Course: Retail Credit Management NIBM, Pune

Module III: Retail Loan Products

Chapter 4: Documentation

Dr R Bhaskaran

Objective

The objective of this chapter is to highlight the importance of documentation in the

credit function. The chapter explains all documents and security in detail and discuss
procedure of charges and relevant laws.

Structure

1. Introduction
2. The need for documentation
3. Important documents
3.1. Promissory note
3.2. Loan agreement
3.3. Other documents
4. Securities and creation of charge
4.1. Types of charges
4.2. Types of securities
4.3. Pledge
4.4. Hypothecation
4.5. Assignment
4.6. Mortgage
5. Insurance of securities
6. Stamping and registration
7. Limitation
7.1. Extension of period of limitation
8. Summary

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1. Introduction

Credit Departments of banks have three major responsibilities: (i) evaluation/appraisal

of an applicant’s credit worthiness and deciding on granting loan; and once the loan is
sanctioned (ii) disburse the loan as per sanction terms and conditions and (iii) follow up
conduct of the account to ensure that amounts are used as per sanction, repayments are
regular and account reviewed as per terms etc.

As regards the disbursement stage an item of work to be done very meticulously and
indeed most critical is documentation. Disbursement of loan cannot take place unless
documentation is complete. Documentation and disbursements are the two proofs of
loan without which banks cannot provide evidence for the loan given and establish their
rights to recover over the assets of the borrower in the event of recovery through legal
means. As such the competence of a credit officer in documentation plays a critical role
in the viability of loan. It should however be added that credit officers do not require a
law degree or specific drafting skills but should have a clear understanding of the set of
documents needed for each type of loan and important contents and provisions of the
documents. This will enable them to explain the importance of the document and be
trusted advisors to their customers at the same time safe guard the interests of the
bank.

Loan is a contract to lend money and repay as per terms. The steps in loan are as under

1. Applicant/Customer submits an application. The information in the application

is supported by various documents.
2. Bank considers the application and approves or sanctions the loan. The contents
of the application, discussions and acceptances through the appraisal process
and information contained in the documents submitted are essential part of the
process and hence contract. Letter of sanction issued by the bank is the offer for
the loan.
3. On receipt of the sanction letter customer accepts the same by signing the copy
of the letter. After that he executes necessary agreements after which
disbursements are made.

The entire process listed above involves documentation. The important points are

i. Application should be filled in full.

ii. Details in the official valid documents (OVD) for KYC should match with the
details in the application
iii. Documents about the financial details and other aspects of the applicant should
match or support the application.

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iv. Additional information asked by the bank should be listed in a separate paper
and kept with the other documents. Important points that emerge in the
discussion should be written and accepted by both parties.
v. Sanction letter should clearly state the terms and conditions. It should also list all
items that the applicant or bank has to do before the sanction becomes effective.
vi. The details of primary security or collateral security and method of charge
should be clearly mentioned in the sanction letter.
vii. Repayment terms should be indicated in the sanction letter. Loan agreement
should contain the schedule of repayment.
viii. If the amount sanctioned is more than the amount applied for, the reason for the
same should be written and accepted by the applicant/borrower.

The next stage is executing the agreements. Banks has developed detailed agreements
for every product. Content of agreement is discussed later in this chapter. Format and
content of agreement could differ slightly from bank to bank and among various types
of limit and security. Both customer and authorised bank official will have to sign every
page of the agreement and should ensure that it is filled up and nothing is left as blank.

In case a bank has to file a suit against the borrower and/or surety for recovery of dues
the above mentioned documents form the basis and evidence the loan. As indicated
above in respect of most loans banks have standard printed documents which are filled
in appropriate places. These loan documents have been prepared by banks with the
help of lawyers. As regards large value collaterals and in respect of project loans,
corporate loans and large value loans where the terms are more closely negotiated,
banks get the documents prepared and vetted by their approved lawyers before
effecting disbursement.

