banking company, the
decision of the Reserve Bank shall be final.
i. Foreign Banks: Under the sub-Section (2) of Section 11 of the BR
Act, a foreign bank (banking company incorporated outside India)
operating in India, has to deposit and keep deposited with the
Reserve Bank, an amount of Rs.15 lacs and if it has a place of
business in Mumbai or Kolkata or both, Rs. 20 lacs. The amount
has to be kept in cash, unencumbered approved securities or partly
in both. Apart from this, an amount of twenty per cent of the profit
for each year in respect of business transacted through the
branches in India as disclosed in the profit and loss account has to
be deposited with the Reserve Bank. The securities deposited can
be replaced by other unencumbered

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19
approved securities or cash deposited can be similarly replaced by
securities. The Central Government can exempt any foreign bank
from this requirement on the recommendation of the Reserve Bank
for a specified period if the amounts deposited already by it are
considered adequate. On the cessation of business by any foreign
bank for any reason, these deposits shall form the assets of the
company on which the creditors in India shall have the first charge.
ii. Indian Banks: In case of banking companies incorporated in
India, the requirements of minimum paid-up capital and reserves
under Section 11 (3) are as follows:
(a)

If it has a place of business in more than one state, Rs. 5 lac

and if such places of business
include Mumbai, Kolkata or both, Rs. 10 lac.
(b)

If the place of business is in only one state and does not

include Mumbai or Kolkata, Rupees 1
lac for its principal place of business, plus Rs. 10,000 for other
places of business, in the same
district in which the principal place of business is situated, plus an
additional Rs. 20,000, for
each place of business elsewhere; in total not exceeding Rs. 5 lacs.
If the bank has only one
place of business, the amount is limited to Rs. 50,000.
For banking companies commencing business after the
commencement of the Act, paid-up capital is stipulated as Rs 5 lac.
(c)

If places of business are in one state only, but one or more of

them is in Mumbai or Kolkata,
Rs. 5 lac, plus Rs. 25,000 for each place of business outside these

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cities and the aggregate not
exceeding Rs. 10 lac.
During 2005, RBI stipulated the minimum capital requirement for
a new Private Bank at Rs 300 crore as a part of Corporate
Governance guidelines and as a policy of Foreign Direct
Investment.
iii. Paid-up Capital, Subscribed Capital and Authorised Capital:
Apart from the above, Section 12(1) of the Banking Regulation Act
stipulates that the subscribed capital of a banking company shall
not be less than half of its authorised capital; and the paid-up
capital shall not be less than half of its subscribed capital. If capital
is increased, this requirement has to be complied within a period
not exceeding two years as allowed by the Reserve Bank.
Banking companies are permitted to have only ordinary or equity
shares. However, preference shares issued before 1 July 1944 are
exempt. Further, the provisions of Section 12(1) are not applicable
to banks incorporated before 15 January 1937. Now preference
shares and other capital instruments are also allowed. Since 2005,
Banks have been permitted by RBI to raise capital even in the from
of innovative debt instruments which are perpetual and perpetual
non-cumulative preference shares in addition to the equity capital.
2.5 SHAREHOLDING IN BANKING COMPANIES
i. Voting rights of shareholders: There is no specified ceiling on a
person's holding of shares in a banking company under the
Banking Regulation Act or any other law. However, Section 12(2) of
the Act puts certain restrictions on voting rights of shareholders.
Accordingly, no shareholder can exercise voting rights in respect of
the shares held by him/her in excess of ten per cent of the total

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voting rights of all the shareholders of the banking company. This
provision does not in any way affect the transfer of shares or the
registration of such transfers. It only puts a limit on voting rights.
However, Section 12(3) bars suits or other proceedings against
registered shareholders by any other person claiming title except
by a transferee of shares, in accordance with the law or on behalf of
minors or lunatics for whom the registered shareholder holds the
shares. The provisions of the Companies Act also govern transfer of
shares of banking companies.
ii. Acknowledgement by Reserve Bank: Reserve Bank has
instructed banking companies that when
20
they receive more than the specified percentage of their shares for
transfer to one party, the bank's board must refer the matter to the
Reserve Bank. The banks shall not transfer the shares without
receiving Reserve Bank's acknowledgement. This is with a view to
ensure that the controlling interest in a banking company does not
change hands without the knowledge and approval of the Reserve
Bank.
iii. Reports on shareholding: A report regarding the particulars of
shareholding of the chairman, managing director or chief executive
officer, by whatever name called, of every banking company,
requires submission to the Reserve Bank. Such report should
contain the full particulars and extent of value of shares held
directly or indirectly and of any change in the extent of holding or
of any variation in the rights attaching thereto. The Reserve Bank
may also order for any other information relating to those shares.

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iv. Commission, brokerage, discount: Section 13 of the Banking
Regulation Act imposes a ceiling on the commission, brokerage,
discount or remuneration on the sale of shares of banking
companies. Accordingly, the payments on this account in any form
should not exceed two-and-a-half per cent of the paid-up value of
the shares.
v. Dividend: There are also certain restrictions on the payment of
dividend to the shareholders of banking companies. Thus, under
Section 15 of the Banking Regulation Act, no dividend is payable
until all capitalised expenses are completely written off. Such
expenses include preliminary expenses, organisation expenses,
share-selling commission, brokerage, loss incurred and any other
item, of expenditure not represented by tangible assets. However,
dividends are payable without writing off depreciation, bad debt
etc., as under:
(a)

Depreciation in value of approved securities, which is not

capitalised or accounted for as a
loss.
(b)

Depreciation in investment of shares, bonds or debentures,

other than the approved securities
for which adequate provision has been made.
(c)

Bad debts for which an adequate provision is provided.

RBI has given detailed eligibility criteria for declaration of dividend
by banks and also guidelines on the quantum of dividend that can
be declared by banks. The eligibility criteria require a minimum 9
% of CAR and Net NPAs not exceeding 1%. The quantum of
dividend that can be declared is based on the levels of net NPAs
and in a graded level (Maximum 40% pay out ratio) and can be

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paid out of only current year's profits.
2.6 SUBSIDIARIES OF BANKING COMPANIES
i. Formation of Subsidiaries: There are certain restrictions under
Section 19 of the Banking Regulation Act on the formation of
subsidiaries by banking companies. This is for purpose of
preventing banks from carrying on trading activities by acquiring a
controlling interest in non-banking companies. Accordingly,
subsidiaries are permissible only for the following purposes:
(i) Undertaking any business which is permissible for banking
companies under Section 6(1) clauses (a) to (o).
(ii) Carrying on the business of banking exclusively outside India.
Prior permission of the Reserve Bank is a must for this banking
business.
(iii) Undertaking any other business which Reserve Bank with prior
approval of the Central Government permits. Reserve Bank may
permit only such other business which it considers conducive to the
spread of banking in India or otherwise useful or necessary in the
public interest. The undertaking of any business by a subsidiary
will not be deemed to amount to the bank itself taking up that
business directly or indirectly for the purpose of Section 8.
21
ii. Shareholding in other companies: Apart from the restriction on
subsidiaries, there is also a ceiling [Section 19(2)] on shareholding
in companies other than subsidiaries. Thus, the holding of shares
by a banking company in any company as pledgee, mortgagee or
absolute owner shall not be exceeding thirty per cent of the paid-up
share capital of that company or the paid-up share capital and

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reserves of the banking company. Further, holding of shares in any
company in which the managing director or manager of a banking
company is interested in or concerned with in any manner, is
prohibited except in the case of subsidiaries.
2.7 BOARD OF DIRECTORS
i. Qualifications: Section lOAofthe Banking RegulationAct
stipulates certain qualifications fordirectors of banking companies.
Accordingly at least fifty-one per cent of the total number of
directors shall be persons, who have special knowledge or practical
experience, with respect of accountancy, agriculture and rural
economy, banking, cooperation, economics, finance, law, small
scale industry or any other matter, the special knowledge or
practical experience which is useful to the banking company, in the
opinion of the Reserve Bank. Further, at least two of the directors
should have special knowledge or practical experience in
agriculture and rural economy or co-operation or small scale
industry.
ii. Substantial interest: The directors of a banking company shall
not have a substantial interest in or be connected with as employee,
manager or managing agent in a company or firm which carries on
trade, commerce or industry as per Section 10A (2)(b) of the BR
Act. However, companies registered under Section 25 of the
Companies Act and small scale industrial concerns are not included
for the purpose. The proprietors of trading, commercial or
industrial concerns other than small scale industrial concerns are
also disqualified for directorship. 'Substantial interest' for this
purpose is defined in Section 2 of the Banking Regulation Act.
Accordingly, holding of beneficial interest by any individual or his

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spouse or minor child, whether singly or taken together in the
shares of a company exceeding Rs. 5 lacs or ten per cent of the
paid-up capital of the company amounts to substantial interest. In
the case of firms, such holding of beneficial interest exceeding ten
per cent of the total capital of the firm amounts to substantial
interest.
iii. Period of office: The directors of a banking company shall not
hold office for more than eight years continuously. However, this
provision is not applicable to the chairman or a whole-time
director. When the chairman or a whole-time director of a bank is
removed from office, he/she ceases to be a director of the bank and
shall not be eligible for further appointment as director of that
banking company for a period of four years.
iv. Reconstitution of Board: When the board of a banking company
is not constituted in accordance with the requirements of Section
10A of the BR Act, the board has to be reconstituted, to comply
with the provisions. If any director has to be retired for such a
reconstitution, this may be done by lots, in the prescribed manner
and such decision shall be binding on every director of the board. If
the Reserve Bank is of the opinion that the board of any banking
company does not fulfil the requirements, it may order such a bank
to reconstitute the board after giving reasonable opportunity of
being heard. If, within two months' time, the bank does not fulfil
the order of the Reserve Bank, the Bank may then remove any
director (determined by lots drawn in the prescribed manner) and
such a person shall cease to hold office. The Reserve Bank may also
appoint a new director in the place of the person removed and
he/she shall continue in office until the date up to which his

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predecessor would have held office. However, any proceedings of a
banking company will not be invalid only because of any defect in
the composition of the board.
22
2.8 CHAIRMAN OF BANKING COMPANY
i. Whole-time Chairman/Managing Director: Section 1 OB of the
Banking Regulation Act provides that every banking company
should have a full-time or part-time chairman, appointed from
among its directors. The chairman, if appointed on a whole-time
basis is entrusted with the management of the entire affairs of the
bank. The chairman on a part-time basis has to be appointed with
the prior approval of the Reserve Bank and such an appointment
shall be subject to any conditions that may be imposed by the
Reserve Bank while granting approval. In the absence of a
chairman, the management of the whole of the affairs of the
banking company shall be entrusted to a managing director. The
exercise of powers by the whole-time chairman or managing
director is subject to the superintendence, control and directions of
the board of directors. The whole-time chairman and a managing
director shall hold office for a period not exceeding five years as the
board may fix and is also eligible for reelection or reappointment.
Although the chairman is in full-time employment of the bank, he
may be a director of a subsidiary of the bank or of a company
registered under Section 25 of the Companies Act. The Reserve
Bank may also permit the whole-time chairman or the managing
director to undertake part-time honorary work not likely to
interfere with the duties of the chairman or the managing director.

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The whole-time chairman or the managing director of a banking
company may continue in office at the end of the term of the office
until his/her successor assumes office, subject to the approval of
the Reserve Bank.
ii. Qualifications of Whole-time Chairman/Managing Director: The
whole-time chairman or the managing director of a banking
company should have special knowledge or practical experience of
the working of a banking company or the State Bank or a
subsidiary bank or a financial institution or financial, economic or
business administration. The whole-time chairman or the
managing director will be disqualified under the following
circumstances:
(a)

if he/she is director of a company other than a subsidiary of

the banking company or a charitable
company (registered under Section 25 of the Companies Act);
(b)

if he/she is a partner of any firm which carries on trade,

business or industry;
(c)

if he/she has substantial interest in any other company or

firm or is director, manager, managing
agent, partner or proprietor of any trading, commercial or
industrial concern; or
(d)

if he/she is engaged in any other business or vocation.

iii. Removal of Wholetime Chairman/Managing Director: If the
Reserve Bank is of the opinion that the person elected to be the
chairman of the board of directors and appointed on a whole time
basis or the managing director is not a fit and proper person to
hold such office, the Reserve Bank may require the banking
company to remove such a chairman or the managing director and

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appoint a suitable person. However, before taking such an action,
the Reserve Bank has to give such a person, as also the banking
company, a reasonable opportunity of being heard. If the banking
company does not comply with the order within two months, the
Reserve Bank may remove the person from the office and appoint a
suitable person in his/her place. Such a chairman or managing
director would continue in office, for the residual period of office of
the person removed from office.
The banking company or the person affected by the Reserve Bank's
order may appeal to the Central Government within thirty days.
The order of the Government where an appeal is filed and the order
of the Reserve Bank, where no appeal is filed shall be final and not
liable to be challenged before any civil court.
vi. Temporary vacancies: In cases where the wholetime chairman
or the managing director dies or
23

he/she resigns or is not capable of discharging his/her functions
due to illness, temporary arrangements can be made to carry out
the duties of the chairman or the managing director for a period
not exceeding four months. However, this has to be done with the
approval of the Reserve Bank.
v. Power of Reserve Bank to appoint Chairman: In certain cases,
the office of the whole-time chairman or the managing director of a
banking company may fall vacant and may not be filled up by the

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bank immediately. This may adversely affect the interests of the
banking company. If the Reserve Bank is of the opinion that
continuation of such vacancy is likely to be against the interests of
the banking company, it may appoint an eligible person to fill such
vacancy under Section 10BB of the Banking Regulation Act. If the
chairman or the managing director so appointed is not a director of
the banking company, he/she shall be deemed to be a director of
the banking company. Such appointment may be for a period not
exceeding three years. There is also a provision for reappointment
after the initial period. The chairman or the managing director so
appointed may be removed from office only by the Reserve Bank
and shall draw pay and allowances from the banking company, as
determined by the Reserve Bank.
vi. Qualification shares: The whole-time chairman or the managing
director of a banking company is exempted under Section IOC of
the Banking Regulation Act from the requirement of holding
qualification shares. Similar exemption is also available to a
director of a banking company appointed by Reserve Bank under
Section 10A of the Act.
vii. Overriding provisions: The provisions of Section 10A, Section
10B and Section 10BB of the Banking Regulation Act regarding the
appointment and removal of a director, managing director or the
chairman shall have overriding effect over all other laws, contracts,
etc. Any person affected by any action taken under these provisions
is not entitled to any compensation for any loss or for termination
of office.
2.9

APPOINTMENT OF ADDITIONAL DIRECTORS

i. The Reserve Bank has the power to appoint additional directors

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on the boards of banking companies under Section 36AB of the
Banking Regulation Act. One or more additional directors may be
so appointed when the bank is of the opinion that it is necessary to
do so in the interest of:
(a) banking policy

(b) public

(c) banking company

(d) depositors of the banking company.

ii. The directors so appointed shall not require any qualification
shares. They hold office during the pleasure of the Reserve Bank.
Subject to this, appointment may be for a period not exceeding
three years or further extended periods not exceeding three years
at a time as specified by the Reserve Bank. The additional directors
are protected from any liability or obligation for executing their
functions in good faith. The provisions of Section 36AB have
overriding effect over other laws.
2.10

RESTRICTIONS ON EMPLOYMENT

i. The Banking Regulation Act (Section 10) prohibits employment
of managing agents and imposes restrictions on employment of
certain type of persons, namely —
(a) a person who is or has been adjudicated insolvent or has
suspended payment or has compounded
with his/her creditors;
a nprtnn
\\\r 9 r*riminQl rrmrt r\f 'An
invnivina mortal

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24
(c)

a person whose remuneration or part thereof is by way of

commission or share in the profits
of the company;
(d)

a person whose remuneration is excessive in the opinion of

the Reserve Bank. Before forming
an opinion regarding the remuneration, the Reserve Bank has to
consider the financial condition
and history of the banking company, its area of operation,
resources, volume of business and
the trend of its earning capacity, number of its branches,
qualifications, age and experience of
the person concerned, remuneration of other personnel in the bank
or persons holding similar
positions in other banks and the interest of depositors.
The above restrictions are applicable to workmen as well as
management personnel, as held by the Supreme Court in Central
Bank of India vs Their Workmen (AIR 1960 SC 12). However, the
restriction on remuneration does not affect payment of bonus
according to a settlement or award or in accordance with a scheme
framed by the bank or in accordance with the prevailing practice in
banking business. Commission paid to brokers, auctioneers,
forwarding agents, etc., who are not regular members of the bank's
staff, is also not covered by these provisions.
ii. Persons who are directors of any company other than a
subsidiary of a banking company or company registered under
Section 25 of the Companies Act are also prohibited from

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managing a banking company. However, this prohibition shall not
apply to a director for a temporary period of three months, or a
further period not exceeding nine months, if allowed by the
Reserve Bank. Apart from this, persons engaged in any other,
business or vocation or whose term of office as a person managing
the company is for a period exceeding five years also fall in the
prohibited category. However, the period of office can be renewed
or extended for further periods not exceeding five years at a time.
2.11 CONTROLS OVER MANAGEMENT
i. Power to remove Management and other personnel: The Reserve
Bank is empowered under Section 36AA of the Banking Regulation
Act to remove any chairman, director, chief executive officer (by
whatever name called), or other officer or employee of a banking
company. For this purpose, the bank has to be satisfied that it is
necessary to do so. The bank (RBI) has the discretionary power to
remove management and other personnel in the following
circumstances:
(a)

Public interest

(b)

Preventing the affairs of the banking company being

conducted in a manner detrimental to the
interest of depositors
(c)

Securing proper management of the banking company.

The Reserve Bank has to pass such an order recording the reasons
in writing. Before passing the order, the affected person has to be
given a reasonable opportunity of making a representation against
the proposed order. Where an urgent action is required and delay
would be against the interests of the company or its depositors, the
Reserve Bank is empowered to direct by order, at the time of giving

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opportunity of making a representation that the person concerned
shall not act in his/her official capacity or directly or indirectly take
part in the management of the bank from the date of such order,
pending consideration of the representation. The person so
removed shall not be entitled to any compensation for loss of office
notwithstanding anything contained in any law, the memorandum,
articles or any contract to the contrary as the provisions of Section
36AA have overriding effect.
ii. Appeal: An appeal against the order of removal lies with the
Central Government. Such an appeal has to be filed within thirty
days from the date of communication of the order. The appellate
decision of the Central Government, and subject thereto the order
of the Reserve Bank, shall be final and not liable to challenge in any
Civil Court.
25
iii. Effect of the order of removal: On the Reserve Bank passing a
removal order, the person concerned ceases to hold office which
he/she was holding till then. Further, he/she is prohibited, from
directly or indirectly taking part in the management of any banking
company for a period not exceeding five years as may be specified
in the order. Contravention of the order is punishable with a fine of
Rs. 250 for each day during which the contravention continues.
iv. Appointment of a suitable person: When any chairman,
director, chief executive officer, other officer or employee is
removed by the Reserve Bank under Section 36AA as above, the
Reserve Bank may appoint a suitable person in his place. Such
person shall hold office at the pleasure of the Reserve Bank.

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Subject to this, the appointment may be for a period not exceeding
three years and is extendable for further periods not exceeding
three years at a time. Such appointee shall not incur any obligation
or liability for action taken in good faith in the execution of the
duties of his office.
2.12 CORPORATE GOVERNANCE
i. The Concept: Corporate governance is a dynamic concept
involving promotion of corporate fairness, transparency and
accountability in the interest of shareholders, employees,
customers and other stakeholders. It is a concept of recent origin.
However, there is considerable divergence in the understanding
and practice of corporate governance across different jurisdictions.
The concept has evolved since the first major study by the Cadbury
Committee in 1992. The DECO principles of corporate governance
published in 1999, the first international code of good corporate
governance approved by governments, was revised in 2004.
Corporate governance can be seen as 'the way in which boards
oversee the running of a company by its managers, and how board
members are in turn accountable to shareholders and the company'
and it has implications for company behaviour towards employees,
shareholders, customers, banks and other stakeholders. Further,
good corporate governance plays a vital role in ensuring the
integrity and efficiency of financial markets and the lack of it can
pave the way for financial difficulties and sometimes even fraud.
ii. OECD Principles of Corporate Governance, 2004: The OECD
principles of corporate governance, 2004 stipulate what the
corporate governance framework should ensure, which is briefly as
under:

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(a)

Ensuring the basis for an effective corporate governance

framework: To promote transparent
and efficient markets which are consistent with the rule of law.
Also, to articulate clearly the
division of responsibilities among the different supervisory,
regulatory and enforcement
authorities.
(b)

The rights of shareholders and key ownership functions: To

protect and facilitate the exercise
of shareholders' rights.
(c)

The equitable treatment of shareholders: In the equitable

treatment of shareholders are included
the minority and foreign shareholders. Further, all shareholders
should have the opportunity to
obtain an effective redress for violation of their rights.
(d)

The role of stakeholders in corporate governance: To

recognise the rights of stakeholders,
established by law or through mutual agreements and encourage
active cooperation between
the corporations and stakeholders in creating wealth, jobs, and the
sustainability of financially
sound enterprises.
(e)

Disclosure and transparency: Timely and accurate

disclosures made on all material matters,
regarding the corporation, including the financial situation,
performance, ownership, and
governance of the company.
(f)

The responsibilities of the board: Strategic guidance of the

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company, effective monitoring of
management by the board and the board's accountability to the
company and the shareholders
are the important aspects. These principles are applicable to all
types of companies including
banks.
26
iii. Corporate Governance and Banks: Banks hold a special position
in corporate governance as they accept and deploy large amounts
of public funds in fiduciary capacity and also leverage such funds
through credit creation. The position of banks is also important for
the smooth functioning of the payment system. Accordingly, legal
prescriptions for ownership and governance of banks laid down in
the statutes are supplemented by regulatory prescriptions. The
Basel Committee on Banking Supervision has issued guidance
(February 2006) for promoting the adoption of sound practices of
corporate governance by banking institutions. This guidance,
entitled Enhancing Corporate Governance for Banking
Organisations, highlights the importance of:

the roles of boards of directors (with a focus on the role of

independent directors) and senior
management

effective management of conflicts of interest

the roles of internal and external auditors, as well as internal

control functionaries

governing in a transparent manner, especially where a bank

operates in jurisdictions, or through

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structures, that may impede transparency

the role of supervisors in promoting and assessing sound

corporate governance practices.(See,
http://www.bis.org/press/pO6O213.htni).
Apart from the fiduciary role of banks, their cross-border
operations add a special dimension. This provides an added
impetus for convergence in standards internationally. In almost all
countries, the policy framework with regard to corporate
governance involves a multiplicity of agencies. In India, the
Department of Company Affairs, Securities and Exchange Board of
India (in respect of listed entities) are involved apart from the
Reserve Bank in respect of banks.
iv. Reserve Bank's approach: Following the formal policy
announcement in regard to corporate governance, in the mid term
Review of the Monetary and Credit Policy, in October, 2001, the
Reserve bank constituted a Consultative Group in November, 2001
under the chairmanship of Dr. A.S. Ganguly with a view to
strengthen the internal supervisory role of the boards of banks. The
report of the group was transmitted to all the banks for their
consideration in June, 2002 and simultaneously to the
Government of India for consideration. Earlier, an advisory group
on corporate governance under the chairmanship of Dr. R.H. Patil
had submitted its report in March, 2001 which examined the issues
relating to corporate governance in banks in India, including the
public sector banks and made recommendations to bring the
governance standards in India on par with the best international
standards. There were also some relevant observations by the
advisory group on banking supervision under the chairmanship of

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Shri M.S. Verma which submitted its report in January, 2003.
Keeping all these recommendations in view and the cross-country
experience, the Reserve Bank initiated several measures to
strengthen the corporate governance in the Indian banking sector,
including the concept of 'fit and proper' criteria for directors of
banks which included the process of collecting information,
exercising due diligence and constitution of a nomination
committee of the board to scrutinise the declarations made by the
bank directors. The RBI guidelines on ownership and governance
in the private sector banks released on February 28, 2005 (Paras 5
and 6) provide as under:
Shareholding
(i) The RBI guidelines on acknowledgement for acquisition or
transfer of shares issued on 3 February, 2004 will be applicable for
any acquisition of shares of five per cent and above of the paid-up
capital of the private sector bank.
(ii) In the interest of diversified ownership of banks, the objective
will be to ensure that no single entity or group of related entities
has shareholding or control, directly or indirectly, in any bank in
excess of ten per cent of the paid-up capital of the private sector
bank. Any higher level of
27
acquisition will be with the prior approval of RBI and in
accordance with the guidelines of 3 February, 2004 for grant of
acknowledgement for acquisition of shares.
(iii) Where ownership is that of a corporate entity, the objective will
be to ensure that no single individual/entity has ownership and

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control in excess of ten per cent of that entity. Where the
ownership is that of a financial entity the objective will be to ensure
that it is a well-established regulated entity, widely held, publicly
listed and enjoys good standing in the financial community.
(iv) Banks (including foreign banks having a branch presence in
India)/FIs should not acquire any fresh stake in a bank's equity
shares, if by such acquisition, the investing bank's/FI's holding
exceeds five per cent of the investee bank's equity capital as
indicated in RBI circular dated 6 July, 2004.
(v) As per the existing policy, large industrial houses will be
allowed to acquire, by way of strategic investment, shares not
exceeding ten per cent of the paid-up capital of the bank, subject to
RBI's prior approval. Furthermore, such a limitation will also be
considered, if appropriate, in regard to important shareholders
with other commercial affiliations.
(vi) In case of a restructuring of the problem/weak banks or in the
interest of consolidation in the banking sector, RBI may permit a
higher level of shareholding, including by a bank.
2.13 DIRECTORS AND CORPORATE GOVERNANCE
(i) The board of directors should ensure that the responsibilities of
directors are well defined and the banks should arrange need based
training for the directors in this regard. While the respective
entities should perform the roles envisaged for them, private sector
banks will be required to ensure that the directors on their boards
representing specific sectors, as provided under the B.R. Act, are
indeed representatives of those sectors in a demonstrable fashion,
they fulfil the criteria under corporate governance norms provided
by the Ganguly Committee and they also fulfil the criteria

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applicable for determining 'fit and proper' status of important
shareholders (i.e., shareholding of five per cent and above) as laid
down in RBI circular dated 25 June, 2004.
(ii) As a matter of desirable practice, not more than one member of
a family or a close relative (as defined under Section 6 of the
Companies Act, 1956) or an associate (partner, employee, director,
etc.) should be on the board of a bank.
(iii) Guidelines have been provided in respect of 'fit and proper'
criteria for directors of banks by the RBI circular dated 25 June,
2004 in accordance with the recommendations of the Ganguly
Committee on corporate governance. For this purpose a
declaration and undertaking is required from the
proposed/existing directors.
(iv) Being a director, the CEO should satisfy the requirements of
the 'fit and proper' criteria applicable for directors. In addition,
RBI may apply any additional requirements for the chairman and
CEO. The banks will be required to provide all information that
may be required while making an application to RBI for approval of
appointment of chairman/CEO.
With regard to public sector banks, the principles of corporate
governance have been statutorily recognised as per Banking
Companies (Acquisition and Transfer of Undertakings) Financial
Institutions Laws (Amendment) Act, 2006. The Act as amended
provides for shareholder directors to be a person having 'fit and
proper' status and the Reserve Bank has to notify the 'Fit and
Proper' criteria [Section 9(2)].
28

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2.14

LET US SUM UP

A company wanting to commence banking business requires prior
licence from the Reserve Bank. The Reserve Bank has the
discretion to reject licence or approve the licence on such
conditions as it thinks fit. Before granting licence, Reserve Bank
has to be satisfied by inspection or otherwise of the suitability of
the company for licence. A licence once given may also be cancelled
after giving the bank an opportunity to be heard. Further, for
opening new branches or shifting branches outside a city, town or
village, permission of the Reserve Bank is required. Banking
companies have to have minimum capital and reserves as specified
in the Banking Regulation Act. The shareholders of a banking
company are entitled to dividends only after all the capitalised
expenses are written off. The commission or brokerage payable on
selling shares is restricted to two and half per cent of the paid-up
value of the shares. The board of directors of a bank has to be
constituted with persons having special knowledge or experience in
accountancy, banking, economics, law, etc., as stipulated. The
directors should not have substantial interest in other companies
or firms. The maximum period of office is limited to eight years
continuously. The Reserve Bank is empowered to reconstitute the
board, if the board is not properly constituted. Every banking
company should have a full-time chairman (or a full-time
managing director, if there is no full-time chairman) with the
specified qualifications. The Reserve Bank has powers to remove
the chairman and appoint a suitable person in his place in certain
cases. The Reserve Bank also has powers to remove the directors or

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managerial personnel or other employees of banking companies.
The principles of corporate governance including the 'fit and
proper' criteria for directors apply to banking companies as well as
public sector banks.
2.15

KEYWORDS

Additional Director; Authorised Capital; Overriding Provisions;
Paid-up Capital; Place of Business; Substantial Interest; Subscribed
Capital; Subsidiary.
2.16

CHECK YOUR PROGRESS

1. Fill in the gaps choosing the answers from the brackets.
(i) A company has to obtain a

from the Reserve Bank to

commence banking business
in terms of Section 22 of the BR Act. (registration; licence;
commencement certificate)
(ii) Shifting of a bank's branch in the same

does not require

Reserve Bank's permission
arising out
under Section 23. (district; state, city, town or village) (iii) Foreign
banks are required under Section 11 of the BR Act to deposit
of their business in India with the Reserve Bank, (twenty per cent
of profit for each year; thirty
per cent of profit for each year; twenty per cent of the deposits
collected each year)
(iv) Banks may float subsidiaries for carrying on the business
specified in . (their
Memorandum of Association; Section 6(1 )(a) to (o) of the BR Act;
their Articles of Association)
(v) A shareholder of a banking company can exercise voting rights

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up to of the total
voting rights of all shareholders, (one per cent; ten per cent;
hundred per cent)
(vi) Banking companies are not permitted to give dividend until all
are written off.
(bad debts, expenses, capitalised expenses)
2.
Say whether True or False, (i) A temporary branch for less than
thirty days in a town where a bank has an existing branch
does not require permission from Reserve Bank. (ii) A company
whose banking licence is rejected can undertake business as a
moneylender or
undertake other business, (iii) The decision of Reserve Bank to
revoke licence is final and no appeal lies from it.
29
(iv) Banking companies are permitted to give brokerage up to twoand-half per cent of the paid-up
value of shares.
(v) No person can hold the shares of banks beyond ceiling specified
under the BR Act. (vi) A banking company cannot hold shares in
any other company other than a subsidiary.
3.

Fill in the gaps choosing the answer from the brackets.

(i) A director of a banking company should not have

in any other

company, (beneficial
interest, any interest, substantial interest)
(ii) At least

of the directors should have the qualifications

prescribed under Section

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10A(2) of the BR Act. (50 per cent, 75 per cent, 51 per cent) (iii)
When the board of a banking company is ordered to be
reconstituted under Section 10A of the
BR Act, directors will be removed for the purpose of reconstitution.
(by rotation,
by lots, by majority decision)
(iv) Before removing the chairman of a bank from office, Reserve
Bank has to . (give
compensation for loss of office, give opportunity of being heard,
give an option to continue as
director) (v) The provisions of Section 36AA of the BR Act
regarding removal of managerial personnel have
over other laws, (no effect, overriding effect, persuasive
effect)
(vi) Reserve Bank is authorised to appoint

under Section

36AB of the BR Act. (directors,
additional directors, managing director)
(vii) The

(Central Government; RBI; SEBI) has stipulated the

'fit and proper' criteria
for directors of banking companies.
4.

Say whether True or False.

(i) The maximum period of office that may be held continuously by
an ordinary director in a
banking company is eight years, (ii) The decisions of the board of
directors, during the period when the board's constitution is
defective shall be void.
(iii) The post of chairman of a banking company may be on parttime basis, (iv) The chairman of a banking company can hold office

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only for a maximum period of eight
years, (v) From the order removing chairman of a banking
company, appeal lies to the Central Government
within thirty days of the order. (vi) Reserve Bank has the power to
remove any officer or other staff of a banking company under
Section 36M of the BR Act.' (vii) The concept of 'fit and proper'
criteria for directors is not applicable to public sector banks.
2.17

ANSWERS TO CHECK YOUR PROGRESS'

1.

(i) licence; (ii) same city, town or village; (iii) 20 per cent of

profit for each year; (iv) Section
6(l)(a) to (o) of BR Act; (v) 10 per cent; (vi) capitalised expenses.
2.

(i) True; (ii) True; (iii) False; (iv) True; (v) False; (vi) False.

3.

(i) substantial interest; (ii) 51 per cent; (iii) by lots; (iv) give

opportunity of being heard; (v) over¬
riding effect; (vi) additional directors; (vii) RBI
4.

(i) True; (ii) False; (iii) True; (iv) False; (v) True; (vi) True;

(vii) False
2.18

TERMINAL QUESTIONS

Fill in the gaps choosing answers from the brackets.
30
. (such conditions as the Central Government may specify;
such conditions as the
Reserve Bank may think fit to impose; confirmation by the Central
Government).
2.

Reserve Bank is not empowered to cancel the licence

granted to a banking company on the
ground that . (the company ceases to carry on any of its business;

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the company
changes its registered office from one state to another state; the
company is not in a position to pay its depositors in full as their
claims accrue).
3.

A bank requires permission of the Reserve Bank for opening

a new branch or shifting an existing
branch

. (to any new location from where it is situated;

otherwise than within the
same city, town or village; otherwise than in the same building).
4.

In addition to the requirements as to minimum capital and

reserves under Section 11 of the BR
Act, Reserve Bank

. (cannot look into the capital structure of a

banking company;
has to satisfy itself under Section 22(3) of the BR Act as to
adequacy of capital structure and earning prospects; has to consult
the Central Government as to the adequacy of the capital structure
of a banking company before licensing).
5.

In the case of a banking company, a shareholder cannot

exercise voting rights on poll

.

(in excess of ten per cent of the total voting rights of all the
shareholders of the company; in excess of two per cent of the total
voting rights of all the shareholders of the company; in excess of
ten per cent of the total voting rights of all the shareholders except
with prior permission of the Reserve Bank).
Choose the correct statements from the following.
6.

(i) There are no restrictions in the BR Act on payment of

dividend by banking companies,
(ii) Before payment of dividend by a banking company, all its

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capitalised expenses, unless
specifically exempted under the BR Act, have to be completely
written off. (iii) Banking companies are not permitted to pay
dividend above ten per cent of net profits.
7.

(i) There are no specific qualifications required for the

directors of a banking company.
(ii) At least fifty-one per cent of the directors of a banking company
should consist of persons
with professional or other experience as provided in the BR Act.
(iii) At least fifty-one per cent of the directors of a banking
company should be chartered accounts
or experts in finance.
8.

(i) There is no provision for maintenance of reserves by a

banking company under the BR Act.
(ii) Every banking company has to maintain a reserve fund and
transfer before declaring dividend,
not less than twenty per cent of the profit to the reserve fund, (iii)
The maintenance of a reserve fund is optional for a bank.
9.

(i) The chairman of a banking company has to be always on

whole-time basis and should be
entrusted with the management of the whole of the affairs of the
banking company, (ii) The chairman of a banking company can be
on part-time basis and a managing director can
be appointed on whole-time basis who shall be entrusted with the
whole of the affairs of the
banking company, (iii) The chairman of a banking company can be
on part-time basis and the whole of the affairs
of the banking company shall be entrusted to a committee of the

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board of directors. 10. (i) A banking company can form
subsidiaries for undertaking any business approved by its
board of directors, (ii) A banking company can form subsidiaries
for undertaking any business mentioned in Section
6(1) (a) to (o) of the BR Act, which is permissible for a banking
company to undertake, (iii) A banking company does not require
the permission of the Reserve Bank to form a subsidiary
for doing banking business exclusively outside India.
UNIT
3
REGULATION OF BANKING BUSINESS

STRUCTURE
3.0

Objectives

3.1

Introduction

3.2

Power to Issue Directions

3.3

Acceptance of Deposits

3.4

Nomination

3.5

Loans and Advances

3.6

Regulation of Interest Rate

3.7

Regulation of Payment Systems

3.8

Internet Banking Guidelines

3.9

Regulation of Money Market Instruments

3.10

Banking Ombudsman

3.11

Reserve Funds

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3.12

Maintenance of Cash Reserve

3.13

Maintenance of Liquid Assets

3.14

Assets in India

3.15

Let Us Sum Up

3.16

Keywords

3.17

Check Your Progress

3.18

Answers to 'Check Your Progress'

3.19

Terminal Questions

32
3.0

OBJECTIVES

The objectives of this unit are to understand the law, in particular
the provisions of the Banking Regulation Act, relating to:

issue of directions by Reserve Bank to banks

regulation of acceptance of deposits by banks

regulation of loans and advances

regulation of interest rates of banks on deposits and

borrowing

maintenance of reserve fund

maintenance of cash reserve by scheduled banks and other

banks

maintenance of liquid assets

maintenance of assets in India

3.1

INTRODUCTION

The Banking Regulation Act provides for regulation of the business
activities of banking companies. Accordingly, the Act empowers the
Reserve Bank to issue directions for regulating terms and
conditions of making of loans and advances and other matters

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including acceptance of deposits. The Banking Regulation Act also
imposes certain restrictions on loans and advances to the directors
of banking companies, and companies and firms in which they are
interested. The Act contains provisions for creation of a reserve
fund and transfer of a percentage of profits to that fund. There are
also provisions for maintenance of cash reserve, liquid assets and
assets in India. In this unit, we look at the relevant provisions of
law in this regard.
3.2

POWER TO ISSUE DIRECTIONS

i. The Banking Regulation: Act authorises the Reserve Bank to
issue directions to banks under Sections 21 and 35Aof the Act.
While Section 21 gives the power to regulate advances by banking
companies, Section 35A gives wide powers generally to regulate
banking companies. The Reserve Bank has been issuing directions
from time to time under Section 21 (read with Section 35A)
regulating rates of interest and other terms and conditions of
acceptance of deposits and making of loans and advances.
Regulation of deposits and loans and advances are discussed below
(See, Paras 3.4 and 3.5, respectively).
ii. Nature of Directions: The directions issued by the Reserve Bank
in exercise of powers under Sections 21 and 35A of the BR Act,
being statutory directions, are binding on the banks. The circulars
of the Reserve Bank giving instructions to banks where it has
statutory powers to give such instructions are also binding on the
banks, even if they do not specifically refer to any statutory
provisions. However, as held by the Supreme Court in State Bank
of India vs. CIT (AIR 1986 SC 757), non-statutory circulars of the
Reserve Bank cannot affect legal rights. The Reserve Bank's powers

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to issue directions are over the banks. Hence, the directions are
addressed to banks only and not to customers or the public. The
effect of violation of Reserve Bank's directions/ instructions which
are binding on banks, has been considered by the Supreme Court
in BOI Finance Ltd. vs. The Custodian (AIR 1997 SC 1952) in the
context of some banks entering into certain repo transactions
against the circulars of the Reserve Bank prohibiting such
transactions. The court found that the action of the banks violated
the Reserve Bank's instructions and held that the violations would
not invalidate the contracts with third parties but would render the
banks liable to prosecution. The effect of directions will be
prospective and not retrospective in the absence of any statutory
provisions providing for retrospective operation of directions.
33
iii. Bonafides: The powers of the Reserve Bank to issue directions
have to be exercised with bonafide intentions, as held by the
Gujarat High Court in RBI vs Harisidh Co-op. Bank Ltd. (AIR 1988
Guj 107). In that case the Court considered the power of the
Reserve Bank to issue directions for superseding the board of a cooperative bank for securing its proper management and upheld the
action taken by the Reserve Bank on the finding that it was without
mala fide.
iv. Caution and Advice: Apart from giving directions, the Reserve
Bank may also caution or give advice to banking companies.
Section 36 of the Banking Regulation Act provides that the Reserve
Bank may caution or prohibit banking companies generally or any
banking company in particular against any transaction or class of

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transactions. Further, the Reserve Bank may generally give advice
to any banking company.
3.3 ACCEPTANCE OF DEPOSITS
i. As discussed in unit I, the essence of banking business is the
acceptance of deposits from the public withdrawable by cheque.
[See also the judgement of Madras High Court in Sajjan Bank Pvt.
Ltd. vs RBI (AIR 1961 Mad 8)]. The definition of "banking" in
Section 5(b) of the Banking Regulation Act acknowledges this
position.
ii. Types of Deposits: Banks accept different types of deposits, both
time and demand deposits, from the public. While time deposits,
like fixed deposits or recurring deposits are repayable after an
agreed period, demand deposits, like deposits in current account
and savings bank accounts, are repayable on demand, subject to
the terms and conditions of the deposits. The period of the deposit
and rate of interest applicable to the deposit are matters to be
agreed between the depositor and the bank under the terms of the
deposit, subject to any directions given by the Reserve Bank in this
regard.
iii. Regulation of acceptance of deposits: The Banking Regulation
Act does not contain any specific provisions for regulation of
acceptance of deposits of banks. However, Section 35 A which
authorises the Reserve Bank to give directions is wide enough to
cover acceptance of deposits. Accordingly, acceptance of deposits
may be regulated in the public interest or in the interest of banking
policy or in the interests of depositors by issuing directions. The
Reserve Bank issues directions from time to time regulating the
rates of interest applicable to deposits. The directions may either

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fix the rates or specify the minimum and/or maximum rate of
interest on savings deposits and time deposits for various periods
as also for special categories of deposits like senior citizen, NRI
deposits. If only minimum and/or maximum rates are specified or
no rates are specified, the banks are free to decide their rates
accordingly. The directions issued by the Reserve Bank may also
stipulate conditions regarding minimum or maximum periods for
which deposits may be accepted, reduction of interest payable on
premature withdrawal and payment of interest on renewal of
overdue deposits.
However, currently RBI prescribes the minimum and maximum
period for which deposits can be accepted and prescribes interest
rates only in respect of Savings Deposits and NRI deposits leaving
others for the individual banks.
iv. Returns on unclaimed deposits: Banks have to file a return every
year on their unclaimed deposits under Section 26 of the Banking
Regulation Act. The return has to be filed within thirty days of the
end of each calendar year in the form and manner prescribed and
should cover all deposits not operated for ten years. In the case of
fixed deposits the period of ten years starts from the expiry of the
period of the deposit.
34
3.4

NOMINATION

i. Repayment of Deposits: Section 45ZA of the Banking Regulation
Act provides that a depositor or depositors of a banking company
(including co-operative banks) may nominate one person in the
prescribed manner as nominee to whom the deposit may be

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returned in the event of death of the sole depositor or depositors.
Unless the nomination is varied or cancelled, the nominee is
entitled to all the rights of the depositor/s in the event of death of
the depositor/s. In the case of minor nominees, there is also a
provision to appoint a person to receive the deposit on behalf of the
minor. Payment by a bank in accordance with these provisions
gives a valid discharge to the bank, but this does not affect the right
or claim a person may have against the nominee in respect of the
amount received by him. Rule 2 of the Banking Companies
(Nomination) Rules, 1985 provides for the procedure and forms for
making nomination in respect of deposits with commercial banks.
In the case of Co-operative banks, similar provisions are
incorporated in the Co-operative Banks (Nomination) Rules, 1985.
ii. Articles in Safe Custody and Safety Lockers: There are also
provisions in the Banking Regulation Act for nomination in respect
of articles kept in safe custody with banks and safety lockers.
Sections 45ZC and 45ZE provide that any person who leaves any
article in safe custody and in safety lockers respectively with a
banking company, may nominate one person as nominee to receive
the article in the event of death of that person. The nomination has
to be in the prescribed manner and on return of articles kept in safe
custody or removal of contents of locker by nominees as provided,
the bank gets a valid discharge. Rules 3 and 4 of the Banking
Companies (Nomination) Rules, 1985, and also the Rules 3 and 4
of the Co-operative Banks (Nomination) Rules, 1985 deal with the
form and procedure applicable to articles in safe custody and safety
lockers respectively in the case of banking companies and cooperative banks.

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3.5

LOANS AND ADVANCES

i. The definition of 'banking' in Section 5(b) of the Banking
Regulation Act indicates that acceptance of deposits may be for
lending or investment. Thus, lending or making of loans and
advances is a core business of a banking company. Lending may be
for short term or long term, on secured or unsecured basis and for
different purposes.
ii. Regulation of Loans and Advances
(a)

The Reserve Bank is empowered under Section 21 of the

Banking Regulation Act to issue
directions to control advances by banking companies. Such
directions may be issued to banking
companies generally or to any particular banking company. The
Reserve Bank may determine
the policy in relation to advances and issue directions when it is
satisfied that it is necessary to
give directions:
(i) In public interest (ii) In the interests of depositors
(iii) In the interests of banking policy.
(b)

The directions given by the Reserve Bank are binding on

banking companies, and may be on
one or more of the following matters:
(i) Purpose for which advances may or may not be made.
(ii) Margins, to be maintained in respect of secured advances.
(iii) Maximum amount of advances or other financial
accommodation which may be made to any company, firm,
association of persons or individual. The policy on these matters
may be specified having regard to the paid-up capital, reserves and

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deposits of the banking company and other relevant
considerations.
35
(iv) Maximum amount up to which guarantees may be given by a
banking company on behalf of any company, firm, association of
persons or individual. In this case, also the paid-up capital,
reserves, deposits and other relevant considerations have to be
taken into account for determining the maximum amount.
(v) Rate of interest and other terms and conditions on which
advances and other financial accommodation may be made or
guarantees may be given.
The Reserve Bank issues directions from time to time regulating
the lending operations of banking companies in exercise of these
powers vested under Section 21. Apart from this, the general
powers to give directions under Section 35A are also available for
regulation of loans and advances.
iii. Selective Credit Control
(a)

Purpose: Banks have been traditionally financing trade and

commerce and against items they
deal in even before the country started industrializing. To ensure
that prices of essential
commodities like food grains, pulses, edible oils, sugar, jaggery and
cotton and textiles are not
increased by certain sections of the business community with a
motive of profit maximisation
by hoarding with the help of bank finance, these restrictions have
been put in place. These

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cover the quantum of credit that can be extended and also the rate
at which it can be extended.
With self-sufficiency achieved by our country over the years in
almost all of the above, RBI
had taken them out of the purview of selective credit control and
currently restrictions are
there only in case of levy sugar.
(b)

Methods and tools: Selective credit control seeks to

influence the demand for credit by
(i) making borrowing more costly for certain purposes which are
considered relatively inessen¬tial, or
(ii) by imposing stringent conditions on lending for such purposes,
or (iii) by giving concessions for certain desired types of activities.
The tools employed for exercising selective credit control are:
(i) minimum margins for lending against selected commodities; •
(ii) ceilings on the levels of credit; and
(iii) charging of minimum rate of interest on advances against
specified commodities.
The quantum and cost of credit are regulated by operating these
tools of control.
iv. Price control: In India, selective credit control has been
generally used for preventing speculative hoarding of essential
commodities and basic raw materials using bank credit. This is
with a view to check the undue rise of prices of such sensitive
commodities.
v. Restrictions on loans and advances: Section 20 of the Banking
Regulation Act imposes certain restrictions on loans and advances.
Accordingly, no banking company shall grant loans or advances on

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the security of its own shares. Further, a banking company, is
prohibited from entering into any commitment for granting any
loans or advances to or on behalf of any of its directors. The
prohibition also applies to loans and advances to:
(a)

firms in which any director is interested as a partner,

manager, employee or guarantor, and
(b)

any company (other than a company registered under

Section 25 of the Companies Act) in
which a director of the banking company holds substantial interest
as defined in Section 5(ne)
of the Act or of which he is director, manager, managing agent,
employee or guarantor.
If the director of a banking company is a partner or guarantor of
any individual, loans and advances to such individual are also
barred. 'Director' includes a member of any board for managing or
36
advising the bank regarding management of all or any of its affairs.
It is open to the Reserve Bank to specify any transaction as not
being a loan or advance for this purpose by a general or special
order. In so doing the bank has to consider the nature of the
transaction, period, manner and circumstances in which the
amount is likely to be realised, the interest of depositors and other
relevant considerations. If there is any doubt or dispute as to
whether a transaction is a loan or advance, the decision of the
Reserve Bank in the matter shall be final.
vi. Restrictions on power to remit debt: For remitting any debt to
its directors, a banking company requires prior permission of the

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Reserve Bank under Section 20A of the Banking Regulation Act.
Permission is also required for remission of loans to:
(a)

any firm or company in which a director is interested as

director, partner, managing agent, or
(b)

any individual for whom a director is partner or guarantor.

Any remission made in contravention
of Section 20 is void and will have no effect.
3.6 REGULATION OF INTEREST RATE
The Reserve Bank is authorised to regulate interest rates under
Section 21 (read with Section 35A) of the Banking Regulation Act.
This includes rates of interest for loans and advances as well as
deposits. While giving directions on interest rates, there should not
be any discrimination against any class of depositors or loanees or
banks. Any differential treatment should be justifiable in law as not
being against the principles of equality. In Harjit Singh vs Union of
India (AIR 1994 SC 1433), the Supreme Court held in the context of
reduction of rate of interest on bank loans to riot victims that the
concession should be extended to loanees from financial
institutions also, as there was no basis for discrimination between
loanees from banks and loanees from financial institutions.
i. Interest on deposits: The rates of interest on deposits were not
regulated by the Reserve Bank until 1964. Hence, it was open to the
banks to decide their deposit rates freely. Thereafter the Reserve
Bank has been issuing directions from time to time regulating rates
of interest applicable to different types of deposits. Accordingly,
payment of interest on current account was prohibited. As the
directions are issued by virtue of the powers vested in the Reserve
Bank under Section 35A of the Banking Regulation Act, before

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issuing the directions the Bank has to be satisfied that the
directions are necessary in public interest or in the interest of
depositors or of banking policy. Reserve Bank may permit higher
rate of interest in favour of certain categories of depositors like
former/existing employees or depositors of certain classes of banks
like co-operative banks. Of late, the movement has been in the
direction of liberalisation of interest rates, thereby giving increased
freedom to banks to decide the rates themselves.
ii. Interest rate on loans and advances: Interest rate on loans and
advances is subject to regulation specifically under Section 21(2)(e)
of the Banking Regulation Act apart from the general provisions of
Section 35A. The Reserve Bank has been issuing directions from
time to time under Section 21 (read with Section 35A) of the Act
regulating different aspects of lending including lending rates.
Accordingly, different rates are permissible for different sectors
like small-scale industries, agriculture, large-scale industries, etc.,
and of late, much freedom has been given to banks to decide the
rates themselves. Further, the rate of interest may vary on the basis
of the period of the loan. The Reserve Bank tightens the regulations
or gives relaxations thereby permitting banks to decide the rates on
their own, depending on the position of money supply in the public
interest or in the interest of depositors or of banking policy.
Currently the directions of RBI regarding interest rates of advances
cover only finance to exporters and small loans with limits up to Rs
2 lac and DRI loans.
37
iii. Usurious loans Act, 1918: The Usurious Loans Act, 1918

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prohibits lending at exorbitant rates. The law has been made to
protect the weaker borrowers from the powerful moneylenders.
Similarly, debt relief legislation in different states attempts to
protect the agriculturists and other weaker sections from
unscrupulous lenders, by remitting debts or giving other
concessions. Although the lending rates of banks are regulated by
the Reserve Bank, borrowers often used to resort to these laws for
remitting loans or reducing rates of interest in respect of loans
taken by them from banks. This was coming in the way of the
monetary policy decided by the central bank. Accordingly, Section
21A was inserted in the Banking Regulation Act to make the rates
of interest charged by banking companies beyond the scrutiny of
courts.
iv. Protection to interest rate: Section 21A of the Banking
Regulation Act provides that a transaction between a banking
company and its debtor cannot be reopened by any court on the
ground that the rate of interest charged is excessive. This provision
is given an overriding effect over the provisions of the Usurious
Loans Act, 1918 or any other law relating to indebtedness in force
in any state.
Section 21A was held to be valid and not ultra vires the
Constitution by the Supreme Court. In Corporation Bank vs D. S.
Gowda [(1994) 5 SCC 213], the Supreme Court held that banks can
compound interest on annual rates and not half yearly rates in view
of the express directives of the Reserve Bank. The court further
held that where the Reserve Bank fixes both minimum and
maximum rates of interest, courts would not interfere in the matter
of interest rate, if the rate charged by the bank is not in violation of

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the Reserve Bank directive. However, the court did not express any
opinion on the question whether Section 21A would debar the
courts from interfering if the circulars or directives of the Reserve
Bank do not fix the maximum and leave it to the discretion of the
banks to fix the rate above the minimum.
3.7 REGULATION OF PAYMENT SYSTEMS
The Reserve Bank of India Act, until recently, did not contain any
provision for regulation of payment systems. Section 58 empowers
the Bank to make regulations for giving effect to the provisions of
the Act and Clause (g) of the sub-Section (2) thereof, provides for
making provisions for regulation of clearing houses for the banks
including post office saving banks. (The clearing houses are now
functioning under the uniform clearing house rules and regulations
framed by the mutual consent of members and no statutory rules
or regulations have been framed.) However, the regulation of
payment systems has become important in the context of electronic
payment systems becoming popular and the probability of
complications in the absence of a suitable regulatory framework
with statutory backing. In the absence of specific powers under the
Act, the Bank has not been able to frame any regulations relating to
payment systems. Hence, the Information Technology Act, 2000
has amended the Reserve Bank of India Act, inserting the Clause
(pp) in Section 58 (2) empowering the Reserve Bank to frame
regulations for payment systems of banks and financial
institutions. Financial institution for this purpose will have the
same meaning as provided in the Clause (c) of Section 45 of the
Reserve Bank of India Act. Accordingly, the Central Board of the
Reserve Bank has framed the Reserve Bank of India (Board for

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Regulation and Supervision of Payment and Settlement Systems)
Regulations, 2005. Further, RBI is in the process of finalising the
guidelines under the Payment and Settlement Systems Act, 2007.
i. Board for regulation and supervision of Payment and Settlement
Systems: The Reserve Bank, in terms of the RBI (Board for
Regulation and Supervision of Payment and Settlement Systems)
Regulations, 2005, has constituted a Board for Regulation and
Supervision of Payment and Settlement Systems (BPSS) as a
committee of its Central board. The Board has the Governor of the
Bank as its chairman and its functions include prescribing policies
relating to the regulation and supervision of all types of payment
and settlement systems, setting standards for existing and future
systems,
38
authorising the payment and settlement systems, determining
criteria for membership to these systems including continuation,
termination and rejection of membership.
3.8

INTERNET BANKING GUIDELINES

The Reserve Bank has issued guidelines in respect of internet
banking. These guidelines cover:
(i) technology and security issues; (ii) legal issues;
(iii) regulatory and supervisory issues.
These guidelines apply, in addition to Internet banking, to other
forms of electronic banking to the extent relevant. All banks
offering internet banking have to make a review of their systems in
the light of these guidelines and report to the Reserve Bank the
types of services offered, extent of their compliance with the

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recommendations, deviations, if any and their proposal indicating
a timeframe for compliance.
3.9

REGULATION OF MONEY MARKET INSTRUMENTS

The Reserve Bank of India (Amendment) Act, 2006 (Section 45W)
empowers the Bank, in public interest or to regulate the financial
system of the country to its advantage, to determine the policy
relating to interest rates or interest rate products and give
directions in that behalf to all agencies or any of them, dealing in
securities, money market instruments, foreign exchange,
derivatives, or other instruments of like nature as the Bank may
specify from time to time. Further, the Bank may, for the purpose
of enabling it to regulate these agencies call for any information,
statement or other particulars from them, or cause an inspection of
such agencies to be made. However, the directions issued by the
Bank in this behalf shall not relate to the procedure for execution
or settlement of the trades in respect of the transactions on the
recognised Stock Exchanges. Every director or member or other
body for the time being vested with the management of the affairs
of the agencies falling under Section 45 W has to comply with the
directions given by the Reserve Bank and submit the information
or statement or particulars as required.
3.10

BANKING OMBUDSMAN

Ombudsman is generally an authority (official) appointed to
receive and investigate on the public grievances against the
Government or any other authority or institution or organisation
and redress such grievances as a non-adversarial adjudicator, or an
alternative to the adversary system for resolution of disputes. The
position is that of an independent and non-partisan officer who

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deals with specific complaints from the public against
administrative injustice and maladministration. The banking
ombudsman is an authority originally established under the
Banking Ombudsman Scheme, 1995 by the Reserve Bank of India
in exercise of the powers vested in it under Section 35A of the
Banking Regulation Act. The scheme aimed at resolution and
settlement of complaints of the banking public against the
commercial banks (excluding RRBs) and the scheduled primary cooperative banks without resorting to courts. It was modified by the
Banking Ombudsman Scheme, 2002 and later by the Banking
Ombudsman Scheme, 2006 to enlarge the extent and scope of the
authority and functions of banking ombudsman for 'redressal of
grievances against deficiency in banking services, concerning loans
and advances and other specified matters'. All commercial banks,
regional rural banks and scheduled primary co-operative banks are
required to comply with the modified scheme.
1.

Object of the scheme: The object of the scheme is to enable

resolution of complaints relating to
specified services rendered by the banks and to facilitate the
satisfaction or settlement of such
complaints.
2.

Grounds of complaint: The grounds on which complaints

may be made to the banking ombudsman
are:
39
3.

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(i) Deficiency in banking or other services in respect of:
(a)

non-payment or inordinate delay in the payment or

collection of cheques, drafts, bills, etc.;
(b)

non-acceptance, without sufficient cause, of small

denomination notes tendered for any
purpose, and for charging of commission in respect thereof;
(c)

non-acceptance, without sufficient cause, of coins tendered

and for charging of commission
in respect thereof;
(d)

non-payment or delay in payment of inward remittances;

(e)

failure to issue or delay in issue of drafts, pay orders or

bankers' cheques;
(f)

non-adherence to prescribed working hours;

(g)

failure to honour guarantee or letter of credit commitments;

(h) failure to provide or delay in providing a banking facility (other
than loans and advances)
promised in writing by a bank or its direct selling agents;
(i) delays, non-credit of proceeds to parties' accounts, non-payment
of deposit or non-observance of the Reserve Bank directives, if any,
applicable to rate of interest on deposits
in any savings, current or other account maintained with a bank; (j)
delays in receipt of export proceeds, handling of export bills,
collection of bills, etc., for
exporters provided the said complaints pertain to the bank's
operations in India; (k) complaints from Non Resident Indians
having accounts in India in relation to their remittances
from abroad, deposits and other bank-related matters; (1) refusal

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to open deposit accounts without any valid reason; (m) levying of
charges without adequate prior notice to the customer; (n) nonadherence by the bank or its subsidiaries to the instructions of
Reserve Bank on ATM/
Debit card operations or credit card operations; (o) nondisbursement or delay in disbursement of pension (to the extent
the grievance can be
attributed to the action on the part of the bank concerned, but not
with regard to its
employees); (p) refusal to accept or delay in accepting payment
towards taxes, as required by Reserve
Bank/Government; (q) refusal to issue or delay in issuing, or
failure to service or delay in servicing or redemption
of Government securities;
(r) forced closure of deposit accounts without due notice or without
sufficient reason; (s) refusal to close or delay in closing the
accounts; (t) non-adherence to the fair practices code as adopted
by the bank; (u) any other matter relating to the violation of the
directives issued by the Reserve Bank in
relation to banking services.
(ii) Deficiency in banking service in respect of loans and advances
pertaining to:
(a)

non-observance of Reserve Bank Directives on interest

rates;
(b)

delays in sanction, disbursement or non-observance of

prescribed time schedule for disposal
of loan applications but not declining credit;
(c)

non-acceptance of application for loans without furnishing

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valid reasons to the applicant;
(d)

non-observance of any other direction or instruction of the

Reserve Bank as may be
specified by the Reserve Bank for this purpose from time to time;
(iii) Such other matters as may be specified by the Reserve Bank
from time to time in this behalf.
Jurisdiction and Procedure: The location and the territorial
jurisdiction of the ombudsman are as specified by the Reserve
Bank. A complaint may be made in writing by a person himself or
through an authorised representative. No complaint to the banking
ombudsman shall lie unless,
40

(a)

the complainant had, before making a complaint to the

banking ombudsman, made a written
representation to the concerned bank and the bank had rejected
the complaint or the complainant
had not received any reply within a period of one month after the
bank received his representation
or the complainant is not satisfied with the reply given to him by
the bank;
(b)

the complaint is made not later than one year after the

complainant has received the reply of the
bank to his representation or, where no reply is received, not later
than one year and one month
after the date of the representation to the bank;

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(c)

the complaint is not in respect of the same subject matter

which was settled or dealt with on
merits by any previous banking ombudsman proceedings whether
or not received from the
same complainant or along with one or more complainants or one
or more of the parties
concerned with the subject matter;
(d)

the complaint does not pertain to the same subject matter

for which any proceedings before
any court, tribunal or arbitrator or any other forum is pending or a
decree or award or order
has been passed by any such court, tribunal, arbitrator or forum;
(e)

the complaint is not frivolous or vexatious in nature;

(f)

the complaint is made before the expiry of the period of

limitation prescribed under the Indian
Limitation Act, 1963 for such claims.
The Supreme Court has in a recent case, M/s Durga Hotel Complex
vs. Reserve Bank of India and Ors. [Appeal (civil) 1389 of 2007],
observed that a banking ombudsman, though might have initially
jurisdiction to entertain a complaint on the basis that it has a legal
foundation, in terms of the scheme, he may be divested of that
jurisdiction, or the foundation in law might be lost, on either of the
parties, approaching the Court, the arbitrator or the debts recovery
tribunal in respect of the same subject matter. This is on the basis
that the complaint must continue to have a foundation in law at the
time the ombudsman takes up the claim for his consideration and
renders his decision or award and that foundation would be lost
when the complaint is taken to a Court, Arbitrator, Tribunal or any

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other competent forum. The ombudsman being an authority or
tribunal of limited jurisdiction conferred by the scheme, the
exercise of jurisdiction or power by the ombudsman would depend
on his having jurisdiction, not only to entertain a claim but also to
end it. Accordingly, once he/she is deprived of his jurisdiction or
gets deprived of his jurisdiction over the subject matter, he/she
could no more proceed with a complaint which was earlier filed
and therefore, a complaint goes out of his/her purview when the
subject matter of it is taken to a court, arbitrator, tribunal or
forum. Moreover, the relief that can be granted by the ombudsman
may not conflict with a more comprehensive adjudication by a
court, arbitrator, tribunal or forum with wider powers.
In short, when the ombudsman is about to pronounce his award,
he finds that the subject matter of the dispute has been taken to the
debts recovery tribunal or a civil court or an arbitrator or to any
other competent forum, the ombudsman will have to decline
jurisdiction to pass any order or award on the complaint to bring
about a resolution of the complaint by way of a non adversarial
adjudication.
The ombudsman may call for information from the bank concerned
and make endeavour to promote a settlement with the bank. The
ombudsman is free to follow the procedure considered appropriate.
Where a complaint is not settled by agreement within a period of
one month from the date,of receipt of the complaint or such further
period as the banking ombudsman may consider necessary, he may
pass an award after affording the parties reasonable opportunity to
present their case. He shall be guided by the evidence placed before
him by the parties, the principles of banking law and practice,

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directions, instructions and guidelines issued by the Reserve Bank
from time to time and such other factors which in his/her opinion
are necessary in the interest of justice. An award shall not be
binding on a bank against which it is passed unless the
complainant furnishes a letter of
41
acceptance of the award in full and final settlement of his claim
within a period of fifteen days from the date of receipt of copy of
the award. If the complainant fails to furnish his/her letter of
acceptance within this time or within extended time of fifteen days,
the award will lapse. However, on a written request for extension of
time, the banking ombudsman may grant extension of time up to a
further period of fifteen days for such compliance. Within one
month from the date of receipt by the bank of the acceptance in
writing of the award by the complainant (or within such time not
exceeding a period of fifteen days that may be granted by the
banking ombudsman), the bank has to comply with the award.
However, if the bank or the complainant is aggrieved by the award,
it/ he can make an appeal to the appellate authority (Deputy
Governor, Reserve Bank) under the scheme.
4.

Banking Ombudsman and Reserve Bank Directions: The

legal position of banking ombudsman vis¬
a-vis the Reserve Bank has been considered by the Supreme Court
in Canara Bank vs P.R.N.
Upadhyaya (AIR 1998 SC 3000). The court observed that since an
ombudsman is appointed by
virtue of the scheme framed under S 35A of the Banking Regulation

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Act, 1949, he/she is obliged to
comply with the directions/circulars and notifications issued by the
Reserve Bank under Section
35A or 21 of the Act. He/She is also required to issue directions to
banks based on the Reserve
Bank directions/circulars and ensure their compliance. The
ombudsman cannot ignore these circulars
and directions while dealing with the complaints filed by customers
of banks. The impugned award
having been made, ignoring various circulars/directions issued by
the Reserve Bank, the same was
held to be not sustainable. The court, therefore, set aside the
impugned award and remitted the
complaint to the ombudsman for its fresh disposal in the light of
the circulars/directions issued by
the Reserve Bank with regard to charging of rate of interest from
the landlord loanees, whose
buildings were taken on lease/rent by the concerned bank and
calculating the interest rate at quarterly
rests.
5.

Banking Ombudsman and Debt Recovery Tribunals: As

regards the position of banking ombudsman
vis-a-vis the debt recovery tribunal, the Allahabad High Court in
M/s Hindustan Ferro and Industries
Ltd. vs Debt Recovery Tribunal (AIR 2001 All 155) observed that
while the object of the scheme
is to enable resolution of complaints relating to provision of
banking services and the satisfaction

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or settlement of such complaints, the purpose of the Act is to
provide for the establishment of
tribunals for expeditious adjudication and recovery of debts due to
banks and financial institutions
and for matters connected therewith or incidental thereto. The
procedure prevailing prior to the
enactment of the Act for recovery of debts due to the banks and
financial institutions has blocked
a significant portion of their funds in unproductive assets, the value
of which deteriorated with the
passage of time. It was for this compelling reason and to obviate
the difficulties in recovering debts
due to the banks and financial Institutions that the Act was
enacted. The scheme has nothing to do
with the proceedings of recovery of debts due to the banks and
financial institutions. The scheme
formulated by the Reserve Bank under the Banking Regulation Act,
1949 cannot override the
provisions of the Act.
3.11 RESERVE FUNDS
i. Creation of Reserve Fund: Every banking company incorporated
in India has to create a reserve fund under Section 17(1) of the BR
Act out of the profits as shown in the profits and loss account
prepared under Section 29 of the Act. Every year, a sum equivalent
to not less than twenty per cent of such profits has to be transferred
to the reserve fund. Such transfer of profits to reserve fund has to
be made before any dividend is declared.
ii. Exemption from Contribution: If any banking company has an

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adequate paid-up capital and reserves
42
in relation to its deposit liabilities, the Reserve Bank may
recommend to the Government of India for exemption from the
requirement of transfer of profits to reserve fund. Thereupon, the
Government may pass an order in writing, exempting the banking
company from Section 17(1) for such period as may be specified in
the order. No such order shall be made unless the amount already
in the reserve fund together with the amount in the share premium
account is not less than the paid-up capital of the banking
company.
iii. Appropriation from Reserve Fund/Share Premium Account:
Appropriation of any amount from the reserve fund or the share
premium account has to be reported to the Reserve Bank within
twenty-one days of such appropriation. The banking company has
also to explain the circumstances in which such appropriation was
made. It is open to the Reserve Bank in any particular case to
extend the period for submitting the report or to condone the delay
in making the report.
iv. Foreign Banks: The provisions of Section 17(1) of the Banking
Regulation Act for creating a reserve fund do not apply to foreign
banks operating in India. In their case, instead of creating a reserve
fund under Section 17(1), Section 11(2) of the Act requires them to
deposit and keep deposited with the Reserve Bank an amount
calculated at twenty per cent of the profit for each year in respect of
all the business transacted through their branches in India. The
amount may be deposited in cash or unencumbered approved

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securities or partly in cash and partly in unencumbered approved
securities. Section 11 (2A) also provides for exemption by Central
Government on the recommendation of the Reserve Bank, where
the deposits already made are considered adequate in relation to
the deposit liabilities of the banking company.
3.12 MAINTENANCE OF CASH RESERVE
Every banking company which is a scheduled bank has a duty to
maintain certain cash reserve with the Reserve Bank under Section
42 of the Reserve Bank of India Act. In the case of non-scheduled
banks, Section 18 of the Banking Regulation Act provides for the
maintenance of cash reserve.
i. Scheduled Banks: A scheduled bank is a bank included in the
second schedule of the Reserve Bank of India Act. Under Section
42(6) of the Act, the Reserve Bank may include any bank in the
second schedule if it satisfies the following requirements (a)

it has a paid-up capital and reserves of an aggregate value of

not less than Rs. 5 lac;
(b)

it satisfies the Reserve Bank that its affairs are not

conducted in a manner detrimental to the
interests of depositors;
(c)

it is:

(i)

a state co-operative bank, or

(ii)

a company as defined in Section 3 of the Companies Act, or

(iii)

an institution notified by the Central Government in this

behalf, or
(iv)

a corporation or a company incorporated outside India

under the foreign laws.
Thus, a banking company which has the requisite capital and

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reserves of Rs. 5 lac and the affairs of which are not conducted in a
manner detrimental to the interests of depositors is eligible to be
included in the second schedule. The Reserve Bank, may exclude
any bank from the second schedule, if the aggregate value of its
paid-up capital falls below Rs. 5 lac, or its affairs are found to be
conducted in a manner detrimental to the interests of depositors
on an inspection under Section 35 of the Banking Regulation Act,
or if it goes into liquidation, or otherwise ceases to carry on
banking business.
ii. Quantum of Cash Reserve: The cash reserve required to be
maintained by a scheduled bank with the Reserve Bank under
Section 42(1) of the Reserve Bank of India Act (as amended in
2006) is an
43
average daily balance, being 'such per cent of the total of the
demand and time liabilities in India of that bank as shown in the
return referred to in the sub-Section (2), as the Reserve Bank may
from time to time, having regard to the needs of securing the
monetary stability in the country, notify in the Gazette of India'.
Thus, under the amended statute, the Reserve Bank can, in order to
secure monetary stability in the country, determine the CRR for
scheduled banks without any ceiling or floor rate (as against a
statutory minimum of three per cent earlier). 'Average daily
balance' for this purpose means the average of the balances held at
the close of business of each day for a fortnight. The liabilities, for
this purpose do not include paid-up capital and reserves and any
credit balance in the profit and loss account.

