BANKING LAW, NEGOTIABLE AND INSTRUMENTAL ACT

Study Material for B. (5Year) –

VIII Semester

 
 

CONTENTS
UNIT - I
Banking Definition
Commercial Banks
Functions
Systems of Banking
Unit Banking
Branch Banking
Group Banking
Chain Banking
Law Relating to Banking in India
The Banking Regulation Act 1949
Important Questions

UNIT -II
Central Bank - Evolution
Characteristics
Functions of Central Bank
The Reserve Bank of India
Objectives of RBI
Organizational Structure
Legal Status and Functions
Important Questions

UNIT -III
Lending by Banks
Principles of Good Lending
Guarantee
Kinds of Guarantee
Surty's Rights and Liabilities
Debt Recovery Tribunals (DRT)
Important Questions

UNIT - IV
Merchant Banking in India
SEBI (Merchant Banker) Regulations 1992
Letter of Credit and Defend Guarantee

 
 

Negotiable Instruments Act 1881

Kinds of Negotiable Instruments
Holder and Holder in Due Course
Important Questions References

UNIT - V
Negotiable Instruments Act 1881
Negotiation
Presentment
Discharge from Liability
Dishonour
The Paying Banker
The Collecting Banker
Customer-Bank Relationship

Important Questions
Suggested Readings

 
 

UNIT - I

BANKING- DEFINITION

According to some economists, the word 'Bank' has been derived from the German word 'BANC' which
means a joint stock firm. But some other economists say that it has been derived from the Italian word
'BANCO' which means a heap or mound. As the matter of fact, at the time of establishment of Bank of
Venice in 1157, the Germans were influential and hence, perhaps the word Banc or 'Banco' was used by
Italians to denote the accumulation of securities or money with a joint stock firm which later on with the
passage of time came to be known as 'Bank'.

There is still another group of people who believe that the word 'Bank' has been derived from the Greek
word 'BANQUE' which means a bench. In the older days, when Jews started their money transactions
business as bankers they started using a bench for sitting and if they were not able to pay their obligations,
the bench would be broken into pieces and he was taken as Bankrupt. Thus, both the words Bank or
Bankrupt are said to have their origin from the word 'Banque'.

Definitions: First of all we discuss the definition given under Banking Regulation Act 1949.
Sec. 5 (b) "Banking" means the accepting for the purpose of lending or investment, of deposit of money
from public, repayable on demand or otherwise, and withdraw able by cheque, draft, order or otherwise.

According to, Sir John Paget "No person or body, corporate or otherwise, can be a banker who does not
(1) take deposit accounts (2) take current account (3) issue and pay cheque and (4) collect cheques,
crossed and uncrossed, for his customers."

This definition denotes only the essential feature of Banking company stead of Banking. 'Banking
company' means that which transacts the business of banking in India.

Explanation: Any company which is engaged in the manufacture of goods or carries on any trade and
which accepts deposits of money from the public merely for the purpose of financing its business; as such
manufacturer or trader shall not be deemed to transact the business of banking within the meaning of this
clause. (Sec 5c of Banking Regulation Act 1949)

Forms of Business in which banking company may engage:

According to sec 6, the following business may be undertaken by a banking company -

a) The following functions form the bulk of a bank's activities and are called its main functions:
I. The borrowing, raising or taking of money;
II. The lending or advancing of money either upon security or without security;

III. The drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of
exchange, hundis, promissory notes, coupons, drafts, bills of lending, railway receipts, warrants,

 
 

debentures, certificates, scripts and other instruments and securities whether transferable or
negotiable or not;

IV. The granting and issuing of letters of credit, travellers' cheques and circular notes;

V. The buying, selling and dealing in bullion and species;

VI. The buying and selling of foreign exchange including foreign bank notes;

VII. The acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares,
debentures, debenture stock, bonds, obligations, securities and investments of all kinds;

VIII. The purchasing and selling of bonds, scrips and other forms of securities on behalf of constituents
or others;

IX. the negotiating of loans and advances;

X. The receiving of all kinds of bonds, scrips and other forms of securities on behalf of constituents
or others;

XI. The providing of safe deposit vaults; and

XII. The collecting and transmitting of money and securities.

b) It may act as an agent of the Government, local authority or person and can carry on agency business
but it cannot act as secretary and treasurer of a company.

c) It may contract for public and private loans and negotiate and issue the same.

d) It may effect, insure, guarantee, underwrite, participate in managing and carrying out of any issue of
State, municipal or other loans or of shares, stock, debenture stock of companies and may lend money
for the purpose of any such issue.

e) It may carry on and transact every kind of guarantee and indemnity business.
f) It may manage, sell and realise any property which may come into its possession in satisfaction of its
claims.

g) It may acquire and 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) It may undertake and execute trusts.

i) It may undertake the administration of estate as executor, trustee or otherwise.

 
 

j) It may establish, support and aid associations, institutions, funds, trusts, etc., for the benefit of its
present or past employees and may grant money for charitable purposes.

k) It may acquire, construct and maintain any building for its own purpose.

l) It may sell, improve, manage, develop, exchange, lease, mortgage, dispose of all or any part of the
property and rights of the economy.

m) It may 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 Sec. 6(1).

n) It may do all such things which are incidental or conducive to the promotion or advancement of the
business of the company.

o) It may undertake any other form of business which the Central Government may specify as a form of
business in which it is lawful for a banking company to engage.

COMMERCIAL BANKS

Meaning: A Banking company is one which transacts the business of banking which means the accepting
for the purpose of lending all investments, of deposits of money from the public, repayable on demand or
otherwise and withdrawble by cheque, draft or otherwise.

The discussion in the preceding pages indicate that commercial banks provide useful services in all walks
of life. They function as a catalytic agent for bringing about economic, industrial and agricultural growth
and prosperity of the country. The banking can therefore be conceived as a 'a sector of economy on the
one hand and as a lubricant for the whole economy on the other'.

FUNCTIONS
The functions of the commercial banks are now wide and diverse. They have assumed great significance
in the role of an agent for economic renaissance and social transformation because of their vital role in
mobilization of resources well as their deployment for meeting the said objectives. They are no longer
considered as institutions only for affluent sections of the population. They have acquired broad base and
have emerged as effective catalytic agents of social economic change.

In order to understand better the functions of commercial banks, it will be better to study them under the
following two categories.

(I) Primary Functions of commercial Banks.

(II) Secondary Functions of commercial Banks.

I. Primary Functions of Commercial Banks

The primary functions of commercial banks are: (i) Accepting of deposits, and (ii) Lending of money.

 
 

Accepting of Deposits: Deposits are an important source of a banks funds. They can broadly be classified
into three categories.

(a) Savings Deposits: These deposits are of small amounts and are accepted by banks to encourage
persons of small means to make savings; frequent withdrawals are not allowed.
(b) Fixed Deposits: These deposits are made with the banks for fixed periods specified in advance.
They are also known as term deposits.

(c) Current Deposits: These deposits are repayable on demand. The banks undertake the obligation
of paying all cheques drawn against these deposits by the customers till they have adequate funds
of the customer. The banks usually do not pay any interest in respect of such deposits. These
deposits accounts are usually kept by large business houses.

Lending of Money: A major portion of the deposits received by a bank is lent by it. This is also the
major source of a bank's income. However, lending money is not without risk and, therefore, a banker
must take proper precautions in this process. The lending may be in any of the following forms:

(a) Loan: It is a kind of advance made with or without security. It is given for a fixed period at an
agreed rate of interest. The amount of loan is usually credited to the credit of the customer's
account who may withdraw from there as per his requirements. The loan may be secured or
unsecured.

(b) Cash Credit: It is an arrangement by which a banker allows his customer to borrow money upto
a certain limit against security of goods.

(c) Overdraft: It is an arrangement whereby a customer has been allowed temporarily to overdraw
his current account. It is without any security.

(d) Discounting and Purchasing of Bills: Time bills are discounted while demand bills are
purchased by the banks. In both the cases the banks credit the account of their customers by the
amount of bills less any discount or commission charged for such discounting or purchasing of
the bills.

Thus, commercial banks render a unique service by tapping savings from a wide spectrum of people and
lending to those who really need and use them for various productive purposes. They play an active and
not a passive role in the economic development of the country.

Secondary Functions of Commercial Banks

These functions can be classified into the following two categories:

(a)Agency Service: In many cases the commercial banks act as the agents of their customers.
As agents they provide the following services:

 
 

(i) Collection of drafts, bills, cheques, dividend etc. on behalf of customers.

(ii) Execution of standing orders of the customers viz-payment of subscription, rent, bills, promissory
notes, insurance premium etc.

(iii) Conducting stock exchange transactions i.e., purchasing and selling of securities for the
customers.

(iv) Acting as a correspondent on representative of customers, other banks and financial corporations.

(v) Functioning as an executor, trustee or administrator of an estate of a customer.

(vi) Preparation of income tax return, claiming of tax refunds and checking of assessments on behalf
of the customers.
(b) General Utility Services: Commercial banks provide a variety of general utility services viz.
issue of letters of credit, travelers cheques, accept valuables for safe custody, acting as a referee
as to the respectability and financial standing of the customers, providing specialized advisory
services to customer, issue of credit cards, providing of information through regular bulletins
about general trade and economic conditions both inside and outside the country etc.

With the opening up of the insurance sectors, banks can now take up insurance business. In the discussion
paper issued by the RBI in 1999, it was stated that insurance comes within the scope of universal banking.
The term universal banking refers to the combination of commercial banking and investment banking. In
other words universal banks refer to those banks that offer a wide range of financial services beyond
commercial banking and investment banking such as Insurance. However, as per the guidelines issued by
the Reserve Bank of India, banks are not allowed to conduct insurance business departmentally. They
cannot also set up separately subsidiary companies for this purpose. However, they can set up joint
venture companies for insurance as per government or insurance regulatory and development authority
guidelines and with prior permission of Reserve Bank of India.

SYSTEMS OF BANKING
UNIT BANKING

Unit banking is a system where the operations of a bank are confined to a single office located in a
particular area. A unit bank has virtually no branches. In order to provide facilities to its customers in
remittance and collection of funds, a unit bank resorts to correspondent banking system. In case of this
system small banks serving small communities place deposits in nearby city banks which in turn hold
deposits in giant banks located in giant cities. The gaint banks also hold reciprocal deposits of one
another. Consequently, every bank gets connected directly or indirectly with each other and it can safely
make payment on behalf of other banks.

Branch Banking is a system where a bank with a network of branches throughout the country carries out
its banking operations. Sometimes branches are also opened outside the country. However, small banks
may like to restrict their branches or offices to a certain region of the country.

 
 

Features: The main features of branch banking system are as follows:

(i) The bank is owned by a group of shareholders and controlled by a single Board of Directors.

(ii) The bank has a central office popularly termed as the Head Office of the bank which controls the
operations of different branches.

(iii) Each branch is managed by a branch manager who manages the affairs of the branch as per the
directives and policies of the Head office.

(iv) For external reporting the assets and liabilities of the branches and the Head Office are
aggregated.

The branch banking system which developed in England is prevalent in most countries of the world
including Australia, Canada, South Africa, India, Pakistan etc. In India the public sector banks,
numbering 27 in all have more than 90% of the branches of all commercial banks. The also control more
than 90% of the banking business in all.

Advantages of Brach Banking: The protagonist of branch banking put forward the following arguments
in favour of branch banking:

1. Economies of Scale: In case of branch banking the level of operations is quite large as compared
to unit banking. As such the cost per unit of service in case of the former is lower as compared to
the latter. Moreover, under branch banking system it is possible to hire more competent and
qualified staff and have better division of work resulting in increase in overall efficiency.

2. Lower Cash Reserves: A large bank with a number of branches can manage its business with
lower cash reserves since each of its branch can draw upon the resources of another branch or
branches, if an emergency arises. However, a unit bank cannot confidently depend upon the
resources of another unit bank. Hence, it may be required to keep higher cash reserves to run its
operations smoothly.

3. Diversification of Risk: In branch banking industrial as well geographical diversification of loan

risks is possible. As a result the loss suffered by branches on account of fall in industrial activity
in a particular area may be more than compensated on account of profit made by branches in
areas where there may be boom in business and industrial activity. This is not possible in case of
unit banking where a bank is having its operation only in a particular area.

4. Better Customer Service: Branch banking provides better service to customers in remittance and
collection of funds. Moreover, the objective of opening branches is to take banking service to the
doors of the people who need them. Thus, service is cheap as well as convenient. Each branch has
to handle a limited number of customers of the locality, hence the branch manger can personally
look to their problems.

 
 

5. Greater Mobility of Capital: Branch banking permits better mobility of capital and thus bring
more uniformity in interest rates. Surplus funds can be transferred from one area to another with
convenience and speed and thus bring equilibrium in demand and supply of funds resulting in
better returns to the investors.

6. Safety of Loans: While lending money, the branches of banks follow the policies as laid down
by their Head office. The chances of favouritism are therefore reduced to the minimum.
Moreover, loans beyond a particular limit are to be approved by the Head Office as per the
prescribed procedure. This all ensured safety of loans and reduces the chances of banks suffering
losses due to bad loans.

7. Emergence of Strong and Solvent Banks: Branch banks have large resources, better
management; and greater diversification of risk. All this results in emergence of strong and
solvent banks. The chances of bank failures are reduced to the minimum.

Disadvantages of Branch Banking: The protagonists of unit banking raise the following objections
against branch banking:

1. Individual Needs Ignored: In case of branch banking the branches are guided by the policies
laid down by the Head Office which is quite unaware of the individual needs. The Branch
Manager has not much role to play, while a unit bank operates only in a limited area and hence it
is possible for it to take personal care of the individual needs of each of its customers.

2. Red Tapism: In branch banking, a branch manager is required to take the instructions of the
Head office from time to time. He cannot take several decisions at this level. Thus, there is bound
to be red tapism and delay in processing loan applications etc. In unit banking all matters are
decided at the unit bank level itself. Thus, there is quicker and better service.

3. Lack of Effective Control: In case of branch banking, the banks sometimes become
unmanageable due to large increase in the number of branches. As a result, the control gets
slackened and it increases the chances of frauds and manipulations.

4. Local Needs Ignore: Branch banks do not have attachment with a particular place. Branch
managers are also not local people. They are subject to frequent transfers. The funds collected
from local sources may be used for meeting the requirements of other places where the bank may
find the investment more lucrative. Thus, local needs are not given that much of attention in case
of branch banking as is done in case of unit banking.

5. Failure of Banks: In branch banking unremunerative and inefficient branches continue to exist at
the expense of remunerative and efficient branches. In case this practice goes too far, it may cause
failure of banks having repercussions throughout the country.

 
 

6. Concentration of Economic Power: The branch banks have huge resources raised from a wide
spectrum of people. The Boards of Directors of these banks, therefore, possess immense
economic power which they may use for promoting their own business interests. It may thus
cause concentration of economic power in a few hands. As a matter of fact, this was one of the
important reasons for the first phase of nationalisation of 14 major commercial banks in India.

Here we have explained the advantages and disadvantage of branch banking versus unit banking. A close
perusal of the disadvantages of branch banking show that they are not too serious as they are made out to
be. Proper orientation of lending policies, delegation of authority at different levels and proper fixation of
priorities can improve the matter. As a matter of fact, branch banking is the logical development of
growth of banking industry in any country.

Group Banking and Chain Banking

Chain Banking and Group Banking are the outcome of unit banking system devised to avail some of the
advantages of branch banking system. They are both common in United State of America.

GROUP BANKING
It is a system where two or more banks are controlled by a holding company. Thus, group banking is
similar to chain banking except with the difference that instead of an individual or group of individuals or
members of family, an incorporated company having a separate legal entity holds majority of the voting
power in the companies of the group. Such holding company mayor may not be engaged in the banking
business.

CHAIN BANKING

Chain Banking is a system where an individual or group of individuals or members of a family control the
operations of two or more banks. The control is exercised either through holding majority of shares in
each bank or inter-locking directorships. However, each bank retains its individual entity.

Chain banking or group banking brings the advantages of pooling of resources, economies of scale and
reducing idle cash balances etc., to the member banks. However, it has the disadvantages of lack of
effective control over member units, and misutilisation of resources of the member units particularly by
the holding company. Moreover, it leads to concentration of economic power in a few hands. Due to these
disadvantages, the system of chain banking or group banking is considered to be unworthy of adoption.

LAW RELATING TO BANKING IN INDIA

THE BANKING REGULATION ACT
The Banking Regulation Act came into effect on 16 March, 1949 and applies to the whole of India.

Scheme of the Act: The Banking Regulation Act, 1949 has been divided into the following parts:

Part I Preliminary (Section 1 to SA)

Part II Business of Banking Companies (Section 6 to 36A)

 
 

Part II A Control over Management (Sections 36AA to 36AC)

Part II B Prohibition of certain activities in relation to Banking companies (Section 36AD)
Part II C Acquisitions of the undertakings of Banking companies in certain cases (Sections 36 AE
to 36 AJ)
Part III Suspension of Business and Winding up of Banking Companies (Sections 36B to 45)
Part III A Special provisions for speedy disposal of winding up proceeding (Section 45A to 45X)
Part III B Miscellaneous Section (46 to 55A)
Part IV Application of the Act to cooperative Banks (Sections 56, effective from 1st March,
1966).