What is a Document
Section 3 of Indian Evidence Act, 1872 defines a document as:

– Anything in writing, words printed, words lithographed or Xeroxed or

photocopied or photographed,
– An inscription on a metal plate or stone ,
– A caricature or
– A plan,

2. Need for documentation

In normal business atmosphere, agreements and documents are drafted after
negotiation between the lender and the borrower. Given this documentation is done in
order to fulfil certain objectives of both the borrower and the lender.
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Documents should ensure that the objectives of borrower and the bank is well
expressed. The common expectations of a borrower will include:

 That sure that funds (under the loan) will be available as and when needed.
 That terms of credit such as interest and repayments are clearly mentioned
 The terms of penalties if any and conditions for prepayment of loans are
mentioned and
 The various information and details to be given to the bank and its periodicity is
clearly mentioned.

Through the documents lenders would like to

 Define conditions under which it is offering the loans

 Secure the loan as much closely as possible and
 Ensure that borrowers will provide necessary information as possible as also
allow monitoring the borrower’s financial conditions

From the above it will be clear that documents are necessary to

• identify both parties to the loan transaction

• understand and accept all the terms & conditions by both the lender and
borrower
• identify securities for the loan
• have written evidence of loans issued by the bank;
• ensure repayment of the loan by the borrower;
• enable the bank to, in case of need, seek recourse to legal course recovery of the
loan. It will be impossible to seek legal action in the absence of a document.
Documents help the bank to prove and establish before a court of law that the
amount was lent and the same has not been fully/partly repaid;
• create a legally enforceable charge on the securities in favour of the bank
• preclude creation of fresh charge on security given to the bank by other creditors
• determine and ensure that the loan does not suffer from period of limitation

3. Important Documents

3.1 Promissory Note:

This document is taken in the case of all Demand Loans, Cash Credits, Overdrafts, Bills
discounted and other similar limits. Promissory Note contains a promise to pay the
amount of loan and interest on demand. It specifies the terms of repayment, including
principal and interest, the length of the loan, late fees, and prepayment penalty if any.

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Promissory note itself or a support document will state the circumstances under which
the borrower may wind up in default, and what action bank may take the event of such a
default. The following is an example of a simple Promissory Note.

I/We……………………………………Jointly and severally ( Borrowers) promise to pay a

sum of Rs……………………………………….for value received to
…………………………………( name of the bank/lender together with interest thereon
at the rate of (rate of interest %) per annum.

It could be added that

If there is default in the above payment we promise to pay the lender all
reasonable costs to collection, penal interest @ ….. on the amount defaulted and
reasonable attorney and collection charges.

Promissory note will be supported by hypothecation, pledge or other document as per

the loan purpose and type.

3.2 Loan Agreement

Loans by commercial banks and other lending institutions are given under a contract
between the lender (debtor) and the borrower (creditor). As such, there is a need for a
written loan agreement between the two parties that will provide the details on the
rights and obligations of both the debtor and creditor with respect to the loan.
Key sections of loan agreement: Knowledge of the key sections and their contents is
important for credit and loan officers. The key sections of the agreement and its content
are as follows.
 Definitions and interpretations: This section will provide a list of terms used in
the agreement, their definitions and explanations if any. As these terms will
appear at several places in the agreement, credit officers should be familiar with
these terms and their interpretations.

 The Loan: The type/s of loans provided and the purpose for which the loans may
be used.
 Utilization of the Loans: This section will provide the details of when and how
will be the loans will be disbursed. For instance, at what stage of a project and
how much loan will be released by the bank or that the loan for house will be
released based on the demand raised by the builder on various stages of
completion as agreed in the purchase agreement. It will also specify in what
currency and in what form the loan will be made available.
 Terms and conditions. This will elaborate on various costs such as Rate of
interest, calculation of interest, and fees payable. Fees may include loan