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Further, the amounts borrowed from the Reserve Bank, IDBI,
Exim Bank, IIBI, National Housing Bank and National Bank for
Agriculture and Rural Development, are also excluded. Apart from
this, in case of a scheduled bank, other than a state co-operative
bank, the aggregate of liabilities of the scheduled bank to the State
Bank, subsidiary banks, Nationalised banks, banking companies,
co¬operative banks and any financial institutions notified by the
Government in this behalf, shall be reduced by the aggregate of
liabilities of these banks and institutions to that scheduled bank.
Further, the Reserve Bank is empowered under the sub-Section
(1C) of Section 42 to specify, from time to time whether any
transaction shall be regarded as liability in India of a scheduled
bank.
iii. Interest: Until the amendment to the RBI Act in 2006, the
Reserve Bank was authorised under the Act [Section 42(1 B)] to
pay interest to a scheduled bank when it maintained reserves above
the statutory minimum as required under the Reserve Bank's
notification under the erstwhile proviso to the sub-Section (1) or
under the sub-Section (1A) of Section 42. As the sub-Section (IB)
providing for interest has been omitted now, the Reserve Bank
cannot pay interest on any portion of the CRR balances of banks.
iv. Returns: Every scheduled bank has to submit a return to the
Reserve Bank showing its demand and time liabilities and
borrowings from banks in India, classifying them into demand and
time liabilities and giving other details required under Section
42(2) of the Reserve Bank of India Act. The return has to be as at
the close of business on each alternate Friday and has to be sent

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not later than seven days after the date to which it relates. In some
cases, it may be impracticable to furnish fortnightly returns by
reason of the geographical position of the banks and its branches.
If so, the Reserve Bank may permit presentation of a provisional
return fortnightly, to be followed by a final return within twenty
days after the date to which it relates. Alternatively, such a bank
may be permitted to file a monthly return within twenty days after
the end of the month. In addition to the above, where the last
Friday of the month is not an alternate Friday for the purpose of
return, a special return as at the close of business on that day has to
be submitted within seven days. Where the relevant Friday is a
holiday under the Negotiable Instruments Act, the return has to be
prepared as at the close of the preceding working day.
v. Penalties: When the balance maintained by any scheduled bank
falls below the stipulated minimum, such a bank shall be liable to
pay a penal interest to the Reserve Bank. During the first fortnight,
when such shortage occurs, the penal interest shall be three per
cent above the bank rate and if the shortage continues in the next
fortnight, the penal interest shall increase to five per cent above the
bank rate. Where the shortfall still persists in the third fortnight,
every director, manager or secretary of the bank who is a wilful
party thereto shall be punishable with a fine. In that case, the
Reserve Bank may also prohibit the bank from accepting fresh
deposits. Contravention of the order of prohibition is also
punishable with a fine. Failure to file the return as required, also
attracts a penalty under Section 45(4) of the Act. Where Reserve
Bank is satisfied that a bank had sufficient reason for committing
the default, either in maintaining reserves or in filing return, the

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penalty may be
44
waived. When penalty is imposed for a default, the amount has to
be paid within fourteen days of the notice demanding payment. On
failure to pay accordingly, Reserve Bank may obtain a direction
from the Principal Civil Court for levying the penalty and obtain a
certificate for the amount which may be enforced like a decree of a
civil court.
vi. Cash Reserves of Non-Scheduled Banks: In the case of banking
companies, which are not scheduled banks under Section 18 of the
Banking Regulation Act, the cash reserve need not be maintained
with the Reserve Bank. It may be with the bank itself, or in a
current account with the Reserve Bank or by way of net balance in
current accounts or in one or more of these ways. The balance
maintained should not be less than three per cent of the demand
and time liabilities as on the last Friday of the second preceding
fortnight. The bank has also to submit a return to the Reserve Bank
before the twentieth day of every month showing the amount so
held on alternate Fridays during the month, along with particulars
of its demand and time liabilities in India on such Fridays. If the
Fridays concerned fall on holidays under the Negotiable
Instruments Act, the returns have to be filed as on the preceding
working day.
3.13 MAINTENANCE OF LIQUID ASSETS
Every banking company has a duty to maintain a certain
percentage of their assets in India under Section 24 of the Banking
Regulation Act in the form and manner specified by the Reserve

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Bank by notification in the official gazette. Recently, the Banking
Regulation (Amendment) Ordinance, 2007 amended the
provisions of Section 24, omitting the sub-Sections (1) and (2) of
Section 24 which provided for a statutory minimum requirement of
25 per cent. Under the sub-Section (2A), as modified by the
Ordinance, a scheduled bank, in addition to the average daily
balance which it is, or may be required to maintain under Section
42 of the Reserve Bank of India Act, 1934 shall maintain in India,
assets, the value of which shall not be less than such percentage not
exceeding 40 per cent of the total of its demand and time liabilities
in India as on the last Friday of the second preceding fortnight.
Banking companies other than scheduled banks have also to
maintain such assets in addition to the cash reserve, which they are
required to maintain under Section 18 of the BR Act.
i. Returns: For ensuring compliance with the above provisions, a
monthly return has to be submitted to the Reserve Bank by every
banking company. The return has to be submitted not later than
twenty days from the end of the month to which it relates, in the
prescribed form and manner and giving particulars of assets and
demand and time liabilities at the close of business of each
alternate Friday. If such a Friday is a public holiday, the return has
to be prepared as at the close of the preceding working day.
Without prejudice to the above, the Reserve Bank is also
empowered to require a banking company to furnish a return
showing particulars of the assets and demand and time liabilities as
at the close of each day of a month.
ii. Penalty for Default: If the balance on any alternate Friday (or the
preceding working day, when such Friday is a holiday) falls below

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the minimum requirement, the banking company is liable to pay to
the Reserve Bank penal interest at the rate of three per cent above
bank rate on the shortfall for the day. If the default recurs on the
succeeding alternate Friday, the penal interest is raised to five per
cent above the bank rate on the shortfall. If the default occurs on
the next succeeding Friday, then every director, manager and
secretary of the banking company is punishable with a fine. The
Reserve Bank is also empowered to impose a similar penal interest
for shortfall in the assets on any day and if shortfall continues on
the succeeding working day, the higher penal interest is payable as
above. If the Reserve Bank is satisfied on the application of a
banking company that it had sufficient cause not to comply with
the provisions as to maintenance of assets, penal interest may be
waived.
45
3.14 ASSETS IN INDIA
i. Quarterly position of assets: Every banking company has to
maintain in India certain amount of assets as required under
Section 25 of the Banking Regulation Act. Accordingly, at the close
of business on the last Friday of every quarter, such assets shall not
be less than seventy five per cent of the demand and time liabilities
of the banking company in India. If the last Friday is a holiday
under the Negotiable Instruments Act, the assets are based upon as
at the close of business on the preceding working day. 'Quarter' for
this purpose means the period of three months ending on the last
day of March, June, September and December. This provision is
meant to ensure that the resources mobilised by banks operating in

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India, especially the foreign banks, are largely invested within the
country. The assets may be in cash, gold or unencumbered
approved securities. 'Assets in India' also include export bills
drawn in and import bills drawn on and payable in India and
expressed in currencies approved by the Reserve Bank for this
purpose. Such bills and securities approved by the Reserve Bank in
this behalf are treated as assets in India even if these assets were
held outside India. The paid-up capital, reserves and any credit
balance in the profit and loss account of a banking company shall
not be treated as 'liabilities in India' for this purpose.
ii. Returns: A return regarding the assets maintained in India
under Section 25(1) of the Banking Regulation Act has to be
submitted to the Reserve Bank within one month from the end of
every quarter. Such return has to be filed in the form and manner
prescribed by the rules made under the Act.
3.15

LET US SUM UP

i. The Banking Regulation Act empowers the Reserve Bank to issue
directions to banking companies in public interest, in the interest
of banking policy and in the interest of depositors. Section 21
provides for the issue of directions to regulate loans and advances
by banking companies. This may be done by regulating the
purposes of lending, margins in respect of secured loans, rate of
interest and terms and conditions of lending. Section 35A gives
wide general powers to issue directions. The Reserve Bank issues
directions from time to time under Section 21 (read with Section 35
A) regulating acceptance of deposits and lending. Under Section
21A of the Act, the rate of interest on loans and advances
contracted between a bank and its customer is not liable to be

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reopened by a court of law. Section 20 of the Act imposes
restrictions on loans and advances to directors, and companies and
firms in which directors are interested as director, partner, etc.
ii. A banking company which is a scheduled bank has to maintain a
certain percentage of the time and demand liabilities as cash
reserve with the Reserve Bank under Section 42 of the Reserve
Bank of India Act, as notified by the Reserve Bank from time to
time. Failure to do so renders the banking company liable to
penalty. For non-scheduled banking companies, Section 18 of the
BR Act provides for cash reserve. Banking companies have also to
maintain a certain percentage of their demand and time liabilities
in liquid assets as stipulated under Section 24 of the BR Act. These
assets may be maintained to the extent and in the form and
manner as notified by the Reserve Bank. Apart from this, banking
companies are required to maintain such assets in India at not less
than seventy five per cent of demand and time liabilities as at the
close of business of the last Friday of every quarter. Banking
companies also have to transfer to the reserve fund twenty per cent
of their annual profits as disclosed in the profit and loss account.
3.16

KEYWORDS

Bank Rate; Demand Liabilities; Scheduled Bank; Selective Credit
Control; Time Liabilities; Usurious Loans.
46
3.17 CHECK YOUR PROGRESS
1. Fill in the gaps choosing the answers from the brackets.
(i) Reserve Bank may issue directions to banking companies under

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Section 21 of BR Act on
. (audit, loans and advances, capital structure)
(ii)

may regulate acceptance of deposits including rate of

interest on deposits by
(iii) (iv)
(v)
(vi)
2.

Say

(i)
(ii) (iii)
(iv) (v) (vi)
3.

Fill

(i)
(ii) (iii)
(iv) (v) (vi)
4.

Say

(i)
(ii)
banking companies under Section 35A of the BR Act. (Government,
Reserve Bank, Board of Directors)
The banking ombudsman can settle a dispute between . (a bank and
its customer/
s, two or more customers, a bank and the Government)
Directions can be issued to banking companies on loans and
advances

. (in strict

confidence, in public interest, in the interest of borrowers)
The purpose of

is to make credit available to essential sectors

of the economy

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according to national priorities, (selective credit control,
maintenance of cash reserve, reserve fund)
Act prohibits lending at exorbitant rates and empowers
reopening of such contracts.
(BR Act, RBI Act, Usurious Loans Act)
whether the following statements are true or false.
Reserve Bank can issue directions on loans and advances under
Section 21 of the Banking
Regulation Act.
Regulation of credit to different sectors of the economy is known as
selective credit control.
Banks are free to lend to their directors.
Banks have to file a return to Reserve Bank regarding unclaimed
deposits under Section 26 of
the BR Act.
Directions may be issued under RBI Act to banks in respect of
loans and advances in the
interest of depositors.
The directions issued by Reserve Bank under Section 35 A of the
BR Act may be either generally
to banks or to a particular bank.
in the gaps choosing the answers from the brackets.
The amount transferable to the reserve fund by the banks
incorporated in India is
of the profit for each year. (25 per cent, 20 per cent, 10 per cent)
Every banking company has to maintain certain amount of assets
under Section 25 of the
Banking Regulation Act as at the (last Friday of every fortnight,

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last Friday of
every month, last Friday of every quarter)
The penalty which is payable by a banking company which is a
scheduled bank for failure to
maintain the cash reserve in any week for the first time is

(3 per

cent, 3 per cent
over the bank rate, 5 per cent over the bank rate)
have to maintain cash reserve under Section 18 of the BR
Act. (Cooperative
banks, Banking companies which are not scheduled banks,
Nationalised banks)
The liquid assets to be maintained under Section 24(2A) of BR Act
are
of the
balances maintained under Section 42 of the RBI Act. (inclusive,
not inclusive, partly inclusive)
The payment of penalty under Section 24 of BR Act can be enforced
by making an application
before (the Government, civil court, high court)
whether the following statements are true or false.
Only scheduled banks have a duty to maintain cash reserve under
Section 42 of the Reserve
Bank of India Act.
Every banking company has to maintain the liquid assets as
required under Section 24 of the
Banking Regulation Act.
47

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(hi) The share capital and reserves of a banking company form part
of its demand and time liabilities
for the purpose of Section 42 of the RBI Act. (iv) The cash reserve
required under Section 42(1) of the RBI Act will be a minimum of
three per
cent of the demand and time liabilities, (v) Interest is payable to
scheduled banks on the cash reserve maintained as required under
Section
42(1) of the RBI Act. (vi) No banking company incorporated in
India is required to maintain reserve fund under Section
17(1) of the BR Act.
3.18 ANSWERS TO 'CHECK YOUR PROGRESS'

(ii) Reserve Bank (iv) in Public Interest (vi) Usurious Loans Act
1.
2. 3.
4.
(i) Loans and Advances (iii) a bank and its customer/s (v) Selective
Credit Control
(i) True; (ii) True; (iii) False; (iv) True; (v) False; (vi) True
(i) 20 per cent
(ii) last Friday of every quarter (iii) 3 per cent over bank rate
(iv) banking companies which are not scheduled banks (v) not
inclusive (vi) civil court
(i) True; (ii) True; (iii) False; (iv) False; (v) False; (vi) False

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3.19 TERMINAL QUESTIONS
Fill in the gaps choosing answers from the brackets.
1.

The directions of the Reserve Bank issued to the banking

companies under Section 35A of the
Banking Regulation Act are

. (binding on them only; not

binding on them and are in
the nature of guidelines; binding on the banks and the public)
2.

A contract if entered into by a banking company with any

party in contravention of a direction
issued by the Reserve Bank. (shall be invalid; shall render the
banking company
liable to prosecution for violation of directions; shall render the
bank and any other party to the contract liable to prosecution for
violation of directions)
3.

Liquid assets are required to be maintained in India under

Section 24 of the BR Act, may be held
in the form of

. (cash only; cash and gold only; cash, gold or

unencumbered approved
securities)
4.

For the purpose of maintenance of liquid assets under

Section 24 of the BR Act, unencumbered
approved securities shall be valued at

. (face value; current

market price; average of
market price for previous six months)
5.

The penal interest chargeable on a banking company under

Section 24(4) of the BR Act for not
maintaining liquid assets as specified under Section 24(2A) of the
Act

. (may be

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waived by the Reserve Bank if it is satisfied that the bank had
sufficient cause for the failure; has to be charged in all cases and
the Reserve Bank has no option but to waive penal interest; can be
reduced by the Reserve Bank, but, not completely waived).
Choose the correct statements from the following:
6.

(i) There are no restrictions on a banking company against

grant of loans or advances on the
security of its own shares.
48

(ii) (iii)
7.

(i)
(ii)
(iii)

8.

(i)
00
(iii)

9.

(i) (ii)
(iii)

10.

(i)
(ii)
(iii)

A banking company can lend to any firm in which its director is a
partner. A banking company is prohibited from entering into any
commitment for granting loans or advances to or on behalf of any

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individual in respect of whom any of its directors is a partner or
guarantor.
The power of the Reserve Bank to control advances extends to
specifying the purposes for
which advances may or may not be made.
A direction, regarding advances may be issued by Reserve Bank to
banking companies
generally and not to any banking company in particular.
A direction regarding advance can be issued by the Reserve Bank
only in the interest of
banking policy and on no other grounds.
The depositor of a banking company can make a nomination in the
form prescribed under
the Banking Companies (Nomination) Rules, 1985.
There is no form prescribed for nomination by depositors under
Banking Companies
(Nomination) Rules, 1985.
The nominee is entitled to receive the proceeds of the deposit on
maturity of the deposit
during the lifetime of the depositor or later.
Banking ombudsman is appointed by the Government under the
Banking Regulation Act. Banking ombudsman is appointed by the
Reserve Bank under the Banking Ombudsman Scheme, 2006
framed in the nature of directions under the Banking Regulation
Act, 1949. Banking ombudsman is appointed by the Reserve Bank
under the Reserve Bank of India Act.
For maintenance of cash reserve under Section 42 of the RBI Act,
'demand and time liabilities'

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do not include paid-up capital of the banking company.
Loan taken from the Reserve Bank and Exim Bank are included in
'demand and time liabilities'
under Section 42 of the RBI Act.
Any loan taken by a regional rural bank from its sponsor, forms
part of its demand and time
liabilities for the purpose of cash reserve under Section 42 of the
RBI Act.
UNIT
4
RETURNS, INSPECTION, WINDING UP
STRUCTURE
4.0

Objectives

4.1

Introduction

4.2

Annual Accounts and Balance Sheet

4.3

Audit and Auditors

4.4

Submission of Returns

4.5

Preservation of Records and Return of Paid Instruments

4.6

Inspection and Scrutiny

4.7

Board for Financial Supervision

4.8

Acquisition of Undertakings

4.9

Amalgamation of Banks

4.10

Winding up of Banks

4.11

Penalties for Offences

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4.12

Let Us Sum Up

4.13

Keywords

4.14

Check Your Progress

4.15

Answers to 'Check Your Progress'

4.16

Terminal Questions

50
4.0

OBJECTIVES

The objectives of this unit are to understand the laws applicable to
banking companies in respect of

preparation of accounts and balance sheet

audit of accounts

filing of returns

inspection and scrutiny

acquisition of assets by the Central Government

amalgamation with other banks

winding up

penalties for default or contravention

4.1

INTRODUCTION

Banking companies have to prepare their balance sheet and
accounts annually as provided in the Banking Regulation Act. The
accounts have to be audited by duly qualified auditors as stipulated
in the Act. The audited balance sheet and accounts have to be
submitted as returns to the Reserve Bank and copies thereof have
to be submitted to the Registrar of Companies. Banking companies
have to file many other returns to the Reserve Bank. The Banking
Regulation Act also provides for inspection and scrutiny of the

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books and accounts of banking companies. The board for financial
supervision has been set up for this purpose. The Central
Government is authorised to acquire the assets of banking
companies and order the amalgamation of any banking company
with another banking company. The Reserve Bank has the power to
apply to the High Court for the winding up of banking companies.
Non-compliance with the provisions of the Reserve Bank of India
Act, the Banking Regulation Act and the orders, rules, regulations,
or directions issued under them is punishable under these acts. In
this chapter, we examine the law relating to the above matters.
4.2 ANNUAL ACCOUNTS AND BALANCE SHEET
i. All Banks whose shares are listed with Stock Exchanges are
required to publish their unaudited quarterly results as per
proforma prescribed by the SEBI. Every banking company has to
prepare its balance sheet and profit and loss account as stipulated
in Section 29 of the Banking Regulation Act. The balance sheet and
profit and loss account, has to be prepared at the end of each
calendar year or on expiry of the twelve months period, ending
with any other date which the Central Government may notify in
the official gazette in this behalf, as on the last working day of the
year or the period, as the case may be. For this purpose, banking
companies incorporated in India, have to cover their entire
business and in the case of foreign banks operating in India, the
business transacted through all their branches in India. While
preparing the accounts, the banking company has to comply with
the directions and instructions issued by the Reserve Bank in
respect of income recognition, asset classification, provisioning,
etc., from time to time.

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ii. The balance sheet and profit and loss account of a banking
company incorporated in India has to be signed by the manager or
principal officer of the company and at least three directors if there
are more than three directors and by all directors if there are not
more than three directors. In the case of foreign banks, the
manager or the agent of its principal office in India can sign.
iii. The balance sheet and profit and loss account have to be
prepared in the forms set out in the III Schedule to the BR Act or as
near thereto as circumstances permit. The Companies Act requires
every company to prepare its balance sheet and profit and loss
account in the forms set out in the part I of schedule VI to that Act.
However, the respective provisions of the Banking Regulation Act
have overriding effect in respect of banking companies. Hence, the
provisions of the Companies
!

51
Act that are inconsistent with the provisions of the Banking
Regulation Act are not applicable to banking companies. However,
those provisions of the Companies Act that are consistent with the
Banking Regulation Act are applicable. The forms specified in the
third schedule of the Banking Regulation Act may be modified by
the Central Government from time to time by notification in the
official gazette.
iv. In the case of banking companies, the profit and loss account,

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which has to be placed before the annual general meeting should
relate to the period ending with the last working day of the year
immediately preceding the year in which the annual general
meeting is held. The provisions of Section 210 of the Companies
Act, in this behalf have been specifically made inapplicable to
banking companies by Section 2y^3A) of the Banking Regulation
Aci.
v.
Publication of Accounts and Balance Sheet: The accounts and
balance sheet prepared under Section 29 of the Banking Regulation
Act along with the auditors' report have to be published, as
provided in Section 31 thereof read with Rule 15 of the Banking
Regulation (Companies) Rules, 1949. Accordingly, the publication
has to be made in a newspaper, which is in circulation at the place
where the banking company has its principal office, within a period
of six months from the end of the period to which the account and
balance sheet relate. For this purpose, 'newspaper' means any
newspaper or journal published at least once a week but does not
include a journal other than a banking, commercial, financial or
economic journal. As per current guidelines, Banks whose shares
are listed in the capital market are required to publish their
unaudited quarterly results as per proforma prescribed by SEBI.
VI
Submission to Reserve Bank: Every banking company has to
submit three copies of its balance sheet and profit and loss account
to the Reserve Bank within three months from the end of the
period to which they relate. This period may be extended by the
Reserve Bank by a further period not exceeding three months.

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vu
Furnishing of Accounts and Balance Sheet to Registrar: Section
220 of the Companies Act provides for submission by companies of
copies of accounts and balance sheet along with the auditor's
report to the Registrar of Companies. However, in the case of
banking companies, Section 32 of the Banking Regulation Act
provides for furnishing to the registrar three copies of the accounts,
balance sheet and auditor's report submitted to the Reserve Bank
under Section 31 of the Act, which would be dealt with in all
respects, as if these were submitted under Section 220 of the
Companies Act. When any company submits additional
information relating to balance sheet and profit and loss account to
the Reserve Bank under Section 27(2) of the Banking Regulation
Act, the company has to send a copy thereof to the Registrar as
well.
viii. Display of Balance Sheet and Accounts: Foreign banks
(banking companies incorporated outside India) operating in India
have to display in a conspicuous place, in their principal office a
copy of the last audited balance sheet and profit and loss account.
This has to be done not later than the first Monday in August of any
year in which it carries on business. The accounts and balance
sheet have to be kept displayed until replaced by a copy of the
subsequent balance sheet and profit and loss account. Similarly,
foreign banks have also to display copies of their complete audited
balance sheet and profit and loss account relating to their banking
business as soon as these are available and keep displayed till the
subsequent accounts are available.
4.3 AUDIT AND AUDITORS

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The balance sheet and profit and loss account of a banking
company have to be audited, as stipulated under Section 30 of the
Banking Regulation Act. Accordingly, a person duly qualified under
any law for the time being to be an auditor of companies is eligible
to be the auditor of a banking company.
52
i. Powers and Functions of Auditors: The powers, functions and
duties of the auditors and the liabilities and penalties to which they
are subjected to under Section 227 of the Companies Act are
applicable to auditors of banking companies. In addition to the
above, the auditor of a banking company has to give certain
additional information in his audit report. In the case of banks
incorporated in India, the additional matters are as under:
(a)

Whether or not information and explanation, required by

him were found to be satisfactory;
(b)

Whether or not the transactions of the company, as noticed

by him were within the powers of
the company;
(c)

Whether or not returns from branches were adequate for the

audit;
(d)

Whether or not profit and loss account shows a true picture

of the profit and loss for the
period covered;
(e)

Any other matter, which the auditor considers necessary to

bring to the notice of the shareholders
of the company.
In dealing with bank accounts, the responsibility of the auditor is

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not confined to safeguarding the interests of the proprietors. The
auditor will be reasonably blamed, if after signing the usual
auditor's report on an apparently sound balance sheet, the bank is
afterwards found insolvent (See the judgment of the Kerala High
Court in Institute of Chartered Accountants vs. Srinivasa, AIR 1960
Kerala. 309 at 311 and the judgment of Madras High Court in
Registrar of Companies vs. RM. Hegde, AIR 1954 Madras 1080 at
1084).
ii. Special Audit: Reserve Bank is empowered under Section 30( IB)
of the Banking Regulation Act to order a special audit of the
accounts of any banking company. Such an order may be passed
when the Reserve Bank is of the opinion that special audit is
necessary in the public interest or in the interest of the banking
company or its depositors. An order, on special audit may relate to
any transaction or class of transactions or such period or periods as
the Reserve Bank may specify in the order. The bank may by the
same order or by a different order appoint a duly qualified auditor
for this purpose or may direct the auditor of the banking company
himself to conduct such a special audit. The Reserve Bank's
directions are binding on the auditor of the banking company and
the auditor has to make a report of such an audit to the Reserve
Bank and also give a copy thereof to the banking company. The
expenses in relation to the special audit have to be borne by the
banking company.
4.4 SUBMISSION OF RETURNS
Every banking company has to furnish several returns to the
Reserve Bank under various provisions of the Banking Regulation
Act and under the Reserve Bank of India Act. The details of these

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returns are discussed below.
i. Return on Liquid Assets: Every banking company has to submit a
return of its liquid assets under Section 24(3) of the Banking
Regulation Act. The return has to be submitted within twenty days
from the end of the month to which it relates. The return has to be
in the form prescribed under Rule 13A of the Banking Regulation
(Companies) Rules, 1949. The return should contain particulars of
assets and the demand and time liabilities, as at the close of
business of each alternate Friday or when such a Friday is a
holiday, as at the close of business of the preceding working day.
The Reserve Bank is also empowered to require a banking company
to furnish returns showing particulars of assets and demand and
time liabilities as at the close of each day of the month.
ii. Monthly Returns: Every month, a banking company has to
submit to the Reserve Bank a return under Section 27 of the BR
Act, showing its assets and liabilities in India as at the close of
business
53
on the last Friday of the previous month. Such a return has to be
submitted before the close of the month succeeding to which it
relates. The return has to be in the form prescribed under Rule 14A
of the Banking Regulation (Companies) Rules, 1949. Apart from
this, the Reserve Bank may also call for statements and
information relating to the business or affairs of a banking
company at any time. The bank may direct the banking company to
submit such statement or information within such time as it may
direct. The Bank may also call for information every half year

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regarding investments of a banking company or the classification
of its advances in respect of industry, commerce or agriculture.
iii. Accounts and Balance Sheet: The annual accounts and balance
sheet have to be submitted to the Reserve Bank within three
months from the end of the period to which they relate. The
Reserve Bank may extend the time by a further period of three
months.
iv. Return of Assets in India: A banking company has to submit to
Reserve Bank under Section 25(1) of the Banking Regulation Act, a
quarterly return regarding its assets in India. The return has to be
submitted within one month of the end of the quarter. The return
has to be filed in the form specified in the Rule 14A of the Banking
Regulation (Companies) Rules.
v. Return of Unclaimed Deposits: Under Section 26 of the BR Act, a
banking company has to file within thirty days of the close of each
calendar year a return on unclaimed deposits (not operated for ten
years). This has to be submitted as specified in the Rule 14B of the
Banking Regulation (Companies) Rules.
vi. Return of Cash Reserve of Non-Scheduled Banks: Every banking
company, not being a scheduled bank, has to furnish a return to the
Reserve Bank under Section 18(1) of the BR Act relating to cash
reserve. The return has to be submitted before the twentieth day of
every month showing the amounts held on the alternate Fridays
during a month along with the particulars of demand and time
liabilities in the form stipulated in the Rule 13A of the BR
(Companies) Rules.
vii. Return by Scheduled Banks: Under Section 42 of the RBI Act,
scheduled banks have to submit returns to the Reserve Bank of

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their demand and time liabilities as specified in the sub-Section (2)
thereof.
4.5 PRESERVATION OF RECORDS AND RETURN OF PAID
INSTRUMENTS
i. Preservation of Records: The Central Government is empowered
under Section 45 Y of the Banking Regulation Act to make rules
specifying the periods of preservation of books, accounts and other
documents by banks and the periods of preservation of different
instruments paid by banks. Accordingly, the Government has
notified the Banking Companies (Preservation of Records) Rules,
1985 and the Cooperative Banks (Period of Preservation of
Records) Rules, 1985. These rules specify the period of
preservation of different types of ledgers and registers, and records
other than ledgers and registers. The rules further provide that,
notwithstanding this, the Reserve Bank may, having regard to the
factors specified in Section 35A(1) of the BR Act, direct any bank by
an order in writing for preserving any books, accounts or registers
for a longer period than the period specified under the rules.
ii. Return of Paid Instruments: Under Section 45Z of the Banking
Regulation Act, a bank is authorised to return paid instruments to
their customers even before the end of the period of preservation
specified under the Act. However, in that case, the bank shall not
return the instrument without making and keeping in its
possession a true copy of all relevant parts of the instruments by a
mechanical or another process ensuring accuracy of the copy.
Banks are not entitled to charge the customers (including
Government departments and corporations) for giving such copies
of instruments.

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54
4.6

INSPECTION AND SCRUTINY

i. Inspection: The Reserve Bank is empowered under Section 35 of
the Banking Regulation Act to conduct an inspection of any
banking company. The bank may conduct such an inspection at any
time. The Central Government may also direct the Reserve Bank to
conduct inspection of any bank and in that case, the Reserve Bank
is bound to comply with such a direction. After inspection of the
books and accounts of the banking company, a copy of the
inspection report has to be given to the banking company. The
directors and officers of a banking company are bound to produce
for inspection all books, accounts and other documents in their
custody. The inspecting team may also require the bank to furnish
any statements or information relating to the affairs of the banking
company within the time specified by them. The inspecting officer
is authorised to examine any director or officer of a banking
company on oath.
ii. Powers of the Government: A copy of the report of inspection
has to be sent to the Central Government in all cases where
inspections have been conducted as directed by the Central
Government. In other cases, it is optional for the Reserve Bank to
send copies of inspection to the Government. On consideration of
the report, if the Central Government is of the opinion that the
affairs of a banking company are being conducted to the detriment
of the interests of the depositors, the Government may (a)

Prohibit the banking company from receiving fresh deposits.

(b)

Direct the Reserve Bank to apply for winding up of the

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banking company under Section 38 of
the BR Act.
However, before taking such action, the Government has to give an
opportunity to the banking company to make a representation in
respect of the report. The Central Government is authorised to
defer the passing of such an order or to cancel or modify such an
order subject to any terms and conditions imposed by it. It is also
open to the Central Government to publish an inspection report or
a portion thereof after giving the banking company a reasonable
notice.
iii. Scrutiny: Apart from making regular inspections, Reserve Bank
is also empowered to conduct a scrutiny of the affairs and the
books and accounts of any banking company under the sub-Section
(1 A) of Section 35 of the Banking Regulation Act. One or more
officers of the Reserve Bank may conduct such a scrutiny. A copy of
the report has to be furnished to the banking company, if it makes
a request for the same or if adverse action is contemplated against
the banking company, based on the scrutiny. Otherwise, unlike in
the case of inspection, it is not mandatory to give a copy of the
report to the banking company. The powers of the Reserve Bank to
call for books, accounts and documents or statements and
information as for examination of any director or officer of the
banking company on oath extend to scrutiny as well.
4.7

BOARD FOR FINANCIAL SUPERVISION

i. Constitution of the Board: The Board for Financial Supervision
(Board) is a committee established under Regulation 4 of the
Reserve Bank of India (Board for Financial Supervision)
Regulations, 1994. These regulations were framed by the Reserve

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Bank under Section 58 of the Reserve Bank of India Act, 1934 with
the previous sanction cfthe Central Government. The Board has
jurisdiction over the banking companies, Nationalised banks, State
Bank and its subsidiaries.
ii. Composition of the Board: The Board consists of the following
members:
(a)

Governor of the Reserve Bank of India, (S)he is the

chairperson of the board.
(b)

Deputy Governors of the Reserve Bank of India, one of the

deputy Governors shall be nominated
by the Governor as the full time vice chairman.
(c)

Four directors from the central board of the Reserve Bank

nominated by the Governor as
55
members, the Governor has to make the nominations to the board
in consultation with the central board of the Reserve Bank (Central
Board) for a specified period,
iii. Functions and Powers: The board performs the functions and
exercises the powers of supervision and inspection under the
Reserve Bank of India Act and the Banking Regulation Act, in
relation to different sectors of the financial system, including
banking companies. The board shall also perform any other
function as may be notified by the central board of the Reserve
Bank. The board is assisted by the department of supervision in the
Reserve Bank and may also draw personnel from outside. The
chairman, vice-chairman and members can jointly and severally
exercise the powers vested in the board, as may be specified by the

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central board from time to time. The board can also authorise
senior officers of the department of supervision with prior approval
of the central board to carry out certain functions. The board has to
report to the central board on a half yearly timeline.
iv. Meetings of the Board: The board meets at least once in a
month. Three members, of whom, one shall be the chairman or the
vice chairman shall form a quorum for the meeting. A member who
absents himself/herself without leave of the chairman for three
consecutive meetings of the board, would cease to hold office.
v. Executive Committee: The board has the power to constitute
sub-committees. One such sub¬committee is the executive
committee. The vice chairman of the Board, is the ex-officio
chairman of the committee and there shall also be not less than two
members of the board in that committee. The committee meets as
often as necessary.
vi. Advisory Council: Governor may constitute an advisory council
to tender advice from time to time to the board. This council will
have not less than five members having special knowledge of
accountancy, law, economics, banking, finance and management.
The Governor presides over the meetings of the council and the
vice-chairman and other members are members of the council.
4.8 ACQUISITION OF UNDERTAKINGS
The Central Government can acquire the undertakings of banking
companies in certain cases as mentioned in Section 36AE of the
Banking Regulation Act. 'Undertaking' means the entire
organisation (See the judgement of the Supreme Court in R.C.
Cooper vs Union of India, AIR 1970 SC 564). Acquisition may be
made if on receipt of a report from the Reserve Bank, the

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Government is satisfied that it is necessary to acquire any
undertaking on certain grounds. Before passing the order, the
Central Government may make such consultation with the Reserve
Bank as it thinks fit. The grounds for acquisition are as under:

Banking company has failed on more than one occasion to

comply with the Reserve Bank's directions
under Section 21 or 35A of the Banking Regulation Act.

Banking company is managed in a manner detrimental to

the interests of depositors and it is
necessary to acquire its undertaking in the interests of depositors
or in the interests of banking
policy or for better provision of credit generally or to any particular
section of the community or
any particular area.
Before acquiring the assets of a banking company, it has to be given
a reasonable opportunity of showing cause against the proposal.
i. On acquisition of the undertaking all the assets and liabilities of
the acquired bank stand transferred to and vests in the Central
Government. It is also open to the Central Government to order the
vesting of the undertaking of the acquired bank in a company or
corporation instead of vesting in the Government. In that case, the
transferee bank takes over all the acquired assets and liabilities of
the transferer bank.
56
ii. Power to make scheme: The Central Government is empowered
under Section 36AF to make a scheme for any acquired bank. Such
a scheme is framed in consultation with the Reserve Bank. The

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scheme may provide for all matters relating to property, assets,
liabilities, board of management, service of employees and their
terms and conditions, payment of compensation to shareholders of
acquired bank and other matters. The Central Government may
modify or vary any such scheme after consulting the Reserve Bank.
The scheme and any subsequent modification thereof is published
in the official gazette and laid down before the Parliament. The
provisions of part IIC of the Act providing for acquisition of
undertakings of banks by the Government and of any scheme
framed there under shall have an overriding effect on other laws.
The scheme shall have binding effect on the Government, the
acquired bank, members, creditors and depositors of the acquired
bank and all other persons having any rights or liabilities in respect
of the acquired bank.
iii. Compensation to shareholders: The shareholders of an acquired
bank have a right to get compensation under Section 36AG of the
Banking Regulation Act. The amount thereof will be determined as
provided in the fifth schedule to the Act, after consultation with the
Reserve Bank. There is also a provision (Section 36AH) for a
reference to a tribunal for hearing claims relating to compensation.
If the compensation offered by the Government or the transferee
bank is not acceptable to any person to whom such compensation
is payable, he may request the Central Government to refer the
matter to the tribunal, and a reference has to be made to the
tribunal, subject to the satisfaction of certain conditions. In the
case of acquisition of the undertaking of a foreign bank in India, a
reference has to be made to the tribunal, if requested by the foreign
bank.

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4.9 AMALGAMATION OF BANKS
i. Voluntary Amalgamation: A banking company may be
amalgamated with another banking company under Section 44A of
the Banking Regulation Act. For this purpose, a scheme has to be
prepared, containing the terms of such an amalgamation in a draft
and placed before the shareholders of the two companies
separately. The scheme has to be approved by a resolution passed
by majority of members representing two-thirds in value of the
shareholders of each company present in person or by proxy.
Notice has to be given to every shareholder in this behalf. A share
holder who votes against such scheme or dissents to the scheme
and gives notice as stipulated, may claim the value of his shares
from the banking company, in the event of sanction of the scheme
by the Reserve Bank. After the scheme is approved by the requisite
majority, the scheme has to be submitted to the Reserve Bank for
sanction. On sanction by Reserve Bank, the assets and liabilities of
the amalgamated company pass to the banking company, with
which it is to be amalgamated. The Reserve Bank may also direct
that the amalgamated company will stand dissolved from any
specified date and intimate the Registrar of Companies
accordingly. The order of sanction of amalgamation by Reserve
Bank will be the conclusive evidence of amalgamation.
ii. Amalgamation by Government: The Central Government is
empowered to order amalgamation of two banking companies
under Section 396 of the Companies Act. However, such power has
to be exercised only after consultation with the Reserve Bank.
iii. Moratorium and Amalgamation: The Reserve Bank is
authorised under Section 45 of the Banking Regulation Act to apply

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to the Central Government for an order of moratorium in respect of
any banking company where it appears to it that there is good
reason to do so. After considering the application, the Central
Government may pass an order of moratorium staying the
commencement or continuation of any action or proceedings
against the banking company for a fixed period. This may be on
such terms and conditions as the Government thinks fit and prefers
to impose. The
57
period of moratorium is extendable from time to time. However,
the total period of moratorium shall not exceed six months. During
the period of moratorium, the banking company shall not make
any payment to depositors or discharge any liabilities or
obligations to any other creditors unless otherwise directed by the
Central Government in the order of moratorium or at any time
thereafter.
iv. Scheme of Amalgamation:
(a)

During the period of moratorium, Reserve Bank may

prepare a scheme either for reconstruction
of the banking company, or for amalgamation of the banking
company with any other banking
institution. Such a scheme may be prepared if the Reserve Bank is
satisfied that it is necessary
to do so:
(i) in the public interest;
(ii) in the interests of the depositors;
(iii) for securing the proper management of the banking company;

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(iv) in the interest of the banking system of the country as a whole.
(b)

The scheme of amalgamation or reconstruction may contain

provisions for all or any of the
matters specified in the clauses (a) to (I) of the sub-Section (5) of
Section 45. These include:
(i) constitution, name, registered office, capital assets, powers,
rights, duties and obligations
of the banking company after reconstruction of the transferee
company; (ii) transfer of assets from transferrer bank to transferee
bank, and terms and conditions
thereof in the case of amalgamation; (iii) change in or appointment
of board of directors; (iv) alteration in memorandum and articles;
(v) continuation of action by or against the banking company after
amalgamation or
reconstruction; (vi) reduction of the interest or rights of members,
depositors or other creditors considered
necessary in public interest or in the interest of members,
depositors or creditors or for
maintenance of the business of banking company; (vii) payment in
cash or otherwise to creditors and other depositors; (viii) allotment
of shares of the transferrer bank to the shareholders of transferrer
bank for
shares held by them in the transferrer bank; (ix) continuance of
service of employees after reconstruction or amalgamation.
The scheme has to provide for the continuance of all workmen and
other staff (excepting those specifically excluded by name in terms
of the scheme) on the same terms and conditions of service as
before. The scheme should also provide that within three years,

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these employees have to be given the same pay and terms and
conditions as are applicable to the other employees of the
transferee bank of corresponding rank or status of equivalent
qualifications and experience. See the judgements of the Supreme
Court in State Bank of Travancore vs Elias (1970)2 SCC 761 and
also K.I. Shepherd and others vs Union of India and others AIR
1988 SC 686. In the case of any dispute regarding rank, status, etc.,
of employees in this regard, the decision of the Reserve Bank shall
be final.
Scheme has also to provide for payment of terminal benefits to
workers who have opted not to continue in service on
amalgamation or reconstruction and other employees, who have
been specifically mentioned in the scheme for exclusion from
service. The scheme may contain other terms and conditions of
amalgamation or reconstruction and also incidental matters.
(c)

Sanction of Scheme by Government: A copy of the draft of

the scheme prepared by the
Reserve Bank has to be sent to the Government and also to the
banking company, transferee
58
bank and any other banking company concerned in the
amalgamation, for their suggestions and objections, if any. The
Reserve Bank may specify the period for receipt of such suggestions
and objections. In the light of any suggestions and objections
received, modification may be made in the draft, as considered
necessary by the Reserve Bank. Thereafter, the scheme, may be
placed before the Central Government for sanction. The

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Government may sanction the scheme with such modifications as it
may consider necessary. The scheme shall come into force from the
date of the sanction.
(d) Effect of Sanction: On the Central Government sanctioning the
scheme, it becomes binding on the banking company, transferee
bank and the members, depositors and other creditors, employees
and any person having any right or liability in relation to the
banking company. The sanction by the Central Government is the
conclusive evidence that the amalgamation or reconstruction has
been done in compliance with the provisions of Section 45 of the
Act. The assets and properties of the banking company shall stand
transferred to and vest in, and liabilities shall stand transferred and
become liabilities of the transferee bank as provided in the scheme.
If any difficulty arises in implementing the scheme, the Central
Government may pass the necessary orders for removing the
difficulties. A copy of the scheme and any orders passed for
removing difficulties has to be placed before the Parliament.
Consequent to amalgamation, the transferee bank has to carry on
the business of the banking company acquired by the transferee
bank, according to the law governing the transferee bank. The
Central Government may give necessary exemptions and
modifications in this behalf on the recommendation of the Reserve
Bank. However, such modification or exemption should not last for
more than seven years.
A single scheme of amalgamation can be made in respect of several
banking companies under moratorium. The provision of Section 45
and the scheme sanctioned there under shall have overriding effect
on other laws, agreements, awards or instruments.

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4.10 WINDING UP OF BANKS
i. Suspension of Business and Winding Up: A banking company
which is temporarily unable to meet its obligations may apply to
the High Court under Section 37 of the Banking Regulation Act for
staying the commencement or continuance of any proceedings
against it. Such stay will be for a fixed period and subject to any
terms and conditions imposed by the High Court as it may think fit.
The total period of such moratorium shall not exceed six months.
An application for moratorium shall be supported by a report of the
Reserve Bank indicating that the banking company will be able to
pay its debts if the application is allowed. The Court, for sufficient
reasons, may grant the relief, even if the application is not
supported by the Reserve Bank's report. In that case, a report will
be called for and the order, may be modified or rescinded based on
the report. On passing of moratorium order the court may appoint
a special officer to take custody and control of the assets, books,
etc., of the banking company in the interests of the depositors.
If the Reserve Bank is satisfied that the affairs of a banking
company under moratorium as above, are being conducted in a
manner detrimental to the interests of the depositors, it may apply
to the High Court for winding up of the company. Thereafter, the
High Court shall not extend the period of moratorium.
ii. Winding Up by High Court:
(a) The High Court shall order the winding up of a banking
company in the circumstances mentioned in Section 38 of the
Banking Regulation Act. They are:
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(i) The banking company is unable to pay its debts;
(ii) An application for winding up has been made by the Reserve
Bank under Section 37 or Section 38 of the Act.
(b)

The Reserve Bank is bound to make an application for

winding up under Section 38, if directed
by the Central Government under Section 35(4) of the Banking
Regulation Act. The Central
Government may issue such direction under Section 35(4) when,
on consideration of the
report of inspection or scrutiny made by the Reserve Bank at the
direction of the Central
Government, it is of opinion that the affairs of the bank are being
conducted to the detriment
of the interests of the depositors. However, before giving such
direction, the banking company
has to be given an opportunity to make a representation in
connection with the report of
inspection or scrutiny.
(c)

It is open to the Reserve Bank to apply for winding up of a

banking company in certain other
cases as follows:
(i) failure to comply with the requirements of Section 11 regarding
minimum paid-up capital
and reserves; (ii) bank being not entitled to carry on banking
business in India under Section 22 of the BR
Act by reason of rejection or cancellation of licence; (iii)
prohibition to accept fresh deposits under Section 35(4) of the BR
Act or Section 42

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(3A)(b) of the Reserve Bank of India Act; (iv) failure to comply with
the requirements of the BR Act other than Section 11 and
continuance of such failure or contravention beyond the period or
periods specified by
the Reserve Bank in this behalf and after notice in writing of such
failure or contravention.
In addition to the above, the Reserve Bank may apply for winding
up of a banking
company if it is of the opinion that:
(a)

a compromise or arrangement sanctioned for a banking

company cannot be worked
satisfactorily with or without modification; or
(b)

the returns, statements and information given by the bank

under the Act show that
it cannot pay its debts; or
(c)

the continuance of the banking company is prejudicial to the

interests of the
depositors.
A banking company shall be deemed to be unable to pay its debts if
it has refused to meet any lawful demand made at any of its offices
or branches within the stipulated time and the Reserve Bank
certifies in writing that the banking company is unable to pay its
debts. If the demand is made at a place where the Reserve Bank has
an office, branch or agency, the time limit is two days and in other
cases five days. When the Reserve Bank makes an application for
winding up, the court is bound to allow the application. As held by
the Supreme Court in the Palai Central Bank case (AIR 1962 SC
1371 at 1383), as between the Court and the Reserve Bank, the

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momentous decision to wind up in the interests of depositors may
reasonably be left to the Reserve Bank.
iii. Official Liquidator: Section 38A of the BR Act provides for a
liquidator to be appointed by the Central Government, attached to
respective High Court, for conducting the winding up proceedings
relating to banking companies. Such a liquidator need not be
appointed where enough cases of winding up of banking companies
are not available in any High Court.
iv. Reserve Bank as Liquidator: Although there is a provision for an
official liquidator as above, if the Reserve Bank applies to the Court
under Section 39 of the Act, the Reserve Bank, State Bank or any
other bank notified by the Central Government in this behalf or any
individual stated in the application may be appointed as the official
liquidator. The remuneration of the liquidator and other costs and
expenditure of winding up shall be borne by the banking company.
All provisions of the Companies
60
Act, which are not inconsistent with the Banking Regulation Act
shall be applicable to such a liquidator. The liquidator has to make
a preliminary report to the High Court within two months of the
winding up order on the availability of assets for making
preferential payments under Section 530 of the Companies Act and
for discharging liabilities to depositors and other creditors. Within
fifteen days of the winding up order, the liquidator has to give
notice calling for claims for preferential payment and other claims
from every secured and unsecured creditor. Under Section 43 of
the Act, the depositors need not make claims. The claims of every

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depositor of a banking company is deemed to have filed for the
amount as shown in the books of the banking company standing to
his credit.
v. Preferential Payment: In the winding up proceedings, the
liquidator of a banking company has to make certain preferential
payments under Section 43 A of the Banking Regulation Act.
Accordingly, the preferential payments referred to in Section 530
of the Companies Act, in respect of which, claims have been made
within one month of service of notice, get the first preference. After
that, depositors in savings bank account up to Rs. 250 and then
other depositors up to Rs. 250 get priority over all other creditors.
After making these payments, the balance available will be utilised
for payment to general creditors and then for payment of further
amounts due to the depositors. The provision for preferential
payment by liquidator will not apply to depositors covered by the
DICGC Act.
vi. Voluntary Winding Up: Apart from the provision for
compulsory winding up as above, Section 44 provides for voluntary
winding up by banking companies. However, no such winding up
will be permissible unless the Reserve Bank certifies that the bank
will not be able to pay in full all its debts as they accrue. It is open
to the High Court to order during voluntary winding up of a
banking company that it shall continue, subject to the supervision
of the Court. The High Court may also order winding up by Court
either on its own motion or on the application by the Reserve Bank,
if during voluntary winding up it becomes clear that the company is
not able to meet its debts as they accrue or if continuing voluntary
winding up or winding up under supervision of the court may be

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detrimental to the interests of depositors.
4.11 PENALTIES FOR OFFENCES
A banking company has to abide by the requirements of the
Reserve Bank of India Act and the Banking Regulation Act and the
subordinate legislation there under, namely statutory rules,
directions, etc., issued under these Acts. Failure to do so invites
penalties.
i. Penalties Under the RBI Act: Chapter V of the Reserve Bank of
India Act deals with penalty for violation of the Act. Banking
companies have to make applications and furnish returns,
statements, etc., under different provision of the Act, regulations,
orders, directions, etc. While doing so, the making of any statement
which is false in any particular material, knowing it to be false or
wilfully omitting to make any material statement, is punishable
with imprisonment up to a period of three years and also a fine.
Failure to produce any books, accounts or other documents or
statements, or information which a person is duty bound to make
under the Act, or any order, regulation or direction is punishable
with fine up to Rs. 2,000 for each offence. For continuing offences,
there is a provision for fine of Rs. 100 for each day when the
offence continues. There are penalties under the sub-Section (3) to
(5B) of Section 58B for contravention of specific provisions of the
Act or orders, direction, etc., made there under. Apart from this,
for contravention of any other provisions or not complying with
any requirements under the Act, order, regulation or direction, the
guilty shall be punishable with fine up to Rs. 2,000, and further Rs.
100 every day for continuing the offence.
In the case of offences by companies, every person who was in

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charge of or responsible for conduct of the company's business
shall be deemed guilty of the contravention or default unless he
proves that the offence was committed without his knowledge or
that he had exercised due diligence to prevent the
61
offence. The court will not take cognizance of an offence under the
Act (except offences relating to acceptance of deposits under the
Chapter IIIC) otherwise than on a complaint by an officer of the
bank generally or specially authorised in writing in this behalf by
the Bank. A metropolitan magistrate or magistrate of the first class
or court superior thereto shall try the offences.
ii. Penalties under the BR Act: The provisions of the Banking
Regulation Act, relating to penalties, are provided in Section 46
thereof. Accordingly, making wilfully any false statement in any
return, balance sheet or other document or information given
under the Act is punishable. Similarly, wilful omission to make any
material statement is also punishable. In both cases, punishment is
up to three years imprisonment and fine.
Failure to produce any book, account or other document or to
furnish a statement or information that is obligatory to be
produced under Section 35(2), during inspection or scrutiny is
punishable with fine up to Rs. 2,000. Similarly, failure to answer
any question relating to the business of the banking company
during inspection is also punishable. Continuance of the offence is
punishable with fine of Rs. 100 for every day during which the
offence continues. Acceptance of deposits against an order
prohibiting acceptance of deposits under Section 35(4) is

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punishable with a fine up to twice the amount of deposits accepted.
Every director or officer is punishable in this case, unless he proves
that the contravention was without his knowledge or that he had
exercised all diligence to prevent it. Any contravention of other
provisions of the Act, or any rule, order or direction made or
condition imposed, is punishable with fine up to Rs. 50,000 or
twice the amount involved in the contravention. In the case of
continuing offences, a fine up to Rs. 2,500 for each day may be
imposed. In the case of offences by companies, every person who
was in charge of the company at the time of commission of the
offence is punishable unless he proves that the offence was
committed without his knowledge or in spite of his exercising due
diligence to prevent it.
Under Section 47, the offences are cognizable only by a
metropolitan magistrate, judicial first class or a court superior
thereto on a complaint by an officer of the Reserve Bank and in
some cases by the National Bank.
Under Section 47A, the Reserve Bank is empowered to impose a
penalty for default or contravention. If the Reserve Bank exercises
that power, no complaint shall be filed in a Court in respect of the
same contravention or default.
4.12 LET US SUM UP
Every banking company has to prepare its balance sheet and profit
and loss account annually as at the end of the calendar year or at
the end of twelve months as on a date notified by the Central
Government. The accounts have to be audited by auditors duly
qualified to be auditors of companies. Three copies of the balance
sheet, profit and loss account and the auditor's report have to be

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submitted as returns to the Reserve Bank and to the Registrar of
Companies. Banking companies have also to furnish other returns
like return on maintenance of cash reserve, maintenance of liquid
assets, etc. The Reserve Bank is authorised to inspect or conduct,
scrutiny of banking companies, their books and accounts. The
Board for Financial Supervision set up by the Reserve Bank by
statutory regulations framed under the Reserve Bank of India Act
supervises the affairs of banking companies. The Government may
acquire the undertakings of banking companies in certain
circumstances based on a report from the Reserve Bank. The
Central Government may also order moratorium on banking
companies on the application of the Reserve Bank. During
moratorium, the Reserve Bank may prepare a scheme for
amalgamation, which may be sanctioned by the Central
Government. Such an amalgamation scheme will have overriding
effect on any laws, agreements, etc. The Reserve Bank may also
apply to the High Court for winding up of a banking company when
it is not able to pay its debts and also in certain other
circumstances. The Reserve Bank of India Act and the Banking
Regulation Act impose certain penalties for contravention or
default committed by banking companies or other persons.
62
4.13

KEYWORDS

Amalgamation; Board for Financial Supervision; Continuing
Offence; Inspection; Moratorium; Scrutiny; Winding up.
4.14

CHECK YOUR PROGRESS

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1. Fill in the gaps choosing answers from the brackets.
(i) A banking company has to prepare profit and loss accounts and
balance sheet as at the
or at the expiration of twelve months ending with such date
as notified by the
Central Government, (end of calendar year, end of March, end of
June) (ii) The balance sheet and profit and loss account shall be
audited by a person duly qualified to
be

. (a certified financial analyst, auditor of companies, auditor

of cooperative
societies)
(iii) Three copies of the balance sheet and accounts along with the
auditor's report of a banking company sent to the Reserve Bank
under Section 31 of the BR Act, have also to be sent to
. (the Central Government, Registrar of Companies,
Company Law Board)
(iv) Reserve Bank is empowered to conduct

of a banking

company under Section
35(1) of the BR Act. (inspection, special audit, audit)
(v) A copy of the inspection report, relating to a banking company,
to that banking
company, (should be given, need not be given, should be given at
request)
(vi) The board for Financial Supervision is constituted by

. (the

Government, Reserve
Bank, Indian Banks Association) (vii) Under Section 35(4) of the
BR Act, Central Government can prohibit a banking company
from accepting fresh deposits if the business of the banking

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company is conducted
. (not profitably, not in compliance with the Act, to the
detriment of interest of
its depositors)
2.
Say whether true or false:
(i) Foreign banks have to prepare accounts and balance sheet in
respect of all business transacted
by them in India, (ii) Reserve Bank requires the permission of the
Central Government for ordering special audit
of a banking company, (iii) Three copies of the balance sheet, profit
and loss account, and auditor's report of a banking
company have to be submitted to the Reserve Bank as returns, (iv)
A copy of scrutiny report has to be given to the banking company
whether requested by it
or not. (v) The Board for Financial Supervision is set up under the
regulations framed by the Reserve
Bank under Section 58 of the Banking Regulation Act. (vi) The
Central Government is not empowered to order Reserve Bank for
inspection of a
banking company, (vii) Central Government has to give notice to
the banking company before publishing its
inspection report or any part of it.
3.
Fill in the gaps choosing answers from the brackets.
(i) The undertaking of a banking company may be acquired by the
Central Government if it is satisfied on a report from the Reserve
Bank that the banking company has failed on more

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than one occasion to comply with the

. (directions of the

Government, directions
under Sections 21 and 35A of BR Act, provisions of the Companies
Act)
(ii) The Central Government may make a

after consultation

with the Reserve Bank
63
for carrying out the purposes of part IIC of the BR Act, in relation
to an acquired bank.
(scheme, plan, memorandum)
may apply to the High Court for winding up of a banking
company under
(iii)
Section 38 of the BR Act. (Registrar of Companies, Reserve Bank,
Central Government) (iv) The High Court shall order winding up of
a banking company if the banking company is
unable to

(pay its debts, file returns in time, eliminate non-

performing assets)
(v) In a winding up proceeding the depositors shall

for the

amounts shown in the
books of the bank standing to their credit, (be deemed to have filed
claim, have to file claim,
have no claim)
(vi) The

may apply to the Central Government for an order of

moratorium in
respect of a banking company, (banking company, Registrar of
Companies, Reserve Bank) (vii) The provisions of a scheme of

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amalgamation sanctioned by the Central Government under
Section 45 of the BR Act will

the provisions of other laws, (not

affect, have
overriding effect on, will be subject to).
4. Say whether true or false
(i) Central Government can acquire the undertaking of a banking
company under Section
36AE of the Banking Regulation Act in the interest of banking
policy without any report
from the Reserve Bank on the affairs of the banking company, (ii)
The undertaking of an acquired bank may vest in the Central
Government or in any company
or corporation as directed by the Central Government, (iii) On the
application of Reserve Bank, the High Court may stay the
commencement or
continuance of proceedings against any banking company for any
period, (iv) The Reserve Bank or State Bank or another person as
specified by the Reserve Bank in its
application before the High Court may be appointed as liquidator
of a banking company, (v) On winding up of a banking company,
all the depositors as a class get the first preference
for payment, (vi) The Reserve Bank may prepare a scheme for
reconstruction or amalgamation of a banking
company under moratorium under Section 45 of the BR Act. (vii)
Making any false statement in a return or other document
submitted under the provisions of
the BR Act is punishable with imprisonment and fine also.
4.15

ANSWERS TO 'CHECK YOUR PROGRESS'

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1.

(i) end of calendar year

(ii) auditor of companies

(iii) Registrar of Companies

(iv) Inspection

(v)

should be given

(vi) Reserve Bank

(vii)

to the detriment of interest of the depositors

2.

(i)

True; (ii) False; (iii) True; (iv) False; (v) False; (vi)

False; (vii) True
3.

(i)

directions under Sections 21 and 35A of the BR Act

(ii)

Scheme

(iv)

Pay its debts (v) be deemed to have filed claim

(vi)

Reserve Bank

4.

(i)

(iii) Reserve Bank
(vii) have overriding effect on

False; (ii) True; (iii) False; (iv) True; (v) False; (vi)

True; (vii) True
4.16

TERMINAL QUESTIONS

Fill in the blanks choosing answers from brackets —1 A banking
mmpany has tn prepare its annual accounts in the forms
_. (decided by the
64
board of the banking company and approved in general meeting;
specified by the Department of Company Affairs; in the form set
out in the Third Schedule to the BR Act or as near thereto as
circumstances admit)
2.

A banking company has to submit three copies of its

accounts and balance sheet together with
auditors' report

. (to the Reserve Bank and also to the Registrar

of Companies; only
to the Reserve Bank; only to the Registrar of Companies).
3.

The expenses incidental to a special audit under Section

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3O(1B) of the BR Act shall be borne by
. (the Reserve Bank of India; the banking company; the
Government of India)
4.

The balance sheet and profit and loss account of a banking

company, have to be audited, as
stipulated under Section 30 of the Banking Regulation Act, by
. (a person duly qualified
under any law for the time being in force to be an auditor of
companies; Reserve Bank; Registrar of Companies).
5.

Reserve Bank shall cause an inspection of a banking

company, by one or more of its officers
. (if so required by shareholders representing at least ten per
cent of the shares of the
bank; if so required by the Central Government; if so required by
the Registrar of Companies.)
Choose the correct statements from the following:
6.

(i) Reserve Bank may publish, if they consider in the public

interest to do so, any information
obtained by them under the BR Act in such consolidated form as it
thinks fit. (ii) Reserve Bank may not publish any information in
whatever form collected from a banking
company in exercise of the powers under the BR Act. (iii) Reserve
Bank may not publish information obtained during inspection of a
banking company
even in a consolidated form.
7.

(i) Board of Financial Supervision is a body established by

the Government under the provisions
of the BR Act. (ii) Board of Financial Supervision is a body

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established under the Reserve Bank of India Act for
the supervision of banks and financial companies, (iii) Board of
Financial Supervision is a body established by the Government for
supervising the
securities market.
8.

(i) The Reserve Bank may order moratorium in respect of a

banking company when it is satisfied
that there is good reason to do so. (ii) The Central Government may
order moratorium on its own motion when it is satisfied that
the financial position of the banking company is not satisfactory,
(iii) The Central Government may after considering the application
made by the Reserve Bank
for an order of moratorium in respect of a banking company, order
moratorium staying the
commencement and continuance of all actions and proceedings
against the banking company.
9.

(i) The High Court shall under Section 38 of the BR Act

order winding up of a banking company
if it is unable to pay its debts, (ii) The High Court shall under
Section 38 of the BR Act order winding up of a banking company
if the Government makes an application therefore under Section 37
of the BR Act. (iii) The High Court shall under Section 38 of the BR
Act order winding up of a banking company
if the continuance of the banking company is prejudicial to the
interests of its shareholders
and the Reserve Bank applies to the court on that ground. 10. (i)
No provisions of the Companies Act apply to the liquidator in the
winding up of a banking

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company, (ii) All provisions of the Companies Act apply to the
liquidator in the winding up of a banking
company, (iii) All provisions of the Companies Act relating to
liquidator, insofar as they are consistent with
BR Act, apply to a liquidator of a banking company.
UNIT
5
PUBLIC SECTOR BANKS AND CO-OPERATIVE BANKS

STRUCTURE
5.0

Objectives

5.1

Introduction

5.2

State Bank and Its Subsidiaries

5.3

Regional Rural Banks

5.4

Nationalised Banks

5.5

Application of Banking Regulation Act to Public Sector

Banks
5.6

Disinvestment of Shares by Government

5.7

Co-operative Banks

5.8

Let Us Sum Up

5.9

Keywords

5.10

Check Your Progress

5.11

Answers to 'Check Your Progress'

5.12

Terminal Questions

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66
5.0

OBJECTIVES

The objectives of this unit are to understand:

the special laws governing the public sector banks, namely,

State Bank and its subsidiaries,
Nationalised banks, and regional rural banks;

the applicability of Banking Regulation Act and the Reserve

Bank of India Act to these banks;

laws governing the co-operative banks, in particular

applicability of Banking Regulation Act to co¬
operative banks;

extent of legal control of state governments over co-

operative banks.
5.1

INTRODUCTION

i. The public sector banks, namely, the State Bank of India and its
subsidiaries, Nationalised banks and regional rural banks are
established by special statutes. These statutes and the rules,
regulations and/or schemes framed thereunder provide the
powers, functions and management of these banks. The Banking
Regulation Act is applicable to these banks only in a limited way, as
some of the provisions are not applicable.
ii. In the case of co-operative banks, these banks being created and
governed by the laws relating to co-operative societies, if they
operate only in one state, the State Act and if they operate in
different states, the Central Act applies. The Banking Regulation
Act is applicable to co-operative banks in a modified manner as
provided in Section 56 of the Act.
iii. In this unit, we study the special laws applicable to the public

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sector banks and co-operative banks as also the Banking
Regulation Act and Reserve Bank of India Act as they apply to
these banks.
5.2

STATE BANK AND ITS SUBSIDIARIES

i. Establishment of State Bank: State Bank of India was established
under Section 3 of the State Bank of India Act, 1955 for taking over
the undertaking of the Imperial Bank and to carry on the business
of banking and other business in accordance with that Act. It is a
body corporate, with perpetual succession and common seal and
shall sue and be sued in its name. The majority of ; shares are held
by the GOI. Further, no shareholder other than the GOI can
exercise voting right above ten per cent, unless otherwise specified
by the Central Government in consultation with the Reserve Bank.
Now the complete holding of RBI is acquired by the central
government.
ii. Management: The State Bank has its central office in Mumbai
and local head offices at Mumbai, Kolkata, Chennai and other
places as decided by its Central Board in consultation with the
Central Government. The superintendence and direction of the
affairs of the bank is vested in the Central Board, which has to
function according to the business principles having regard to
public interest. The Central Government can give directions to the
bank on matters of policy involving public interest in consultation
with the Governor of the Reserve Bank and the Chairman of the
State Bank. The directions have to be given through the Reserve
Bank. The board is empowered to make regulations for carrying
out the purposes of the Act in consultation with the Reserve Bank
and with the previous sanction of the Central Government.

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iii. Composition of the Board: The Board shall consist of Chairman,
Vice-Chairman, not more than two Managing Directors appointed
by the Central Government, presidents of local boards and other
directors. There are directors falling in different categories,
namely, appointed by the Government to represent workmen and
officers, nominated by the Central Government in consultation
with the Reserve Bank from among persons with special knowledge
of co-operatives and rural
67
economy, nominated by Reserve Bank, nominated by Central
Government and elected by shareholders other than Reserve Bank.
The chairman and managing directors are appointed for a period
not exceeding five years and are eligible for reappointment. Their
services can be terminated by the Central Government by giving a
three month's notice or notice pay in lieu thereof, after consultation
with the Reserve Bank.
Local boards are set up at each place where there is a local head
office to exercise all powers and to perform the functions and
duties of the bank delegated under Section 2 IB of the Act. The
local board consists of the chairman and other elected and
nominated members as specified in Section 21 of the Act.
iv. Business of State Bank: The State Bank shall act as an agent of
the Reserve Bank at the places where it has a branch and where
Reserve Bank has no branch, if so required, by the Reserve Bank,
for transacting Government business and other business entrusted
to it by the Reserve Bank. The terms and conditions thereof shall
be as agreed between the Reserve Bank and the State Bank. If

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agreement is not reached, the terms shall be decided by the Central
Government. The State Bank may transact the work through its
subsidiaries or an agent approved by the Reserve Bank. Apart from
this, the State Bank may carry on the business of banking as
defined in Section 5(b) of the Banking Regulation Act and other
business specified in Section 6(1) of that Act. The bank is permitted
to acquire business of other banks with the sanction of the Central
Government or if so directed by the Central Government in
consultation with the Reserve Bank.
v. Accounts and Audit: The State Bank has to close its books and
balance accounts each year as on 31 March or such other date as
may be specified by the Central Government. Within three months
of the closing date, it has to furnish to the Central Government and
the Reserve Bank its balance sheet and profit and loss account
together with auditors' report and a report by the Central Board on
the working and activities of the bank. The audit may be conducted
by any person duly qualified to be auditors of companies under
Section 226 of the Companies Act. No Director, member of local
board, local committee or an officer of the State Bank shall be
eligible to be the auditor. The appointment of auditors is done by
the Reserve Bank in consultation with the Central Government.
The auditors' report and report of the Central Board have to be
placed before the Parliament. The State Bank has also to transmit
to the Central Government and the Reserve Bank within two
months of the date of annual closing of accounts, the particulars of
its shareholders as on that date. The balance sheet and profit and
loss account, auditor's report and report of the Central Board shall
be open for discussion by the shareholders at the annual general

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meeting. The annual general meeting has to be held within six
weeks of the date of sending the balance sheet, etc., to the Central
Government and the Reserve Bank.
vi. Subsidiary Banks: The subsidiary banks of the State Bank of
India were established by different special statutes. The State Bank
of Hyderabad was constituted as Hyderabad State Bank under the
Hyderabad State Bank Act and later renamed as State Bank of
Hyderabad under the State Bank of Hyderabad Act, 1956. The State
Bank of Saurashtra was constituted under the Saurashtra State
Banks (Amalgamation) Ordinance, 1950. The other banks were
established under Section 3 of the State Bank of India (Subsidiary
Banks) Act, 1959. Every subsidiary bank is a body corporate with
perpetual succession and common seal and shall sue and be sued in
its own name. The majority of the issued share capital of the
subsidiary banks is held by the State Bank. The shares of the
subsidiary banks are freely transferable as provided in Section 18 of
the Act. However, the State Bank is not entitled to transfer the
shares if such transfer would result in reducing its shareholding to
less than fifty per cent of the issued capital.
vii. Management of Suhsidiarv Ranlrs- Tht* opnprai
cimonnton/fon^ ^~A ~
,,-,+ ,-v-f-* f*4?£nZ-~r* rt-C ~ . 1-. — 1 .31
68
bank vests in its board of directors and the board may exercise all
the powers and carry out all functions with the assistance of the
managing director, subject to the directions and instructions given
by the State Bank from time to time.

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The board consists of the chairman (State Bank Chairman, exofficio), managing director and other directors. The directors are
nominated or appointed by the Central Government, Reserve Bank
or the State Bank except for the directors to be elected by the
shareholders other than the State Bank. The State Bank appoints
the managing director after consulting the board of the subsidiary
bank and with the approval of the Reserve Bank. The day-to-day
administration vests in the managing director. The State Bank
may, with the approval of the Reserve Bank and after giving
opportunity to show cause, remove the managing director from
office. The Act provides for an executive committee, consisting of
directors, which may deal with any matter within the competence
of the board subject to any regulations made under the Act.
viii. Business of Subsidiary Banks: A subsidiary bank has to act as
agent of the State Bank under Section 36 of the (SBI Subsidiary
Banks) Act, at any place as required by the State Bank to receive,
collect and remit money, bullion and Government securities on
behalf of the Government of India, and undertake other business
which the Reserve Bank may entrust the State Bank from time to
time, with the approval of the Reserve Bank. Under Section 36A, a
subsidiary bank has also act as an agent of the Reserve Bank if
required by it, to undertake Government work or other work
entrusted by the Reserve Bank. The terms and conditions of agency
with the Reserve Bank will be as agreed between the Reserve Bank
and the subsidiary bank and if no agreement is reached or dispute
arises, the decision of the Central Government shall be final. A
subsidiary bank shall also transact the business of banking as
defined in Section 5(b) of the Banking Regulation Act and any

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other business specified in Section 6(1) of that Act.
The Central Government may after consultation with the State
Bank and Reserve Bank, by order in writing authorise a subsidiary
bank to undertake other form of business or prohibit it from
carrying on any business, which is otherwise lawful for it to engage
in. It is open to a subsidiary bank to acquire the business of other
banks with the approval of State Bank. The Reserve Bank may
direct the bank in consultation with State Bank to acquire the
business of any bank.
ix. Accounts and Audit: Subsidiary banks have to close and balance
their accounts annually as on 31 March or such other date as may
be specified by the Central Government by notification in the
official gazette. After providing for bad and doubtful debts and
other matters specified in Section 40 of the SBI (sub-Banks) Act, a
subsidiary bank may declare a dividend out of its profits.
The audit of accounts has to be done by a qualified auditor of
companies as specified under Section 226 of the companies Act
who shall be appointed by the State Bank in consultation with the
Reserve Bank.
The balance sheet and profit and loss account together with
auditors' report and report of the board on the working and
activities of the bank have to be submitted as returns to the State
Bank, Reserve Bank and the Central Government within three
months of the date of closing accounts. The Reserve Bank may
extend the period by further three months in consultation with the
State Bank.
A general meeting of shareholders shall be held annually as
required under Section 44 of the Act within six weeks of sending

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the accounts, etc., to the State Bank and others. The shareholders
are entitled to discuss the balance sheet, profit and loss account,
auditor's report and the board's report at such meeting.
The State Bank is empowered under Section 47 to inspect the
subsidiary banks.
69
x. Rules and Regulations: The Central Government is empowered
to make rules under Section 62 of the Act for giving effect to the
purposes of the Act. The State Bank is also empowered to make
regulations under Section 63 with the approval of the Reserve Bank
for giving effect to the purposes of the Act.
5.3 REGIONAL RURAL BANKS
The Regional Rural Banks (RRBs) are public sector institutions,
regionally based, rural oriented and engaged in commercial
banking. They were first set up in 1975 under the Regional Rural
Banks Ordinance, 1975. The ordinance was later replaced by the
Regional Rural Banks Act, 1976. The formation of these banks was
the result of the growing realisation that the ethos and attitude of
the existing public sector banks were not fully conducive to meet
the credit needs of the rural people. As stated in the preamble to
the Act, the object of setting up regional rural banks is to develop
rural economy by providing credit and other facilities for the
purpose of development of agriculture, trade, commerce, industry
and other productive activities in rural areas, particularly to small
and marginal farmers, agricultural labourers, artisans and small
entrepreneurs.
i. Establishment of RRBs: Section 3 of the Act authorises the

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Central Government to establish regional rural banks by
notification in the official gazette at the request of a sponsor bank
to operate within specified local limits. 'Sponsor Bank' is a bank by
which a regional rural bank is sponsored and it holds 35 per cent of
the issued capital of the RRB, while the Central Government holds
50 per cent and the State Government holds the remaining fifteen
per cent of the issued capital. Every RRB is a body corporate with
perpetual succession and common seal with power to acquire, hold
and dispose of property and to sue and be sued in its name.
Generally, a regional rural bank is allotted a compact area of
operation comprising a few districts with homogeneous agroclimatic conditions and rural clientele: These banks may accept all
types of deposits from the public and engage in the business of
'banking' as defined in Section 5(b) of the Banking Regulation Act.
ii. Management of the Affairs of an RRB: The management of RRB
vests in the board of directors. The board has to function on
business principles with due regard to public interest. The board is
empowered to make regulations for giving effect to the provisions
of the Act in consultation with the sponsor bank and with previous
approval of the Central Government. The Central Government is
empowered to give directions to RRBs on matters of policy
involving public interest.
The board consists of a chairman appointed by the sponsor bank
from among its officers in consultation with the National Bank, or
otherwise in consultation with the Central Government. The
chairman holds office on whole-time basis and is removable by the
sponsor bank, where the chairman is an officer of the sponsor
bank, in consultation with the National Bank and in other cases in

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consultation with the Central Government.
A person who is adjudged insolvent or is convicted of an offence
involving moral turpitude is disqualified to be a director and has to
vacate office. Absence from three meetings consecutively without
leave of the board also results in vacation of office.
iii. Business of Regional Rural Banks: Regional rural banks may
transact the business of banking as defined in Section 5(b) of the
Banking Regulation Act and any other business permissible for a
bank to undertake under Section 6(1) of that Act. However, the
main thrust of the business would be granting of loans and
advances to small and marginal farmers, agricultural labourers,
agricultural marketing societies, farmers' service societies, artisans,
small entrepreneurs, etc., within the notified area of operation.
70
other date as the Central Government may specify. The auditors
have to be appointed with the approval of the Central Government.
A person qualified to act as an auditor of companies under Section
226 of the Companies Act is qualified to be an auditor of a regional
rural bank. The auditor's report and report on the working of the
bank has to be laid before the Parliament. The sponsor bank is
empowered to monitor the progress of the RRBs by inspection,
internal audit and scrutiny and suggest corrective measures.
v. Amalgamation: Two or more RRBs may be amalgamated by the
Central Government by notification in the official gazette. Such
notification shall provide for all terms and conditions of
amalgamation including continuation of service of employees and
shall be binding on the banks and all other parties concerned.