General Provisions
Definition

Banking: According to Section 5(b) of the Act 'banking' means: "the accepting for the purpose of lending
or investment of deposits of money from the public repayable on demand or otherwise, and withdrawable
by cheque, draft, order or otherwise."

The chief characteristics of banking business are:

i) There should be acceptance of deposits: Generally, when a mounts are borrowed on condition
that they should be repaid on the expiry of a term, they are regarded as loans rather than
deposits. In case of deposits, the liability to repay arises only when a demand for repayment
has been made.
ii) Deposits should be from the public.
iii) Repayable on demand or otherwise.
iv) Withdrawable by Cheque, draft order or otherwise: Withdrawal may be permitted in any
other form ego a request may be made to transfer funds from one account to some other
account.
v) Purpose of Acceptance of Deposits: The purpose of accepting deposit should be 'lending' or
'investment' .

Banking Company ['Sec. 5(c)]: Banking company means "any company which transacts the business of
banking in India"

Banking policy [Section 5(ea)]: Banking policy means any policy which is specified from time to time
by the Reserve Bank in the interest of the banking system or in the interest of monetary stability or sound
economic growth, having due regard to the interests of the depositors, the volume of deposits and other
resources of the bank and the need for equitable allocation and the efficient use of these deposits and
resources.

"Branch" or "Branch Office" [See 5(cc)]: Branch or branch office in relation to banking company,
means any branch or branch office, whether called a pay office or sub pay office or by any other name, at
which deposits are received, cheques cashed or moneys sent.

 
 

Company [See 5(d)]: Company means any company as defined in section 3 of the Companies Act 1956,
and includes a foreign company within the meaning of section 591 of that Act.
According to section 3 of the companies Act, "company means a company formed and registered under
this Act or an existing company".

'Demand' and 'Time' Liabilities [Sec. 5(f)]: 'Demand' liabilities means liabilities which must be met on
demand, and 'Time' liability means liabilities which are not demand liabilities.

Secured Loan or Advance [Sec. 5(n)] : 'Secured loan or advance' means a loan or advance made on the
security of assets the market value of which is not at any time less than the amount of such loan or
advance and "unsecured loan or advance" means a loan or advance not so secured.

Banking may engage in the following forms of business (Sec. 6)

a) The main functions of a bank include:

i) Borrowing raising or taking up of money.
ii) Lending or advancing secured or unsecured loan
iii) The drawing, making, accepting, discounting, buying, selling, collecting and dealing in
negotiable instruments.
iv) The granting and issuing of letters of credit, travellers cheques and circular notes.
v) Providing of safe deposit vaults.
vi) Negotiating of loans and advances.

b) Acting as an agent for any government or local authority or any other person or persons.

c) It may carry on and transact every kind of guarantee and indemnity business.

d) It may carry on any other form of business which the central government may, by notification in the
official gazette, specify as a form of business in which it is lawful for a banking company to engage.

Requirements as to Minimum Paid up Capital and Reserves (Sec. 11): As per the amendment in
1961, a banking company commencing business after the coming into force of the Banking Companies
(Amendment) Act, 1962, shall have a paid up capital of not less than RS.5 lakhs irrespective of the
number of places of its business.

A banking company incorporated outside India shall deposit with the Reserve Bank either in cash or in
the form of unencumbered approved securities or partly in cash and partly in the form of such securities:

i) An amount which shall not be less than the minimum required as above.
ii) As soon as may be after the expiration of each calendar year, an amount calculated at 20% of its
profit for that year in respect of all business transacted through its branches in India, as disclosed
in the profit and loss account prepared with reference to that year under section 29.

 
 

Reserve Fund (Sec. 17) : Every banking company incorporated in India is required to transfer at least
20% of its profits of each year, prior to the declaration of dividend to the Reserve fund.

Management and Control

Restrictions regarding Employment of Managerial Personnel; Restrictions on certain forms of
Employment (Sec. 10)

A banking company shall not employ or continue the employment of any of the following persons:
i) Who is or at any time has been adjudicated insolvent or has suspended payment or has
compounded with his creditors, or who is or has been convicted by a criminal court of an
offence involving moral turpitude.

ii) Whose remuneration or part of whose remuneration takes the form of commission or of a
share in the profits of the company. However, the above provision shall not apply to the
payment by a banking company of:

a) any bonus in pursuance of settlement or award arrived at or made under any law relating to
industrial disputes or in accordance with any scheme framed by such banking company or in
accordance with the usual practice prevailing in banking business.

b) Any commission to any broker, cashier, contractor, clearing and forwarding agent, auctioneer or
any other person, employed by the banking company under a contract otherwise than as a regular
member of the staff of the company.

iii) Whose remuneration is, in the opinion of the Reserve Bank, excessive.
iv) A banking company shall not be managed by a person
v) Who is Director of any other company; or
vi) Whose term of office as a person managing the company is for a period exceeding 5 years at one
time.
Provided that, the term of office of any such person may be renewed or extended by further periods not
exceeding 5 years on each occasion, subject to the condition that such renewal or extension shall not be
sanctioned earlier than 2 years from the date on which it is to come into force.

Constitution of Board of Directors (Sec. 10A): It provides that not less than 51 % of the total number of
members on the Board of Directors of a banking company shall consist of persons who satisfy the
following conditions:

1) They shall have special knowledge or practical experience in respect of one or more of the following
matters, namely:

i) Accountancy
ii) Agriculture and rural economy

 
 

iii) Banking
iv) Cooperation
v) Economics
vi) Finance
vii) Law
viii) Small scale industry
ix) any other matter the special knowledge or practical experience in which would, in the opinion of
the Reserve Bank, be useful to the banking company.

2) They shall not:

a) have substantial interest in, or be connected with, whether as employees, managers of :
i) any company, not being a company registered u/s 25 of the companies act 1956, or
ii) any firm, which carries on any trade, commerce or industry and which, in either case is not a
small scale industrial concern, or
b) be proprietors of any trading, commercial or industrial concern, not being a small scale industrial
concern.

Where the Reserve bank is of opinion that the composition of the Board of Directors of a
banking company is such that it does not fulfill the above requirements, it may, after giving to such
banking company a reasonable opportunity of being heard, by an order in writing, direct the banking
company to re-constitute its Board of Directors as to ensure that the said requirements are fulfilled. If
within two months from the date of receipt of that order, the banking company does not comply with
the directions made by the Reserve Bank, the Reserve Bank may remove such persons from the Board
who do not satisfy the requirements prescribed and appoint suitable persons to fill in the vacancies so
caused.

Moreover, a director of a banking company, other than its Chairman or whose time director cannot hold
offence continously for a period exceeding 8 years.

Chairman (Sec.10B)

Every banking company shall have one of its directors as a whole time or a part time chairman. The
chairman shall exercise his power subject to the superintendence, control and direction of the Board of
Directors.

Where a chairman is appointed on a part time basis, the following additional provisions shall be
applicable:

i) Such appointment shall be with the previous approval of the Reserve Bank and subject to
such conditions as the Reserve Bank may specify while giving such approval.

 
 

ii) The management of whole of affairs of such a banking company shall be trusted to a
managing director who shall exercise his powers subject to the superintendence, control and
direction of the Board of Directors.

A whole time chairman or a managing director of a banking company shall hold office for such
period not exceeding 5 years as the Board of Directors may fix. However, he shall be eligible for re-
election or re-appointment.

A person shall be disqualified for being a whole time chairman or a managing director of a banking
company if he:

a) is a director of any company other than (i) a company which is subsidiary of the banking
company, (ii) a company registered u/s 25 of the Companies Act.
b) is a partner of any firm which carries on any trade, business or industry, or
c) has substantial interest in any other company or firm, or
d) is a director, manager, partner or proprietor of any trading, commercial or industrial concern, or
e) is engaged in any other business or vocation.

Prohibition of Common Directors (Sec. 16): A banking company incorporated in India:

a) cannot have as a director in its board of directors any person who is a director of any other
banking company, and

b) cannot have in its board of directors more than 3 directors who are directors of companies which
among themselves are entitled to exercise voting rights in excess of 20% of the total voting rights
of all the share holders of that banking company.

Loans and Advances Restrictions on Loans and Advances (Sec. 20): A banking company shall not:
a) grant any loans or advances on the security of its own shares, or
b) enter into any commitment for granting any loan or advance to on behalf of
i) any of its director
ii) any firm in which any of its directors in interested as partner, manager, employee or
guarantor, or
iii) any individual in respect of whom any of its directors is a partner or guarantor.

Remission of Debts (Sec. 20A): A banking company cannot, except with the approval of the Reserve
Bank remit in whole or in part any debt due to it by :

a) Any of its directors, or

b) any firm or company in which any of its directors is interested as director, partner, managing
agent on guarantor, or
c) any individual if any of its directors is his partner or guarantor.

Assets of a Banking Company

 
 

Maintenance of Liquid Assets (Sec. 24): Every banking company is required to maintain in India in
cash, gold or unencumbered approved securities, valued at a price not exceeding the current market price,
an amount which shall not at the close of business on any day be less than 25% of the total of its time and
demand liabilities in India.

This is known as statutory liquidity ratio (SLR). The Resene Bank has the power to increase this ratio up
to 40% and thus compel the banking company to maintain a larger portion of their liabilities in liquid
form.

Assets in India (Sec. 25): The assets in India of every banking company at the close of business on the
last Friday of every quarter or, if that Friday is a public holiday under the Negotiable instruments Act,
1881, at the close of the business on the preceding working day, shall not be less than 75%, of its demand
and time liabilities.

Monthly Returns [Section 27(1)]: Every banking company is required to submit to the Reserve Bank
before the close of the month succeeding that to which it related, a return in the prescribed form and
manner showing its assets and liabilities in India at the close of business on the last Friday of every month
or if that Friday is a public holiday under the Negotiable Instruments Act, 1881, at the close of the
business on the preceding working day.

Powers of the Reserve Bank

1. Election of New Directors (Sec. 12A): The Reserve bank may, by order, require any ban king
company to call a general meeting of the shareholders of the company within such time, not less
than 2 months from the Date of the order, as may be specified in the order or within such further
time as the Reserve bank may allow in this behalf, to elect, in accordance with the voting rights
permissible under this Act, fresh directors.

2. Cash Reserve (Sec. 18): Under Section 42 of the Reserve Bank of India Act, every scheduled
bank has to maintain a sum equal to at least 3% of its time and demand liabilities in India as cash
reserve with the RBI. The Reserve bank has the power to increase the percentage up to 20% by a
notification in the government Gazette.

3. Licensing of Banking companies (Sec. 22): Prior to granting license to a banking company, the
Reserve bank may require to be satisfied by an inspection of the books of the banking company
or all or any of the following conditions should be fulfilled, namely:

a) What the company is or will be in a position to pay its present or future depositors in full as they
become due
b) That the affairs of the company are not being, or are not likely to be conducted in a manner
detrimental to the interest of the depositors.
c) In the case of a company incorporated outside India that the carrying on of banking business by
such company in India will be in the public interest and that the government or law of the country

 
 

in which it is incorporated does not discriminate in any way against banking companies registered
in India.

Cancellation of the License: The license of any banking company may be cancelled by the Reserve
Bank due to the following reasons:
i) If the company ceases to carry on banking business in India; or
ii) If any of the conditions imposed by the Reserve bank are not fulfilled.

Any banking company aggrieved by the decision of the Reserve bank cancelling a license may, within
thirty days from the date on which such decision is communicated to it, appeal to the central government.

4) Opening of New and Transfer of Existing place of Business (Sec. 23): Without obtaining prior
approval of the Reserve Bank:

a) No banking company shall open a new place of business in India or change otherwise than within
the same city, town or village, the location of an existing place of business situated in India.

b) No banking company incorporated in India shall open a new place of business outside India or
change, otherwise than within the same city, town or village in any country or area outside India,
location of an existing place of business situated in that country or area.

The permission of the Reserve bank is not necessary where a banking company opens a temporary place
of business for a period not exceeding one month, within a city, town or village within which the
company has already a place of business, for the purpose of affording the banking facilities to the public
on the occasion of an exhibition, a conference or a mela or any other like occasion.
5) Power to call for information relating to the business of any banking company [Sec. 27(2)] : Sec.
28 gives power to the Reserve Bank to publish such information if it considers it proper to do so in the
public interest.

The Reserve bank can at any time a banking company to furnish within the specified time, with such
statements and information relating to business of the banking company as the Reserve bank may
consider necessary.

6) Power of Inspection (Sec. 35) : The Reserve Bank may at any time, and shall at the direction of the
central government inspect a banking company and its books and accounts to find out whether or not the
affairs of the banking company are conducted in the interest of the depositors.
The central government may after giving reasonable notice to the banking company, publish the report
submitted by the Reserve Bank of such portion thereof as may appear necessary

7) Power to give Directions (Sec. 34) : The Reserve Bank may from time to time issue directions to
banking companies generally or to any banking company particularly. The Reserve Bank shall do so
when it deems it necessary to issue such directions :
a) in the public interest; or
b) to secure the proper management of any banking company generally.

 
 

c) to prevent the affairs of any banking company being conducted in a manner detrimental to the interest
of the depositors or in a manner prejudicial to the interests of the banking company;

8) Reserve Bank's approval necessary for the amendment of provisions relating to appointment of
managing directors (Sec. 35B) : The appointment or reappointment of a managing or a whole time
director, manager or chief executive officer, by whatever name called, shall not have any effect unless it
is made with the previous approval of the Reserve Bank.

9) Power of Reserve Bank to appoint additional directors (Sec. 36AB) : The Reserve Bank, if
considers necessary for the protection of the interest of depositors, from time to time may appoint
additional directors but the number should not exceed five or one third of the maximum strength fixed for
the Board by the articles whichever is less. Additional directors shall hold office at the pleasure of the
Reserve bank not exceeding three years at a time.

10) Power of Reserve Bank to remove managerial and other persons from office (Sec. 36AA): For
preventing the affairs of the banking company, the Reserve bank may remove any director, chief
executive officer by writing an order the order shall contain reasons for his removal and the date from
which it is effective. Reasonable opportunity should also be given to such a person for explaining his
position before such order is actually passed against him. Such person, within 30 days, can appeal to
central government.

Further powers and functions of the Reserve Bank (Sec. 36)

a) It may on a request being made, assist in a proposal for the amalgamation of banking companies
concerned.
b) It may assist any banking company by means of the grant of a loan or advance to it.
c) It shall make an annual report to the central government on the trend and progress of the banking
in the country. It shall also include in such report its suggestions for the strengthening of banking
business throughout the country.

Accounts and Audit

Profit and Loss Account and Balance Sheet (Sec. 29): At the expiration of each calendar year or at the
expiration of a period of 12 months ending with such date as the central government may, by notification
in official gazette specify in this behalf, every banking company incorporated outside India, in respect of
all business transacted through its branches in India, shall prepare with reference to that year or the
period, as the case may be a balance sheet and a profit and loss account as on the last working day of the
year of the period in the forms set out in the third schedule or as near thereto as circumstances admit :

The balance sheet and profit and loss account shall be signed:

a) In the case of a banking company incorporated in India, by the manager or the principal officer of
the company and where there are more than three directors of the company, by at least three of
those directors, or where there are not more than three directors, by all the directors, and

 
 

b) In the case of a banking company incorporated outside India, by the manager or principal officer
of the company in India.

Audit of Bank Accounts (Sec. 30) : According to Sec. 30, the balance sheet and profit and loss account
prepared in accordance with Sec. 29 shall be audited:
a) In the case of a banking company incorporated in India, by a person duly qualified under any law
for the time being in force to be auditor of companies;

b) In the case of banking company incorporated outside India, either by such an auditor as aforesaid
or by a person duly qualified to be an auditor under the law of the country in which the company
is incorporated.

Submission of Returns (Sec. 32) : The profit and loss account and balance sheet together with the
auditor's report shall be published in the prescribed manner and three copies thereof shall be furnished as
return to the Reserve Bank within 3 months from the last day of the period to which they refer. This
period may, however, be extended by the Reserve Bank by a further period not exceeding 3 months.
Three copies of the profit and loss account and balance sheet together with auditors report shall also be
sent by the banking company to the registrar or companies at the same time when it sends them to the
Reserve bank.

Display of Audited balance sheet by Companies incorporated outside India (Sec. 33): Every banking
company incorporated outside India is required not later than the first Monday in August of every year in
which it carries on business, to display in a conspicuous place in its principal office and in every branch
office in India a copy of its last audited balance sheet and profit and loss account prepared u/s 29.

Production of Document of Confidential Nature (Sec. 34A): A banking company cannot be compelled
by any authority before which any proceedings under the industrial Disputes Act, 1947 are pending to
produce any document or furnish or disclose any statement or information which is of a confidential
nature and the production furnishing or disclosure of which would result in disclosure of information
relating to:

a) any reserves not shown in its published balance sheet; or

b) any particulars not shown therein in respect of provisions made for bad and doubtful debt and
other usual or necessary provisions.

Acquisition of Banking Companies (Sec. 36AC): This section gives power to the central government to
acquire the undertaking of a banking company. It provides that if on receipt of a report the central
government is satisfied that a banking company.

1) Has failed to comply with the directions given to it by the Reserve Bank relating to policy matters
u/s 21 and 35A, or
2) Is being managed in a manner detrimental to the interest of its depositors, and that
a) in the interests of the depositors of such banking company, or
b) in the interest of banking policy, or

 
 

Before acquiring the under taking of any banking company the central government shall give a reasonable
opportunity to the banking company proposed to be acquired of showing cause against the proposed
action.