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processing fee, cost of valuation, legal verification, commitment charges, costs of

inspection by the bank, etc.
 Security: This section will cover issues such as margin, primary security,
collateral security, hypothecation or pledge of material and the margin against it
for arriving drawing limit.
 Collateral/ surety and Guarantee: If the loan is secured by other collaterals or
guaranteed by another person or an entity the responsibilities and obligations of
the guarantor should be decided and the same will be included in this section.
Insurance conditions if any is also mentioned here.
 Representations and undertakings: This is the most critical section of the loan
agreement because this section contains all the obligations and responsibilities
of the borrower. The subsections of the section are as under.

o Representations: This section will contain the statements of the borrower

including who is he/it, the company is in good shape, it can enter into the
deal, the officers authorised to sign the deal, and the law governing the
deal.
o Undertakings: Covenants, credit triggers, etc will be mentioned in this
section.
o There will be clear statements about what the bank will deliver and what
it expects from the borrower in terms of statement, information etc.
 Default and other related issues.
o This section will contain definition of default and the responsibilities of
the borrower in the event of default and course of action that the bank
will take.

Agreement will have a number of schedules for (a) describing the borrower through ID
(PAN, Aadhaaretc), the place of business and (b) Rate of interest, (c) schedule of
properties and assets which are offered to secure the loan, (d) special terms and
conditions.

3.3 Other Documents

Beside the promissory note and loan agreement lenders may include any of the
following documents, depending on the nature of the financing and the credit
arrangements:

 Inter-creditor Agreement: An inter-creditor agreement is executed between one

or more creditors who have shared interests in a particular borrower say two
banks financing the same borrower. The agreement spells out aspects of their
relationship to each other and to the borrower so that, in the event a problem
emerges, there will be ground rules in place to handle the situation. The contents

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of an inter-creditor agreement would vary depending on the borrower, the type

of debt, and other factors, such as the presence of co-obligors.
 Security Agreement: A document that provides a lender a security interest in a
specified asset (other than mortgage) or property that is pledged as collateral. In
the event that the borrower defaults, the pledged collateral can be seized and
sold. A security agreement contain covenants that outline provisions for the
loaned funds such as repayment schedule or insurance requirements. The
borrower may also allow the lender to hold the collateral for the loan until
repayment. Security agreements may also pertain to intangible property, such as
patents or receivables.
 Mortgage Deed: This is executed if the loan is secured against mortgage of
property. This will mention the title, encumbrances etc.
 Disclosure and Authorizations: This is an agreement that permits the disclosure
of private information acquired during an insurance-related business. The
agreement will detail what the lender can disclose and what information will be
collected and who it will be shared with.

4. Securities and Creation of Charge

All security documents must be stamped as per the laws of respective state government.
In case of execution of documents by corporate or legal entity, common seal needs to be
affixed on documents creating charge. As regards security and collaterals, documents
evidencing ownership will be in the form of agreements, land records etc.

The security documents are valid for a period of 3 to 12 years from the date of execution
depending on the type of documents. A promissory note is valid for three years and a
term agreement for 12 years To extend the validity of the same lender/bank must
obtain a document of Acknowledgement of Debt and Security from the borrower and
guarantor on annual basis. The borrower / guarantor when they sign this document
acknowledge execution of banks security documents for the advance availed and also
confirm balance outstanding in the advance a/c as on particular date. This extends the
validity period by three years.

4.1 Types of Charges

• Fixed Charge: This is charge over specific asset of the company. Company cannot
sell the asset unless the dues are paid or unless permitted in writing by the
lender/bank. Floating Charge: This is an equitable charge created on certain
property of the company, which is continuously changing i.e. Stock in Trade,
receivables etc. The charge gets fixed the day the bank gives a notice for recovery
and specifies the assets covered
• PariPassu Charge: This charge is created in favour of several creditors with
priority. All parties with paripassu have equal right. This means that irrespective

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of the date of agreement or mortgage the parties to PP agreement enjoys a right

as if all of them entered into the agreement on the same day. The share however
will depend on the amount and will be proportional.
• Second charge: This means the person having second charge will get, in the event
of liquidation or sale of asset the balance after the person with first charge is
paid. If the first charge covers the entire value realized then the second charge
will get nothing.