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5.4 NATIONALISED BANKS
The Bank Nationalisation Acts [Banking Companies (Acquisition
and Transfer of Undertakings) Act, 1970 and Banking Companies
(Acquisition and Transfer of Undertakings) Act, isfeO] transferred
the undertakings of then existing private banks to the
corresponding new banks established under these Acts. These
corresponding new banks, are popularly known as Nationalised
banks. Originally, the entire paid-up capital (equity shares), of the
Nationalised banks were held by the Central Government. Some of
these banks have recently made public issues of shares, but the
Central Government still holds the majority of shares in all these
banks. The Banking Companies (Acquisition and Transfer of
Undertakings) and Financial Institutions Laws (Amendment) Act,
2006 enables these banks to raise capital by way of public issue or
preferential allotment or private placement of equity shares or
preference shares. The Central Government shall, however, at all
times hold not less than fifty one per cent of the equity of these
banks. The shares other than those held by the Central
Government are freely transferable. The guidelines for issue of
preference shares (including those on the classes of preference
shares) shall be issued by the Reserve Bank. No equity shareholder
other than the Central Government can exercise voting rights in
excess of one per cent of the total voting rights of all the
shareholders. In the case of the preference shareholders, they shall
have a right to vote in respect of those shares only on resolutions
which directly affect the rights attached to the preference shares.
Further, no preference shareholder shall be entitled to exercise
voting rights in respect of the preference shares held by him in

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excess of one per cent of the total voting rights of all the
shareholders holding preference share capital only.
Every Nationalised bank is a body corporate having perpetual
succession and common seal and power to acquire, hold and
dispose of property and enter into contracts and to sue and be sued
in its name. These banks may carry on the business of banking as
defined in Section 5(b) of the Banking Regulation Act and other
forms of business specified in Section 6(1) of that Act. The
Nationalised banks have also to act as agents of the Reserve Bank,
if so required by the Reserve Bank to undertake the banking
business of Central Government and any other business entrusted
by the Reserve Bank.
a. Management: The general superintendence, direction and
management of the affairs of a Nationalised bank vests in the board
of directors. The board can exercise all the powers and functions of
the bank and shall be entitled to discuss, approve and adopt the
annual accounts. The Central Government is empowered to issue
directions to the bank in the discharge of its functions on matters
of policy involving public interest after consultation with the
Governor of the Reserve Bank, to supersede the board on the
recommendation of the Reserve Bank and also to appoint an
administrator. Further, under Section 9 of both the Nationalisation
Acts, the Central Government has the power to make a scheme for
carrying out the provisions of the Act after consultation with the
Reserve Bank. The
71
Government may also amend or vary the scheme in consultation

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with the Reserve Bank. Such a scheme has to be laid before
Parliament and is binding on the bank and any person having any
right or liability in relation to the bank.
b.

Directors: The directors of Nationalised banks are

nominated by the Central Government or elected
from the shareholders. The nomination of directors is as under:
(i) not more than four whole-time directors (as against two earlier);
(ii) one director who is an official of the Central Government to be
nominated by the Central
Government; (iii) one director, possessing necessary expertise and
'experience in matters relating to regulation
or supervision of commercial banks, to be nominated by the
Central Government on the
recommendation of the Reserve Bank; (iv) a director representing
workmen employees of the bank; (v) a director representing
officers of the bank; (vi) one chartered accountant with not less
than fifteen years experience nominated in consultation
with Reserve Bank; (vii) not more than six directors to be
nominated by Central Government.
The other shareholders can elect up to a maximum of three
directors to the board. No person shall be eligible to be elected as
director, unless he is a person having fit and proper status based
upon track record, integrity and such other criteria as the Reserve
Bank may notify from time to time in this regard. The Reserve
Bank may also specify in the notification, the authority to
determine the fit and proper status, the manner of such
determination, the procedure to be followed for such
determination and such other matters as may be considered

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necessary or incidental thereto.
The directors nominated under Item (vii) and the elected directors
should have special knowledge or practical experience of
agriculture and rural economy, banking, cooperation, economics,
finance, law, small scale industry or other knowledge or experience
useful to the bank in the opinion of the Reserve Bank or must
represent the interest of depositors or farmers or workers and
artisans. An elected director, who in the Reserve Bank's opinion
does not qualify the requirements, can be removed by the Reserve
Bank after giving an opportunity of being heard. The board can coopt any other qualified persons in his place who will continue until
another director, is duly elected in the next annual general
meeting. Apart from the direction and management of affairs of the
bank, the board has also the power to frame regulations under
Section 19 for giving effect to the provisions of the Act. This has to
be done in consultation with the Reserve Bank and with the
sanction of the Central Government.
c.

Additional directors: The Reserve Bank may appoint one or

more additional directors on the board
of a Nationalised bank, if it is of the opinion that in the interest of
banking policy or in the public
interest or in the interests of the bank or its depositors, it is
necessary to do so. The appointment
may be made from time to time, by order in writing, with effect
from such date, as may be
specified in the order and the additional directors shall hold office
during the pleasure of the
Reserve Bank and subject thereto, for a period not exceeding three

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years or such further periods
not exceeding three years at a time as the Reserve Bank may
specify. They shall not incur any
obligation or liability by reason only of being a director or for
anything done or omitted to be done
in good faith in the execution of the duties of this office or in
relation thereto.
d.

Accounts and Audit: Every Nationalised bank has to close its

account as on 31 March or such
other date specified by the Central Government by notification in
the official gazette as provided in
Section 10 of the Act. The auditor shall be a person duly qualified to
be an auditor of a company
under Section 226 of the Companies Act. The auditor shall make a
report to the Central Government
72
upon the balance sheet as stipulated in Section 10 of the Act. The
auditor shall send copies of the report to the bank and the Reserve
Bank. The bank has to furnish copies of the balance sheet, profit
and loss account and auditor's report along with the report of the
board of directors on the working and activities of the bank to the
Central Government and the Reserve Bank. The auditor's report
and report of the board have to be laid before the Parliament.
Without prejudice to the above, the Centra] Government is also
empowered to appoint auditors as it thinks fit at any time to
examine and report on the accounts of a Nationalised bank.
A Nationalised bank may pay dividends out of profits after making

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the necessary provisions under the law or as usually provided by
banking companies. An annual general meeting of shareholders
has to be held within six weeks of the date of forwarding the
balance sheet, etc., to the Central Government. In such meeting,
the shareholders will be free to discuss the balance sheet, accounts,
auditors' report and report of the board. For the purpose of Income
Tax Act, a Nationalised bank is treated as an Indian company.
e. Schemes of Management: In exercise of the powers under
Section 9 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 and Section 9 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1980, the Central
Government has framed two schemes, namely:
(i) Nationalised Banks (Management and Miscellaneous
Provisions) Scheme, 1970. (ii) Nationalised Banks (Management
and Miscellaneous Provisions) Scheme, 1980.
These schemes provide in detail for constitution of board of
directors, appointment of chairman and managing director, term of
office of whole-time director including managing director, term of
office of other directors, disqualifications of directors and vacation
of office, meetings of board and committees of the board
(management committee and advisory committee), regional
consultative committees, increase in paid-up capital and other
miscellaneous matters.
5.5

APPLICATION OF BANKING REGULATION ACT TO

PUBLIC SECTOR BANKS
Section 51 of the Banking Regulation Act provides that certain
provisions of the Act would apply to State Bank and its
subsidiaries, Nationalised banks and Regional Rural Banks as they

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apply to banking companies. The applicable provisions are Sections
10, 13 to 15, 17, 19 to 21 A, 23 to 28, 29 [excluding the sub-Section
(3)], the sub-Sections (IB), (1C) and (2) of Sections 30, 31, 34, 35,
35A, 36 [excluding clause (d) of the sub-Section (1)], 45Y to 45ZF,
46 to 48, 50, 52 and 53. The proviso to Section 51 also gives certain
exemptions from the applicable provisions regarding holding of
office in approved institutions under Section 10(l)(c), to the
chairman and the managing director of State Bank, granting of
loan, etc., under Section 20(l)(b)(iii) to all banks and nominee
directors in respect of Sections 46 and 47A.
The provisions which are not made applicable, are mainly the
preliminary provisions up to Section 9, provisions relating to
capital (Sections 11 and 12), prohibition of common directors
(Section 16), licensing (Section 22) audit except special audit
(Section 30), control over management [Part IIA (Sections 36AA to
36AD)], acquisition of undertaking in Part C (Sections 36AE to
36AJ) and winding up in Part III and Part IIIA (Sections 36B to
45X).
i. Public Sector Banks as Scheduled Banks: All the public sector
banks are scheduled banks under Section 42 of the Reserve Bank of
India Act and have to comply with the requirements of maintaining
cash reserve as provided therein.
5.6

DISINVESTMENT OF SHARES BY GOVERNMENT

In the context of the Government policy to dilute the holdings in
public sector banks, certain amendments
72
upon the balance sheet as stipulated in Section 10 of the Act. The

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auditor shall send copies of the report to the bank and the Reserve
Bank. The bank has to furnish copies of the balance sheet, profit
and loss account and auditor's report along with the report of the
board of directors on the working and activities of the bank to the
Central Government and the Reserve Bank. The auditor's report
and report of the board have to be laid before the Parliament.
Without prejudice to the above, the Central Government is also
empowered to appoint auditors as it thinks fit at any time to
examine and report on the accounts of a Nationalised bank.
A Nationalised bank may pay dividends out of profits after making
the necessary provisions under the law or as usually provided by
banking companies. An annual general meeting of shareholders
has to be held within six weeks of the date of forwarding the
balance sheet, etc., to the Central Government. In such meeting,
the shareholders will be free to discuss the balance sheet, accounts,
auditors' report and report of the board. For the purpose of Income
Tax Act, a Nationalised bank is treated as an Indian company.
e. Schemes of Management: In exercise of the powers under
Section 9 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 and Section 9 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1980, the Central
Government has framed two schemes, namely:
(i) Nationalised Banks (Management and Miscellaneous
Provisions) Scheme, 1970. (ii) Nationalised Banks (Management
and Miscellaneous Provisions) Scheme, 1980.
These schemes provide in detail for constitution of board of
directors, appointment of chairman and managing director, term of
office of whole-time director including managing director, term of

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office of other directors, disqualifications of directors and vacation
of office, meetings of board and committees of the board
(management committee and advisory committee), regional
consultative committees, increase in paid-up capital and other
miscellaneous matters.
5.5

APPLICATION OF BANKING REGULATION ACT TO

PUBLIC SECTOR BANKS
Section 51 of the Banking Regulation Act provides that certain
provisions of the Act would apply to State Bank and its
subsidiaries, Nationalised banks and Regional Rural Banks as they
apply to banking companies. The applicable provisions are Sections
10, 13 to 15, 17, 19 to 21 A, 23 to 28, 29 [excluding the sub-Section
(3)], the sub-Sections (IB), (1C) and (2) of Sections 30, 31, 34, 35,
35A, 36 [excluding clause (d) of the sub-Section (1)], 45Y to 45ZF,
46 to 48, 50, 52 and 53. The proviso to Section 51 also gives certain
exemptions from the applicable provisions regarding holding of
office in approved institutions under Section 10(l)(c), to the
chairman and the managing director of State Bank, granting of
loan, etc., under Section 20(l)(b)(iii) to all banks and nominee
directors in respect of Sections 46 and 47A.
The provisions which are not made applicable, are mainly the
preliminary provisions up to Section 9, provisions relating to
capital (Sections 11 and 12), prohibition of common directors
(Section 16), licensing (Section 22) audit except special audit
(Section 30), control over management [Part IIA (Sections 36AA to
36AD)], acquisition of undertaking in Part C (Sections 36AE to
36AJ) and winding up in Part III and Part IIIA (Sections 36B to
45X).

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i. Public Sector Banks as Scheduled Banks: All the public sector
banks are scheduled banks under Section 42 of the Reserve Bank of
India Act and have to comply with the requirements of maintaining
cash reserve as provided therein.
5.6

DISINVESTMENT OF SHARES BY GOVERNMENT

In the context of the Government policy to dilute the holdings in
public sector banks, certain amendments

were made in the statutes governing public sector banks. The State
Bank of India Act, was amended by the State Bank of India
(Amendment) Act, 1993. Section 4 was modified to divide capital
into shares of Rs. 10 each instead of Rs. 100. The restriction on
voting rights (which existed under Section 11, being up to two
hundred shares only) was modified as up to ten per cent of the
issued capital and restriction on dividends was deleted.
The Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 (and also the 1980 Act) were modified by
Amendment Acts of 1994 and 1995, for facilitating public holding
of shares. Section 3 was amended to provide for an authorised
capital of Rs. 1,500 crore, divided into shares of Rs. 10 each, to
increase or reduce the authorised capital between Rs. 1,500 crore
and Rs. 3,000 crore, for transferability of shares, other than those
held by the Government, raising of capital through public issue,
voting rights of shareholders (limited to one per cent per
shareholder) and keeping register of shareholders including in
floppies. Section 10A was amended to declare dividends, as earlier

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balance of profits was to be transferred to the Central
Government..
5.7 CO-OPERATIVE BANKS
i. Applicability of BR Act:
(a)

Co-operative banks are registered either under the state

laws governing co-operatives or under
the multi-state Co-operative Societies Act. If a co-operative bank
operates only in one state,
the state law applies and in the case of co-operative banks
operating in more than one state, the
Central Act applies. While the state law/Central law governs the
constitution and related matters,
the business of banking is regulated by the Banking Regulation Act
as applicable to co-operative
societies.
(b)

The Banking Regulation Act is applicable to co-operative

societies subject to the modifications
stipulated in Part V (Section 56) of the Act. The Act was made
applicable to co-operative
societies by the Banking Laws (Application to Co-operative
Societies) Act, 1965. As defined in
Section 5 (cci) of the BR Act (as applicable to co-operative
societies), a co-operative bank
means a state co-operative bank, a central co-operative bank and a
primary co-operative bank.
A primary co-operative bank is a co-operative society other than a
primary agricultural credit

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society, which satisfies the following criteria;
(i) The primary object or principal business is the transaction of
banking business, (ii) The paid-up share capital and reserves are
not less than Rs. 1 lac. (iii) The byelaws do not permit admission of
any other co-operative society as a member (except the
membership of a co-operative bank by subscribing to the share
capital of the society out of the funds provided by the state
Government).
(c)

A state co-operative bank is the principal co-operative

society in a state with the primary
objective of financing other societies. A central co-operative bank is
the principal co-operative
society in a district with the primary objective of funding other cooperative societies in the
district
The reference to banking company in the Act shall be construed as
a reference to co-operative banks unless the context otherwise
requires.
ii. Bank, Banker, Banking: No co-operative society other than a cooperative bank is permitted to use as part of its name or in
connection with the business, the words 'bank', 'banker' and
'banking'. Further, a co-operative society carrying on banking
business has to use at least one of such words as part of its name.
However, certain categories of co-operative societies are exempt
from these provisions as follows:
(a) a primary credit society;
74

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(b)

a co-operative society formed for the protection of the

mutual interest of co-operative banks
or co-operative land development banks;
(c)

a co-operative society other than a primary credit society

formed by employees of the State
Bank, a subsidiary bank, a Nationalised bank or a co-operative
bank, a primary credit society,
or a co-operative land development bank.
iii. Paid-up Capital and Reserves: The minimum paid-up capital
and reserves required to commence or carry on banking business
by a co-operative bank is not less than Rs. 1 lakh under Section 11
(as applicable to co-operative banks). However, this provision is
not applicable to a primary credit society, which becomes a
primary co-operative bank after the commencement of the Act, for
a period of two years from the date it becomes a primary cooperative bank. The Reserve Bank may give a further period of one
year in the interests of depositors of the primary co-operative bank
in any particular case. For calculating the value of paid-up capital
and reserves, the real and exchangeable value and not the nominal
value would be considered. In the case of a dispute regarding the
value of paid-up capital and reserves, Reserve Bank's decision shall
be final.
iv. Cash Reserve: Co-operative banks other than scheduled Cooperative Banks and scheduled state co-operative banks have to
maintain in India by way of cash reserve with itself or by way of
balance in current account with the Reserve Bank or the state cooperative bank of the state concerned or district Co-operative Bank
or by way of net balance in current accounts or any one or more of

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these ways a sum equivalent to at least three per cent of its total
demand and time liabilities in India. In the case of a primary cooperative bank the balance in current accounts with the central cooperative bank of the district concerned may also be taken into
account. The balance has to be reckoned as on the last Friday of the
second preceding fortnight. The co-operative bank has to submit a
return every month showing such amount held by it on alternate
Fridays during a month along with the particulars of its demand
and time liabilities in India on such Fridays. When the relevant
Friday is a holiday under the Negotiable Instruments Act, the
return shall be required as at the close of business on the preceding
working day. The demand and time liabilities have to be calculated
as stipulated in Section 18 (as applicable to co-operative societies).
For scheduled Primary Co-operative Banks and State co-operative
Banks, CRR has to be maintained as per Section 42 of RBI Act.
v. Restrictions on Loans and Advances:
(a) Section 20 of the Banking Regulation Act (as applicable to cooperative societies) lays down certain restrictions on loans and
advances by co-operative banks. Accordingly, a co-operative bank
shall not grant loans and advances as under:
(i) loans and advances on the security of its own shares; (ii)
unsecured loans or advances to any of its directors;
(iii) unsecured loans or advances to firms or private companies in
which any of its directors are interested as partner, managing agent
or guarantor, or to individuals in cases where any of its directors is
a guarantor for the loans or advances;
(iv) unsecured loans or advances to any company in which the
chairman of the co-operative bank is interested as managing agent

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or chairman or managing director.
However, these restrictions do not apply to unsecured loans or
advances made by a co¬operative bank against bills for supplies or
services made to Government or bills of exchange arising out of
bona fide, commercial or trade transactions. Further, unsecured
loans or advances in respect of which trust receipts are furnished to
the co-operative bank and loans to directors or any other persons
within the limits and on terms and conditions approved by the
Reserve Bank are also exempted.
i
Ii
ij
75
(b) Every co-operative bank has to submit a return in the
prescribed form showing the unsecured loans and advances
granted by it to companies in which its directors are interested as
director, managing agent, or guarantor. Such returns have to be
filed before the close of the month succeeding to which the return
relates. If it appears to the Reserve Bank on examination of any
return that the loans or advances were granted to the detriment of
the interest of depositors, Reserve Bank may prohibit granting of
such further loans or advances. The Reserve Bank may also impose
other restrictions on the grant of such loans and direct the cooperative bank to secure the repayment of the loan or advance
within a stipulated time.
Note: It must be noted here that RBI with effect from 1 October

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2003, has prohibited co-operative banks from providing, renewing
secured or unsecured loans and advances or any other funded or
non-funded financial accommodation to their directors or their
relatives and firm/companies in which their relatives are
interested.
vi. Licensing of Co-operative Banks:
(a)

Every co-operative society requires a licence from the

Reserve Bank under Section 22
of the Banking Regulation Act (as applicable to co-operative
societies) to carry on
banking business in India. However, primary credit societies are
exempt from the requirement.
The Reserve Bank may impose such conditions as it may deem fit
while granting licence
to a co-operative bank. Co-operative societies carrying on banking
business at the commence¬
ment of the Banking Laws (Application to Co-operative Societies)
Act, 1965 were given
exemption for a period of one year. Every co-operative society
carrying on banking
business at the commencement of the Act had to apply for a licence
within three months
from such commencement and every primary co-operative society,
which becomes a
primary co-operative bank after such commencement has to apply
for a licence before
three months from the date of it becoming a primary co-operative
bank. After applying

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for licence the co-operative bank can continue to carry on banking
business unless its
licence is rejected.
(b)

A co-operative bank requires the prior permission of the

Reserve Bank for opening a new place
of business or changing an existing place of business otherwise
within the same city, town or
village where it has an existing place of business. However, opening
of temporary branches for
a period not exceeding one month within the city, town or village
where it has a place of
business, on the occasion of an exhibition, conference, mela or any
like occasion is permissible.
The opening or changing of location of branches by a central cooperative bank within its area
of operation is also exempt. The application of a co-operative bank
for permission to open a
branch, other than of a primary co-operative bank, has to be routed
through the National Bank.
However, an advance copy of the application has to be sent directly
to Reserve Bank.
vii. Liquid Assets: Co-operative banks have to maintain liquid
assets as provided in Section 24(1) of the Banking Regulation Act.
In computing the amount of liquid assets any balances maintained
by a co¬operative bank in current account with the Reserve Bank
or by way of net balances in current accounts would be taken into
account. In the case of state co-operative banks, which are
scheduled banks, the balances required under Section 42 of the

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RBI Act will also be accounted. In the case of the Central cooperative banks, balances maintained with the state co-operative
bank concerned and in the case of primary co-operative banks the
balances maintained with Central co-operative banks or the state
co-operative bank concerned shall be accounted. The co-operative
banks have also to maintain as specified in Section 24(2A) liquid
assets being not less than 25 per cent or such other percentage not
exceeding forty per cent as the Reserve Bank may stipulate by
notification in the Gazette. The amount has to be maintained as at
the close of business on any day. For this
76
purpose, any balance maintained by a scheduled private cooperative banks and state co-operative bank with the Reserve Bank
in excess of the balance required under Section 42 of the RBI Act
shall be accounted. Similarly, cash or balances maintained in India
by a non-scheduled co-operative bank with itself or with the state
co-operative bank or in current account with Reserve Bank or net
balance in current accounts in excess of the requirement of Section
18 would be accounted. In the case of primary co-operative banks,
such balances maintained with the Central co-operative bank of the
district concerned will also be taken into account.
The co-operative banks have to file a return with the Reserve Bank
and every co-operative bank, other than a primary co-operative
bank has also to furnish a copy thereof to the National Bank.
viii. Accounts and Audit: Every co-operative bank has to prepare a
balance sheet and profit and loss account of its business as on the
last working day of the year. The balance sheet and accounts have

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to be prepared in the forms set out in the third schedule to the Act
or as near thereto as circumstances admit. Three copies of such
balance sheet and accounts, along with statutory auditor's report
has to be submitted to the Reserve Bank within six months. A state
co-operative bank and a central co¬operative bank have to submit
such return to the National Bank also.
ix. Inspection: The provisions of Section 35 relating to inspection
are applicable to co-operative banks with minor modifications. It is
also open to Reserve Bank to call for inspection of a primary
co¬operative bank by one or more officers of the state co-operative
bank in the state where the primary co-operative bank is
registered. The Reserve Bank may supply a copy of the report on
any inspection or scrutiny to the state co-operative bank or the
Registrar of Co-operative Societies concerned.
x. Insured Co-operative Banks:
(a)

Registration with DICGC: The Deposit Insurance and Credit

Guarantee Corporation Act, 1961,
which provides for insuring deposits of banks, is applicable to cooperative banks also.
Accordingly, under Section 13C of the Act, co-operative banks have
to be registered with the
corporation for this purpose. The registration of a co-operative
bank may be cancelled if:
(i) it is prohibited from accepting deposits;
(ii) its licence is cancelled;
(iii) it has been ordered to be wound up;
(iv) it has ceased to be a co-operative bank under the sub-Section
(2) of Section 36A of the

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BRAct;
(v) it has converted into a non-banking co-operative society; (vi) it
has been amalgamated with any other co-operative society; (vii) it
has transferred its deposit liabilities to any other institute or; (viii)
it ceases to be an eligible co-operative bank.
(b)

Eligible Co-operative Bank: An eligible co-operative bank is

defined in Section 2(gg) of the Act.
Accordingly, for a co-operative bank to become an eligible cooperative bank, the law governing
that co-operative bank should have the following provisions:
(i) An order for the winding up, or an order sanctioning a scheme
of compromise or arrangement or of amalgamation or
reconstruction of the bank, may be made only with the previous
sanction in writing of the Reserve Bank.
(ii) An order for the winding up of the bank shall be made, if so
required by the Reserve Bank in the circumstances referred to in
Section 130.
(iii) An order shall be made for the supersession of the committee
of management or other managing body of the bank and the
appointment of an administrator therefore for such period or
periods not exceeding five years in the aggregate as may be
specified by the
77
Reserve Bank if so required by the Reserve Bank in the public
interest or for preventing the affairs of the bank being conducted in
a manner detrimental to the interests of the depositors or for
securing the proper management of the bank.

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(iv) An order for the winding up of the bank, or an order
sanctioning a scheme of compromise or arrangement or of
amalgamation or reconstruction or an order for the supercession of
the committee of management or other managing body of the bank
and the appointment of an administrator therefore made with the
previous sanction in writing or on the requisition of the Reserve
Bank shall not be liable to be called in question in any manner.
(v) The liquidator or the insured bank or the transferee bank, as the
case may be, shall be under an obligation to repay the corporation
as provided in Section 21 of the Act.
(c) Requisition by Reserve Bank for Winding Up: Section 130 of the
DICGC Act mentions the circumstances in which Reserve Bank
may require winding up of a co-operative bank. Such
circumstances are that:
(i) the co-operative bank has failed to comply with the
requirements as to minimum paid-up
capital and reserves specified in Section 1 ] of the Banking
Regulation Act; (ii) the co-operative bank has under Section 22 of
the Act (dealing with licence) become disentitled to carry on
banking business in India;
(iii) the co-operative bank has been prohibited from receiving fresh
deposits by an order under Section 35(4) of the Act or under
Section 42(3A)(b) of the Reserve Bank of India Act;
(iv) the co-operative bank having failed to comply with any
requirement of the Banking Regulation Act, 1949, other than the
requirements laid down in Section 11 thereof, has continued such
failure or having contravened any provisions of the Act, has
continued such contravention beyond such period or periods as

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may be specified by the Reserve Bank, after notice in writing of
such failure or contravention has been conveyed to the co-operative
bank;
(v) the co-operative bank is unable to pay its debts;
(vi) in the opinion of the Reserve Bank, a compromise or
arrangement sanctioned by a competent authority in respect of the
co-operative bank cannot be worked satisfactorily with or without
modification, or the continuance of the co-operative bank is
prejudicial to the interests of its depositors.
A co-operative bank, shall be deemed to be unable to pay its debts
if, (i) on the basis of the returns, statements or information
furnished to the Reserve Bank under or in pursuance of the
provisions of the Banking Regulation Act, the Reserve Bank is of
opinion that the co-operative bank is unable to pay its debts, (ii) if
the co-operative bank has refused to meet any lawful demand made
at any of its offices or branches within two working days, if such
demand is made at a place where there is an office, branch or
agency of the Reserve Bank, or within five working days if such
demand is made elsewhere and, in either case, the Reserve Bank
certifies in writing that the co-operative bank is unable to pay its
debts
5.8 LET US SUM UP
1. The public sector banks, namely, State Bank and its subsidiaries,
the Nationalised banks and the regional rural banks are statutory
corporations (or body corporate) established under special
statutes. State Bank and its subsidiaries, as Nationalised banks, are
commercial banks engaged in the business of banking and other
forms of business permissible for banking companies. The regional

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rural banks are also commercial banks but operating in limited
local areas to cater to rural industries,
71
trade, farmers, artisans, etc. The State Bank and its subsidiaries
and the Nationalised banks also act as agents of the Reserve Bank
to transact the banking business of the Central Government. All
public sector banks are governed by their respective, statutes and
the rules, regulations or schemes made under these statutes. In
addition to this, these banks are also governed by certain
provisions of the Banking Regulation Act as stipulated in Section 51
of that Act. The provisions of the Reserve Bank of India Act are also
applicable to them.
2. The co-operative banks, functioning in one state only are
registered under the state laws on co-operative societies. The cooperative banks operating in more than one state, are registered
under the multi-state Co-operative Societies Act. The Banking
Regulation Act is applicable to co-operative banks as provided in
Section 56 of that Act with certain modifications. For this purpose,
a co-operative bank means a state co-operative bank, Central cooperative bank and a primary co-operative bank. While, the
constitution of the bank is governed by the co¬operative laws, the
business of banking undertaken by them is regulated by the
Reserve Bank under the BR Act.
5.9 KEYWORDS
Nationalised Bank; Subsidiary Bank; Primary Co-operative Bank;
Regional Rural Bank; Sponsor Bank; Co-operative Bank; Central

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Co-operative Bank; State Co-operative Bank; Co-operative Credit
Society.
5.10 CHECK YOUR PROGRESS
1. Fill up the blanks choosing answers from the brackets.
(i) The State Bank of India is a
constituted under the State Bank of India Act.
(ii) (iii)
in consultation with the Reserve
(banking company, body corporate, society) The Chairman of the
State Bank is appointed by.
Bank, (the Central Board, Banking Service Recruitment Board,
Central Government)
State Bank has to act as

and carry out Central Government

business and other
business entrusted by the Reserve Bank, (agent of Reserve Bank,
agent of Central Government,
advisor to the Central Government)
(iv) The provisions of the are applicable to State Bank as
stipulated in Section 51 of
_. (Reserve Bank, Central
the BR Act. (RBI Act, Banking Regulation Act, Companies Act)
(v) The majority of shares of subsidiary banks are held by
Government, State Bank)
(vi) Regional rural banks operate in

. (a notified area, the

whole of a state, only a
district)
(vii) The management of the affairs of a regional rural bank vests in
. (the Sponsor

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Bank, its board of directors, the National Bank)
2.
Say whether true or false
(i) The State Bank can make statutory regulations for carrying out
the purposes of the State
Bank of India Act, in consultation with Reserve Bank and with
previous approval of the
Central Government, (ii) The Central Government is not
authorised to give any directions to the State Bank in matters
of policy involving public interest, (iii) The provisions of Section 42
of the Reserve Bank of India Act relating to cash reserve apply
to State Bank.
(iv) Subsidiary banks do not have to maintain liquid assets under
Section 24 of the BR Act. (v) Regional rural banks may transact the
business of banking as defined in Section 5(b) of the
BR Act and also other business specified in Section 6(1) of that Act.
2. 3.
79
3.
4.
(vi) Two regional rural banks may be amalgamated by the Reserve
Bank by notification in the
gazette, (vii) The management of Nationalised Banks is governed
by the Nationalised Banks (Management

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and Miscellaneous Provisions) Schemes of 1970 and 1980.
Fill in the gaps choosing answers from the brackets.
in the Banking
(i) Unless the context otherwise requires, the reference to a
Regulation Act shall be construed as reference to a co-operative
bank, (co-operative society,
banking company, body corporate)
(ii)

in relation to a co-operative society, for the purpose of BR

Act, includes a
member of any committee or body for the time being vested with
the management of the
affairs of that society. (Director, Member, Manager) (iii) The
requirement of minimum paid-up capital and reserves for a cooperative bank to
commence or carry on banking business is

. (Rs. 1 crore, Rs. 1

lakh, Rs. 10 lakh)
(iv) There are restrictions on co-operative banks on

in other co-

operative societies
under Section 19 of the BR Act. (holding of shares, keeping
deposits, acquiring any interest) (v) Central and state co-operative
banks have to submit their returns under Section 31 of BR
Act to . (Reserve Bank and National Bank, National Bank only,
Reserve Bank only)
(vi) Under Section 23 of the BR Act, without the permission of
Reserve Bank, a
can open a new place of business within the area of its operation,
(central co-operative
bank, state co-operative bank, primary co-operative bank) (vii) Co-

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operative banks have to prepare their balance sheet and profit and
loss account in the
forms set out in the Third Schedule to

. (Banking Regulation Act,

Reserve Bank
of India Act, State Co-operative Societies Act)
Say whether true or false.
(i) Banking Regulation Act was made applicable to co-operative
banks by the Banking Laws
(Application to Co-operative Societies) Act, 1965. (ii) A primary cooperative bank does not require licence from the Reserve Bank to
carry on
banking business, (iii) The provisions of the Banking Regulation
Act as provided in Section 56 of the Act apply to
co-operative banks, (iv) A 'Co-operative Bank' means a primary cooperative bank, central co-operative bank and a
state co-operative bank, (v) There are no restrictions under the BR
Act on lending by co-operative banks to their directors
or firms in which they are interested, (vi) A scheduled co-operative
bank has to maintain cash reserve as stipulated in Section 42 of
the Reserve Bank of India Act (as applicable to co-operative
societies).
(vii) Inspection of co-operative banks is done by the state
Government under the Co-operative Socie¬ties Act and the
Reserve Bank has no power to inspect under the Banking
Regulation Act.
5.11 ANSWERS TO CHECK YOUR PROGRESS'

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Central Government
BRAct
notified area
1.

(i)

body corporate

(ii)

(iii)

Agent of Reserve Bank

(iv)

(v)

SBI

(vii)

its board of directors

2.

(i)

(vi)
True; (ii) False; (iii) True; (iv) False; (v) True; (vi)

False; (vii) True
3.

(i)

Banking company

(iii)

Rs. 1 lakh

(ii) Director

(iv) Holding of shares

(vi) Central co-operative bank (vii) Bunking Regulation Act 4. (i)
True; (ii) False; (iii) True; (iv) True; (v) False; (vi) True; (vii) False
5.12 TERMINAL QUESTIONS
Fill in the blanks choosing answers from brackets. 1. State Bank
may act as agent of the Reserve Bank
. (for transacting only Government
business; for transacting Government business and other business
entrusted by the Reserve
Bank; only for collection of taxes)
2.
shall be the ex-officio chairman of the subsidiary banks.
(Chairman of State Bank;
Finance Secretary to Central Government; Managing Director of
the State Bank)
3.

The thrust of business of regional rural banks is to make

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loans and advances available 'in rural
areas' (only to farmers; only to small enterprises; small and
marginal formers, agricultural labourers,
artisans and small entrepreneurs in particular).
4.

Nationalised banks can undertake

(only such business

as permitted by the
Government from time to time; only such business as permitted by
the Reserve Bank in consultation with Central Government;
banking business and any other business permissible for banks
under Section 6(1) of the BR Act.
5.

The auditor of a Nationalised bank has to be

(an officer of

the Central Government
under the C&AG; an officer of the Reserve Bank; a person duly
qualified to be an auditor of a company under Section 226 of the
Companies Act.
Choose the correct statements from the following:
6.

(i) The provisions relating to licensing under Section 22 of

the BR Act are applicable to Nationalised
banks, (ii) The provisions of Section 22 of the BR Act relating to
licensing are not applicable to Nationalised
banks, (iii) The provisions relating to cancellation of licence under
Section 22 of the BR Act are applicable
to Nationalised banks.
7.

(i) All public sector banks are scheduled banks.

(ii) All regional rural banks are not scheduled banks, (iii) Some
public sector banks are not scheduled banks.
8.

(i) BR Act is not applicable to primary agricultural credit

societies.

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(ii) Primary credit societies are required to hold a licence under the
BR Act. (iii) BR Act is applicable to co-operative land development
banks (Agricultural and Rural Development Banks)
9.

(i) A co-operative bank is not eligible for insurance under

the DICGC Act.
(ii) An eligible co-operative bank under Section 2(gg) of the DICGC
Act has to be registered with the DICGC for insurance.
(iii) The registration of a co-operative bank for insurance with
DICGC cannot be cancelled even
if it converts into a non-banking co-operative society.
10. (i) Reserve Bank can direct the Registrar of co-operative
societies to wind up an insured co¬operative bank if it is unable to
pay its debts.
(ii) Reserve Bank can suo moto wind up a co-operative bank if the
bank is unable to pay its debts.
(iii) The Registrar can suo moto wind up a co-operative bank in the
circumstances mentioned in Section 13D of the DICGC Act.
MODULE -B
LEGAL ASPECTS OF BANKING OPERATIONS
Unit 6.

Case Laws on Responsibility of Paying Bank

Unit 7.Case Laws on Responsibility of Collecting Bank
Unit 8.

Indemnities

Unit 9.

Bank Guarantees

Unit 10.

Letters of Credit

Unit 11.

Deferred Payment Guarantee

Unit 12.

Laws Relating to Bill Finance

Unit 13.

Various Types of Securities

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Unit 14.

Law Relating to Securities and Modes of Charging -1

Unit 15.

Law Relating to Securities and Modes of Charging - II

Unit 16.

Different Types of Borrowers

Unit 17.

Types of Credit Facilities

Unit 18.

Secured and Unsecured Loans, Registration of Firms,

Incorporation of Companies
Unit 19.

Registration and Satisfaction of Charges

CASE LAWS ON RESPONSIBILITY OF PAYING BANK
STRUCTURE
6.0

Objectives

6.1

Introduction

6.2

Negotiable Instruments Act and Paying Banks

6.3

Liability of Paying Banker when Customer's Signature on

Cheque is Forged
6.4

Payment to be in Due Course for Bank to Seek Protection

6.5

Payment in Good Faith, without Negligence of an

Instrument on which Alteration is not
Apparent
6.6

Payment by Bank Under Mistake Whether Recoverable

6.7

Let Us Sum Up

6.8

Keywords

6.9

Check Your Progress

6.10

Answers to 'Check Your Progress'

' L.K.A.D-7

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84
6.0

OBJECTIVES

After studying this unit, you should be able to:

explain the various laws applicable to a paying bank;

explain the responsibilities of a paying bank based on case

laws;

explain the protection given under law to a paying bank as

decided by Courts.
6.1

INTRODUCTION

The Negotiable Instruments Act, 1881 lays down the law relating to
payment of a customer's cheque by a banker and the protection
available to a banker. The relationship between a banker and
customer being debtor-creditor relationship the banker is bound to
pay the cheques drawn by his customer. This duty on the part of
the banker, to honour his customers' mandate, is laid down in
Section 31 of the Negotiable Instruments Act.
Sections 10, 85, 85A, 89 and 128 of the Negotiable Instruments
Act, 1881, grant protection to a paying banker. We shall in detail,
examine individually these sections and with the help of case laws
apply the provisions of these sections to a given set of facts.
6.2

NEGOTIABLE INSTRUMENTS ACT AND PAYING BANKS

As stated in Part 1.1 of this unit, the customer who has deposited
money with a bank being a creditor has the right to ask back the
money from the banker who is a debtor. The duty on the part of the
banker to pay has been laid down in Section 31 of the Negotiable
Instruments Act, 1881 in the following terms:
'The drawee of a cheque having sufficient funds of the drawer in his
hands properly applicable to the payment of such cheque must pay

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the cheque when duly required to do so, and, in default of such
payment, must compensate the drawer for any loss or damage
caused by such default.'
The following points are important to note:
i. Section 31 Applies Only to Bankers: This is because as per Section
6 of the Negotiable Instruments
Act, 1881 'cheque' has been defined as a "bill of exchange drawn on
a specified banker and not
expressed to be payable otherwise than on demand'", ii. Sufficient
Funds: The banker should have sufficient funds of the drawer, i.e.
there should be
sufficient credit balance in the customer's account, iii. Properly
Available: The funds available in the customer's account should
also be properly available
for the payment of the cheque. The funds may not be available to
pay the cheque if:
(a)

the banker has exercised his right of set off for amounts due

from the customer, or
(b)

there is an order passed by a Court, competent authority or

other lawful authority restraining
the bank from making payment.
iv. When Duly Required to Do So: The banker is duty bound to pay
the cheque only when he is duly required to do so. It means that
the cheque must be properly drawn and signed by the drawer.
v. Compensate the Drawer: In case the banker refuses payment
wrongfully, then he is liable only to the drawer of the cheque and
not to any endorsee or holder, except when
(a)

the bank is wound up, in which case the holder becomes a

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creditor entitled to make a claim;
(b)

the banker pays a cheque disregarding the crossing, wherein

the true owner can hold the
banker liable.
vi. Loss or Damage Caused by Default: A banker is liable to the
drawer for any loss or damage, which may have occurred to the
drawer due to the wrongful dishonour of the customer's cheque.
85
Protection to paying banker: For a paying banker to claim
protection under the Negotiable Instruments Act, one of the
criteria he has to satisfy, is that the payment is in due course. As to
what is, payment in due course has been stated in Section 10,
which reads as follows:
Payment in due course: 'Payment in due course' means payment in
accordance with the apparent tenor of the instrument in good faith
and without negligence to any person in possession thereof under
circumstances which does not afford a reasonable ground for
believing that he is not entitled to receive payment of the amount
therein mentioned.
From the above definition, it can be seen that payment in due
course requires the payment to be made
(a)

in accordance with the apparent tenor of the instrument;

(b)

in good faith;

(c)

without negligence;

(d)

to the person in possession of the instrument; and

(e)

while making payment the banker should not have reasons

to 'believe' that the person in possession

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of the instrument is not entitled to receive payment of the amount
mentioned in the instrument.
Section 85 of the Negotiable Instruments Act, 1881 grants
protection to a banker on his making payment of a cheque. Though
this principle may sound as a simple logic, it is to be noted that the
protection granted as per Section 85 is not absolute.
Section 85 of the Negotiable Instruments Act, 1881 can be
explained as follows:
1.

Where a cheque payable to order purports to be endorsed by

or on behalf of the payee, the drawee
is discharged by payment in due course.
2.

Where a cheque is originally expressed to be payable to

bearer, the drawee is discharged by payment
in due course to the bearer thereof, notwithstanding any
endorsement whether in full or in blank
appearing thereon, and notwithstanding that any such
endorsement purports to restrict or exclude
further negotiation.
Section 89 of the Negotiable Instruments Act states the effect of
making payment on instrument on which alteration is not apparent
and reads as follows:
Section 89
Payment of instrument on which alteration is not apparent: Where
a promissory note, bill of exchange or a cheque has been materially
altered but does not appear to have been so altered, or where a
cheque is presented for payment which does not at the time of
presentation appear to be crossed or to have had a crossing which
has been obliterated, payment thereof by a person or banker liable

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to pay, and paying the sum according to the apparent tenor thereof
at the time of payment and otherwise in due course, shall discharge
such person or banker from all liability thereon, and such payment
shall not be questioned by reason of the instrument having been
altered or the cheque crossed.
6.3 LIABILITY OF PAYING BANKER WHEN CUSTOMER'S
SIGNATURE ON THE CHEQUE IS FORGED
Section 128
Where the banker on whom a crossed cheque is drawn has paid the
same in due course, the banker paying cheque, and in case such
cheque has come to the hands of the payee the drawer thereof, shall
respectively be entitled to the same rights, and be placed in the
same position in all respects as they would respectively be entitled
to and placed in if the amount of the cheque, has heen pair! tn and
received by the true owner thereof.
i. When the customer's signature on the cheque is forged there is
no mandate to the hank tn
86
pay. As such a banker is not entitled to debit the customer's
account on such forged cheque: Canara Bank vs Canara Sales
Corporation and Others [(1987) 2 Supreme Court Cases 666]: The
company had a current account with the bank which was operated
by the company's Managing Director. The Company's accountant
in whose custody the cheque book was, forged the signature of the
Managing Director in forty-two cheques totalling Rs. 3,26,047.92
over a period of time. This was detected by another accountant.
The company immediately on detection of the fraud demanded the

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amount from the bank. The bank refused payment and therefore
the company filed a suit against the bank. The bank lost the suit
and took the matter up to the Supreme Court. The Supreme Court
dismissed the appeal of the bank and held that:
"Since, the relationship between the customer and the bank is that
of a creditor and debtor, the bank had no authority to make
payment of a cheque containing a forged signature. The bank
would be acting against the law in debiting the customer with the
amount of the forged cheque, as there would be no mandate on the
bank to pay. The Supreme Court pointed out that the document in
the cheque form on which the customer's name as drawer was
forged was a mere nullity. The bank would succeed only when it
would establish adoption or estoppel."
In deciding the case, the Supreme Court relied on its earlier
judgement in Bihta Co-operative Development and Cane Marketing
Union Ltd. vs Bank of Bihar (AIR 1967 Supreme Court 389).
ii. In a joint account if one of the signatures is forged then there is
no mandate and banker cannot make payment: The case law in this
case is of Bihta Co-operative Development and Cane Marketing
Union Ltd. vs Bank of Bihar: The Co-operative Marketing Union
had an account with the bank, which was authorised to be operated
by the joint secretary and treasurer of the Co-operative Marketing
Union. On 16 April 1948, the bank made payment of Rs. 11,000 on
a loose leaf cheque and not on a cheque from the cheque book
issued to the Society. Though the two signatures appeared on the
cheque, one of them, the signature of the Joint Secretary was
forged. The bank made payment, whereupon the Co-operative
Marketing Union sued the bank for recovery of the money. Though

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the bank admitted negligence on its part, it argued that the
employees of the Co-operative Marketing Union were dishonest in
the discharge of their duties and as such it cannot succeed. The
matter went up to the Supreme Court and the Supreme Court,
while allowing the case of the Co-operative Marketing Union held
that 'one of the signatures was forged so that there never was any
mandate by the customer at all to the banker and the question of
negligence of the customer in between the signature and the
presentation of the cheque never arose.'
6.4 PAYMENT TO BE IN DUE COURSE FOR BANK TO SEEK
PROTECTION
i. The Supreme Court in Bank of Bihar vs Mahabir Lai (AIR 1964
Supreme Court 397) held that a banker can seek protection under
Section 85 only where payment has been made to the holder, his
servant or agent, i.e. payment must be made in due course.
In this case, the bank had agreed to grant the firm a cash credit
facility against the pledge of cloth bales, on the firm fulfilling
certain conditions, one of which, was that the money for
purchasing the cloth would not be directly given to the firm, but
instead, the supplier would be paid the amount by the bank and the
cloth bales would be kept by the bank as pledge for the loan. The
firm thereafter was required to draw a cheque on itself which was
handed over to the bank. The bank instead of handing over cash to
the firm's partner to be paid over to the wholesalers, entrusted it
with one of the bank's employees (Potdar) who accompanied the
partner to the wholesalers. However, before the rnoney could be
paid to the wholesalers the Potdar absconded. The bank

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87
sought repayment of the money, which was refused by the firm.
The bank therefore sued the firm for the money relying on Sections
85 and 118 of the Negotiable Instruments Act, 1881. The matter
reached the Supreme Court and it was held that, before the
provisions of Section 85 can assist the bank it had to be established
that payment had in fact, been made to the firm or to a person on
behalf of the firm. Payment to a person who had nothing to do with
the firm or a payment to an agent of the bank would not be a
payment to the firm.
ii. The Calcutta High Court had occasion to consider as to whether
a bank had made payment in due course or not in the case of
Bhutoria Trading Company (BTC) vs Allahabad Bank (AIR 1977
Cal. 363) the facts of which are as follows:
BTC, a limited company, had sold some jute to WFD another
limited company, for payment of which WFD issued an un-crossed
cheque payable to BTC or order which was delivered to one of the
officials of BTC. The official using the company's seal endorsed the
cheque as manager and encashed it over the counter. BTC later
sued the bank for recovery of the money on the grounds of
damages or in the alternative on the grounds of money had and
received by the bank. The Court held that:
'The Expression payment in due course has been defined in Section
10 of the Negotiable Instruments Act to mean payment in
accordance with the apparent tenor of the instrument in good faith
and without negligence to any person in possession thereof, under
circumstances which do not afford reasonable ground for believing
that he is not entitled to receive payment of the amount therein

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mentioned. It can hardly be questioned that the payment by the
defendant bank of the cheque in question has been made by the
defendant bank in accordance with its apparent tenor. The cheque
is an un-crossed cheque payable to the plaintiff or order. The
cheque was endorsed by the plaintiff through its Manager. The fact
that Jethmall is the Manager is borne out by the seal of the
company which is unquestionably an authentic seal. The seal of the
Manager is also equally authentic. That the payment was made in
good faith has not been disputed for all practical purposes. There is
not a grain of evidence before the Court from which it remotely
appears that the payment was not made in good faith. Now that the
entire evidence is before the Court, the question of onus to prove
good faith loses much of its importance. No negligence has been
proved against the bank. The defendant bank insisted on
identification of Jethmall and Jethmall was, in fact, identified by
Kishanlal Maheswari, a constituent of the bank, the defendant No.
3. The defendant bank therefore took all reasonable precautions
even though the circumstances in which the cheque was presented
for payment did not afford any reasonable ground for believing
that Jethmall was not entitled to receive payment of the amount
mentioned therein. The plaintiff having failed to prove the trade
practice which he alleged and the bank having paid the cheque, in
accordance with the apparent tenor of the instrument, in good
faith, and without negligence, to Jethmall who was in possession
thereof, the defendant is entitled to succeed. There were no
circumstances which afforded any reasonable ground for believing
that he was not entitled to receive payment of the cheque. It must
be held that the bank made the payment in due course. The learned

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Judge, in our opinion has rightly pointed out that payment in due
course is necessarily payment in the ordinary course.
iii. Whether payment made by a bank was payment in due course
would depend on the facts of a given case. In Madras Provincial Cooperative Bank Ltd. vs Official Liquidator, South Indian Match
Factory Ltd. (AIR 1945 Mad 30) the Court held that payment to a
liquidator against the cheque presented across the counter was not
a payment in due course and the bank was not entitled to seek
protection under Section 85 of the Negotiable Instruments Act.
In this case the Official Liquidator of the Company had sold certain
properties of the company, for which payment was made by the
purchaser by giving a cheque in favour of the liquidator. The
liquidator presented the cheque over the counter and obtained
payment in cash which he
88
!!
misappropriated. He was later prosecuted and convicted and
removed from office. His successor proceeded against the bank for
recovery of the amount on the ground that the bank was negligent
and the amount was wrongly paid. The Court held that under
Section 244A of the Indian Companies Act, 1913, an official
liquidator was required to open an account with a bank and pay
therein moneys received by him in the course of the liquidation.
Rule 66 of the Rules framed by the Madras High Court under the
Act required that all bills and other securities payable to the

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company or to the liquidator should, unless the judge otherwise
directs, shall as soon as they came into the hands of the liquidator,
be deposited by him in the bank. From the cheque itself the bank
had noticed that it was payable to the liquidator in his official
capacity. That the bank realised this in full was shown by the fact
that it called for the order of his appointment. The learned judge
therefore concluded:
We have no doubt that the officers of the bank did not realise, as
they should have done, that the bank was doing something
improper, but in the circumstances there was negligence. They
knew or must have deemed to have known that this money could
only be collected by the payee through his own bank and therefore
it was most improper on his part to ask for payment over the
drawee's counter. In our judgement there was a clear breach of a
statutory duty placed upon the bank and the learned judge was
right in holding the bank liable.
6.5 PAYMENT IN GOOD FAITH WITHOUT NEGLIGENCE OF
AN INSTRUMENT ON WHICH ALTERATION IS NOT
APPARENT
i. The effect of Sections 10 and 89, and Section 31 was considered
by the Supreme Court in Bank of Maharashtra vs M/s Automotive
Engineering Co. (1993) 2 SCC 97.
The question, which arose for consideration in this appeal, was
whether the paying bank was bound to keep an ultraviolet ray lamp
and to scrutinise the cheque under the said lamp even if no
infirmity on the face of the said cheque on visual scrutiny was
found.
Briefly stated, the respondent, a partnership firm, opened a current

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account with the Wagle Industrial Estate branch of the appellant
bank. The said branch was in the industrial area on the outskirts of
City of Bombay, where forgery of cheques were rampant and
although other branches of the appellant bank were provided with
ultraviolet ray lamps, the said branch was not provided with such
lamp. On 26 May 1967, one Shri Shah, as a proprietor of Messrs
Imperial Tube and Hardware Mart, opened an account, in the
name of his firm, with a branch of the Union Bank of India.
Shri Shah presented a cheque dated 29 May 1967 for Rs. 6,500 in
favour of his firm to Union Bank of India. On presentation of the
cheque through clearing, the appellant bank passed the cheque and
debited the amount to the account of the respondent. Later on, on
receipt of the objection from the respondent-defendant, the said
cheque was examined under the ultraviolet ray lamp when it
transpired that the original cheque was issued in favour of Shri
G.R. Pardawala and the amount of the said cheque was Rs. 95.98.
The writing on the cheque was chemically altered with regard to
date, the name of the payee and also the amount. The respondent
made demands to the appellant bank to credit the amount to its
account.
The appellant bank filed a suit in which the agent of the appellant
bank was examined, who stated that before passing the said cheque
for payment he had checked the serial number and date of the
cheque and had compared the signature of the respondent with the
specimen signature and that from visual appearance of the cheque
no infirmity was noted by him and from the tenor of the cheque it
appeared to be a genuine one.
The Trial Court dismissed the suit on the ground that by not

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providing the facility of ultraviolet ray lamp, the appellant bank
had failed to discharge proper care and, therefore, did not pass the
said cheque with the due diligence.
89
On appeal, the District Judge, while agreeing that no abnormal
features to suspect the genuineness of the cheque could be found
on visual inspection of the cheque, was of the view that the
appellant bank was not entitled to protection for the lapse in
subjecting the said cheque for scrutiny under the ultraviolet ray
lamp.
On further appeal, the High Court of Bombay, while accepting the
finding that the cheque in question apparently did not show any
sign of alteration, held that the appellant bank did not act with
proper care and caution in not providing necessary device for
detecting forged cheques. Since the absence of such a lamp
amounted to negligence on the part of the appellant bank, no
protection was available because payment was not made in due
course.
The appellant bank preferred this appeal to the Supreme Court.
The Supreme Court allowed the appeal of the bank on the following
grounds:
(i) Section 89 of the Negotiable Instruments Act gives protection to
the paying banker of a cheque which has been materially altered
but does not appear to have been so altered, if payment was made
according to the apparent tenor thereof at the time of payment and
otherwise in due course.
(ii) Section 10 of the said Act defines payment in due course to

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mean payment in accordance with the apparent tenor of the
instrument in good faith and without negligence to any person in
possession thereof under circumstances which do not afford a
reasonable ground for believing that he is not entitled to receive
payment of the amount therein mentioned.
(iii) Section 31 of the said Act obliges the drawee bank having
sufficient funds of the drawer in its hands properly applicable to
the payment of such cheque to make payment of the cheque when
duly required to do so.
(iv) On analysing the evidence, the Courts below have held that on
visual examination no sign of forgery or tampering with the
writings on the cheque could be detected. It was found that the
agent of the appellant bank had verified the serial number and
signature on the cheque and had compared the signature on the
cheque with the specimen signature of the respondent and on
scrutiny of the cheque visually, no defects could be detected by
him. There were sufficient funds of the drawer with the appellant
bank, which had no occasion to doubt about the genuineness of the
cheque from the apparent tenor of the instrument. There was no
evidence to hold that, the payment was not made in good faith.
Simply, because the ultraviolet ray lamp was not kept in the branch
and the said cheque was not subjected to such lamp would not be
sufficient to hold the appellant bank guilty of negligence, more so
when it has not been established on evidence that the other
branches of the appellant bank or the other commercial banks had
been following a practice of scrutinising each and every cheque or
cheques involving a particular amount under such lamp by way of
extra precaution.

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(v) In such circumstances, it is not a correct legal proposition that
the bank, in order to get absolved from the liability of negligence,
was under an obligation to verify the cheque for further scrutiny
under advanced technology or for that matter, under ultraviolet ray
lamp, apart from visual scrutiny even though the cost of such
scrutiny was only nominal and it might be desirable to keep such
lamp at the branch to take aid in appropriate case.
(vi) The Courts below were not justified in holding that the bank
had failed to take reasonable care in passing the cheque for
payment without subjecting it to further scrutiny under ultraviolet
ray lamp because the branch was in the industrial area where such
forgery was rampant and other branches of the appellant bank
were provided with such lamp.
The appeal was, therefore, allowed and the Suit of the appellant
bank was decreed only for the principal amount without any
interest on the same.
ii. The protection granted to a banker under Section 89 had come
up for consideration before the Calcutta High Court in Brahma
Shumshere Jung Bahadur vs Chartered Bank of India, Australia
and China (AIR 1956 Cal. 399):
90
In this case B who was a member of the royal family of Nepal had
an overdraft account with the bank, for which certain securities
were deposited with the bank. The overdraft limit was not a fixed
limit and fluctuated depending on the securities deposited. In April
1946, B requested the bank to enhance the overdraft limit which
however, was not agreed to by the bank and the limit was Rs.

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70,000. In July 1946, B sent a cheque by post, drawn on the
overdraft account which was intercepted in the mail and the
amount was raised from Rs. 256 to Rs 2,34,081. The cheque was
put for collection in another bank which was paid by B's bank. B on
coming to know about the forgery, sued both the paying and
collecting bank, contending that though the cheque was signed by
him it was written out by some other person and as such it should
have aroused the suspicion of the bank. The Court, however, held
that since no alteration or obliteration was visible at the time of
payment, the payment was made according to the apparent tenor
at the cheque. Further since B had on other occasions also issued
cheque signed by him and written by others, the bank's suspicion
could not have aroused. The Court also held that the words 'liable
to pay' appearing in the third paragraph of Section 89 included a
liability to pay under an overdraft agreement as much as it applied
to an ordinary deposit account.
As regards exceeding the overdraft limit, the Court held that no
definite limit was fixed at any time and it fluctuated according to
the securities deposited by B. In this case the collecting bank was
liable for other reasons for which we shall see in the next unit.
iii. In the case of Tanjore Permanent Bank vs S.R. Rangachari (AIR
1959 Madras 119) the High Court was called upon to decide a case
in which cheque was materially altered and the bank sought
protection under Section 89. In this case R had an overdraft
account with the bank and requested the Manager to advance him
Rs. 16,000 to the debit of his account. The Manager asked R to
send him three blank cheques signed.
R accordingly did the same. However, of the three cheques only

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one was utilised for the payment of Rs. 16,000. The other two
cheques were alleged to have been filled by the accountant of the
bank for Rs. 7,600 and Rs. 4,200 and the names of two clerks were
written as the payees. In both the cheques the alterations were
apparent and visible but the bank paid these cheques. On R not
clearing the debit because of his overdraft account, the bank sued
him. R contended that the two debit entries for Rs. 7,600 and
4,200 were made by the bank wrongly and as such he cannot be
held liable.
The Court held that since the material alteration on both the
cheques were visible and since they were not authenticated by the
drawer's initials, the payment made by the bank was not according
to the apparent tenor of the instrument and as such the bank
cannot claim protection under Section 89 of the Negotiable
Instruments Act. The Court in coming to the above conclusion
relied on the following paragraph of Bhashyam and Adiga's
Negotiable Instruments Act:
The bank has also to see whether there are any alterations in the
cheque and whether they have been properly authenticated.
Therefore, where an alteration in a cheque is initialled not by all
the drawers but only some of them, the bank will be paying the
amount on the said cheque at its own risk. In this connection it is
necessary to notice that under Section 89 protection is afforded to
the bank paying a cheque where the alteration is not apparent.
It is to be noted that as per Section 89, the bank can seek
protection only if there is no material alteration in the cheque and
does not appear to have been altered. This, however, does not
protect a banker in case the signature of the customer is forged. As

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stated earlier a forged cheque is no mandate of the customer and as
such the bank cannot make payment on a cheque where the
signature of the customer is forged. The question whether a
signature is forged or not depends on the evidence and the court in
coming to a conclusion that the signature is forged would look into
the facts and circumstances that led to the payment of the cheque.
91
iv. Bareilly Bank Ltd. vs Naval Kishore (AIR 1964 All 78): N opened
an account with the bank by making a cash deposit of Rs. 19,900. N
was issued a cheque book containing 25 cheques. 17 months after
the opening of the account N drew a cheque for the first time for
Rs. 5,900 which was dishonoured by the bank. On enquiries N was
informed that 11 months back three cheques aggregating Rs.
19,500 were paid by the bank and the present balance in the
account was a mere Rs. 437. N denied issuing of the cheques and
sued the bank.
In evidence it came out that 3 cheques used to withdraw the
amounts were not from the cheque book issued to N and were from
a different cheque book. Though bank was not in a position to
explain this lapse, they made an attempt to counter the contentions
of N by producing his specimen signature which appeared to be
similar to the ones on the cheques. N however denied that the
specimen signature was his and the Court concluded that the
alleged specimen signature were totally different from N's regular
signature. Evidence also was led to show that the bank's own
employees were involved in the forgery since the ledger page of N's
account showed that certain erasures and scorings were made and

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the signature of N missing in the cheque book issue register.
Therefore the Court refused to accept the bank's contention.
6.6 PAYMENT BY BANK UNDER MISTAKE WHETHER
RECOVERABLE
The question whether a bank paying a forged cheque can recover
the same from the payee was considered by the Calcutta High
Court in United Bank of India vs AT Ali Hussain & Co. (AIR 1978
Calcutta 169).
In this case, a cheque for Rs. 5,000, purportedly drawn by a
company was presented by the collecting bank to the paying bank,
and was paid. The signature as well as all other writings on the
cheque were forged. The forgery was so perfect that it was not
possible even for a trained eye to detect it. The paying bank, having
subsequently come to know of the forgery, filed a suit against the
collecting bank and the payee of the cheque, for recovery of the
amount paid, on the ground of payment under mistake. Defending
the suit, the collecting bank contended that it received the cheque
in the ordinary course of its business, and presented the same for
encashment in good faith. The payee contended, that he received
the cheque from some persons claiming to be representatives of a
company, in the ordinary course of business, towards payment of
the price of the goods to be supplied by him, that he acted in good
faith, having no reason to suspect that the cheque was forged, and
that he parted with the goods only on receipt of intimation from
the collecting bank that the cheque had been encashed.
The Trial Court having dismissed the suit on the ground that the
paying bank had no cause of action, an appeal was preferred to the
High Court.

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Decision: The High Court dismissed the appeal and held that both
from the point of view of equitable principles and the doctrine of
estoppel, the paying bank was disentitled to recover the money
either from the collecting bank or the payee. In the course of his
judgement, M.M. Dutt. J. said:
The evidence on record supports the findings of the learned Judge
that the forgery was so accurate that it was not possible even to a
trained eye to detect the same. In these circumstances, it is difficult
to hold that the plaintiff bank had acted carelessly or negligently.
The encashment was made by the plaintiff bank on the mistaken
belief that the cheque was a genuine one. The defendant United
Bank had nothing to do with the question as to whether the cheque
was genuine or forged. In due course of business, it presented the
cheque to the plaintiff bank for collection and after the cheque was
encashed, intimation was given by it to its constituent, namely, the
defendant No.l, and the latter, in its turn, sold goods to the persons
who came with the forged cheque as the representatives of the
Metal Alloy Co. Thus, it appears that the parties in the suit acted in
good faith in due course of business. It was due to
92
the mistake that was committed by the plaintiff bank that it had to
suffer the loss of the said sum of Rs. 5,200. Upon the consideration
of the principles of law as noticed above, it seems to us that so long
as the status quo is maintained and the payee has not changed his
position to his detriment, he must repay the money back to the
payer. If, however, there has been a change in the position of the
payee who, acting in good faith, parts with money to another

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without any benefit to himself before the mistake is detected, he
cannot be held liable. Equity disfavours unjust enrichment. When
there is no question of unjust enrichment of the payee by reaping
the benefit of an accidental windfall he should not be made to
suffer, for he would be as innocent as the payer who paid the
money acting under a mistake.
6.7

LET US SUM UP

The Negotiable Instruments Act, 1881 lays down the law relating to
the payment of a customer's cheque and the protection that is
available to a banker making payment of a cheque in due course.
Sections 10, 85, 85A, 89 and 128 of the Act deal with the protection
available to a banker whereas Section 31 lays down the condition as
to when a bank has to make payment on a cheque drawn by the
customer. The banker on making the payment in due course is
entitled to seek protection provided the cheque has not been
altered or the alteration, if altered, is not apparent. However, the
banker does not get protection, if signature of the customer is
forged
6.8

KEYWORDS

Apparent Tenor of the Instrument; Material Alteration.
6.9

CHECK YOUR PROGRESS

1. State whether true or false.
(i) The law relating to the payment of cheques and protection to a
banker is contained in the
Indian Contract Act. (ii) The responsibility of a banker to pay back
the money of the customer specifically stated in
the Negotiable Instruments Act, 1881.
(iii) Section 31 of the Negotiable Instruments Act applies only to

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the banker, (iv) The banker is first bound to honour a customer
cheque and only thereafter exercise his
right of set off.
(v) A forged signature is no mandate of the customer, (vi) A
customer is bound to inform the bank about lost cheque leaves,
(vii) In a joint account if one of the signatures is forged, the bank
and the customer are equally
liable, (viii) Payment to be made in due course need not always be
made to holder but can be made to
his agent or servant, (ix) In case bank makes payment by mistake it
can recover the same even if the payee has
changed his position, (x) If a bank makes payment without
checking the instrument under an ultraviolet lamp, it can
be held liable on the grounds of negligence.
6.10

ANSWERS TO 'CHECK YOUR PROGRESS'

1. (i) False; (ii) True; (iii) True; (iv) False; (v) True; (vi) False; (vii)
False; (viii) True; (ix) False; (x) False
I
Rs.
;as >ay ho,
:is of ide
UNIT
7
CASE LAWS ON RESPONSIBILITY OF COLLECTING BANK

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r's se. ;as he he
lOt

STRUCTURE
7.0

Objectives

7.1

Introduction

7.2

Statutory Protection to Collecting Bank

7.3

Duties of the Collecting Bank

7.4

Let Us Sum Up

7.5

Keywords

7.6

Check Your Progress

7.7

Answers to 'Check Your Progress'

94
7.0

OBJECTIVES

After studying this unit you should be able to understand:

the duties of a collecting banker when opening an account

and collecting cheques in the account;

the protection granted under the Negotiable Instruments

Act to a banker collecting a cheque.
7.1

INTRODUCTION

In the earlier unit, we had studied the duties imposed on a paying
banker under the Negotiable Instruments Act and the protection

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granted to him. In this unit, we will be studying the duties of a
collecting banker that has been imposed, more by the practice
adopted by bankers over a period rather than by law. We shall also
be studying the protection available to a collecting banker which is
granted by certain provisions under the Negotiable Instruments
Act. Before we delve into the subject, it would be worth trying to
understand who a collecting bank is by an illustration.
Illustration
Ram has an account with Ideal Bank Ltd. The bank has issued a
cheque book to Ram to withdraw money from the account. Ram
owes Rs. 400 to Shyam and to repay this amount, Ram draws
(issues) a cheque in favour of Shyam. Shyam has two ways to
obtain payment of the cheque. He can go straight to the Ram's
bank (Ideal Bank Ltd.) and collect cash against the cheque if it is
not crossed or he can deposit the cheque in his account with his
banker, who would send the same to Ram's banker (Ideal Bank
Ltd.) and collect the amount. Here, Shyam's banker is the
collecting bank and Ram's bank, i.e. Ideal Bank Ltd. is the paying
bank. If in the above illustration, Ram were to post the cheque to
Shyam and the same were stolen by X in transit and X were to open
an account in the name of Shyam and collect the cheque, the bank
that opened the account of X to collect the proceeds of the cheque
would be the collecting bank.
7.2

STATUTORY PROTECTION TO COLLECTING BANK

Section 131 of the Negotiable Instruments Act grants protection to
a collecting banker and reads as follows:
Section 131
i. Non-liability of a Banker Receiving Payment of Cheque: A

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banker, who has, in good faith and without negligence, received
payment for a customer of a cheque crossed generally or specially
to himself shall not, in case the title to the cheque proves defective,
incur any liability to the true owner of the cheque by reason only of
having received such payment.
Explanation: A banker receives payment of a crossed cheque for a
customer within the meaning of this section notwithstanding that
he credits his customer's account with the amount of the cheque
before receiving payment thereof.
The provisions of the above section has been applied to drafts as
per Section 131A of the Negotiable Instruments Act.
ii. Conditions for Protection: Though Section 131 grants protection
to a collecting banker, the protection is conditional. For the
collecting banker to claim the protection under Section 131 he has
to comply with certain conditions and they are:
1.

The collecting banker should have acted in good faith.

2.

He should have acted without negligence.

3.

He should receive payment for a customer.

4.

The cheque should be crossed generally or specially to

himself.

I
95
7.3 DUTIES OF THE COLLECTING BANK
Since no specific enactment has been laid down prescribing the
nature of duties a banker will have to observe while acting as a

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collecting banker, Section 131 of the Negotiable Instruments Act,
which affords protection to the collecting bank requires amongst
other conditions that the bank should not have been negligent. To
show that the bank has not been negligent the bank will have to
prove that it has taken all precautions that would be required of a
prudent banker in collecting a cheque. Over the years based on
practice and judicial pronouncements, these precautions have been
laid down as duties imposed on bankers, the non-compliance of
which can make the bank liable on the grounds of negligence. We
shall now individually examine these duties.
i. Duty to Open the Account with References and Sufficient
Documentary Proof: The duty to open an account only after the
new account holder has been properly introduced is too well
ingrained in the today's banker's mind that it would be impossible
to find an account without introduction. The necessity to obtain
introduction of a good customer is to keep off crooks and
fraudsters who may open accounts to collect forged cheques or
other instruments. As an added precaution, RBI has insisted that
while opening accounts photograph of the customer and sufficient
documentary proofs for constitution and address be obtained
under the applicable KYC norms.
In this regard, the English Decision Ladbroke vs Todd (1914) 30
TLR 433 can be referred to. In this case, a thief stole a cheque in
transit and collected the same through a bank, where he had
opened an account without reference and by posing himself as the
payee whose signature the thief forged. After collection of the
cheque, the thief withdrew the amount. The bank was held liable to
make good the amount since it acted negligently while opening the

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account inasmuch as it had not obtained any reference.
In Syndicate Bank vs Jaishree Industries and Others AIR 1994
Karnataka 315, the appellant opened an account in the name of
M/s Axle Conductor Industries Ltd. by the Proprietor, R.K. Vyas. A
person Mr Nanjunde Gowda, who was having a small shop at the
address given by the account holder, gave the introduction. The
address of the account holder, given by the account holder, was just
opposite the appellant bank. In the account opening form, the
name of the account holder was given as M/s Axle Conductor
Industries by the Proprietor R.K. Vyas. No information was sought
or inquiry neither held as to the incorporation of the account
holder nor was the memorandum of association, resolution, etc.,
scrutinised. On 3 January 1979, partners of Firm 'A' purchased a
draft for Rs. 2,51,125 from State Bank of India, Ahmednagar, in
favour of M/s Axle Conductor Industries Ltd. The draft was
deposited in the account with the appellant on 5 October 1979 and
the amount was collected by the appellant and credited to the
account on 9 October 1979. On 10 October 1979, the monies were
withdrawn from the account. The partners of 'A filed a suit against
the appellant and State Bank of India for recovery of Rs. 2,51,125
wrongly collected by appellant and paid by State Bank of India.
The High Court held that there was failure to follow the proper
procedure for opening account in the name of a limited company,
that the account was opened as if it was a proprietary concern, the
staff of the appellant bank did not bestow sufficient care even to
notice the word 'Ltd.' on several occasions, such as, at the time of
opening of the account or withdrawal of amounts from the account.
The High Court felt that having accepted the application as if it was

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an application by a proprietary concern, strangely the appellant
bank allowed the account to operate in the name of the limited
concern. There was, therefore, lack of care on the part of the
appellant bank in the entire transaction.
The conditions to be satisfied for claiming protection under Section
131 of the Negotiable Instruments Act are:
(a) that the banker should act in good faith and without negligence
in receiving payment, i.e. in the process of collection;
96
(b)

that the banker should receive payment for a customer, i.e.

act as mere agent in the collection of
the cheque, and not on his account as holder;
(c)

that the person for whom the banker acts must be his

customer;
(d)

that the cheque should be one crossed generally or specially

to himself.
The High Court stated that if the draft was drawn in favour of a
fictitious person, it could not be said that the ownership stood
transferred to a non-existent person for the purpose of examining
the question whether the bank as a collecting banker acted
negligently or not. The ownership would pass to the true owner.
The High Court did not consider it necessary to decide as to what
extent a person obtaining a draft in favour of a fictitious person
would lose the ownership in favour of a bona fide 'holder in due
course'.
In view of the aforesaid, the appellant bank was held to have acted
without taking any care, and was found negligent throughout and

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was not entitled to the protection under Section 131 of the
Negotiable Instruments Act.
In Indian Bank vs Catholic Syrian Bank AIR 1981 Mad 129, the
Madras High Court had occasion to consider negligence of the
collecting banker, which had opened an account after proper
introduction.
Briefly, the facts were that one D had opened an account with
Salem branch of bank 'A'. A customer of that branch had taken D to
the said branch and had informed the manager that D was a man
from Indore and that .he wanted to open a bank account to enable
him to purchase carpets from Salem. Although the bank A had
claimed that the customer, who had introduced D, was a wellknown customer of the bank A and was a leading merchant of
Salem and had a large volume of business, it was found in the
evidence recorded by the Court that these claims were not true. The
introducer had an account and had some fixed deposits with the
bank A. The transactions were for paltry amounts and the amount
standing to the credit of the introducer at the relevant time, was
only Rs. 192.57.
On 12 June 1969, M obtained a demand draft for Rs. 20 from the
branch at Singanallur of the bank B. The draft was drawn on the
branch office of bank B in favour of D and company. By means of a
clever forgery, the draft was altered for Rs. 29,000 drawn in favour
of D. D presented the draft on 13 June 1969 for credit to his
account opened with Salem branch of bank A and the amount was
collected by bank A from bank B and credited to the account of D.
On 14 June 1969, the Salem branch of bank B came to know from
its Singanallur branch that the draft issued for Rs. 20 and was

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drawn in favour of D and company, payable at Cochin and that no
draft for a sum of Rs. 29,000 had been issued. At once the Salem
branch of bank A was contacted and was informed of the fraud, but
unfortunately by then bank A had already paid a large part of the
draft amount to D under a self cheque.
Bank B (Paying banker) filed the suit against bank A (collecting
banker) for recovery of Rs. 29,000 on the ground that the
collecting banker had been negligent while opening an account in
the name of D and by reason of its negligence and want of good
faith, the forged draft got to be wrongly converted.
The High Court observed that the collecting banker had opened the
account in the name of D on a mere introduction of one of its
account holders, knowing fully well that the said account holder
was not a well known leading merchant and had no large business
with it at the relevant time. Further, the collecting banker had not
independently questioned D about his business and his
creditworthiness before allowing him to open an account. When D
stated that he had come from Indore, the manager of the collecting
banker did not even care to find out his permanent address, more
so, when in the application for opening account filed by D, the
address given was of that of the introducer. Moreover,
97
when D told the manager of collecting banker that he had not until
then opened any account although he had come from Indore to
Salem to do business, the collecting banker, before opening the
account, should have been more alert.
ii. Duty to Confirm the Reference where the Referee is not known

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or has given Reference in Absentia: However, as a matter of
practice, bankers in India require introduction by an existing
customer of the bank, this may not always be possible especially
when the branch is newly opened. In such cases, the customers are
required to get references from known persons in the locality or
from the existing bankers. In such case, the banker is required to
make enquiries with the referee to confirm that the person whose
account is newly opened is a genuine person. Under the current
KYC norms, the authenticity of the customer is required to be
verified by calling for a direct identification document like a copy of
passport, PAN number issued by IT department, Identity
certificate issued by Election authorities or identification issued by
the employer if the company is a prominent one. The address can
be authenticated by obtaining a copy of a electricity or Telephone
bill, or copy of ration card, or copy of any bank statement where the
customer has already an account. Only in the case of very small
customers, this requirement is waived and a third party
introduction is accepted.
In Harding vs London Joint Stock Bank [1914] 3 Legal Decision
Affecting Bankers 81, an account was opened for a new customer
after complying with the necessary formalities. The account was
not opened by deposit of cash, as is the usual practice but was
opened by paying in a third party cheque. The bankers in the case
made enquiries with the customer who thereupon produced a
forged letter issued by his employer giving him power to deal with
the cheque. It was thereafter found that the cheque was stolen by
the customer and credited to his account. The bank was held
negligent for failure to make necessary enquiries from the

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employer as to whether the customer who was an employee had, in
fact, the necessary power to deal with the cheque.
iii. Duty to Ensure Crossing and Special Crossing: It is the duty of
the banker to ensure that the cheque is crossed specifically to
himself and if the cheque is crossed to some other banker they
should refuse to collect it. Similarly, where the cheque is crossed to
a specific account then crediting the same to another account
without necessary enquiries would make him liable on the grounds
of negligence. In case of 'non-negotiable' crossing a banker cannot
be held negligent merely because of collection of such instruments.
In the case of Crumpling vs London Joint Stock Bank Ltd. [1911-13]
All England Rep 647. It was held that a non-negotiable crossing is
only one of the factors amongst others to be considered to decide
about the bankers, negligence and that the mere taking of a nonnegotiable cheque cannot be held to be evidence of negligence on
the part of the bankers.
iv. Duty to Verify the Instruments or any Apparent Defect in the
Instruments: Sometimes the instrument, which is presented for
collection would convey to the banker a warning that a customer
who has presented the instrument for collection either is
committing a breach of trust or is misappropriating the money
belonging to some other. In case the banker does not heed the
warning, which is required of a prudent banker, then he could be
held liable on the grounds of negligence as can be seen from the
following cases:
(a)

In Underwood Ltd. vs Bank of Liverpool Martin Ltd. [1924]

1 KB 775, the Managing Director
of a company paid into his private account large number of

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cheques which were to be paid into
the company's account and the bank was held negligent since it did
not make enquiries as to
whether the managing director was, in fact, entitled to the amounts
represented by these
cheques.
(b)

In Savory Company vs Llyods Bank [1932] 2 KB 122, the

cheques which were payable to the
employer was collected by the employee in a private account
opened by him and the bank was
98
held liable for negligence. In this case, two dishonest clerks of a
stock broker stole bearer cheques belonging to their employer
which were collected in an account maintained by one of the clerks
and in another account in his wife's name. It was held that the bank
had been negligent in opening the clerk's account inasmuch as they
had not obtained his employer's name while opening the account
and that in the case of his wife's account the bank was negligent
inasmuch as it had not obtained the husband's occupation and his
employer's name while opening the account.
(c)

In the case of Australia and New Zealand Bank vs Ateliers de

Constructions Electriques de
Cherleroi [1967] 1 AC 86 PC, an agent paid his principal's cheque
into his personal account
and the bank was charged with conversion. However, the bank
defended the same because
there was implied authority from the principal to his agent to use

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his private account for such
purpose. Though the banker was negligent in dealing with the
cheques without specific authority
the bank escaped liability since it was found that the principal had,
in fact, authorised his agent
to use his private account.
(d)

In Morrison vs London County and Westminster Bank Ltd.