Suspension, Winding up and Miscellaneous

Suspension of Business (Sec. 37): The high court may, on the application of a banking company which is
temporarily unable to meet its obligations, make an order stating the commencement or continuance of all
actions and proceedings against the company for some period. This temporary suspension of the
enforcement of liability against the banking company is called "Moratorium". The period of
"Moratorium" shall not exceed 6 months in all.

Where the Reserve Bank is satisfied that the affairs of a banking company is respect of which a
moratorium order has been made, are being conducted in a manner detrimental to the interests of the
depositors, it may make an application to the high court for winding up of the company.

Winding up of a Banking Company: A banking company can be wound up like any other company Le.
may be wound up compulsorily or voluntarily or subject to the supervision of the court.

Winding Up by the Court: The high court shall order the winding up of a banking company:

- If the banking company is unable to pay its debts; or

- If an application for its winding up has been made by the Reserve Bank.

A banking company shall be deemed to be unable to pay its debts in the following circumstances:

a) If it has refused to meet any lawful demand made at any of its offices within two working days, if
such demand is made at a place where there is office, branch, or agency of the Reserve bank or
within five working days if such demand is made elsewhere; and

b) If the Reserve Bank certifies in writing that the banking company is unable to pay its debts.

Liquidator: Sec. 38A provides for the appointment of a liquidator by the central government who should
be attached to every high court. He shall conduct all winding up proceedings in the case of winding up of
a banking company by the high court.

Notice to Preferential Claimants and Secured and Unsecured Creditors (Sec. 41 A) : The official
liquidator shall within 15 days of the winding up order of a banking company, for the purpose of making
an estimate of the debts and liabilities of the banking company (other than its liabilities and obligations to
depositors), serve a notice on the following persons:

1. Every claimant entitled to preferential payment u/s 530 of the companies act, 1956.
2. Every secured and every unsecured creditor.

 
 

The notice shall require each claimant to send to the official liquidator within one month from the date of
service of the notice, a statement of the amount claimed by him.

Preferential Payment of Depositors (Sec. 43A) : After making the adequate provisions for preferential
payments, the liquidator shall pay within 3 months, to depositors in the following order:

a) In the first place, to every depositor in the savings bank account of the banking company a sum of
two hundred and fifty rupees or the balance at his credit, whichever is less and thereafter.
b) In the next place to every other depositor of the banking company a some of two hundred and
fifty rupees or the balance at his credit, whichever is less, in priority to all other debts from out of
remaining assets of the banking company available for payment to general creditors. But the sum
total of the amounts paid under clause (a) and clause (b) to anyone person who in his own name
(and not jointly with any other person) is a depositor in the savings bank account of the banking
company and also a depositor in any other account, shall not exceed the sum of two hundred and
fifty rupees.

Powers of the High Court in Voluntary Winding up (Sec. 44): A banking company cannot be
voluntarily wound up unless the Reserve bank certifies in writing that the company is able to pay all its
debts to its creditors as they accrues.

Where a banking company is being voluntarily wound up, the high court may:

a) make an order that the voluntary winding up shall continue but subject to the supervision of the
court, or

b) order for the winding up of the company by the high court if at any stage during the voluntary
winding up proceedings, the company is not able to meet its debts as they accrue; or voluntary
winding up cannot to continued without detriment to the interests of the depositors.

Amalgamation of Banking Companies (Sec. 44A): No banking company can amalgamate with another
banking company unless a scheme containing the terms of such amalgamation has been placed in draft
form before the shareholders of each of the banking companies concerned separately, and approved by a
resolution passed by a majority in number representing two thirds in value of the shareholders of each of
the said companies. If the scheme of amalgamation is approved by the requisite majority of shareholders
in accordance with the provisions of this section. If the scheme is sanctioned by the Reserve bank by an
order in writing it shall be binding on the banking companies concerned and also on all the shareholders
thereof.

Restrictions on Compromise or Arrangement (Sec. 448): No high court can sanction a compromise or
arrangement between a banking company and its creditors or shareholders unless the compromise or the
arrangement is certified by the Reserve bank as not being incapable of being worked and as not being
detrimental to the interest of the depositors of such banking company.

 
 

Power of the Reserve Bank to apply to the Central government for suspension of business by a banking
company and to prepare scheme of reconstruction or amalgamation (Sec. 45) - The central government
may, after considering the application of the Reserve Bank, make an order of moratorium for period not
exceeding six months in all.

During the period of moratorium if the Reserve Bank is satisfied that -

1. in the public interest, or

2. in the interest of depositors or
3. in the order to secure the proper management of the banking company or
4. in the interest of the banking system as a whole it is necessary so to do, the reserve bank may
prepare a scheme
i) for the reconstruction of the banking company or
ii) for the amalgamation of the banking institution with other banking institution.

The scheme of amalgamation of reconstruction, may contain provisions for all or any of the following
matters:
a) The constitution, name and registered office, the capital, assets, powers, rights, interests,
authorities, the abilities, duties and obligation of the banking company.

b) Any change in the Board of Directors or the appointment of a new Board of Directors, of the
banking company.

c) The alteration of memorandum and articles of association of the banking company.

d) The continuance of the services of all the employees of the banking company, excepting those
mentioned in the scheme, at the same remuneration and on the same term and conditions:

A copy of the scheme prepared by the Reserve Bank shall be sent in draft to the banking company and
also to the transferee bank and any other banking company concerned in the amalgamation for
suggestions and objections, if any, within such period as the Reserve Bank may specify for this purpose.
Special Provisions for Speedy Disposal of Winding up Proceedings (Sec. 45A to 45X): The main
provisions are as follows:

Power of the High Court to Decide all Claims (Sec. 458 and 45C): Where any legal proceedings are
pending against the banking company in respect of which high court has the jurisdiction, in any court on
the date of the winding up order, they will be stayed. The official liquidator shall submit to the high court,
within three months from the date of the winding up order the details of all such pending proceedings.

On receipt of such a report the high court may give the parties concerned an opportunity to show cause
why the proceedings should not be transferred to itself. In case the high court decides to transfer to itself
the pending proceedings, they shall be disposed of by the high court.

 
 

Settlement of the List of Debtors (Sec. 450): The high court may settle in, the following manner the list
of debtors of a banking company which is being wound up :

1. The official liquidator shall, within six months from the date of the winding up order, from time
to time file to the high court a list of debtors.

2. On receipt of such a list the high court shall, wherever necessary, cause notices to be issued on all
persons affected and after making an enquiry it shall make an order settling the list of debtors.

3. At the time of settlement of any such list the high court shall pass an order for the payment of
amount due by each debtor.

4. Every such order shall, subject to the provisions for appeal, be final and shall be deemed to be a
decree in a suit.

Calls on Contributories (Sec. 45E): The high court may, if necessary, at any time after making a
winding up order, make a call on and order payment thereof by any contributory under Sec. 470(1) of the
Companies Act, 1956, if such contributory has been placed on the list of contributories by the official
liquidator and has not appeared to dispute his liability.

Nomination of Deposit Accounts and Lockers

Nomination for Payment of Depositor's Money (Sec. 452A):

1. Where a deposit is held by a banking company to the credit of one or more persons, the depositor
or, as the case may be, all together, may nominate, in the prescribed manner, one person to whom
in the event of the death of the sole depositor or the death of all the depositor, the amount of
deposit may be returned by the banking company.

2. Where the nominee is a minor, it shall be lawful for the depositor making the nomination to
appoint in the prescribed manner any person to receive the amount of deposit in the event of his
death during the minority of the nominee.

3. Payment by a banking company in accordance with the provision of this section shall constitute a
full discharge to the banking company of its liability in respect of the deposit.

Notice of Claims of other persons Regarding Deposits not Receivable (45ZB): No notice of the claim of
any person, other than the person or person in whose name a deposit is held by a banking company, shall
be receivable by the banking company nor shall the banking company be bound by any such notice even
though expressly given to it.

Nomination for return of articles kept in safe custody with Banking company (45ZC) : No notice of the
claim of any person other than the person or persons in whose name a deposit is held by a banking

 
 

company, shall be receivable by the banking company nor shall the banking company be bound by any
such notice even though expressly given to it.

Nomination for Return of Articles Kept in Safe Custody with Banking Company (45ZC)
1. Where any person leaves any article in safe custody with a banking company, such person may
nominate, in the prescribed manner one person to whom in the event the death of the person
leaving the article in safe custody, such article may be returned by the banking company.

2. Where the nominee is a minor, it shall be lawful for making the nomination to appoint in the
prescribed manner any person to receive the article deposited in the event of his death during the
minority of the nominee.

3. The banking company shall before returning any articles under this section to the nominee or the
person appointed under sub section (2), prepare, in such manner as may be directed by the
Reserve Bank from time to time, an inventory of the said articles which shall be signed by such
nominee or person and shall deliver a copy of the inventory so prepared to such nominee or
person.

Release of Contents of Safety Lockers (45ZE)

1. Where an individual is the sole hirer of a locker from a banking company, whether such locker is
located in the safe deposit vault of such banking company, or elsewhere, such individual may
nominate one person to whom, in the event of the death of such individuals, the banking company
may give access to the locker and liberty to remove the contents of the locker.
2. Every nomination under sub section (1) or sub section (2) shall be made in the prescribed manner.
3. On the removal of the contents of any locker by any nominee and survivors as aforesaid the
liability of the banking company in relation to the contents of the locker shall stand discharged.
4. No suit, prosecution or other legal proceedings shall lie against a banking company for any
damage caused or likely to be caused, for allowing access to any locker, and liberty to remove the
contents of such locker in pursuance of the provisions of sub section (1) or sub section (2), as the
case may be.

Miscellaneous: Some of the miscellaneous provisions dealt in the Banking Regulation Act are discussed
below:

Penalties (Sec. 46) : Some of the penalties prescribed under the Act are as follow:

1. Whoever in any return, balance sheet or other document or in an information required or

furnished by under the Banking Regulation Act, willfully makes a statement which is false in any
material particular, knowing it to be false or willfully omits to make a material statement, shall be
punishable with imprisonment for a term which may extend to 3 years and shall so be liable to
fine.
2. If any person fails to produce any book, account or other document or to furnish any statement or
information u/s 35(2), or answer any question relating to business of a banking company which is
asked by an officer making an inspection under that section, he shall be punishable with a fine

 
 

which may extend to RS.2000 in respect of each offence. If the offense continues, he shall be
punishable with a further fine which may extend to RS.100 for every day which the offence
continues.
3. If any deposits are received by a banking company in contravention of an order under clause (a)
sub section (4) of section 35, every director or other officer of the banking company, unless he
proves that the contravention took place without his knowledge or that he exercised all due
diligence to prevent it, shall be deemed to be guilty of such contravention. Such person shall be
punishable with a fine which may extend to twice the amount of the deposit so received.
4. Where a contravention or default has been committed by a company every person who, at the
time the contravention or default was committed, was in-charge of and was responsible to the
company, for the conduct of the business of the company as well as the company, shall be
deemed to be guilty of the contravention or default and shall be liable to be proceeded against all
punished accordingly.

IMPORTANT QUESTIONS

Q.1. Explain the functions of commercial banks.

Q.2. Describe the banking system following:

a) Unit Banking
b) Branch Banking
c) Group Banking
d) Chain Banking

Q.3. The salient features of the Banking Regulation Act 1949. Q.4. What types of Business are run by
Banking Company?

 
 

UNIT - II

CENTRAL BANK – EVOLUTION

In Europe prior to the 17th century most money was commodity money, typically gold or silver.
However, promises to pay were widely circulated and accepted as value at least five hundred years earlier
in both Europe and Asia. The medieval European Knights Templar ran probably the best known early
prototype of a central banking system, as their promises to pay were widely regarded, and many regard
their activities as having laid the basis for the modern banking system. At about the same time, Kublai
Khan of the Mongols introduced fiat currency to China, which was imposed by force by the confiscation
of specie.

As the first public bank to "offer accounts not directly convertible to coin", the Bank of Amsterdam
established in 1609 is considered to be the "first true central bank". This was followed in 1694 by the
Bank of England, created by Scottish businessman William Paterson in the City of London at the request
of the English government to help pay for a war.

Although central banks are generally associated with fiat money, under the international gold standard of
the nineteenth and early twentieth centuries central banks developed in most of Europe and in Japan,
though elsewhere free banking or currency boards were more usual at this time. Problems with collapses
of banks during downturns, however, were leading to wider support for central banks in those nations
which did not as yet possess them, most notably in Australia.

With the collapse of the gold standard after World War II, central banks became much more widespread.
The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill,
signed by President Woodrow Wilson on December 23, 1913, whilst Australia established its first central
bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the
aftermath of the Great Depression in 1934. By 1935, the only significant independent nation that did not
possess a central bank was Brazil, which developed a precursor thereto in 1945 and created its present
central bank twenty years later. When African and Asian countries gained independence, all of them
rapidly established central banks or monetary unions.

CHARACTERISTICS
A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive
privilege to lend a government its currency. Like a normal commercial bank, a central bank charges
interest on the loans made to borrowers, primarily the government of whichever country the bank exists
for, and to other commercial banks, typically as a 'lender of last resort'. However, a central bank is
distinguished from a normal commercial bank because it has a monopoly on creating the currency of that
nation, which is loaned to the government in the form of legal tender. It is a bank that can lend money to
other banks in times of need. Its primary function is to provide the nation's money supply, but more active
duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking
sector during times of financial crisis (private banks often being integral to the national financial system).
It may also have supervisory powers, t ensure that banks and their financial institutions do not behave
recklessly or fraudulently.

 
 

FUNCTIONS OF CENTRAL BANK

The important functions f Central Banks are as flows:

1. Sole Right of Note Issue: The Central Bank in every country, now, has the monopoly note issue.
The issue of notes is governed by certain regulation which is enforced by the state.

2. Banker to the State : A Central Bank acts as a banker to the government. It holds cash balances
of the government free of interest.

3. Banker's Bank: The central bank acts as a banker to the commercial banks.

4. Banker's Clearing House: The Central Bank acts as a clearing house for the settlement of
mutual obligations of different commercial banks. If a difference exists, it is paid by a cheque
drawn on the banks accounts carried at the Central Bank.

5. Lender to the Last Resort: The Central Bank helps the member banks in times of crisis.

6. Financial Agent: The Central Banks act as financial agents for the government. It is an agent for
the government in purchasing and selling of gold and foreign exchange.

7. Effective Monetary Policy: The aim of the government is to create employment in the country,
resist undue inflation and achieve a favorable balance of payment.

THE RESERVE BANK OF INDIA

The Reserve Bank of India was established on 1st April 1935 with the capital of RS.5 crores. The bank
was started originally as a shareholders bank and the bank took over the function of currency issue from
the government of India and power of credit control from the Imperial Bank of India.

The Reserve Bank of India as the Central Bank, has to perform not merely the negative role of controlling
credit and currency in the economy to maintain the internal and external value of the rupee to ensure price
stability in the economy. But also to act as a promoter of financial institutions in the country so that its
policies could be effective promoting economic growth as per the guidelines and policies formulated by
the Government backward element. When the Reserve Bank of India was established in 1935, our country
was a backward country which lacked a well-developed commercial banking system apart from the
absence of a well-developed money market in the country. After 1948 the Reserve Bank of India became
very active to take steps to promote and develop financial institutions so that the Reserve Bank of India
can pursue appropriate credit and monetary policies for economic growth and development in an era of
planned economic development of the country.

OBJECTIVES F RBI

Monetary Authority

 
 

• Formulates, implements and monitors the monetary policy.

• Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and Supervisor of the Financial System.

• Prescribes broad parameters of banking operations within which the country's banking and
financial system functions.

Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective
banking services to the public. The Banking Ombudsman Scheme has been formulated by the Reserve
Bank of India (RBI) for effective redressal of complaints by bank customers.

Manager of Exchange Control

• Manages the Foreign Exchange Management Act, 1999.

• Objective to facilitate external trade and payment and promote orderly development and
maintenance of foreign exchange market in India.

Issuer of Currency
• Issues and exchanges or destroys currency and coins not fit for circulation.
• Objective: the main objective is to give the public adequate supply of currency of good quality
and to provide loans to commercial banks to maintain or improve the GDP (Gross Domestic
Product).

The basic objectives of RBI are to issue bank notes, to maintain the currency and credit system of the
country to utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic
structure of the country so that it can achieve the objective of price stability as well as economic
development, because both objectives are diverse in themselves.

Developmental Role
- Performs a wide range of promotional functions to support national objectives.

Related Functions
- Banker to the Government: performs merchant banking function for the central and the state
governments; also acts as their banker.
- Bank to banks: maintains banking accounts of all scheduled banks

There is now an international consensus about the need to focus the tasks of a central bank upon central
banking. RBI is far out of touch with such a principle, owing to the sprawling mandate described above.
The recent financial turmoil world over, has however, vindicated the Reserve Bank's role in maintaining
financial stability in India.

ORGANIZATIONAL STRUCTURE

 
 

The affairs of RBI are managed by the Central Board and Local Boards. Central Board

Central Board
The control board consists of following members under section 8 of RBI Act 1934

1. A Governor and not more than four Deputy Governor appointed by the Central Government.
2. Four Directors nominated by the Central Government one from each of the four Local Boards.
3. Ten Directors nominated by the Central Government.
4. One government official nominated by the central government.