4.2 Types of securities

• Primary Security: Hypothecation/pledge/assignment or mortgage of assets

created out of bank finance
• Collateral security: Mortgage of land, Third party guarantee, security by way of
deposits, assignment of policy etc.

4.3 Pledge

Pledge is the bailment of goods as a security for payment of a debt or performance of a

promise. Pledge means delivery of goods by the borrower to the lender (bailee) with
some purpose and with the condition that when the purpose is accomplished the goods
will be delivered back to the first person (bailor). Pledge can be only in respect of
movable goods like stocks.

Two types of pledge is practiced one where the goods pledged are in banks go down or
approved warehouse and the pledged goods are released or added as and when needed.
Drawing limit is arrived on the basis of value of pledged goods less margin. In the other
model the godown can be of the borrowed but the key will be with the banker. Banker
will collect the godown or warehouse rent as the case may be.

In the case of pledge, ownership remains with the borrower and only possession is
transferred to the banker. The bank as a bailee/pledgee must take good care of the
goods pledged, Bank can sell the pledged goods without intervention of the court in case
the borrower (bailor/pledger) fails to repay the bank loan. But the sale can be done only
after giving reasonable notice to the borrower. Bank as a pledgee has priority right over
the goods and Bank's right of sale under pledge cannot be extinguished even by lawful
seizure of goods pledged to it.

Pledge of godown if owned by the borrower will display a board announcing that goods
are pledged to the bank.

Gold loans are pledge loans. Here the pledged jewellery is kept in banks locker.

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4.4 Hypothecation

Hypothecation charge can be created on moveable things/property like stocks. In case

of hypothecation both ownership as well as possession remains with the borrower i.e.
neither ownership nor possession are transferred to the bank. In these cases, in the
event of default the bank has to freeze and possess the hypothecated goods. The charge
created in Hypothecation is a floating charge. When he invokes the hypothecation the
charge becomes fixed. Basic difference between pledge and hypothecation is one of
possession. In practice when bank creates a hypothecation charge on stocks etc. a board
or announcement to that effect is displayed in borrower’s business premises, more
particularly where the goods are kept. This can be a notice to public about bank’s
charge. In case of financing vehicles and fixed assets the name of Bank/Branch with
whom it is hypothecated is displayed by painting a notice to that effect on the backside
of the vehicle.

4.5 Assignment

Assignment is transfer of right or interest in an asset to recover the debt. Assignment is

practiced in the case of financial collaterals. The borrower (transferor) of claim is called
as the Assignor and the banker (transferee) is called the Assignee. Assignment can be
done in the case of Book Debts, Supply Bills, LIC policy, fixed deposit etc. Assignment
has to be recorded in writing. Assignment is required to be acknowledged by original
debtor say Insurance Company in the case of life insurance policy. Assignor cannot give
better title to the assignee than what assignor has.

In case of default, the assignee can recover the amount to the extent of value of
actionable claim from the original debtor without reference to assignor.

4.6 Mortgage

Mortgage is the transfer of interest in a specific immovable property, for the purpose of
securing an existing or future debt. The borrower is the person creating the mortgage
and is called as the mortgage. The bank in whose favour mortgage is created is called as
the mortgagee. Mortgage is created on immovable property like land and building.

There are six types of mortgages namely, (i)Simple Mortgage, (ii)Mortgage by

Conditional Sale (iii) Usufructuary Mortgage (iv)English Mortgage (v)Mortgage by
Deposit of title Deeds (Equitable Mortgage) and (vi)Anomalous Mortgage. Of these, all
mortgages except Equitable Mortgage require registration with the Registrar of
Assurances. In some states equitable mortgage has to be informed to the registrar in the
form of memorandum of information. The two most common type of mortgages in India
are as under:

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4.6.1 Registered Mortgage:

In the case of registered mortgage (also called legal mortgage) a mortgage deed is
written, which is stamped as per provisions of Stamp Act of the concerned state. The
deed is then executed in the presence of two witnesses. Thereafter, in terms of the
Indian Registration Act 1908, it is e registered with the Registrar of Assurances (Sub-
Registrar) within 4 months of the execution. Prudence demands that registration is
done immediately to ensure that if the property is mortgaged again the registration will
ensure first charge. A property could be mortgaged a number of times. In this
background, the first, second charge etc., over the property are decided on the basis of
date of registration.