[1914-5] All ER Rep 853, the
manager of the plaintiff was permitted to draw cheques per pro his
employer and he drew
some cheques payable to himself which he collected into his private
account. The bank was
held negligent for collecting such cheques without making
necessary enquiries even though
there was a clear indication that the manager was signing as an
agent of the firm.
v. Duty to take into Account the State of Customer's Account: The
collecting banker is required to take into account the status of the
customer and the various transactions that have taken place in the
customer's account to know the circumstances and the standard of
living of the customer. If for example, a person is an employee and
the nature of his employment is that of a clerk, his salary would be
approximately known to the bank and any substantial credits by
way of collection of cheques would be suspected and it would be
the duty of the banker to take necessary precautions while
collecting such cheques.
In Nu-Stilo Footwear Ltd. vs Lloyds Bank Ltd. [1956] 7 Legal
Decisions Affecting Bankers P. 121, the plaintiffs who were

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manufacturers of ladies footwear were defrauded by their secretary
and works accountant who converted nine cheques payable to the
plaintiffs into his account. The secretary opened the accounts in the
defendant's bank in a false name and as reference gave his real
name. The bank thereupon called the reference and got a
satisfactory reply, which included the fact that the account holder
had recently come down from Oxford and intended setting up a
business of his own. The secretary thereupon presented nine
cheques totally aggregating to £ 4855. Since these cheques were
drawn on the plaintiffs, they sued the defendant bank who had
collected the cheques. The Court held that the collecting bank was
negligent inasmuch as the collecting bank did not take necessary
precautions because the amounts collected were inconsistent with
the business of the account holder and therefore necessary
enquires should have been made by the bank.
vi. Negligence of Collecting Bank in Collecting Cheques Payable to
Third Parties: The collecting bank has to make necessary enquiries
before any third party cheques, are collected on behalf of its
customer. In Ross vs London County Westminster and Parrs Bank
Ltd. [1919] 1 KB 678, cheques payable to 'the Officer in charge,
Estate Office, Canadian Overseas Military Force' were used by an
individual to payoff his debts. There was an instruction in all the
cheques that it was negotiable by the concerned officer. However, it
was held that the fact that the cheques were drawn in favour of the
officer in charge should have put the banker on enquiry and since
no such enquiry was made by the banker the bank is liable on the
grounds of negligence.

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99
7.4 LET US SUM UP
However, the Negotiable Instruments Act does not specifically lay
down the duties of a collecting banker while collecting cheque, it
gives protection to a collecting banker under Section 131. From
Section 131, it can be deduced that a banker to claim protection
should comply with certain basic duties failing which he will not be
entitled to seek protection under Section 131. These duties are:
1.

The collecting banker should have acted in good faith.

2.

He should have acted without negligence.

3.

He should receive payment for a customer.

4.

The cheque should be crossed generally or specially to

himself.
In concluding whether the bank had been negligent or not the
following matters would be relevant and if the banker has failed to
carry out any of the following duties then he can be liable on the
grounds of negligence. These duties are:
(i)

To open the account with proper references and

documentary proof.
(ii)

To confirm the reference, where the referee is not known

and or does not come personally.
(iii)

To ensure crossing and special crossing.

(iv)

To verify the instruments or any apparent defect in the

instruments.
(v)

To take into account the state of customer's account.

(vi)

To make enquiries by the collecting bank in collecting

cheques payable to third parties.
7.5 KEYWORDS

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Conversion; Non-negotiable crossing.
7.6

CHECK YOUR PROGRESS

1. State whether true or false.
(i) The statutory protection to a collecting banker is as per Section
6 of the Indian Contract Act. (ii) Section 131A of the Negotiable
Instruments Act extends the protection granted to a banker
while receiving payment of a cheque, and drafts, (iii) The duties of
collecting bank to claim protection has been laid down under the
Indian Contract
Act and Banking Regulation Act.
(iv) In the absence of proper reference the banker can be held liable
on the grounds of negligence, (v) It is necessary for the banker to
make enquiries regarding the reference given by the customer.
7.7

ANSWERS TO 'CHECK YOUR PROGRESS'

1. (i) False; (ii) True; (iii) False; (iv) True; (v) True
L.K.A.B.8

INDEMNITIES
STRUCTURE
8.0

Objectives

8.1

Introduction

8.2

Contract of Indemnity Defined

8.3

Distinctive Features of Indemnity Contract and Guarantee

8.4

Scope and Application of Indemnity Contracts to banks

8.5

Rights of an Indemnity Holder

8.6

Let Us Sum Up

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8.7

Keywords

8.8

Check Your Progress

8.9

Answers to 'Check Your Progress'

102
8.0

OBJECTIVES

After studying this unit, you should be able to understand:

the definition and concept of indemnity;

distinctive features of an Indemnity Contract and how it

differs from a guarantee;

when and why bankers take indemnities;

know the rights of an indemnity holder;

know the liabilities of the indemnifier.

8.1

INTRODUCTION

The word indemnity means 'to save from loss'. This loss could be
either due to the act of the party giving the indemnity or due to the
act of a third party. The law regarding indemnity as laid down in
Sections 124 and 125 of the Indian Contract Acts, is not exhaustive.
The law of indemnity is much wider than as stated in the Contract
Act, since Courts applying the principles of equity have developed
it. A Contract of Indemnity is a contingent contract, i.e. its
performance is made dependent upon the happening or nonhappening of some event.
8.2 CONTRACT OF INDEMNITY DEFINED
Section 124 of the Indian Contract Act, 1872 defines contract of
indemnity as follows:
Sectionl24. 'Contract of Indemnity' defined: A contract by which
one party promises to save the other from loss caused to him by the

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conduct of the promisor himself or by the conduct of any other
person, is called a 'Contract of Indemnity'.
Section also gives an illustration of a Contract of Indemnity as
follows:
A contract to Indemnify B against the consequences of any
proceedings which C may take against B in respect of a certain sum
of Rs. 200, is called a contract of Indemnity.
In the above definition, the person giving the promise is called the
indemnifier and the person to whom the promise is made is called
the indemnified or the indemnity holder. As stated, earlier the
contract of indemnity as defined in the contract is narrow and not
exhaustive and the law regarding indemnity is much wider than
that as defined in the Contract Act. For example, all insurance
contracts come within the ambit of a contract of indemnity, but are
not dealt with under Section 124 of the Contract Act. Section 124
deals only with one particular type of indemnity, viz., where a
person gives a promise to save another person from loss caused by
either the conduct of the person giving the promise or by the
conduct of any other person. Over and above the kind of indemnity
stated in Section 124, there are cases where the Courts applying the
principles of general law have held a person liable to indemnify,
though the person never did undertake such a liability. The
decision of the Privy Council in Secretary of State vs Bank of India
Ltd. (AIR 1938 PC 191) best illustrates this point. In this case, Ms.
G was the holder of a Government promissory note which she had
handed over to Mr. A, her broker. Mr. A forged Ms. G's signature
and endorsed it in his favour. Mr. A then endorsed it for value to
the bank. The bank in good faith applied to the Government Public

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Debt Office to have the note exchanged in their name, which was
done. Ms. G on being aware that she has been defrauded, sued the
Government and recovered the appropriate damages. The
Government in turn sued the bank to indemnify the Government
against the loss suffered by them. The Court held the bank to be
liable because under common law covering right of indemnity, the
bank is responsible for an injury to a third party's rights.
A contract of indemnity, though similar to a contract of guarantee
differs on various counts. To know the difference between these
two types of contracts we shall examine their respective features
one by one in the next part.
103
8.3

DISTINCTIVE FEATURES OF INDEMNITY CONTRACT

AND GUARANTEE
i. Number of Parties to the Contract of Indemnity: In a contract of
indemnity there are two parties, viz., the indemnifier and the
indemnified whereas in a contract of guarantee there are three
parties, viz., the debtor (the person on whose behalf the guarantee
is given), the creditor (the beneficiary, the person to whom the
guarantee is given) and the surety (the person who gives the
guarantee).
ii. Contingent Risk: In an indemnity, the risk is contingent whereas
in a guarantee the liability is
subsisting.

,

iii. Nature of Liability: In a contract of indemnity, the indemnifier
is required to make good the loss as soon as it occurs and he cannot
rely on the fact that the person on whose behalf the indemnity is

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given has not made good the loss, whereas in a contract of
guarantee, the surety's liability is secondary and the principal
debtor is primarily liable.
iv. Number of Contracts: There are only two parties to a contract of
indemnity and as such only one contract. However, in a contract of
guarantee there are at least three contracts: one between the debtor
and creditor, the other between the creditor and the surety and the
third between the surety and the debtor.
v. Purpose of Contract: An indemnity is for the reimbursement of a
loss whereas a guarantee is for the security of the creditor.
8.4

SCOPE AND APPLICATION OF INDEMNITY CONTRACTS

TO BANKS
As far as a banker is concerned, the law relating to indemnities is of
great importance. Customers of the bank who have lost a demand
draft or travellers' cheque are required to give an indemnity before
the issuance of a fresh instrument in lieu of the lost one. These
indemnities are required since the bank has to protect itself from
any subsequent claim made by a person who may have for value
received these instruments. In some cases over and above the
indemnity, banks ask for surety. This is usually done in cases where
the amount involved is quite substantial or the banker does not
know the customer well enough, since the customer must have had
only one or two dealings with the banker. Indemnity bonds are also
insisted by bankers while issuing duplicate FDRs, settling death
claims to heirs or while issuing duplicate pay orders (bankers'
cheque), etc.
In the indemnity taken by the bank the customer undertakes to
protect the bank from any loss or damage and for costs incurred. In

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most states, these indemnities are stamped as an agreement.
However, if they are witnessed, they would be treated as an
indemnity bond thereby being liable for payment of ad valorem
stamp duty.
8.5

RIGHTS OF AN INDEMNITY HOLDER

Section 125 of the Contract Act lays down the rights of an
indemnity holder.
125. 'Rights of indemnity holder when sued: The promisee in a
contract of indemnity, acting within the scope of his authority, is
entitled to recover from the promisor the following:
i. All damages which he may be compelled to pay in any suit in
respect of any matter to which the
promise to indemnify applies, ii. All costs which he may be
compelled to pay in any such suit if, in bringing or defending it, he
did
not contravene the orders of the promisor, and acted as it would
have been prudent for him to act
in the absence of any contract of indemnity, or, if the promisor
authorised him to compromise the
suit, iii. All sums which he may have paid under the terms of any
compromise of any such suit, if the
compromise was not contrary to the orders of the promisor, and
was one, which it would have
104
been prudent for the promisee to make in the absence of any
contract of indemnity, or, if the promisor authorised him to
compromise the suit.

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A reading of the above Section shows that the rights of an
indemnity holder are subject to:
(a)

his acting within the scope of his authority;

(b)

he does not contravene the specific directions of the

promisor.
In case the indemnity holder does not violate the above two
conditions, he is then entitled to be indemnified by the indemnifier
to the extent of:
(a)

the damages paid by him;

(b)

the costs required either to file the suit or defend it;

(c)

any amounts paid by him pursuant to a compromise in the

suit provided that the compromise
was not contrary to any of the order or directions of the
indemnifier and the compromise was
such that it was an act of prudence in the absence of a contract of
indemnity.
1.

Damages: As regards damages, it is to be noted that High

Courts have differed in the views as to
when the indemnifier's liability commences. Some High Courts
have held that the liability commences
only from the time the indemnity holder actually incurs loss,
whereas some others have held that an
indemnity holder can compel the indemnifier to put him in a
position to meet the liability. The
former view is to be preferred.
2.

Costs: As regards costs, costs paid to solicitors, travelling

expenses and also costs reasonably

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incurred in resisting or reducing or ascertaining the claim, may be
recovered. The general principle
in computing the costs is that it should be such as, would a
reasonable man think if necessary to
incur.
3.

Sums paid on Compromise: As per Section 125, if the

indemnity holder acts within the scope of his
authority, then he is entitled to recover from the indemnifier all the
sums that he may have paid
pursuant to a compromise in a suit, provided however that
(a)

such compromise was not contrary to the orders of the

indemnifier;
(b)

such compromise was prudent to be made by the indemnity

holder in the absence of any
contract of indemnity;
(c)

the indemnifier had authorised the indemnity holder to

compromise the suit.
The Madras High Court in Venkataramana vs Mangamma AIR
1944 Mad. 457, has held that even in the absence of a notice to the
indemnifier (promisor), the compromise would bind him, if not
contrary to the orders of the promisor, and is entered bona fide and
without any collusion and is not imprudent.
8.6

LET US SUM UP

Sections 124 and 125 of the Indian Contract Act respectively, lays
down the laws of indemnity and the rights of indemnity holder.
These sections are not exhaustive and the general law of indemnity,
which is wider, has been applied in cases not covered by Sections

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124 and 125. The indemnifier has to compensate the indemnity
holder who is entitled to the damages suffered, costs incurred and
to recover any sums paid in a compromise of any suit. Bankers
obtain indemnities to protect themselves from any loss that they
may incur while issuing duplicate of instruments like demand
drafts or travellers' cheques, FDRS, pay-orders, etc.
8.7

KEYWORDS

Indemnity; Indemnifier; Indemnity holder.
105
8.8 CHECK YOUR PROGRESS

A. 1. Fill in the blanks,
(i) Section
of the Indian Contract Act defines an indemnity.
(ii) A person promising to save another from loss is called
(iii)

is a person who is promised to be saved from loss.

2. State whether the statements are true or false.
(i) Contract of Indemnity as defined in the Contract Act is
exhaustive, (ii) Insurance Contracts are not contracts of indemnity.
B. 1. Fill in the blanks.
(i) There are parties to a contract of indemnity.
(ii) Indemnifiers liability in a contract of indemnity is .
2. State whether the following statements are true or false.
(i) There are three parties to a contract of indemnity, the
indemnifier, the indemnity holder and

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the person on whose behalf the indemnity is given, (ii)
Indemnifter's liability occurs only if the indemnity holder suffers
loss.
C.

1. State whether the statements are true or false.

(i) Customers as a matter of right and without an indemnity can
obtain duplicate of demand
drafts or travellers' cheques.
(ii) Indemnities are required by banks purely as a formality and
does not serve any other purpose, (iii) The indemnity obtained by
banker only protects him from the actual value of the instrument.
D.

1. What are the two conditions that an indemnity holder is

bound to comply before being indemnified
for a loss?
2.

To what extent is the indemnity holder entitled to be

indemnified?
3.

In case of compromise the indemnity holder has to satisfy

certain conditions before recovering
the loss from the indemnifier, what are these conditions?
4.

State whether the statements are true or false.

(i) An indemnity holder can act beyond his authority.
(ii) An indemnity holder can be compensated only for damages and
not for the costs incurred
by him. (iii) An indemnity holder is entitled to compromise a suit
as thought fit by him though contrary
to the orders of the indemnifier.
8.9 ANSWERS TO 'CHECK YOUR PROGRESS'
A.

1. (i) 124; (ii) Indemnifier; (iii) Indemnity holder

2. (i) False; (ii) False

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B.

1. (i) 2; (ii) Primary

2. (i) False; (ii) True
C.

1. (i) False; (ii) False; (iii) False.

D.

1. (i) He should act within the scope of his authority and

should not contravene any directions
of the indemnifier.
2.

To the extent of the damages suffered, costs incurred and

sums paid for compromise of any
suit.
3.

(i) The compromise was not contrary to the orders of the

indemnifier.
(ii) Such compromise was prudent.
(iii) the indemnifier had authorised the indemnity holder to
compromise the suit.
4.

(i) False; (ii) False; (iii) False

BANK GUARANTEES
STRUCTURE
9.0

Objectives

9.1

Introduction

9.2

Bank Guarantees

9.3

Various Ttypes of Bank Guarantees

9.4

Banker's Duty to Honour Guarantee

9.5

Issuance of Bank Guarantee - Precautions to be taken

9.6

Payment Under Bank Guarantee - Precautions to be taken

9.7

Let Us Sum Up

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9.8

Keywords

9.9

Check Your Progress

9.10

Answers to 'Check Your Progress'

108
9.0

OBJECTIVES

After studying this unit, you should be able to understand:

various kinds of bank guarantees, their nature and scope;

the precautions to be taken while issuing a bank guarantee;

the precautions to be taken on invocation of a bank

guarantee.
9.1

INTRODUCTION

In commercial transactions, bank's customers are sometimes
required to give a bank guarantee. This is mostly as an alternative
to keep cash as a security deposit. The third party who seeks the
guarantee, not being aware of the customer's financial standing,
prefers a bank guarantee. In turn, the bank, which very well
understands the financial standing of the customer, undertakes to
guarantee the customer's financial commitments or the
performance of contracts by him. The bank charges a commission
for this service which depends on the security available and the
financial stability of the customer. In this Chapter, you will learn
what exactly is a bank guarantee, the various types of bank
guarantees, the precautions to be taken while issuing a bank
guarantee and on making payment on a bank guarantee the
distinction between a bank guarantee and an ordinary guarantee,
why in a bank guarantee the banker's duty to honour the guarantee
is of prime importance and the limit to which this duty can be

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extended.
9.2

BANK GUARANTEES

The term 'bank guarantee' briefly stated means:
a guarantee given by a bank to a third person, to pay him a certain
sum on behalf of the bank's customer, on the customer failing to
fulfil any contractual or legal obligations towards the third person.
From the above, it can be seen that there should first be a
commitment on the part of the customer to fulfil certain
obligations to a third party. This could be contractual or legal, i.e.
imposed by law. This commitment of the customer is guaranteed
by a bank and if the customer fails to honour his commitment the
banker pays the amount, it has promised to pay. Once the bank
gives a guarantee, then its commitment to honour the guarantee is
onerous and as such, it is prudent that a banker before issuing a
guarantee on behalf of his customer takes appropriate security and
understands his rights and duties. Before we embark on a study of
the banker's duty to honour guarantees and the onerous obligation
he undertakes on behalf of the customer when he issues a
guarantee, it would be necessary to understand the various kinds of
guarantees that a banker usually issues.
9.3

VARIOUS TYPES OF BANK GUARANTEES

Though under law, bank guarantees have not been classified by the
nature of the underlying contract entered into by the customer, in
practice such classification has been made. Though there are
various types of guarantees, the important ones, which a banker
would be regularly required to issue in the course of his business
are as follows:
i. Financial Guarantee: These are guarantees issued by banks on

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behalf of the customers, in lieu of the customer's requirement to
deposit a cash security or earnest money. These kinds of
guarantees are mostly issued on behalf of customers/contractors
dealing with Government departments. Such guarantees are also
issued in situations where a party is required to deposit cash as a
part of contract. Most Government departments insist that before
the contract is awarded to contractor he should show that he is
willing to perform the contract and to ensure that now frivulous
tenders
109
are mad, insist on an Earnest Money Deposit. However in lieu of
the earnest money government departments are generally willing
to accept a bank guarantee. This also helps the contractor who can
utilise the funds for fulfilling his obligations under the contract. In
case the contractor does not take up contract of awarded then the
Government departments invoke the guarantee and collect the
money from the banks.
ii. Performance Guarantee: These are guarantees issued by the
bank on behalf of its customer whereby the bank assures a third
party, that the customer will perform the contract entered into by
the customer as per the condition stipulated in the contract, failing
which the bank will compensate the third party up to the amount
specified in the guarantee. These types of guarantees are usually
issued by bankers on behalf of their customers, who have entered
into contracts to do certain things on or before a given date.
Though the bank assures, that the conditions as stipulated in the
contract will be complied with by the customer in practice, the

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banks on being served a notice of default by the third party pays
over the amount guaranteed without going into the technicality of
the contract. This is because, after a guarantee is issued, the
contract of guarantee is independent of underlying commercial
transaction and any claim as per terms of guarantee is required to
be honoured. Though, in certain performance guarantees a clause
is inserted, that proof of default of the customer is necessary, most
bank guarantees do not insist on such proof. A mere demand from
the beneficiary that there has been a default by the bank's customer
is sufficient for the bank to make payment. This is so, since banks
by the nature of their expertise prefer to deal with documents and
they would not like to go beyond the contract and verify whether
there has been a breach of the contract or not. This is because,
generally the guarantee document makes it obligatory on the part
of the issuing bank to honour their guarantee without going into
the points of differences between the beneficiary and the principal
on whose behalf he had issued the guarantee.
iii. Deferred Payment Guarantee: Under this type of guarantee, the
banker guarantees payment of instalments spread over a period.
This type of guarantee is required, when goods or machinery are
purchased by a customer on long-term credit and the payment is to
be made in instalments on specified dates spread over more than a
year. In terms of the contract of sale, the seller draws drafts (bills of
exchange) of different maturities on the customer which are to be
accepted by the customer. The banker guarantees due payment of
these drafts. A deferred payment guarantee constitutes an
undertaking on the part of the bank to make payments of deferred
instalments to the seller (beneficiary) on the due dates, in the event

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of default by the customer (buyer). While issuing a deferred
payment guarantee, the banker has to assess the ability and sources
of funds of the customer to honour the payment of instalments on
due dates.
9.4 BANKER'S DUTY TO HONOUR GUARANTEE
Bank guarantees are called 'the life blood of national and
international commerce' and even though they are an offshoot of a
primary contract between the debtor and creditor, these guarantees
are independent commitments taken by bank on the behalf of their
customers. In most bank guarantees, banks undertake to make
payment merely on demand by the beneficiary. It is therefore
absolutely necessary that irrespective of the underlying contract
and any dispute between the parties to the contract, the bank
makes payment, if the guarantee has been invoked properly. We
shall now examine this duty of the banker to honour his
commitment under a guarantee and the grounds on which
payments can be refused.
i. Bank's Obligation to Pay Primary
(a) The obligation of a banker, to honour his commitment on a
guarantee given by him being primary, casts a duty on the bank to
honour it irrespective of the disputes between the beneficiary
110
and the debtor. The first of the cases wherein the bank's
commitment to honour its guarantee was discussed was the
English case of R.D. Harbottle Ltd. vs National Westminster Bank
Ltd. (1978) OB 146, wherein Justice Kerr held as follows:
Such guarantees even though having their genesis in the primary

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contract between the parties are nevertheless autonomous and
independent contracts and a bank, which has given a performance
guarantee must honour that guarantee according to its terms. It is
not concerned in the least with relations, between the supplier and
the customer, nor with the question whether the supplier has
performed his contracted obligations or not, nor with the question
whether the supplier is in default or not and the only exception is
when there is a clear fraud, of which the bank has notice.
(b) The above principle has been accepted by Courts in India and
they have refused to grant injunctions against banks from making
payment under the guarantee except in cases of fraud or special
equities in favour of the person on whose behalf the guarantee has
been issued. The decision of the Calcutta High Court in Texmaco
Ltd. vs State Bank of India AIR (1979) Cal 44, the first among the
Indian cases illustrates the duty imposed on a bank to honour its
guarantee. In this case, the bank had issued a guarantee to STC on
behalf of M/s Texmaco Ltd., wherein the bank irrevocably and
unconditionally guaranteed the due performance of the contractual
obligations of M/s Texmaco and in case of default by Texmaco, the
bank, on first demand by STC, guaranteed payment of the amount
without any contestation, demur or protest and/or without
reference to Texmaco and/or without questioning the legal
relationship subsisting between Texmaco and STC. The guarantee
was invoked by STC upon which Texmaco filed a suit for injunction
to restrain the bank from making any payment. The High Court
held that:
In the absence of such special equities and in the absence of any
clear fraud, the bank must pay on demand, if so stipulated, and

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whether the terms are such must have to be found out from the
performance guarantees as such. Here though the guarantee was
given for the performance by Texmaco in an orderly manner their
contractual obligation, the obligation was taken by the bank to
repay the amount on 'first demand' and 'without contestation,
demur or protest and without reference to Texmaco and without
questioning the legal relationship subsisting between STC and
Texmaco'. It further stipulated, as I have mentioned before, that
the decision of STC as to the liability of the bank under the
guarantee and the amounts payable thereunder shall be final and
binding on the bank. It has further stipulated that the bank should
forthwith pay the amount due 'notwithstanding any dispute
between STC and Texmaco'. In that context, in my opinion the
moment, a demand is made without protest and contestation, the
bank has obliged itself to pay irrespective of any dispute as to
whether there has been performance in an orderly manner of the
contractual obligation by the party.
The Supreme Court has also considered the liability of a banker on
a guarantee and after referring to the various English decisions and
the decisions of various High Courts held in UP Co-operative
Federation vs Singh Consultant [1988 (1) SCC 174] that
commitments of banks must be honoured free from interference by
the Courts. Otherwise, trust in commerce, internal and
international, would be irreparably damaged. It is only in
exceptional cases, that is to say, in case of fraud or in case of
irretrievable injustice be done, the Court should interfere.
LIABILITY OF BANK UNDER A GUARANTEE GIVEN ON
BEHALF OF A COMPANY ORDERED TO BE WOUND UP

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In Maharashtra Electricity Board, Bombay vs Official Liquidator,
High Court of Ernakulam and Another (AIR 1982 SC. 1497), the
Supreme Court had occasion to consider the liability of a bank on a
guarantee
111
given by it on behalf of a company that was being wound up, the
facts of which; in a nutshell are as follows:
The Cochin Malleable Private Limited (Company) entered into a
contract with Maharashtra State Electricity Board, Bombay (Board)
for supply of goods from time to time. As per the terms of the
contract, the company furnished a bank guarantee for Rs. 50,000
as earnest money deposit. As per the guarantee given by Canara
Bank Limited (Bank), the bank agreed unequivocally and
unconditionally to pay within forty-eight hours on demand in
writing from the board a sum not exceeding Rs. 50,000. On 30
July 1973, a petition for winding up of the company was presented
and the High Court, Kerala, on 16 September 1974, ordered the
company to be wound up. On 27 August 1973, the board called
upon the bank to pay the guarantee amount of Rs. 50,000 followed
by several reminders and final demand was made on 23 July 1974.
On 4 November 1974, the Bank wrote to the official liquidator
stating that the company was liable to the bank for payment of Rs.
1,64,353.12 which included the guaranteed amount. Thereupon,
the official liquidator filed an application before the company
Judge, praying for an order restraining the board from realising the
amount covered by the bank guarantee on the ground that since
the company was ordered to be wound up, the board could not

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claim payment under the bank guarantee.
The learned company Judge upheld the plea of the official
liquidator and issued an order restraining the board from realising
the amount from the bank. The board filed an appeal to the
Division Bench of the High Court, which was also dismissed. The
board thereupon approached the Supreme Court. The Supreme
Court held that:
Where under a letter of guarantee the bank has undertaken to pay
any amount not exceeding Rs. 50,000 to the board, within fortyeight hours of the demand and the payment of the amount
guaranteed by the bank was not made dependent on the proof of
any default on the part of the company in liquidation, the bank was
bound to make payment to the board. The board was not
concerned with what the bank did in order to reimburse itself after
making the payment under the bank guarantee. It was the
responsibility of the bank to deal with the securities held by it in
accordance with law. The Supreme Court observed that under
Section 128 of the Contract Act, the liability of the surety is coextensive with that of the principal debtor, unless, it is otherwise
provided in the contract. Further, a surety is discharged under
Section 134 by any contract between the creditor and the principal
debtor by which the principal debtor is released or by any act or
omission of the creditor, the legal consequence of which is the
discharge of the principal debtor. But a discharge which a principal
debtor may secure by operation of law in bankruptcy (or in
liquidation proceedings in the case of a company) would not
absolve the bank from its liability under the bank guarantee.
LIABILITY OF BANKS UNDER A GUARANTEE WHEN THE

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MAIN CONTRACT IS SUSPENDED
The question whether the bank is absolved of its liability under a
guarantee issued by it when the main contract is suspended by a
statute was considered by the Bombay High Court in Messrs SCII
(India) Limited vs Indian Bank and Another (AIR 1992 Bom. 121).
The facts of the case are as follows:
For carrying out erection, testing and commissioning of IP pipe
works, the company engaged the services of a contractor. At the
request of the contractor, the bank furnished a performance
guarantee where under the bank undertook to pay to the company
on demand 'any and all monies payable by the contractor to the
extent of Rs. 10,72,806 at any time up to 30 June, 1989 without
demur, reservation, contest, recourse of protest and/or without
reference to the contractor'.
The Government of West Bengal had issued a notification under
which the contractor was declared as an unemnlovment relief
undertaking under the West Bengal Act, 1972, and had suspended
all contracts
112
On invocation of the guarantee the contractor, therefore, submitted
that the contract of erection, etc., entered into by the contractor
with the company stood suspended.
On behalf of the company, it was submitted that the bank
guarantee was an independent contract between the bank and the
company and was not affected or suspended by operation of the
above referred to Act or the notification.
The High Court observed that the company had not invoked the

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guarantee fraudulently or mala fide. The High Court pointed out
that according to the decision of the Bombay High Court and
Supreme Court, the contract of bank guarantee is an independent
and separate contract. The High Court noted, that in several
Supreme Court decisions, particularly in M.S.E.B. Bombay vs
Official Liquidator, AIR 1982, S.C. 1497, and in State Bank of India
vs Messrs Saksaria Sugar Mills Limited, AIR 1986, S.C. 868, it was
held that the liability of the guarantor to pay was not affected by
suspension of liability of the principal debtor under some statutory
provisions. In the result, the High Court refused to grant any
injunction restraining the bank from making payment under the
bank guarantee more so when there was no special equity in favour
of the contractor.
From the above decisions, it can be seen that the liability of the
bank is not dependent on the underlying contract but is an
independent contract which the Courts would enforce except in
case of fraud.
ii. Exceptions
(a) Cases of fraud: The Supreme Court in United Commercial Bank
vs Bank of India AIR 1981 SC 1426 observed as follows:
Except possibly in clear case of fraud of which the banks have
notice, the Courts will leave the merchants to settle their disputes
under the contracts by utilisation or arbitration as available to
them or as stipulated in the contracts.
Fraud, has been held to be one of the exceptions to the general rule
regarding the contracts of guarantee. A banker, who has knowledge
of fraud, can therefore refuse payment of the amount guaranteed.
The question however, would arise as to how a banker can decide

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as to whether a fraud has been committed or not. In such cases, it
is advisable that the banks inform their customer about the
invocation of the guarantee by the creditors and the banks
intention to pay within a given time if the unless restrained by an
injunction order of a court. This would relieve the bank of the task
of judging as to whether a fraud has been committed or not. On
this point the observations of Supreme Court in UP Co-operative
Federation vs Singh Consultants 1988 (1) Section 174 is worth
noting, whether it is a traditional letter of a credit or a new device
like performance bond or performance guarantee, the obligation of
banks appears to be the same. If the documentary credits are
irrevocable and independent, the banks must pay when demands
are made. Since the bank pledges its own credit involving its
reputation, it has no defence except in the case of fraud. The bank's
obligations, of course should not be extended to protect the
unscrupulous seller, that is, the seller who is responsible for the
fraud. However, the banker must be sure of his ground before
declining to pay. The nature of the fraud that the Courts talk about,
is fraud of an 'egregious nature as to vitiate the entire underlying
transaction'. It is fraud of the beneficiary, not the fraud of
somebody else. If the bank detects, with a minimal investigation,
the fraudulent action of the seller the payment could be refused.
The bank cannot be compelled to honour the credit in such cases.
However, it may be very difficult for the bank to take a decision on
the alleged fraudulent action. In such cases, it would be proper for
the bank to ask the buyer to approach the court for an injunction.
M/s Escorts Limited vs Messrs Modern insulators and Another
AIR 1988 Delhi 345 also illustrates the point that banks in case of

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doubt should seek appropriate direction from the Court. In this
case, the
113
Escorts supplied generator sets to Modern Insulators the
performance of which were guaranteed by the bank. Modern
invoked the guarantee, whereupon Escorts moved the Court to
restrain Modern from recovering the amount and the bank from
making payment of the guaranteed sum. The Court granted
injunction since the guarantee was not invoked properly.
Thereafter Modern invoked the guarantee once again but the bank
did not pay. The matter came before the High Court and Escorts
pleaded that Modern had played a fraud and hence were not
entitled to the guaranteed amount. The High Court held that
averments of fraud have to be pleaded and proved, which was not
done by Escorts. Of importance in this judgement is the Court's
remark as regards the conduct of the bank. The Court remarked
that the bank should have approached the Court for appropriate
directions if it had any doubts. Merely because an application for
injunction was made, would not be a ground for the bank not to
honour its commitment under the bank guarantee.
It is therefore important to ensure that a clear cut case of fraud is
established before a bank can refuse payment.
(b) Special equity in favour of debtor: If there is a possibility of an
irretrievable harm or injustice to one of the parties concerned, the
Courts would adjunct the bank from making payment. As an
illustration to the exception the Supreme Court cited and approved

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the decision of the US Court in Itek Corp. vs First National Bank of
Boston (566 Fed. Supp 1210). In this case, an exporter in USA
entered into an agreement with the Imperial Government of Iran
and sought an order terminating its liability on stand by letters of
credit issued by an American Bank in favour of an Iranian Bank as
part of the contract. The relief was sought because of the situation
created after the Iranian revolution when the American
Government cancelled the export licences in relation to Iran and
the Iranian Government had forcibly taken 52 American citizens as
hostages. The US Government had blocked all Iranian assets under
the jurisdiction of the United States and had cancelled the export
contract. The Court upheld the contention of the exporter that any
claim for damages against the purchaser if decreed by the
American Courts would not be executable in Iran under these
circumstances and realisation of the bank guarantee/letters of
credit would cause irreparable harm to the Plaintiff. This
contention was upheld. To avail of this exception, therefore,
exceptional circumstances, which make it impossible for the
guarantor to reimburse himself if he ultimately succeeds, will have
to be decisively established. Clearly, a mere apprehension that the
other party will not be able to pay, is not enough. In the Itek case
there was a certainty on this issue. Secondly, there was good
reason, in that case for the Court to be prima facie satisfied that the
guarantors, i.e. the bank and its customer would be found entitled
to receive the amount paid under the guarantee.
9.5 ISSUANCE OF BANK GUARANTEE - PRECAUTIONS TO BE
TAKEN
The liability of a bank under a guarantee depends on two

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fundamental criteria, viz., the amount guaranteed and the period of
the guarantee. These two factors have to be specifically stated since
in the absence of any one or both of these factors, the bank's
liability could be unlimited either in the amount guaranteed or the
period during guarantee. The banker should also obtain a counter
guarantee from his customer on whose behalf he has given the
guarantee, so that in case he is required to pay the guarantee he
can fall back on the counter guarantee to claim the amount paid by
him. We shall study these aspects in detail since in your day-to-day
practice as a banker you will come across these aspects quite
frequently.
i. Amount Guaranteed: When the bank issues a guarantee, the first
and foremost consideration that should weigh in a banker's mind is
the amount of the guarantee he is called upon to issue. In the
guarantee agreement, the amount has to be specifically stated, both
in figures and words. While
114
stating the amount, that the bank would guarantee to pay, care
should be taken to state whether or not the amount is inclusive of
all interests, charges, taxes and other levies. This is important to
avoid unnecessary disputes regarding the liability of the bank. On
invocation, the bank is liable to pay the whole amount of the
guarantee unless as stated earlier a case of fraud has been brought
to its notice.
ii. Period of Guarantee: Banks always specify the period for which
their guarantee subsists and an additional period during which a
claim has to be made on the bank to make payment. The former

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period during which the guarantee subsists, is called the validity
period and the latter, the claim period. If any default has been
committed by the debtor (i.e. the bank's customer) it should be
within the validity period. The claim period is only to facilitate the
beneficiary to prepare and lodge claim, if any, under the guarantee.
It is thus, necessary as a matter of great caution that this period be
specified to the exact date, for example, 'this guarantee is valid up
to 31 December 2007.'
Once this outer limit for the bank to guarantee a default of the
debtor is fixed, then the creditor can make a claim only if the
default has occurred within this period, and for any default beyond
this date the bank cannot be held liable. Once a default is made
then the beneficiary has to make a claim on the bank to make good
the loss within the claim period.
Claim period in a guarantee: In a guarantee, it is necessary to
provide for a period slightly longer than the validity period for the
beneficiary to make a claim. The claim period is usually a few
months more than the validity period of the guarantee. Since if the
debtor were to commit a default on the last day of the validity
period, then the beneficiary, at the earnest, invoke the same only
on the next day. Taking into account the time to communicate the
invocation, etc., the claim period should at least be fifteen to thirty
days after the validity period. For example, if the validity period of
the guarantee is up to 31 December 2007, then the claim period
would normally be up to 31 January 2008.
Amendment to Section 28 of Indian Contract Act and its effect on
Bank Guarantee: Prior to the amendment of Section 28 of the
Indian Contract Act, 1872 most bank guarantees had a standard

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clause at the end of their guarantee agreements. As per this clause,
the beneficiary was required to enforce his claims within a period
of three to six months, failing which, the bank's liability was
extinguished and hence the rights of the beneficiary. The above
clause was necessitated due to the fact that in the absence of it,
Government departments and municipal bodies can file a suit
against the bank under a bank guarantee within a period of thirty
years after making a claim. The banks would therefore be required
to carry forward this liability for a long period and thereby required
to make provisions for the same in their balance sheets. Added to
this, the customers cash margin and security would have to be
retained either until the guarantee is returned by the beneficiary or
until the expiration of the period of limitation. However, this
clause, had been challenged before various High Courts and the
High Courts have held that such clauses in the bank guarantees to
be valid, and not violative of Section 28 of the Contract Act.
However, from 1 January 1997, Section 28 of the Indian Contract
Act has been amended due to which the standard limitation clauses
in the bank guarantees by which the bank extinguished their
liability as been declared illegal. As such, at present if a beneficiary
were to invoke the guarantee within the claim period, for a default
committed by the debtor during the validity period then in case the
bank did not make payment, the beneficiary can sue the bank
within the normal period as provided in the Limitation Act, 1963.
This period under the Limitation Act is thirty years in case the
beneficiary is Government department or municipal body and
three years in all other cases.
As such it is prudent to insist that the bank guarantee be returned

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after the claim period duly cancelled by the beneficiary or a
certificate be obtained from the beneficiary that there are no claims
under the
115
guarantee, and until such time the cash margin and the security of
the debtor (customer) has to be retained.
iii. Counter Guarantee and Other Security: Though a bank
guarantee is a contingent liability, it is always prudent for a banker
to secure this contingent liability to cover himself in case it is
enforced. This can be done by obtaining a counter guarantee-cumindemnity executed by the customer in favour of the bank. The
counter guarantee-cum-indemnity, should be carefully drafted to
ensure, that in case the bank were to make payment on behalf of
the customer, then the customer in turn 1 should not only make
good the amounts paid by the bank to the creditor but also any
expenses connected therewith including costs of attorney, any
interest on delayed payment, taxes and other levies. It is to take
care of all the above payments that the counter guarantee also
includes an indemnity aspect. The counter guarantee should also
include a clause that it would remain in force until the guarantee
given by the bank subsists, viz., until the bank is duly discharged by
the beneficiary or a certificate to this effect is issued by the
beneficiary.
Though a counter guarantee-cum-indemnity is taken as a security
for every guarantee issued by the bank, its value would depend on
the financial standing of the person/company giving the counter
guarantee. As such, it is preferable that keeping in mind the

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financial worth of the counter guarantor necessary security in the
form of tangible securities like fixed deposits, other paper
securities or immovable properties, etc., are obtained or the
existing charge of the debtor be also extended to cover the
guarantee.
9.6 PAYMENT UNDER BANK GUARANTEE - PRECAUTIONS TO
BE TAKEN
Before making payment, a banker has to ensure that the invocation
of the guarantee has been properly made; failing which he may not
have any recourse against the debtor. The banker should also see
that no order of injunction has been passed by any Court of law
prohibiting the bank from making payment. In case, a banker
makes payment ii1 spite of there being an order by a competent
Court in which the bank is a party, then the bank will be
answerable for Contempt of Court.
i. Proper Invocation of Guarantee: The bank while making payment
on its guarantee has to be careful and ensure that the invocation
has been properly made. There are divergent views as regards the
proper manner in which a bank guarantee should be invoked. The
Delhi High Court, in M/s Harprashad and Co. Ltd. vs Sudarshan
Steel Mills, AIR 1980, Delhil74, had occasion to consider this
question. In this case, the High Court took the view that:
The duty of the beneficiary in making the demand on the bank is
like the duty of the plaintiff to disclose the cause of action in the
plaint. Just as a plaint is liable to be rejected for non-disclosure of
the cause of action, a demand by the beneficiary of the bank
guarantee is liable to be rejected by the bank if it does not state the
facts showing that the conditions of the bank guarantee have been

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fulfilled.
However, in contrast to the above views of the Delhi High Court,
the Calcutta High Court in Road Machines (India) Pvt. Ltd. vs The
Project and Equipment Corporation of India Ltd. and Another (AIR
1983 Cal91) held that:
It is not necessary that a bank guarantee should be invoked in an
exact and punctilious manner setting out the entire case of the
beneficiary under the guarantee in the same way as setting out a
cause of action in a plaint. A bank guarantee is a commercial
document and is neither a statutory notice nor a pleading in a legal
proceeding. A bank guarantee may be invoked in a commercial
manner. The invocation would be sufficient and proper if the bank
concerned understands, that the guarantee is being invoked by the
beneficiary, in terms of the guarantee.
As a banker, it would be prudent to verify that the invocation made
is proper and in deciding whether the invocation made is proper
the banker has to see among other things that the following
requirements are satisfied:
116
1.

The invocation is within validity period.

2.

The invocation amount is not more than the guaranteed

amount. In case it is more then only the
maximum amount stipulated in the guarantee need be paid.
3.

The authority invoking the guarantee is competent or

empowered to invoke the guarantee. In
guarantees issued to Government departments the authority to
invoke is usually designated by the

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post, so as to avoid any later problems by change in the person
holding the post. The banker has to
ensure that the person invoking has the powers to do so.
The Supreme Court in its decision in Hindustan Construction Co.
Ltd. vs State of Bihar (1999) 8 SCC436 has held that where as per
the terms of the guarantee the invocation was to be done by the
chief engineer, the invocation by the executive engineer was wholly
wrong and the refusal of the bank to make payment was valid.
ii. No Injunction Prohibiting Payment: Though Courts are reluctant
to interfere with the bank guarantee, there have been instances
where Courts have granted injunction restraining the banks from
making payment under a guarantee. In one such case that came up
before the Calcutta High Court injunction was granted. The facts of
the case in Messrs G.S. Atwal Co. Engineers Pvt. Ltd. vs Hindustan
Works Construction Limited (AIR 1989 Cal 184) is as follows:
Under the terms of the contract entered into between the HWC
Ltd. and the GSA Co, the Petitioner was to furnish a bank
guarantee for mobilisation advance made by the Respondent to the
Petitioner for Rs. 32.50 lakh. The contract did not require the
Petitioner to give any bank guarantee for the due performance of
the contract. The Petitioner requested the bank to issue a
guarantee for Rs. 32.50 lakh to cover the mobilisation advance
received by the Petitioner from the Respondent. The bank made
use of its standard format of guarantee and did not delete certain
clauses therein because of which the guarantee issued by it became
a mobilisation advance-cum-performance guarantee. Since the
bank and the Respondent, as beneficiaries, were the only parties to
the bank guarantee, the Petitioner never knew of the mistake on

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the part of the bank. The Respondent took advantage of the
mistake and although the mobilisation advance was recovered in
full, it invoked the bank guarantee for recovery of its claim for
damages for loss suffered, as a result of non-performance of the
contract by the Petitioner and demanded payment from the bank.
On the bank showing its willingness to make payment of the
amount guaranteed by it, the Petitioner approached the High Court
for an order restraining the bank from making payment.
The High Court held that: The Respondent was aware of the
mistake on the part of the bank and with ulterior motive took
advantage of the mistake by demanding payment in respect of its
claim for damages for non-performance and not in respect of any
amount due for mobilisation advance given to the Petitioner.
The bank has no right to saddle its customer with any additional
liability under the guarantee by issuing the same contrary to the
instructions by its customer.
The Respondent has invoked the guarantee for recovery of loss and
damages, alleged to have been suffered due to alleged breach of
contract by the Petitioner.
Though the general principle of non-interference by the Court in
cases of bank guarantee and letter of credit is for the smooth
functioning of international trade and commerce, this principle
would not apply where the bank has acted negligently and issued
bank guarantee contrary to the customer's instructions.
Whether the invocation of the bank guarantee was in terms of the
guarantee or not will depend upon the terms of the guarantee and
the letter of invocation. The bank cannot act arbitrarily or
whimsically in deciding whether the invocation was in terms of the

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guarantee when in fact it was not.
In the instant case, the bank guarantee" was for mobilisation
advance and not for performance of the contract and the invocation
of the bank guarantee was admittedly for recovery of damages for
the
alleged non-performance of the contract. The High Court,
therefore, held that there was special equity in favour of the
Petitioner and he can prevent the beneficiary from enforcing the
bank guarantee.
It is, therefore, absolutely necessary for the bank to confirm that no
injunction order has been issued restraining the bank from making
payment.
9.7

LET US SUM UP

A bank guarantee is a contract by which the bank guarantees a
certain sum to a person/entity on the customer failing to fulfil any
contractual or legal obligation to the said person/entity. Guarantee
issued by banks mainly are financial guarantees, performance
guarantees, deferred payment guarantees and statutory
guarantees. Bank under a contract of guarantee is bound to honour
its guarantee and its obligations to pay is primary and independent
of the underlying contract between the customer on whose behalf
the guarantee is given and the beneficiary. This has been settled by
the various decisions of the Courts. The only exception for a bank
not to make payment under a guarantee is when a fraud exists,
which must be proved beyond doubt or special equity is in favour
of the debtor.
While issuing a guarantee a bank has to ensure that, the amount

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guaranteed and the period of the guarantee is specifically stated in
the guarantee. Pursuant to the amendment to Section 28 of the
Indian Contract Act, the limitation period on a contract of
guarantee cannot be restricted to less than the period provided
under the Limitation Act. As such, if the guarantee is invoked in
time then the beneficiary can sue the bank within thirty years in
case the beneficiary is a Government or municipal body or three
years in all other cases. The bank while making payment under a
guarantee has to ensure that the invocation is proper and that the
person invoking the guarantee has the authority to invoke the
guarantee. The bank while issuing a guarantee has to obtain a
counter guarantee from its customer and if necessary, additional
security to protect the bank in case it is required to pay under the
guarantee.
9.8

KEYWORDS

Bank guarantee; Beneficiary; Counter guarantee; Debtor; Surety.
9.9

CHECK YOUR PROGRESS

1.

State briefly what is a bank guarantee?

2.

What purpose does a bank guarantee serve?

3.

List the various types of bank guarantees and explain in

brief their specific nature.
4.

Explain in brief- 'On a bank guarantee the banks duty to pay

is primary.'
5.

There are two exceptions to the general rule that banks must

pay on a guarantee. What are these
two exceptions? Explain in brief.
6.

Choose the right answer from the choices given:

(i) In bank guarantees the bank makes payment on:

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(a)

being convinced that the beneficiary has incurred loss;

(b)

on being sued by the beneficiary;

(c)

on the guarantee being invoked and after seeking

concurrence of the debtor;
(d)

merely on demand by the beneficiary.

(ii) In case of bank guarantees on behalf of company that is in
liquidation the bank on invocation of the guarantee by the
beneficiary:
(a)

must pay the amount to the Liquidator and not the

beneficiary;
(b)

must deposit the amount in the court to avoid any

controversy;
(c)

must pay the beneficiary;

(d)

need not pay, since the bank guarantee lapses on the

company being liquidated.
118
7.

State in brief the precautions to be taken while issuing a

bank guarantee.
8.

While issuing a guarantee the bank omits to mention the

amount and the period of the guarantee.
Can the bank still be held liable? What would be the extent of the
liability?
9.

What is a validity period and claim period in a bank

guarantee?
10.

Can the bank in a guarantee issued by it restrict the claim

period so as to avoid its liability?

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11.

What is a counter guarantee and when is it obtained?

9.10 ANSWERS TO 'CHECK YOUR PROGRESS'
6. (i) d; (ii) c.

LETTERS OF CREDIT
STRUCTURE
10.0

Objectives

10.1

Introduction

10.2

Letters of Credit - General Consideration

10.3

Parties to a Letter of Credit

10.4

Types of Letters of Credit

10.5

Documents Under a Letter of Credit

10.6

Uniform Customs and Practice for Documentary Credits -

UCPDC 600
10.7

Payment Under Letter of Credit - Banks Obligation Primary

10.8

Let Us Sum Up

10.9

Keywords

10.10 Check Your Progress
10.11 Answers to 'Check Your Progress'
120
10.0

OBJECTIVES

After studying this unit, you should be able to understand:

what is a letter of credit and its purpose;

the parties involved in a letter of credit transaction;

the various types of letters of credits;

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the various documents involved in a letter of credit

transaction;

the law as laid down in UCP 600.

10.1

INTRODUCTION

The simplest form of payment in a business transaction is payment
by cash, and then comes payment by cheques, drafts, travellers
cheques, etc. However, all these modes of payment require
proximity between the buyer and seller and the element of trust
between them. In international trade, the buyer and seller are miles
apart, having different legal systems and each unaware of the
other's financial position. In such cases, it would be preferable that
both parties deal through their bankers. This is done when the
documents covering the goods traded re-routed through the
bankers. However, in this method the seller should have
confidence that the buyer would pay for the goods as and when the
same is due either immediately or after the agreed period of credit.
In case the seller is not fully satisfied about this he may ask for an
assurance from a banker that the terms of trade would be complied
with and his interest would be protected. One of the methods of
achieving this assurance more in international trade is by
completing the transaction through the system of a letter of credit.
Due of the devices used by the bankers to effect payment for goods
supplied or services provided is called Banker's Commercial Credit
or Letter of Credit (LC for brevity). Though this device for payment
is the creation of the British merchants, it has now become a
universally accepted method of payment. As a banker, you will at
some point of time in your career, be required to deal with letters of
credit. As such, it is necessary that you understand the various

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provisions relating to LC and the legal aspects involved therein.
In this chapter, unless specifically stated so, the term letters of
credit is used interchangeably as LC or credits and should not be
mistaken as a different term.
10.2

LETTERS OF CREDIT - GENERAL CONSIDERATION

An LC can be compared to a guarantee given by a bank on behalf of
its customer to the effect that the bank would make payment to the
beneficiary when the beneficiary presents the documents as is
required in the LC. They are not negotiable instruments.
To understand better a LC transaction, let us consider a practical
situation.
M/s Bharath & Co. in India want to import certain machinery,
which they know is manufactured by M/s Edward & Co. in
England. They enter into a contract for purchase of the machinery,
payments for which are required to be made by a LC. Since neither
party knows the other, they are not sure whether the other will
fulfil his part of the obligation. In such a situation, M/s Bharath &
Co. will approach its banker, Bank of India and make a request by
an application for opening a letter of credit (LC) in favour of M/s
Edward & Company. Bank of India, after opening a letter of credit
LC in favour of M/s Edward & Co., informs another bank in
England, the UK bank with whom Bank of India has an
arrangement, to forward the letter of credit LC to M/s Edward &
Co. The UK bank (say Barclays Bank) after verifying the
authenticity of the LC (letter of credit) and finding it as
genuineness forwards the same to M/s Edward & Co. After
verifying that the LC has been drawn according to the sale contract
M/s Edward & Co. ships the machinery to M/s Bharath & Co. M/s

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Edward & Co. now collect the bills of lading handed over by the
shipping Co. and other documents required as per the LC and
draws a bill of
121
exchange (Bills) under the LC and presents it to its bankers, the
Barclays Bank, for negotiating the bill and to obtain the payment.
Barclays Bank, on their part, receive the bill and the documents
from M/s Edward & Co. and checks that they are as per the terms
of the LC. On finding them to be in order, Barclays Bank negotiates
the bill and makes payment to M/s Edward & Co. Barclays Bank
thereafter sends the bill and documents to Bank of India. Bank of
India on its part verifies the bill and documents and if found in
order sends the bill to M/s Bharath & Co. for payment. M/s
Bharath & Co. on receiving the bills checks the documents or pays
the bill. On M/s Bharath & Co. making payment, Bank of India will
release the shipping document so that M/s Bharath & Co. can
collect the goods from the shipping company.
The above illustrates the simplest form of payment under a letter of
credit. The terms of an LC are sometimes complicated and various
kinds of LCs have been devised since the concept of LC was
introduced, which requires a banker to be very well versed in this
aspect of financing.
Before we proceed to understand the parties to a letter of credit
and the various types of letters of credit, it would be worthwhile to
examine the advantages of a letter of credit (LC). As regards the
Buyer, i.e. M/s Bharath & Co. in the above illustration the major
advantages are as follows:

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(a)

No payment has to be made in advance to the seller.

(b)

The buyer can induce the seller to give credit from his

supplier, which he may not be otherwise
willing to give, since there is a guarantee from a banker regarding
payment on due date.
(c)

In most cases the bills are payable over a period of time

(called usance bills) thereby giving additional
credit to the buyer.
(d)

The buyer can, while opening the LC insist that the quality

of goods are certified by an independent
body and such certificate be sent along with the bill for negotiation,
thereby assuring himself that
the goods meet with the required quality as specified. In case the
seller does not enclose such a
document then the banks will not make payment on the Bills. He
can also stipulate other terms and
conditions to protect his interests and which are also acceptable to
the seller.
As regards the seller, i.e. M/s Edward & Co. in the illustration the
advantages are as follows:
(a)

The seller is assured that he will receive payment on his

complying with the terms of the LC.
(b)

On shipment of the goods the seller can draw and negotiate

the bills thereby getting immediate
payment in his country, which payment otherwise would be made
only after the goods are received
by the buyer, which would cause delay in payment.
(c)

The seller need not bother himself about the import

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regulations of the buyer's country since this is
the responsibility of the buyer.
(d)

The seller also need not bother about the fluctuations in

currency since this will be the responsibility
of the buyer.
10.3 PARTIES TO A LETTER OF CREDIT
You have learnt by now that in a letter of credit transaction various
parties are involved. Various terms, have been coined to identify
these parties, which you, as a banker, will be required to know
since, in all transactions involving letters of credit, the terminology
used to identify parties will be on these lines. To help us better
understand the parties we shall be making use of the illustration
given in Para 10.2.
(i) Applicant-Buyer-Importer-Opener: He is the person who
applies to the bank to open a letter of credit, since he would be
either purchasing goods or availing services for which payment has
to be made. In the illustration - M/s Bharath & Co.
(ii) Issuing Bank: The bank which opens the letter of credit LC on
the request of the applicant/ buyer. Also called the opening bank or
importers bank. In the illustration - Bank of India.
122
(iii) Beneficiary-Exporter-Seller: Is the person who is entitled to
receive the benefit under a LC (letter of credit), i.e. the right to
receive payment or to draw bills and receive payment as per the
terms of the LC. In the illustration - M/s Edward & Co..
(iv) Advising Bank: The bank in the beneficiary/exporters country
through which the letter of credit is advised to the beneficiary. The

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advising bank only forwards the LC to the beneficiary, thereby
enabling the beneficiary to rely on its authenticity and genuineness.
The advising bank is also sometimes termed as the Notifying Bank.
In the illustration - The UK Bank.
(v) Negotiating Bank: The bank in the beneficiary/exporters
country which negotiates the bills (i.e. makes payment on the bills
drawn by the seller and accepts the documents). If the LC specifies
a bank then that bank is the negotiating bank and is also called the
nominated bank or paying bank. If the LC however does not specify
a bank, then any bank can be the negotiating bank, since the
issuing banks open invitation contained in the credit is an offer,
which is accepted as soon as the negotiating bank negotiates the
bills and accepts the documents. In the illustration, Barclays Bank
would be the negotiating bank. If Barclays Bank was also
specifically mentioned in the credit as the negotiating bank, then
Barclays Bank will also be the nominated Bank.
(vi) Confirming Bank: The advising bank is only required to advise
the credit to the beneficiary. If the seller is not conversant with the
issuing bank or not satisfied with his financial position, he may ask
for an additional assurance/guarantee from another bank located
in his country/place and the second guarantee is called confirming
the LC. The seller would look to the confirming bank to pay the
amount covered by the bill if drawn as per terms of the LC. If
however in addition to' advising the credit the advising bank were
to confirm it, then the advising bank will also be the confirming
bank. In such case, the confirming bank is deemed to undertake on
its part the liabilities of the credit vis-a-vis the beneficiary or the
Negotiating bank.

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(vii) Reimbursing Bank: It is the bank, which is appointed by the
Issuing bank to make reimbursement to the negotiating, paying or
confirming bank.
10.4 TYPES OF LETTERS OF CREDIT
i. Acceptance Credit: Ordinary letters of credit are usually sight
credits, i.e. immediate payment should be made of the bills drawn
by the beneficiary. However, sometimes as per the terms of the
letter of credit (LC) the bills will be payable after an agreed period
of time (such bills being called usance bills). Such an LC under
which usance bills can be drawn is an acceptance credit or time
credit. The bills drawn on the various dates, will be honoured on
their maturity. This is one of the methods by which, a buyer can
obtain credit from the seller. The seller can either wait until the
date of maturity to receive money or he can discount the bills and
obtain immediate value for the goods supplied.
ii. Irrevocable Credit: An irrevocable credit is a credit, that can
neither be amended nor cancelled without the consent of the
beneficiary. The issuing/opening bank is bound by the
commitments given in the credit. As per the latest uniform customs
and practice for documentary credits 600, all credits are
irrevocable.
iii. Confirmed Credit: If a bank advising the credit to the
beneficiary adds its own confirmation to the credit, then the credit
would be called a confirmed credit. Only irrevocable letters of
credit can be confirmed, since in a revocable credit the issuing
bank can amend or cancel the credit without notice, and as such if
an advising bank were to confirm it, it would be liable without
having any recourse to the 'issuing bank'. Confirmation here means

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that the confirming bank would fulfil the obligation under the letter
of credit if the beneficiary complies with the terms contained
therein. A confirming bank accepts this responsibility only on
instructions by the issuing bank and as such, if
123
any of the terms in the LC have to be changed then the concurrence
of all the parties would be necessary.
iv. With Recourse and Without Recourse Credits: When a
beneficiary draws a bill under a letter of credit, he is generally
liable to any negotiating LC bank if the drawee fails to make
payment under the Negotiable Instruments Act. In other words, his
liability is extinguished only on the drawee making payment. LC
calling for these kinds of bills is with recourse LCs. However, the
beneficiary can exclude this liability by adding to the bill the
following words 'without recourse', which means that the right
(recourse) against the drawer under the bill is not available to any
endorsee of the bill of exchange. This defence however is available
to the beneficiary only on the bills drawn by him. In case there is
any discrepancy in the documents submitted then the beneficiary
cannot avail any protection on a bill with the endorsement 'without
recourse'. However, as per the current guidelines from RBI, banks
are not supposed to accept any inland bill drawn 'without recourse'
for negotiation.
v. Transferable Credits: As stated earlier, a letter of credit is not a
negotiable instrument, though the bills of exchange drawn under it
are negotiable. As such, the rights under an LC cannot be
transferred and is vested in the beneficiary. A transferable credit is

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one under which the beneficiary can transfer his rights to third
parties (secured beneficiaries). Unless specifically stated an LC is
not transferable.
vi. Back-to-Back Credits: This a credit which is an offshoot of the
credit issued to the beneficiary. In a back-to-back credit, the
beneficiary in whose favour an LC is issued uses the same to open
another credit from his (beneficiary's) bank in favour of his
supplier. There are thus three banks involved in a back-to-back
credit. First, the bank issuing the original credit to the beneficiary,
the second, the advising bank through which the credit has been
advised to the beneficiary and the third the bank, which issues an
ancillary credit against the security of the original credit, vii.
Anticipatory Letter of Credit:
(i) Red Clause letter of credit: In a usual LC transaction, the
beneficiary will be entitled to receive payment only on his handing
over the documents and the bills drawn under the LC to the
negotiating bank. However, in certain credits the beneficiary will
be entitled to get an advance of the price. These credits contain a
'red clause' (because the clause is printed in red) which authorises
an intermediary bank to make an advance to the beneficiary before
shipment. Red Clause LCs are however dying out.
(ii) Green Clause letter of credits: This is a refinement of the 'Red
Clause'. This type of LC not only permits pre shipment advance but
also permits advances to the exporter to cover storage at the port of
shipment. The red clause and green clause credit are called
anticipatory credits since payment of an advance is provided for in
anticipation of the seller making shipment.
ix. Revolving Letter of Credit: In a regular LC transaction, once the

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bills are negotiated the entire transaction comes to an end. If fresh
shipment is to be made, another LC will have to be drawn. This
procedure becomes time consuming especially when there is
regular trade between the same parties. In such cases, it is
preferable to open a revolving letter of credit. In this type of credit
though the amount is fixed, it can be renewed as soon as the earlier
bills have been paid.
10.5 DOCUMENTS UNDER A LETTER OF CREDIT
One of the two basic doctrines that underlie the letter of credit
transaction is the principle of strict compliance. The other being
the independent nature of the letter of credit transaction.
As per the strict compliance doctrine all the parties to a letter of
credit transaction should strictly observe the terms and conditions
under which the credit is issued and on failure to do so, the
defaulting party would be either liable to the others or have no
cause of action to recover any payment if made by the defaulting
party.
124
Within the sweep of the strict compliance doctrine comes the duty
of a banker to "ensure that the documents tendered are strictly
those specified in the letter of credit. In this regard it would be
worth noting the observation given more than half a century back
by LORD SUMNER in Equitable Trust Co. vs Dawson Partners (27
Lloyds Law Reports 49).
There is no room for documents which are almost the same or
which will do just as well.
In this case, the credit required inter alia a certificate testifying to

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the quality of the purchase that was to be signed by (experts).
However, due to a decoding error, the message received by the
advising bank required only a certificate signed by 'an expert'. The
beneficiary therefore, while presenting the documents submitted a
certificate signed by a single expert, which was honoured by the
advising bank and accepted by the issuing bank. However, since
the goods were defective, the applicant refused to reimburse the
issuing bank, which was upheld by the Courts.
The issuing bank owes a duty to its customer to ensure that the
documents tendered by the beneficiary under the credit comply
with the instructions given by its customer. Any default, on the part
of issuing bank would forbid the bank from claiming
reimbursement from its customer with the added disadvantage
that it would not be entitled to claim any remuneration for the
transaction. The matter of strict compliance as far as a bank is
concerned has been emphasised by Courts of Law all over the
world. A bank is not compelled to honour the credit unless the
beneficiary pursues and conforms in every material particular to
the authority conferred therein. Due to the prime importance given
to documents under a letter of credit transaction, it is necessary for
a banker to understand the documents that accompany a letter of
credit.
i. Bill of Exchange: This is a financial document. Payment is made
on this document. This for brevity sake is called 'bill' and is
sometimes referred to as 'draft' (to be distinguished from a
'demand draft'). In a letter of credit transaction the right to draw a
bill is conferred only on the beneficiary. The bill amount should be
within the limit fixed in the letter of credit. The tenor, endorsement

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and the drawee should be the same as given in the letter of credit.
This document should be distinguished from 'bills of lading', which
is a transport document and is discussed later on in this chapter.
Bills or drafts can be payable on presentation (sight bills) or on a
certain date (usance bill).
ii. Invoice: This is the basic commercial document. This document
gives details of the sale. It should be made in the name of the
opener/importer unless required otherwise in the letter of credit.
All the details mentioned in the invoice must tally with those
mentioned in the letter of credit, failing which it may amount to a
discrepancy, making the documents liable for rejection. Where the
quantities are specified in a letter of credit, the form in which they
are specified should be adhered to. For example, if the letter of
credit calls for 100 kg of tea, the invoice should be made
accordingly and converting the measure to equivalent pounds or
quintals would make it liable to be rejected. A further problem
posed is whether it would be in order, whereas per the credit the
value of the shipment is Rs. 15 lakh and the goods shipped is worth
Rs. 20 lakh, with a request that Rs. 15 lakh be paid and excess Rs. 5
lakh collected to be repaid later. This would not comply with the
credit terms and the opener/buyer/importer would be legally
entitled to reject the documents.
iii. Transport Documents: The mode of despatch of goods or the
transporting of goods would depend on the terms of contract
between the buyer and the seller and the same is incorporated in
the letter of credit. The two main modes of transport of goods are
either by sea or by air. In case the goods are shipped, the document
evidencing the shipment of the goods is called the 'Bill of Lading'.

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In case the goods are transported by air, the documents evidencing
receipt of goods would be the 'Airway Bill' in case the goods are
directly handed over to an Airline or its agent. In case goods are
transported through postal system or courier service, the document
evidencing receipt of goods would be either the 'Post Parcel
Receipt' or the 'Courier Receipts'.
125
iv. Bills of Lading: Bills of Lading are of two types - one, the
traditional ship bill of lading and the other, the 'Combined
Transport Bill': a creation of modern age containerisation of
shipments which permits more than one means of carriage and is
also known as 'Multimodal Transport'. Bill of lading is a document
to title to goods, i.e. they are representatives of the goods and
holder of the same is entitled to get possession of the goods. A bill
of lading, to a certain extent is negotiable inasmuch as a bona fide
transfer of the same by endorsement entitles the transferee the
right to the goods. A bill of lading is issued in sets of 2, 3, or 4 and
all are termed as originals. A banker should see that all the
originals are received. Unless otherwise specified in the letter of
credit, a bill of lading must be a 'shipped' bill of lading and a
'received for shipment' or 'transportation' bill of lading or a 'charter
party' bill of lading is not acceptable. This is because the shipped
bill indicates that the goods have been taken on board of a specified
ship and the journey has commenced while in the case of received
for shipment bill though the goods have been delivered to the
transporter the journey is yet to commence.
v. Airway Bill: This is a document, which evidences that the goods

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have been received by an airline company or its agent. Unlike a bill
of lading an airway bill does not carry with it the right to the goods,
i.e., it is not a document of title to the goods. If however the letter
of credit terms permit acceptance of an airway bill then the banker
is within his rights to accept it.
vi. Post Parcel Receipt and Courier Receipts: When the goods to be
sent are small in quantity, then they can be sent through post or
courier. The document issued by the postal department or the
courier are similar in nature to the airway bill. They are not title to
goods and only evidence that the goods have been entrusted for
transportation to either the postal department or the courier
company and most often than not the goods are addressed directly
to the buyer.
vii. Insurance Documents: The goods shipped, if required to be
insured under the terms of the letter of credit should be so insured
and the insurance document as required in the letter of credit
should be enclosed with the other documents. Either an insurance
company or underwriter or their agents should sign it. The type of
insurance cover should be the same as specified in the credit. The
requirements of the buyer regarding the amount of the policy, the
currency, the risk to be covered and the place of payment in case of
claim are to be strictly complied with.
viii. Other documents: Over and above, the major documents
discussed above which are required in all letters of credit
transaction, the letter of credit may also call for certain other
documents among which include certificate of origin, certificate of
weight or quality or analysis, Health authorities certificate, etc.
Such documents/enclosures are mandatory with the other

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documents, failing which payment can be refused. In interpreting
these documents too, the Courts have applied the principle of strict
interpretation.
10.6 UNIFORM CUSTOMS AND PRACTICE FOR
DOCUMENTARY CREDITS - UCPDC 600
The ICC Banking Commission, approved the UCP 600, ICC's new
rules on documentary credits, on 25 October 2006. UCP 600,
which came into effect on 1 July 2007, contains significant changes,
including:

A reduction in the number of articles from 49 of UCP 500 to

39.

New articles on 'Definitions' and 'Interpretations' to provide

more clarity and precision in the
rules.

The replacement of the phrase 'reasonable time' for

acceptance or refusal of documents by a
definite period of five banking days.

New provisions which allow for the discounting of deferred

payment credits.