The governor and deputy governor shall devote their whole to the affairs of the bank and shall receive
such salaries and allowances as may be determined by the central board, with the approval of the central
government. The governor and deputy governor shall hold office for such term not exceeding five years
as the central government may fix when appointing them and shall be obliged for reappointment.

The chairman of the central board of directors of the bank is called the chief executive authority of the
bank and he is known as the Governor. The Governor has the power of general superintendence and
direction of the affairs and business of the bank and he is authorised to exercise all power, which may be
exercised or done by the bank. In the absence of the governor the deputy governor nominated by the
governor in this behalf exercises his powers.

Local Boards
A local board shall be constituted for each of the four areas specified in the first schedule and consists of
five members to be appointed by the central government to represent, as far as possible, territorial and
economic interest and the interest of co-operative and indigenous banks. Every member of a local board
shall hold office for a term of four years and thereafter until his success or shall have been appointed and
shall be eligible for re-appointment. The bank has local boards with headquarters at Mumbai, Kolkata,
Chennai and New Delhi.

LEGAL STATUS AND FUNCTIONS

A bank is a body corporate by the name of the Reserve Bank of India, having perpetual succession and a
common seal, and shall by the said name sue and be sued.

Main Functions

1. Monetary Authority: The Reserve Bank of India Formulates, implements and monitors the
monetary policy. Its main objective is maintaining price stability and ensuring adequate flow of
credit to productive sectors.

2. Regulator and Supervisor of the Financial System: Prescribes broad parameters of banking
operations within which the country's banking and financial system functions. Their main
objective is to maintain public confidence in the system, protect depositors' interest and provide
cost-effective banking services to the public.

 
 

3. Manager of Exchange Control: The manager of the exchange control department manages the
Foreign Exchange Management Act, 1999. His main objective is to facilitate external trade and
payment and promote orderly development and maintenance of foreign exchange market in India.

4. Issuer of Currency: Under Section 22 of the Reserve Bank of India Act, the Bank has the sole
right to issue bank notes of all denominations. The distribution of one rupee notes and coins and
small coins all over the country is undertaken by the Reserve Bank as agent of the Government.
The Reserve Bank has a separate Issue Department which is entrusted with the issue of currency
notes. The Bank shall not be liable to the payment of any stamp duty under the Indian Stamp Act,
1899 (2 of 1899) in respect of bank notes issued by it

5. Banker to Government: The Reserve Bank of India is to act as Government banker, agent and
adviser. The Reserve Bank is agent of Central Government and of all State Governments in India.
The Reserve Bank has the obligation to transact Government business, via. to keep the cash
balances as deposits free of interest, to receive and to make payments on behalf of the
Government and to carry out their exchange remittances and other banking operations. The
Reserve Bank of India helps the Government - both the Union and the States to float new loans
and to manage public debt.

6. Controller of Credit: The Reserve Bank of India is the controller of credit i.e. it has the power to
influence the volume of credit created by banks in India. It can do so through changing the Bank
rate or through open market operations. According to the Banking Regulation Act of 1949, the
Reserve Bank of India can ask any particular bank or the whole banking system not to lend to
particular groups or persons on the basis of certain types of securities. Since 1956, selective
controls of credit are increasingly being used by the Reserve Bank.

7. Developmental Role : The Reserve Bank of India performs a wide range of promotional
functions to support national objectives. The promotional functions are such as contests, coupons,
maintaining good public relations.

8. Banker to Banks: The Reserve Bank of India acts as the bankers' bank. According to the
provisions of the Banking Companies Act of 1949, every scheduled bank was required to
maintain with the Reserve Bank a cash balance equivalent to 5% of its demand liabilites and 2
percent of its time liabilities in India. By an amendment of 1962, the distinction between demand
and time liabilities was abolished and banks have been asked to keep cash reserves equal to 3 per
cent of their aggregate deposit liabilities. The minimum cash requirements can be changed by the
Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting bills of
exchange. Since commercial banks can always expect the Reserve Bank of India to come to their
help in times of banking crisis the Reserve Bank becomes not only the banker's bank but also the
lender of the last resort.

 
 

9. Amalgamation of Banking Company by Reserve Bank: No banking company shall be

amalgamated with another banking company, unless a scheme containing the term of such
amalgamation, drafted by the companies, has been approved by the reserve bank of India. The
bank will also determine the purchase consideration for swapping of share between the two
companies.

10. Issuing of Bank Notes: This function which was once considered to be the most paying part of a
banker's business, is in modern times performed generally by central banking institutions in most
of the countries of the world. Its importance to banks in general has dwindled in some of the
countries, in which the cheque currency has replaced bank-notes to a large extent. For instance in
England and in the United States of America, the part which is played by bank notes is becoming
less and less significant althought they are still very popular in certain European countries such as
France and Germany, where serious efforts are being made to popularise the use of cheques as a
means of payment.

11. Transferring Money from Place to Place: Modern banks are, generally, in a position to remit
money, from one place or country to another, by means of drafts drawn upon their branches or
agents. They are, also by purchasing bills of exchange, enable merchants and others to receive
money from their debtors, in other cities or countries. Of late such transfers are also made
electronically. These facilities have helped not only the internal trade of different countries, but
also the international commerce.

12. Granting Licenses to Banking Companies: The RBI is empowered to grant licenses for
banking companies which have requested for them under Section 22 of the RBI Act, for carrying
on the business of banking in India. Before granting the licence, the RBI will satisfy itself that the
applicant bank fulfills the following conditions:
a) That the capital structure and earning prospects of the company are adequate.
b) The general character of the proposed management is of a high order and not detrimental to the
interests of the depositors;
c) That the granting of licence will be in public interest.
d) That the granting of licence would not be prejudicial to the operation and consolidation of the
banking system, and that it will be consistent with the monetary stability and economic growth.

13. Official Liquidator: In any proceeding for the winding up of a Banking Company, upon an
application made to High Court, the High Court shall appoint Reserve Bank as the official
liquidator of the Banking Company. The liquidator, if any, all ready functioning ain such
proceeding shall vacate office upon such appointment.

Supervisory Functions
In addition to its traditional central banking functions, the Reserve bank has certain non-monetary
functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve
Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI wide powers of supervision
and control over commercial and co-operative banks, relating to licensing and establishments, branch
expansion, liquidity of their assets, management and methods of working, amalgamation, reconstruction,

 
 

and liquidation. The RBI is authorised to carry out periodical inspections of the banks and to call for
returns and necessary information from them. The nationalisation of 14 major Indian scheduled banks in
July 1969 has imposed new responsibilities on the RBI for directing the growth of banking and credit
policies towards more rapid development of the economy and realisation of certain desired social
objectives. The supervisory functions of the RBI have helped a great deal in improving the standard of
banking in India to develop on sound lines and to improve the methods of their operation.

Promotional Functions
The Bank now performs a variety of developmental and promotional functions, which, at one time, were
regarded as outside the normal scope of central banking. The Reserve Bank was asked to promote
banking habit, extend banking facilities to rural and semi-urban areas, and establish and promote new
specialized financing agencies. Accordingly, the Reserve Bank has helped in the setting up of the IFCI
and the SFC; it set up the Deposit Insurance Corporation in 1962, the Unit Trust of India in 1964, the
Industrial Development Bank of India also in 1964, the Agricultural Refinance Corporation of India in
1963 and the Industrial Reconstruction Corporation of India in 1972. These institutions were set up
directly or indirectly by the Reserve Bank to promote saving habit and to mobilise savings, and to provide
industrial finance as well as agricultural finance. As far back as 1935, the Reserve Bank of India set up
the Agricultural Credit Department to provide agricultural credit. But only since 1951 the Bank's role in
this field has become extremely important. The Bank has developed the co-operative credit movement to
encourage saving, to eliminate moneylenders from the villages and to route its short term credit to
agriculture. The RBI has set up the Agricultural Refinance and Development Corporation to provide
long-term finance to farmers.

IMPORTANT QUESTIONS

Q.1. Explain the main functions of RBI.

Q.2. Describe the organizational structure of RBI.

Q.3. Promotional Role in Indian Banking system of RBI.

Q.4. Write short note on supervisory functions of RBI.

Q.5. What do you mean by Central Bank? Explain the function of Central Bank.

 
 

UNIT - III
LEADING BY BANKS

The concept of bank lending has been undergoing a change since the introduction of social control over
commercial banks and more especially after the nationalisation of major banks in 1969. Prior to
nationalisation, the commercial banks provided credit only to large customers with larger resources at
their command against the securities which were more than adequate to cover the advances. In other
words, a large part of the banks lending was security oriented and that to a selected customers in the
corporate sector. However, since nationalisation there has been a view that the bankers should not insist
on security in consideration of the proposals for advances. They should look at the productivity of a
proposal in terms of its potentialities to contribute to increased production.

Lending of funds to the constituents, mainly business and industrial enterprises, traders, constitutes the
main business of the banking company. The major portion of the bank's fund is employed by way of loans
and advances, which is the most profitable employment of its funds.

The business of lending, nevertheless, is not without certain inherent risks. Largely depending on the
borrowed funds a banker cannot afford to take undue risks in lending.

When banker lending his finds, follows a very cautious policy and conducts his business on the basis of
the well known principles of sound lending in order to minimise the risks.

1) Safety: 'Safety first' should be the first guiding principle of a banker. A banker must look to the
safety of the funds as he cannot afford to lose the money he lends. He should take a long term
view rather than the immediate prospects.

Banks always provided fully secured loans and advances in the ordinary course of his business.
This has led people to believe that bank will never advance any loan unless it is fully secured.
Such is no doubt the ideal conception of banking, but as a result of competition from other banks,
every bank has sometimes to grant loans to its customer against their personal security.

In many cases, the manager of the bank uses his discretion and never lends a sum obviously
beyond his customer's recourses.

2) Liquidity: Secondly, the banker while making advances must see that the money he is lending is
not going to be locked up for a long time, which should make his loans and advances less liquid
and more difficult to release in case of emergency. Banks always depend on borrowed funds; they
spread their investment in such a way that they are in a position to acquire cash with in short
period of time. Their borrowings also come from deposits which are usually not for a very long
period.

3) Profitability: Commercial banks are profit earning institutions. The nationalized banks are no
exception to this. They must employ their funds profitably so as to earn sufficient income out of
which to pay interest to the depositors, salaries to the staff and to meet various other

 
 

establishment expenses and distribute dividend to the shareholders. The rates of interest charged
by banks were in the past primarily dependent on the directives issued by Reserve Bank. Now
banks are free to determine their own rates of interest on advances of above Rs. 2 Lakhs. The
variations in the degree of risk are involved in lending to them. A customer with high reputation
is charged the lower rate of interest as compared to an ordinary customers. The sound principle of
lending is not to sacrifice safety or liquidity for the sake of higher profitability. That is to say that
the banks should not grant advances to unsound parties with doubtful repaying capacity, even if
they are ready to pay a very high rate of interest.

4) Security: The security offered against the loan may consist of a large variety. It may vary from a
piece of land or a building to a commercial paper or bullion. There may be cases where there is
no security except the personal security of the debtors. Whatever be the security, a banker must
realize that it is only a cushion to fall back upon in case of need and its adequacy alone should not
from the sole consideration for judging the suitability of a loan. Of course, the security, if
accepted, must be adequate, readily marketable, easy to handle and free from encumbrance.

5) Loans Repayable on Demand: Bankers generally make their loans repayable on demands,
although there may be an understanding that the customer would be allowed to use the funds for
at least a certain period, provided he complies with the term of the agreement. They also reserve
to themselves the power of cancelling or reducing the amount of advances, but generally they
have to give a reasonable notice.

For expo: A banker who has promised his customer an overdraft to the extent of Rs.20,000/-, wishes
to reduce its amount to Rs. 15,000/-. He cannot refuse to honour his customer's cheque issued before
the receipt of the notice by the customer, so long as it does not exceed the limit of the overdraft
originally agreed upon Rouse Vs. Bradford Banking company (1894) AC 595.

6) Investment of Their Fund in Various Sectors : It is also necessary to remember that a prudent
banker must avoid lending the major portion of his funds in meeting the needs of any one
industry on anyone group of Industries for consideration of self -
Interest as well as the large public good. The imprudence of putting one's all eggs in one basked can
not be too often reiterated.

7) Adequate Return on his Investment: Another important factor that will determine the decision
of the banker whether or not to grant a loan will depend upon the answer to the question whether
or not he will get a fair return on his investment. The difference between his borrowing and
lending rates constitutes his gross profit and no banker ordinarily will think of an advance without
a satisfactory margin of profit. No hard and fast rules can however, be laid down regarding this
margin between borrowing and lending rates, but generally 2 to 2112 % is considered reasonable.

GUARANTEE
Contracts of Guarantee have special importance in banking business as a means to ensure safety to
banker's funds lent to customers. The bank while lending to customers generally secure a charge over the
tangible assets of the borrowers and/or personal security of the debtor. But when the value of tangible

 
 

assets offered by a borrower is not sufficient to cover the amount of loan or where the borrower has no
tangible assets to offer and the personal security of the borrower is not considered sufficient, an additional
security is sought by the banker in the form of a guarantee of one or more persons who have some
standing in the eyes of the banker. The person who provides guarantee is known as 'Guarantor' or 'surety'.
The surety undertakes the liability to pay to the creditor (banker) if the debtor (borrower) makes a default
in repaying the amount of loan according to the terms of contract. The guarantor, therefore, is the personal
security of a third person to the creditor to pay the amount of loan and other dues, if the debtor fails to
pay.

Contract of Guarantee: A contract of guarantee is a specific contract and is governed by provisions of

the Indian Contract Act. 1872. Section 126 of the Indian Contract Acts defines a contract of guarantee as
lOa contract to perform the promise or discharge the liability of a third person in case of this default".
There are, therefore, three parties in a contract of guarantee. The person who undertakes the liability to
pay the liability of third person the debtor is called the surety or the guarantor. The person in respect of
whose default, the guarantee is given is called the principal debtor and the person to whom the guarantee
is given is called the creditor. A contract of guarantee is thus a secondary contract and is enforceable only
when the principal contract between the principal debtor and the creditor is not fulfilled or discharged.
The contract of guarantee may be either written or oral (Sec. 126)

Essential Features of a Contract of Guarantee: A contract of guarantee like other contracts must
possess all the elements of a valid contract. But, there are certain distinctive features of a contract of
guarantee which are as follows:
1. A contract of guarantee may be either oral or written: Bankers, however have the contract of
guarantee in writing to avoid mis-constructed interpretation and likely conflicts in future and to
bind the surety by his words.
2. The bank should see that the guarantor should not be under the direct control or authority
of the principal debtor or he should not be in some other fiduciary relationship with him like
doctor and patient, father and son, wife and husband or a trustee and a beneficiary.
3. There are two contracts in a contract of guarantee i.e. between creditor and principal debtor
and between creditor and surety. The first contract is a principal contract and the second one is a
secondary contract.
4. There are three parties in a contract of guarantee the principal debtor, the creditor and the
surety.
5. A contract of guarantee, like any other contract, must have consideration. According to
section 127 of Indian Contract Act, 1872, "anything done or any promise made, for the benefit of
the principal debtor may be a sufficient consideration to the surety for giving the guarantee."
6. A Contract of guarantee is not a contract of uberrimae fidei (requiring good faith).
Nevertheless, the suretyship relation is one of the trust and confidence, and the validity of the
contract depends upon good faith on the part of the creditor of guarantee must have all the
essentials of a valid contract and competency of parties, free consent of parties consideration and
lawful object.

Purpose: Contracts of guarantee are usually entered into (a) to secure the performances of something
linch may be immediately related to a mercantile engagement, or (b) to secure the honesty and fidelity of

 
 

someone who is to be appointed to some office, or (c) to secure someone from injury arising out of some
wrong committed by another.

KINDS F GUARANTEE
Contracts of guarantee may be (1) specific (2) continuing.

1) Specific Guarantee: Specific guarantee means a guarantee for one specific transaction. In this
case the liability of the surety extends only to a single transaction.

Example: UCO bank guarantees payment to B of price of five sacks of flour to be delivered by B
to C and to be paid in a month. B delivers 5 sacks to C. C pays for them. Afterwards B delivers
four sacks to C, which C does not pay. The guarantee given by UCO bank was only a specific
guarantee and accordingly it is not liable for the price of the four sacks.

2) Continuing Guarantee: A continuing guarantee is that which extends to a series of transactions

(Sec. 129)

Revocations of a Continuing Guarantee

1) By Notice: (Sec. 130) A continuing guarantee ~ay at any time be revoked by the surety as to
future transactions, by giving a distinct notice to the creditor.
2) By Death : (Sec. 131) Death of the surety will operate as a revocation of the continuing guarantee
with regard to the future transactions unless the contract provides otherwise. No notice of death
need be given to the creditor.
3) Nature of Surety's Liability: Where the parties do not specifically agree as to the extent of the
liability or the surety does not put any limit on his liability at time of entering into the contract,
the liability of the surety will be coextensive with that of the principal debtor (Sec. 128) The
quantum or obligation of the surety will be the same as that of a principal debtor. In other words,
whatever amount of money a creditor can legally realise from the principal debtor including
interest, cost of litigation, damages etc., the same amount he can recover from the surety.