A definitive description of negotiation as 'purchase' of drafts

of documents.
126
The new UCP 600 also contains within the text the 12 Articles of
the eUCP, ICC's supplement to the UCP governing presentation of
documents in electronic or part-electronic form.
10.7 PAYMENT UNDER LETTER OF CREDIT - BANKS
OBLIGATION PRIMARY

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We had earlier while studying the various aspects pertaining to
bank guarantees, noted that under a bank guarantee the liability of
the bank to make payment is primary and unless a case of fraud is
made out or there are special equities in favour of the debtor,
Courts would not adjunct a bank from making payment under a
guarantee. The same analogy applies to payment by banks under a
letter of credit. The Supreme Court had occasion to consider this
aspect in various cases and in all these cases, the Court has held
that the obligation of a bank to pay under a letter of credit is
primary, irrespective of the underlying contract. We shall now refer
to some of the decisions of Supreme Court, which have been the
touch stone for later judgements of the Supreme Court and also the
High Courts.
I. Tarapore and Company, Madras vs Messrs v/o Taractor.expert,
Moscow, Another (AIR 1970 Supreme Court 891)
(i) Facts of the case: The Indian firm opened in favour of the
Russian firm a confirmed, irrevocable and divisible letter of credit
with the Bank of India for the entire value of the machinery. Under
the letter of credit, the bank was required to pay to the Russian
firm twenty-five per cent on presentation of documents specified
therein and the balance of seventy-five per cent on the expiry of
one year from the date of first payment. The Russian firm supplied,
and the Indian firm took possession of, the entire machinery to be
supplied under the contract. After using the machinery for some
time, the Indian firm complained that the performance of the
machinery was not satisfactory and was causing considerable loss.
With a view to preventing the Russian firm from realising the
balance of the amount payable under the letter of credit, the Indian

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firm filed a suit against the Russian firm, but the same was
withdrawn on an agreement having been arrived at between the
parties. In pursuance of the said agreement, it was agreed that the
Russian firm would instruct its bankers not to make a demand for
further payment against the letter of credit for a period of six
months from the due dates of the drafts and that, during this
period the parties would do their best to reach an amicable
settlement. It would appear that the parties did not amicably settle
the dispute and when the extended time was about to come to a
close, the Indian firm instituted another suit praying that the
Russian firm and the Bank of India be restrained from taking any
further steps in pursuance of the letter of credit opened by the
Indian firm in favour of the Russian firm.
(ii) Decision: Rejecting the contention of the Indian firm that the
Russian firm should not be allowed to take away the money
secured by the letter of credit, since the Russian firm had no assets
in India and the Indian firm might not be able to enforce its claims
under any decree that might be passed in its favour, the Supreme
Court observed:
'An irrevocable letter of credit has a definite implication. It is a
mechanism of great importance in international trade. Any
interference with that mechanism is bound to have serious
repercussions on the international trade of this country. Except,
under exceptional circumstances, the Court should not interfere
with that mechanism.'
The Supreme Court considered some of the important decisions of
the Courts in England and America and observed:
'A letter of credit is independent of an unqualified contract of sale

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or underlying transaction. The autonomy of an irrevocable letter of
credit is entitled to protection. As a rule, Courts refrain from
interfering with that autonomy.'
127
II. In United Commercial Bank vs Bank of India (AIR 1981 SC
1426)
(i) Facts of the case: The question, considered by the Supreme
Court in this appeal was whether the Court should grant injunction
at the instance of the beneficiary of an irrevocable letter of credit,
restraining the issuing bank from recalling the amount paid under
reserve from the negotiating bank, acting on behalf of the
beneficiary, against a document of guarantee/indemnity at the
instance of the beneficiary.
Facts were rather complicated, but briefly, the relevant facts were
that G agreed to supply to B 1000 metric tonnes of 'Sizola Brand
Pure Mustard Oil'. A letter of credit was opened in favour of G by
the appellant bank. The goods were supplied in two lots. When the
documents were presented by G for payment of the amount against
first lot, the appellant bank refused to make payment except under
reserve on the ground of discrepancies in the documents presented
to it. The main discrepancy was that the goods were described in
the railway receipts as 'Sizola Brand Pure Mustard Oil
"Unrefined"'. Bank of India, under instructions of G, accepted
payment under reserve. Regarding the second lot, also payment
was made and accepted under guarantee in favour of United
Commercial Bank, whereby the Bank of India unconditionally
agreed to hold the United Commercial Bank harmless and

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indemnified for all consequences of non-acceptance and/or nonpayment of bills due to the discrepancies in the documents. The
goods despatched, were not accepted by B. The United Commercial
Bank, therefore, made a demand upon the Bank of India, to refund
the amounts paid under reserve. Thereupon G approached the
High Court for interim injunction restraining Bank of India from
making payment. The single Judge of the High Court made
absolute the temporary injunction granted earlier, until the
disposal of the suit on the ground that the United Commercial
Bank, in terms of the credit, could not unilaterally impose the
condition of payment 'under reserve' or refuse to pay against the
documents tendered by G merely because of alleged discrepancies.
The matter on further appeals finally reached the Supreme Court.
After considering the case law on the subject, the Supreme Court
allowed the appeal for the following reasons:
(a)

A letter of credit constitutes the sole contract with the

banker and the bank issuing the letter of
credit has no concern with any question that may arise between the
seller and the purchaser of
goods. The judicial authority lays down the necessity of strict
compliance both by the seller with
the letter of credit and by the banker with his customer's
instructions.
(b)

As pointed out by Halsbury's Laws of England, the

documents must be those called for, and not
documents which are almost the same or which will do just as well.
(c)

The banker is not called upon to know or interpret trade

customs and terms.

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(d)

In Paget's Law of Banking, 8th Edn. p. 648, it has been

stated thus - Unless documents tendered
under a credit are in accordance with those for which the credit
calls and which are embodied in
the promise of the issuing banker, the beneficiary cannot claim
against him and it is the banker's
duty to refuse payment.
(e)

The well established rule is that a bank issuing or

confirming a letter of credit is not concerned with
the underlying contract between the buyer and seller. Duties of a
bank under a letter of credit are
created by the documents itself, but in any case, it has the power
and is subject to the limitations
which are given or imposed by it, in absence of the appropriate
provisions in the letter of credit.
(f)

The Courts usually refrain from granting injunction to

restrain the performance of a contractual
obligation arising out of a letter of credit or a bank guarantee
between one bank and another. The
whole banking system would fail if the banker making payment
under reserve were restrained by
injunction from recalling the amount.
(g)

Buyer-customer cannot instruct the banker not to pay in

view of banker's obligations to pay under
irrevocable letter of credit. Confirmed letter of credit imposes an
absolute obligation to the banker
to pay.

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128
(h) A bank giving a performance guarantee must honour that
guarantee according to its terms.
(i) It is in exceptional cases that the Court would interfere with the
machinery of irrevocable obligations
assumed by the banks, such as, clear cases of fraud of which the
banks have notice, (j) The payments were made 'under reserve'
and against the indemnity or guarantee of Bank of India.
Therefore, when the bills of exchange were dishonoured, on being
presented, the amount became
immediately, payable on demand.
10.8

LET US SUM UP

A letter of credit (LC) otherwise called a banker's commercial credit
is a device used for effecting payment by bankers for goods
supplied or services provided between two parties and is mostly
used in foreign trade. It is similar to a bank guarantee, inasmuch as
the bank, issuing the LC, guarantees payment to the seller, in case
the terms as required under the LC are complied with. There are
various parties to a letter of credit transaction. The opener of the
letter of credit otherwise called the Buyer or Importer. The bank,
which issues the LC called the Issuing Bank or the Opening Bank or
Importer's Bank. The person in whose favour the LC is issued - the
Beneficiary, also called the Exporter or Seller. The Advising Bank
that advises the LC to the beneficiary, also called the Notifying
Bank. The Negotiating Bank,.i.e. the bank that makes payment on
the bills drawn by the seller also called the Nominated Bank or
Paying Bank. The Confirming Bank, which is the advising bank
when it also confirms the credit. The Reimbursing Bank, which

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reimburses, the negotiating/paying/confirming bank. Letter of
credit are classified based on the various terms and conditions they
contain. Main among them, are the following Acceptance Credit,
where the payment is made after a certain period; Revocable
Credit, where the credit terms can be unilaterally altered or
cancelled by the issuing bank in contrast to an Irrevocable Credit
where any alteration of terms or cancellation requires the
concurrence of beneficiary; Confirmed Credit, where the advising
bank adds its own confirmation to the credit while advising the
beneficiary; With Recourse Credits - where the beneficiary is liable
on a bill drawn by him under an LC in contrast to a Without
Recourse, where the beneficiary is not liable; Transferable Credits,
where rights under an LC can be transferred to third parties; Backto-Back Credits, where on the basis of LC in favour of the
beneficiary, his bank opens another LC in favour of the
beneficiary's supplier. Red Clause Credits, where the beneficiary is
entitled to advance payment before production of documents;
Green Clause Credits wherein addition to advance, the beneficiary
is entitled to payment of storage/warehousing charges; Revolving
Credits, where the amount is fixed but can be utilised repeatedly as
and when the earlier bills drawn are paid. There are two basic
principles that underline every LC transaction the first one being
that in every transaction strict compliance of terms is required and
the other being the independent nature of LC transaction. As such,
it is necessary to ensure strict compliance of the documents
required under an LC. The documents include bill of exchange
(drafts, bills), invoice, transport documents, insurance documents
are primary for most transactions. Over and above these

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documents the credit terms, which may require various certificates
and/or other documents. The rights and liabilities of all parties to
an LC have been laid down in the UCP 600 a document published
by the International Chamber of Commerce. The UCP 600 though
not enforceable as law, is incorporated as a part of the credit terms
and as such is enforceable as a contractual term.
A letter of credit being similar to a bank guarantee, the liability to
make payment by a bank under an LC is primary and the Supreme
Court has endorsed this view in various decisions.
10.9

KEYWORDS

Acceptance Credit; Advising Bank; Airway Bill; Applicant; Back-toBack Credit; Bankers Commercial
129
Credit; Beneficiary; Bill of Exchange; Bill of Lading; Confirmed
Credit; Confirming Bank; Green Clause Credit; Invoice; Issuing
Bank; Negotiating Bank; Red Clause Credit; Reimbursing Bank;
Revocable Credit; Revolving Credit; Transferable Credit; UCP 600;
With Recourse Credit; Without Recourse Credit;
10.10 CHECK YOUR PROGRESS
1.

State whether true or false.

(i) A letter of credit is a form of guarantee given by banks on behalf
of its customer. (ii) Letters of credit are bills of exchange drawn by
a seller or a buyer, (iii) LCs are negotiable instruments.
2.

Choose the right answer.

(a)

The letter of credit is opened on the request of

(ii) Applicant (iv) Confirming bank

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(i) Issuing bank (iii) Beneficiary
(b)

The LC issuing bank is also called

(i) the importers bank or the opening bank
(ii) the advising bank or the confirming bank (iii) the negotiating
bank or the nominated bank (iv) the reimbursement bank
(c)

The right to receive payment under a letter of credit or the

right to draw bills on a letter of
credit is vested in
(i) the opener of the LC

(ii) the issuing bank only

(iii) the seller only (iv) all the three parties
(d)

The advising bank's responsibility is

(i) to inform the issuing bank as to whom to issue the letter of
credit (ii) to advise the buyer the despatch of documents by the
seller (iii) to inform the beneficiary/seller about the letter of credit
(iv) none of the above
(e)

The advising bank is also called the

(i) Confirming bank (ii) Notifying bank
(iii) Reimbursing bank
(f)

(iv) None of the above

Negotiating bank is the bank which

(i) negotiates the preliminary contract of sale between the buyer
and the seller (ii) makes payment of the bills drawn by the seller
and accepts the documents
(iii) guarantees payment by the issuing bank
(iv) none of the above
(g)

When the LC specifies the bank that is to negotiate the bills

drawn under the LC then the
bank is also called
(i) Confirming bank (ii) Reimbursing bank

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(iii) Nominated bank

(iv) None of the above

(h) The confirming bank is
(i) the issuing bank when it confirms the issue of the LC (ii) the
negotiating bank when it confirms the negotiation of the bills (iii)
the advising bank when it confirms the LC (iv) none of the above
(i) When the confirming bank confirm the credit it (i) does not take
any liability
130
(ii)

undertakes on its part the liability under the LC

(iii)

undertakes to make timely delivery of the documents and

bills to the buyer or his bank
(iv)

none of the above

(j) Reimbursing bank is the bank
(i)

that reimburses the seller

(ii)

that reimburses the negotiating/paying or confirmingbank

(iii)

that reimburse the buyer on the goods being found defective

(iv)

none of the above

3.

Fill in the blanks.

(a)

Ordinary letters of credit are usually

, i.e. the bills drawn

hereunder have to be
paid immediately.
(b)

Letter of credit under which usance bills can be drawn is

called an

.

(c)

In a revocable LC the credit can be amended or cancelled by

the

.

(d)

Only letters of credit can be confirmed.

(e)

Credit in which the beneficiary is not liable for the bills

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drawn thereunder is
credit.
(f)

A back-to-back credit would involve at least bank, viz., the
bank, the

bank and the bank.
4.

State whether true or false.

(a)

All parties to a letter of credit transaction need to comply

with the terms only as far as
practical and not strictly.
(b)

In case the documents submitted by seller do not comply

with the terms of letter of credit
then the same can be accepted and sent for confirmation of buyer.
(c)

A bill of exchange is a document to title to goods.

(d)

A bill of exchange is also called a 'bill' or a 'draft'.

(e)

Invoice in a letter of credit transaction is a document similar

to a quotation based on which
the buyer places his order.
(f)

A bill of lading on a bona fide transfer confers on the

transferee a right to the goods.
(g)

An airway bill is also a document evidencing title to goods.

10.11 ANSWERS TO CHECK YOUR PROGRESS'
1.

(i) True; (ii) False; (iii) False

2.

(a) ii; (b) i; (c) iii; (d) iii; (e) ii; (f) ii; (g) iii; (h) iii; (i)ii;j)ii

3.

(a) Sight credits; (b) Acceptance credits; (c) Issuing bank;

(d) Irrevocable; (e) without recourse;
(f) Three; issuing, advising, third
4.

(a) False; (b) False; (c) False; (d) True; (e) False; (f) True;

(g) False

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DEFERRED PAYMENT GUARANTEE
STRUCTURE
11.0

Objectives

11.1

Introduction

11.2

Purpose of Deferred Payment Guarantee

11.3

Method of Payment

11.4

Let Us Sum Up

11.5

Keywords

11.6

Check Your Progress

11.7

Answers to 'Check Your Progress'

132
11.0

OBJECTIVES

After studying this unit, you should be able to understand:

a deferred payment guarantee,

purpose of a deferred payment guarantee,

various methods of payment under a deferred payment

guarantee.
11.1

INTRODUCTION

Though we had touched this type of guarantee while studying bank
guarantees, we shall deal with it here in more detail, since this type
of a guarantee is regularly issued by banks. 'Deferred Payment
Guarantee' as the name itself suggests, is a guarantee that indicates
that deferred (postponed) payments. Suppose a bank's customer
were to import capital goods on a deferred payment credit where

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the price is to be paid in instalments spread over a five year period,
the exporter will have to wait for each instalment to mature until
the whole amount is paid. In the meantime, the chances of the
importer going bankrupt or failing to pay may arise. To avoid such
a situation the exporter can request the importer to obtain a
guarantee that the payment in instalments will be made. The
importer would therefore, approach his banker to guarantee the
payments in instalments. This guarantee of the bank, assuring the
exporter of the timely payment of the instalments, is in short,
called 'Deferred Payment Guarantee' in brevity referred to as DPG.
11.2

PURPOSE OF DEFERRED PAYMENT GUARANTEE

When import or export of raw materials or consumer goods are
made the payment is done either immediately or within 360 days.
This period is called short term. However, in the case of capital
goods the amount involved being quite substantial, short-term
credit would not be of much help to the buyer, unless he has made
arrangements to get a term loan. Added to this, the requirement of
substantial amount of foreign exchange, may place the buyer at a
great disadvantage. To overcome this payment problem, since the
fifties the concept of deferred payment was introduced in India. As
stated earlier, in a deferred payment arrangement, the
buyer/importer is not required to make the entire payment of the
goods at one time, instead the price of the goods is paid in
instalments over a period of time as per terms mutually agreed to
with the seller.
In a deferred payment guarantee, a third party, mostly banks and
financial institutions, guarantee the payment of the instalments.
This guarantee ensures timely payment of the instalments to the

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seller/ exporter, failing which, the guarantee can be invoked and
payment received. To understand better the deferred payment
guarantee, it is necessary to understand how a payment is made in
a deferred payment contract and how the same is guaranteed by a
bank.
11.3

METHOD OF PAYMENT

In a contract for import of goods on deferred payment terms, the
importer is required to make payments in instalments over a
period of time which may range from one to seven years, in a
normal deferred payment contract. The payment, is usually done
on the following terms:
1. Advance payment of ten per cent to fifteen per cent of the price
of the goods is made by the buyer. 3. Another ten per cent to
fifteen per cent on receipt of documents under letter of credit. 3.
The balance amount, is paid in instalments spread over a period of
one to seven years, which is secured by a 'Deferred Payment
Guarantee'.
In a deferred payment guarantee, which as stated earlier, issued by
banks and financial institutions,
iED PAYMENT GUA
133
what is guaranteed, is the timely payment of instalments and
interest if provided. This is done by issuing a deferred payment
guarantee in which the following terms are mandatory:
1.

the supply of goods by the seller to the buyer and the seller

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agreeing to postpone the payment of the
price, this being the consideration of the guarantee;
2.

the payment schedule of both the instalment and the

interest;
3.

the unconditional and irrevocable assurance of the bank that

it would make payments on the
invocation of the guarantee.
As regards the supply of goods by the seller, it is to be remembered,
that banks do not take the respon¬sibility to ensure that the goods
shipped are what is required by the buyer/importer. Since the
guarantee, is mostly given prior to shipment of the goods, if the
documents are, as required under the letter of credit, and are valid,
then the guarantee of the bank subsists and the buyer cannot after
receipt of the goods, request the bank to stop payment on a
deferred payment guarantee on the grounds of defective goods.
As regards the payment schedule, it is to be noted that the payment
schedule is usually incorporated in the main contract between the
buyer/importer and the seller/exporter and the bank guarantees
the payment as stipulated in the schedule. Some banks as a matter
of abundant caution or to have better clarity of the payment
schedule incorporate the same in the guarantee issued by them,
though it is, for all purpose a verbatim reproduction of the payment
schedule from the main contract. In certain cases the
seller/exporter would draw bills on the buyer/importer for the
amounts of the deferred instalments including interest, which are
usance bills (being payable on a particular date and not
immediately) and payment of these bills are guaranteed by the
bank. The advantage of this method is that the seller/ exporter can

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discount these bills with his banker and get immediate finance.
In a deferred payment guarantee, like all other bank guarantees,
the banks undertake to make payment without any demur or
protest, since as per the guarantee, the bank has given an
unconditional and irrevocable assurance to the seller/exporter. It is
on such assurance that the seller/exporter has sold the goods. It is
therefore, of prime importance that the bank honours its
commitment. We have studied earlier while dealing with the bank
guarantees, that the bank's liability in a bank guarantee is primary
and independent of the underlying contract between the
buyer/importer and the seller/exporter. These principles apply in
toto to a DPG also.
11.4

LET US SUM UP

A deferred payment guarantee (DPG) is an unconditional and
irrevocable guarantee given by a bank to a seller/exporter that on
his supplying goods to the buyer/importer (who is the bank's
customer) on instalment basis the bank would ensure payment on
the due dates. DPGs are usually insisted upon, when capital goods
are imported and the seller/exporter requires an additional
assurance that the instalment payment allowed by him to the
buyer/importer is met. In a DPG the bank guarantees either the
payment of the instalments and the interest on the due dates or the
payment of the bills drawn on various dates by the seller/exporter.
A DPG being a guarantee given by a bank, its commitment to
honour the same is absolute unless there exists a case of fraud.
11.5

KEYWORDS

Deferred Payment; Deferred Payment Guarantee.
11.6

CHECK YOUR PROGRESS

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1. Say whether true or false.
(i) In a deferred payment guarantee, the guarantee is to ensure
delivery of eoods.
134
(ii) A deferred payment guarantee is mostly based on a primary
contract between the buyer and
the seller, (iii) A deferred payment guarantee differs from other
kinds of guarantee issued by banks as
regards payment liability of the bank on invocation, (iv) In a
deferred payment guarantee the banks liability comes into
existence only if all the
instalments are not paid and not on the non-payment of any one
instalment by the customer.
11.7 ANSWERS TO CHECK YOUR PROGRESS
1. (i) False; (ii) True; (iii) False; (iv) False.

er and nks as
ill the tomer.
LAWS RELATING TO BILL FINANCE
STRUCTURE
12.0

Objectives

12.1

Introduction

12.2

Class of Bills and Law Governing Bills

12.3

Classification of Bills

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12.4

Various Categories of Bill Finance

12.5

Bill Finance and Legal Position of a Banker

12.6

Let Us Sum Up

12.7

Check Your Progress

12.8

Answers to 'Check Your Progress'

136
BEGUL/
12.0

OBJECTIVES

After studying this unit, you should be able to understand:

basic law relating to bill finance;

legal position of banker in case of bill finance.

12.1

INTRODUCTION

Bill finance is one of the modes of lending by a banker. As
compared to other modes of financing, Bill finance offers a banker
an easy mode of lending. From the banker's point of view, bill
finance has many advantages. Bill finance involves discounting or
purchase of commercial bills arising out of sale of goods. Bill
finance, as compared to cash credit and overdraft, has the following
advantages:
(a)

The underlying transactions are easily identifiable

(b)

There is definite date of repayment

(c)

The bill will carry more than one signature if it is on usance

basis
(d)

It represents an easily transferable asset and in case of need

the same can be rediscounted to

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improve the liquidity of the bank.
12.2

CLASS OF BILLS AND LAW GOVERNING BILLS

(a)

Bills Discounted by banks belong to one of the following

categories
(i) Clean bills (ii) Documentary bills
(iii) Bills drawn under credit
(b)

Laws Governing Bills: The law on bills deals with the

liabilities and rights of parties to a bill is
governed by the Negotiable Instruments Act, 1881.
(i) What is a BUI? The term 'Bill' is the short form of 'Bill of
Exchange'. Section 5 of Negotiable Instruments Act, 1881 defines
bill of exchange as 'instruments in writing containing an
unconditional order signed by maker, directing a certain person to
pay certain sum of money only, to or to the order of a certain
person or to the bearer of the instrument.'
(ii) 'Drawer', 'Drawee', 'Payee': Section 7 of the Act provides that
amaker of 'Bill of Exchange' is called 'Drawer' and the person who
is directed to pay is called 'Drawee' and the person entitled to
receive payment of amount represented by 'Bill' is called 'Payee',
(iii) Relationship of Parties to a Bill: 'Drawer' of bill is a
creditor/seller and the 'Drawee' of a bill is the debtor/buyer. If the
bill is assigned to third parties, then such assignees will become
creditors and drawer would be liable for such assignees in case of
default by drawee.
(c)

A Glimpse of some important provisions of Negotiable

Instruments Act relating to Bills: It
will have to be noted that a 'Bill' is a negotiable instrument. Any
person to whom the bill is transferred in accordance with the

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provisions of the Act, would become entitled to receive the
amounts represented by the bill. We shall now examine certain
important provisions of the Act.
Section 8 'Holder': Section 8 of the Negotiable Instruments Act
defines the word 'Holder'. A Holder of bill of exchange means a
person entitled in his own name to possess the bill and recover the
amount represented by bill.
Section 9 'Holder in Due Course': 'Holder in due course' means any
person who for consideration became the possessor of the bill (that
is a person to whom the bill is transferred).
Section 10 'Payment in Due Course': 'Payment in due course'
means payment in accordance with
137
the apparent tenor of bill of exchange to the holder or holder in due
course in good faith and without negligence.
Section 14 'Negotiation': When a bill is transferred for
considerations to any person so as to entitle him to claim the
amount represented by bill, then such transfer is called
'Negotiation'.
Section 15 'Endorsement': If the holder of instrument signs the bill
of exchange for the purpose of transferring it, such signing is called
'Endorsement'.
Section 30 'Liability of Drawer': The drawer of a bill of exchange or
cheque is bound in the case of dishonour (failure to pay) by the
drawee or acceptor thereof, to compensate the holder, provided
due notice of dishonour has been given to, or received by, the
drawer.

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Section 32 'Liability of Acceptor/Drawee of Bill': An acceptor of bill
of exchange is bound to pay the amount thereof at maturity
according to apparent tenor of the acceptance.
Section 35 'Liability of Endorser': In the absence of contract to the
contrary, whoever endorses and delivers a negotiable instrument is
bound thereby to every subsequent holder in the case of dishonour
unless his liability is excluded.
Section 79 'Interest rate Specified': When interest at a specified
rate is expressly made payable on a bill of exchange, then interest
shall be calculated at such rates specified and payable.
Section 80 'Interest when no rate is specified': When no rate of
interest is specified in the instrument, interest due thereon shall be
calculated at the rate of eighteen per cent p.a.
12.3 CLASSIFICATION OF BILLS
'Bills' used under bill finance can be classified depending upon the
place where drawn, period and their nature as under:

Place
Inland bills
Period
3.

Demand bills

4.

Usance bills

Nature
1.
5. Clean bills
2. Foreign bills
1.

4. Usance bills

6. Documentary bills

Inland Bills: Bills drawn or made in India and made payable

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in or drawn upon any person resident
in India are inland bills. The necessary requisites of inland bills
are:
(a)

it must be drawn and made payable in India; (or)

(b)

it must be drawn in India upon some person resident in

India, though it may be made
payable in a foreign country.
Inland instruments are defined in Section 11 of Negotiable
Instruments Act, as under - Inland Instrument:
"A promissory note, bill of exchange or cheque drawn or made in
India and made payable in or drawn upon any person resident in
India shall be deemed to be an inland instrument."
2.

Foreign Bills: As per Section 12 of the Negotiable

Instruments Act, Foreign Bills are:
(a)

Bills, drawn outside India and made payable in or drawn

upon any person, resident in any
country outside India;
(b)

Bills drawn outside India and made payable in or drawn

upon any person, resident in India.
3.

Demand Bills: Section 19 of the Negotiable Instruments Act,

defines 'Demand Bill': It is an instrument
payable on demand and no time for payment is specified therein.
'Demand Bill' is otherwise called
'sight bill'. In these bills, the payee is entitled to the value of the bill
on demand and on presentation.
4.

Usance Bills: A usance bill is a bill payable otherwise than

on demand. It specifies nnrmaiiv <. *;~~

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138
li
for payment of the value it represents. 'Usance Bills' are otherwise
called 'Bills payable after sight'. In these kinds of bills, the drawer
draws a bill of exchange and specifies a time within which the
payment shall be made and presents the same to drawee for
acceptance. Once the drawee accepts the bill, the drawer at the
time or date specified on bill for payment can present the same to
drawee and demand payment. The date specified for payment is
otherwise called 'maturity/due date'.
5.

Clean Bills: A clean bill is a bill of exchange drawn as per the

requirements of the Negotiable
Instruments Act and is not supported by documents of title to
goods. Clean bills are drawn normally
to effect discharge of a debt or claim. Clean bills also arise when the
goods covered by the bill are
directly sent to the buyer due to mutual consent e.g. local bills and
supply bills.
6.

Documentary Bills: A bill of exchange accompanying

documents of title to goods, is called
'Documentary Bill'. These bills, are drawn to claim price of goods
supplied.
(i) Bills drawn with an instruction to deliver against payment: (or)
D.P. Bills: In a transaction for supply of goods, a seller draws a bill
on the buyer and sends the same to his banker along with

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document of title to goods like bill of lading, or railway receipt or
lorry receipt. The seller instructs the banker to deliver the bill and
documents of title to goods only when the buyer pays the price of
goods. These types of bills are D.P. bills in other words 'Delivery
against Payment Bills'.
(ii) Bills drawn with instruction to deliver against acceptance or
DA. Bills: An usance bill supported by documents of title to goods
bearing an instruction that the documents can be delivered, if the
buyer accepts the bill of exchange drawn on him. These are called
D.A. Bills or 'Delivery against Acceptance Bills'.
Besides the above, when the government department is supplied
goods or raw materials a bill is drawn on them for the price of
goods supplied. These are called supply bills. They do not squarely
fall within the ambit of Negotiable Instruments Act. However,
principle underlying to bills is also applied to 'Supply Bills'.
12.4 VARIOUS TYPES OF BILL FINANCE
Basically, a banker offers following types of bill finance.
1. Bill Purchase (B.P.)

2. Bill Discount (B.D.)

3. Advance against Bills for Collection (A.B.C.)
1.

Bills Purchased: When the bank negotiates bills payable on

demand, whether clean or documentary,
the facility is known as bill purchase. The face value of the bill, is
immediately paid to the holder.
The bank, after purchasing the bill, becomes the holder in due
course of the bill and acquires all the
rights of ownership over the instrument. Bill purchase facility is
extended generally in the case of
bills payable on demand. However, in the case of usance bills also

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this is extended when the due
date of the bill is not readily known at the time of extending this
facility. Such a situation arises
when the bill is drawn payable after some days after sight. The due
date of such a bill is known
when the bill is presented to the drawee and the period of usance
commences from the date of
presentation.
2.

Bills Discounting: This facility is extended by banker when

the bills of exchange are payable after
a particular period, that is bills payable otherwise on demand. For
example, 'A' draws a bill on 'B'
payable after three months and 'B' on presentation accepts the
same and agrees to pay after three
months. Such a bill is called a bill payable, otherwise on demand or
usance bill. In this type of
facility a banker pays the face value of the bill less discount,
becomes holder in due course, and
acquires all the rights under the bill.
139
3. Advance Against Bills for Collection: When the bank advances
against the bills, which are in course of collection, the facility is
known as advance against bills for collection. Under this facility, a
prescribed margin is kept by the bank and the amount, in
consideration of this is allowed to the customer. The bill thereafter
is sent for collection.
In all these cases, the legal effect is that the banker, who lends

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money, becomes holder in due course for the bill.
12.5 BILL FINANCE AND LEGAL POSITION OF A BANKER
Bill Discounting and Rights of a Banker: In the case of bills
discounting or bills purchase the bill of exchange drawn by the
borrower on third parties is presented to banker. Then the banker
pays the value of the bill of exchange to the borrower after charging
a commission or after a discount and gets the bill transferred to his
name. By such transfer, which is made by endorsement by the
borrower, the banker becomes the 'Holder in due course' and
would be entitled to receive the amounts from the acceptor of the
bill. Hence, it is imperative that a banker acquaints himself with
the legal aspects of lending through 'Bills discounting'.
Legal Relationship in the Case of Bills Discounting: In 'Bills
discounting' transactions a banker becomes a lawful holder of the
bill by taking a proper endorsement of the bill in his favour. The
banker becomes 'payee' of the bill and is entitled to recover the
amount represented by the bill. We will study some cases in respect
of bills discounting facilities that have been decided by courts.
(i) Irinjalakuda Bank Ltd. vs Pourthussery Panchayat (1970) 40
Compo Cases. 767: In this case a document in the form of cheque
issued by a Panchayat on a Government treasury payable to 'self or
order' was discounted by a bank. It was dishonoured by the
treasury, since Panchayat Inspector countermanded the payment.
The Court held that the banker is a holder in due course and hence
can recover the amount from the Panchayat.
(ii) Shambumal Gangaram and Another vs State Bank of Mysore
(AIR 1971 Mys. 156): In this case, legal action was initiated by the
bank for the recovery of dues from the customer because of the bill

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discounting facility granted to the customer. The bank was
providing 'Local Bill Discounting' (LBD) facility to its customer by
discounting the bills drawn by customer and endorsed by the
customer in bank's favour. The drawees of the bills generally paid
the amounts of bills. However, several bills remained unpaid and
bank filed a suit for recovery from the customer. The customer
contended that bank should have filed suit against the drawees of
bill of exchange. The Court rejected the argument of the customer
and directed him to pay the amount to bank holding that customer
being drawee is liable to bank who are holders in due course.
Discounting of Documentary Bills
A banker provides discounting of 'Documentary Bills', as a credit
facility to his customer.
What is a Documentary Bill?
'Documentary Bill' is a bill which is supported or accompanied by a
document of title to goods.
A lorry receipt or railway receipt, warehouse receipt, bill of lading,
etc., are some of the examples of documents of title to goods.
Law relating to Documents of Title to Goods
Sale of Goods Act and Bill of Lading Act: Government documents
of title to goods. Under these Acts, 'documents of title to goods' is
one in which ownership in goods can be transferred by
endorsement and delivery. Therefore, a banker as an endorsee of a
lorry receipt, railway receipt or bill of lading becomes the owner of
goods on transfer of said documents in his name.
140
In the case of Morvi Merchantile Bank Ltd. vs Union of India

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(1965) 35 Compo Cases 629, a Bombay firm, sent by rail (to self)
six boxes stated to contain menthol crystals from Thana to Okhla.
The railway receipts were endorsed by the firm to a bank against an
advance of Rs. 20,000. The boxes were not delivered at Okhla and
the bank sued the railway claiming damages amounting to Rs.
35,000 which was stated to be the value of the consignments. The
Trial Court dismissed the suit. On appeal by the bank, the Bombay
High Court held that the bank as an endorsee of railway receipts
was entitled to receive the amount. The Supreme Court confirmed
the order of High Court.
Drawee Bills Acceptance and Bill Co-acceptance Facilities
In 'Drawee Bills Acceptance Facility', the bank agrees to pay the
drawer the amount of bills drawn on the borrower on presentation
and recovers from the drawee on the respective due dates. This
credit facility is normally extended to borrowers who have been
granted working capital facilities. This is an alternative to cash
credit or overdraft. The amounts of bills accepted by the bank are
debited to 'drawee bills' discounting account and the borrower
reimburses the bank the amounts paid by bank with interest on the
respective due dates. These advances, are also governed by the
principles of law under the Negotiable Instruments Act. The bank
would be entitled to sue the borrower and recover from him the
amount due on bills. The bank will have also an additional
advantage of suing the drawer in event of dishonour of bill.
In the case of 'Bills Co-acceptance Facility', the banker accepts the
bills along with the borrower. Under this facility banker undertakes
a joint liability along with the borrower and enters into agreement
with the borrower for reimbursement.

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12.6

LET US SUM UP

1.

Law relating to bills is provided in the Negotiable Act, 1881.

2.

Categories of bills financed by banker are:

(i) Clean bills (ii) Documentary bills
(iii) Bills drawn under credit
3.

Maker of bill of exchange is called drawer.

4.

Drawee of a bill of exchange is a person who is directed to

pay the value of bill, and in the case
of usance bill of exchange, the drawee is called acceptor.
5.

In the case of bills relationships between the parties are:

(i) The drawer of the bill is creditor, (ii) The drawee of a bill is the
debtor.
6.

Holder in due course means any person who for

consideration became the possessor of the bill
and is entitled to all the rights of holder of the bill.
7.

Payment in due course means payment in accordance the

tenor of bill to the holder in due course
or to the holder of the bill, in due course and in good faith and
without negligence.
8.

Endorsement means signing the bill of exchange for the

purpose of transfer.
9.

Depending upon the place where the bills are made, they

can be classified into
(i) Inland Bills

(ii) Foreign Bills

10. Documentary bill means a bill accompanying documents of title
to goods.
12.7

CHECK YOUR PROGRESS

1.

Bill of exchange means a unconditional direction to the

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drawer to pay the moneys. (True/False)
2.

The maker of the bill is called

.

-^ rtrr? ATIM.
3.

Bill purchase facility is granted in the case of demand bills.

(True /False)
4.

facility is granted in the case of usance bills.

5.

of the bill is bound in case of dishonour of bill.

6.

Ownership of goods can be transferred by endorsement and

delivery of
7.

.

In bills co-acceptance facility the banker becomes a surety

for the value of bill. (True/False)
/
12.8 ANSWERS TO 'CHECK YOUR PROGRESS'
1. True; 2. Drawer; 3. True; 4. Bill Discounting; 5. Drawer; 6.
Document of title to goods; 7. True.

VARIOUS TYPES OF SECURITIES
STRUCTURE
13.0

Objectives

13.1

Introduction

13.2

Various Kinds of Securities

13.3

Let Us Sum Up

13.4

Keywords

13.5

Check Your Progress

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13.6

Answers to 'Check Your Progress'

144
13.0

OBJECTIVES

After studying this unit, you should be able to understand:

various kinds of securities;

advantages and disadvantages of the various securities.

13.1

INTRODUCTION

An advance made by a banker may be secured by a collateral
security. The effectiveness of a security would largely depend on
the nature of the security. The effectiveness of the securities can be
broadly classified on two aspects, the first being the economic
aspect, that is the marketability, valuation and other economic
factors that has a bearing on the value of the security. The other the
legal aspect is the validity and enforceability of the security. The
requisites of a good and acceptable security are as follows:
1.

The borrower should have a good title to the security.

2.

It should be easily and freely transferable.

3.

It should not have any encumbrance or liability for, e.g.,

partly paid shares.
4.

It should be easily marketable.

5.

It should not be liable to wide price fluctuations.

6.

Its value should be easily ascertainable.

7.

Its storing should not be difficult.

8.

It should be durable.

9.

It should be easily transportable.

We shall now study the various kinds of securities in the light of
above requisites and understand their advantages and

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disadvantages.
13.2

VARIOUS KINDS OF SECURITIES

1. Land/Real Estate: Bankers in the olden days were very much
averse to accept land and building as a security, but this prejudice
has over a period of time changed and land and building as a
security has become an acceptable collateral in most advances,
more particularly to corporate customers. The advantages and
disadvantages of this form of security cannot be universally applied
to all lands and it depends on the nature of the land offered. We
shall now discuss both the advantages and disadvantages.
Advantages
(i) The advantage that land has over other types of securities is that
its value generally increases with time. With every fall in the value
of money, the value of land goes up and due to its scarce
availability in developing areas its value is bound to increase.
(ii) It cannot be shifted, a fact which sometimes is also a
disadvantage.
Disadvantages
(i) Valuation is at-times difficult: The value of a building depends
on several factors such as location, size of property, state of repair,
amenities, etc., and in the case of factories and industrial buildings,
the machinery, nature of industry, etc. This makes the valuation
very difficult. Buildings and the materials used in the buildings are
not alike. In fact, buildings must be valued on a conservative basis
because of limited market in the event of sale.
(ii) Ascertaining the title of the owner: The banker cannot obtain a
proper title unless the borrower himself has title to the property to
be mortgaged. In India, the laws of succession

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145
a security >e broadly lation and >ect is the ty are as
d their
ngas :urity ners. ands and
ises its
as id
particularly those relating to Hindus and Muslims being very
complicated, it is difficult to ascertain whether a person has a
perfect title to the property or not. The banker would therefore
have to consult solicitors and obtain their opinion before accepting
it as a security, which in many cases delays lending. Title
verification, must also be done to know whether the property was
encumbered. This has to be done by verifying record with the
Registrar's office, which involves expense and time. In the case of
agricultural land, with the introduction of land ceiling legislation,
legislation protecting the tenants' rights, absence of up-to-date and
proper land records, it has become less valuable as a security.
Added to this there have been a number of legislations in different
states giving debt relief to the farmers and prohibiting transfer of
land to persons other than agriculturists.
(iii) Difficult to realise the security: Land is not easily and quickly
realisable due to lack of ready market. It may take months to sell
and some times if the market is not favourable, it may fetch a lower
price than what was anticipated.
(iv) Creating a charge is costly: The security can be charged either

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by way of legal mortgage or by way of an equitable mortgage. An
equitable mortgage may be created by a simple deposit of title
deeds with or without a memorandum. Although equitable
mortgage is less expensive, a banker always prefers legal mortgage
to an equitable mortgage, since the remedies under a legal
mortgage are better than those under an equitable mortgage.
However, completing a legal mortgage involves expenses including
stamp duty and lot of formalities.
(v) Difficulty on account of Rent Control Act: In the case of
buildings, which come within the purview of the Rent Control Act,
it would be difficult to sell the building, particularly when a tenant
has been occupying it for a long time. This reduces the
marketability and value.
Precautions to be taken by the banker
(i) Financial soundness of borrower: The banker should place more
reliance on the financial soundness of the borrower.
(ii) Borrower's title: The banker should get a solicitor to verify the
title to the property and the right of the borrower to mortgage.
(iii) Enquiry regarding prior charges: The borrower should produce
a certificate from the Registrar's office listing the charges over the
property over a period of time (generally 30 years) that the
property is free from encumbrances. This is commonly understood
as non-encumbrance certificate. If any prior charges exist the
banker's right will be subject to such prior charges.
(iv) Freehold or leasehold: A freeholder is the absolute owner of his
land and is able to deal with it as he likes. A leasehold property is
one which is taken on lease for a period and a leaseholder derives a
legal status for a term of years from the freeholder and is free to

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deal with the land when acting within the terms of the lease and
within the law during that period. When the lease expires, the land
reverts to the freeholder. In the case of leasehold property, the
unexpired period of the lease is an important consideration. The
longer the unexpired period of the lease, greater is the value of the
security. The bank should also ensure by verifying a copy of lease
deed that there are no onerous covenants such as the necessity of
taking the freeholder's consent before mortgaging the property.
The banker should also obtain the last ground receipt to ensure
that the lease is active.
(v) Valuation of the property: Valuation can be done in anyone of
the following ways:
(a)

By utilising the services of recognised valuers who would be

engineers or architects.
(b)

Making enquiries with local real estate agents.

(c)

By local authorities.

146
(d)

Latest sale transaction of neighbouring properties.

(e)

Calculations based on the annual rental value.

(vi) Registration: Where the principal money secured is Rs. 100 or
more, a mortgage charge
is required to be registered unless the charge is an equitable
mortgage, (vii) Documentations: The mortgage deed must be
drafted carefully considering all the legal
stipulations. It should be witnessed by at least two persons. In case
of simple mortgage it
attracts ad-valorum stamp duty, (viii) Verification of Tax Receipts:

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The banker should request the borrower to produce latest
property tax receipts since any arrears of tax constitute a
preferential charge on property, (ix) Insurance of the property: To
avoid loss of security by fire, natural calamities, it is prudent
that in case of buildings the banker insist on insurance of the
property for its full value at the
borrower's expense.
2. Stocks and Shares
Shares: These may be classified into preference shares (which
enjoy preference both with regards the payment of dividend and
repayment of capital) and equity shares, i.e., shares which are not
preference shares. Banks accept only quoted shares as security.
Advantages
(i) Value of the security can be ascertained without any difficulty.
(ii) In normal times, stocks and shares enjoy stability of value and
are not subject to wide
fluctuations.
(iii) Stocks and shares require very little formalities for taking them
as security, (iv) It is easier compared to real estate to ascertain the
title, more so with the advent of depositories. (v) Creating a charge
of this is less expensive than real estate, (vi) They yield intermittent
income by way of dividends, which can be appropriated towards
the
loan account.
(vii) Being a tangible form of securities they are more reliable, (viii)
The release of such securities involves very little expense and
formality.
Disadvantages

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(i) Being easy to realise, they are fraud prone and as such they must
be properly secured, (ii) In the case of partly paid shares, the
following demerits are there:
(a)

The banker may have to pay the calls.

(b)

Partly paid shares are subject to violent price fluctuations.

(c) They are not easily realisable because of the restricted market
for such shares.
Precautions while taking stocks and shares as security: Banker
must take the following precautions while advancing against stocks
and shares:
(i) In the case of partly paid shares (a) the banker should never
register them in his name.
(b)

He must ensure that pending calls are paid.

(c)

Sufficient margin should be taken to avoid any future loss or

change in the value of
the security.
(d)

The banker should verify share certificate and ensure that

the calls are paid properly
and entered in the space provided for the same.
Other precautions
(i) Update the list of shares which the particular bank is willing to
lend against on a regular basis.
I
147
(ii) Updating the amount that can be lent against a particular share

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which is called the card limit
at regular intervals, (iii) Yearly review of the portfolio or more
frequent review depending upon the volatility in the
capital market.
3. Debentures: Debenture is a document issued by a company
acknowledging its indebtedness to the bearer or a registered
holder. A fixed rate of interest is payable at stated periods on such
debentures. In the case of mortgage debentures, a charge is created
on the assets of the company issuing such debentures in favour of a
trustee who is responsible to take care of the interest of individual
investors.
Advantages
(i)

Easy to sell.

(ii)

Not subject to violent price fluctuations.

(iii)

They can be transferred at minimum cost.

(iv)

Bearer debentures are fully negotiable.

(v)

They rank in priority to shares and mostly secured by a

charge on the company's property.
Disadvantages
(i) If interest is not paid regularly on the debentures, it would affect
its price and marketability, (ii) If the charge on property of
company is not registered, the subsequent charges will get a
priority, (iii) Debentures may be issued by companies having no
power to borrow money.
Precautions to be taken while taking debentures as security
(i) The nature of the debentures must be ascertained, i.e., whether
they are unsecured or
secured, the later being preferred, (ii) The borrowing powers of the

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company issuing the debentures must be ascertained and to
verify that the same has not been exceeded.
(iii) Deposit of the debentures plus a memorandum of deposit is
necessary, (iv) The nature and value of the assets charged must be
examined frequently. (v) The banker must find out whether there
are any uncancelled redeemed debentures.
4. Goods: Though, earlier, bankers were not forthcoming to
advance against goods or documents of title to goods, now more
and more secured advances of the scheduled banks in India are
against goods.
Merits of this Security
(i) Goods have a ready market and as such can be easily sold unlike
other kinds of security.
(ii) Valuation of the goods can be easily done.
(iii) The banker gets a tangible form of security compared to
unsecured advances, which in
case of default by the borrower, can be realised by sale of pledged
goods, (iv) Advances against goods are normally given for short
periods and therefore the risk of the
banker is considerably reduced, (v) Barring a few states where the
stamp duty is heavy, creating a charge on the security is less
costly and involves minimum formalities, (vi) Banker acquires a
good title to the goods when dealing with customers of repute and
standing.
Demerits of this Security
(i) Certain goods are liable to perish or deteriorate in quality over a
period of time, thus resulting in reduction of the value of the
banker's security.

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148
(ii) There are possible risks of fraud or dishonesty on the part of the
borrower. For example, when 10,000 tins of cashew nuts are
shown in the godown as security for an advance, it is not possible
for the banker to verify the quality and quantity in every tin. It is
not even possible to verify whether all the 10,000 tins contain
cashew nuts. A fraudulent borrower may not store the full stocks as
declared in the godown.
(iii) The value of the security in certain cases more particularly
electronic consumer goods are subject to wide fluctuations.
Therefore, the valuation of such goods is difficult. Even in the case
of necessaries, there being several varieties, unless the banker has
expert knowledge, the valuation may be misleading. Disposing of
large quantities of goods within a short time may be difficult and
may not fetch the expected / declared price.
(iv) The banker may find it difficult to store the goods.
(v) Transporting the goods from the borrower's premises to the
banker's premises and thereafter to the market in case of sale is a
considerably costly and time-consuming affair.
(vi) When the banker releases goods for sale on the execution of
trust receipts, the money realised by the sale of such goods may not
be deposited with the banker and the borrowers may default to the
bankers.
(vii) If the goods are warehoused, the warehouse keeper enjoys a
lien over the goods for any unpaid charges. The banker therefore,
has to ensure periodically that all charges are duly paid.
Valuation of Goods

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(i) Advances are given based on the stocks and their value declared
in monthly stock/statements.
The stock/goods are to be inspected at regular intervals and prices
verified and tallied with
purchase invoices.
(ii) By visiting factory/godown by officials and valuers like cost
accountants, (iii) Follow up of account ensuring payment to
creditors for stock and collection of debtors
thus avoiding diversion/misuse of funds.
Precautions to be taken
(i) Advances against goods should be restricted to genuine traders
and not to speculators, (ii) Loans must be given for short periods,
since the quality and thereby the value of the security
is likely to diminish, (iii) The banker must have a working
knowledge and gather information of the different types
of goods regarding their character, price movements, storage value,
etc. (iv) The banker should confirm the state of goods, (v) The
goods should be insured against loss by theft or fire, (vi) The
banker should verify and confirm the title of the borrower to the
goods by inspecting
the invoices or cash memos. (vii) The banker as a Pawnee is liable,
if reasonable care is not taken of the goods pledged. He
should therefore, take proper care for their storage and also take
reasonable steps to protect
them from damage and pilferage.
(viii) The price of the goods must be accurately ascertained, (ix)
Necessary margin must be taken by the banker to protect him
against fluctuations in the

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price of goods.
(x) The banker must obtain absolute or constructive possession of
the goods, (xi) In the case of hypothecated goods, the bank should
obtain from the borrower a written
undertaking that the goods are not charged to any bank or creditor
and will not be so
charged as long as the borrower is indebted to the bank. The
banker should obtain at regular
149
periods certificates regarding the quantity and valuation of the
goods, which should be physically verified by the banker.
Documents of Title to Goods: What are Documents of Title to
Goods?
As per the Section 2(4) of the Sale of Goods Act, 1930, a document
of title to goods is 'a document used in the ordinary course of
business as a proof of possession or control of goods authorising or
purporting to authorise either, by endorsement or delivery, the
possessor of the documents to transfer or receive the goods thereby
represented.' Thus, the essential requisites of a document of title to
goods are:
(i) The mere possession of the documents creates a right either by
virtue of law or trade usage,
to possess the goods represented by the documents, (ii) Goods
represented by the documents can be transferred by endorsement
and/or delivery of
the documents.
(iii) The transferee of the documents can take delivery of the goods

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in his own right, (iv) Although they appear to be negotiable
instruments, documents of title to goods are not negotiable
instruments. The title of bona fide transferee for value can be
affected by defects in the title of transferor. They may be called
quasi-negotiable instruments.
Examples of documents of title to goods are bills of lading, dock
warrant, warehouse-keeper's certificate, railway receipts, delivery
orders, etc. Documents of title to goods must be distinguished from
other documents like the warehouse-keeper's non-transferable
receipts, which are mere acknowledgement of the goods.
Documents of title to goods are preferred by bankers because
under Section 52(2)(e) of the Presidency Towns Insolvency Act,
1909, and Section 28(3) of the Provincial Insolvency Act, 1920,
possession of goods represented by such instruments duly
endorsed in his favour are taken out of the order and disposition of
the insolvent. The significance of this is that in case the borrower
becomes insolvent, the Official Receiver or Official Assignee as the
case may be, cannot include such goods in the assets of the
insolvent.
Merits of this Security
(i) By mere pledge of the instruments the goods are pledged and
serve as a good security, (ii) The person in possession of the
document can transfer the goods by endorsement and/or
delivery. The transferee thereafter is entitled to take delivery of the
goods in his own right, (iii) The documents are easily transferable,
and the formalities involved are less compared to
mortgage or assignment.
Demerits of this Security

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(i) Possibility for fraud and dishonesty: Since the bill of lading or a
railway receipt or a warehouse-keeper's certificate does not certify
or guarantee the correctness of the contents of the bags or
packages, the banker will have no remedy against the carrier or
warehouse-keeper, if they turn out to be containing worthless
goods.
(ii) Forged and altered documents: The documents might be forged
ones, or even if genuine,
the quantity may be altered.
(iii) Not Negotiable documents: The document being "Not
Negotiable", the transferee of such documents will not get a better
title than that of the transferor. Therefore, if the person who
pledged the documents has a defective title, the banker will not
acquire a better title, (iv) Unpaid vendor's right of stoppage in
transit: Under the Sale of Goods Act, 1930, an unpaid vendor has
the 'right of stoppage in transit' and he is entitled to direct the
carrier that the goods need not be delivered, if not already done. If
this right is exercised by the unpaid vendor, the banker cannot
obtain the goods and his security is of no value.
150
(v) In the case of lost documents, delivery of the goods is allowed
on the execution of an indemnity bond, this option may be misused
by the borrower by selling the goods to some other customer who
may take delivery of the goods declaring that he had lost/misplace
the document and indemnifying the carrier. To avoid such a
contingency, the banker can give notice to the carrier regarding his
interest and the pledge.

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Precautions to be taken by the banker
(i) The documents must be examined thoroughly to ensure that
they are genuine and of recent origin. In the case of bills of lading,
they are prepared generally in triplicate and as such all the copies
must be obtained by the banker. Otherwise, the carrier is released
from his obligation by delivering the goods on the presentation of
any one copy containing ostensibly regular endorsements.
(ii) The banker should ensure that the documents do not contain
any onerous clauses or prejudicial remarks about the condition of
goods received.
(iii) Banker should ensure that the goods are adequately covered by
insurance for full value against risks of theft, fire, damage in
transit, etc., and in the case of goods shipped by sea, all the marine
risks should be covered.
(iv) Banker should ensure to get consignee copy and banks name
being entered as consignee, so that endorsement/transfer of title is
specific.
Trust Receipt
Whenever the bank releases documents of title to goods to the
borrower without payment being made, then a 'Letter of Trust'
should be taken. So also in the case of goods hypothecated to the
bank. The reasons are as follows:
(i) The borrower on sale of the goods has to hold proceeds in trust
for the banker. (ii) The goods taken under such trust receipts or the
sale proceeds thereof, are not available to the official receiver in
case the borrower becomes insolvent.
A Trust letter incorporates the following clauses
(i) Borrower's recognition, of bank's rights in the goods as security

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and in case of sale, the
proceeds, thereof.
(ii) Borrower's, undertaking to hold the goods or sale proceeds
thereof, in trust for the banker, (iii) Borrower's undertaking, to
ensure proper storage and insurance, at his cost. (iv) Borrower's
undertaking to direct the buyer to pay the monies directly to the
banker, if so
required by the banker, (v) Borrower's undertaking to return
unsold goods on banker's request or dispose of the same
as directed by the banker.
5. Life Policies: Purpose of Life Policy: A life policy is taken for
two purposes:
(i) It is a source of income for the dependents of the assured in case
of his death, (ii) It is an ideal form of saving since along with
income tax deduction on the premium, paid loans can be raised on
the policies in times of need.
Advantages
(i) Life insurance business being highly regulated and permitted
only to companies having sound financial health, the banker need
not doubt the realisation of the policies, which will be done without
any difficulty, if the policy and the claim are in order.
(ii) The assignment of the policy in favour of the banker requires
very little formalities and the banker obtains a perfect title.
151
6.

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(iii) The longer the period for which the policy has been in force,
the greater the surrender value. It is also useful as an additional
security because, in the event of the borrower's death, the debt is
easily liquidated from the proceeds of the policy.
(iv) The security can be realised immediately on the borrower's
default of payment by surrendering the policy to the insurance
company.
(v) The policy is a tangible security and is in the custody of the
bank. The banker only has to ensure that regular payment of
premiums is made.
Disadvantages
(i) If the premium is not paid regularly, the policy lapses and
reviving the policy is complicated.
(ii) Insurance contracts being contracts of utmost good faith, any
misrepresentation or non¬disclosure of any particulars by the
assured would make the policy void and enable the insurer to avoid
the contract.
(iii) The person (proposer) who has obtained the policy must have
an insurable interest in the life of the assured or the contract is
void.
(iv) The policy may contain special clauses, which may restrict the
liability of the insurer.
(v) When the banker accepts a policy coming under Married
Women Property Act he must ensure that all the parties sign in the
bank's form of assignment.
(vi) There is facility to obtain the duplicate policy if the original is
lost. This can be misused by persons by obtaining duplicate
policies. Banker should, therefore, verify that no duplicate policy

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has been issued and there are no encumbrances on the policy.
Advantages
(i) The policy must be assigned in favour of the bank and should be
sent directly to the insurance company for registration and ensured
that only authorised office of Insurance Company has noted
assignment.
(ii) The bank should see that the age of the assured is admitted.
(iii) The banker should ensure the regular payment of premium.
Book Debts: Borrowers can take advances by assigning book debts
in favour of the bank. Section 130 of the Transfer of Property Act
permits assignment of actionable claim and the procedure to be
followed is:
(i) The assignment must be in writing and signed by the transferor
or his duly authorised
agent.
(ii) Notice of the assignment in writing must be given to the debtor;
and. (iii) The assignment may be absolute or by way of charge.
Legal implication of assignment
(i) The assignee can sue in his/their own name and can give a valid
discharge.
(ii) The debtor can exercise any right of set off against the assignee,
which but for such
transfer, he could have exercised against assignor, (iii) As an
actionable claim includes future debts, there can be a valid
assignment of future debts
as well.
Precautions to be taken
(i) The value of the security depends on the solvency of the debtor

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and his right of set off, if
any. The banker must enquire into both aspects, (ii) The
instrument of assignment must be in writing and duly signed in the
presence of the
banker, signed by the assignor or his duly authorised agent.
152
(iii) The banker must serve notices of assignment on debtors, who
must be asked to acknowledge its receipt and confirm:
(a)

The amount of the debt.

(b)

His right of set off, if any, and

(c)

Whether he has received notice of prior assignments, if any.

(iv) An undertaking from the borrower should be taken that the
amount of debts collected directly if any by him will be passed on to
the banker, towards the loan account and operations in account be
controlled to ensure this compliance.
(v) Where the book debts are as assigned by a joint stock company,
the charge must be registered with the Registrar of Joint Stock
Companies.
7.

Fixed Deposit: When money deposited by a customer is not

repayable on demand and is payable on
the expiry of a specified period from the date of deposit such a
deposit is called a 'Fixed Deposit'.
The banker evidences a deposit by issuing a receipt known as fixed
deposit receipt. Interest is paid
at regular intervals at a specified rate on such deposits. Banks
usually permit depositors to borrow
against the deposit. This security is certainly the most valuable, as

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the money represented by the
receipt is already with the bank and there is no problem of
valuation or enquiring the title, or the
problem of storage and costs associated with storage.
Precautions
(i) The banker should grant the advance only to the person in
whose name the money is deposited. Banker should not advance
against fixed deposit receipts of other banks. This is because the
banker who has received the deposit will have a general lien over
such monies. Even if the lending bank gives notice to the bank,
which has received the deposit, the latter may even refuse to
register the lien in favour of the lending bank.
(ii) If the deposit is in joint names the request for loan must come
from all of them.
(iii) When the deposit receipt is taken as security, the banker
should ensure that all the depositors duly discharge it on the back
of the instrument after affixing the appropriate revenue stamp. In
addition to this, the banker should obtain a letter of appropriation
which authorises the banker to appropriate the amount of the
deposit on maturity or earlier towards the loan amount.
(iv) After granting the advance, the banker must note his lien in the
fixed deposit register to avoid payment by mistake and the lien,
must also be noted on the receipt itself.
(v) Advance should preferably not be made against fixed deposit
receipt in the name of a minor, unless a declaration is taken from
guardian, that loan will be utilised for benefit of the minor.
(vi) Where the money is being advanced against the fixed deposit
receipt issued by another branch, the FDR duly discharged must be

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sent to the branch where such money is deposited for the following
purposes:
(a)

To verify the specimen signature of the depositor

(b)

To ensure that no prior lien exists on the fixed deposit

receipt
(c)

To mark lien on the FDR and the FDR register, in favour of

branch advancing money.
(vii) Sometimes a person may approach for advances by offering
the fixed deposit receipts held by third parties as security. In such a
case, the fixed deposit receipt must be duly discharged by the third
party, i.e., FD holder and he should declare in writing the bank's
right to hold the deposit receipt as security, and also to adjust the
deposit amount towards the loan account on maturity or on default
in repayment of instalment if any.
8.

Supply Bills: Supply bills arise in relation to transactions

with the Government and public sector
undertakings. A party might have taken a contract for execution,
and he is entitled to progressive
153
payments based on work done, for which he has to submit bills in
accordance with the terms and conditions of the contract.
Similarly, parties who have accepted tenders for supply of goods
over a period are entitled to payments on the supply of goods, for
which they submit bills in accordance with the terms of the
contract. These bills are known as supply bills.
Procedure followed in respect of supply bills
(i) The supplier delivers the goods supported by a delivery challan

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and produces the documents. The appropriate authority of the
government department inspects these goods and accepts for
payment on due date and the supplier obtains an inspection note.
In the case of contracts, an engineer's certificate regarding work
done is obtained.
(ii) The supplier or the contractor as the case may be, prepares the
bill for obtaining payment. Government departments take quite
some time to verify the bills and pass them for payment. Therefore,
the supplier or contractor submits these bills together with the
accepted delivery challan and inspection note or the engineer's
certificates to the appropriate Government department through the
banker and requests the banker to advance against such bills.
These bills do not enjoy the status of negotiable instruments. They
are in the nature of debts and are assigned, in favour of the banker
for payment, after affixing a revenue stamp for having received the
amount. The bank should also obtain a letter from the supplier or
contractor, requesting the appropriate department to make the
payment directly to the banker.
Risks involved in advancing against supply bills
(i) Although the advance is self-liquidating in nature, in certain
cases it can take quite some
time before the advance is realised because of administrative and
other Governmental
procedures, (ii) It is virtually a clean advance and the bank may not
realise the full amount, because of the
possibility of counter claim or the right of set off by the
Government, as the charge is only
by way of assignment, (iii) Sometimes, the Government may not

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pass the bills for full payment because of the
unsatisfactory quality of goods or defective work done by the
contractor or delays in the
completion of work.
Precautions to be taken by the banker
(i) Advances against supply bills should be made only to borrowers
who have sufficient
experience in Government business and Government regulations.
(ii) The contract between the supplier and the Government
department should be scrutinised
by the banker, to know the volume of transaction, period of supply,
rates agreed upon and
various other terms and conditions. The Government will not pass
the bills unless there is
faithful adherence to the terms and conditions by the supplier, (iii)
The banker should obtain a power of attorney from the supplier
authorising him to receive
the money. The same should be registered with the appropriate
Government department, (iv) The banker should obtain the
inspection note or the engineer's certificates along with the
bills. There should be no adverse remarks in the inspection report
regarding the quality and
quantity of goods supplied, (v) There are two types of bills that are
submitted by the suppliers. They are:
(a)

Interim bills against which Government pays eighty to

eighty-five per cent of the
amount.
(b)

Final Bills for the balance of twenty to fifteen per cent which

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will be paid only after
complete verification of goods at the point of destination. Because
of the delay involved
154
in the settlement of final bills, banks should prefer the interim bills
for advancing and final bills only for collection. Keep sufficient
margin to cover advance with interest thereon from proceeds to be
received.
(vi) Banker must reserve the right of demanding the repayment of
advance, if the bills remain unpaid for a specified period. The
banker, in other words, treats the bills as only items for collection
and the advances are recovered.
13.3

LET US SUM UP

The effectiveness of a security offered to a banker would largely
depend on the nature of the security, which includes its
marketability, valuation and other economic factors and certain
legal aspects, like the borrower's title, existing encumbrance or
liability attached to the security. The various kinds of normally
acceptable securities include land/real estate, stocks and shares,
debentures, goods, life policies, book debts, fixed deposit receipts
and supply bills.
The securities depending on their nature have various advantages
and disadvantages. The banker however, has to verify the worth of
the security and its readability, before accepting it. Of all the kinds
of security, fixed deposit receipt of the bank is the best and most
reliable compared to other forms of security. The security of goods
can be created either by pledging the goods directly or by pledging

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the title to goods, which in turn is a pledge of the goods or by
charge by way of hypothecation.
13.4

KEYWORDS

Preference Shares; Equity Share; Debenture; Documents of Title to
Goods; Life Policy; Trust Receipt.
13.5

CHECK YOUR PROGRESS

1. State whether true or false.
(a)

If money lent is more than Rs 100 on the security of land,

then the mortgaged (simple)
requires registration.
(b)

A mortgage deed need not be witnessed.

(c)

Permission from Income Tax Authorities under the Section

230 to create mortgage is required
only if the land belongs to a company.
(d)

Arrears of tax constitute a preferential charge on the

property.
(e)

There are three types of shares - ordinary, equity and

preference.
(f)

Debenture is a kind of share issued by a company and has

no voting rights.
(g)

Borrower can create a valid pledge with documents of title to

goods.
(h) Bills of lading, dock warrants, warehouse-keeper's certificate,
etc., are some examples of documents of title to goods.
(i) Documents of title to goods are negotiable instruments.
(j) Only Life Insurance Companies can issue life policies, (k)
Insurance contracts are contracts of absolute good faith.
(1) An assignee of a life policy can sue in his/her own name, (m)

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For a loan against fixed deposit receipt, the stamp duty is very high,
(n) Supply bills are bills of exchange.
13.6 ANSWERS TO 'CHECK YOUR PROGRESS'
1. (a) True; (b) False; (c) False; (d) True; (e) False; (f) False; (g)
True; (h) True; (i) False; (j) True; (k) True; (I) True; (m) False; (n)
False.

LAW RELATING TO SECURITIES AND MODES OF CHARGING I
STRUCTURE
14.0

Objectives

14.1

Introduction

14.2

Mortgage

14.3

Let Us Sum Up

14.4

Check Your Progress

14.5

Answers to 'Check Your Progress'

156
14.0

OBJECTIVES

After studying this unit, you should be able to understand:

various types of mortgages and law relating thereto;

essential features of various types of mortgages.

14.1

INTRODUCTION

When land/building is offered as a security, it is charged to the
bank by a mortgage. Mortgages are of six kinds, though as a banker
you would be dealing in only three of them. The law, relating to

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mortgages is dealt with in the Transfer of Property Act, 1882. and
more particularly in Sections 58 to 99 and 102 to 104. We shall now
study these provisions and see how they affect us, as bankers in our
business of lending.
14.2

MORTGAGE

Section 58(a) of the Transfer of Property Act, 1882 defines a
mortgage as follows:
'A mortgage is the transfer of interest in specific immoveable
property, for the purpose of securing the payment of money
advanced or to be advanced by way of loan, on existing or future
debt or the performance of an engagement which may give rise to a
pecuniary liability.'
The transferor is called the 'mortgagor' and the transferee a
'mortgagee' the principal money and interest of which payment is
secured is called mortgage money and the instrument by which the
transfer is effected is called the 'mortgage deed'.
1.

Ingredients of Mortgage: From the above definition of

mortgage, the following are the requirements
of a mortgage:
(i) There should be transfer of interest in the property by the
mortgagor (the owner or lessor), (ii) The transfer should be to
secure the money paid or to be paid by way of loan.
2.

Mortgage of Land - Various Types: The Transfer of Property

Act contemplates six different kinds
of mortgages. They are:
(i)

Simple mortgage

(ii) Mortgage by conditional sale

(iii)

Usufructuary mortgage

(v)

Mortgage by deposit of title deeds (Equitable mortgage)

(iv) English mortgage

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(vi)

Anomalous mortgage

Simple mortgage
According to Section 58(b) of the Transfer of Property Act, a simple
mortgage is a transaction whereby, 'without delivering possession
of the mortgaged property, the mortgagor binds himself personally
to pay the mortgage money and agrees, expressly or impliedly, that
in the event of his failing to pay according to his contract, the
mortgagee shall have a right to cause the mortgaged property to be
sold by a decree of the Court in a suit and the proceeds of the sale
to be applied so far as may be necessary in payment of the
mortgage money.'
Features of simple mortgage
(i) The mortgagee has no power to sell the property without the
intervention of the Court.
In case there is shortfall in the amount recovered even after sale of
the mortgaged property the
mortgagor continues to be personally liable for the shortfall, (ii)
The mortgagee has no right to get any payments out of the rents
and produce of the mortgaged
property.
iOf
02 of
he
he
id
157

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(iii) The mortgagee is not put in possession of the property.
(iv) Registration is mandatory if the principal amount secured is
Rs. 100 and above.
Mortgage by way of conditional sale
As per Section 58(c) of the Transfer of Property Act, a mortgage by
way of a conditional sale of the property is a transaction whereby
the mortgagor ostensibly sells the mortgaged property on the
condition that:
(a)

on default of payment of the mortgage money on a certain

date, the sale shall become absolute, or
(b)

on such payment being made the sale shall become void; or

(c)

on such payment being made, the buyer shall transfer the

property to the seller.
No such transaction shall be deemed to be a mortgage of
conditional sale, unless the condition is embodied in the document,
which effects or purports to effect the sale.
Essential features
(i) The sale is ostensible and not real.
(ii) If the money is not repaid on the agreed date, the ostensible
sale will become absolute upon the
mortgagor applying to the Court and getting a decree in his favour.
The mortgagor in such a case
loses his right to redeem his property, (iii) The mortgagee can sue
for foreclosure, but not for sale of the property. Foreclosure, means
the
loss of the right possessed by the mortgagor to redeem the
mortgaged property, (iv) There is no personal covenant for
repayment of the debt and therefore bankers do not prefer this

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type of mortgage. The mortgagee cannot look to the other
properties of the mortgagor in case the
mortgaged property proves insufficient.
Usufructuary mortgage
According to Section 58(d) of the Transfer of Property Act, 'a
Usufructuary mortgage is a transaction in which
(a)

the mortgagor delivers possession expressly, or by

implication and binds himself to deliver
possession of the mortgaged property to the mortgagee; and
(b)

authorises the mortgagee to retain such possession until

payment of the mortgage money and to
receive the rents and profits accruing from the property or any part
of such rents and profits and
to appropriate the same in lieu of interest, or in payment of the
mortgage money, or partly in lieu
of interest and partly in payment of the mortgage money.
Essential features
(i) The mortgagee is put in possession of the mortgaged property.
Here, by possession it is meant, the legal possession and not the
physical possession. For example, the mortgagor may continue to
enjoy the physical possession as the lessee of the mortgagee or the
mortgagor may be the caretaker of the property directing the
tenants to pay rent to the mortgagee. However, the deed must
contain a clause providing for the delivery of the property to the
mortgagee and authorising him to retain such possession.
(ii) The mortgagee has the right to receive the rents and profits
accruing from the property. Such rents and profits or part thereof,
may be appropriated in lieu, of interest or in payment of the

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mortgage money or partly for both.
(iii) Unless there is a personal covenant for the repayment of the
mortgage money, there is no personal liability for the mortgagor.
Therefore, the mortgagee cannot sue the mortgagor for repayment
of the mortgage debt; nor can he sue mortgagor for the sale or
foreclosure of the mortgaged property.
(iv) There is no time limit specified and the mortgagee remains in
possession of the property until the debt is repaid. The only remedy
for the mortgagee is to remain in possession of the mortgaged
property and pay themselves out of the rents and or profits of the
mortgaged property. If the
158
mortgagor fails to sue for redemption within thirty years, the
mortgagee becomes the absolute owner of the property.
Bankers do not prefer this form of mortgage for the following
reasons:
(i) There is no personal covenant to repay the debt.
(ii) As the mortgaged money can be recovered only by the
appropriation of rents and/or profits, it will take a very long time to
recover money through this process.
English Mortgage
According to Section 58(e) of the Transfer of Property Act, an
'English Mortgage' is a transaction in which, the mortgagor binds
himself 'to repay the mortgage money on a certain date and
transfers the mortgaged property absolutely to the mortgagee, but
subject to the provision that he will retransfer it to the mortgagor
upon payment of the mortgage money as agreed'.

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Essential features
(i) It provides for a personal covenant to pay on a specified date
notwithstanding the absolute
transfer of the property to the mortgagee, (ii) There is an absolute
transfer of the property in favour of the mortgagee.
However, such absolute transfer is subject to a provision that the
property shall be re-conveyed to
the mortgagor in the event of the repayment of mortgage money,
(iii) The mortgagee can sue the mortgagor for the recovery of the
money and can obtain a decree for
sale.
Equitable mortgage or mortgage by deposit of title deeds
According to Section 58(f) of the Transfer of Property Act, 'Where a
person in any of the following towns - namely, the towns of
Kolkata, Chennai and Mumbai and in any other town which the
State Government concerned may, by notification in the official
gazette, specify in this behalf - delivers to a creditor or his agent
documents of title to immoveable property, with intent to create a
security thereon, the transaction is called a mortgage by deposit of
title deeds.'
Documents of title
Documents of title or title deed in case of mortgage by deposit of
title deeds, shall be documents or instruments which relate to
ownership of the mortgagor over the property. In other words, by
virtue of a document or instrument, if a person has a right to
peaceful possession and enjoyment of the immoveable property,
then such a document or instrument is called the title deed. In the
case of Syndicate Bank vs Modern Tile and City Works (1980 KL T

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550); it was explained by the learned Judges that documents of
title or deed means the legal instrument which proves the right of a
person in a particular property.
Essential features
(i) Such a mortgage can be affected only in the towns notified by
the State Government. However, the territorial restriction refers to
the place where the title deeds are delivered and not to the
situation of the property mortgaged.
(ii) To create this mortgage, there must be three ingredients i.e. a
debt, a deposit of title deeds and an intention that the deeds shall
be act as security for the debt.
Anomalous mortgage
According to Section 58(g) of the Transfer of Property Act, 'a
mortgage which is not a simple mortgage, a mortgage by
conditional sale and usufructuary mortgage and English mortgage
or a mortgage by deposit of title deeds within the meaning of this
Section, is called an 'Anomalous Mortgage.'
Essential features
(i) It must be a mortgage as defined by Section 58 of the Transfer of
Property Act. (ii) It is negatively defined and should not be anyone
of the mortgages listed above.
159
(iii) Anomalous mortgages are usually a combination of two
mortgages. Examples of such mortgages are:
(a)

a simple and usufructuary mortgage, and

(b)

an usufructuary mortgage accompanied by conditional sale.