Example: UCO bank guarantees to B the payment of a bill of exchange by C the acceptor. The bill is
dishonoured by C. UCO bank will be liable not only for the amount of the bill but also for any interest
and charges, which may have become due on it.

SURETY’S RIGHTS AND LIABILITIES

Law offers certain protections to the surety in discharge of his legitimate duties under the contract of
guarantee. A surety has the following rights:
1. Rights against the creditor
2. Rights against the principal debtor; and
3. Rights against the co-sureties.
a) Rights Against the Creditor: The surety has the following rights against the creditor.

 
 

1. Require the Creditor to Demand Payment: Once the guaranteed debt becomes due to surety
has every right to require the creditor to demand payment from the principal debtor.

2. Benefit of Security (Sec. 141) : The Surety is entitled to the benefit of every security which the
creditor had accepted from the debtor at the time of entering into contract with the principal
debtor irrespective of whether the surety knows of the existence of such security or not. If the
creditor loses or parts with such security without the consent of the surety, the surety is
discharged from his liability to the extent of the value of security.

3. Right of Set Off : The surety, if pays to the creditor, is entitled to claim the benefit of the
principal debtor's set off against the creditor if it arises out of the transaction.

b) Rights Against the Principal Debtor: The surety is primarily concerned with the principal
debtor. His liability is coextensive with that of the principal debtor. If the principal debtor pays
the debt or fulfills his promise, the surety has no right against the principal debtor. His rights
against the principal debtor arises only when he (the principal debtor) defaults and the surety
makes the payment to the creditor according to the contract. In such a case, the surety has the
following rights against the principal debtor :-

1. Right of Subrogation (Sec. 140) : According to Sec. 140 of the Indian Contract Act, when the
principal debtor defaults in fulfilling his promise and the surety meets his liability to the creditor,
the surety, upon payment or performance of all that he is liable for steps into the shares of the
creditor and acquires all the rights of the creditor.

2. Right to be indemnified by the principal debtor (Sec. 145) : Sec. 145 of the Contract Act lays
down an implied authority on the principal debtor that he will make good the loss caused to the
surety under the contract. The surety has the right to recover all rightful payments made under the
contract. The surety has the right to recover all rightful payments made under the contract of
guarantee.

3. Right to Revoke Continuing Guarantee: The surety may revoke the continuing guaratee at any
time, if he thinks that the principal debtor is failing, fulfill his promise or in repaying the debt
according to terms of contract.

c) Rights Against Co-sureties : When two or more persons are co-sureties for the same debt they
are called co-sureties. If the principal debtor fails to fulfill his promise and one of the cosureties
pays more than his share of the debt, he has the following rights against co-sureties.

1) Right of equal contribution (Sec. 146): When two or more persons are co-sureties for the same
debt, either jointly or severally and whether under the same or different contracts and with or
without the knowledge of each other, the co-sureties, in the absence of any contract to the
contrary, are liable, as between themselves, to contribute an equal share of the whole debt, or of
that part of it which remains unpaid by the principal debtor. If one of the co-sureties pays more
than his share of the debt, he has a right to claim contribution from the other cosureties equally.

 
 

For Example: A, Band C are co-sureties for the sum of Rs.3000 paid by 0 to E. E defaults in
making the payment. A, Band C are liable to contribute equally i.e. Rs.1 000 each. If, suppose A
pays the whole debt to 0, he can claim contribution of RS.1 000 each from Band C.

If one of the co-sureties becomes insolvent, the solvent co-sureties shall contribute the whole
amount equally.

2) Co-sureties bound in different sums (Sec. 147) : Where the co-sureties have guaranteed
different sums, they are bound to contribute to the other co-surety who has paid the amount of
debt due from the principal debtor, equally subject to the liability undertaken.

A release of one or more of the co-sureties by the creditor will not discharge the others from the
obligations nor will it release the surety so released, from his responsibility to the other co-sureties.

Example: A, Band C are sureties for D, for a debt of Rs.60,000 given to E, in which A is liable for
Rs.25,000, B for Rs.20,000 and C for Rs.15,000. E makes default to the extent of Rs.45,000. A, B, C
equally contribute Rs.15,000 each.

Liability

The nature and extent of surety's liability has been discussed in section 128 of the Indian Contract Act. It
provides that the liability of the surety is co-extensive with that of the principal debtor, unless otherwise
provided by the contract. The liability of the surety will never be less or more than that of the principal
debtor. It may be restricted by a specific contract but it will never be greater.

Example: A guarantees the repayment of loan granted to X and Yalongwith interest thereon. The liability
of the principal debtor increases by the amount of interest due with the passage of time. The liability of
the surety will also increase by the amount of interest.

The extent of guarantee may be limited in either of the following two cases:
i) He may guarantee only a part of the entire debt, or
ii) He may guarantee the whole of the amount of debt but subject to a limit specified in the contract.

- The liability of the surety will commence only at the moment principal debtor defaults. Notice of
default is not necessary unless it is required under the contract. If, surety becomes insolvent
before the amount of guaranteed loan has become due (or before the default by the principal
debtor), the debt cannot be proved before the surety's official receiver or assignee. But, if the
principal debtor defaults before the surety's insolvency, the debt can be proved and the creditor
can claim the dividend from surety's estate.
- It is also not necessary for the creditor first to exhaust all remedies against the principal debtor
before claiming the amount of debt from the surety. It means that surety's liability becomes
primary as soon as the principal debtor defaults and the creditor may sue the surety directly
before taking any action against the principal debtor. But, if the contract specifically provides to

 
 

sue the principal debtor first in case of default, then the credit shall first take action against the
principal debtor and only after that against the surety.
- Liability when principal debtor is not liable: If the original contract between the Principal debtor
and creditor is void e.g. when the principal debtor is a minor i.e. not capable of entering into a
contract, the other contract between the surety and the creditor is not void and therefore, the
surety is not discharged from the liability. In this case, the surety will be liable as principal
debtor.
- Liability of Co-sureties: If one of them has paid the entire amount to the creditor, he is entitled to
claim contribution from his co-sureties.

Discharge of Surety: Surety will be discharged from his liability in the following cases:

1) By Notice or Death (Sec. 130 and 131): A contract of continuing guarantee may be terminated
at any time by notice to the creditor. The death of surety also brings an end to a continuing
guarantee. No notice of death need to be given to the creditor.

2) Variations in the terms of the original contract between the principal debtor and the
creditor (Sec. 133): If the contract between the creditor and the principal debtor is materially
altered without the consent of the surety, the surety is discharged as to transactions subsequent to
the alternation. Even the alteration beneficial to the surety would entitle the surety to claim a
discharge.

3) By release or discharge of the principal debtor (Sec. 134) : The surety is discharged 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

4) Compounding by Creditor with the principal debtor (Sec. 135) : A contract between the
creditor and the principal debtor, by which creditor makes a composition with, or promises to
give time to or not to sue the principal debtor discharges the surety unless the surety assents to
such contract.

5) Creditor's Act or omission impairing Surety's eventual remedy (Sec. 139): If the creditor
does any act which is inconsistent with the rights of the surety or omits to do any act which his
duty to the surety requires him to do, and the eventual remedy of the surety himself against the
principal debtor is thereby impaired, the surety is discharged.

6) Loss of Security (Sec. 141): If the creditor loses or without the consent of the surety parts with
any security given to him at the time of the contract of guarantee, the surety is discharged from
liability to the extent of the value of security.

7) By invalidation of the contract of guarantee (Sec. 142, 143 and 144): A contract of guarantee
becomes invalid if guarantee was obtained by fraud or concealment etc. about material facts.
Surety, in such a case, will be discharged from his liability.

 
 

Special Types of Guarantors:

1) Minors, Lunatics etc.: Contracts made with minors and persons of unsound mind are absolutely
void. The banker should not, therefore, accept guarantees from such persons.

2) Undischarged insolvent: They are also incompetent to contract and therefore, the guarantee
given by such persons are void.

3) Married Women: A married Hindu woman can give a valid guarantee which will bind her
separate property called stridhan. However, a banker should be extremely cautious while
accepting the guarantees of such women.

4) Limited Companies: In case of a guarantee executed by a limited company, a banker has to be

extra cautious. The banker must verify from company's memorandum and articles of association,
where the company has been expressly given such power.

5) Partnership Firms: A partner of a firm cannot bind his co-partners by giving guarantees for
loans given by a bank to other parties.

Issue of Guarantees by Banks: The guarantees issued by the bankers are mainly of two types:

1- Money Guarantees: The banker promises to pay the money due by the customer to a third party
in the event of the customer's failure to pay on the due date as agreed.

2- Performance Guarantees: They are given by bankers in favour of the Government or public
bodies in case of turn-key projects on behalf of contractors undertaking to pay a penalty in the
event of non-fulfilment of the contract.

Precautions while issuing such guarantees.

1) Obtain reliable credit reports regarding the customers for whom it is giving the guarantee.
2) The guarantee should be given for a short period.
3) The guarantee bond should be called back, ~uly cancelled by the beneficiary after the period of
guarantee is over.

Rights of the Creditor (Banker): The banker as a creditor enjoys the following rights in a contract of
guarantee:

1. Right to demand payment: As soon as the principal debtor refuses to make payment, the banker
as creditor, can demand payments from the surety.

2. Right to claim dividend: When surety becomes insolvent, the creditor or banker is entitled to
recover the dues from the estate of the insolvent surety and can claim the pro-ratas dividend.

 
 

Obligations (Liabilities of Creditor): In a contract of guarantee, the banker as a creditor has certain
obligations towards surety. If the Creditor defaults in his obligations as imposed by the Indian Contract
Act 1872, the surety is discharged from his liability.

1. Not to make any change in Original Contract (Sec. 133): The creditor must not change the
terms of the original contract between him and the principal debtor without the consent of the
surety. If the creditor changes the terms of the contract without taking the surety into confidence,
the surety will be discharged as to transactions subsequent to that change.

2. Not to release the principal debtor (Sec. 134) : The banker is under an obligation not to
discharge the principal debtor. According to Section 134 the surety is discharged from his
liability if:

i. There is a contract as between the creditor and the principal debtor, by which the principal
debtor is released.

ii. There is any act or omission on the part of the creditor, the legal consequence of which is the
discharge of the principal debtor.

3. Not to indulge, with the principal debtor (Sec. 135) : Where the creditor enters into a contract
with the principal debtor whereby he makes a composition with or he agrees not to sue the
principal debtor or to extend the time of repayment of the debt, the surety will be discharged from
his obligation, unless surety assents to such contract.

4. Not to do any act inconsistent with the right of the surety (Sec. 139): The creditor should not
do any act which is inconsistent with the right of surety or not to omit any act which his duty to
the surety required him to do under the contract of guarantee and the eventual remedy of the
surety himself against the principal debtor is thereby unpaired.

Example: A is a surety for the loan taken by B from P.N.B. on the pledge of wheat stored in the
godown of B. The banks does not inspect the godown in the rainy season, during which a part of the
wheat stock is damaged due to leakage. The surety is discharged to the extent of loss caused by the
negligence on the part of the banker.

5) Not to conceal material facts (Sec. 140) : Any guarantee obtained by a creditor on the basis of
misrepresentation or by concealing of material facts by keeping silence is invalid and the surety is
discharged from his liability.

Example: A engages B as clerk to collect money for him. B fails to account for some of his money and A
in consequence calls upon him to furnish security for his duly accounting C agreed to become a surety. A
does not acquaint C with B's misconduct. B, afterwards, makes a default C will not be liable because
guarantee has' been obtained by the concealment of facts.

 
 

DEBTS RECOVERY TRIUNAL (DRT)

Keeping in line with the international trends on helping financial institutions recover their bad Debt
quickly and efficiently, the Government of India has constituted thirty three Debt Recovery Tribunals and
five Debt Recovery Appellate Tribunals across the country.

The Debt Recovery Tribunals are located across the country. Some cities have more than one Debt
Recovery Tribunal located therein. New Delhi and Mumbai have three Debt Recovery Tribunals. Chennai
and Kolkata have two Debt Recovery Tribunals each. One Debt Recovery Tribunal each has been
constituted at Ahmdabad, Allahabad, Aurngabad, Bangalore, Chandigrah, Coimbatore, Cuttack,
Ernakulam, Guwahati, Hydrabad, Jabalpur, Jaipur, Lucknow, Nagpur, Patna, Pune, Ranchi and
Vishakapatnam. Depending upon the number of cases a Debt Recovery Tribunal is constituted.

The Debts Recovery Tribunal has been constituted under Section 3 of The Recovery of Debts Due to
Banks and Financial Institutions Act, 1993. The original aim of the Debts Recovery Tribunal was to
receive claim applications from Banks and Financial Institutions against their defaulting borrowers. For
this the Debts Recovery Tribunal (Procedure) Rules 1993 were also drafted.

While initially the Debts Recovery Tribunals did perform well and helped the Banks and Financial
Institutions recover substantially large parts of their non performing assets, or their bad debts as they are
commonly known, but their progress was stunted when it came to large and powerful borrowers. These
borrowers were able to stall the progress in the Debts Recovery Tribunals on various grounds, primarily
on the ground that their claims against the lenders were pending in the civil courts, and if the Debts
Recovery Tribunal were adjudicate the matter and auction off their properties irreparable damage would
occur to them.

Apart from the above big lacunae, there were a number of shortcomings too. The dues of workmen
against a company, the State dues, and the dues of other non secured creditors all got enmeshed before the
Debt Recovery Tribunals. As if these were not sufficient, there was clash of jurisdiction between the
Official Liquidators appointed by the High Courts and the Recovery Officers of the Debts Recovery
Tribunals. The Official Liquidator, an appointee of a superior authority, took into his possession all the
properties, which actually belonged to secured creditors who before the Debts Recovery Tribunal. The
High Courts also took umbrage on the activities of the Recovery Officers who away the entire amounts
and paid off to the banks leaving nothing for the other claimants, including the workmen. All these and
other issues lead to drastic amendments to the Recovery of Debts Due to Banks and Financial Institutions
Act by means of an amending notification in the year 2000.

While the amending notification of 2000 did bring in some amount rationalization in the jurisdiction of
the Debts Recovery Tribunal, yet it was not sufficient to coax the big borrowers to acquiesce to the
jurisdiction of the Debts Recovery Tribunal easily. The lenders continued to groan under the weight of the
Non Performing Assets. This led to the enactment of one more drastic act titled as the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interests Act, also called as SRFAESI
Act or SRFAESIA for short.

 
 

This new Act, the SRFAESI Act, empowered the lenders to take into their possession the secured assets
of their borrowers just by giving them notices, and without the need to go through the rigors of a Court
procedure. Initially this brought in lot of compliance from borrowers and many a seasoned defaulter
coughed up the Bank dues. However the tougher ones punched whole in the new Act too. This led
Supreme court striking down certain provisions and allowing the borrowers an adjudicatory forum before
their properties could be taken over by the lenders.

And the adjudicatory forum turned out to be the Debts Recovery Tribunal. The Debts Recovery Tribunal
now deals with two different Acts, namely the Recovery of Debts Due to Banks and Financial Institutions
Act as well as the Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interests Act. While the aim of the both the Acts is one and the same, their route is different.

The Debts Recovery Tribunals have to deal with extraordinary complex commercial laws within the
narrow ambit of the two laws. Over the years the Debts Recovery Tribunals have evolved into fine bodies
with lot of expertise. There is a plethora of judgments from the Supreme Court as well as the various High
Courts which have paved the way of the Debts Recovery Tribunals to chart their courses. The Debts
Recovery Tribunal of India have become model institutions for many a country to follow.

CONSTITUTION

Establishment of Tribnal

1) The Central Government shall, by notification, establish one or more Tribunals, to be known as
the Debts Recovery Tribunal, to exercise the jurisdiction, powers and authority conferred on such
Tribunal by or under this Act.

2) The Central Government shall also specify, in the notification referred to in sub-section (1), the
areas within which the Tribunal may exercise jurisdiction for entertaining and deciding the
applications filed before it.

Composition of Tribunal
1) A Tribunal shall consist of one person only (hereinafter referred to as the Presiding Officer) to be
appointed, by notification, by the Central Government.
2) Notwithstanding anything contained in sub-section (1), the Central Government may authorize
the Presiding Officer of one Tribunal to discharge also the functions of the Presiding Officer of
another Tribunal.

Qualifications for Appointment as Presiding Officer

A person shall not be qualified for appointment as the Presiding Officer of a Tribunal unless he is, or has
been, or is qualified to be, a District Judge.

Term of Office

 
 

The Presiding Officer of a Tribunal shall hold office for a term of five years from the date on which he
enters upon his office or until he attains the age of sixty-two years, whichever is earlier.
Staff of Tribunal
1) The Central Government shall provide the Tribunal with one or more Recovery Officers and such
other officers and employees as that government may think fit.
2) The Recovery Officers and other officers and employees of a Tribunal shall discharge their
functions under the general superintendence of the Presiding Officer.
3) The salaries and allowances and other conditions of service of the Recovery Officers and other
officers and employees of a Tribunal shall be such as may be prescribed.

Resignation and Removal

1) The Presiding Officer of a Tribunal or the Chairperson of an Appellate Tribunal may by notice in
writing under his hand addressed to the Central Government, resign his office:

Provided that the Presiding Officer of a Tribunal or the Chairperson of an Appellate Tribunal shall, unless
he is permitted by the Central Government to relinquish his office sooner, continue to hold office until the
expiry of three months from the date of receipt of such notice or until a person duly appointed as his
successor enters upon his office or until the expiry of his term of office, whichever is the earliest.

FUNCTIONING AND POWERS

(According to the Recovery of Debts due to Banks and Financial Institutions Act, 1993)

1. Jurisdiction, Powers and Authority of Tribunals

(1) A Tribunal shall exercise, on and from the appointed day, the jurisdiction, powers and
authority to entertain and decide applications from the banks and financial institutions for
recovery of debts due to such banks and financial institutions. (Sec. 17)

2. Bar of Jurisdiction
On and from the appointed day, no court or other authority shall have, or be entitled to exercise,
any jurisdiction, powers or authority (except the Supreme Court, and a High Court exercising
jurisdiction under Articles 226 and 227 of the Constitution) in relation to the matters specified in
section 17. (Sec. 18)

3. Sec. (12) The Tribunal may make an interim order (whether by way of injunction or stay or
attachment) against the defendant to debar him from transferring, alienating or otherwise dealing
with, or disposing of, any property and assets belonging to him without the prior permission of
the Tribunal.

(13) (A) Where, at any stage of the proceedings, the Tribunal is satisfied, by affidavit or
otherwise, that the defendant, with intent to obstruct or delay or frustrate the execution of any
order for the recovery of debt that may be passed against him,
(i) is about to dispose of the whole or any part of his property; or

 
 

(ii) is about to remove the whole or any part of his property from the local limits of the
jurisdiction of the Tribunal; or

(iii) is likely to cause any damage or mischief to the property or affect its value by misuse or
creating third party interest, the Tribunal may direct the defendant, within a time to be fixed by it,
either to furnish security, in such sum as may be specified in the order, to produce and place at
the disposal of the Tribunal, when required, the said property or the value of the same, or such
portion thereof as may be sufficient to satisfy the certificate for the recovery of debt, or to appear
and show cause why he should not furnish security.

(B) Where the defendant fails to show cause why he should not furnish security, or fails to furnish the
security required, within the time fixed by the Tribunal, the Tribunal may order the attachment of the
whole or such portion of the properties claimed by the applicant as the properties secured in his favour or
otherwise owned by the defendant as appears sufficient to satisfy any certificate for the recovery of debt.

(14) The applicant shall, unless the Tribunal otherwise directs, specify the property required to be
attached and the estimated value thereof ..

(15) The Tribunal may also in the order direct the conditional attachment of the whole or any portion of
the property specified under sub-section (14).

(20) The Tribunal may, after giving the applicant and the defendant an opportunity of being heard, pass
such interim or final order, including the order for payment of interest from the date on or before which
payment of the amount is found due up to the date of realisation or actual payment, on the application as
it thinks fit to meet the ends of justice.

(22) (1) The Tribunal and the Appellate Tribunal shall not be bound by the procedure laid down by the
Code of Civil Procedure, 1908 (5 of 1908), but shall be guided by the principles of natural justice and,
subject to the other provisions of this Act and of any rules, the Tribunal and the Appellate Tribunal shall
have powers to regulate their own procedure including the places at which they shall have their sittings.

(2) The Tribunal and the Appellate Tribunal shall have, for the purposes of discharging their functions
under this Act, the same powers as are vested in a civil court under the Code of Civil Procedure, 1908 (5
of 1908), while trying a suit, in respect of the following matters, namely,-
(a) summoning and enforcing the attendance of any person and examining him on oath;
(b) requiring the discovery and production of documents;
(c) receiving evidence on affidavits;
(d) issuing commissions for the examination of witnesses or documents; (e) reviewing its decisions;
(f) dismissing an application for default or deciding it ex parte;
(g) setting aside any order of dismissal of any application for default or any order passed by it ex parte;
(h) any other matter which may be prescribed.

 
 

(3) Any proceeding before the Tribunal or the Appellate Tribunal shall be deemed to be a judicial
proceeding within the meaning of sections 193 and 228, and for the purposes of section 196 of the Indian
Penal Code (45 of 1860), and the Tribunal or the Appellate Tribunal shall be deemed to be a civil court
for all the purposes of section 195 and Chapter XXVI of the Code of Criminal Procedure, 1973 (2 of
1974).

Transfer of Pending Cases

(1) Every suit or other proceeding pending before any court immediately before the date of establishment
of a Tribunal under this Act, being a suit or proceeding the cause of action whereon it is based is such that
it would have been, if it had arisen after such establishment, within the jurisdiction of such Tribunal, shall
stand transferred on that date to such Tribunal:

POWER OF TRIBUNAL TO ISSUE CERTIFICATE OF RECOVERY IN CASE OF DECREE

OR ORDER

(1) Where a decree or order was passed by any court before the commencement of the Recovery of Debts
Due to Banks and Financial Institutions (Amendment) Act, 2000 and has not yet been executed, then, the
decree-holder may apply to the Tribunal to pass an order for recovery of the amount.

(2) On receipt of an application under sub-section (1), the Tribunal may issue a certificate for recovery to
a Recovery Officer.

(3) On receipt of a certificate under sub-section (2), the Recovery Officer shall proceed to recover the
amount as if it was a certificate in respect of a debt recoverable under this Act.]

PROTECTION F ACTION TAKEN IN GOD FAITH

No suit, prosecution or other legal proceeding shall lie against the Central Government or against 11 [the
Presiding Officer of a Tribunal or the Chairperson of an Appellate Tribunal] or against the Recovery
Officer for anything which is in good faith done or intended to be done in pursuance of this Act or any
rule or order made thereunder.

IMPORTANT QUESTIONS
Q.1. What are the principles of good lending which are followed by bank?
Q.2. Explain the kinds of guarantee.
Q.3. What are the rights and liabilities of sureties?
Q.4. Constitution, functioning and power of Debt Recovery Tribunals. (DRT)

 
 

UNIT - IV

MERCHANT BANKING IN INDIA

Merchant banking, although a non-banking financial activity, resembles banking function. The functions
of merchant banking which originated, and grew in Europe, were enriched by American patronage, and
these services are now being provided throughout the world by both banking and non-banking
institutions. The terms "Merchant Banking" originated among the Dutch and the Scottish traders, and was
later on developed and professionalized in Britain.

Definition
A set of functions and services rendered by a merchant banker may be termed as 'Merchant Banking'.

1. According to Random House Dictionary, "merchant bank is an organisation that underwrites

securities for corporations, advises such clients on mergers and is involved in the ownership of
commercial ventures." These organizations are sometimes banks which are not merchants and
sometimes which are not banks and sometimes houses which are neither merchants nor banks.

2. According to Charles P.Kindleburger, "merchant banking is the development of banking from

commerce which frequently encountered a prolonged intermediate stage known in England
originally as merchant banking".

3. According to the Securities and Exchange Board of India (Merchant Bankers) Rules, 1992,
management either by making arrangements regarding selling, buying or subscribing to securities
or acting as manager, consultant, adviser or rendering corporate advisory services in relation to
such issue management.

Merchant banking activity was formally initiated into the Indian capital markets when Grindlays bank
received the license from Reserve Bank in 1967. Grindlays started with management of capital issues,
recognized the needs of emerging class of Entrepreneurs for diverse financial services ranging from
production planning and system design to market research. It even provides management consulting
services to meet the requirements of small and medium sectors rather than large sector. Citibank set up its
merchant banking division in 1970. The various tasks were performed by this division namely assisting
new entrepreneur, evaluating new projects, raising funds through borrowing and issuing equity. Indian
banks started banking services as a part of multiple services they offer to their clients in 1972, State Bank
of India started the merchant banking division.
In the initial years the SBI's objective was to render corporate advice and assistance to small and medium
entrepreneurs. Merchant banking activities are of course organized and undertaken in several forms.
Commercial banks and foreign development finance institutions have organized them through formation
of divisions, nationalized banks have formed subsidiaries, companies and share brokers and consultancies
constituted themselves into public limited companies or registered themselves as private limited
Companies. Some merchant banking outfits have entered into collaboration with merchant bankers abroad
with several branches.

 
 

SEBI (MERCHANT BANKERS) REGULATIONS 1992

Registration of Merchant Bankers with SEBI

It is mandatory for a merchant banker to register with the SEBI. Without holding a certificate of
registration granted by the Securities and Exchange Board of India, no person can act as a merchant
banker in India.

1. Only a body corporate other than a non-banking financial company shall be eligible to get
registration as merchant banker.
2. The applicant should not carry on any business other than those connected with the securities
market.
3. All applicants for merchant bankers should have qualifications in Finance, Law or Business
Management.
4. The applicant should have infrastructure like office space, equipment, manpower etc.
5. The applicant must have at least two employees with prior experience in merchant banking.
6. Any associate company, group company, subsidiary or interconnected company of the applicant
should not have been a registered merchant banker.
7. The applicant should not have been involved in any securities scam or proved guilt of any offence

The various categories for which registration can be obtained are:

1. Category I - To carry on the activity of issue management and to act as adviser, consultant,
manager, underwriter, portfolio manager.
2. Category II - To act as adviser, consultant, co-manager, underwriter, portfolio manager.
3. Category III - To act as underwriter, adviser or consultant to an issue
4. Category IV - To act only as adviser or consultant to an issue

The capital requirement for carrying on activity as merchant banker:

The capital requirement depends upon the category. The minimum net worth requirement for acting as
merchant banker is given below:
Category I - Rs. 5 crores
Category II - Rs, 50 lakhs
Category III - Rs. 20 lakhs
Category IV - Nil

Procedure for Getting Registration:

An application should be submitted to SEBI in Form A of the SEBI (Merchant Bankers) Regulations,
1992. SEBI shall consider the application and on being satisfied, issues a certificate of registration in
Form B of the SEBI (Merchant Bankers) Regulations, 1992.

Registration Fee Payable to SEBI

Rs. 5 lakhs should be paid within 15 days of date of receipt of intimation regarding grant of certificate.
Validity period of certificate of registration is three years from the date of issue. Three months before the

 
 

expiry period, an application along with renewal fee of 2.5 lakhs should be submitted to SEBI in Form A
of the SEBI (Merchant Bankers) Regulations, 1992. SEBI shall consider the application and on being
satisfied renew certificate of registration for a further period of 3 years.

Merchant Bankers in India:

There are 135 Merchant bankers who are registered with SEBI now in India. There are public sector,
Private sector and foreign players registered with SEBI. The below are the examples of a few of the
Merchant bankers in each of the Public, private and foreign players.

Public sector Merchant Bankers

• SBI CAPITAL MARKETS LTD
• PUNJAB NATIONAL BANK
• BANK OF MAHARASHTRA
• IFCI FINANCIAL SERVICES LTD
• KARUR VYSYA BANK LTD,
• STATE BANK OF BIKANER AND JAIPUR

Private Sector Merchant Bankers

o ICICI SECURITIES LTD
o AXIS BANK LTD.(FORMERLY UTI BANK LTD.)
o BAJAJ CAPITAL LTD
o TATA CAPITAL MARKETS LTD
o ICICI BANK LTD
o RELIANCE SECURITIES LIMITED
o KOTAK MAHINDRA CAPITAL COMPANY LTD
o YES BANK LTD.
• GOLDMAN SACHS (INDIA) SECURITIES PVT. LTD.
• MORGAN STANLEY INDIA COMPANY PVT LTD
• BARCLAYS SECURITIES (INDIA) PVT. LTD
• BANK OF AMERICA, N.A
• DEUTSCHE BANK
• DEUTSCHE EQUITIES INDIA PRIVATE LIMITED
• BARCLAYS BANK PLC
• CITIGROUP GLOBAL MARKETS INDIA PVT. LTD.
• DSP MERRILL LYNCH L TD
• FEDEX SECURITIES LTD
• LETTER OF CREDIT AND DEFEND GUARANTEE

LETTER OF CREDIT AND DEFEND GUARANTEE

A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers that they will
get paid as long as they do what they have agreed to do.

 
 

Letters of credit are common in international trade because the bank acts as an uninterested party between
buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In
addition, communication can be difficult across thousands of miles and different time zones. A letter of
credit spells out the details so that everybody's on the same page.

Letter of Credit Lingo

To better understand letters of credit, it may help to know the following:
Abbreviations for 'letter of credit' include UC, LC, and LOC
Applicant - the buyer in a transaction
Beneficiary - the seller or ultimate recipient of funds Issuing bank - the bank that promises to pay
Advising bank - helps the beneficiary use the letter of credit
The Money Behind a Letter of Credit

A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if they know the buyer will pay. Some buyers have to deposit
for already have) enough money to cover the letter of credit, and some customers use a line of credit faith
the bank. Sellers must trust that the bank issuing the letter of credit is legitimate.

Executing a Letter of Credit

A seller only gets paid after performing specific actions that the buyer and seller agree to.
For example, the seller may have to deliver merchandise to a shipyard in order to satisfy requirements for
the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he
made delivery. The letter of credit now must be paid even if something happens to the merchandise. If a
crane falls on the merchandise or the ship sinks, it is not the seller's problem.

To pay on a letter of credit, banks simply review documents proving that a seller performed his required
actions. They do not worry about the quality of goods or other items that may be important to the buyer
and seller.

Pitfalls f Letters of Credit

Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you
should be careful when using letters of credit.

As a seller, make sure you:

Carefully review all requirements for the letter of credit before moving forward with a deal. Understand
all the documents required. Can get all the documents required for the letter of credit. Understand the time
limits associated with the letter of credit, and whether they are reasonable. Know how quickly your
service providers (shippers, etc) will produce documents for you. Can get the documents to the bank on
time.

 
 

Make all documents required by the letter of credit match the letter of credit application exactly.

Getting a Letter of Credit

To get a letter of credit, visit your bank. Ask if they can help you with a letter of credit, or if they have
any suggestions. Small banks and credit unions might not be able to accommodate you.

Some of the Documents Called for under a Letter of Credit

Financial Documents
Bill of Exchange, Co-accepted Draft
Commercial Documents
Invoice, Packing list
Shipping Documents
Transport Document, Insurance Certificate, Commercial, Official or Legal Documents
Official Documents
License, Embassy legalization, Origin Certificate, Inspection Cert , Phyto-sanitary Certificate
Transport Documents
Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck receipt, railway receipt,
CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver Challan ... etc

Insurance Document
Insurance policy, or certificate but not a cover note.

NEGOTIABLE INSTRUMENTS ACT 1881

The Negotiable Instruments Act was passed in 1881. Some provisions of the Act have become redundant
due to passage of time, change in methods of doing business and technology changes. However, the basic
principles of the Act are still valid and the Act has stood test of time. The Act extends to the whole of
India.

There is no doubt that the Act is to regulate commercial transactions and was drafted to suit requirements
of business conditions then prevailing. The instrument is mainly an instrument of credit readily
convertible into money and easily passable from one hand to another

Negotiable Instruments

The word "negotiable" means "transferable from one person to another in return for consideration" and
"instrument" means a "written document by which a right is created in favour of some person."

A negotiable instrument is a document which entitles a person to a sum of money and which is
transferable from one person to another by mere delivery or by endorsement and delivery.

"The great element of negotiability is the acquisition of property by your own conduct, not by another's,
that if you take it bona fide and for value, nobody can deprive you of it. Raephal v. Bank of England1 is

 
 

an authority for this proposition. Some banknotes of the Bank of England were stolen in a robbery. The
bank immediately prepared and distributed a list of the stolen notes. The plaintiff who was a
money-changer in Paris, also received one such list. Twelve months after the receipt of this notice a man
came to the plaintiff to exchange a Bank of England note. The plaintiff had no recollection of the notice
and completely forgetting it cashed the note. The note turned out to be a stolen one. It was held that the
plaintiff, having taken the note in food faith, was entitled to its payment. He was no doubt somewhat
negligent, but he had acted honestly.

Characteristics of Negotiable Instrument

1. Freely transferable: The property passes from one person to another by delivery, and by
endorsement and delivery if it is payable to order.

2. Title of holder free from all defects: A holder in due course, gets the instrument free from all
defects in the title of the transferor.

3. Recovery: The holder can sue upon a negotiable instrument in his own name for the recovery of
the amount.

4. Presumptions: Certain presumptions are as follows:

a) Consideration: Every negotiable instrument is presumed to have been made, drawn, accepted,
endorsed, negotiated or transferred, for consideration.

b) Date: Every negotiable instrument bearing a date is presumed to have been made or drawn on
such date.
c) Time of acceptance.
d) Time of transfer.
e) Order of endorsements.
f) Stamp.
g) Holder presumed to be a holder in due course.
h) Proof of protest.

KINDS F NEGOTIABLE INSTRUMENTS

(1) Negotiable by Statute, or

(2) Negotiable by custom or usage.

1. Instruments Negotiable by Statute: Promissory notes, Bills of exchange and Cheques are
negotiable by Statute.

2. Instruments Negotiable by Custom or Usage: exchequer bills, bank notes, share warrants,
circular notes, bearer debentures, dividend warrants, share certificates with blank transfer deeds,

 
 

etc. In India, Government promissory notes, banker's drafts and pay orders, hundis, delivery
orders and railway receipts for goods, have been held to be negotiable by usage or custom.