There may be other forms,

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moulded by custom and local usage.
3.

Merits and Demerits of an Equitable Mortgage

Merits
(i) The borrower saves the stamp duty on the mortgage deed and
the registration charges. It
involves minimum formalities, (ii) It involves less time and can be
conveniently created.
It can be done without much publicity and therefore, the
customer's position is not exposed to public gaze.
Demerits
(i) In case of default, the remedy is to obtain a decree for sale of the
property. Since, this involves going to the Court, it is expensive and
time consuming. This shortcoming, can be overcome by inserting a
covenant by which the mortgagee is given the power of sale. In that
case, the mortgage deed must be properly stamped and registered
and the mortgage loses the advantage of being simple in procedure
and less expensive.
(ii) Where the borrower is holding the title deeds in his capacity as
a trustee and equitable mortgage of the same is effected, the claim
of the beneficiary, under trust will prevail over any equitable
mortgage. Therefore, the banker has to make a proper scrutiny of
the title deeds before accepting them as a security.
(iii) The borrower may create a subsequent legal mortgage in
favour of another party. However, this possibility is not there, if the
equitable mortgagee holds the original title deeds. In India, there is
no difference between the two types of mortgages. According to
Section 48 of the Registration Act, 1908, a mortgage by deposit of
title deeds prevails against any subsequent mortgage relating to the

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same property. Similarly, the title of the equitable mortgagee, is not
defeated by any subsequent sale without notice. However, to avoid
any risk of this type, the equitable mortgage should be accepted
only after obtaining the original title deeds.
The law in England is slightly different. As between equitable
mortgage and legal (simple) mortgage, the latter prevails even
though it is effected subsequently. The law, regarding this is, as
between law and equity, law prevails. As between the equities, the
prior in time prevails.
4.

Difference between Equitable Mortgage and Pledge

Table 14.1: Difference between Equitable Mortgage and Pledge
Pledge Mortgage
Pledgee acquires only a limited interest in the property and
ownership remains with the right of pledger.
The Pawnee has 'special property' in the goods pledged and can sell
the same in the event of default by the pledger of course, after
giving reasonable notice. Pawnee has no right of foreclosure. He
can only sell the property to realise his dues. Here the legal
ownership passes to mortgagee, of course, subject to the mortgagor
to redeem the property. The mortgagee as a rule takes decree of a
Court of Law before having recourse against the property
mortgaged. In certain cases, the mortgagee can foreclose the
property.
5. Priority of Mortgages: Indian Law of Priorities is provided in
Section 48 of the Transfer of Property Act. The rule is based on
maxim 'He has a better title who was first in point of time.' It lays
the

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160
general rule regarding priority of rights created by transfer by a
person at different times in or over the same immoveable property
and provides that, as between such rights, each later created right
is subject to the rights previously created. We may further see, as
how the rule of priorities operate in respect of different
instruments creating mortgages.
(a)

Priority among registered instruments: Section 47 of the

Registration Act, 1908 provides
that a registered document operates, not from the date of its
registration, but from the time
of its execution. Thus, a document executed earlier, though
registered later than another,
has priority over the documents executed later.
(b)

Priority between registered and unregistered instruments:

Let us now deal with the exceptions
to the rule that priority is determined by order of time which either
have been created by
statute or owe their origin to the ancient rule of Hindu Law, which
required delivery of
possession in the case of a security of land. There are also some
exceptions recognised in
the Indian system founded upon those general principles of justice
and equity, which in the
absence of any express enactment, Indian judges are bound to
administer, and which have
been mostly borrowed from the English Law.

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The first exception is that contained in Section 50 of the
Registration Act which under certain circumstances allows a
registered mortgage priority over unregistered mortgage. However,
it may be noted that prior mortgage by deposit of title deeds is not
affected by subsequent registered mort¬gage as the same need not
be registered. This is provided in Section 48 of Indian Registration
Act.
6. Limitation Period in Mortgages: Article 62 of the Indian
Limitation Act, 1963 provides limitation period for filing of suit for
recovery of mortgaged debt and sale of mortgaged property in the
event of non-payment of the mortgaged debt. Article 63(a) of the
said Act provides a limitation period, in case of foreclosure of the
mortgaged property. The limitation period for filing a suit for sale
of mortgaged property is TWELVE YEARS, from the date the
mortgage debt becomes due. The limitation period for filing suit for
foreclosure is THIRTY YEARS from the date the money secured by
mortgage becomes due.
Enforcement of Mortgage - Some Important Aspects
We will now learn some important aspects as to enforcement of
mortgage. It may be noted that a banker, secures moneys advanced
by creating one of the various types of mortgages mentioned above.
Popular types of mortgages obtained by a banker are:
(i) Mortgage by deposit of title deeds

(ii) Simple mortgage and

in some cases
(iii) English mortgage.
Enforcement of all these types of mortgages is by way of filing a
suit for sale of mortgaged properties. The procedure for filing a suit
for a sale is provided for in the Code of Civil Procedure, 1908. The

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Section 16(c) of the Civil Procedure provides that a suit for sale of
mortgaged property shall be filed in the Court within whose
jurisdiction the mortgaged property is situated. Order 34 of the
Code provides for various things to be adhered to while filing suit
for sale of mortgaged property. When a suit for sale is filed, the
Court after hearing the parties passes a preliminary decree.
Through the preliminary decree it directs the mortgagor to pay the
mortgage debt within a certain period and in the event of his failure
to pay the money due under the mortgage, the Court orders for sale
of mortgaged properties by passing a final decree. After passing of
the final decree, the mortgagee with the help of the Court gets the
mortgaged property sold in execution of the mortgage decree.
14.3 LET US SUM UP
1. Mortgage is a transfer of interest in immoveable property to
secure an advanced loan, or an existing debt or a future debt or
performance of an obligation.
161
2.

Transfer of Property Act, contemplates six types of

mortgages, they are:
(a) Simple mortgage(b) Mortgage by conditional sale
(c) Usufructuary mortgage (d) English mortgage
(e) Mortgage by deposit of title deeds
3.

(f) Anomalous mortgage

In Simple mortgage, the mortgage is by deposit of title deeds

and in English mortgage, the
possession of the mortgaged properties is not given to the
mortgagee.
4.

In usufructuary mortgage and in mortgage by conditional

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sale, possession of mortgaged properties
is normally given to the mortgagee.
5.

In the case of simple mortgage and mortgage by deposit of

title deeds, the mortgagee has a right
to proceed against the property mortgaged and also personally
against the mortgagor.
6.

Mortgage is to be created by way of deed and requires to be

registered under the Registration Act.
7.

Mortgage by deposit of title deeds, is not required to be

created by way of a deed and does not
require registration.
8.

The rule of priority in case of successive mortgages is in the

order of time they are created.
9.

Limitation period for filing a suit for sale of mortgaged

property is twelve years from the date
mortgage debt becomes due.
10.

Limitation period for filing a suit for foreclosure is thirty

years from the date mortgage debt
becomes due.
11.

Enforcement of mortgage is governed by the Code of Civil

Procedure, 1908. Suit for sale of
mortgaged properties are to be filed in the Court, within whose
jurisdiction the mortgage property
is situated.
12.

In a suit for sale, of mortgaged properties, the Court first

passes a preliminary decree and thereafter
a final decree.

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14.4 CHECK YOUR PROGRESS

1. Mortgage is
in the immoveable property.
2.

Simple mortgage is created by an instrument in writing.

(True/False)
3.

Mortgage by deposit of title deeds is required to be

registered. (True/False)
4.

In the case of usufructuary mortgage the possession of the

properties is given. (True/False)
5.

In mortgage by way of conditional sale the property is sold

with a condition for re-conveyance.
(True/False)
6.

All successive mortgages created will rank equally and no

mortgage will have a greater priority
over the other. (True/False)
7.

To decide as to which mortgage will have priority over the

other in the case of two or more
mortgages on the same immoveable property, the date of
mortgage is pertinent.
8.

Limitation period for filing a suit for sale of mortgaged

properties is years from the
date the mortgage debt becomes due.
9.

Mortgage suits are filed in the Court within whose

jurisdiction the mortgagee resides. (True/
False)
14.5 ANSWERS TO CHECK YOUR PROGRESS'

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!• transfer of interest; 2. True; 3. False; 4. True; 5. True; 6. False; 7.
execution of; 8. twelve; 9. False

LAW RELATING TO SECURITIES AND MODES OF CHARGING II
STRUCTURE
15.0

Objectives

15.1

Introduction

15.2

Pledge

15.3

Hypothecation

15.4

Let Us Sum Up

15.5

Check Your Progress

15.6

Answers to 'Check Your Progress'

164
15.0

OBJECTIVES

After studying this unit, you should be able to understand:

the law relating to security of pledge and hypothecation;

basic features of pledge and hypothecation.

15.1

INTRODUCTION

A banker, in his business of lending takes security of pledge and
hypothecation of moveable goods to secure cash credit and
overdraft. These are popular securities obtained by a banker. In
this unit, we will learn about the law relating to security of pledge
and hypothecation.
15.2

PLEDGE

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'Pledge means bailment of goods for purpose of providing security
for payment of debt or performance of promise' (as per the Section
172 of Contract Act 1872).
As per the above definition to constitute a valid pledge, three
requirements are to be satisfied:
1.

There must be bailment of goods (bailment means delivery

of goods);
2.

The bailment must be, by or on behalf of the debtor; and

3.

The bailment, must be for the purpose of providing security

for the payment of a debt or performance
of promise.
The person, whose goods are bailed is called the Pawnor, the
person who takes the goods as security is called the Pawnee.
1. Legal Implications of a Pledge: The following are the legal
implications of a pledge:
(a)

The ownership of the property is retained by the pawnor,

which is subject only to the
qualified interest which passes to the pawnee by the bailment.
(b)

One of the main and most essential requirements of a pledge

is the actual or constructive
delivery of the goods to the pawnee. By constructive delivery, it is
meant that there need be
no physical transfer of goods from the custody of the
pledger/pawnor to the pawnee. All
that is required is, that the goods, must be placed in the possession
of the pawnee or of any
person authorised to hold them on his behalf.
Goods, may be delivered by one of the following ways (as

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mentioned in the Sale of Goods Act):
(i) By handing over the key of the godown in which the goods are
kept.
(ii) By attornment, i.e. if goods are in public warehouse, the
warehouseman acknowledges to the pawnee that he will hold the
goods thereafter on behalf of the pawnee.
(iii) Handing over the document of title to goods, such as railway
receipt, bill of lading, warehouse receipts, etc.
(iv) Even if the goods are in possession of the pawnor, he may
acknowledge that he holds them thereafter for and on behalf of the
pawnee. This is again similar to attornment. Thus, delivery may be
physical, when goods are physically transferred or symbolic as in
the case of handing over the key to the godown, where the goods
are stored so as to be out of the control of the pawnor or
constructive as in the case of an attornment.
In the case of Co-operative Hindustan Bank Ltd. vs Surendar Nath
Dey AIR 1932 Cal 524, it was observed that it is essential in a
transaction of pledge that there must be a delivery of goods to the
pawnee and he must keep the goods. The delivery need not be
simultaneous with lending of money. It may be actual delivery or
symbolic delivery, e.g. by delivery of
165
key of the warehouse where the goods are stored or something may
be done which is equivalent to delivery that is keeping of goods
without any actual delivery, as if the pawnee has the possession or
effect of possession.
(c)

Pledge can be created only in the case of existing goods

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which are in the possession of the
pawnor himself. There can be no pledge of future goods or goods
which the pawnor is
likely to get into his possession subsequently. Since delivery is
involved, goods must be
specific and identified.
(d)

Possession of goods is the most important characteristic of

pledge and therefore, pledge is
lost when possession of the goods is lost.
However, the pawnee may release the goods after obtaining a letter
of trust from the pawnor. Such a letter of trust is known as the trust
receipt. It is an instrument by which the borrower receives the
goods or documents of title to goods and undertakes to hold them
or the proceeds thereof, in trust for the lender. Because of the trust
receipt, the bankers, rights as a pawnee remains unaffected. Even if
the borrower becomes insolvent, the Official Receiver cannot claim
the goods.
(e)

An agreement of pledge may be implied from the nature of

the transaction or the
circumstances of the case. However, an agreement in writing
clearly laying down the terms
and conditions leaves no ambiguity.
2.

Who can create a Pledge?

The following persons can make a valid pledge:
(a)

Owner of the goods

(b)

A mercantile agent, provided the following conditions are

satisfied
(i) He should be in possession of the goods, or the documents of

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title to goods with the
consent of the owner.
(ii) The goods must have been entrusted to him in his capacity as a
mercantile agent, (iii) The mercantile agent should create the
pledge in the ordinary course of his business
as such agent, (iv) The pawnee acts in good faith and has no notice
at the time of pledge that the pawnor
has no authority to pledge (as per Section 178 of Contract Act).
(c)

Persons in possession of goods under a voidable contract,

provided the contract, has not
been rescinded at the time of pledge
(d)

Seller of the goods, who continues to be in possession of the

goods even after sale, can create
a valid pledge. The pawnee must act in good faith and without
notice of the previous sale.
A pawnee can repledge the goods, but it is valid only to the extent
of his interest in such goods. When the original pawnor repays the
debt to the first pawnee, he is entitled to the return of the goods
although they may be in the hands of the second pawnee to whom
the first pawnee has not repaid the debt.
3.

Rights of Pawnee

(a)

Right of retainer: As per Section 173 of the Contract Act, the

pawnee can keep the goods
pledged not only for the non-payment of the debt or nonperformance of the promise, but
also for the interest on the debt and for all expenses properly and
necessarily incurred for
the preservation of the goods pledged. This is similar to the rights

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of the bailee.
(b)

Right to claim extraordinary expenses: In respect of such

expenditure incurred for
taking care of the pledged goods, he cannot claim lien over the
goods but can only sue to
recover the goods.
166
4.

(c)

No right to retain in respect of the other debts: In the

absence of a contract to the
contrary, the pawnee cannot retain the goods for a debt or a
promise, other than the promise
or debt for which they are pledged. However, in the case of
subsequent advances made,
such a contract is presumed, in the absence of anything, to the
contrary.
(d)

Rights against third parties: A pawnee has the same

remedies against third persons, as
the owner himself would have, if he is deprived of his goods.
(Morvi Mercantile Bank Ltd.
vs Union of India AIR 1965 Supreme Court 1954.)
(e)

Pawnee's right where Pawnor makes default in payment: In

case where the pawnor
makes default, the pawnee has three rights:

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(i) He may sue the pawnor upon the debt or promise; (ii) He may
retain the pawned goods as collateral security; or (iii) He may sell it
after giving the pawnor reasonable notice of the sale.
The right to retain the pawn(pawned goods) and the right to sell it
are alternative and not concurrent rights. While the pawnor
retains, he does not sell and when he sells he does not retain.
However, the pawnee has the right to sue on the debt or the
promise concurrently with his right to retain the pawn or sell it.
The retention of the pawn does not exclude this right of suit, since
the pawn is a collateral security only.
In Nanak Chand Ramkrishandas vs Lalchand Ganeshilal AIR 1958
Punj. 222, it was held that a pawnee may keep the goods as security
for the debt due to him from the pawnor and although he has got
the right to sell after notice to the pawnor, he is not bound to sell at
any particular time. The mere fact that the pawnee gave a notice
that he would sell the goods cannot possibly be a compelling factor
for sale to be effected. If the goods are sold, by the pawnee without
a notice, as provided by this Section, they will be deemed to have
been converted and an action for conversion of the same would lie
against the pawnee; but damages would be assessed, by taking into
consideration the market rate of the goods in question as on the
date of conversion, which ordinarily, would be the date on which
the goods were wrongfully sold. In case of an improper sale, the
pawnee is liable for conversion, but the sale cannot be set aside.
Whether two notices must be given
It was held in A. Srinivasalu vs Gajaraj Mehta & Sons 1990 (II)
MLJR 188, that a sale notice is only an intimation of the proposed
sale by the pawnee and it is not necessary that such notice must be

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proceeded by another notice informing the pawnor that on his not
making payment the goods would be sold. The sale notice also need
not be signed by the pawnee or the amount due be mentioned.
If the goods are sold by the pawnee after giving reasonable notice,
the pawnor is entitled to receive from him any surplus over and
above the debt amount.
The pawnor has a right to redeem the goods even though the time
stipulated for payment is over, provided the goods have not been
sold by the pawnee.
Duties of Pawnor:
(a)

He must disclose to the pawnee any material faults or extra

ordinary risks in the goods to
which the pawnee may be exposed. Failure to disclose makes him
responsible for damages
for any loss caused to the pawnee.
(b)

The pawnor must reimburse the pawnee for any expenses

incurred for the preservation of
the goods.
(c)

In the case of forced sale, if the amount realised is less than

the debt due from the pawnor,
he is liable to make good the balance.

167
5.
6.

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(d) When the goods are pledged, there is the implied condition that
the pawnor has title to the goods pledged. However, in practice the
banker obtains the pawnor's signature to a document known as an
agreement of pledge. The following are the important points
usually covered in the document:
(i) The pledge is in respect of all the goods delivered and upon all
documents of title to
goods deposited by the pawnor (ii) A declaration that the securities
deposited would cover the existing and future debt,
interest and expenses (iii) The letter stipulates that it will be a
continuing security without the operation of the
rule in Clayton's case, (iv) Pawnors title to the security is clear, that
the goods will be insured adequately at his
expense and that sufficient margin will be maintained as agreed
upon, (v) A promise to pay all the money secured by the pledge on
demand, and in the case of
default in repayment, the bank to have the right of sale, (vi) Where
the pawnor fails to insure the goods, the banker reserves the right
to effect
such insurance and debit the premium and other charges to the
account of the customer, (vii) A declaration by the pawnor not to
hold the bank responsible for the default of any
broker employed to sell the goods. The pawnor undertakes to pay
the rent and other
charges incidental to warehousing, (viii) The banker reserves the
right of general lien and nothing in the agreement, shall be
construed as excluding such right, (ix) The pawnor undertakes to

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submit periodical statements of stocks and to allow inspection
of the goods and records by the bank, all at his cost.
Advantages of Pledge:
(a)

The goods are in the custody of the pawnee and, therefore, it

is easy to sell in case of
default. If the banker takes proper precautions, through periodical
inspections, it will not be
possible for the pawnor to create subsequent charges against the
same goods.
(b)

Because of close supervision, it will not be possible for the

pawnor to manipulate the
stocks.
(c)

Even if the goods are lost, the banker can recover the

amount under the insurance policy.
(d)

The formalities connected with the pledge are simpler than

in the case of mortgage.
Precautions to be taken:
(a)

To ensure that the pawnor has the title to goods.

(b)

To ensure that the contract of pledge is complete in all

respects and incorporates the already
referred to usual clauses.
(c)

To exercise full and effective control over all the goods

pledged.
(d)

To put up a signboard at the godown prominently

displaying, that the goods are pledged to
the banker.
(e)

To take reasonable care of the goods as a man of ordinary

prudence would under similar

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circumstances take of his own goods of the same bulk quantity and
value of the goods
pledged. Any loss arising to the goods due to failure to take such
care must is to be
compensated to the pawnor. In his own interest also, the banker
must take such care so that
the value of security is not eroded.
(f)

Banker must make periodical inspections to verify the

quality, quantity, value, etc., of the goods
and ensure the maintenance of reasonable margin throughout the
period until the debt is repaid.
168
7. Cases Relating to Pledge
(a)

Morvi Mercantile Bank Ltd. vs Union of India AIR 1965 SC

1954. In this case M/s Harshadrai
Mohanlal & Co., a firm, entrusted on 4 Octobe, 1949 to GIP
Railway, 4 boxes of menthol
crystals belonging to the firm for transport from Thane to Okhla
near Delhi. Further, on 11
October 1949 the firm sent two more boxes to Okhla from Thane
through the railways. The
firm was issued railway receipts. The firm endorsed the railway
receipts in favour of Morvi
Mercantile Bank. On failure of railways to deliver the goods, the
bank, claiming as an endorsee
of the railway receipts for valuable consideration, filed a suit
against railways for recovery of

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the value of the goods.
The Supreme Court delivering a judgement in appeal, decided that
the bank was entitled to recover the value of goods for the following
reasons:
(i) Valid pledge can be created by endorsement of railway receipts.
(ii) For a valid pledge, actual delivery is not necessary and
constructive delivery is sufficient, (iii) By endorsing the railway
receipts, the firm created a valid pledge in bank's favour, (iv)
Pledge being the bailment of goods, the bank as a pledgor will have
all the rights of owner
of goods, (v) Hence, the bank is entitled to recover value of goods
from the railway as a pledge.
(b)

Lallan Prasad vs Rahmat Ali and Another AIR 1967 SC 1322.

The question decided in this
case was whether a pawnee can file a suit for recovery of debt due
to him if the pawnee lost
the goods pledged to him. In this case, on 10 January 1946, Lallan
Prasad gave a loan of Rs
20,000 to Rahmat Ali. Lallan Prasad also obtained a pledge of 147
tonnes of aero-scraps from
Rahmat Ali. On failure to repay the loan, Lallan Prasad filed a suit
against Rahmat Ali for
recovery. Rahmat Ali argued that Lallan Prasad is not in a position
to deliver the goods
pledged and he should not be granted a decree for recovery of
money.
Supreme Court after analysing the facts of the case rendered a
judgement that a pawnee under the Contract Act is entitled to

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retain the goods pledged and file a suit for recovery of the money.
However, this right of pawnee can be countenanced only when
pawnee is in a position to return the goods pledged, when pawnor
repays the debt. A pawnee cannot be allowed to have a decree for
recovery, if he is not willing to return the goods pledged.
(c)

Bank of Bihar vs State of Bihar AIR 1971 SC 1210. In this

case the rights of pawnee came up
for consideration of the Court. In this case, Bank of Bihar lent
moneys and took security by
way of pledge of different varieties of sugar. Government of Bihar
seized the bags of sugar
from the borrower and sold them to recover Government dues. The
bank filed a suit for
recovery of moneys due to it against Government of India.
The Supreme Court deciding the case, held that right of bank as a
pawnee cannot be taken away by government and hence, the
Government of Bihar shall pay the amount due to the bank.
(d)

Standard Chartered Bank vs Custodian AIR 2000 SC 1488.

In this case, the Supreme Court
held that, if during the pledge there is an increase in value of the
goods pledged, the pawnee
is entitled to the increase, as an integral part of his security. In this
case, the shares and
debentures were pledged with the bank and these shares and
debentures were entitled to
bonus, dividend and interest. The Supreme Court held, that these
accretions formed part of
the pledged property and as such the pawnee is required to return

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the same only when the
pledged goods were returned and in case of pawnor's default in
payment of debt, the pawnee
has the right to sell the pledged property along with the accretions
after giving reasonable
notice to the borrower.
169
15.3 HYPOTHECATION
Until recently there was no legislative definition of the term
'hypothecation'. This term came to be defined in the S ARFAESI
Act, 2002. As per the definition contained in the Act, the term
'Hypothecation' means a charge in or upon any moveable property,
existing or future, created by a borrower in favour of a secured
creditor, without delivery of possession of the moveable property to
such creditor, as a security for financial assistance and includes
floating charge and crystallisation of such charge into fixed charge
on moveable property.
The mortgage of moveable property is called 'Hypothecation'. It
may be described as 'a transaction whereby money is borrowed by
the debtor (owner of the goods) on the security of the moveable
property without transferring either the property or the possession
to the creditor'. Hart describes hypothecation as 'a charge against
property for an amount of debt where neither ownership nor
possession is passed to the creditor'. Hypothecation differs from
pledge because goods remain in the possession of the borrower and
are equitably charged in favour of the creditor under documents
signed by the borrower. However, the document provides for a

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covenant, whereby the borrower agrees to give possession of the
goods when called upon to do so by the creditor. Once the
possession is given up, the charge becomes transformed into
pledge.
Hypothecation differs from mortgage in two respects. Firstly,
mortgage relates to immoveable property whereas hypothecation
relates to moveables. Secondly, in a mortgage, there is transfer of
interest in the property to the creditor but in hypothecation there is
only obligation to repay money and no transfer of interest.
Facility limited to respectable customers
Law permits hypothecation of assets as a security by sole
proprietorships, partnerships, joint stock companies and even
individuals. However, the charge being only equitable without
possession, the facility is normally granted to customers of
undoubted integrity. There is less risk when such a facility is
granted to a joint stock company because of the registration of such
a charge with the Registrar of Companies. Such a registration
constitutes a constructive notice to the world at large, but such a
facility is not available in the case of other forms of business.
Hypothecation is resorted to in the following cases:
(a)

When loan is to be raised against work-in-progress, the only

way of creating a charge is
hypothecation.
(b)

It is also done in respect of goods which require constant

handling in a factory, e.g. rice mills, oil
expellers, etc.
(c)

This charge is also convenient, where lending is to be done

against goods in a shop or showroom

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which are required in day-to-day business.
1. Drawbacks of Hypothecation
(a)

The fundamental difficulty about this charge is that goods

remain in the possession of the
borrower and therefore the creditor's control over such goods is
almost nil. This may give
rise to fraudulent dealings in such goods by the borrower.
(b)

The borrower may realise stocks hypothecated and pay to

other creditors. He may even sell
marketable stocks and keep only obsolete and slow moving stocks
for the banker to realise.
Thus erosion of security can take place.
(c)

The borrower may hypothecate the same stock with more

than one banker or having
previously hypothecated, the goods may subsequently be pledged
to another creditor.
(d)

The realisation of the assets in case of default of payment is

a difficult, prolonged and costly
affair. As stated earlier, the banker may find only obsolete and
slow-moving items.
170
(e) According to Section 534 of the Companies Act, 1956, any
floating charge on the undertaking or property of the company
created within a period of twelve months preceding the
commencement of the winding up, becomes invalid under certain
circumstances.
2. Precautions to be taken in the case of Hypothecation: Although

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these disadvantages seriously limit the value of hypothecation as a
security, the banker can take certain precautions and avoid at least
some of the disadvantages. The following precautions usually are
taken by banks:
(a)

Banks ensure that the borrower is not enjoying

hypothecation facilities from other banks and is
confining his borrowings to only one bank. An undertaking to this
effect is obtained from the
borrower in writing. Banks also ensure that boards are prominently
displayed on the premises
where the goods are stored stating that the goods are hypothecated
to the bank.
(b)

In the case the borrower is a company registered under the

Companies Act, the charge by
way of hypothecation must be registered within a period of thirty
days of its creation or a
further period of thirty days on payment of fine. If this is not done,
the charge would be
void against the liquidator or any other creditor of the company.
(c)

The banker must obtain periodical statements of stocks with

a declaration regarding the
borrower's clear title to the goods and the correctness of the
quality, quantity and valuation.
Banks should not merely be content with the receipt of the stock
statements, but should also
effectively supervise the goods hypothecated and the financial
position of the borrower from
time to time. Banks should verify in such an inspection that there is

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no depreciation in the value
of the security or any adverse change in the borrower's financial
position. If an inspection
discloses such a state of affairs, the banker should take appropriate
action immediately.
Deed of Hypothecation: While lending against hypothecation of
goods, bankers obtain a letter of hypothecation which serves as the
hypothecation agreement and contains several clauses to protect
the banker's interest under all contingencies. It is a very
comprehensive document and contains the following important
clauses:
(a)

The request made by the borrower for the grant of

accommodation in the form of loan or
cash credit on the hypothecation of goods, resulting in the
agreement.
(b)

The description of the goods in a separate statement giving

the particulars, quality, rate,
quantity, market value and an undertaking that the particulars are
true and that the borrowers
are the absolute owners of the property and with authority to
hypothecate. The statement
also declares that the goods are not subject to any lien, claim or
charge of any sort.
(c)

An undertaking that no further charge or encumbrance will

be created on the goods and that
all money realised by way of sale proceeds or realisation of
insurance claims, will be held
exclusively as the bank's property and such money will be paid in,

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to the satisfaction of the
balance due and owing on the account kept by the bank in respect
of such accommodation.
(d)

The borrower, whenever required by the bank, must give full

particulars of all his assets
and of the hypothecated goods. He must, at all times allow the
bank or its authorised agent
to inspect the hypothecated goods and all records of the borrower.
All costs, charges and
expenses incurred by the bank in respect of such an inspection are
to be paid to the bank on
demand, failing which, the amount and interest thereof will be a
charge upon the hypothecated
goods.
(e)

The borrower undertakes to insure the goods against risks

specified by the banker at his
cost. The policy so taken is to be endorsed and assigned in favour of
the bank.
(f)

The borrower undertakes to maintain the agreed,margin of

security at all times during the
continuance of the security.
(g)

The borrower undertakes to pay all rents, taxes, payments

and outgoings in respect of the
immoveable property, in which the hypothecated goods are kept.
171
(h) The bank reserves the right to call upon the borrower to pay to
the bank the loan amount together with interest and other charges

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at any time. In the event of default, the bank reserves the right to
dispose the hypothecated stocks and apply the proceeds in
satisfaction of the loan amount. If the proceeds are insufficient, it
reserves the right to recover the balance from the borrower.
(i) The borrower undertakes not to dispute the correctness of any
sum due to the banker as stated in the demand made by the banker
under the hypothecation agreement.
(j) A clause stating that the security shall be a continuing security
for the balance due to the bank from time to time. Where by any
chance, the cash credit results in a credit balance, it is not to be
considered to be closed for the purpose of the security. In other
words, the security is not treated as exhausted simply because the
cash credit showed a credit balance at any time.
15.4

LET US SUM UP

1.

Pledge means bailment of goods for the purpose of securing

a payment of debt or an obligation.
2.

Pawnee has special property rights in the goods pledged.

3.

A valid pledge can be created by owner of goods or a

mercantile agent.
4.

A constructive pledge involves only delivery of keys of the

warehouse.
5.

Under the contract of pledge, the pawnee can sell the goods

pledged after notice or retain the
goods and file a suit for recovery of debt.
6.

Mortgage of moveable property is called Hypothecation.

15.5

CHECK YOUR PROGRESS

1.

Pledge means

of goods for purpose of securing a

payment of debt or performance

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of promise, (fill with appropriate words)
2.

The most important characteristic of pledge is of goods,

(fill with appropriate words)
3.

Owner of goods cannot make a pledge. (True/False)

4.

Hypothecation is an implied pledge in cases where

constructive possession of goods is given.
(True/False)
5.

Hypothecation letter gives a banker right to possession of

goods in the event of default.
(True/False)
15.6

ANSWERS TO 'CHECK YOUR PROGRESS'

1. bailment; 2. possession; 3. False; 4. True; 5. True.

DIFFERENT TYPES OF BORROWERS

STRUCTURE
16.0

Objectives

16.1

Introduction

16.2

T^pes of Borrowers

16.3

Let Us Sum Up

16.4

Keywords

16.5

Check Your Progress

16.6

Answers to 'Check Your Progress'

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174
16.0

OBJECTIVES

After studying this unit, you should be able to understand:

the legal aspects pertaining to different borrowers;

the laws governing various types of borrowers.

16.1

INTRODUCTION

One of the prime functions of a banker is lending money. In its
business of lending money, a banker shall acquaint himself with
various laws governing different types of borrowers. The borrowers
of a bank may be Individuals, partnership firms, Hindu Undivided
Family, Companies' and other Corporate entities. This unit deals
with various laws that banker should acquaint himself in his
business of lending.
16.2

TYPES OF BORROWERS

Types of borrowers, for the convenience of our study, can be
classified as follows:
1. Individual 2. Partnership Firm
3. Hindu Undivided Family

4. Companies

5. Statutory Corporations 6. Trusts and Co-operative Societies
1. Individual: An Individual borrower is one of the constituents of a
bank in its business of lending. When a banker lends to an
individual, he should verify certain facts, so that the bank's lending
is not affected.
One of the essential elements of a contract is the capacity of the
parties to contract. The bank, while lending to an individual should
ensure that he is competent to enter into contract. Money lent to an
individual who is not competent to contract cannot be recovered in
the following circumstances:

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(i) If an individual is a. minor: A person who has not attained the
age of eighteen years under Indian Majority Act and twenty-one
years if he is a ward, under the Guardians and Wards Act, is
considered a 'Minor' in the eyes of law. Under the law a 'minor' is
not competent to contract. Therefore, if a banker lends money to a
minor, then the same, cannot be recovered, if the minor fails to
repay.
Exceptions:
The only exception recognised in a contract with a minor is of
supply of necessities to him. If a bank lends money to a minor to
meet the expenses for purchasing necessities of life, then bank can
recover the money from the estate of the minor.
(ii) If an individual is not of sound mind: If a person is not of a
sound mind, then he is incompetent to enter into a contract. The
Contract Act says that a person will be considered not of sound
mind if, at the time when he makes the contract, he is not capable
of understanding it and of forming a rational judgement as to its
effect upon his interests.
Notice that a contract entered, would be invalid if proof is shown
that the borrower at the time of entering into contract was not in
sound state of mind and could not understand what he was doing
and could not understand the implications of entering into
contract.
(iii) Disqualified persons: There may be statutory disqualifications
imposed on certain persons in respect of their capacity to contract.
For example, a person, declared as insolvent under the Insolvency
Law. As long as the person continues to be a non-discharged
insolvent, he cannot enter into contract. The contracts entered into

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by such a person are not enforceable.
175
In our country there are various businesses and economic activities
conducted by a single person which are called sole proprietary
concerns. In the eyes of the law there is no distinction between the
assets and liabilities of the person and the business conducted in
the name of the sole proprietor.
2. Partnership Firm: 'Partnership Firm' is another entity with
which a banker deals within the course of his business. The Indian
Partnership Act, 1932 governs the 'Partnership Firm'. Section 4 of
the Act says, that a partnership is the relation between persons who
have agreed to share the profits of a business, carried on by all or
any of them acting for all. The relationship between the partners is
governed by partnership deed.
Legal position of a partnership
A partnership is not distinct from its partners. Under the law, the
name of a partnership firm, is regarded as an abbreviation of the
names of partners. The Indian Partnership Act, 1932, provides for
registration of a partnership and it is necessary that a banker
dealing with a partnership firm should verify as to whether the firm
is registered or not. This would help him know all the names of
partners and their relationship.
Authority of the partners
Section 19 of the Indian Partnership Act, 1932 deals with the
implied authority of a partner as an agent of the firm and Section
22 deals with the mode of doing acts to bind the firm. In view of the
provisions of Sections 19 and 22, it should be noted that the acts of

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a partner shall be binding on the firm if they are done:
1.

in the usual business of the partnership,

2.

in the usual way of the business, and

3.

as a partner, i.e. on behalf of the firm and not solely on his

own behalf.
Business of partnership firm; How is it done?
In the case of a partnership firm, rights and duties of the partners
are determined by the deed of partnership. It provides for opening
of bank accounts, borrowing powers, signing of cheques, etc.
Generally, there may be a managing partner who conducts the
business on behalf of the other partners. A banker dealing with a
partnership firm, should ensure that the business is conducted as
per the partnership deed. If the managing partner does not have
the powers to conduct certain transactions then, it should be
ensured, that consent of all partners are obtained.
Partnership firm and transactions in immoveable property
Section 19 of the Indian Partnership Act, 1932 states that a partner
cannot affect the transfer of immoveable property of the firm
unless expressly authorised. A banker taking a mortgage security of
firm's immoveable property should ensure that the partner who is
creating the mortgage is expressly authorised to create the
mortgage. If the partner, has no authority to create the mortgage,
then the banker should ensure that all the partners jointly create
the mortgage.
Insolvency of the firm
The banker, on receiving notice of insolvency of the firm, must
immediately stop any further transactions in the account
irrespective of the fact that the account is in credit or debit. In case

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there is a credit balance, and the banker does not intend to set off
the same against the dues in any other account, then the balance
has to be handed over to the official receiver appointed by the
Court or as directed by the Court. In case the account is in debit
then the banker would be required to prove his debt before the
Court and thereafter will be entitled to receive the same from the
Official Receiver either in full or as per the dividend declared by the
Courts.
176
Insolvency of the partner
If at the time of insolvency of one of the partners, the firm's
account is in credit then the other partners can operate the same,
but the banker should obtain a fresh mandate and all previous
cheques issued by the insolvent partner may be paid provided the
other partners confirm the same. In case, the account is in debit
then further transactions in the account should be stopped so that
the rule in Clayton's case does not apply.
Death of a partner
In case of death, the principles as stated in Insolvency of a partner
applies. Since the death of a partner dissolves the partnership firm,
upon receipt of such information, banks are required to stop the
transactions of the firm in a running credit facility like cash credit,
overdraft to crystllise the liability of the deceased partner and make
his/her estate liable for its dues. Banks allow the transactions in a
separate account so that the business of the firm is not adversely
affected.
3. Hindu Undivided Family: 'Hindu Undivided Family' otherwise

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known as 'Joint Hindu Family' is a creature of Customary Law
among Hindus and is governed by personal laws. In Bengal and
other parts of erstwhile Bengal province, a Hindu Undivided
Family is governed by Dayabhag Law. In other parts of India, it is
governed by Mitakshara Law.
Constitution of a Joint Hindu Family
A joint Hindu Family consists of male members descended lineally
from a common male ancestor, together with their mothers, wives
or widows and unmarried daughters bound together by the
fundamental principle of family relationship which is the essence
and distinguishing feature of institution. The Joint Hindu Family,
is purely a creature of law and cannot be created by an act of
parties.
Law governing Joint Hindu Family
Joint Hindu Family is governed basically by two schools of
thought. They are Dayabhag and Mitakshara schools.
The law governing Joint Hindu Family is codified under Hindu
Code and now, succession among Hindus is governed by the Hindu
Succession Act, 1956. Though Hindu Code changed the law
applicable to Hindus substantially, the spirit of joint family concept
is retained; Women are also made members of the Family as its
male members. It is to be noted that a woman member also
inherits properties at par with a male member and is treated as coparceners.
Management of business of a Joint Hindu Family
In a Joint Hindu Family, for as long as members remain undivided,
the senior most male member of the family is entitled to manage
the family properties. He is called 'Manager' or 'Karta' of the joint

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family.
In a Hindu Family, the 'Karta' or Manager, occupies a position
superior to that of the other members insofar as he manages the
family property or business or looks after the family interests on
behalf of the other members. The managership of the joint family
property comes to a person by birth and he does not owe his
position as manager on the consent of other co-parceners. The
liability of the 'Karta' is unlirftited, whereas the liability of the coparceners is limited to their shares in the joint family estate.
Powers and duties of the manager
A manager or 'Karta' of a joint family has the following powers and
duties:
177

Powers
(a)

Right to possession and management of the joint family

property
(b)

Right to income from the joint family property

(c)

Right to represent the joint family

(d)

Right to sell the joint family property for family purpose.

Duties
(a)

Duty to run the family business and manage the property for

the benefit of the family
(b)

Duty to account for the income from the joint family

business and property.

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Banker and his dealings with joint family
(a)

A banker dealing with a Hindu Undivided Family, should

know the 'Karta' of the family.
(b)

Banker should ensure that 'Karta' of the joint family deals

with the bank and borrows only for
the benefit of joint family business.
(c)

The application to open an account must be signed by all the

members and all adult members
should be made jointly and severally liable for any borrowings or if
the account gets overdrawn.
4. Companies: A company is another type of borrower, which a
banker deals with in his business of lending. A company is a juristic
person created by law, having a perpetual succession and Common
seal distinct from its members. A company, depending upon its
constitution is governed by various laws.
Basic laws governing company
In India, companies are governed by the Companies Act, 1956.
Companies as per the Companies Act, 1956 are required to be
registered under the Act. Section 11 of the Companies Act provides
that an association or partnership consisting of more than ten in
the case of banking business and more than twenty in the case of
other business, shall be registered under the Companies Act. If not
registered, the said association or partnership will be illegal.
Incorporation of company
Section 12 of the Companies Act, 1956 provides that any seven or
more persons or where a company formed is a private company,
any two or more persons can form a company, by subscribing their

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names to the Memorandum of Association.
Requirements of forming a company
The business and objects of a company and the rules and
regulations governing its management are known by two important
documents called 'Memorandum of Association' and 'Articles of
Association'. Therefore, for the formation of a company these
documents are essential. What is Memorandum of Association?
The memorandum of association is the charter of the company. Its
purpose is to enable the shareholders, creditors and those dealing
with the company to know its permitted range of business.
Memorandum of Association of a company contains the following
details among others:
(a)

Name of the company

(b)

State in which the registered office of the company is to be

situated
(c)

Objects of the company

(d)

Liability of the members and

(e)

Share capital and its division.

What is Articles of Association?
Articles of Association are rules and regulations governing the
internal management of the company.
178
They define the powers of the officers of the company. Articles of
Association are subordinate to Memorandum of Association and it
contains the following details among other things:
(a)

Number of directors of the company

(b)

Procedure for conducting meetings of the shareholders,

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board of directors, etc.
(c)

Procedure for transfer and transmission of shares

(d)

Borrowing powers of the company

(e)

Officers of the company and other details.

Types of companies
(a)

Private company: According to the Section 3(1) (iii) a private

company is one which contains
following provisions in its Articles of Association:
(i) Restrictions on the right to transfer its shares
(ii) Limitation on number of members to fifty, excluding the
people, who are employees
and ex-employees of the company (iii) Prohibition as to
participation by general public in its capital requirements.
(b)

Public company: A public company is one, which is not a

private company. That is, a
public company does not have any restrictions of the private
company and its main features
are as follows:
(i) Shares are freely transferable
(ii) No restriction on number of members
(iii) Public at large can participate in its share capital.
The public companies can be further classified as:
(i) Limited liability company

(ii) Unlimited liability company

(iii) Limited by guarantee.
It can be seen from the classification itself that in a limited liability
company, liability of the members is limited to their contribution of
capital. In the case of unlimited liability company, the liability of
the members is unlimited. In the case of guarantee companies, the

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liability of members is not limited to the extent of the amount
guaranteed by them.
(c)

Government company: A company in which Central

Government or State Government or
both has not less than fifty-one per cent of the share capital, is
called Government Company.
(d)

Other companies: Besides the above, Companies Act, 1956

classifies companies on the
basis of time, place of incorporation and nature of working of share
capital into the following
categories:
(i) Existing company

(ii) Foreign company

(iii) Holding company

(iv) Subsidiary company, etc.

(i) Existing Company: A company, already existing before the
coming into force of the
Companies Act, 1956.
(ii) Foreign Company: A company registered in a foreign country,
(iii) Holding Company: A company owning more than fifty per cent
of share capital in
another company or a company, which can appoint the majority of
directors in another
company, (iv) Subsidiary Company: It can be seen that when there
is a holding company, the other
company is called a subsidiary company.
We will study in detail in other chapters about incorporation of
companies and the precautions a banker should take while lending
to a company.

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179
ite to
tains
yees
is, a ures
the iny, yof
tor iny. the
ing
the
in
her
her
'
5.

Statutory Corporations: Besides companies registered under

the Companies Act, 1956, there may
be corporations established by an Act of Parliament. These are
called 'Statutory Corporations'. For
example State Bank of India is established under State Bank of
India Act, 1955. Nationalised banks
are established under the Banking Companies (Acquisition and
Transfer of Undertakings) Act,
1970.
These statutory corporations are governed by the Acts under which
they were established. These Acts provide for making rules and
regulations by the Government for the corporation. The Act, rules

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and regulations define the scope, objects and range of business of
the corporations.
6.

Trusts and Co-operative Societies, etc.

(i) Clubs, societies, schools and other non-trading associations:
Such bodies, if not incorporated under the laws governing them,
cannot enter into any transactions. These bodies are usually
governed by the Companies Act or the Co-operative Societies Act
and function within the ambit of those laws. For example clubs can
be registered either under the Companies Act, 1956 or under the
Societies Registration Act or the Co-operative Societies Act. In the
case of lending to these bodies, a banker should study the bye-laws,
rules and regulations applicable to them and ascertain the legality
of lending to them, (ii) Trusts: These are governed by the Indian
Trusts Act, 1882, if they are private trusts and by Public Trusts Act
if they are public trust, or Religious and Charitable Endowments
Act, if they are trusts of Hindus and in the case of Muslims they are
governed by Wakf Act. A banker dealing with trusts should
acquaint himself with the respective laws applicable to them and
should ensure that his lending is within the ambit of those laws,
(iii) Trustee: Trustees manage trusts. The powers and duties of the
trustees are provided in trust deed and are also regulated by the
respective laws applicable to such trusts. For example, in the case
of public trusts, Charity commissioners, or commissioner of
endowments appointed by the Government, have the power to
supervise the activities of the trusts. The trustee of the Muslim
Wakf is called Mutawali and his conduct and functions are
regulated by the Wakf Board. Therefore, a banker dealing with a
trust should ensure that all the permission required for taking a

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loan is obtained from respective Government authorities.
16.3

LET US SUM UP

As a banker, it is necessary to be aware of the various types of
borrowers and the laws applicable along with the precautions to be
taken while dealing with them. Borrowers can be broadly classified
in the following categories: individuals, partnership firms, Hindu
Undivided Family, companies, statutory corporations, trusts and
co-operative societies. The laws applicable to all these different
kinds of borrowers are different. Individuals are governed by the
Indian Contract Act, partnership firms by the Indian Partnership
Act, Hindu Undivided Family by the customary law pertaining to
Hindus, companies by the Companies Act, statutory corporations
by the Acts that created them, trusts by the Indian Trusts Act,
Public Trusts Act, Religious and Charitable Endowments Act, Wakf
Act and co-operative societies by the Co-operative Societies Act or
the Societies Registration Act. .
16.4

KEYWORDS

Memorandum of Association; Articles of Association; Company;
Hindu Undivided Family (HUF); Partnership; Trustee.

ms
L.R.A.B-13
180
16.5 CHECK YOUR PROGRESS

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1. Fill in the blanks.
(a) (b) (c) (d)
(e) (f) (g) (h)
(i)
Individual borrowers are governed by the

Act.

In a Hindu undivided family the business of the family is managed
by
A company is and

from its members.

number of members and a maximum
A Private Limited Company has minimum
of

numbers of members.

transferable.
A Public Limited Company shares are
Statutory corporations are established by Acts of
Private trusts are governed by the Act.
Act. Act.
Trusts of Hindus are governed by the _ Trusts of Muslims are
governed by the
16.6 ANSWERS TO CHECK YOUR PROGRESS'
1. (a) Indian Contract; (b) Karta; (c) separate and distinct; (d) 2,
50; (e) freely; (f) Parliament; (g) Indian Trusts Act; (h) Religious
and Charitable Endowments Act; (i) Wakf.

um

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TYPES OF CREDIT FACILITIES

:nt;
STRUCTURE
17.0

Objectives

17.1

Introduction

17.2

Types of Credit Facilities

17.3

Cash Credit and Overdraft

17.4

Term/Demand Loans

17.5

Bill Finance

17.6

Let Us Sum Up

17.7

Check Your Progress

17.8

Answers to 'Check Your Progress'

182
17.0

OBJECTIVES

After studying this unit, you should be able to understand:

various types of credit facilities and the laws governing

them;

laws affecting credit facilities granted by the bank.

17.1

INTRODUCTION

Lending is a principal activity of a bank. The advances portfolio of a
bank indicates its dynamic perso¬nality. A banker to grow in the
business of banking should have a thorough knowledge of the

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requirements of his customer and should be in a position to cater
to the needs of the customer. It is common know¬ledge that a
bank's existence depends on its customer's need to borrow. A
banker should be in a posi¬tion to identify the needs of the
customer for funds and mould the lending tool, according to the
requirements of the customer conforming to the laws of the land.
Therefore, a banker for his success as a lender is required to
acquaint himself with various types of credit facilities that are
presently in vogue in business of lending and shall understand the
legal relationship existing under different credit facilities. In this
unit, we will study different types of credit facilities and their legal
aspects.
17.2

TYPES OF CREDIT FACILITIES

We have seen earlier that the primary business of a bank is lending.
The business of lending is carried on by the bank by offering
various credit facilities to its customers. We can classify the credit
facilities into 'Fund' based credit facilities and 'Non-Fund' based
credit facilities and customised credit facilities in the case of special
constituents. We know that Nationalisation of Banks ushered in a
new concept in bank's lending and added a dimension of social
banking to business of lending by banks. Basically various credit
facilities offered by banks are generally repayable on demand. That
being the case, a banker, to ensure proper recovery of funds lent by
him, should acquaint himself with the nature of legal remedies
open to him and law affecting the credit facilities provided by him.
Credit facilities are broadly classified into two types based on funds
outflow; they are:
1.

Fund based credit facilities

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2.

Non-fund based credit facilities

1.

Fund Based Credit Facilities: Fund based credit facilities

involve the outflow of funds meaning
thereby, the money of the banker is lent to the customer. They can
be generally of following types:
(a) Cash credits/overdrafts (b) Term loans/Demand loans
(c) Bill finance
2.

Non-Fund Based Credit Facilities: In this type of credit

facility the bank's funds are not directly
lent to the customer and they include:
(a) Bank guarantee (b) Letter of credit facility
(c) Acceptance facility
These have already been dealt with elaborately in other units and
hence, are only outlined here.
17.3

CASH CREDIT AND OVERDRAFT

A cash credit or overdraft is an arrangement by which a banker
allows his customer to borrow money up to a certain limit. This is
the most popular mode of borrowing by the large commercial and
industrial concerns in India, on account of the inherent advantage.
A customer need not borrow at once, the
183
whole of the amount up to the limit as the same may not required
from day one, but can draw such amounts as and when required.
Cash credit/overdraft is a contract of a loan between a bank and its
borrower. The contract of cash credit or overdraft can be express or
implied.
In the case of Bank of Maharashtra vs United Construction Co. &

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Others (1986),[ 60 Compo Cases 163 (Bom).] a customer overdrew
his account. There was no written contract for an overdraft. The
bank demanded repayment of the moneys overdrawn with interest.
The customer refused to pay interest. The bank therefore, filed a
suit for recovery of the monies overdrawn with interest. The
Bombay High Court held that there is no need for express contract
for an overdraft and directed the borrower to repay the moneys
with interest as there is an implied contract of an overdraft.
Rule in Clayton's Case
The credit facility, given in the form of a cash credit/overdraft is
operated normally, through a running account opened and kept by
the customer. Whenever a customer withdraws money, the account
being debited for the amount and whenever the customer pays, the
account being credited. Under the law, each item of debit forms a
separate loan and each credit as a repayment of the earliest debits.
This aspect of discharge of the debit items by subsequent credits
was first enunciated in a case, called the Clayton's case. In that
case, the Courts held that the first sum of money paid into the
account, is deemed to repay the first item recorded on the debit
side of the account. For example, if there are two items on the debit
side of the customer's current account. A debit of Rs. 1,000 on 3
March and Rs 500 on 6 March, in a year and the borrower pays Rs.
750 on 12 March; the sum will be appropriated first, by reducing
the earlier debit of Rs. 1,000 rather than discreating a charge the
later debt of Rs. 500. This creates problems for recovery for the
bank. Hence, the bankers, to avoid the rule in the Clayton's case
agree on the method of appropriation and treat all debits as one
debt.

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Bank not to Terminate Overdraft Facility without Notice
Once a bank grants an overdraft facility, then there is a contract
between the bank and the customer that is not be cancellable
unilaterally. The Gujarat High Court vs Indian Overseas Bank
considered this in M/s Narain Prasad Govindlal Patel (AIR 1980
Guj 158). In this case, a firm was enjoying temporary overdraft
facility to a limit of Rs. 5,000 with the bank, for a period of four
years. No document was executed nor was any security furnished.
The bank unilaterally, without notice, terminated the facility with
the result that a cheque drawn by the firm was dishonoured by the
bank on the ground that there was insufficient balance in the
account. The firm claimed damages for wrongful dishonour of the
cheque. Both the Trial Court and the Appellate Court allowed the
claim of the firm. A further appeal by the bank to the High Court
was dismissed, in which the High Court observed:
The bank grants overdraft facility in order to earn interest. Its
constituents enjoy the overdraft facility in order to develop their
business. Therefore, both are deeply interested in such an
arrangement. Such an arrangement - euphemistically called by Mr
Chhatrapati as a facility - is nothing but a contract. The contract, if
it is well settled, can be inferred from the conduct of the parties.
The enjoyment of overdraft facility for a period of four years
unfailingly points to the conduct of the bank.
A temporary overdraft facility is not one, which can be terminated
unilaterally at the sweet will of the bank without giving its
constituent a notice thereof. It is temporary because, it is not
intended to be a permanent and everlasting arrangement.
Sometimes, a constituent is required to square up his account at

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the end of every half financial year - 30 June and 31 December.
Merely because, the overdraft is called temporary overdraft, it does
not militate against the plaintiff drawing a cheque upon the bank in
favour of its constituent and in getting it honoured by the bank.
184
11
17.4

TERM/DEMAND LOANS

Term/Demand loans are granted to customers generally for
meeting the capital expenditure needs of the business. Term loans
are granted in one lump sum and are allowed to be repaid over a
period in instalments the schedule of which is specified in the
agreement itself. Demand loans are those which are repayable on
demand through a repayment schedule is agreed upon by the bank.
Term loans on the basis of period of repayment are further
classified into:
(i) Short-term Loans,

(ii) Medium-term Loans,

(iii) Long-

term Loans.
Short-term loans are loans that are repayable within one year,
medium-term loans within two to seven years and long-term loans
above seven years periods. Banks normally grant the short-term
and medium-term loans. The development financial institutions
usually grant long-term loans. Banks in certain cases like housing
loans sanction long-term loans which are repayable over longer
period of 20-25 years.
Law relating to term loans

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Term loans are governed by the agreement entered into between
the parties. The loan agreement provides for various eventualities
and contains details of the loan, repayment or amortisation
schedule and other obligations of the borrower like payment of
interests, costs and expenses, etc. We will now consider a case
decided by High Court in respect of term loans.
(i) Acceleration of Repayment: P.K. Achuthan vs State Bank of
Travancore 1974 K.L.T. 806
(FB): A question that came for a decision in this case was, whether
a provision in the hypothecation bond to the effect that on a default
of the borrower in paying any of the instalments, the lender would
be entitled to recover the whole of the debt due, inclusive of the
future instalments in one lump sum is legal. The Kerala High Court
held that where the contract provides for repayment of money in
instalments and also contains a stipulation that on a default being
committed in paying any of the instalments, the whole sum shall
become payable, then the lender would be entitled to recover the
whole sum inclusive of future instalments.
(ii) Time within which a suit for recovery shall be filed: We have
seen earlier that in the case of term loans, periodical repayment in
instalments is allowed. In the event of a default in payment of
instalments, the bank can institute a suit for recovery of the unpaid
instalment. Besides, the bank is entitled to wait until the due date
of the last instalment and then institute a suit for recovery of whole
amount. The limitation period for filing a suit in the case of term
loans is three years from the date of default of a particular/specific
instalment. However, if by doing so the time limit gets over in case
of some earlier defaulted instalments, bank looses its right against

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such unpaid instalments. In the case of a demand loan the time
limit is three years from the date of default.
17.5

BILL FINANCE

Bill finance is also one of the important facets of lending by banks.
Generally, the bill finance is conducted through discounting of bills
of exchange drawn by the borrower or third persons on the
customers of borrower. The methods of bill finance, depending
upon payment obligations incurred by the bank, can be classified
into:
(i) Bill discounting and bills purchase;

(ii) Drawee bill

acceptance;
(iii) Bills co-acceptance.
In all these cases, the banker undertakes an obligation and
depending on the nature of bill finance, the first two are fundbased facilities and the last is a non-fund based facility.
This subject has been dealt with in more detail in the chapter of
'Law Relating to Bill Finance'.
185
Non-Fund Based Facilities
In the business of lending, a banker also extends non-fund based
facilities. Non-fund based facilities do not involve an immediate
outflow of funds. The banker undertakes a risk to pay the amounts
on happening of a contingency. Non-fund based facilities can be of
following types among other:
(a) Guarantee facility;

(b) Letter of credit facility;

(c) Underwriting and credit guarantee.
(a)

Guarantee facility: The banker in his business of lending

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extends various facilities to its constituents.
Under this facility, the bank undertakes to discharge the liability of
the borrower to third parties.
The nature of guarantees includes; performance guarantees,
deferred payment guarantees, advance
payment guarantees, guarantees to Government departments, etc.
(b)

Letter of credit facility: Letter of credit or documentary

credit facility is another non-fund based
facility extended by the bankers to their constituents. Under this
facility the banker undertakes to
pay on presentation of documents of title to goods. The banks
generally adopt the Uniform
Customs and Practices relating to Documentary Credits 600
(UCPDC 600) framed by International
Chamber of Commerce which defines the obligations and rights of
the parties w.e.f. 1 July 2007.
(c)

Underwriting and credit guarantee: Besides the above non-

fund based facilities, some banks also
do underwriting and credit guarantee business. The risk under this
activity involves the obligation
of the banker to provide funds or pay, in the event of the failure of
the borrower to raise moneys,
or to repay moneys. After the advent of merchant banking, this
type of lending by commercial
banks is on the decline.
(d)

Derivative products: In addition to the above traditional

non-fund facilities, banks are now
increasingly offering the derivative products to their clients to

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enable them to hedge their currency
and interest rate risks.
Other credit facilities
A banker besides extending fund based and non-fund based credit
facilities, also extends various other miscellaneous credit facilities
depending upon the constitution of the borrower. For example, in
the case of individual borrowers, many of the banks are extending,
personal loans for purchase of a house, car, and other consumer
durables. This type of lending, otherwise called 'Consumer Credit'
has become very popular these days and contributes significantly to
the profitability of the bank's business.
17.6 LET US SUM UP
1.

Credit facilities are mainly classified into:

(i) Fund based facilities
2.

(ii) Non-fund based facilities

Fund based facilities, among other things, include:

(i) Cash credits/Overdrafts (ii) Term loans
(iii) Bill finance
3.

Non-fund based facilities, among other things, include:

(i) Bank guarantee (ii) Letter of credit facility
4.

Under customary law of bankers, interest can be charged on

the temporary overdrafts granted.
5.

As per rule, in the Clayton's case each credit discharges the

earliest of the debit entries.
6.

Term loans based on period of repayment are classified into:

(i) Short-term loan (ii) Medium-term loan
(iii) Long-term loan
186

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17.7 CHECK YOUR PROGRESS
1. Cash Credit facility is a
2.

Bills co-acceptance facility is a

.

3.

Banker is entitled to charge interest on temporary overdraft

under .
4.

Limitation period for filing a suit in term loans is

years

from the date of default of
instalment.
5.

Period of repayment in the case of medium-term loan is
.

17.8 ANSWERS TO 'CHECK YOUR PROGRESS'
1. Fund based facility; 2. Non-Fund based facility; 3. Banking
custom; 4. 3 (Three); 5. 5-7 years.

SECURED AND UNSECURED LOANS, REGISTRATION OF
FIRMS, INCORPORATION OF COMPANIES
STRUCTURE
18.0

Objectives

18.1

Introduction

18.2

What are 'Unsecured Loans' and 'Secured Loans'?

18.3

Why a Secured Loan?

18.4

Registration of Firms

18.5

Consequences of Non-registration of Firm

18.6

Incorporation of a Company

18.7

Let Us Sum Up

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18.8

Check Your Progress

18.9

Answers to 'Check Your Progress'

188
18.0

OBJECTIVES

After studying this unit, you should be able to understand:

what is a secured and unsecured loan;

the law governing bankers' securities;

the procedure for registration of firms and incorporation of

companies.
18.1

INTRODUCTION

In the earlier units, we have studied about type of borrowers, credit
facilities and the laws governing them. In this unit, we will
endeavour to understand the securities for bank's lending business,
legal status of a banker in the case of unsecured loans, and more
about law relating to partnership firms and companies, their
registration and incorporation.
18.2

WHAT ARE 'UNSECURED LOANS' AND 'SECURED

LOANS'?
Unsecured Loans
Most of the loans granted by banks in India are generally secured
by tangible security being assets purchased out of the bank funds
and/or some valuable collateral such as bonds, shares and
merchandise deposited either in the bank's godowns or in the
godowns of the borrowers under agreement of hypothecation, and
immoveable property, but occasionally loans are granted even
without any security.
An unsecured loan is one for which the banker has to rely upon the

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personal integrity of the borrower. The chief basis of such
transactions is the personal credit or credit worthiness of the
customer. In other words, 'creditworthiness' is the confidence of a
banker on the future solvency of a person or his future financial
strength, which enables him to take a loan at present and pay it in
future. All unsecured loans, otherwise called clean loans are
dependent on the borrower's financial strength to pay in future.
Secured Loans
Secured loans are the antithesis to unsecured loans. These loans
are given by a banker not merely based on his confidence on the
borrower's future financial strength but also based on his present
net worth that he is able to give a banker to rely upon and recover
the moneys lent in the event of his failure to repay the loan in the
ordinary course. We will elaborate it a little further. In the case of
secured loans, a banker besides verifying the future solvency of the
borrower asks for the charge over property of the borrower so that
in the event of failure by the borrower to repay, the banker can sell
the property of the borrower charged to him and recover the
moneys.
18.3

WHY A SECURED LOAN?

We have seen the difference between an unsecured loan and a
secured loan. It would be relevant to know why a 'secured loan' is
preferred over 'unsecured loan'. It is common knowledge that
lending by a banker is generally for the economic activity of the
borrower and recovery of loans given by a banker is mostly
dependent on the economic success of the borrower. Success or
failure of an economic activity depends on various macro and
micro economic factors. A banker lending to a customer can assess

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only the existing macro and micro economic factors and can only
predict success or failure of the borrower's activity in the future
reasonably. A banker cannot be absolutely certain about the
recovery of the amounts lent, if he solely relies on the economic
success of the borrower. Therefore, a banker asks for further
security in form of a charge on property of the borrower. The
charge created over the property of the borrower acts as cushion to
absorb the shocks of economic failure of the borrower as the
banker can safely sell the properties charged to him and recover the
moneys lent. This is the primary reason for preference of secured
loans over unsecured loans.
18.4 REGISTRATION OF FIRMS
We have in an earlier unit, dealt with borrowers who are
'Partnership Firms' and governed by the Indian Partnership Act,
1932. In this unit, we shall study the law relating to registration of
partnership firms.
Registration
It is in the interest of the partners themselves to have their firms
registered under the Partnership Act. The procedure for the
registration of firms and other incidental matters has been dealt in
Sections 56 to 68 of the Unit VII of Indian Partnership Act, 1932.
For registration, an application is to be submitted to the Registrar
of Firms of the area in which any place of business of the firm is
conducted, with a statement in the prescribed form and
accompanied by the prescribed fee, stating
(a)

name of the firm,

(b)

place or principal place of business of the firm,

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(c)

names of any other place where the firm carries on business,

(d)

date of joining of each of the partners,

(e)

names in full and permanent addresses of the partners,

(f)

duration of the firm-length of time for which the firm

wants/proposes to conduct the business.
We have to note that the Act contemplates registration of firms, not
the registration of partnership deed. The registration of the firm is
optional and not compulsory. So a mere non-registration would not
affect the carrying on business and giving effect to partnership
deed.
When the Registrar is satisfied that the provision of Section 58 has
been duly complied with, he will record an entry of the statement
in the register called the Register of Firms. In addition to making
the necessary entries in the Register of Firms, he is required to file
the original of every statement submitted to him. The original
statement and all subsequent statements and notices will be filed
together so that all original papers relating to any firm will be
conveniently found together in one file. Note that the registration
of the firm takes place only when the Registrar makes the
necessary entries in the Register of Firms under-Section 59. In
other words, a firm is deemed to be registered only when the
certificate of registration is granted.
Alterations
Rules relating to alterations are provided in Section 60 which
reads:
1.

When alteration is made in the firm's name or in the

location of the principal place of business of a
registered firm a statement may be sent to the Registrar

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accompanied by the prescribed fee,
specifying the alteration and signed and verified in the manner
required under Section 58.
2.

When the Registrar is satisfied that the provisions of the

sub-Section (1) of the Section 60 has been
complied with, he shall amend the entry relating to the firm in the
Registrar of Firms in accordance
with the statement and shall file it along with the statement filed
under the Section 59. There is no
time limit fixed as to when notices of alterations have to be given.
Section 61 provides that when a registered firm discontinues
business in any place or begins to carry on business at any place,
such a place, not being its principal place of business, any partner
or agent of the firm, may send an intimation thereof 'to the
Registrar', who shall make a note of such an intimation in the entry
relating to firms in the Registrar of Firms and shall file the
intimation along with the statement relating to firm filed under
Section 59. Similarly, when any partner in a registered firm, alters
his name or permanent address, an intimation of the alteration
may be sent by any partner or agent or firm to the Registrar, and he
shall deal with it in the manner nrnv
;« c—
I
ib'U
Section 63 provides for the recording of a change in and the
dissolution of a firm and also the recording of withdrawal of a

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minor.
There is no particular form of notice. If substantial compliance has
been made with the provision that would be sufficient for the
purpose of the section.
Rectification of Mistake
The Registrar has power at all times to rectify any mistake so as to
bring the entry in the Register of firms relating to any firm in
conformity with the documents relating to that firm already filed
with him.
The Registrar may also rectify any mistake on the application made
by the parties who had signed the document. However, this power
is not a general power, but limited to rectifying the mistakes to
bring the entry in conformity with the document filed by the
partners or their agents. If there is an omission in the mention of
one of the places of business of the firm, the omission is capable of
rectification under this provision. Moreover, this omission does not
affect the registration; similarly, if certain persons are wrongly
noted in the Register, this is a mistake which can be rectified under
this provision.
Amendment of Register by Court's Order
Provision is made for a Court deciding any matter relating to a
registered firm may direct the Registrar to make any amendment
in the entry in the Register of Firms relating to such firms which is
consequential upon its decision, and the Registrar shall amend the
entry accordingly.
Inspection
The Register of Firms, the statements, notices and intimations filed
with the Registrar are open to inspection by any person on

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payment of a prescribed fee.
Copies
Similarly, any person can obtain a copy of any entry or portion in
the Register of Firms by making an application to the Registrar and
paying prescribed fee.
Evidentiary Value
Section 68(1) provides, any statement, intimation or notice
recorded or noted in the Register of Firms shall, as against any
person by whom or on whose behalf such statement, intimation or
notice was signed is conclusive proof of any fact stated therein.
Penalty
Section 70 provides that any person who signs any statement,
amending statement, notice or intimation under the Unit VII of the
Partnership Act containing any particulars, which he knows to be
false or does not believe to be true or containing particulars which
he knows to be incomplete or does not believe to be complete, shall
be punishable with imprisonment which may extend to three
month, or with fine or both.
18.5 CONSEQUENCES OF NON-REGISTRATION OF A FIRM
Section 69 of Indian Partnership Act, 1932 sets out the effect of
non-registration of firm and may be conveniently studied under the
following four heads:
(i) suits by partners inter se

(ii) suits by a firm against third

parties
(iii) exceptions

(iv) non-application of provisions to certain

suits,
(i) Suits by Partners Inter se: If a firm is not registered under the
Indian Partnership Act, then no suit to enforce a right, arising from

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a contract or conferred by the Partnership Act, shall be
)rding n that
ter of i him.
:d the bring ssion ation rtain sion.
strar ntial
n to
;an
ins
vas
ion or lot or
be
10 >e
191
instituted in any Court, by or on behalf of any person suing as a
partner in a firm against the firm or against any other partner of
the firm. This prohibition applies to the claim of set off or other
proceeding to enforce a right arising from a contract.
The Supreme Court in the case of Loon Karan Sethia (AIR 1977 SC
336) has held that this provision for registration is mandatory in
character and its effect is to render a suit by the plaintiff in respect
of a right vested in him or required by him under contract, which
he entered into as a partner of a unregistered firm, whether
existing, or dissolved as void. In other words, a partner of an
erstwhile un-registered partnership firm cannot bring a suit to
enforce a right arising out of a contract falling within the ambit of

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Section 69 and simply by making an application for registration
before instituting a suit is also not sufficient.
(ii) Suit by a Firm Against Third Parties: No suit to enforce a right
arising from a contract can be instituted in any Court, by or on
behalf of a firm against any third party, unless the firm is registered
and the persons suing or have been shown in the Register of Firms
as partners in the firm. This provision also applies to a claim of set
off or other proceeding to enforce a right arising from a contract.
Before the bar of the Section 69 can be invoked there should be
clear evidence that the plaintiffs were partners as defined in the
Section 4 of the Act and the loose use of the term 'partnership' on a
firm would not by itself establish that the plaintiffs were partners
in the true sense of the term. Moreover, the burden of proof would
be on the defendant.
The bar under this section applies to rights arising out of a contract
only and not in respect of other rights as the sub-Section (i) above.
Some of the illustrations of such rights are: the right to enforce a
contract embodied in a negotiable instrument, right to eject a
landlord, right to determine the liability of the landlord, etc.
Section 69(2) requires that the person serving must have been
shown in the Register of Firms as a partner, but the mode of proof
of that fact is not in anyway restricted.
(iii) Exceptions: Sub-Section (3) of the Section 69 provides for two
exceptions:
(a)

The enforcement of right to sue for dissolution of a firm, or

for accounts of a dissolved firm
or any right or power to realise the property of the dissolved firm.
(b)

The powers of an official assignee receiver or Court, under

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the Presidency Towns Insolvency
Act, 1909 to realise the property of an insolvent partner.
(iv) Non-application of Section 69: Certain Suits: Sub-Section (4)
of Section 69 provides that the Section 69 shall not apply
(a)

to firms to which the Act extends or whose places of

business in the said territories are
situated in areas to which, by notification under the Section 56
Unit VII of the Partnership
Act does not apply; or
(b)

to any suit or claim of set off not exceeding Rs. 100 in value

which, according to the
Presidency Towns is not of a kind specified in the Section 19 of the
Presidency Small Cause
Courts Act, 1882, or outside the presidency towns, is not of the
kind specified in the second
Schedule to the Provincial Small Cause Courts Act, 1887, or to any
proceedings in execution
or other proceeding incidental to or arising from any such suit or
claim.
The bar does not apply to suits of Small Cause nature, value of
which not exceeding Rs. 100. But when a suit or cross-objection is
not cognisable either by the Presidency Court of Small Causes or by
the Small Causes Court, the Section 69(4)(b) will not apply even
though the relief for accounts may be value at Rs. 100.
192
18.6 INCORPORATION OF A COMPANY
We have seen in the earlier units that among others 'company' is

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also one of the borrowers of a banker. We have also studied briefly
the law governing companies. In this unit, we will study the law
relating to companies and their incorporation.
1. Company - Meaning and Characteristics: A company is an
artificial person, since it is created by law. It is clothed with many
of the rights, liabilities, powers and duties prescribed by law.
Among the two most important characteristics of a company, one is
its separate individuality and the other is perpetuity within the
limits prescribed by law. It can do all acts as a natural person may
do.
A company has a 'Corporate Personality' separate from all the
members who have formed it unlike a partnership firm. Because of
this, a company incurs all the liabilities and possesses all rights of a
natural person subject to the regulation of law. The classical
judgement of the House of Lords in Salomon vs. Salomon & Co.
Ltd. (1897) AC 22 lays down the principle of 'corporate
personality'.
The facts of this case are that one Mr. Salomon who was
individually carrying on the business of boot and shoe
manufacture, incorporated a company named 'Salomon & Co. Ltd.'
which consisted of seven of his family members. This company
took over the personal business assets of Mr. Salomon for 38,782
pounds and in turn Mr. Salomon took 20,000 shares of one pound
each and debentures worth 10,000 pounds, for which there was a
charge on the company's assets and balance in cash.
All his family members took one share of a pound each. The
company later went into liquidation and various unsecured
creditors contended that Mr. Salomon could not be treated as a

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secured creditor of the company in respect of debentures held by
him. The House of Lords after hearing the arguments held that:
The company is by law a different person altogether from its
shareholders and though it may be that after incorporation, the
business is precisely the same as it was before and the same
persons are managers and the same hands receive the profits; the
company is not in law the agent of the shareholders or trustees for
them. Nor are the shareholders liable in any shape or form except
to extent and the manner provided in the Act.
The Salomon Case for the first time authoritatively and clearly
established the fact that a company has its own existence or
personality, which is separate and distinct from its members and as
a result a shareholder cannot be held liable for the acts of the
company, even though he holds virtually the entire share capital.
The case also recognised and accepted the concept of limited
liability. The legal status and position of a company has been aptly
described by Supreme Court in Tata Engineering and Locomotive
Company Ltd. vs State of Bihar AIR 1965 SC 40 in the following
words:
The corporation in law is equal to a natural person and has a legal
entity of its own. The entity of the corporation is entirely separate
from that of its shareholders; it bears its own name and has a seal
of its own; its assets are separate and distinct from those of its
members and it can sue and be sued exclusively for its own
purpose; its creditors cannot obtain satisfaction from the asset of
its members; the liability of the members or the shareholder is
limited to the capital invested by them. Similarly, the creditors of
the members have no right to the assets of the corporation.