Section 13 of the Negotiable Instruments Act, 1881, provides that negotiable instruments include
promissory note, bill of exchange and cheque, whether payable to bearer or order.

"Negotiable instrument": (1) A "negotiable instrument" means a promissory note, bill of exchange or
cheque payable either to order or to bearer.

Explanation (i) - A promissory note, bill of exchange or cheque is payable to the order which is expressed
to be so payable or which is expressed to be payable to a particular person, and does not contain words,
prohibiting transfer or indicating an intention that it shall not be transferable.

Explanation (iij - A promissory note, bill of exchange or cheque is payable to bearer which is expressed to
be so payable or on which the only or last endorsement is an endorsement in blank.
Explanation (iii) - Where a promissory note, bill of exchange or cheque, either originally or by
endorsement, is expressed to be payable to the order of a specified person, and not to him or his order, it
is nevertheless payable to him or his order at his option.

A negotiable instrument may be payable to two or more payees jointly, or it may be made payable in the
alternative to one of two, or one or some of several payees.

Promissory Note
A 'promissory note' is an instrument in writing (not being a bank note or a currency note) containing an
unconditional undertaking signed by the maker, to pay a certain sum of money only to, or to order of, a
certain person, or to the bearer of the instrument (Sec. 4 N.!. Act 1881)
The person who makes the promissory note and promises to pay is called the payer. Illustration
(a) I promise to pay B or order Rs. 500
(b) I acknowledge myself to be indebted to B in Rs. 1000, to be paid on demand, for value
received.

Specimen of a Promissory Note

Rs. 1,000 Dehi, February 10,2010

Three months after date I promise to pay Hari Mohan or order the sum of one thousand rupees, for value
received.

To,
Hari Mohan Stamp
222, Ashok Vihar
Delhi-110052

Essential Elements

 
 

1. Writing: Writing includes print and typewriting and may also be in pencil or ink
2. Promise to Pay: The instrument must contain an express promise to pay.
3. Definite and Unconditional: The promise to pay must be definite and unconditional. If it is
uncertain or conditional, the instrument is invalid.
4. Beardsley v Baldwin a written undertaking to pay a sum of money within so many days after the
defendant's marriage was not recognized as a promissory note, because possibly the defendant
may never marry and the sum may never become payable.
5. Signed by the Maker: Signature means the writing of a person's name in order to authenticate
and give effect to the contract contained in the instrument.
6. Certain Parties: The instrument must point out with certainty as to who the maker is and who
the payee is. A promissory note cannot be made payable to the maker (promisor) himself.
7. Certain Sum of Money: The sum payable must be certain and must not be capable of contingent
additions or subtractions.
8. Promise to Pay Money only: If the instrument contains a promise to pay something other than
money or something in addition to money, it cannot be a promissory note.
9. Bank note or currency note is not a promissory note. This is because a bank note or a currency
note is money itself.
10. Formalities like number, date, place, consideration, etc. The omission of the words 'for value
received', the place where the instrument is made or where it is payable or date (if the date of
execution of the instrument can be independently proved) do not invalidate the instrument. The
date of a promissory note is also not necessary unless the amount is payable at a certain time after
date. But it must bear the necessary stamp under the Indian Stamp Act, 1899.
11. It may be payable on demand or after a definite period of time.
12. It cannot be made payable to bearer on demand. Bill of Exchange

A bill of exchange is an instrument in writing containing an unconditional order, signed by the maker,
directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to
the bearer of the instrument (Sec. 5 N.!. Act 1881).

Parties to a bill. There are there parties to a bill of exchange, viz., the drawer, the drawee and the payee.

The person who gives the order to payor who makes the bill is called the drawer. The person who is
directed to pay is called the drawee.

When the drawee accepts the bill, he is called the acceptor.

The person to whom the payment is to be made is called the payee. Where the payee named in a bill s a
fictitious or non-existing person, the bill is treated as payable to bearer.

The drawer or the payee who is in possession of the bill is called the holder.

When the holder endorses the bill, note or cheque, he is called the endorser. The person to whom the bill,
note or cheque is endorsed is called the endorsee.

 
 

When in the bill or in any endorsement thereon the name of any person is given in addition to the drawee
to be referred to in case of need, such person is called a drawee in case of need (Sec. 7, para 2).

Specimen of a Bill of Exchange

Rs. 500 Mumbai, Jan. 10 2010

Three months after date pay to Shyam or order the sum of five hundred rupees, for vaue received.

To, Ram
235, Subhash Marg,
Delhi-110006

In case of need with Accepted Stamp

Canara Bank, Delhi Ram Sd/- Krishan

Essential Elements:

1) It must be in writing
2) It must contain an order to pay

In Ruff v Webb3 the plaintiff Ruff was a servant of the defendant Webb. The defendant dismissed
him from service and for his wages gave him a draft in the following words: "Mr. Nelson will much
oblige Mr. Webb by paying to J Ruff or order, twenty guineas on his account."

Lord Kenyon was of opinion that the "paper ... was a bill of exchange, that it was an order by one
person to another to pay money to the plaintiff or his order." It is quite apparent that the language of
the draft was very polite, but it has been said that "the introduction of the terms of gratitude does not
destroy the promise (or order) to pay."

3) The order must be unconditional

4) It requires three parties.
First, the person who makes the bill of exchange, called the drawer; second, the person to whom it is
addressed, called the drawee and, thirdly, the payee. All these parties must be indicated with
reasonable certainly. Sometimes the drawer and the payee are the same persons as where a bill is
drawn "Pay to me or my order". In such a case these are only two parties but without this minimum of
two there cannot be a bill of exchange.

5) The parties must be certain.

6) It must be signed by the drawer.
7) The sum payable must be certain.
8) It must contain an order to pay money.
9) The formalities relating to number, date, place and consideration, though usually found in bills,
are not essential in law.

 
 

Distinction between a bill of exchange and a promissory note

1. In a note there are two parties - the maker and the payee. In a bill there are three parties - the
drawer, the drawee and the payee.
2. A note contains an unconditional promise to pay. A bill contains an unconditional order to pay.
3. The maker of a note is the debtor and he himself undertakes to pay. The drawer of a bill is the
creditor who directs the drawee (his debtor) to pay.
4. The liability of the maker of a note is primary and absolute, whereas the liability of the drawer of
a bill is secondary and conditional.
5. A note cannot be made payable to the maker himself, whereas in a bill the drawer and the payee,
may be one and the same person.

Cheque
A cheque is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise
than on demand. Sec.6 of N.1. Act 1881.

A cheque being a bill of exchange must possess all the essentials of a bill and should also meet the
requirements of Section 6.4 For instance, in the case of Cole v Milson5, a document was drawn
absolutely in the form of a cheque. It was made payable to "cash or order." The question was whether it
was a valid cheque. Section 5 of the Indian Act and Section 3(1) of the English Act require that a bill of
exchange must be made payable to or to the order of a specified person or to bearer. This document was
made payable to "cash or order". Hence, it was· not payable to any person or to bearer and, therefore, was
not a bill of exchange within the meaning of the above sections. And if it was not a bill of exchange, it
could not be a cheque either.

R. Pillai v S. Ayyar A District Board had its funds in a Government Treasury and used to withdraw
money by issuing orders in the form of cheques. One such unconditional order in writing have been
issued the question was whether it was a cheque. Ayyar J held that "Treasury is not a bank" and,
therefore, the order was not a cheque under Section 6, but a bill of exchange under Section 5. The reason
is that every person who receives the money of another and pays it according to hi orders cannot be
regarded as a banker, unless he establishes that business for profit.

A cheque is a bill of exchange drawn upon a specified banker and payable on demand and it includes the
electronic image of a truncated cheque and a cheque in the electronic form.

A truncated cheque means a cheque which is truncated during the course of a clearing cycle, either by the
clearing house or by the bank whether paying or receiving payment, immediately on generation of an
electronic image for transmission, substituting the further physical movement of the cheque in ',vriting.

Clearing house" means the clearing house managed by the Reserve Bank of India or a clearing house
recognized as such by the Reserve Bank of India [Sec. 6 as substituted by the Negotiable Instruments i
Amendment and Miscellaneous Provisions) Act, 2002]

A cheque has the following two additional qualifications, viz.,

 
 

It is always drawn on a specified banker, and

It is always payable on demand.

All cheques are bills of exchange, but all bills of exchange are not cheques. A cheque must have all the
essential requisites of a bill of exchange. It must be signed by the drawer. It must contain an unconditional
order on a specified banker to pay a certain sum of money to or to the order of a specified person or the
bearer of the cheque. But it does not require acceptance as it is intended for immediate payment.

The usual form of bank cheque is as follows:

No……………… Date …………….200

Punjab National Bank

Subzi Mandi, Delhi-110007

Pay …………….. r bearer the sum of Rs………………………………………………….

Rs………….. Sd/-

Distinction between a Bill of Exchange and a Cheque

1) A bill of exchange may be drawn on any person, including a banker, but a cheque is always
drawn on a banker.

2) A bill must be accepted before the drawee can be called upon to make payment upon it. A cheque
requires no acceptance.

3) A bill which is not expressed to be payable on demand is entitled to three days of grace. A cheque
is not entitled to any days of grace.

4) A bill may be payable on demand or after the expiry of a certain period after date or sight. A
cheque is always payable on demand.

5) A cheque may be crossed but not a bill.

6) A cheque does not require any stamp whereas a bill, except in certain cases, must be stamped.

Crossing of Cheque

There are two types of cheques, open cheques and crossed cheques. A cheque which is payable in cash
across the counter of a bank is called an open cheque.

A crossed cheque is one on which two parallel transverse lines with or without the words '& Co.' are
drawn. The payment of such a cheque can be obtained only through a banker. Thus crossing is a direction
to the drawee banker to pay the amount of money on a crossed cheque generally to a banker or a
particular banker so that the party who obtains the payment of the cheque can be easily traced.

 
 

Types of Crossing: There are two types of crossing, viz.,

(1) General crossing, and (2) special crossing

Another type of crossing known as 'restrictive crossing' has developed out of business usage.

1) General Crossing: A Cheque is said to be crossed generally where it bears across its face an
addition of

a) The words 'and company' or any abbreviation thereof, between two parallel transverse lines,
either with or without the words 'not negotiable'; or
b) Two parallel transverse lines simply, either with or without the words 'not negotiable' (Sec. 123).

Specimens of general crossing:

Where a cheque is crossed generally, the drawee banker shall not pay it unless it is presented by a banker
(Sec. 126 para 1).

2) Special Crossing: Where a cheque bears across its face an addition of the name of a banker, either
with or without the words 'not negotiable', the cheque is deemed to be crossed specially (Sec.
124). Transverse lines are not necessary in case of a special crossing. The payment of a specially
crossed cheque can be obtained only through the particular banker whose name appears across the
face of the cheque or between the transverse lines, if any
Specimens of Special Crossing: Where" a cheque is crossed specially the banker on whom it is
drawn shall pay it only to the banker on whom it is crossed, or his agent for collection (Sec. 126,
para 2).

3) Restrictive Crossing: In this type of crossing the words 'Ale payee' are added to the general or
special crossing.

Specimens of Restrictive Crossing: The words 'Ale Payee' on a cheque are a direction to the
collecting banker that the amount collected on the cheque is to be credited to the account of the
payee. If he credits the proceeds to a different account, he is prima facie guilty of negligence and
will be liable to the true owner for the amount of the cheque it should however be noted that 'Ale
Payee' cheques are negotiable.

Not Negotiable Crossing

The title of the transferee of such a cheque cannot be better than that of its transferor. The addition of the
words 'not negotiable' does not restrict the further transferability of the cheque. It only takes away the
main feature of negotiability, which is, that a holder with a defective title can give a good title to a
subsequent holder in due course. Anyone who takes a cheque marked 'not negotiable' takes it at his own
risk.

 
 

Who may cross a cheque (Sec. 126) A cheque may be crossed by

1) The drawer: He may cross the cheque generally or specially.

2) The holder: Where the cheque is uncrossed, the holder may cross it generally or specially.
Where it is crossed generally, he may cross it specially. Where it is crossed generally or specially,
he may add the words 'Not Negotiable'.

3) The banker: Where a cheque is crossed specially, the banker to whom it is crossed may again
cross it specially to another banker (his agent) for collection.

Holder and Holder in Due Course

Holder (Sec. 8): The "holder" of a promissory note, bill of exchange or cheque means any person entitled
in his own name (i) to the possession thereof, and (ii) to receive or recover the amount due thereon from
the parties thereto.

Where the note, bill or chqeue is lost or destroyed, its holder is the person so entitled at the time of such
loss or destruction.

Sarjoo Prasad v Rampayari Debi. The plaintiff advanced a sum of Rs. 2459 under a hand note. The
note was executed not in the name of the plaintiff, but in the name of one X who was a name-lender or a
benamidar. On maturity the plaintiff brought an action to recover the amount. The High Court of Patna
rejected his claim. He was not entitled to the possession of the note 'in his own name' and, therefore, was
not the holder.

HOLDER AND HOLDER IN DUE CURSE (SEC.9)

Holder in Due Course: "Holder in due course" means any person who for consideration became the
possessor of a promissory note, bill of exchange or cheque if payable to bearer, or the payee or endorsee
thereof, if payable to order, before the amount mentioned in it became payable and without having
sufficient cause to believe that any defect existed in the title of the person form whom he derived his title.

The phrase "in good faith and for value" has been split up by Section 9 into four elements all of which
must concur to make a holder in due course. They are:

(1) The holder must have taken the instrument for value. (2) He must have obtained the instrument before
its maturity. (3) The instrument must be complete and regular on its face. (4) He must have taken the
instrument in good faith and without notice of any defect either in the instrument or in the title of the
person negotiating it to him.

Any person is a 'holder in due course' if he fulfils the following conditions:

1) That, for consideration, he became (i) the possessor of the negotiable instrument if payable to
bearer, or (ii) the payee or endorsee thereof, if payable to order.

 
 

2) That he became the holder of the instrument before its maturity.

3) That he became the holder of the instrument in good faith, i.e., without sufficient cause to believe
that any infirmity in the instrument of defect existed in the title of the person from whom he
derived his title.

A holder of a negotiable instrument will not be a holder in due course if -

1) He has obtained the instrument by gift or for an unlawful consideration or by some illegal
method; or
2) He has obtained the instrument after its maturity; or
3) He has not obtained the instrument bona fide.

Privileges of a Holder in Due Course: A holder in due course gets title to a negotiable instrument free
from equities.

The special privileges of a holder in due course are as follows:

1) Inchoate Stamped Instrument: A person, who has signed and delivered to another a stamped
but otherwise inchoate instrument, is precluded from asserting, as against a holder in due course,
that the instrument has not been filled in accordance with the authority given by him, the stamp
being sufficient to cover the amount.

Suppose A signs his name on a blank but stamped instrument. He gives the paper to B with
authority to fill it up as a promissory note for Rs. 250 only. But B fraudulently fills the paper for
Rs 1000, the stamp put upon it being sufficient to cover the amount. He then hands it to H for Rs.
1000, who takes it without notice of fraud.8 A will be bound to pay the full amount to H, because
under this section it does not lie in the mouth of the signer to say that in filling the instrument his
authority has been exceeded.

2) Liability of Prior Parties: Every prior party to a negotiable instrument is liable thereon to a
holder in due course untitle the instrument is duly satisfied.

3) Negotiable Instrument Without Consideration : When a negotiable instrument is made, drawn,

accepted or transferred without consideration. An agreement made without consideration is void
(Sec. 25 of the Indian Contract Act, 1872). But if the negotiable instrument gets into the hands of
a holder in due course, he can recover the amount on it from any of the prior parties thereto.

4) Conditional Delivery: If a bill or note is negotiated to a holder in due course, the other parties to
the instrument cannot avoid liability on the ground that the delivery of the instrument was
conditional or for a special purpose only (Sec. 46, para 3)

5) Every Holder is a Holder in Due Course: The law presumes that every holder is a holder in due
course, although the presumption is rebuttable (Sec. 118).

 
 

6) Presumptions: The first privilege is that "every holder is deemed prima facie to be a holder in
due course". The burden of proving his title does not lie on him. If the defendant intends to set up
the defence that there was something wrong in the inception or subsequent negotiations of the bill
the burden of proving that lies on him. Once it is shown that the history of the bill is tainted with
fraud or illegality the burden is shifted to the holder to prove that he is a holder in due course.9
When the burden of establishing his bona fides is thus cast upon the holder, he has to show either
that subsequently to the alleged fraud or illegality value has in good faith been given for the
instrument or that he is a bona fide holder for value.

7) Endorsee from Holder in Due Course: A holder who receives an instrument from a holder in
due course gets the rights of the holder in due course, even if he had knowledge of the prior
defects, provide that he was not a party to them. This will apply to the case of a drawer also who
has received back his bill from a holder in due course. A seller drew a bill upon his buyer for the
price of two consignments of steel the seller discounted the bill with a bank which transferred it
to another bank. It was accepted by the buyer in due course, but he ultimately refused payment
because of a dispute about the quality of steel. The bill came back to the seller by the process of
negotiation back. The seller claimed payment of the bill from the buyer. It was held that although
the seller was the drawer, he was also the holder in due course and his rights fell to be determined
as such. Similarly, where a bill came by process of negotiation to the possession of a bank, who
was the drawer's banker, and though he knew the drawer to be in insolvent circumstances, he was
held to be a holder in due course because he had taken the bill from a holder in due course.

IMPORTANT QUESTIONS

Q.1. Explain the following:

a) Letter of credit
b) Guarantee

Q.2. What do you mean by negotiable instruments? Also explain its kinds.
Q.3. What do you mean by cheque? State different types of crossing of cheque and effect of each.

Q.4. Explain the promissory note and bill of exchange.

Q.5. Write short note on

Holder
Holder in due course

 
 

UNIT-V

NEGOTIABLE INSTRUMENTS ACT 1881

NEGOTIATION

One of the essential characteristics of a negotiable instrument is that it is freely transferable from one
person to another. This transfer may take place either -

1. by negotiation, or
2. by assignment

1) Transfer by Negotiation: When a promissory note, bill of exchange or cheque is transferred by one
party to another, so as to constitute the transferee the holder thereof, the instrument is said to be
negotiated (Sec. 14).

Two methods of transfer by negotiation, namely-

a) Negotiation by delivery. An instrument payable to bearer is negotiable by delivery thereof (Sec. 47).

b) Negotiation by endorsement and delivery. An instrument payable to order is negotiable by the

holder by endorsement and delivery thereof (Sec. 48).

Kinds of Delivery: Delivery may be (1) actual, (2) constructive, or (3) conditional or for a special
purpose.

Actual delivery takes place when the instrument changes hands physically.

Constructive delivery takes place when the instrument is delivered to the agent, or servant of the endorsee
on his behalf or when the endorser, after endorsement, holds the instrument as an agent of the endorsee.

2) Transfer by Assignment: When a person transfers his right to receive the payment of a debt.
'assignment of the debt' takes place.

The Negotiable Instruments Act does not deal with transfer of negotiable instruments by assignment.

Distinction between Negotiation and Assignment

Negotiation
1. Consideration is presumed.
2. The title of the transferee (i.e., the holder in due course) is better than that of the transferor.

Instruments payable to bearer are negotiated by mere delivery and instrument payable to order
are negotiated by endorsement and delivery.

Assignment

 
 

1. Consideration must be proved.

2. The title of the assignee is subject to the defects and equities in the title of the assignor.
3. An assignment can only be made in writing either on the instrument itself or in a separate
document transferring to the assignee the transferor's rights in the instrument.

PRESENTMENT

Presentment of a Negotiable Instrument: Presentment means showing an instrument to the drawee,

acceptor or maker for acceptance, sight or payment. There are, therefore, three kinds of presentment:

1. Presentment of bills of exchange for acceptance.

2. Presentment of promissory notes for sight.
3. Presentment of negotiable instruments for payment.

1. Presentment for Acceptance

It is only bills of exchange of a certain type that require acceptance. A bill is said to be accepted when
the drawee puts his signature on it signifying his assent to the order of the drawer that he will pay the
bill at the time when it is due.
The essentials of a valid acceptance are as follows:

a) It must be written on the bill.

b) It must be signed by the drawee personally or through a duly authorized agent.
c) The accepted bill must be delivered to the holder.

Presentment for acceptance must be made at a reasonable hour on a business day and before the bill is
overdue (Sec. 61).

Modes of Acceptance: An acceptance may be general or qualified.

General Acceptance: An acceptance is general or absolute where the drawee, while accepting the bill,
does not attach any condition or qualification to it.

Qualified Acceptance: An acceptance is qualified where it is given subject to some condition or

qualification.

2) Presentment for Sight : A note payable at a certain period after sight must, however, be
presented to the maker for sight in order to fix its maturity. The presentment should be made
during business hours on a business day. In default of such presentment, no party thereto is liable
thereon to the person making such default (Sec. 62).

3) Presentment for Payment: Promissory notes, bills of exchange and cheques must be presented
for payment to the maker, acceptor or drawee thereof respectively, by or on behalf of the holder.

 
 

DISCHARGE FROM LIABILITY

The term 'discharge' in relation to a negotiable instrument is used in two senses, viz.,

a) discharge of the instrument, and

b) discharge of one or more of the parties from liability thereon.

An instrument is said to be discharged when all rights of action under it are completely extinguished and
when it ceases to be negotiable.

Discharge of an Instrument

1. By payment in due course. The instrument is discharged by payment made in due course by the
party who is primarily liable to pay (Le., the maker or the acceptor), or by a person who is
accommodated in case the instrument was made or accepted for his accommodation.

2. By party primarily liable becoming holder. If the maker of a note or the acceptor of a bill
becomes its holder at or after its maturity in his own right (Le., he has an absolute title and does
not hold it conditionally or as an agent), the instrument is discharged (Sec. 90).

3. By express waiver. When the holder of a negotiable instrument at or after its maturity absolutely
and unconditionally renounces in writing or gives up his rights against all the parties to the
instrument, the instrument is discharged.

4. By cancellation. Where an instrument is intentionally cancelled by the holder or his agent and the
cancellation is apparent thereon, the instrument is discharged.

5. By discharge as a simple contract. A negotiable instrument may be discharged in the same way as
any other contract for the payment of money.

Discharge of a Party or Parties

1. By Payment: When payment on an instrument is made in due course, both the instrument and the
parties to it are discharged [Sec. 82 (c)].

2. By Cancellation: When the holder of a negotiable instrument or his agent cancels the name of a
party on the instrument with intent to discharge him, such party and all subsequent parties, who
have a right of recourse against the party whose name is cancelled, are discharged from liability
to the holder [Sec. 82 (a)].

 
 

3. By Release: Where the holder of a negotiable instrument releases any party to the instrument by
any method other than cancellation, the party so released is discharged from liability [Sec. 82
(b)].

4. By Allowing drawee more than forty-eight hours: If the holder of a bill of exchange allows the
drawee more than forty-eight hours exclusive of public holidays, to consider whether he will
accept the same, all previous parties not consenting to such allowance are thereby discharged
from liability to such holder (Sec. 83).

5. By Non-presentment of cheque: Where a cheque is not presented by the holder for payment
within a reasonable time of its issue and the drawer suffers actual damage through the delay
because of the failure of the bank, he is discharged from liability to the extent of such damage.

6. Cheque payable to order: Where a cheque payable to order purports to be endorsed by the
payee, the banker is discharged by payment in due course. Where a cheque is originally expressed
to be payable to bearer the drawee is discharged by payment in due course to the bearer thereof.

DISHONOUR

A bill may be dishonoured by non-acceptance or by non-payment. A promissory note and a cheque are
dishonoured by non-payment only. When a negotiable instrument is dishonoured, the holder must give a
notice of dishonour to all the prior parties in order to make them liable on the instrument.

Dishonour by non-acceptance (Sec. 91)

A bill of exchange is dishonoured by non-acceptance in anyone of the following ways:

1. If the drawee does not accept the bill within forty-eight hours from the time of presentment
though it is duly presented for acceptance;
2. If there are several drawees (who are not partners) and all of them do not accept;
3. When presentment for acceptance is excused, and the bill is not accepted;
4. When the drawee is incompetent to contract;
5. When the drawee gives a qualified acceptance;
6. When the drawee is a fictitious person or after reasonable search cannot be found.

Dishonour by non-payment (Sec. 92)

A promissory note, bill of exchange or cheque is said to be dishonoured by non-payment when the maker
of the note, acceptor of the bill or drawee of the cheque makes default in payment upon being duly
required to pay the same. (Sec. 92).

Notice of Dishonour

 
 

When a negotiable instrument is dishonoured either by non-acceptance or by non-acceptance or by non-

payment, the holder of the instrument or some party to it who is liable thereon, must give a notice of
dishonour to all the prior parties whom he wants to make liable on the instrument.

THE PAYING BANKER

The bank of while a cheque is drawn (the bank whose name is printed on the cheque) and which pays the
amount for which the cheque is writen and deducts that sum from the customer's account.

THE COLLECTING BANKERS

Collection of cheques, bills of exchange and other instruments on behalf of a customer is an indispensable
service rendered by a modern banker to his customer. When a customer of a banker receives a cheque
drawn on any other banker he has two options before him - (i) either to receive its payment personally or
through his agent at the drawee bank, or (ii) to send it to his banker for the purpose of collection from the
drawee bank. In the latter case the banker, deputed to collect the amount of the cheque from another
banker, is called the 'collection banker' he presents the cheque of encashment to the drawee banker and on
its realisation credits the account of the customer with the amount so realised.

A banker is under no legal obligation to collect his customer's cheques but collection of cheques has now
become an important function of a banker with the growth of banking habit and with wider use of crossed
cheques, which are invariably to be collected through a banker only. While collecting his customer's
cheques, a banker acts either.
(i) As a holder for value, or
(ii) As an agent of the customer

The legal position of the collection banker, therefore, depends upon the capacity in which he collects the
cheques. It does not make any difference if the collection banker presents the cheque through the clearing
house.

1. Collecting banker as Holder for Value: Collection of cheques takes some time, specially in case of
outstation cheques. If the collecting banker pays to the customer the amount of the cheque or credits
such amount to his account and allows him to draw on it, before the amount of the cheque is actually
realised from the drawee banker, the collecting banker is deemed to be its 'holder for value'. He takes
an undertaking from the customer to the effect that the latter will reimburse the former in case of
dishonor of the cheque.

A banker becomes its holder for value by giving its value to the customer in any of the following ways:
(a) by lending further on the strength of the cheque;
(b) by paying over the amount of the cheque or part of it in cash or in account before it is
cleared;
(c) by agreeing either then or earlier, or as a course of business, that customer may draw
before the cheque is cleared;
(d) by accepting the cheque in avowed reduction of an existing overdraft; and

 
 

(e) by giving cash over the counter for the cheque at the time it is paid in for collection.

In any of these circumstances the banker becomes the holder for value and also the holder in due course.
He bears the liability and possesses the right s enjoyed by the holder for value. If the last but one
endorsement is proved to be forged, he will be liable to the true owner of the cheque. But he shall have
the right to recover the money from the last endorser, Le., his own customer. If the customer is unable to
pay, the banker himself will bear the loss. If the cheque sent for collection is returned dishonored, the
collecting banker can sue all the previous parties after giving them notice of dishonor. It is, however,
essential that the amount of the cheque is paid to the customer in good faith.

2. Collecting Banker as an Agent : A collecting banker acts as an agent of the customer if he credits
the latter's account with the amount of he cheque after amount is actually realised from the drawee
banker. Thereafter the customer is entitled to draw the amount of the cheque. The banker thus acts as
an agent of the customer and charges from him a commission of collecting the amount from
outstation banks.

As an agent of his customer, the collecting banker does not possess title to the cheque better than that of
the customer. If the customer has no title thereto, or his title is defective, the collecting banker cannot
have good title to the cheque. In case the cheque collected by him did not belong to his customer, he will
be held liable for 'conversion of money' i.e., illegally interfering with the rights of the true owner of the
cheque.

Functions of a Collecting Banker

(i) Collecting Banker as Holder for Value: When a collecting banker pays to the customer the
amount of the cheque or credit such amount to his account and allows him to draw it, before the amount
of the cheque is in fact realised from the drawee banker, the collecting banker will be known as holder for
value of the cheque. The customer in such case is obliged to reimburse the banker if the cheque is
dishonoured.

(ii) The Rights of a Banker as Holder for Value: In either case aforementioned, the banker would
bear the liability and possess the rights enjoyed by the holder for value. If the last but one endorsement is
proved to be forged, the collecting banker would be liable to the true owner of the cheque.

(iii) Banker as an Agent: A collecting banker acts as an agent to a principal, who is his customer.

Arising from this legal burden the collecting banker enters Ipso facto into the region of Section 212, inter
alia of the Contract Act, 1872. This section concerns itself expansively with the skill and diligence
required from an agent, by emphasizing that an Agent is bound to conduct the business of agency with as
much skill as is generally possessed by persons engaged in similar business, unless the principal has
notice of his want to skill. The Agent is always bound to act with reasonable diligence, and to use such
skill as he possesses.

 
 

(iv) Conversion: Conversion has not been defined in the Negotiable Instruments Act, 1881. As per
Thomson's Dictionary of Banking, "Any person who, however innocently obtains possession of goods or
the property of another who has been fraudulently deprived of the possession of them and disposes of
them, whether for his own benefit or that of another person is guilty of conversion." Hollins vs. Fowler,
(1875) LT 7 HL 757.

Conversion means unlawful possession use, deposing or destroying of goods or property by a person,
whether for his own benefit or that of another person, in a manner inconsistent with the owner's right of
possession. Thus, conversion is the wrongful interference with the goods of another person inconsistent
with the owner's right of possession. The term 'goods' includes bill of exchange, cheque or promissory
note. Conversion may be committed innocently. Conversion is a wrong that renders the person
committing it personally liable. Thus liability exists even when a person acts merely as an agent.

For example, A draws a cheque for Rs. one lakh favouring B from whom it is stolen by C, the thief. Here,
C is guilty of conversion and liable for the amount of the cheque to B, the true owner. But suppose C pays
the cheque into his account with the bank which collects the proceeds from the drawee bank. C then
withdraws the money and disappears, or merely spends it. Inspite of complete innocence of the actual
theft, C's bank as his agent is itself now liable for conversion when the true owner B, discovers his loss,
he will seek to recover it from C's bank which always has ample funds to meet such claims, while the
thief has rarely and money or assets to pay over when he is caught. Thus, the bank may be liable for the
amount of the cheque which is collect quite innocently as agent of a customer who had no title to it.

The term 'customer' of a bank is not defined by law. Ordinarily, a person who has an account in a bank is
considered its customer. Banking experts and the legal judgments in the past, however, used to qualify
this statement by laying emphasis on the bank.

To constitute a customer the following essential requisites must be fulfilled:

(i) a bank account - savings, current or fixed deposit - must be opened in his name by making
necessary deposit of money, and

(ii) The dealing between the banker and the customer must be of the nature of banking business.
A customer of a banker need not necessarily be a person. A firm, joint stock Company, a
society or any separate legal entity may be a customer. Explanation to section 45-Z of the
Banking Regulation Act, 1947, clarifies that in that section "customer" includes a
Government department and a corporation incorporated by or under any law.

General Relationship between Banker and Customer

A banker renders a number of services to his customer. The relationship between them primarily is that of
a creditor and a debtor. A banker also acts as an agent r trustee of his customer if the latter entrusts the
former with agency or trust work. In such cases, or the banker acts as a debtor an agent and a trustee
simultaneously but in relation to the specified business.

Relationship as Debtor and Creditor: On the opening of an account the banker assumes the position of
a debtor. He is not a depository or trustee of the customer's money because the money handed over to the

 
 

banker becomes a debt due from him to the customer. A depository accepts something for safe custody on
the condition that it will not be opened or replaced by similar commodity. A banker does not accept the
depositors money on such condition. The money deposited by the customer with the banker is in legal
terms, lent by the customer to the banker, who makes use of the same according to his discretion. The
creditor has the right to demand back his money from the banker, and banker is under an obligation to
repay the debt as and when he is required to do so. But it is not necessary that the repayment is made in
terms of the same currency notes and coins. The payment, of course, must be made in terms of legal
tender currency of the country.

A depositor remains a creditor of his banker so long as his account carries a credit balance. But he does
not get any charge over the assets of his debtor/banker and remains an unsecured creditor or the banker.
Since the introduction of deposit insurance in India in 1962, the element of risk to the depositor is
minimised as the Deposit Insurance and Credit Guarantee Corporation undertakes to insure the deposits
up to a specified amount.

Banker's relationship with the customer is reversed as soon as the customer's account is overdrawn.
Banker becomes creditor of the customer who has taken a loan from the banker and continues in that
capacity till the loan is repaid. As the loans and advances granted by a banker are usually secured by the
tangible assets of the borrower, the banker becomes secured creditor of his customer.

(i) The creditor must demand payment.

(ii) Proper place and time of demand.
(iii) Demand must be made in proper manner

Banker as Trustee: A banker is a debtor of his customer in respect of the deposits made by the latter, but
in certain circumstances he acts as a trustee also. A trustee holds money or assets and performs certain
functions for the benefit of some other person called the beneficiary. For example, if the customer
deposits securities or other valuables with the banker for safe custody, the latter acts as a trustee of his
customer. The customer continues to be the owner of the valuables deposited with the banker. The legal
position of the banker is as a trustee

Banker as Agent: A banker acts as an agent of his customer and performs a number of agency functions
for the convenience of his customers. For example, he buys or sells securities in behalf of his customer,
collects cheques on his on his behalf and makes payment of various dues of his customers, e.g., insurance
premium, etc. the range of such agency functions has become much wider and the banks are now
rendering large number of agency services of diverse nature. For example, some banks have established
Tax Service Departments to take up the tax problems of their customers.

IMPORTANT QUESTIONS

Q.1. Who is customer? Explain the relationship between customer and bank.

Q.2. What is meaning of collecting banker? Express the duties and functions of collecting bankers.

 
 

Q.3. Write short notes on following:

a) Negotiation
b) Presentment

SUGGESTED READINGS
1. Banking Law & Practice, S.N. Maheshwari
2. Banking Law & Practice, P.N. Varshney
3. The Banking Law in Theory & Practice, S.N. Gupta
4. Negotiable Instrument Act, Dr. Avtar Singh
5. Tannen's Banking Law & Practice in India, M.L. Tannen
6. Banking Law & Practice, T.K. Mukherjee