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The main characteristics of a company are summed up as under:
(i) Company is a voluntary association of persons who have come
together to carry on some business
for profit, (ii) It has a perpetual existence and though members
may come and members may go, the company
continues forever. Change in its members or in their identity does
not affect the legal existence or
its identity. Only law can dissolve it, since it is a creation of law.
193
(iii) The shares of joint stock companies are freely transferable and
in the case of a private limited company, the Companies Act has
put certain restrictions on the transferability of shares. Every
member who owns fully paid-up shares is free to dispose of his
shares according to his choice but subject to any regulation of the
company. Any absolute bar or restriction on the right to transfer
shares is void.
(iv) The member's/shareholder's liability in a company is limited to
the extent of the nominal value of the shares held by them. Under
no circumstance, is a member/shareholder directed to pay
anything more than the unpaid value of his shares. As regards a
company limited by guarantee, the members are liable only to the
extent of the amount guaranteed by them and not beyond and that
too only when the company goes into liquidation.
(v) As a corporate person, a company is entitled to own and hold
property in its own name.
(vi) A company being a body corporate can sue and be sued in its
own name.

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In brief, the most striking features of a company are its distinct
legal personality, the easy transferability of its shares, and the
limited liability of its members.
Incorporation of a Company
We shall now in brief understand the various steps to be taken and
as to how a company comes into existence. It is to be noted that at
the time of formation of the company the promoters have to
amongst other things decide the following aspects:
(a)

Type of company: Under the Companies Act, 1956 only two

types of companies can be registered,
viz.,
(i) Public companies

(ii) Private companies.

These companies may further be classified as follows:
(i) Companies limited by shares
(ii) Companies limited by guarantee with or without share capital
and (iii) Unlimited companies with or without share capital.
(b)

Name of company: A company is identified by the name

under which it is registered. According
to Section 13 of the Act, the Memorandum of Association of a
company should state the name of
the company. To avoid delay and to afford flexibility to the
Registrar to decide the availability of
names the promoters are required to submit at least three suitable
names in the order of preference.
The name of a company must necessarily end with the word
'limited' in the case of a public
company and the words 'private limited' in case the company is a
private company. In case of a

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Section 25 Company, the inclusion of the word 'limited' can be
dispensed with by obtaining a
licence from the Regional Director. Section 20 prohibits the
registration of a company, the name
of which is undesirable or which is identical with or too nearly
resembles the name of an existing
company. A company will not be permitted to use a name which is
prohibited under the Emblems
and Names (Prevention of Improper Use) Act, 1950.
The Registrar is required by law to make preliminary enquiries so
as to ensure that the name permitted by him will not be misleading
or is not intended to deceive with reference to its objects clause.
(c)

Memorandum of Association: The memorandum of

association is the constitution of a company
and amongst other things, defines the area withiirwhich the
company can act. It is, therefore,
necessary to state the object for which the company has been
formed, the various businesses that
it can undertake, the liability of its members, etc. For a banker it is
absolutely essential to verify
the memorandum and ensure that the business undertaken by the
company is within its objects,
if not, any loan made to the company would not be recoverable.
194
(d)

Articles of Association: The other important document of a

company is the articles of association,
which contains the rules and regulations relating to the internal

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management of a company.
Section 15 of the Companies Act stipulates that every
memorandum should be signed by each
subscriber who should add his address, description and
occupation, if any, in the presence of at
least one witness who shall attest the signature and shall likewise
add his address, description and
occupation, if any. As regards companies having a share capital the
subscribers to the memorandum
should at least take one share each and they have to state clearly
the number and nature of the
shares taken by them.
The articles of association should similarly be signed separately by
persons subscribing to the same. The signatures of the subscribers
in the Articles of Association are also to be attested by a witness.
(e)

Preparation of other documents: The promoters forming the

company are also required to submit
various other forms and documents prescribed under Companies
(Central Governments' General
Rules and Forms) Act, 1959.
(f)

Payment of registration fees: The fee prescribed for

registration of a company is required to be
paid the quantum of which depends on the nominal capital of the
company to be incorporated in
the case of companies having share capital.
(g)

Certificate of Incorporation: Once all the formalities as

detailed above are satisfied, the promoters
are entitled to get from the Registrar of Companies the certificate

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of Incorporation. Section 33(3)
of the Companies Act states that if the Registrar is satisfied that all
the requirements, as stated
above have been complied with by the company and that it is
authorised to be registered under the
Act, he shall retain and register the memorandum, articles, if any.
On the registration of the
memorandum of a company the Registrar shall certify under his
hand that the company is
incorporated and, in the case of a limited company that the
company is limited. From the date of
incorporation mentioned in the certificate of incorporation, such of
the subscribers of the
memorandum and other persons, as may from time to time be
members of the company, shall be
a body corporate by the name contained in the memorandum,
capable forthwith of exercising all
the functions of an incorporated company and having perpetual
succession and a common seal,
but with such liability on the part of the members to contribute to
assets of the company in the
event of its being wound up as mentioned in the Act (Section 34).
Certificate of Incorporation: Conclusive Evidence
Section 35 of the Act states that a certificate of incorporation given
by the Registrar in respect of any association shall be conclusive
evidence that all the requirements of the Act have been complied
with in respect of registration and matters precedent and incidental
thereto, and that the association is a company authorised to be

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registered and duly registered under the Act. The certificate of
incorporation is conclusive evidence that everything is in order as
regards registration and that the company has come into existence
from the earliest moment of the day of incorporation stated therein
with rights and liabilities of a natural person, competent to
contracts. Once a certificate of incorporation has been issued its
validity cannot be impeached. In the case of Moosa vs Ebrahim
[ILR (1913)40 Cal.l (PC.)] the memorandum of association of a
company was signed by two adults and by a guardian of the other
five members, who happened to be minors. The Registrar,
however, registered the company and issued under his hand a
certificate of incorporation. It was contended that the certificate of
incorporation should be declared to be void. Lord Macnaughten
deciding the case said:
Their Lordships will assume that the conditions of registration
prescribed by the Indian Companies Act were not duly complied
with; that there were no seven subscribers to the memorandum
and that the Registrar ought not to have granted the certificate. But
the certificate is conclusive for all purpose. Thus, the certificate
prevents anyone alleging that the company does not exist.
195
Though the certificate of incorporation makes the existence of a
company legally valid, it does not mean that the certificate legalises
an illegal object mentioned in the memorandum. In fact, it is for
the purpose of incorporation only that the certificate is made
conclusive by law.
(h) Certificate of Commencement of Business: Once a certificate of

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incorporation has been issued, a company becomes forthwith
capable of exercising all the functions of an incorporated company.
This however applies only to private companies and a company
having no share capital. In the case of companies other than a
private company and a company having no share capital, a further
requirement is to be complied with, namely, obtaining a certificate
of commencement of business before commencing any business.
Thus, whereas a private company and a company having no share
capital can commence business right from the date of its
incorporation, a public company is required to file either a
prospectus or a statement, in lieu of prospectus and the declaration
of statutory compliances, as prescribed under Section 149 with the
Registrar of Companies of the State where the company is situated
and obtain from the Registrar a certificate of commencement of
business before the company commences business.
Documents to be filed with the Registrar (Section 33)
After taking the above steps, the following documents are required
to be filed with the Registrar of Companies of the state in which the
registered office of the company is to be situated:
(i) The memorandum of association duly signed by the prescribed
minimum number of
subscribers, duly stamped and signed by witness.
(ii) The articles of association should also be similarly signed,
stamped and witnessed, (iii) Any agreement which the company
proposes to enter into with any individual for appointment
as its managing or whole time director or manager, (iv) Any other
agreement, if referred to in the memorandum and articles of
association, in case,

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it will form part of the memorandum and articles, (v) Letter of
authority (stamped as a specific power of attorney) signed by the
subscribers
authorising a representative to make amendments and/or
alterations in the memorandum
and articles of association, (vi) A copy of the letter received from
the Registrar of Companies intimating the availability of
the proposed name, (vii) A statutory declaration in the prescribed
form by an advocate, an attorney or pleader entitled
to appear in a High Court or a secretary or a chartered accountant
practising in India, who
is engaged in the formation of the company, or by a person who is
named as a director or
manager or secretary of the company stating that all requirements
of the Act and the Rules
thereunder have been complied with in respect of registration and
matters precedent and
incidental thereto (Section 33). (viii) In case the first directors are
appointed by the articles, or named in the prospectus or
statement in lieu of prospectus:

a written consent of each director to act as such, signed by

him or by an agent duly
authorised in writing in prescribed form; and

an undertaking in the same form as referred above in

writing, agreeing to take from the
company and pay for his qualification shares, if any, or sign the
memorandum for
shares not being less than his qualification shares (Section 266). In

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case, a prospectus
is issued in relation to the intended company and proposed
directors are named therein,
then the consent and undertaking must be filed before the
publication of the prospectus.
(i) Payment of the requisite fee for registration
Procedure for the incorporation of a company limited by
guarantee: Though the procedure involved for the incorporation of
a company limited by guarantee is the same as that of the public
196
company or a private company, as described above, following must
however be noted in this regard:

In the memorandum of association of such a company, a

clause stating the amount of guarantee
will have to be added in addition to the other necessary clauses to
this effect.

A guarantee company may be a company with the share

capital or without the share capital.

A company formed with no intention to generate profit is

usually formed as a guarantee
company.

A company limited by guarantee can either be a private or a

public company.
18.7 LET US SUM UP
1.

An insecured loan is one for which the banker has to rely

upon the personal security of the
borrower.

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2.

Secured loans are antithesis to insecured loans.

3.

Various methods of securing a loan are pledge,

hypothecation, mortgage and assignment of debts
of the borrower.
4.

If two or more persons come together and agree to share

profits of a business, it is called a
partnership.
5.

A partnership firm can be registered under the Section 58 of

Partnership Act, 1932.
6.

If a firm is not registered, then a partner cannot sue the

other partners or third parties to enforce
contractual rights.
7.

A company is an artificial person created by law.

8.

There are only two types of companies that are registered

under the Companies Act. They are:
(a) Public Limited Company
9.

(b) Private Limited Company

Certificate of incorporation is the conclusive evidence of

coming into existence of the company.
10. Certificate of commencement of business is required for a
public company to start business.
18.8 CHECK YOUR PROGRESS
loans.
1.

Only personal security of the borrower is available in the

case of.
2.

Secured loans are normally secured by

3.

Pledge is

4.

Hypothecation is treated as

.

of goods as a security for debt.
pledge.

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5.

Personal obligation of mortgagor is a distinct feature of

6.

Section 58 of Partnership Act, 1932 provides for

7.

A partner on behalf of firm cannot institute a suit on

.

contract, if the firm is registered.
(True/False)
8.

Shares of public limited company are freely transferable.

(True/False)
9.

Certificate of incorporation is a document evidencing

existence of company. (True/False)
10. Certificate of commencement of business is required for private
limited company to start business. (True/False)
18.10 ANSWERS TO 'CHECK YOUR PROGRESS'
1. Insecured; 2. pledge, hypothecation, mortgage or assignment of
debts; 3. bailment; 4. constructive; 5. mortgage by deposit of title
deeds; 6. registration of partnership; 7. False; 8. True; 9. True; 10.
False.

REGISTRATION AND SATISFACTION OF CHARGES
STRUCTURE
19.0

Objectives

19.1

Introduction

19.2

What is a Charge?

19.3

Procedure for Registration of Charge

19.4

Effect of Non-registration of Charges

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19.5

Provisions of Law Relating to Registration of Charges

19.6

Let Us Sum Up

19.7

Check Your Progress

19.8

Answers to 'Check Your Progress'

198
19.0

OBJECTIVES

After studying this unit, you should be able to briefly understand:

the creation of charge over the properties, registration of

charges under different enactments;

registration of charges with the various authorities.

19.1

INTRODUCTION

We have seen in earlier units, the types of loans granted by a
banker and methods of securing a loan. In this unit, we will focus
on the meaning of 'charge' under the Companies Act and
registration of charges.
19.2

WHAT IS A CHARGE?

1. Before studying the meaning of word 'charge' and provisions
relating to the registration of charges, we will learn the general
meaning of the word 'charge'.
It may be noted that the word 'charge' is used to mean any form of
security for debt, unless the word is used otherwise. We have seen
in the earlier chapters, that a banker accepts different types of
securities to secure a loan granted to borrowers. Section 125(4) of
the Companies Act, 1956 provides, that for the purpose of
registration under the said Act, it includes all the following charges:
(a)

A charge for the purpose of securing debentures

(b)

A charge on uncalled capital of the company

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(c)

A charge on any immoveable property, wherever situated, or

any interest therein
(d)

A charge on any book debts of the company

(e)

A charge, not being a pledge, on any moveable property of

the company
(f)

A floating charge on the undertaking or any property of the

company including stock-intrade
(g)

A charge on calls made but not paid

(h) A charge on a ship or any share in a ship
(i) A charge on goodwill, on a patent or a licence under a patent, or
a trademark, or on a
copyright or a licence under a copyright
2. Types of Charges: 'Charges' registered under the Companies Act
can be classified into the two types:
(i) Fixed charge

(ii) Floating charge

(i) Fixed charge- 'Fixed charge' is also called 'specific charge'. It
extends over a specific property or properties of the company. In
other words, when a particular or a specific property of the
company is given as a security for loan, then a 'fixed charge' is said
to be created over the property. It may be noted, that charges
specified in Section 125(4)(b) ot the Companies Act, 1956, created
in conformity with the provisions of the said Act over a specific
property gives right to the creditor so secured, to sell the said
property and claim the proceeds towards the dues payable by the
company.
(ii) Floating Charge: A 'floating charge' means a 'charge' that is
general and not specific. It can be said to be a charge

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(a)

that floats over the present and future property of the

company subject thereto, that
means it does not fasten on or attach to any particular or specific
property;
(b)

that does not restrict the company from assigning the

property, subject to charge to
third persons, whether by way of sale or security;
(c)

that on happening of an event or contingency, crystallises as

a fixed charge.
199
From the above, it can be noted that when the charge is floating,
the company may, in the ordinary course of business, deal with the
property in any manner until the charge attaches. In other words, a
floating charge is an equitable charge which does not fasten on any
specific property but covers the whole of the company's property
whether it is or is not subject to fixed charge.
When floating charge becomes fixed or crystallised/attaches
When the debtor company ceases to carry on business or goes into
liquidation or the debenture holder or creditor, in whose favour
charge is created, intervenes by getting a receiver appointed or
doing some other act which affects the powers of the company to
dispose the assets charged. A floating charge may also crystallise on
the happening of an event specified in the creating a charge deed.
Effect of floating charge becoming fixed or crystallised
When a floating security upon all the property or assets of the
company becomes fixed, it constitutes a charge upon all the
property or assets then belonging to the company. It has priority

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over the subsequent equitable charges and over insecured creditors
and over money advanced to the liquidator.
19.3

PROCEDURE FOR REGISTRATION OF CHARGE

Companies Act, 1956 under Section 125(1) provides that all the
particulars of a charge created by the company shall be filed with
the Registrar of Companies together with an instrument, creating
charge, for registration within thirty days of the creation of charge.
The time limit of thirty days within which the charge shall be
registered can be extended by Registrar of Companies by further
thirty days.
The procedure for registration is provided under the Rule 6 of the
Companies (Central Government's) General Rules and Forms:
(a)

It provides that for the registration of charge, the company

shall file the prescribed particulars for
creation, modification or satisfaction of the charge in the Form 8,
or Form 13 or Form 17 in
triplicate. The forms are prescribed under the rules.
(b)

A copy of every instrument evidencing any charge or

modification of charge is required to be filed
with the registrar duly verified and certified.
(c)

The fee prescribed for registration shall be paid.

Recently Government of India has introduced electronic filing of
returns. This is a centralized registry and all companies are
required to file all returns which they were filing with ROC earlier
are required to file them with this new registry. Even banks and
other charge holders are required to file the particulars of the
charges created in their favour by the companies under this
method. This is to ensure reduction in delays and one point

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availability of information about any company.
19.4

EFFECT OF NON-REGISTRATION OF CHARGES

Section 125 of the Companies Act provides that the charge created
by the company over the properties, if not registered, would not be
valid against the liquidator and any creditor of the company.
It has been held in various cases by the Courts that nonregistration of charge under Section 125 would not render the
security invalid automatically. The only consequence of nonregistration is that the charge would not be valid against the
liquidator and other creditors of the company in the event of
winding up.
It must be noted that, as against the company itself, so long as the
company does not go into liquidation, the mortgage or charge is
good and maybe enforced.
200
19.5 PROVISIONS OF LAW RELATING TO REGISTRATION OF
CHARGES
Sections 124 to 145 of the Companies Act, 1956 provides for the
registration of charges. They can be stated briefly as follows:
Section 124: This Section provides that 'charge' means and includes
mortgage over any or all properties of the company.
Section 125: This Section provides that the charge created over the
properties of the company shall be registered with the Registrar of
Companies within thirty days of creation of charge. It also provides
that if the charge is not registered then the charge created would be
invalid as against the liquidator and other creditor of the company
in its winding up.

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Section 126: This Section provides that after registration of charge
created, any other person acquiring such property charged or any
party thereof, shall be deemed to have notice of the charge
registered and shall take the property subject to such charge.
Section 127: This Section provides that if a company acquires a
property charged under Section 125, then the company shall
declare the same by filing the particulars of the property, so
acquired, subject to charge.
Section 128: This Section provides that provision for registration
charges is also applicable for securing debentures issued by the
company. The registration of charge for securing debentures shall
be carried out by filing particulars of the amount of debentures, the
date of the resolutions authorising the issue of the series of
debentures, general description of property charged, and the
names of the trustees.
Section 129: This Section provides that the particulars filed for
creating the charge for securing deben¬tures shall also contain any
commission, allowance or discount paid directly or indirectly by
the company to any person in consideration of his subscribing or
agreeing to subscribe or procuring subscriptions.
Section 130: It is provided under this Section that Registrar of
Companies shall keep a register of charges containing particulars of
all charges requiring registration. This Section further provides
that a copy of particulars contained in the register of charges can be
obtained by any person on payment of fee.
Section 131: This Section provides that Registrar of Companies
shall maintain an index of register of charges.
Section 132: This Section provides that the Registrar shall give a

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certificate under his hand of the registra¬tion of any charge
registered, stating the amounts thereby secured; and the certificate
shall be a conclusive evidence of that the requirements of
Companies Act as to registration has been complied with.
Section 133: This Section directs that the company, in the case of
secured debentures, shall cause a copy of every certificate of
registration given under Section 132 to be endorsed on every
debenture or certificate of debenture stock.
Section 134: This Section imposes duty on a company to register a
charge required to be registered under the Act. It also provides that
any person interested in registration of charge can also apply for
registration.
Section 135: This Section provides that the procedure and law of
registration of charges is equally applicable to modification of
charges.
Section 136: This Section requires the company that a copy of an
instrument or document creating the charge shall be kept at the
registered office of the company.
Section 137: Under this Section any person appointed as receiver or
manager of the property charged, shall give notice to Registrar of
Companies within 30 days of his appointment.
201
Section 138: Under this Section, the company shall give intimation
to the Registrar of the payment or satisfaction in full, of any charge,
relating to the company and requiring registration under this part,
within thirty days from the date of such payment or satisfaction.
Thereafter the Registrar of Companies shall record such

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satisfaction of charge.
Section 139: Under this Section, Registrar of Companies that on
evidence being given to his satisfaction with respect to any
registered charge:
(a)

that the debt for which the charge was given has been paid

or satisfied in whole or in part; or
(b)

that part of the property or undertaking charged has been

released from the charge, or has ceased
to form part of the company's property or undertaking can record
the fact that charge is satisfied
or property is released.
Section 140: This Section provides that the Registrar after entering
memorandum of satisfaction in whole or in part, in pursuance of
Section 138 or 139, he shall furnish the company with a copy of
memorandum.
Section 141: Under this Section the Company Law Board can order
for the creation of charge or modification or satisfaction of the
charge, if the company due to inadvertence or by accident, omitted
filing charges under those provisions.
Section 142: This Section empowers Registrar to impose a penalty
on the company, if it fails to comply with the provisions of law
relating to registration of charges.
Section 143: This Section enjoins upon a company to keep at its
registered office a register of charges and enter therein all the
charges specifically affecting the property of the company.
Section 144: This Section provides that any creditor or member of
company can inspect the books relating to charges created by the
company and it is the duty of the company to keep the register of

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charges open to inspection.
19.6 LET US SUM UP
1.

The word 'charge' means any form of security for debt,

unless the word is used otherwise.
2.

All charges created by a company are required to be

registered with Registrar of Companies
under Section 125 of the Companies Act, 1956.
3.

Charges can be fixed or floating.

4.

Charge will have to be registered within thirty days of

creation of the charge.
5.

If the charge created is not registered, then the same is

invalid against liquidator and other
creditors on winding up of the company.
6.

Sections 124 to 145 of the Companies Act deal with

Registration of Charges.
19.7 CHECK YOUR PROGRESS
for
(a) Charge means any form of
(b)

Charges created by company shall be registered with .

(c)

Under Companies Act a charge includes .

(d)

Charge, if not registered is not enforceable against company.

True/False
(e)

Charge shall be registered within days from the date of

creation of charge.
19.8 ANSWERS TO 'CHECK YOUR PROGRESS'
(a) Security, debt; (b) Registrar of Companies; (c) Mortgage; (d)
False; (e) 30

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MODULE -C
BANKING RELATED LAWS
r
SECURITISATION AND RECONSTRUCTION OF
FINANCIAL ASSETS AND ENFORCEMENT OF SECURITY
INTEREST, 2002 (SARFAESI ACT, 2002)
Unit 20. Introduction to Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest, 2002
(SARFAESI Act, 2002)
Unit 21. Definitions of SARFAESI Act, 2002
Unit 22. Regulation of Securitisation and Reconstruction of
Financial Assets of Banks and Financial Institutions
Unit 23.

Enforcement of Security Interest

Unit 24.

Central Registry

Unit 25.

Offences and Penalties

Unit 26.

Miscellaneous Provisions

THE BANKING OMBUDSMAN SCHEME, 2006
Unit 27. The Banking Ombudsman Scheme, 2006: Purpose,
Extent, Definitions, Establishment and Powers
Unit 28. Procedure for Redressal of Grievance
RECOVERY OF DEBTS DUE TO BANKS AND FINANCIAL
INSTITUTIONS ACT, 1993 (DRT ACT)
Unit 29. Recovery of Debts Due to Banks and Financial Institutions
Act, 1993 (DRT Act) Preliminary
Unit 30. Establishment of Tribunal and Appellate Tribunal

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Unit 31. Jurisdiction, Powers and Authority of Tribunals
Unit 32. Procedure of Tribunals
Unit 33. Recovery of Debts Determined by Tribunal and
Miscellaneous Provisions
THE BANKERS' BOOKS EVIDENCE ACT, 1891 Unit 34. The
Bankers' Books Evidence Act, 1891
THE LEGAL SERVICES AUTHORITIES ACT, 1987 Unit 35. The
Legal Services Authorities Act, 1987: Lok Adalats
204
THE CONSUMER PROTECTION ACT, 1986
Unit 36. The Consumer Protection Act, 1986: Preamble, Extent and
Definitions Unit 37. Ponsumer Protection Councils Unit 38.
Consumer Disputes Redressal Agencies
THE LAW OF LIMITATION Unit 39. Limitation of Filing Suits,
Appeals and Applications
TAXLAWS Unit 40. Income Tax, Banking Cash, Transaction Tax,
Fringe Benefit Tax and Service Tax

INTRODUCTION TO SECURITISATION AND
RECONSTRUCTION OF FINANCIAL ASSETS AND
ENFORCEMENT OF SECURITY INTEREST, 2002 (SARFAESI
ACT, 2002)

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STRUCTURE
20.0 Objectives
20.1

Introduction

20.2

Constitutional Validity of the Act

20.3

Let Us Sum Up

20.4 Keywords
20.5

Check Your Progress

20.6 Answers to 'Check Your Progress'
20.7

Multiple Choice Terminal Questions

206
20.0 OBJECTIVE
The objective, of this unit is to see why there was a need for the
new legislation, viz., Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest, 2002 (SARFAESI Act
2002) and why it was enacted. The Act has created a new legal
framework, new concepts about security and new procedures for
recovery of dues by banks and financial institutions.
20.1

INTRODUCTION

1.

Banks and Financial institutions lend money by obtaining

security, except for the category of clean
loans. The security obtained is to act as a protection for the money
advanced and in the case of
need, the money can be realised by the sale of securities.
2.

The lender's rights over the securities, both moveable and

immoveable, for realisation of the
amount advanced, were limited and less effective since they were
required to take help of the legal

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system which was taking unduly long time to complete prior to the
passing of the SARFAESI Act,
2002. This Act introduced major changes in the legal framework
for the recovery of dues by laying
hands on the securities.
3.

The Act is a major step in financial sector reforms. It has

brought a legal framework for the
following important activities in the credit market:
(a)

Securitisation of financial assets.

(b)

Reconstruction of financial assets.

(c)

Recognition of any 'interest' created in the security for due

repayment of a loan as a 'security
interest', irrespective of its form and nature but when it is not in
the possession of the creditor.
(d)

Power to enforce such a security for the realisation of money

due to banks and the financial
institutes in the event of a default, without the intervention of the
Courts.
(e)

Enabling provisions for the setting up a central registry for

the purpose of registration of
transactions of securitisation, reconstruction and the creation of
the security interest.
4.

The Act extends to whole of India including the State of

Jammu & Kashmir. It is effective from 21
June, 2002. The Act is applicable also to housing finance
companies whose names are notified by

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the Central Government for such applicability.
5.

The provisions of the Act, relating to enforcement of the

security interest, applies to cases in
which the security interests are created for due repayment of
financial assistance. The Act has
presupposed a simple thing, that there is an obligation on the part
of the borrowers to repay loans
and if they are unable to repay, then the securities for the loans are
liable to be sold for the recovery
of loans. The Act has retrospective application, i.e., it applies for
loans and securities created prior
to the Act coming into operation of the Act.
20.2

CONSTITUTIONAL VALIDITY OF THE ACT

1. In Mardia Chemicals vs Union of India (2004) 21 ILD 521 SC, a
three member bench of the Supreme Court has declared this Act as
constitutionally valid, except a part of the Section 17(2). The
Section 17(2) had laid down that when the lender intends to take
action of taking possession of the security asset, the borrower can
file an appeal to the DRT only after depositing seventy-five per cent
of the amount claimed by the lender. The Supreme Court has
declared this condition of the deposit of seventy five per cent of the
claim amount as unreasonable, oppressive, arbitrary and violative
of the Article 14 of the Constitution.
After the Supreme Court decision in the Mardia case and its fall out
on the very intention of the legislation giving importance for
recovery and prevent long legal battles that borrowers create
without

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207
any payment, the Government of India has issued a notification
amending the Section 17(2) of the SARFAESI Act. The amendment
now stipulates payment of fifty per cent amount instead of seventy
five per cent as originally enacted. An aggrieved person has now a
right to refer the matter to DRT and then to the Appellate Tribunal
by depositing fifty per cent of the claimed amount.
20.3

LET US SUM UP

In this unit, we have seen how new changes are brought in by the
Act. The comfort available for the lender for his money to come
back will give him a confidence for lending.
20.4 KEYWORDS
Security in Possession; Remedy with and/or without Court
Intervention; Prudential Norms; Security Interest; Financial
Assets; Securitisation of Financial Asset; Reconstruction of
Financial Asset; Enforcement of Security; Possession and Sale of
Asset.
20.5

CHECK YOUR PROGRESS

1.

Banks obtain security while lending, so that in the case of

need, the money can be

of

securities.
2.

The SARFAESI Act is applicable to the housing finance

companies whose names are notified by
the Central Government. (True or False)
3.

In Mardia Chemical Case the Supreme Court decided that

the condition of deposit of amount is
fully invalid. (True or False)
4.

After Mardia Chemical Case, the amendment made in the

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SARFAESI Act stipulates deposit of
amount before preferring the appeal to DRT (Appellate
Tribunal).
20.6 ANSWERS TO CHECK YOUR PROGRESS'
1. realised by sale; 2. True; 3. True; 4. 50 per cent.
20.7 MULTIPLE CHOICE TERMINAL QUESTIONS
1.

Whether moveable securities in possession of the bank can

be sold by the bank without the
intervention of the Court?
(a)

Now, a Court order is required to sale the security.

(b)

Yes, bank can sell as provided in the Contract Act, 1872.

(c)

Yes, as the SARFAESI Act, 2002 has made provisions to that

effect.
(d)

No, until the account is not declared as NPA by the bank.

2.

As per the laws existing today, the mortgaged security

cannot be sold without a Court intervention.
Is this correct?
(a)

Yes, Court intervention is required as per the provisions of

the Transfer of Properties Act.
(b)

No, SARFAESI Act, 2002 has now made enabling

provisions.
(c)

Yes, since the Contract Act has made no provisions about

any Court intervention.
(d)

No, due to the recent amendments in the Transfer of

Property Act no Court intervention is
required.
rto-wmxrrseeurifies?
(a) Any moveable or immoveable security charged to the bank or

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financial institution.
208
(b)

To mortgage securities only.

(c)

Where the security interests are created for repayment of

financial assistance given by the
bank or a financial institution.
(d)

To the properties owned by the defaulter borrower, but

those that are not charged to the
bank.
4. In the Mardia case what did the Supreme Court declared as
invalid?
(a)

Entire SARFAESI Act, 2002.

(b)

Creation of security interest.

(c)

Formation of Reconstruction Companies.

(d)

Condition to pay seventy-five per cent of the amounts as

pre-condition while preferring
appeal to the DRT.
Ans. I. (b); 2. (b); 3. (c); 4. (d).
UNIT
21
DEFINITIONS OF SARFAESI ACT, 2002

STRUCTURE
21.0

Objective

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21.1

Introduction

21.2

Preamble

21.3

Appellate Tribunal

21.4

Asset Reconstruction

21.5

Bank

21.6

Board

21.7

Borrower

21.8

Central Registry

21.9

Debt Recovery Tribunal

21.10 Default
21.11 Financial Assistance
21.12 Financial Asset
21.13 Financial Institution
21.14 Hypothecation
21.15 Non-performing Asset
21.16 Originator
21.17 Obligor
21.18 Property
21.19 Qualified Institutional Buyer
21.20 Reconstruction Company
21.21 Scheme
21.22 Securitisation
21.23 Securitisation Company
21.24 Security Agreement
21.25 Secured Asset
21.26 Secured Creditor
21.27 Secured Debt

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210
21.28 Security Interest
21.29 Security Receipt
21.30 Sponsor
21.31 Keywords
21.32 Check Your Progress
21.33 Answers to 'Check Your Progress'
21.34 Multiple Choice Terminal Questions
211
r
21.0

OBJECTIVE

The objectives of this unit, are to understand:

The purpose of enacting the Act;

Important definitions given in the SARFAESI Act, 2002.

21.1

INTRODUCTION

For any Act, different concepts and effects revolve mainly around
certain defined words. The Act also takes some definitions from
some other Acts, to the extent it is relevant and applicable. The
preamble to the Act gives in a nutshell, the purpose of the
enactment.
21.2

PREAMBLE

The preamble indicates the purpose of the enactment. For the
SARFAESI Act, the preamble states 'An Act to regulate
securitisation and reconstruction of financial assets and the

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enforcement of security interest and for the matters connected
therewith or incidental thereto.'
21.3 APPELLATE TRIBUNAL
Any person aggrieved by the order passed by the 'Debt Recovery
Tribunal' can file an appeal to the authority called as the 'Appellate
Tribunal', subject to the maintainability of the appeal. These
tribunals are constituted by the Central Government for the various
States as per the provisions of the Recovery of Debts due to Bank
and Financial Institutions Act, 1993.
21.4

ASSET RECONSTRUCTION

Acquisition of any right or interest, of any bank or financial
institution, in any financial assistance, by any securitisation
company or reconstruction company, for the purpose of realisation
of such financial assistance, is called as asset reconstruction. In
simple words, it is the takeover of loans or advances from the bank
or financial institution for the purpose of recovery.
21.5

BANK

All the banking companies, Nationalised banks, the State Bank of
India as well as its subsidiary banks and co-operative banks are
within the meaning of the word bank for the purpose of this Act.
This definition has excluded the regional rural banks. So the
SARFAESI Act is not applicable to RRBs.
21.6 BOARD
The word 'Board' is used in the Act to mean the Securities and
Exchange Board of India (SEBI). It is established under the
Securities and Exchange Board of India Act, 1992.
21.7 BORROWER
The borrower means,

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(i) any person, who has been granted financial assistance by any
bank or financial institution, or (ii) who has given any guarantee,
or
(iii) who has created any mortgage or pledge as a security for the
financial assistance granted by any bank or financial institution, or
212
(iv) a person who becomes the borrower of a securitisation
company or reconstruction company, consequent upon acquisition
by it of any right or interest of any bank or financial institution, in
relation to such financial assistance.
21.8

CENTRAL REGISTRY

Under this Act, 'Central Registry' means the registering office, set
up or caused to be set up by the Central Government. With this
proposed set up, all the transactions of asset securitisation,
reconstruction as well as transactions of creation of security
interests, will have to be registered with this authority. The
registration system will operate on a priority of registration basis,
i.e., first in time to register gets priority over the person doing
registration at a later time. The registry will also serve the purpose
of maintaining credit information for the lenders.
21.9

DEBT RECOVERY TRIBUNAL

These tribunals were established under the Recovery of Debts Due
to Banks and Financial Institutions Act, 1993, to deal with the cases
of recovery of debts above Rs. 10 lakh due to the banks and
financial institutions.
21.10 DEFAULT
1.

When the borrower does not pay any principal debt or any

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interest on the principle debt or any
other amount payable to the secured creditor and due to such nonpayment the account of such
a borrower is classified as a non-performing asset (NPA) in the
books of accounts of the secured
creditor, as per the RBI guidelines, it is called default.
2.

For getting the right of security enforcement, under this Act,

there should be a default committed
by the borrower. The creditor must also be a secured creditor. Any
insecured creditor has no
right of any nature in this Act.
3.

In the Mardia Chemicals case, it was argued before the

Supreme Court by the bank, that bank can
classify the account as NPA as per its decision. The Supreme Court
rejected this argument and
stated that it should be done as per RBI guidelines only.
21.11 FINANCIAL ASSISTANCE
Whenever any bank or financial institution grants a loan or
advance or makes subscription of debenture or bonds or gives
guarantee or issues letters of credit or extends other credit facility,
it is called financial assistance.
21.12 FINANCIAL ASSET
Financial asset means debt or receivables and includes:
(i)

a claim to any debt or receivables or part thereof whether

secured or insecured, or
(ii)

any debt or receivable secured by mortgage of or charge in

immoveable property, or
(iii)

a mortgage charge, hypothecation or pledge of moveable

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property, or
(iv)

any right or interest in the security, whether full or part,

securing debt, or
(v)

any beneficial interest in any moveable or immoveable

property or in debt, receivables, whether
such an interest is existing, future, accruing, conditional or
contingent, or
(vi)

any financial assistance.

213
21.13 FINANCIAL INSTITUTION
The financial institution means:
(i) A public financial institution within the meaning of the
Companies Act, 1956.
(ii) Any institution specified by the Central Government under the
Recovery of Debts due to Bank
and Financial Institutions Act, 1993. (iii) The 'International
Finance Corporation', established under the International Finance
Corporation
(Status, Immunities and Privileges) Act, 1958. (iv) Any other
institution or non-banking financial company as defined in the
Reserve Bank of India
Act, 1934, which the Central Government may specify as a financial
institution for the purpose
of this Act.
21.14 HYPOTHECATION
1.

Hypothecation means:

a charge in or upon any moveable property

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existing or future

created by a borrower

in favour of a secured creditor

without delivery of possession of the moveable property to

such creditor as a security for
financial assistance and includes floating charge and crystallisation
of such charge into fixed
charge on moveable property.
2.

Prior to this Act no Indian Law has defined the term

hypothecation though hypothecation is a very
common type of charge on a security for a banks' lending.
21.15 NON-PERFORMING ASSET
It is an asset or account of a borrower classified by a bank or
financial institution as sub-standard, doubtful or a loss asset, in
accordance with the directions or under guidelines relating to asset
classification issued by the Reserve Bank. For classification of any
account as NPA it is important that the classification is done as per
the RBI directives.
\
21.16 ORIGINATOR
Originator is the owner of a financial asset that is acquired by a
securitisation company or reconstruction company for the purpose
of securitisation or asset reconstruction. In plain meaning, when
the bank or financial institution lends money against security they
are the originator.
21.17 OBLIGOR

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Obligor means a person liable,
(i) To pay to the originator, whether under a contract or otherwise,
or
(ii) To discharge any obligation in respect of a financial asset,
whether existing, future, conditional
or contingent, or
(iii) and includes a borrower.
214
21.18 PROPERTY
1.

Property means:

(i) Immoveable property, (ii) Moveable property,
(iii) Any debt or any right to receive payment of money whether
secured or insecured, (iv) Receivables, whether existing or future,
(v) Intangible assets such as; know-how, patents, copyright,
trademarks, licence, franchise or any other business or commercial
right of a similar nature.
2.

Definition of property is made much wider by this Act. Prior

to this Act, property has been defined
under various Acts such as Transfer of Property Act, Registration
Act, etc. By this Act, the addition
of properties stated at sub-clauses (iii), (iv) and (v) here above is
made. Due to this, now security
interest can be created against these properties for raising loans
from the banks and financial
institutions.
21.19 QUALIFIED INSTITUTIONAL BUYER
1.

Such buyer means a financial institution or an insurance

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company or a bank or a state financial
corporation or state industrial development corporation or trustee
or any asset management company,
making an investment on behalf of a mutual fund or provident
fund or gratuity fund or pension
fund or a foreign institutional investor, registered under the SEBI
Act, 1992 or any other body
corporate as may be specified by SEBI.
2.

This definition covers several categories of institutional

investors but does not include a company
registered under the Companies Act, 1956. If any company wants to
become a qualified institutional
buyer then it will have to get such a registration from SEBI.
21.20 RECONSTRUCTION COMPANY
A company formed for the purpose of asset reconstruction and
registered under the Companies Act, 1956 is called Reconstruction
Company.
21.21 SCHEME
The securitisation company or the reconstruction company can
raise funds from qualified institutional buyers by formulating
schemes. Funds so raised are required to be maintained in,
separate and distinct accounts scheme-wise,. The scheme invites
subscription to security receipts proposed to be issued by such a
company.
21.22 SECURITISATION
1.

Securitisation means acquisition of financial asset by the

securitisation or reconstruction company
from the originator. Such an acquisition may be by raising of funds

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by such a securitisation or
reconstruction company from the qualified institutional buyers by
issue of security receipts
representing undivided interest in the financial assets or otherwise.
2.

The concept and modality of securitisation defined here is

new for the Indian laws as well as for
the markets. This is a process where non-liquidated financial assets
are converted into marketable
securities, i.e., security receipts that can be sold to the investors. It
is also a process of converting
the receivables and other assets into securities, i.e., security
receipts that can be placed in the
market for trading. In Indian laws, there is no provision for
transfer of claims that are secured by
215
any security. Now SARFAESI Act has made the loans secured by
mortgage or other charges transferable.
On acquisition of a financial asset, the securitisation or
reconstruction company becomes the owner of the financial asset
and steps into the shoes of the lender bank or financial institution.
This acquisition can also be said to be, as a sale of asset without
recourse to the bank or financial institution. RBI is the regulatory
authority for all securitisation or reconstruction companies.
3. As per present guidelines of 29 March, 2004, the minimum
capital requirement for the securitisation or reconstruction
company is Rs. 2.00 crore at the time of registration and these
companies are required to maintain capital adequacy of fifteen per

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cent of total asset acquired or Rs. 100 crore whichever is less.
21.23 SECURITISATION COMPANY
It is a company registered under the Companies Act, 1956 for the
purpose of securitisation. The securitisation company also needs a
registration from the RBI as per the SARFAESI Act. The
securitisation company can set up separate trusts scheme wise and
act as trustee for such schemes, as provided in the Securitisation
Companies and Reconstruction Companies (Reserve Bank)
Guidelines and Directions, 2003. The investors in the
securitisation company are the beneficiaries of such trusts.
21.24 SECURITY AGREEMENT
Security agreement means an agreement, instrument or any other
document or arrangement under which security interest is created
in favour of the secured creditor. This includes creation of
mortgage by deposit of title deeds with the secured creditors.
21.25 SECURED ASSET
Secured asset means the property on which a security interest is
created. The powers given by SARFAESI Act for the enforcement of
securities are against the secured assets only. If the borrower has
any property over which no security interest is created, such a
property is outside the purview of enforcement powers under the
SARFAESI Act.
21.26 SECURED CREDITOR
Any bank or financial institution or any consortium or group of
banks or financial institutions in whose favour the security interest
is created by the borrower for due repayment is called a secured
creditor. It includes debenture trustee appointed by any bank or
financial institution or securitisation company or reconstruction

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company. It also includes, any other trustee holding securities on
behalf of a bank or financial institution.
21.27 SECURED DEBT
Secured debt means a debt which is secured by any security
interest.
21.28 SECURITY INTEREST
1.

Any right, title and interest of any kind whatsoever upon the

property created in favour of any
secured creditor is called as security interest. It includes any
mortgage charge, hypothecation,
assignment other than those specified in Section 31 of the
SARFAESI Act.
2.

Whenever any lender takes any security from the borrower,

the lender pets i
216
The type of interest depends on the nature of charge created over
the security. Until now, such interest of the lender in the security
was not defined in any law. SARFAESI Act has, for the first time
defined this. Now, any type of charge or any type of security has
come under one wide scoped definition, called the security interest.
21.29 SECURITY RECEIPT
1.

A receipt or another security issued by a securitisation

company or reconstruction company to any
qualified institutional buyer pursuant to a scheme evidencing the
purchase or acquisition by the
holder thereof of an undivided right, title or interest in the financial
asset involved in securitisation

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is called the security receipt.
2.

The security receipt evidences the purchaser's undivided

right, title and interest in the security.
These receipts are transferable in the market. By this Act, a new
type of transaction in the financial
market has been created for transfer of the security interest.
21.30 SPONSOR
Sponsor is an entity holding not less than ten per cent of the paidup equity capital of securitisation or reconstruction company.
21.31 KEYWORDS
Appellate Tribunal; Asset Reconstruction; Central Registry; Debt
Recovery Tribunal; Non-performing Asset; Notification; Obligor;
Originator; Qualified Institutional Borrower; Reconstruction
Company; Securitisation; Securitisation Company; Security
Agreement; Secured Asset; Security Interest; Security Receipt;
Sponsor.
21.32 CHECK YOUR PROGRESS
1.

The SARFAESI Act is applicable for pledged securities also.

(True or False)
2.

For the enforcement of a mortgage security, court

intervention is required even for actions under
the SARFAESI Act. (True or False)
3.

Banks and financial institutions can issue notice for

enforcement over security under SARFAESI
Act only if these securities are not creditor and only when the
account is classified
as

.

4.

If the borrower does not pay within

'

days after

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notice by the secured creditor the
creditor can . of the security.
5.

After receipt of notice from the secured creditor for

repayment of dues by the borrower, the
borrower is legally prevented from transferring his property in any
way. (True or False)
6.

On request of the secured creditor the District Magistrate or

the Chief Judicial Magistrate can
take possession of the security for handing over it to the creditor.
(True or False)
7.

When the management of the company is taken over by the

secured creditor, the directors of
such company are entitled to compensation for loss of office. (True
or False)
In this unit we have studied various definitions given in the
SARFAESI Act, 2002. Some definitions are creating new notions.
Definitions for asset reconstruction, borrower, default, financial
assistance, hypothecation, property, securitisation, security interest
and security receipt are some of the important definitions to clear
the concepts of the Act.
217
21.33 ANSWERS TO 'CHECK YOUR PROGRESS'
1. False; 2. False; 3. in possession, NPA; 4. Sixty, take possession; 5.
True; 6. True; 7. False.
21.34 MULTIPLE CHOICE TERMINAL QUESTIONS
1.

When any bank or financial institution obtains a charge

against property, with which authority

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will the transaction have to be registered under the SARFAESI Act,
2002?
(a)

With the Central Registry.

(b)

With the ROC.

(c)

With the Registrar of Assurances within whose jurisdiction

the property lies.
(d)

With the Reserve Bank of India.

2.

When can the provisions of SARFAESI Act, 2002 be invoked

for proceeding against the charged
property?
(a)

When the bank feels that it is necessary for the recovery at

any time.
(b)

When the RBI directs to do so.

(c)

When there is default in repayment by the borrower.

(d)

When there is default in repayment and the bank declares

the account as NPA.
3.

Whether existing or future receivables are property?

(a)

Yes.

(b)

No.

(c)

Yes, but if and when charged to the lender.

(d)

No, if hypothecated to the lender.

4.

From the following which function is of a securitisation

company?
(a)

Acquisition of loan transaction from the lender.

(b)

Help the lender in recovery by sale of charged property.

(c)

Take legal steps against the defaulter borrower on behalf of

the lender.
(d)

Acquisition of financial asset from the originator.

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Ans. 1. (a); 2. (d); 3. (a); 4. (d)

REGULATION OF SECURITISATION AND RECONSTRUCTION
OF FINANCIAL ASSETS OF BANKS AND FINANCIAL
INSTITUTIONS
STRUCTURE
22.0

Objectives

22.1

Introduction

22.2

Registration of Securitisation Company or Reconstruction

Company
22.3

Cancellation of Certificate of Registration

22.4

Acquisition of Rights or Interest in Financial Assets

22.5

Notices to Obligor and Discharge of Obligation of Such

Obligor
22.6

Issue of Security Receipts and Raising of Funds by

Securitisation Company or
Reconstruction Company
22.7

Exemption from Registration of Security Receipt

22.8

Measures of Assets Reconstruction

22.9

Other Functions of Securitisation Company or

Reconstruction Company
22.10 Resolution of Dispute
22.11 Power of Reserve Bank to Determine Policy and Issue
Directions
22.12 Let Us Sum Up
22.13 Keywords

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22.14 Check Your Progress
22.15 Answers to 'Check Your Progress'
22.16 Multiple Choice Terminal Questions
220
22.0

OBJECTIVE

The objective of this unit is to understand the regulatory
framework, in which the securitisation and reconstruction
companies are required to work, how they have to raise the funds,
acquisition of assets and other such functional modalities.
22.1

INTRODUCTION

The SARFAESI Act has streamlined the functions of the
securitisation and reconstruction companies for dealing with
financial assets of banks and financial institutions. For this
purpose, procedures as well and regulatory control measures were
required. In this unit we will consider these aspects.
22.2

REGISTRATION OFSECURITISATION COMPANY

OR RECONSTRUCTION COMPANY
1.

The securitisation or reconstruction company can

commence or carry business, only after complying
the following two conditions:
(i) It obtains certification of registration from the Reserve Bank of
India by applying in prescribed
format; and (ii) It has the owned funds at the time of registration
not less than Rs. 2 crore or such other
amount not exceeding fifteen per cent of the total financial assets
acquired or to be acquired
as the RBI may specify.

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2.

As per the SARFAESI Act the securitisation of an asset or

reconstruction of an asset, are treated as
similar activities and the provisions relating to the registration of
these companies are same. Such
registered companies can raise money for their acquisition
activities by issue of security receipts
for formulating schemes. This Act has provided the legal
framework for this activity.
3.

Depending on the nature of security asset the Reserve Bank

of India has the powers to specify
different amounts of owned funds for different class or classes of
securitisation companies or
reconstruction companies. The Reserve Bank of India may impose
such other conditions as it
deems fit on the company.
4.

If any securitisation or reconstruction company wants to

make any substantial change in its
management or a change in the registered address or change in the
name, then that needs prior
approval of the Reserve Bank of India.
5.

The scheme of the Act and the guidelines published by the

Reserve Bank of India under the Act,
gives a business pattern of the securitisation or reconstruction
company as under.
(i) The company can formulate separate schemes for the
acquisition of a financial asset.
(ii) Create separate trusts for each scheme and maintain separate
and distinct records and

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accounts in respect of each scheme and issue security receipts to
the investors, (iii) The securitisation company or reconstruction
company can act as trustees for such trusts
and manage the assets held in trust.
(iv) As the assets acquired in trust are scheme-wise, the risk of
non-realisation of assets will be impacting the investors who are
the beneficiaries under the trust. As such there should not be loss
to the company. These companies do the activity in such a way that
they make arrangements for realisation of money from the asset
acquired. They do not invest their own funds in the acquisition of
asset but utilise the money invested on risk assessment and act on
careful considerations for asset acquisition decision. The risk
factors are required to be assessed, anticipated and also disclosed
to the investors.
221
22.3

CANCELLATION OF CERTIFICATE OF REGISTRATION

1.

The registration granted to the securitisation or the

reconstruction company by the Reserve Bank
of India is cancellable on following grounds:
(i) The company ceases to carry on the business of securitisation or
asset reconstruction, or (ii) The company ceases to receive or hold
any investment from a qualified institutional buyer,
or (iii) The company fails to comply with any of the conditions
subject to which the certificate of
registration was granted, or (iv) The company fails to,
(a)

comply with any of the directions issued by the Reserve

Bank, or

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(b)

maintain accounts in accordance with the requirements of

any law or any direction or
order issued by the Reserve Bank of India, or
(c)

submit or offer for inspection its books of accounts or other

relevant documents
when so demanded by the Reserve Bank of India, or
(d)

obtain prior approval of the Reserve Bank of India for

change in management or
change in registered office or change of name.
2.

The Act has provided that the cancellation of registration

may be of two categories. In the first
category the cancellation of registration is without giving any
opportunity to the company if the
company does any of the following:
(i) Ceases to carry on the business of securitisation or
reconstruction, or
(ii) Ceases to carry or hold any investment from a qualified
institutional buyer, or
(iii) Fails to comply with RBI directions, or
(iv) Fails to maintain accounts in accordance with directions issued
by RBI, or
(v) Fails to give accounts and documents to RBI for inspection.
The second category of cancellation is done with an opportunity to
comply with the defaults other than the above. However, even in
this second category, the RBI has powers and discretion, to deny
opportunity, if the RBI feels that a delay in the cancellation of
registration shall be prejudicial to the public interest or the
interests of the investors of the company. It is required that the

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order is with reasons recording the reasons as to why the company
has been denied the opportunity.
3.

The securitisation or reconstruction company whose

registration is cancelled can prefer an appeal
within thirty days from the date of communication of order, to the
Central Government. The
company is required to be given a hearing before rejecting the
appeal.
4.

Even if the application for registration is rejected or the

already existing registration is cancelled,
the company shall be deemed as registered, until the company pays
the dues of the investors along
with interest within the period as the RBI may specify.
22.4

ACQUISITION OF RIGHTS OF INTEREST IN FINANCIAL

ASSETS
1. The securitisation company or the reconstruction company can
acquire the financial asset of any bank or financial institution by
any of the following ways:
(i) By issuing a debenture or bond or any other security in the
nature of debenture for the agreed consideration and agreed terms
and conditions between the bank/financial institution and the
securitisation company/reconstruction company as the case may
be,
(ii) By entering into an agreement with such bank or financial
institution for the transfer of financial asset to such company on
terms and conditions as may be agreed between them.
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2.

The securitisation or the reconstruction company can

acquire financial assets without execution of
any deed of assignment or transfer in its favour by the concerned
bank or the financial institution.
Assignment is complete on the acquiring company issuing a
debenture or bond and incorporating
therein the terms and conditions of acquisition. There is no need
for execution of any other
document. The document to be executed requires payment of
stamp duty as per the Indian Stamp
Act, which is an Act of the Union of India. The said document is not
required to be stamped as per
the State Stamp Duty laws.
3.

As stated earlier, the securitisation transaction involves two

stages. The first is acquisition of
financial assets and undivided interest therein. The second is issue
of security receipts in favour of
the investors for the purpose of raising money from investors.
4.

If the bank or financial institution is a 'lender' in relation to

any financial asset acquired by the
securitisation or a reconstruction company, then such a company is
deemed as lender in context
with the acquired property. Therefore, all the rights of such bank or
financial institution in the
security vest in the company which acquired the assets.
5.

The statutory provisions say that acquiring company shall be

vested with all the rights of such
bank or financial institution. The provisions have excluded the

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liabilities. Thus, if there is any
liability or commitment to be discharged from the side of bank or
financial institution, it will not
pass on to the securitisation or reconstruction company. Even if
there is any commitment to lend
further to the borrower, such commitment will not pass on to the
asset acquiring company. On this
issue, the Reserve Bank of India in the guidance note for
securitisation companies and reconstruction
companies has provided recommendatory guidance as under:
(i) Acquisition of funded assets, should not include takeover of
outstanding commitments, if
any, of any bank or financial institution to lend further, (ii) Terms
of acquisition of the security interest in non-fund-based
transactions should provide
for the relative commitments to continue with bank or financial
institute until demand for
further funding arises.
6.

In relation to the financial asset all contracts, deeds, bonds,

agreements, power of attorney, grants
of legal representations, permissions, approvals, consents or no
objections under any law or otherwise
to which the bank or financial institution is a party or which are in
favour of the bank or financial
institution are fully enforceable upon in place of bank or financial
institution by and in favour of
securitisation company or reconstruction company.
7.

If at the time of acquisition of an asset by the securitisation

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company or reconstruction company,
any suit, appeal or other proceeding of whatever nature related to
the asset is pending by or against
the bank or financial institution it does not get discontinued or
abated or get in any way prejudicially
affected because of the acquisition of asset. In such an event the
suit, appeal or other proceeding
can be continued, prosecuted and enforced by or against the
securitisation or reconstruction
company, as the case may be. If a securitisation company or
reconstruction company acquires the
assets of more than one bank or financial institution, where cases
before different Debt Recovery
Tribunals are pending, the securitisation company or
reconstruction company can file an application
to any of the Appellate Tribunal under which, such DRT come for
transfer of all applications to
anyone of the DRT as the Appellate Tribunal may decide.
8.

Following documents are involved in a securitisation

transaction.
(i) Offer document: The Reserve Bank of India in its guidelines of
2003 has mentioned details about the form of offer and details to
be incorporated therein. By and large the full details and
particulars about the financial asset, loan details of bank, trustees'
details, etc., are included. Some quarterly details are also required
to be disclosed. These include details
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about profit-loss, prepayments, expenses, defaults, collection, etc.,
and also any other material thing affecting the securitisation
arrangement.
(ii) Debenture: A debenture, for the payment of consideration, is to
be paid to the bank or the financial institution for the acquisition of
financial asset from it. As per the extant guidelines from RBI, the
rate of interest offered in the debenture cannot be less than one
and half per cent above the Bank Rate as on the date of issue of the
debentures and the period of redemption of debenture cannot
exceed six years.
(iii) An agreement: It is with the originator to continue to service
the assets of the securitisation.
(iv) Security receipt: It is in favour of the investors.
22.5

NOTICES TO OBLIGOR AND DISCHARGE OF

OBLIGATION OF SUCH OBLIGOR
1.

When the bank or financial institution decides, that the

financial asset be now acquired by the
securitisation or reconstruction company, a notice may be given
about such an acquisition to the
obligor, i.e., borrower or any other person liable to repay to the
bank or financial institution. Giving
of such notice is optional and not compulsory under the Act. In
case, the obligor is a company and
creation of charge has been registered, then also the giving of
notice to the respective registrar is
optional. Thus, there is no need of modification of charge with the
Registrar of Companies. However,
if the bank or financial institution decides to give notice to the

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obligor, then notice to the ROC is
required to be given when the obligor is a company.
2.

If notice of acquisition as said above is given to the obligor,

it is necessary that the obligor should
make payments to the concerned securitisation or reconstruction
company. Such payments amount
to a valid discharge of liability of the obligor making the payment.
If notice of acquisition, as said above is not given, the money or
property received by the bank or financial institution from the
obligor shall be held by such bank or financial institution in trust
and shall be handed over to the concerned securitisation company
or reconstruction company.
22.6

ISSUE OF SECURITY RECEIPTS AND RAISING OF

FUNDS BY
SECURITISATION OR RECONSTRUCTION COMPANY
1.

The securitisation or reconstruction company raises funds

for acquisition of an asset by issue of
security receipts. Only the qualified institutional buyers can buy
these security receipts. The security
receipts are not issued to the public. The investment and financial
market in this field is very
complex and much risk assessment is required to be done by the
investor. The individual investor
does not possess such expertise. Therefore, the Act has debarred
individuals from making an
investment in securitisation or reconstruction company.
2.

When the securitisation or reconstruction company decides

to raise funds from qualified institutional

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investors following conditions apply:
(i) For each financial asset acquired or to be acquired there should
be a separate scheme.
(ii) Scheme-wise and asset-wise separate distinct accounts should
be maintained.
(iii) Realisation of the asset is held and applied towards
redemption, i.e., repayment of investments as assured while
issuing the security receipt.
(iv) In case there is no realisation and repayment as said above, the
qualified institutional buyers, holding not less than seventy-five per
cent of the total value of the security receipts issued are entitled to
call a meeting of all qualified institutional buyers making
investments in that scheme and the resolutions passed in such a
meeting are binding on the concerned securitisation or
reconstruction company.
(v) When the qualified institutional investors call the meeting, as
said above, to decide the further course of action due to nonrealisation of the asset, they have to follow the same procedure, as
nearly as possible as is followed at meetings of the board of
directors of the securitisation company or reconstruction company,
as the case may be.
(vi) The funds raised or assets acquired out of the raised funds by
the securitisation or reconstruction company shall be held by such
company in trust for the investors.
3. When separate schemes are made and funds are raised by the
securitisation or reconstruction company, the provisions of
SARFAESI Act do not directly provide for setting up of trusts for

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each scheme. However, in totality the legal effect is that there are
resultant trusts in respect of each scheme. The investors in such
schemes become the beneficiaries under the trust and the company
framing the scheme is the trustee, managing the trust. The Reserve
Bank of India guidelines for securitisation also provide for such an
arrangement. Due to such trust arrangement the money held by the
company are held in trust and do not form the assets of the
company. Due to this, in the eventuality of liquidation of such a
company the money does not pass on to liquidator and the
beneficiaries get the money on priority and distinctly.
22.7

EXEMPTION FROM REGISTRATION OF SECURITY

RECEIPT
1.

When the securitisation company or reconstruction

company issues security receipts the holder of
the security receipts is entitled to an undivided interest in the
financial assets. In such an event the
security receipt does not require registration that is otherwise
compulsory under the Registration
Act, 1908.
2.

However registration of the security receipt is required in

following cases or eventualities,
(i) There is a transfer of the security receipt.
(ii) If the security receipt is creating, declaring, assigning, limiting
or extinguishing any right, title or interest to or in an immoveable
property.
22.8

MEASURES OF ASSET RECONSTRUCTION

1.

Asset reconstruction means the acquisition of any right or

interest of any bank of financial institution

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in any financial asset for the purpose of realisation. Powers to take
various measures for asset
reconstruction are given without prejudice to the provisions
contained in any other law. Thus, the
powers given under the SARFAESI Act are subject to the provisions
of all the other existing laws.
2.

The measures for asset reconstruction are as under :

(i) To change or takeover of the management of the business of the
borrower for proper management of business of the borrower.
Until now, the recovery actions against the defaulting borrowers
were taken as a last stage and as a last resort when the unit is
closed and has incurred losses. Such legal actions at the last stage
when unit is unable to function do not give desired recovery. With
these new provisions under SARFAESI Act, a borrowal unit that
has been classified as NPA as per the applicable norms of ninety
days default, but is still functioning, can be treated differently by
banks and financial institutions. If the cause of default in such a
unit is any mismanagement or lack of expertise on the part of the
existing management, the securitisation company or
reconstruction company has the powers to takeover the
management or change the management. This power can be
exercised even when there is no default. On realisation of the
secured debt in full the management of the business can be
restored back to the borrower. When the lender lends money
against a security asset and creates charge over the assets, the
ownership of the asset still remains with the borrower who has
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created the charge. The lender has charge and the only objective is
to have a secured
lending and getting repayment by realising the asset, (ii) To sell or
lease of a part or whole of the business of the borrower, (iii)
Rescheduling of payment of debts payable by the borrower.
(iv) Enforcement of security interest in accordance with the
provisions of the SARFAESI Act. (v) Settlement of dues payable by
the borrower, (vi) Taking possession of secured asset in accordance
with the provisions of the SARFAESI
Act.
3. In respect of these powers for asset securitisation, the following
important operative points need to be kept in mind.
(i) The power is not linked with any default by the borrower. Even
without there being any
default these powers can be exercised, (ii) The exercise of powers is
subject to existing laws.
(iii) There is no provision for having an overriding effect on the
loan agreements between the bank/financial institution and the
borrower.
(iv) There is no civil appeal provided for against any action under
this section.
(v) The SARFAESI Act is silent about the grounds or reasons based
on which the action of acquisition can be taken. Therefore, loan
agreements between the bank/financial institution and the
borrower are required to be taken into account as provisions of this
section do not have an overriding effect on existing contracts and
laws.
(vi) The Act does not provide giving notice to the borrower before

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initiating any action under this section. However, considering a
Supreme Court ruling in the Swadeshi Cotton Mills vs Union of
India AIR 1981 SC 818, a hearing at pre-decisional stage must be
given before resorting to any action. The said ruling is under a
different law but on similar powers of taking over of the
undertaking by the Central Government. The same principle laid
down in the said case, will apply to these actions. Therefore, before
taking action, notice to the borrower will be required to be given.
(vii) The provisions contained in the SARFAESI Act for taking
forcible possession of the assets
are applicable to the secured assets only and not to other assets.
(viii) Since the actions can be taken in accordance with the loan
agreements, it is necessary that defaults as contemplated in such
agreements have occurred.
(ix) If the contractual power arising out of the loan agreements to
takeover or change the management or to sale or to lease the
business of the borrower becomes exercisable, the same must be
exercised under the provisions of the SARFAESI Act.
(x) There are cases that the controlling shares of the promoter
directors are pledged with the bank/financial institution with
power to transfer and sale of such shares in case of default. In such
cases, the power to change or takeover the management or sale of
business of the borrower can be done by sale of such shares in
accordance with the powers derived under loan agreements and the
provisions of the Indian Contract Act. Provisions of SARFAESI Act
will not apply to such cases because pledge and enforcement of
pledge are kept outside the purview of SARFAESI Act. For such
transfer and sale of shares, compliance of SEBI regulations

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regarding the takeover code and other applicable laws and
regulations will have to be done.
(xi) The acquisition powers under the SARFAESI Act are
exercisable subject to guidelines framed by Reserve Bank of India.
This provision is incorporated in the Act itself.
226
22.9

OTHER FUNCTIONS OF THE SECURITISATION

COMPANY
OR RECONSTRUCTION COMPANY
1.

Any securitisation company or reconstruction company

registered under the SARFAESI Act may,
(i) Act as an agent for any bank or financial institution for the
purpose of recovering their dues from the borrower on payment of
fees or charges as may be mutually agreed upon between them.
(ii) Act as a manager for the secured assets, of which the possession
is taken by any bank or financial institution for such bank or
financial institution on fees as may be mutually agreed upon
between the parties. However, if acting such as manager gives rise
to any pecuniary liability on the securitisation or reconstruction
company, then no such acting as manager can be done.
(iii) Act as receiver if appointed by any Court or Tribunal.
2.

The securitisation company or reconstruction company can

act as stated above without the prior
approval of the Reserve Bank of India. For any other acts as well as
business other than securitisation
or asset reconstruction prior approval of the Reserve Bank of India
is required.

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For the purposes of above said provisions the 'securitisation
company' or 'reconstruction company' does not include its
subsidiary.
22.10 RESOLUTION OF DISPUTE
1.

Any dispute between the bank or financial institution and

the securitisation or reconstruction company
as well as with or by qualified institutional buyer relating to
securitisation or reconstruction or
non-payment of any amount due or interest, is required to be
settled by conciliation or arbitration
as provided in the Arbitration and Conciliation Act, 1996. The
dispute may be amongst any of the
three parties stated above. The Act provides that settlement of
dispute through arbitration and
conciliation shall be as if the concerned parties have consented in
writing for such a settlement and
the provisions of Arbitration and Conciliation Act, 1996 shall apply.
2.

Here it should be noted that only the said three parties are

mentioned in the provision made in the
Act. Obligor or borrower is not mentioned. Therefore, the
provisions of mandatory arbitration and
conciliation are not applicable to the dispute by or against the
borrower.
22.11 POWER OF RESERVE BANK TO DETERMINE POLICY
AND ISSUE DIRECTIONS
1.

If the Reserve Bank of India is satisfied that it is necessary

or expedient so to do, it may determine
the policy and give directions,

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(i) In the public interest, or
(ii) To regulate financial system of the country to its advantage, or
(iii) To prevent the affairs of any securitisation company or
reconstruction company from
being conducted in a manner prejudicial to the interest of such
securitisation company or
reconstruction company.
2.

The Reserve Bank of India directions are given to or policies

are framed, in respect of the
securitisation company or reconstruction company in matters
related to,
(i) Income recognition,
(ii) Accounting standards,
(iii) Making provisions for bad and doubtful debts,
227
(iv) Capital adequacy based on risk weights for the assets,
(v) Deployment of funds by the said companies.
Whenever, the Reserve Bank of India decides the policy, and issues
directions, the securitisation company or the reconstruction
company is bound to follow the same as it has a statutory effect.
3.

In addition to the above stated powers vested with the RBI

for making policy or giving directions
generally, the RBI has the powers to make policy or issue directions
to any particular securitisation
or reconstruction company or a class of such companies or all such
companies. In such cases, in
addition to the aspects given above, on which the policy can be

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framed or directions can be issued,
the RBI may do so on the following aspects also:
(i) The type of financial asset of a bank or financial institution
which can be acquired and procedure for such an acquisition of
such assets and valuation thereof.
(ii) The aggregate value of financial asset which may be acquired by
any securitisation company or reconstruction company.
4.

Some important points from the guidelines issued until

October 2004 by the RBI are as under:
(i) On the acquisition of a financial asset that has been classified by
the bank or financial
institution as a non-performing asset, the securitisation company
or the reconstruction
company has to formulate a plan for realisation of such an asset
within twelve months.
During such a planning period, the asset can be classified as a
Standard Asset, (ii) Definition of a non-performing asset, has been
linked to an overdue period, which is now
ninety days, (iii) Any entity not registered with the Reserve Bank of
India under the SARFAESI Act, may
conduct the business of securitisation or asset reconstruction
outside the purview of
SARFAESI Act. (i v) The securitisation company or reconstruction
company can undertake activities and functions
as given in the SARFAESI Act and no other business.
(v) A securitisation company or reconstruction company cannot
raise money by way of deposits, (vi) At the time of enforcing
securities as per provisions of the SARFAESI Act, the securitisation

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company or reconstruction company may itself acquire secured
assets for use or resale if
such resale is through a public auction, (vii) When the asset is
acquired for reconstruction there is a limit of five years for such
reconstruction, (viii) The securitisation company or reconstruction
company is permitted to set up trusts that
can issue security receipts. Trusteeship of such trusts vests in the
concerned securitisation
or reconstruction company, (ix) While issuing security receipts,
detailed disclosures are required to be made by the concerned
securitisation or reconstruction company, (x) The balance sheet of
the asset acquiring company should disclose names and addresses
of
the banks/financial institutions from whom the assets are acquired
with values thereof,
industry-wise and sponsor-wise dispersion of assets and related
party disclosures, (xi) Maintaining of the capital adequacy of fifteen
per cent of total assets acquired or the capital
of Rs. 100 crore, whichever is less.
5.

The RBI has powers to call for statements and information

at any time from the securitisation or
reconstruction company, relating to the business and affairs of
these companies as the RBI may
consider necessary.
L.R.A.D-16
228
22.12 LET US SUM UP

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In this unit, we have seen about the functional part of the
securitisation and reconstruction company. It includes the
registration of these companies, their functional freedom and the
RBI restrictions thereon. There are some stipulations for capital
requirements and for raising the same. The existing companies
require registration. There are various conditions based on which
the registration is considered by the RBI. We have seen when
registration of the company can be cancelled and reasons thereof.
How financial assets are acquired is important and it involves
detailed procedure. The effect of contracts, deeds, suits by or
against involving the security asset is also seen. There are specific
documents involved and the procedure for securitisation
transaction. The acquisition of asset involves the proper notice and
procedure. There are conditions for raising funds from the
qualified institutional investors. Issuance of security receipts and
conditions/exemptions for the same is also seen. The asset
reconstruction company can take various measures for realisation
from the asset. The Act provides for dispute settlement between the
securitisation/reconstruction company and the investor by
arbitration. RBI has powers to issue various guidelines under the
Act.
22.13 KEYWORDS
Securitisation Company and Reconstruction Company;
Experienced Professional Directors; Nominees of Sponsor
Restrictions; No Conviction; No Controlling Interest; Prudential
Norms; Notice of Acquisition; Contents and Procedure; Funds
from Institutional Investors; Scheme-wise Trust; Security Receipt;
Arbitration.

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22.14 CHECK YOUR PROGRESS
1.

A securitisation or reconstruction company needs

registration from the RBI for commencement
of business. (True or False)
2.

Right of acquisition of a financial asset by the securitisation

or reconstruction company is subject
to the prior agreements or contracts about the asset. (True or
False)
3.

Acquisition of a financial asset by the securitisation

company or reconstruction company is with
the liability also over such an asset. (True or False)
4.

Which are the four documents involved in the securitisation

transaction?
5.

For each asset acquired or to be acquired, by the

securitisation company or the reconstruction
company there should be scheme.
6.

When the securitisation company or reconstruction

company issues security receipts, the holder
thereof, is entitled to a
7.

in the financial asset.

The security receipt issued by the securitisation or

reconstruction company requires registration.
(True or False)
8.

Any direction issued by the RBI under the SARFAESI Act

has

effect and is
on the parties concerned.

22.15 ANSWERS TO 'CHECK YOUR PROGRESS'
1. True; 2. False; 3. False; 4. offer document, debenture, agreement
and security receipt; 5. separate; 6. undivided interest; 7. False; 8.

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statutory, binding.
22.16 MULTIPLE CHOICE TERMINAL QUESTIONS
1. After application of the SARFAESI Act what have the existing
companies to do about registration with RBI?
229
(a)

They are automatically deemed to be registered.

(b)

They are required to stop functioning.

(c)

Existing companies do not require registration

(d)

They have to get registered within six months from the

commencement of the Act.
2. Which, from amongst the following, is a reason for the
cancellation of registration of the securitisation company and
reconstruction company without giving a hearing opportunity?
(a)

The company does not keep accounts as per the RBI norms.

(b)

The company ceases to carry on the business of

securitisation or reconstruction.
(c)

The company fails to hold investment from the qualified

investor.
(d)

The company does not fulfil any of the conditions imposed

at the time of registration.
Ans. 1. (d); 2. (b).
UNIT
23
ENFORCEMENT OF SECURITY INTEREST

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STRUCTURE
23.0

Objectives

23.1

Introduction

23.2

Enforcement of Security Interest

23.3

Chief Metropolitan Magistrate or District Magistrate's

Assistance for Taking Possession
of Secured Asset
23.4

Manner and Effect of Take Over of Management

23.5

No Compensation to Directors for Loss of Office

23.6

Right to Prefer Application to DRT

23.7

Appeals to Appellate Authority

23.8

Right of Borrower for Compensation and Costs

23.9

Let Us Sum Up

23.10 Keywords
23.11 Check Your Progress
23.12 Answers to 'Check Your Progress'
23.13 Multiple Choice Terminal Questions
232
23.0

OBJECTIVES

We know that when immoveable property is obtained as security by
way of mortgage for its sale and realisation of money, Court
intervention is required. Similarly, in the case of moveable
property also, except for the pledged security, Court intervention is
required for sale of property and realisation of money. Now with
the provision of this Act, there are changes in the procedures for
sale of securities. The creditor can also take the help of the District
Magistrate or the Chief Metropolitan Magistrate. We will see all

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these provisions in this unit.
23.1

INTRODUCTION

With introduction of NPA norms and its higher levels on one side
and delay in realisation of money by sale of properties through
Court intervention on the other side, giving powers to the lender to
enforce security was essential, by the introduction of new suitable
enactment.
The SARFAESI Act empowers banks and financial institutions to
enforce securities in the event of default by the borrower without
the intervention of either, the Civil Court or the Debt Recovery
Tribunal. The powers so given by this Act, have an overriding effect
on other laws in this respect. The powers are also over and above
other remedies available for recovery, by filling appropriate
proceeding either in a Civil Court or Debt Recovery Tribunal. The
secured creditor has been given the option to decide which course
of action should be adopted in respect of defaulted loans.
From the angle of banks and financial institutions this unit is very
important. In this unit, see about the powers to enforce the
securities obtained, while lending money and realise money
therefrom. These powers can be exercised by the creditor, i.e.
lender without intervention of the Court.
23.2

ENFORCEMENT OF SECURITY INTEREST

1.

Under the SARFAESI Act a secured creditor can enforce the

security interest created in his favour
without the intervention of the Court or Tribunal. This power given
to the secured creditor, has an
overriding effect over the provisions related to mortgage in the
Transfer of Property Act, 1882, as

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in that Act Court intervention is required.
2.

Section 13(2) of the SARFAESI Act speaks about the notice

to be given by the secured creditors to
the borrower, who has defaulted in making the repayment and
whose account is classified as
NPA. The precondition to get the right to serve this notice is that
the notice should be given asking
the borrower to discharge in full his liabilities to the secured
creditors within the sixty days from
the date of notice. Failing to do so by the borrower, the secured
creditor gets further rights as
detailed in the Act, that we will see later herein below.
3.

The notice referred to above, should give the details of the

amount payable by the borrower and the
secured asset intended to be enforced by the secured creditor in the
event of non-payment of
secured debt by the borrower.
Though the Act contemplates giving of only two particulars, viz.,
details of amount payable and details of securities, in the notice
said above, it is more proper to give the details of defaults, overdue
period and the date from which the account is classified as NPA,
facility-wise securities provided for the loans and particulars of
security documents executed.by the borrower. The Act or the rules
made there under, have not prescribed any format of notice to be
given. However, this notice is a statutory notice having
consequence, that the borrower is prohibited from transferring the
property mentioned in the notice in any way. Any contravention of
these legal consequences, if made, by the borrower is punishable

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under the SARFAESI Act. So it is advisable that the notice
mentions about the legal consequences and the penal provisions.
233
4.

The Act does not Contemplate a reply from the borrower to

the notice. But the borrower may reply
or make representation to the notice, so received by him. The
Supreme Court in Mardia Chemicals
Ltd. case, has laid down certain guidelines about what the bank or
the financial institution should
do when the borrower submits any reply or representation to the
said notice. These guidelines
broadly are as under:
(i) The secured creditor must apply his mind to the objection raised
by the borrower in reply or representation to the notice served on
him by the secured creditor.
(ii) An internal mechanism must be particularly evolved to
consider the reply of the borrower.
(iii) There may be some meaningful consideration in the objection
raised by the borrower and the rejection of the points raised by the
borrower should not be ritually followed by execution of drastic
action under the Act.
(iv) The reasons for overriding the objections of the borrower must
be communicated to him by the secured creditor.
(v) While directing that the reasons for the rejection must be
conveyed to the borrower, the Supreme Court has clarified that the
communication to the borrower giving the reasons for not
accepting the objections of the borrower does not give an occasion

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to resort to any proceedings, such as a stay application, injunction,
any other type of suit to restrain the creditor's actions.
After this ruling, there has been an amendment to the Act. Now,
Section 13(3A) says that if the borrower on receipt of the notice
under Section 13(2) from the secured creditor makes any
representation or raises any objection, the secured creditor has to
consider the representation or the objection and, if it is not tenable
or acceptable it has to be communicated within one week to the
borrower. The borrower has to be communicated the reasons for
non-acceptance of the representation or the objections. However,
such communication or reasons mentioned therein by the secured
creditor or the likely action as contemplated does not confer any
right upon the borrower to prefer an appeal to the DRT or to any
Civil Court.
5.

If the borrower does not pay in full as per the notice such

non-payment by the borrower gives the
secured creditor right to take recourse to one or more of the
following measures to recover his
secured debt:
(i) Take possession of the secured assets of the borrower including
the right to transfer by way of lease, assignment or sale for the
realisation of money from the secured asset. This right can be
exercised only when a substantial part of the business of the
borrower is held as security for the debt.
(ii) Takeover the management of the secured asset of the borrower
including the right to transfer by way of lease, assignment or sale
and realise the secured asset.
(iii) Appoint any person as manager to manage the security assets

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the possession of which has been taken over by the secured
creditor.
(iv) Require at any time, by giving a notice in writing, any person
who has acquired the secured asset from the borrower and from
whom any money is due or may become due to the borrower, to
pay to the secured creditor. Such demands from the other person
will be to the extent of secured debt. If such other person pays any
amount to the secured creditor the person so paying gets a valid
discharge as if he has made payment to the borrower.
6.

Any transfer of secured asset effected by the secured creditor

as provided under this Act, shall
vest in the transferee all rights in, or in relation to, the secured
asset as if the transfer has been
made by the owner of such a secured asset.
7.

When sale of the secured asset is made the appropriation of

sale proceeds realised are required to
be made in the following order:
234
(i) Firstly, towards costs, charges and expenses incidental towards
preservation and protection of securities, insurance premiums,
etc., that are recoverable from the borrower.
(ii) Secondly, towards the due of the secured creditors.
(iii) Thirdly, if there is any surplus it will be paid to the person
entitled thereto, in accordance with the right and interests.
The above stated order of payment thus gives the right of secured
creditors to realise their securities in preference to all other
creditors and even the other preferential payments like the dues

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payable to the Government labour, etc.
8.

If the borrower pays the entire dues, costs charges and

expenses incurred by the creditor at any
time before the date fixed for sale or transfer, the secured creditor
shall not sell or transfer the
secured asset and no further steps shall be taken for sale or
transfer. In cases of joint finance or
consortium finance by two or more secured creditors no secured
creditor can take any action of
taking possession of secured asset, unless exercise of such right is
agreed upon by the secured
creditors representing not less than three-fourths in value of the
outstanding dues on the record
date. The 'outstanding amount' shall include principal, interest and
any other dues payable by the
borrower to the secured creditors in respect of secured asset as per
the books of account of the
secured creditors. The 'record date' means the date agreed upon by
the secured creditors representing
not less than three-fourths in value, of the amount outstanding on
such date. Any decision taken by
such creditors is then binding on all other remaining creditors.
9.

In case the borrower is a company under winding up

process, the dues payable to the workmen
have pari passu charge with the secured creditors as provided in
Sections 529 and 529A of the
Companies Act. This is the exception for the priorities the secured
creditor otherwise gets when he

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initiates recovery actions under the SARFAESI Act. The dues of the
workmen are required to be
deposited from the realised amount with the liquidator. In case the
dues are not ascertained or
ascertainable at such a time, then the liquidator has to give an
estimated amount to be deposited.
The liabilities of the secured creditor to payout of the realised
amount from the secured asset is not
finished due to the payment of the estimated amount but the
balance amount on finalisation is
required to be paid.
If after the sale of the secured asset the entire dues of the secured
creditors are not recovered and still there is due balance then the
secured creditor can file an application before DRT or a civil suit in
a competent Civil Court. Depending on the amount to be recovered
the pecuniary jurisdiction will be decided.
10.

Apart from the security assets, many times the secured

creditor may be holding security by way of
pledge of any moveable or guarantee of any person for the due
repayment of the loan amount. In
such cases, secured creditors are entitled to sell the pledged goods
or proceed against the guarantor
to recover the defaulted loan without initiating any actions against
the security asset. Thus, the
right against security under the SARFAESI Act and the one against
the pledged security and
proceeding against guarantor are kept separate and distinct.
11.

The SARFAESI Act has given different rights to the secured

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creditor. The rights of a secured
creditor under the Act may be exercised by one or more of its
officers authorised in this behalf in
such manner as may be prescribed. As the powers of enforcing
securities need to be exercised
prudently, fairly, and with due care and caution the Rules framed
under the SARFAESI Act provide
that the authorised officer should be of the level equivalent to a
Chief Manager of a public sector
bank or equivalent or any other authorised person exercising
powers of superintendence, direction
,s and control of the business or affairs of the creditors, as the
case may be.
235
12.

When the borrower receives the notice from the creditor

under Section 13(2), the borrower shall
not transfer by way of sale, lease or otherwise, other than in the
ordinary course of business, any
of his secured assets referred to in the notice without prior written
consent of the secured creditor.
Non-compliance with this provision attracts penal provisions
under the SARFAESI Act that provide
for punishment of imprisonment of one year or fine or both.
13.

The provision of Section 13 at different sub-sections gives

power to the secured creditor for
taking the security into possession and then sell the same. This
entire process involves several

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factors of fairness and technicalities. Therefore, the Rules framed
under the SARFAESI Act, have
laid down certain procedural aspects in this connection. Some
broad procedures and precautions
as per the Rules are as under:
(i) Inventory of the property taken into possession be made and the
property must be entrusted
to any person authorised or appointed by the secured creditor, (ii)
The secured creditor shall take care of the property under his
possession as an owner of
ordinary prudence, preserve and protect the secured assets and
insure the same if necessary
until they are sold, (iii) If the property is subject to speedy or
natural decay or the expense of keeping such property
in custody is likely to exceed its value, then the authorised officer
can sell it at once, (iv) For taking of possession and then sale of
immoveable property, the secured creditor is
required to serve a possession notice as nearly as possible as given
in Appendix IV to the
Rules on the borrower and by affixing the possession notice on the
outer door or at a
conspicuous place at the property, (v) The authorised officer is
required to obtain a valuation of the immoveable property before
sale, fix the reserve price after consulting the secured creditor and
sell it by methods permitted
under Rule 8. (vi) The authorised officer is required to publish the
possession notice in two leading newspapers,
one of which should be in the local vernacular language, (vii) Thirty

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days before sale of the immoveable property, the borrower should
be given a notice
about the sale. If the sale is by public auction or by inviting tenders
from the public, notice
is required to be published in two leading newspapers, one of
which should be in the local
vernacular language, detailing the terms of sale, (viii) If the price
for the secured asset is coming to less than the reserve price, the
authorised
officer can sell the asset at a lower price with the consent of the
borrower and secured
creditor, (ix) When the offer of sale of property is accepted by the
purchaser and the secured creditor
accepting the offer confirms the sale, the purchaser has to deposit
twenty-five per cent of
the offer price, (x) In case of immoveable property, the purchaser
has to deposit the amount required to clear
the encumbrance. The authorised officer then has to pay and
remove the encumbrance
after giving notice to the concerned parties.
14.

The authorised officer is authorised to issue the sale

certificate. Such a certificate is conveyance of
immoveable property and requires stamping, as may be required
under the relevant State laws.
23.3 CHIEF METROPOLITAN MAGISTRATE OR DISTRICT
MAGISTRATE'S ASSISTANCE FOR TAKING POSSESSION OF
SECURED ASSET
1. When the secured creditor is required to take possession or

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control of the secured asset or when the secured asset is required to
be sold or transferred under the provisions of the SARFAESI Act,
236
the secured creditor can take the help of the Chief Metropolitan
Magistrate or the District Magistrate. For seeking such help the
secured creditor has to make a request in writing to the said
authority within whose jurisdiction the secured asset or documents
related to it are situated.
2. On such request being made the Chief Metropolitan Magistrate
or the District Magistrate, as the case may be, shall take possession
of the security asset and documents relating thereto.
For compliance of the provisions of the Act as stated above, the
Metropolitan Magistrate or the District Magistrate may take or
cause to be taken such steps and use or cause to be used such force
as may be in his opinion necessary. Any act of the Metropolitan
Magistrate or the District Magistrate for and while taking
possession of the security shall not be called in question in any
Court or before any authority.
A very important aspect of these provisions is that the powers of
taking possession, or causing the same, are given to the judicial
authority, who will take the possession and hand it over to the
secured creditor.
23.4 MANNER AND EFFECT OF TAKE OVER OF
MANAGEMENT
1.

When the secured creditor takes over the management of

business of a borrower, he may publish
a notice in a newspaper published in the English language and in a

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newspaper published in an Indian
language in circulation in the place where the principal office of the
borrower is situated, for
appointment of:
(i) If the borrower is a company as defined in the Companies Act,
1956, to be the directors of
such company, or (ii) In any other case, to be the administrator of
the business of borrower.
2.

On publication of such a notice, the directors of the

company, in case the borrower is a company
and in other cases, the person holding any office having power of
superintendence, direction and
control of the business of the borrower immediately before the
publication of the notice, shall be
deemed to have vacated their offices. As an effect of this, any
management contract between the
borrower and any directors or manager thereof shall be deemed to
be terminated.
3.

On publication of the above said notice and then after the

appointments of directors or the
administrators as stated above, all the property and effects of the
business of borrower are deemed
to be in the custody of the directors or the administrators so
appointed, as the case may be. All the
directors or the administrators are empowered to take such steps
as may be necessary to take into
their custody or under their control all the property, effect and
actionable claims to which the

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borrower is entitled. Thereafter, the directors or the administrators
are alone entitled to exercise all
the powers of superintendence, direction and control of the
business of the borrower. Such powers
are derived as if from the memorandum or articles of association of
the company or from any
other source whatsoever.
4.

Where the management of the business of a borrower which

is a company as defined in the Companies
Act, 1956, is taken ever by the secured creditor, then,
notwithstanding anything contained in the
Companies Act, 1956 or the memorandum or in the articles of
association following effects apply:
(i) The shareholders of the company can lawfully appoint any
person to be a director of the
company, (ii) No resolution passed by the shareholders of the
company shall be given effect to, unless
approved by the secured creditor, (iii) No proceeding for the
winding up of such company or for the appointment of a receiver
for
the company shall lie in any Court, except with the consent of the
secured creditor.
237
5. Where the management of the business of a borrower has been
taken over by 'the secured creditor', on realisation of the debt in
full the secured creditor shall restore the management of the
business of the borrower to him.

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23.5

NO COMPENSATION TO DIRECTORS FOR LOSS OF

OFFICE
No managing director or director or any person in charge of
management of the business of the borrower shall be entitled to
any compensation for the loss of office or for premature
termination of any contract of management, entered into by him
with the borrower. This provision has an overriding effect over any
other laws or contract.
However, if any director or any other person controlling the
management has to recover any amount from borrower, it can be
recovered.
23.6

RIGHT TO PREFER APPLICATION TO DRT

1.

Any person, including the borrower, aggrieved by any of the

measures taken by the secured
creditor or his authorised officer for taking possession of the
security may make an application
along with the prescribed fees, to the Debts Recovery Tribunal
having jurisdiction within fortyfive days from the date on which such measures are taken. There
can be different prescribed fees
for the borrower's application and the application from other than
the borrower. The right to file an
application is provided not only to the borrower but also to any
person aggrieved by the action
taken by the secured creditor.
2.

The Debts Recovery Tribunal has to dispose of the

application, in accordance with the provisions
of the recovery of debts due to Banks and Financial Institutions

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Act, 1993 and the Rules made
thereunder. The application has to be disposed as early as possible,
but within sixty days. If for any
reason it is not possible to so dispose the application, the Tribunal
has to record the reasons for
delay, but such delay should not be beyond four months from the
date of filing of the application.
If any such application is not disposed within four months, the
aggrieved party can prefer an
application to the Appellate Tribunal for seeking directions for the
early disposal of the application.
23.7

APPEAL TO APPELLATE AUTHORITY

Any person aggrieved by any order made by the debts recovery
tribunal can prefer an appeal along with the prescribed fees to the
Appellate Tribunal within thirty days from the date of receipt of the
order of debts recovery tribunal. There can be different fees
prescribed for the borrower's appeal and an appeal by anyone other
than the borrower. The amendments to the Act made in November
2004 have now stipulated that no appeal can lie unless the
borrower deposits fifty per cent of the debt claimed by the secured
creditor. The tribunal has powers for reasons to be recorded, to
reduce this amount to twenty-five per cent of the claim amount.
23.8

RIGHT OF THE BORROWER FOR COMPENSATION AND

COSTS
1. If the debt recovery tribunal or the appellate tribunal, as the
case may be
(i) holds that the possession of secured asset by the secured
creditor is not in accordance with

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the provisions of the Acts or Rules framed thereunder and (ii)
directs the secured creditor to return the secured asset to the
borrower, then such borrower
shall be entitled to payment of such compensation and costs as may
be determined by the
tribunal or the appellate tribunal.
238
2. No pecuniary limit is fixed by the Act for the appellate
jurisdiction. The jurisdiction of the DRT is Rs. 10 lakh and above
under the Recovery of Debts due to Banks and Financial
Institutions Act, 1993. However, the SARFAESI Act does not
provide any pecuniary limit. Therefore, appeal before the DRT
against the actions initiated by the secured creditors in cases even
below Rs. 10 lakh would lie.
23.9

LET US SUM UP

In this chapter, we have seen the details about enforcement of
securities by banks and financial institutions and the procedural
requirements thereof. We have discussed how, on default being
committed by the borrower, the creditor can enforce the securities
as per provisions of the Act. For this no Court intervention is
required as earlier. The service of notice calling for payment and on
failing to pay, the creditor can invoke the provisions for the take
over of the asset/management. After the notice, transfer by the
borrower is prohibited. The reply to the notice needs consideration
on lines with Supreme Court directions as in Mardia case. Creditor
can also call for payment due to the borrower from a third party.
For the remaining dues after sale of assets, the remedy at Civil

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Court or DRT are open as per jurisdiction. For initiating various
actions under the Act there is need of an authorised person. While
taking possession of the asset, various precautions are required to
be taken. For talcing possession, help of the Chief Metropolitan
Magistrate or District Magistrate can be taken. In such an event the
possession is taken by such authorities and handed over to the
creditor. Against the possession notice, appeal can be made but on
payment of the amount as prescribed. If possession is wrongfully
taken, the creditor has to pay compensation to the borrower. For
appeal to the tribunal fifty per cent of the debt amount is required
to be deposited.
23.10 KEYWORDS
Enforcement of Security; Notice for Default; Contents; Take Over
Management; Payment in Hands of Third Party; Consortium/Joint
Finance; Payment of Labour; Pari Passu; Independent Remedy.

23.11 CHECK YOUR PROGRESS
1. Asset reconstruction means
by any securitisation company or reconstruction
company of any right or interest of the creditor in any
2.

SARFAESI Act is applicable to the Regional Rural Banks.

(True/False)
3.

Mortgage or asset backed debt instruments can be issued by

the securitisation company or
reconstruction company to the general public. (True/False)
4.

A guarantor to the loan is within the meaning of the word

borrower under SARFAESI Act.

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(True/False)
5.

SARFAESI Act is applicable only when there is security.

(True/False)
6.

Has SARFAESI Act defined hypothecation and whether the

Act is applicable to hypothecation
security? (True/False)
23.12 ANSWERS TO CHECK YOUR PROGRESS'
1. acquisition, financial assistance; 2. False; 3. False; 4. True; 5.
True; 6. True
23.13 MULTIPLE CHOICE TERMINAL QUESTIONS
1. On giving of a default notice by the creditor, the borrower gives a
reply to it. What should the creditor do?
239
)RTis
is Act, before )lakh
itions
iy the
:ourt
Y, the
nsfer
lourt
)arty.
tfion.
ision
:hief
aken

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lade
pay
ired

(a)

Ignore the notice as the law does not provide for any reply

option to the bank.
(b)

Wait until the borrower initiates any legal action based on

his reply.
(c)

Give due consideration to the reply as per the guidelines

issued in the Mardia Chemical case
by the Supreme Court and reply to it.
(d)

Take the matter before DRT for resolving issues raised in the

reply.
2. On sale of the security asset, the sale proceeds are appropriated
firstly.
(a)

Towards the satisfaction of dues of secured creditor.

(b)

Towards the payment of dues of labour.

(c)

Towards payment of cost, charges and expenses for the

preservation and protection of
securities, insurance premiums, etc.
(d)

Towards payment of legal costs incurred by the creditor for

taking possession and for
effecting sale.
Ans. 1. (c); 2. (c).
s of
ion

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or
ct.
on

CENTRAL REGISTRY

STRUCTURE
24.0

Objectives

24.1

Introduction

24.2

Central Registry

24.3

Central Registrar

24.4

Register of Securitisation, Reconstruction and Security

Interest Transactions
24.5

Filing of Transactions of Securitisation, Reconstruction and

Creation of Security Interest
24.6

Modification of Security Interest Registered

24.7

Satisfaction of Security Interest

24.8

Right to Inspect Particulars of Securitisation,

Reconstruction of Security Interest
Transactions
24.9

Let Us Sum Up

24.10 Keyword
24.11 Check Your Progress
24.12 Answers to 'Check Your Progress'
24.13 Multiple Choice Terminal Questions

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242
24.0

OBJECTIVES

The SARFAESI Act has brought in a new concept of security and
the enforcement of security. For a proper noting and registering of
the charges created in favour of the secured creditors against the
properties that would eventually be enforced, the charges created
need to be noted with authority. It is like the charges noted with
the Registrar of Companies in case of charges created against the
property of the Company. This unit deals with the central registry
created under the SARFAESI Act.
24.1

INTRODUCTION

The creation of a security interest in property has gained
importance and significance with the provisions of the SARFAESI
Act. It has given various powers to the creditor. The securitisation
and reconstruction companies will be carrying on transactions of a
different nature in accordance with the provisions of the Act.
Therefore, both of these need an authentic registration. In this
unit, we will see about the central registry with whom the
transactions above and the creation of charges over security will be
required to be registered. In this unit, we will see the provisions
about the same.
24.2

CENTRAL REGISTRY

1.

The Central Government is authorised to set up or cause to

be set up a 'Central Registry' by issue
of notification from such date as may be specified in the
notification for the purpose of registration
of following transactions:

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(i) Securitisation and reconstruction of financial assets (ii) Creation
of security interest under the SARFAESI Act.
Maintaining the records of the 'Registry' on computers is
permissible under the Act. The Government can also establish
branch offices at other places. The Government has the authority to
decide the territorial jurisdiction of these offices for the purpose of
registration.
2.

There are some other Acts which require registration of

certain things and charges. These Acts are:
(i) Registration Act, 1908 (ii) Companies Act, 1956
(iii) Merchant Shipping Act, 1958 (iv) Patents Act, 1970
(v) Designs Act, 2000

(vi) Motor Vehicles Act, 1988

The registration contemplated before the central registry is in
addition to the respective registrations contemplated under the
above stated six Acts or any other Act. Thus, the registration under
SARFAESI Act is not in substitution of the other registrations
required under different laws. This is obvious because the purpose
and effect and consequence of registration are different under
different respective Acts. The registration under different laws will
have priority of charge depending on the provisions of respective
registration laws.
24.3

CENTRAL REGISTRAR

The Central Government has to appoint by notification a person as
central registrar for the purpose of registration contemplated
under the Act. The Central Government is also empowered to
appoint such other officers with such designations as it thinks fit
for the purpose of discharging various duties for registrations
under the Act.

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24.4

REGISTER OF SECURITISATION, RECONSTRUCTION

AND
SECURITY INTEREST TRANSACTIONS
A record shall be maintained at the central registrar at the head
office of the central registrar in which transactions relating to
243
(i) Securitisation of financial assets,
(ii) Reconstruction of financial assets,
(iii) Creation of security interests shall be maintained.
The record of central registrar can be kept fully or partly on
computer, floppies, diskettes, or any other electronic form. Any
entry made with the central registrar shall be a reference to any
such transaction. The central registrar shall have the control and
management of the central register.
24.5

FILING OF TRANSACTIONS OF SECURITISATIQN,

RECONSTRUCTION AND CREATION OF SECURITY INTEREST
Under the SARFAESI Act, now filing of details of transactions of
securitisation, reconstruction and the creation of security interest
is required to be filed with the central registrar. The period of filing
such details in proper form as may be prescribed, is thirty days
after the date of transaction or the creation of security. The central
registrar has to prescribe fees for such filing. The particulars are
required to be filed as stated above by the securitisation company
or the reconstruction company or the secured creditor, as the case
may be. The delay in filing the said particulars can be condoned by
the central registrar for a period of next thirty days after the first
thirty days prescribed, on payment of fees not more than ten times

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of the prescribed fees.
24.6

MODIFICATION OF SECURITY INTEREST REGISTERED

Whenever any security interest is registered with the central
registrar is modified, the modification is required to be filed before
central registrar. It is the duty of the securitisation or the
reconstruction company or the secured creditor to file the
modification. For filing the modification same provisions as are
made for registration of charge apply. This means, modification
will have to be filed within thirty days in the prescribed forms with
prescribed fees. Delay condonation will be for a period of next
thirty days on payment of fees not more than ten times of the
prescribed fees.
24.7

SATISFACTION OF SECURITY INTEREST

1.

The security interest registered with the central registrar is

required to be satisfied on the payment
of full amount by the borrower. The duty to report satisfaction is on
the securitisation or
reconstruction company or the secured creditor, as the case may
be. The reporting is required to
be done within thirty days of payment in full or satisfaction of the
charge.
2.

On receipt of the satisfaction of the charge the central

registrar is required to cause a notice to be issued
to the securitisation or reconstruction company or the secured
creditor, calling upon to show cause
within a time not exceeding fourteen days as to why the payment or
satisfaction should not be recorded
as intimated. If no cause is shown then the central registrar has to

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order that a memorandum of
satisfaction shall be entered in the central register. If any cause is
shown the central registrar shall record
a note to that effect in the central register and shall inform to the
borrower about it.
24.8 RIGHT TO INSPECT PARTICULARS OF
SECURITISATION,
RECONSTRUCTION OF SECURITY INTEREST TRANSACTIONS
The particulars of securitisation or reconstruction or security
interest entered in the central register are open for inspection by
any person during office hours on payment of fees as may be
prescribed. Same is applicable if the data is kept in the electronic
form at the office of the central registrar.
L.K.A.B-17
244
24.9

LET US SUM UP

Central Government has to set up or cause to set up central registry
for registration of securitisation and reconstruction transaction
and creation of security interest. Registration under other
applicable laws will continue. All transactions and creation of
security interest needs to be noted. Modification and satisfaction
also needs noting in prescribed form with payment of fees.
24.10 KEYWORD
Central Registry.
24.11 CHECK YOUR PROGRESS
1.

After coming into operation, the provisions relating to

central registry the banks and financial

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institutes will have to register all security interests created in the
asset. (True/False)
2.

The period stipulated in the Act for filing details of security

interest is
3.

days.

Duty to report satisfaction of charge to the central registrar

is on creditor or on the borrower?
24.12 ANSWERS TO 'CHECK YOUR PROGRESS'
1. True; 2. 30; 3. Creditor.
24.13 MULTIPLE CHOICE TERMINAL QUESTIONS
1. Besides the SARFAESI Act, some other laws require some
registration of charge created in the property. Is such double
registration avoidable?
(a)

Yes, the creditor can choose under which law he needs

registration.
(b)

No, registration under the SARFAESI Act as well as any

other applicable law will have to be
made as the SARFAESI Act is not substitution of any other law.
(c)

Yes, if one charge noting is by a registered document.

(d)

No, as the Civil Courts and DRT still have jurisdiction

against the properties both registrations
are required.
Ans. 1. (b)

tion ible and
OFFENCES AND PENALTIES

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rial
the
)be
STRUCTURE
25.0

Objectives

25.1

Introduction

25.2

Penalties

25.3

Penalties for Non-compliance of Directions of Reserve Bank

of India
25.4

Offences

25.5

Cognisance of Offences

25.6

Let Us Sum Up

25.7

Keyword

25.8

Check Your Progress

25.9

Answers to 'Check Your Progress'

25.10 Multiple Choice Terminal Questions
ons
246
25.0 OBJECTIVE
The objective of this unit is to know the penal provision of the Act.
For effective implementation of the law and as a deterrent step to
prevent improper actions by parties concerned penal provisions are
kept in laws.

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25.1

INTRODUCTION

The Act has given many statutory obligations. If anything said in
the law is not acted upon or is not followed there is a breach of the
legal provisions. So there are penalties provided in the Act. In this
chapter, we will see about the offences and penalties. It also gives
details about which Court should be dealt with for imposition of
penalty for breach of provisions of the Act.
25.2

PENALTIES

Section 23 of the Act provides for filing of the particulars of charge
created. Section 24 has provides for modification of the charge filed
and the Section 25 has provides that the satisfaction of the charge
has to be intimated to the central registrar. If the securitisation or
reconstruction company or the secured creditor fails to perform
any of the duties as stated above, the company and the officers
concerned for the default, as per provisions of this section, are
punishable with a fine that may extend to five thousand rupees for
each day during which the default continues.
25.3

PENALTIES FOR NON-COMPLIANCE OF

DIRECTIONS OF RESERVE BANK OF INDIA
Under the Section 12 of the SARFAESI Act, the Reserve Bank of
India is statutorily empowered to issue directions to the
securitisation or reconstruction company. If any such company
fails to comply with any of the directions issued by the Reserve
Bank of India, then such company is punishable with a fine not
exceeding Rs. 5 lakh for the default. In case of further continuation
of the offence, an additional fine up to Rs. 10,000 per day of the
default can be imposed.
25.4

OFFENCES

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If any person:
1.

contravenes, or

2.

attempts to contravene, or

3.

abets the contravention of the provisions of the SARFAESI

Act or rules made thereunder, he shall
be punishable with imprisonment for a term, which may extend to
one year or with a fine or both.
The Act has made various provisions where duties are cast on the
borrower, the secured creditor, the securitisation and the
reconstruction company. Any contravention of these provisions is
punishable as stated above under the provisions of this section.
25.5

COGNISANCE OF OFFENCES

Section 30 provides that cognisance of the offence under the
SARFAESI Act shall be taken by the Metropolitan Magistrate or the
Judicial Magistrate of First Class only. No Court below rank than
this can take cognisance of such offences.
25.6

LET US SUM UP

If the charges created, modified and satisfied are not intimated to
the central registrar it is an offence. The securitisation company or
the reconstruction company is required to perform various duties
under the Act. Breach thereof is also an offence. The punishments
are up to Rs. 5,000 for each day of default. Breach of RBI directives
is also punishable by a fine up to Rs. 5 lakh and Rs. 10,000 for
continuation per day. Any general infringement of provisions of
SARFAESI Act is punishable with imprisonment for one year or
fine or both.
25.7

KEYWORDS

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Offences for Breach.
25.8

CHECK YOUR PROGRESS

1.

Is there any punishment provided in the Act for not

following RBI directions? (Yes/No)
2.

Can the Honorary Magistrate take cognisance of offence

under the SARFAESI Act?
25.9

ANSWERS TO 'CHECK YOUR PROGRESS'

1. Yes; 2. No
25.10 MULTIPLE CHOICE TERMINAL QUESTIONS
1. Whether breach of RBI directives is punishable offence and to
what extent?
(a)

Yes, a fine up to Rs. 5 lakh and for continuation of offence a

fine of up to Rs. 10,000 per
day.
(b)

Yes, by cancellation of licences of the company.

(c)

No, these are the administrative directions.

(d)

No, the Act has not provided for any punishment in specific.

Ans. 1. (a)

MISCELLANEOUS PROVISIONS
STRUCTURE
26.0

Objective

26.1

Introduction

26.2

Non-Applicability of the Provisions of the SARFAESI Act in

Certain Cases
26.3

Protection of Action Taken in Good Faith

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26.4

Offences by Companies

26.5

Civil Court not to have Jurisdiction

26.6

Overriding Effect on Other Laws

26.7

Limitation

26.8

Power of the Central Government to Make Rules

26.9

Certain Provisions of the Act to Apply after Central Registry

is Set Up or Cause
to be Set Up
26.10 Amendments to Certain Other Enactments
26.11 Let Us Sum Up
26.12 Check Your Progress
26.13 Answers to 'Check Your Progress'
26.14 Multiple Choice Terminal Questions
250
26.0

OBJECTIVE

The objective of this unit is to understand the exceptions of
securities to which this Act is not applicable. At the same time, the
person or the organisation utilising the provisions and powers
given under this Act should know about the legal protections the
Act has given when it is implemented properly and in good faith. At
the same time, if any of the provisions are not followed, then it has
penal provisions also.
26.1

INTRODUCTION

In this unit, we will see some miscellaneous provisions about
implementation of the Act. Section 31 gives some exclusions of
securities to which the Act is not applicable. For creditor it is
important to note these exclusions. The Act has given many strict

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powers to take possession of security, change of management, etc.
These require some hard steps to be taken. So the person
exercising the rights under the Act needs a legal protection. Section
32 gives such protection for action taken in good faith under the
Act. Similarly, to curb the tendency of the borrowers to go to Civil
Court or any other authority and bring injunctions, stay, orders for
status quo, etc., the Act has barred the jurisdiction of Civil Court as
well as other authorities for the matters covered by this Act. The
unit also deals with offences, limitation period for actions,
overriding effect on other laws, Central Government powers to
make rules and some such provisions for effective implementation
of the Act.
26.2

NON-APPLICABILITY OF THE PROVISIONS OF

THE SARFAESI ACT IN CERTAIN CASES
The object of the SARFAESI Act is to give powers to the banks and
financial institutions to enforce the securities given to the loans
and advances by the borrowers without the intervention of the
Court. It should be noted that the securities not in possession of the
bank or financial institution are only covered by this Act. The
securities in possession of the secured creditors are not covered by
this Act and provisions of the Act are not applicable to them.
Therefore, the Section 31 gives the exclusions for securities that can
be taken possession of and to some other specific securities to
which the Act is not applicable. These exclusions, to which the
provisions of the Act are not applicable, are
(i) A lien, on any goods, money or security given by or under the
Indian Contract Act, 1872 or the
Sale of Goods Act, 1930 or any other law for the time being in force.

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(ii) A pledge of movable, within the meaning of Section 172 of the
Indian Contract Act, 1872. (iii) Creation of security interest in any
vessel as defined within the meaning of Section 3(55) of the
Merchant Shipping Act, 1958.
(iv) Creation of security in any aircraft as defined in Section 2 of
Aircraft Act 1934. (v) Any conditional sale, hire-purchase or lease
or any other contract in which no security interest
has been created.
(vi) Any rights of unpaid seller under Section 47 of the Sale of
Goods Act, 1930. (vii) Any properties not liable for attachment or
sale under the first proviso to Section 60(1) of the
Civil Procedure Code, 1908.
(viii) Any security interest for securing repayment of any financial
asset not exceeding one lakh rupees, (ix) Any security interest
created in agricultural land, (x) Any case, in which the amount due
is less than twenty per cent of the principal amount and
interest thereunder.
26.3

PROTECTION OF ACTION TAKEN IN GOOD FAITH

The secured creditors and their officers are protected for actions
taken in good faith by the provisions made in the Act. For initiating
actions under the Act no suit, prosecution or any other legal
proceeding
251
can be taken against the secured creditor or his officers. This
protection is given so that actions contemplated and authorised
under SARFAESI Act, can be taken without fear of counteraction
from the borrower or any other person having interest in the

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property.
26.4

OFFENCES BY COMPANIES

1.

If a company and its officers commit any offence under the

provisions of the SARFAESI Act the
same is punishable. There are provisions in the Act that cast some
statutory obligations. If these
statutory obligations are not observed then there is contravention
of the Act which amounts to
offence. If any offence is committed under the provisions of this
Act by a company, such company,
as well as any person who is in charge of the business of the
company, are deemed to be guilty of
the offence and they are liable to be prosecuted and punished. It is
permissible for a person acting
for the company to prove that the offence was committed without
his knowledge or that he had
exercised due diligence to prevent the commission of such offence.
In such cases and on proving
his stand the person concerned shall not be punishable. If such
offence is committed with the
consent or connivance of any director or officer of the company,
such director or officer shall be
deemed to be guilty for the offences along with the company.
2.

The penal provisions are applicable to all categories of

borrowers such as individuals, partnership
firms, companies incorporated under the Companies Act or any
other association of individuals.
The Act has clarified, that company includes a partnership firm or

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other association of individuals
and the expression director includes a partner of a firm.
26.5

CIVIL COURT NOT TO HAVE JURISDICTION

1. The SARFAESI Act has conferred jurisdiction on many matters
to the debts recovery tribunal or the appellate tribunal. Therefore,
for any such matters where empowerment and jurisdiction is to the
debts recovery tribunal or the appellate tribunal, no Civil Court
shall have jurisdiction to entertain any suit or proceedings.
Similarly, any Court or authority cannot grant injunction in such
matters and actions taken, or to be taken, under this Act as well as
under Recovery of Debts Due to Banks and Financial Institutions
Act, 1993. Due to such provisions the implementation of the Act
becomes effective.
26.6

OVERRIDING EFFECT ON OTHER LAWS

The provision of this Act has overriding effect on any other laws if
the provisions in the other law are inconsistence with this Act. If
for any particular point, the provisions of this Act and in some
other Act are inconsistent with each other, a question will come as
to which provisions are to be followed, when both such Acts are
applicable to that particular point. The Act, therefore, provides that
the provisions of the SARFAESI Act will have overriding effect on
the other Act. Mainly, such inconsistencies are in the Transfer of
Property Act and the Registration Act. The provisions the
SARFAESI Act will apply, overriding the provisions in those Acts.
26.7

LIMITATION

The actions that secured creditor can take against the security
under the SARFAESI Act are required to be taken within the
limitation as per Section 36 of the Limitation Act. That means, the

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action has to be taken within three years from the date on which
the cause of action arose.
Due to the provisions of this section, all secured creditors are
required to take measures such as taking possession of the
securities, provided their claim is within the period of limitation. It
will be necessary
252
for the banks and financial institutions to comply with the
limitation aspect. If after sale of securities the claim is not fully
satisfied and still there are any dues to be recovered from the
borrower, the creditor is required to file civil suit before the Civil
Court or a claim before the debt recovery tribunal within the
limitation period. Therefore, the secured creditor will have to make
an assessment, before taking possession of the security, whether it
would be possible to sell the security and make an eventual claim
for shortfall within the limitation period.
26.8

POWER OF CENTRAL GOVERNMENT TO MAKE RULES

1.

For carrying out the provisions of this Act, the Central

Government can frame rules and notify
them in the Official Gazette. The Act also allows the Government to
notify the rules in the Electronic
Gazette as defined in the Information Technology Act, 2000, i.e. on
the website of the Government.
2.

Whenever the Government makes a rule under the Act, the

rule is so required to be kept before
each House of Parliament, while in session for a total period of
thirty days. Both the Houses should

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agree to the rules as framed and they can make modifications
therein or decide not to make the
rules. The rule gets the validity in the manner as decided by both
the Houses. If already made rules
are modified or cancelled, then any act done under the then
existing rule does not get vitiated or
modified in any way.
26.9

CERTAIN PROVISIONS OF THE ACT TO APPLY AFTER

CENTRAL REGISTRY IS SET UP OR CAUSE TO BE SET UP
The provisions contained in sub-Sections (2) to (4) of Sections 20
and 21 to 27 that provide for registration of the security interest
created, satisfaction of charge, etc., are applicable only after the
central registry is set up or caused to be set up by the Central
Government.
26.10 AMENDMENTS TO CERTAIN OTHER ENACTMENTS
For effective purpose of this Act, it has amended some related
provisions of the Companies Act, 1956, The Securities Contracts
(Regulation) Act, 1956 and The Sick Industrial Companies (Special
Provisions) Act, 1985.
The amendments are as under:
1.

Section 4A of the Companies Act, 1956 is amended for the

purpose of declaring any securitisation
company or reconstruction company registered with the Reserve
Bank of India as a Public Financial
Institution within the meaning of Section 4A of the Companies Act,
1956.
2.

The Securities Contracts (Regulation) Act, 1956 is amended

at Clause (h) of Section (2 )for

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including security receipt as defined in Clause (zg) of Section 2 of
the SARFAESI Act.
3.

Amendment to The Sick Industrial Companies (Special

Provisions) Act, 1985 is made to provide
that
(i) no reference to the Board for Industrial and Financial
Reconstruction (BIFR) shall lie, where financial assets are acquired
by any securitisation company or reconstruction company under
sub-Section 5 of the SARFAESI Act, and
(ii) for the purpose of providing that a reference pending before
BIFR shall abate if the secured creditors, representing not less than
three-fourths in value of the amount outstanding, take any
measures to recover their secured debt under sub-Section (4) of
Section 13 of SARFAESI Act.
253
26.11 LET US SUM UP
The Act is applicable to securities not in possession of the creditors.
We have seen a list of securities to which the Act is not applicable.
Contravention of the provisions of the Act is punishable. Act has
dealt with the situations for offences committed by individuals,
partnerships and a company. By debarring Civil Court or any other
authority for jurisdiction for giving injunction, etc., the
implementation of the Act is made effective by removing legal
hindrance, which otherwise the borrower can bring. We have also
seen how and when the Act has an overriding effect. The Act has
provided that the provisions of the Limitation Act are applicable for
the actions under this Act also. The Central Government has

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powers to make rules for procedural implementation of the Act.
The central registry is not yet formed and the provisions relating to
the registrations required under Sections 21 to 27 are not yet made
applicable. The chapter also has dealt with the powers of the
Central Government to remove difficulties that may arise while
giving effect to the provisions of the Act and about the
amendments made in the other Acts by this Act.
26.12 CHECK YOUR PROGRESS
1.

For challenging an action initiated by secured creditor

against the defaulting borrower under the
SARFAESI Act, the borrower can go to the Civil Court for an
injunction. (True/False)
2.

Can the bank take action under SARFAESI Act against a

deposit under lien with it? (Yes/No)
3.

Are hire-purchase and lease contracts covered under

SARFAESI Act? (Yes/No)
4.

After the bank's notice a defaulting borrower has paid within

sixty days a substantial amount and
the present dues are Rs. fifteen lakh which is fifteen per cent of the
claimed amount. Can bank
proceed to take possession of the security? (Yes/No)
5.

If on some point the provisions of the Transfer of Property

Act and the SARFAESI Act are
different, which Act will prevail?
6.

Can a bank proceed to take possession of the security after

four years of cause of action?
(Yes/No)
26.13 ANSWERS TO 'CHECK YOUR PROGRESS'

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1. False; 2. No; 3. No; 4. No; 5. SARFAESI Act; 6. No
26.14 MULTIPLE CHOICE TERMINAL QUESTIONS
1.

Provisions of the SARFAESI Act are applicable to which of

the following?
(a)

Pledged goods.

(b)

Only mortgaged properties.

(c)

Securities that are not otherwise charged to the creditors.

(d)

Securities charged to creditors and not in possession of the

creditor.
2.

When the rules, framed by the Central Government, under

the Act get validity?
(a)

After the appellate tribunal of DRT approves them.

(b)

On Supreme Court approving the same.

(c)

Immediately on framing of the rules by the Government and

notifying the same.
(d)

When both the Houses of Parliament approve the Rule so

framed.
Ans. 1. (d); 2. (d)

THE BANKING OMBUDSMAN SCHEME, 2006: PURPOSE,
EXTENT, DEFINITIONS, ESTABLISHMENT AND POWERS
STRUCTURE
27.0

Objective

27.1

Introduction

27.2

Object of Scheme and Extent

27.3

Definitions

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27.4

Appointment and tenure

27.5

Territorial Jurisdiction and Location of Office

27.6

Secretariat

27.7

General Powers of Banking Ombudsman

27.8

LetUsSumUp

27.9

Keywords

27.10 Check Your Progress
27.11 Answers to 'Check Your Progress'
27.12 Multiple Choice Terminal Questions
256
27.0

OBJECTIVE

The objective of this unit is to understand the purpose of
introduction of the scheme, viz., 'The Banking Ombudsman
Scheme 2006, various words and the terms used in the scheme and
how the appointment of banking ombudsman is done, its
establishment and powers.
27.1

INTRODUCTION

In this unit, we will see the definitions of the words used in the
scheme. The definitions are important, as they have an assigned
meaning in the scheme and these words are used in the scheme in
the context of definitions. If the definitions are well mastered, it is
easy to understand the scheme. We will also see the provisions
relating to establishment of office of banking ombudsman. The RBI
decides his appointment and other terms of office, his secretariat,
his powers, etc. The RBI also decides the territorial jurisdiction of
the banking ombudsman. The scheme has come in force with effect
from 1 January 2006.

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27.2

OBJECT OF SCHEME AND EXTENT

1.

The scheme was introduced with the following objectives:

(i) To resolve complaints relating to banking services and to
facilitate the satisfaction or settlement
of such complaints, (ii) Resolve disputes between a bank and its
constituents as well as amongst banks, through the
process of conciliation, meditation and arbitration.
2.

The scheme extends to the whole of India. It is applicable to

the banks in India. The Reserve Bank
has the authority to suspend the operation of the scheme fully or
partly for such period as may be
specified in the order. Such suspension, may be general or in
relation to any specified bank. The
period of suspension can be extended if deemed fit by the Reserve
Bank.
27.3

DEFINITIONS

1.

'Award' means an award passed by the banking ombudsman

in accordance with this scheme.
2.

'Appellate Authority' means the Deputy Governor in charge

of the department of the RBI
implementing the scheme.
3.

'Authorised Representative' means a person duly appointed

and authorised by a complainant to
act on his behalf and represent him before a banking ombudsman,
for consideration of his complaint.
4.

'Banking Ombudsman' means any person appointed under

Clause No. 4 of the scheme.
5.

'Bank' means,

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a banking company,

and includes a corresponding new bank,

a Regional Rural Bank,

State Bank of India and its Subsidiary banks as defined in

Part I of the Banking Regulation Act,
1949,

and also includes a scheduled primary co-operative bank

and included in the second Schedule
to the RBI Act, 1934 having a place of business in India.
6.

'Complaint' means a representation in writing or through

ELECTRONIC MEANS containing a
grievance, alleging deficiency in banking service.
7.

'Settlement' means an agreement reached by the parties

either by conciliation or mediation under
the Scheme.
257
27.4

APPOINTMENT AND TENURE

The Reserve Bank may appoint one or more of its officers in the
rank of Chief General Manager or General Manager to be known as
the banking ombudsmen to carry out the functions entrusted to
them by or under the scheme. This appointment may be made for a
period not exceeding three years at a time.
27.5

TERRITORIAL JURISDICTION AND LOCATION OF

OFFICE
1.

The Reserve Bank shall specify the territorial limits to which

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the authority of each of the banking
ombudsman shall extend.
2.

The office of the banking ombudsman will be located at such

places as may be specified by the
Reserve Bank.
3.

The banking ombudsman may hold sittings at such places

within his area of jurisdiction as may be
considered necessary and proper by him, in respect of a complaint
or reference before him.
27.6

SECRETARIAT

(i) The Reserve Bank shall depute such number of its officers and
other staff to the office of the banking ombudsman as considered
necessary to function as the secretariat of the banking ombudsman.
(ii) The cost of the secretariat will be borne by the Reserve Bank.
27.7

GENERAL POWERS OF BANKING OMBUDSMAN

The banking ombudsman shall have the following powers and
duties:
(a)

to receive complaints relating to banking services

(b)

to consider such complaints relating to the deficiencies in

the banking and other services and
facilitate their satisfaction or settlement by agreement through
conciliation and mediation between
the bank and the aggrieved parties or by passing an award in
accordance with the scheme.
27.8

LET US SUM UP

The object of the scheme makes clear the purpose behind
introduction of the scheme. We have seen the definitions of
different words used in the scheme. The definition of words have

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importance as they are used in a particular context in the scheme.
We have seen the provisions about appointment and tenure of
banking ombudsman. The RBI is the authority for appointment
and deciding terms of appointment, etc. RBI also decides the
territorial jurisdiction of the banking ombudsman. We have seen
about his powers and duties and how he has to deal with the
complaint.
27.9

KEYWORDS

Conciliation; Meditation.
27.10 CHECK YOUR PROGRESS
1.

Disputes amongst two banks can be taken up before the

banking ombudsman. (True/False)
2.

Co-operative banks are not covered by the banking

ombudsman scheme. (True/False)
3.

Banking ombudsman is appointed by a committee of

Supreme Court Judges. (True/False)
4.

It is not within the powers of banking ombudsman to deal

with the complaint unless both parties
agree for his intervention. (True/False)
258
27.11 ANSWERS TO CHECK YOUR PROGRESS'
1. True; 2. False; 3. False; 4. False
27.12 MULTIPLE CHOICE TERMINAL QUESTIONS
1.

What is the object of introducing the banking ombudsman

scheme, 2006?
(a)

For effective monitoring of the NPA accounts in the banks.

(b)

It is the RBI agency to regulate the disputes amongst the

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banks.
(c)

To enable resolution of complaints relating to banking

services.
(d)

For executing the orders passed by the DRT.

2.

Complaints relating to non-acceptance of small

denomination notes by a bank, can be made to a
banking ombudsman:
(a)

Such small denomination notes and coins to be deposited

with the Reserve Bank.
(b)

They may be deposited with a bank having a currency chest

facility.
(c)

Banking ombudsman can deal with the complaints under

the scheme.
(d)

The complainant can seek no remedy at all through banking

ombudsman, but has to approach
the consumer disputes redressal machinery.
3.

Complaints can be made against promises made by sales

agents but not fulfilled by the bank
represented by them under the banking ombudsman Scheme
2006?
(a)

No complaint is admissible as he is not the employee of the

bank.
(b)

The sales agent has no authority to make any promise and

hence the bank is not bound to
fulfil them.
(c)

The banking ombudsman can entertain the complaint under

the scheme.
(d)

Agency functions are outside the purview of the banking

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ombudsman scheme.
Ans. 1. (c); 2. (c); 3. (c)

PROCEDURE FOR REDRESSAL OF GRIEVANCE
STRUCTURE
28.0 Objective
28.1

Introduction

28.2

Grounds of Complaint

28.3

Procedure of Filing Complaint

28.4

Power to Call for Information

28.5

Settlement of Complaint by Agreement

28.6

Award by the Banking Ombudsman

28.7

Rejection of the Complaint

28.8 Proceeding Before the Review Authority
28.9

Banks to Display Salient Features of the Scheme for

Common Knowledge of Public
28.10 Let Us Sum Up
28.11 Keywords
28.12 Check Your Progress
28.13 Answers to 'Check Your Progress'
28.14 Multiple Choice Terminal Questions
260
28.0 OBJECTIVE
The objective of this unit is to understand the procedure adopted
by the banking ombudsman for dealing with the grievance of the

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complainant. A banker must know, on what issues and matters
complaint can be filed.
28.1

INTRODUCTION

From procedural point of filing a complaint and the manner of
dealing with it, this unit is very important. The aspects on which a
complaint can be filed are exhaustive and cover all of the services
the bank offers to its customers. The grounds include some matters
related to loans and advances also. Though there cannot be a
complaint for not sanctioning a loan, it can be for non-observance
of RBI directives, delay in decision, interest rate directives and
non-acceptance of a loan application. In a broader sense, the
aspects also cover what the customers expect from the bank about
its declared services. For effectively dealing with the complaint the
banking ombudsman has powers to call for information from the
parties concerned. The complaint needs to be in writing and
supported by documents and declarations as given in the scheme.
The limitation period for filing a complaint is one year.
28.2

GROUNDS OF COMPLAINT

A complaint on any of the following grounds alleging deficiency in
banking service may be filed with the banking ombudsman having
jurisdiction:
(i) non-payment/inordinate delay in the payment or collection of
cheques, drafts, bills, etc; (ii) non-acceptance, without sufficient
cause, of small denomination notes or coins tendered
for any purpose, and for creating a charge of commission in respect
thereof; (iii) non-payment or delay in payment of inward
remittances; (iv) failure to issue or delay in issue of drafts, pay
orders or bankers cheques; (v) failure to honour a guarantee or

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letter of credit commitments; (vi) failure to provide or delay in
providing a banking facility (other than loans and advances)
promised in writing by a bank or its direct selling agents;
(vii) delays, non-credit of proceeds to parties accounts, nonpayment of deposit or non-observance of the Reserve Bank
directives, if any, applicable to rate of interest on deposits in any
savings, current and other account maintained with a bank; (viii)
delay in receipt of export proceeds, handling of export bills,
collection of bills etc., for
exporters provided that the said complaints pertain to the bank's
operations in India; (ix) complaints form non-resident Indians
having accounts in India in relation to their remittances
from abroad, deposits and other bank related matters; (x) refusal
to open deposit accounts without any valid reason for refusal; (xi)
levying of charges without adequate prior notice to the customer;
(xii) non-adherence by the bank or its subsidiaries to the
instructions of Reserve Bank on ATM/
Debit card operations or credit card operations;
(xiii) non-disbursement or delay in disbursement of pension (to the
extent the grievance can be attributed to the action on the part of
the bank concerned, but not with regard to its employees); (xiv)
refusal to accept or delay in accepting payment towards taxes, as
required by Reserve
Bank/Government; (xv) refusal to issue or delay in issuing, or
failure to service or delay in servicing or redemption
of Government securities; (xvi) forced closure of deposit accounts
without due notice or without sufficient reason;

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261
(xvii) refusal to close or delay in closing the accounts; (xviii) nonadherence to the fair practices code as adopted by the bank;
(xix) any other matter relating to the violation of the directives
issued by the Reserve Bank of India in relation to banking services.
2.

Complaints concerning loans and advances may also be

filed, only in so far as they relate to the
following:
(i) non-observance of Reserve Bank of India directives on interest
rates.
(ii) delays in sanction, disbursement or non-observance of
prescribed time schedule for disposal
of loan applications.
(iii) non-acceptance of application for loans without furnishing
valid reasons to the applicant, (iv) non-observance of any other
directions or instructions of the Reserve Bank of India, as may be
specified by it from time to time.
3.

The banking ombudsman may also deal with such other

matter as may be specified by the Reserve
Bank of India from time to time in this behalf.
28.3 PROCEDURE FOR FILING COMPLAINT
1.

Any person who has a grievance against a bank relating to

the banking services for reasons as
detailed above, may himself or through his authorised
representative other than an advocate make
a complaint to the banking ombudsman within whose jurisdiction
the branch or office of the bank
complained against is located. Complaints arising out of the

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operation of credit cards shall be filed
before the banking ombudsman within whose jurisdiction the
billing address of the complainant is
located.
2.

The complaint shall be in writing, duly signed by the

complainant or his authorised representative.
The complaint shall be in a form specified in Annexure - A of the
scheme and shall state clearly
following particulars:
(i) The name and address of the complainant
(ii) The name and address of the branch or office of the bank
against which the complaint is
made
(iii) The facts giving rise to the complaint (iv) The nature and
extent of the loss caused to the complainant (v) The relief sought
from the banking ombudsman
3.

No complaint to the banking ombudsman shall lie unless

(a)

the complainant had before making a complaint to the

banking ombudsman made a written
representation to the bank and either the bank had rejected the
complaint or the complainant
had not received any reply within a period of one month after the
bank concerned received
his representation or the complainant is not satisfied with the reply
given to him by the bank;
(b)

the complaint is made not later than one year after the cause

of action has arisen as per
Clause (a) above;

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(c)

the complaint is not in respect of the same subject matter

which was settled through the
office of the banking ombudsman in any previous proceedings;
(d)

the complaint does not pertain to the same subject matter,

for which any proceedings
before any court, tribunal or arbitrator or any other forum is
pending or a decree or award
or a final order has already been passed by any such competent
court, tribunal, arbitrator or
forum;
(e)

the complaint is not frivolous or vexatious in nature;

262
(f) It is made before the expiry of the period of limitation
prescribed under the Indian Limitation Act 1963 for such claims.
28.4

POWER TO CALL FOR INFORMATION

1.

The banking ombudsman may require the bank named in

the complaint or any other related bank to
provide any information or furnish certified copies of any
document relating to the subject matter
of the complaint that is or is alleged to be in the possession of such
bank. In the event of the failure
of a bank to comply the requisition without any sufficient cause,
the banking ombudsman may
draw the inference that the information, if provided or copies if
furnished, would be unfavourable
to such bank.
2.

The banking ombudsman shall not disclose any information

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or document to any person except
with the consent of the person furnishing such information or
document. However, the banking
ombudsman may disclose information or document furnished by a
party in complaint to the opposite
side of the complaint, to the extent considered by him to be
reasonably required to comply with the
principles of natural justice and fair play in the proceedings.
28.5

SETTLEMENT OF COMPLAINT BY AGREEMENT

1.

The banking ombudsman has to serve a notice of the receipt

of complaint along with a copy of the
complaint to the branch or office of the bank named in the
complaint. He has to attempt for a
settlement of the complaint by an agreement between the
complainant and the bank through
conciliation or mediation.
2.

For the purpose of promoting a settlement of the complaint,

the banking ombudsman may follow
such procedures as he may consider appropriate and he shall not
be bound by any legal rule of
evidence.
3.

The proceedings before the banking ombudsman shall be

summary in nature.
28.6

AWARD BY THE BANKING OMBUDSMAN

1.

If a complaint is not settled by agreement within a period of

one month from the date of receipt of
the complaint or such further period as the banking ombudsman
may consider necessary, he may

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pass an award after affording the parties a reasonable opportunity
to present their case. He shall be
guided by the evidence placed before him by the parties, the
principles of banking law and practice,
directions, instructions and guidelines issued by the Reserve Bank
of India from time to time and
such other factors which in his opinion are necessary in the interest
of justice.
2.

The award passed under the sub-clause above shall state the

direction(s), if any, to the bank for
specific performance of its obligations in addition to the amount to
be paid by the bank to the
complainant by way of compensation for the loss suffered by him
and may contain any direction
to the bank.
The banking ombudsman shall not give any direction(s) in the
award under sub-clause above regarding payment of compensation
in excess of that which is necessary to cover the loss, suffered by
the complainant, as a direct consequence of the commission or
omission of the bank, or for an amount exceeding Rs. 10 lakh
whichever is lower.
3.

In case of complaints relating to credit card operations, the

banking ombudsman shall take into
account the loss of complainant's time, expenses incurred by the
complainant, financial loss,
harassment and mental anguish suffered by the complainant, while
determining the amount of
compensation.

;

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263
4.

A copy of the award shall be sent to the complainant and the

bank named in the complaint. An
award shall not be binding on a bank against which it is passed
unless the complainant furnishes to
it within a period of fifteen days from the date of receipt of copy of
the award, a letter of acceptance
of the award in full and final settlement of his claim in the matter.
If the complainant does not
accept the award passed by the banking ombudsman and fails to
furnish his letter of acceptance
within such time, without making any request for extension of time
to comply with such
requirements, the award shall lapse and be of no effect.
5.

The bank shall within one month from the date of receipt by

it, of the acceptance in writing of the
award by the complainant comply with the award and intimate the
compliance to the banking
ombudsman.
28.7

REJECTION OF THE COMPLAINT

1.

The banking ombudsman may reject the complaint at any

stage if it appears to him that the complaint
made is:
(i) frivolous, vexatious, mala-fide; or (ii) without any sufficient
cause; or
(iii) that it is not pursued by the complainant with reasonable
diligence; or ! (iv) prima facie, there is no loss or damage or

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inconvenience caused to the complainant; or (v) beyond the
pecuniary jurisdiction of the banking ombudsman under the
scheme
2.

The banking ombudsman may reject a complaint at any

stage, if after consideration of the complaint
and evidence produced before him the banking ombudsman is of
the opinion that the complicated
nature of the complaint requires consideration of elaborate
documentary and oral evidence and the
proceedings before the banking ombudsman are not appropriate
for adjudication of such a complaint.
The decision of the banking ombudsman in this regard shall be
final and binding on the complainant
of the bank.
28.8 PROCEEDING BEFORE THE APPELLATE AUTHORITY
1.

Any person aggrieved by the award has the right to prefer an

appeal against the award before the
appellate authority within forty-five days form the date of receipt of
the award. The appellate
authority is empowered to allow a further period not exceeding
thirty days on his being satisfied
that the appellant had sufficient cause for not preferring the appeal
in time. In case the appeal is by
the bank, the filing of appeal should have been with the previous
sanction of the Chairman or in his
absence the Managing Director or Executive Director or the Chief
Executive Officer or any other
officer of equal rank.

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2.

The appellate authority after giving the parties a reasonable

opportunity of being heard, may pass
the following orders:
(a)

dismiss the appeal; or

(b)

allow the appeal and set aside the award; or

(c)

remand the matter to the banking ombudsman for fresh

disposal in accordance with such
directions as the appellate authority may consider necessary or
proper; or
(d)

modify the award and pass such directions as may be

necessary to give effect to the award
so modified; or
(e)

pass any other order as it may deem fit.

The order of the appellate authority has also the same effect as that
of the award of the banking ombudsman.
264
28.9

BANKS TO DISPLAY SALIENT FEATURES OF

THE SCHEME FOR COMMON KNOWLEDGE OF THE PUBLIC
1.

The banks covered by the scheme shall ensure that the

purpose of the scheme and the name and
address of the banking ombudsman to whom the complaints are to
be made by the aggrieved party
are displayed in all the branch/office premises.
2.

The banks covered by the scheme are required to ensure that

a copy of the scheme is made
available with the designated officer of the bank for perusal in the

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office premises of the bank.
There should be a notice displayed at each office of the bank about
the availability of the copy of
the scheme with such a designated officer.
The banks covered by the scheme are required to appoint nodal
officers at their Regional/Zonal offices and inform the respective
office of the banking ombudsman. The nodal officer appointed
shall be responsible for representing the bank and furnishing
information to the banking ombudsman in respect of complaints
filed against the bank.
28.10 LET US SUM UP
We saw the grounds on which a complaint can be filed. It touches
all aspects of banking services. It relates to some issues about loans
and advances also. The procedural part of filing and dealing with
the complaint is material and needs to be well noted. We have seen
how the information required by the banking ombudsman can be
called and how he deals with the complaint. How an award is
passed. For awareness of the public, a notice about the scheme is
required to be displayed at each office along with copy of the
scheme.
28.11 KEYWORDS
Banking Ombudsman.
28.12 CHECK YOUR PROGRESS
1.

Bank can refuse acceptance of small denomination notes

from the customer and therefore, on
this ground there cannot be a complaint to banking ombudsman.
(True/False)
2.

On valid grounds bank can refuse the opening of a new

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account, but on this ground, complaint
before the banking ombudsman is maintainable. (True/False)
3.

Can a prospective borrower go before the banking

ombudsman for non-sanction of his loan by
the bank? (Yes/No)
4.

Banking ombudsman has powers to call for any information

and certified copies from bank when
he is dealing with the complaint.
5.

For settling the complaint the banking ombudsman is

bound by legal rules of evidence.
(True/False)
6.

What is the maximum amount the banking ombudsman can

award as compensation? (No limit /
10 lakh)
7.

Limitation period for filing of the review application against

the award given by the banking
ombudsman is

days. (60/45 days)

28.13 ANSWERS TO CHECK YOUR PROGRESS'
1. False; 2. False; 3. No; 4. Yes; 5. False; 6. Rs 10 lakh; 7.45
265
e and party
made bank, pyof
tonal inted sman
ss. It hthe Mhe . For with
28.14 MULTIPLE CHOICE TERMINAL QUESTIONS

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1.

Can a customer from whose account someone fraudulently

has withdrawn money make a complaint
before the banking ombudsman?
(a)

No, as the offence committed, is of criminal nature, FIR with

police has to be filed.
(b)

Yes, but if the police authorities who have received the FIR

permit filing of the complaint
with ombudsman.
(c)

Yes, as this aspect comes under the powers of the banking

ombudsman.
(d)

No, as the loss caused to the customer is of a civil nature for

recovery, civil suit is required
to be filed.
2.

Reserve Bank and the Central Government may forward a

complaint to the banking ombudsman?
(a)

The right to complaint is given to the complainant only.

(b)

Neither the Reserve Bank nor the Central Government has

the right to refer the matter to the
banking ombudsman under the scheme.
(c)

Reserve Bank and the Central Government are empowered

to send the complaint received
by them to the banking ombudsman.
(d)

Only an individual's complaint can be sent by the Reserve

Bank and the Central Government.
3.

Can the complaint be filed through an advocate as the

authorised representative of the complainant?
(a)

Advocates are not allowed to act as authorised

representatives of the complainants under

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the scheme.
(b)

Advocates can file the complaint, provided he has been

given the vakalatnama by the party.
(c)

Advocates can appear for the parties as they can present the

case well before the banking
ombudsman.
(d)

Advocates are allowed to appear only if the party does not

stay within the jurisdiction of the
banking ombudsman.
Ans: 1. (c); 2. (c) and 3. (a).
!, on laint a by rhen ice. nit/ ting
UNIT
29
RECOVERY OF DEBTS DUE TO BANKS AND FINANCIAL
INSTITUTIONS ACT, 1993 (DRT ACT) PRELIMINARY
STRUCTURE
29.0

Objective

29.1

Introduction

29.2

Constitutional Validity of the Act

29.3

Preamble, Extent, Commencement, Application and

Definitions
29.4

Let Us Sum Up

29.5

Keywords

29.6

Check Your Progress

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29.7

Answers to 'Check Your Progress'

29.8

Multiple Choice Terminal Questions

268
29.0

OBJECTIVE

The objective of this unit is to understand the purpose of this
specific legislation viz., Recovery of Debts due to Banks and
Financial Institutions Act, 1993 (DRT Act 1993). This is an Act
enacted to cope up with the much felt requirement of time. The Act
is quite procedural in nature.
29.1

INTRODUCTION

Recovery of the dues from the borrowers through courts was a
major cause of concern for the banks and financial institutions due
to huge back log of pending cases with various courts. Even in
recovery of decreed debts, considerable difficulties were faced by
them prior to the passing of this Act in 1993 it was observed and
felt that the existing laws are not adequate to solve the issues faced
by the banks and financial institutions, and huge assets were
blocked as unproductive assets. Besides, in this process of recovery
considerable manpower of the banks and financial institutions gets
involved wasting their productivity. Because of delays involved in
finalising of cases the industrial assets were getting damaged and
deteriorating in value in 1991, the Recovery of Debts due to Banks
and Financial Institutions Act, 1993 (DRT Act, as commonly known
or called) was passed and it came into operation from 24 June
1993. This Act constituted the special, 'Debt Recovery Tribunals'
for speedy recovery.
In this unit, we will see how the Act received legal challenges and

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subsequent declaration of the Act as constitutionally valid by the
Supreme Court. We will also see the definitions of different words
used in the Act.
29.2

CONSTITUTIONAL VALIDITY OF THE ACT

The constitutional validity of the Act was challenged by the Delhi
High Court Bar Association before the Delhi High Court. The Delhi
High Court decided the law to be unconstitutional, void and hit by
Article 14 of the Constitution. The High Court held that the Civil
Courts who are directly under control and superintendence of the
High Court have been deprived of their jurisdiction and, therefore,
it is against the theme of the Constitution and independence of the
judiciary.
However, on appeal in Union of India vs Delhi High Court Bar
Association (2002)4 SCC 274, the Supreme Court decided in favour
of the constitutional validity of the DRT Act. The Supreme Court
observed that the Parliament alone can enact law in regard to
banking business which includes recovery of bank's dues and for
that purpose setting up adjudicatory body like the Banking
Tribunal is valid.
A question of applicability was referred to the Supreme Court
regarding the applicability of this Act to co-operative banks.
However, it was decided that DRT mechanism is not applicable to
dues of Co¬operative banks since the recovery mechanism in those
banks is separate and if working satisfactorily.
29.3

PREAMBLE, EXTENT, COMMENCEMENT, APPLICATION

AND DEFINITIONS
1.

The preamble to the DRT Act describes the Act as, 'An Act to

provide the establishment of tribunals

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for expeditious adjudication and recovery of debts due to banks
and financial institutions and for
matters connected therewith or incidental thereto.'
2.

The Act is applicable to the whole of India except the State

of Jammu & Kashmir. The Act is made
applicable from 24 June 1993, through the DRTs were established
progressively across the country.
The Act is applicable for the debt due to any bank or financial
institution or a consortium of them, when the debt is above Rupees
ten lakh. The Central Government may, by notification make the
Act applicable to such other amount of debt not less than rupees
one lakh. At present there is no notification from the Government
about any other amount of debt less than Rupees ten lakh.
Therefore, the jurisdiction of the DRT Act is to the debt above
Rupees ten lakh.
269
3. Some important definitions as per this Act are as under:
(i) 'Appellate Tribunal'It is a body established for the purpose of
preferring an appeal against the order passed by the tribunal. It is
established under the sub-Section (1) of Section 8 of the Act. (ii)
'Application' means an application made to a tribunal for recovery
of the debt, under section
19. (iii) 'Appointed day' in relation to a tribunal or an appellate
tribunal, means the date on which such
tribunal is established.
(iv) 'Bank' means, a banking company, a corresponding new bank,
i.e., bank commonly known as Nationalised Bank established with

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the Act that Nationalised them, State Bank of India and its
subsidiary bank or a Regional Rural Bank.
(v) 'Chairperson' means a chairperson of an appellate tribunal
appointed under Section 9. (vi) The important definition is about
the 'debt'. As the purpose of the Act is to have faster recovery of
debts due to banks and financial institutions, it is important to
define the debt to decide the jurisdiction of the tribunal under DRT
Act As per the definition given at Section 2(g) the expres¬sion
'debt' shall cover following categories of debts of the banks and
financial institutions: (i) any liability inclusive of interest, whether
secured, (ii) any liability inclusive of interest, whether insecured, or
(iii) any liability payable under a decree or order of any Civil Court
or any arbitration award
or otherwise, or (iv) any liability payable under a mortgage and
subsisting on and legally recoverable on the
date of application.
What constitutes debt has been interpreted by different courts in
many cases. In G.V. Films vs UTI [2000] 100 Compo Cases 257
(Mad) (HC), it was held that payment made by the bank by mistake
is a debt. In the State Bank of India vs S.S. Engineering
Corporation [1998] 1 BC 702 (Mad), it was held, that money
overdrawn from a bank account without any overdraft facility is a
debt recoverable under the DRT Act.
The Supreme Court in United Bank of India vs DRT [1999] 4 SCC
69, held that if the bank had alleged in the suit that the amounts
were due to it from respondents as the liability of the respondents
had arisen during the course of their business activity and the same
was still subsisting, it is sufficient to bring such amount within the

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scope of definition of debt under the DRT Act and is recoverable
under that Act.
However, if an employee commits fraud and misappropriation of
money, the amount recoverable from him is not a debt within the
meaning of DRT Act, Bank of India vs Vijay Ramniklal AIR 1997
Guj. 75.
(vii) 'Financial institution' means a public financial institution
within the meaning of Section 4A of the Companies Act, 1956 and
securitisation and reconstruction company and such other
institutions as the Central Government may, by notification,
specify, (viii) 'Presiding Officer' means the presiding officer of the
Debts Recovery Tribunal appointed
under sub-Section (1) of Section 4.
(ix) 'Recovery Officer' means a recovery officer appointed by the
Central Government for each tribunal under the sub-Section (1) of
Section 7. These officers are appointed under the Act for
implementing the recovery orders passed by the Tribunal.
29.4 LET US SUM UP
There was need to have an effective law for recovery. Prior to this
Act, the recovery laws were found inadequate. Huge assets of the
banks' were involved in recovery because of huge pendency with
270
various courts. Introduction of the NPA norms aggravated the
problems. This affected the financial sector. The Act was
introduced in 1993. Initially, Delhi High Court decided the Act as
constitutionally invalid. Supreme Court then decided the Act as
valid. Applicability to co-operative banks was decided only recently

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by Supreme Court. Preamble to Act states that Act is for
expeditious adjudication and recovery of debts. The Act is
applicable from 24 June 1993 and is applicable to debts above Rs
10 lakh. In this chapter we have seen the definition of words which
are very important and used in the context of this Act.
29.5 KEYWORDS
Unproductive Assets; DRT Act; Presiding Officer; Recovery Officer.
29.6 CHECK YOUR PROGRESS
1. DRT Act is applicable only if the debt recoverable is above Rs.
_.(Rs. 151akh/Rs. 10 lakh)
2.

The debt recoverable through DRT may be secured or

insecured. (True/False)
3.

Overdrawn amount in an account is not a debt recoverable

under DRT Act. (True/False)
4.

If a Civil Court has passed a decree it has to be executed

through that court only and cannot come
to recovery tribunal. (True/False)
29.7

ANSWERS TO 'CHECK YOUR PROGRESS'

1. Rs. 10 lakh; 2. True; 3. False; 4. False.
29.8

MULTIPLE CHOICE TERMINAL QUESTIONS

1. A bank has allowed a current A/c holder an ad hoc overdraft of
Rs. 15 lakh. The amount is due. Whether this is recoverable under
provisions of DRT Act?
(a)

No, as it is not a regular loan.

(b)

No, as only secured loans can be recovered under the DRT

Act.
(c)

Yes, as it is a legally recoverable amount by the bank.

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(d)

Yes, but if the tribunal grants special permission to lodge the

case.
Ans. 1. (c)

incial nally ;ided i and lakh, itext
ESTABLISHMENT OF TRIBUNAL AND APPELLATE TRIBUNAL

kh)
me
e.
STRUCTURE
30.0 Objective
30.1

Introduction

30.2

Establishment of Tribunal

30.3

Composition of Tribunal

30.4 Qualification for Appointment as Presiding Officer and
Term of Office
30.5

Staff of Tribunal

30.6 Establishment and Composition of Appellate Tribunal
30.7

Qualification for Appointment as Chairperson of the

Appellate Tribunal and
Term of Office
30.8 Filling up of Vacancies at Tribunal and Appellate Tribunal

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30.9 Finality of Orders Constituting T