4.6.2 Equitable Mortgage:

Equitable Mortgage is created by mere deposit of title deeds of property with intention
to create a charge there on. Title deeds may be deposited by the mortgagor himself or
his agent. In the case of a bank loan, the title deeds should be deposited with the bank
at any town notified by the State Government in this regard. Property may be situated
anywhere in India. For property located in Lucknow, title deeds can be deposited at
Chennai.

Since no special documentation is undertaken for creation of charge of equitable

mortgage, Bank maintains a register in which it records date, the name of person who
deposited the title deeds with details of property and purpose of deposit of title deed i.e.
creating a charge on said property offered as security for repayment of debt etc. It is
signed by official of the bank only. Borrower does not sign this register. This register is
admissible as evidence in court.

In no case the bank should part with the title deeds of equitable or registered mortgage
even for a short duration at the request of the mortgagor because if some other creditor
is induced to finance on the basis of title deeds, the bank may lose priority over the
mortgaged property.

Equitable Mortgage does not require registration with Registrar of Assurances. But in
case of a limited company charge in respect of equitable mortgage under Section 125 of
the Companies Act. 1956 must be registered with Registrar of Companies.

All mortgages in favour of bank require registration with CERSAI (established under
SARFAES1 Act) within 30 days.

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Table 1: Various kinds of charges over securities

Type of Security Type of Charge
Immovable Property like Land and Building Mortgage
Actionable claims like Book Debts, FDR, Assignment
NSC, Life Insurance Policies
Movable property / goods like Plant and Pledge or Hypothecation
Machinery, Stocks, Vehicle, Railway Receipt
Paper securities like shares, debentures, MF Lien
units, bonds

5. Insurance of security

Banks need to insure the assets financed for Fire/Natural Calamities/Floods/Theft/

War and other risks. It should be ensured that the name of borrower and address/es
where assets are located are correctly mentioned in policies. Bank Clause, which
mentions that bank has the first right over the claim amount settled by the insurance
company, must be mentioned in insurance policy. Original policy should be kept on
Bank record. In case of vehicles it should be 3 rd Party Insurance. All policies should be
renewed in time before due date.

6. Stamping and Registration

A document/agreement which has not been stamped as per the Indian Stamp Act is
invalid. There are certain documents on which stamp duty is prescribed by Central
Government and is uniform throughout India. These documents are Promissory Note,
Bill of Exchange, Receipt etc. Stamp duty on these documents will be same throughout
India except J & K. On all other documents, the ad valorem (based on value) stamp duty
rates are prescribed by the State Govt. Such documents are Power of Attorney,
Agreements, Guarantee Bond, Indemnity Bond etc.

7. Limitation

Documents executed by borrowers have limited life within which the banks are
supposed to exercise the rights conferred on them by the documents. In fact, the rights
are limited by the Limitation Act 1963. The Act limits the period within which a suit can
be filed against the borrower for recovery of loans. If the loans are not recovered and
the bank wants to proceed against the borrower it should do so before the expiry of
limitation period. Limitation period depends on the document. According to the Act the
period of limitation for different types of documents is as in the Table 2 below.

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Table 2: Loan account-wise limitation period

Type of Loan/Document Limitation

Demand loan: Promissory Three years from the date of loan

note
Temporary over draft : Three years from the date of loan
Promissory Note
Demand loan: Period 5 Three ears from the date of execution of document.
years: Promissory note
Term loan: Term agreement 12 years from the date of execution. In case of installments
or Mortgage 12years for each installment when it falls due
Cash credit Hypothecation: Three years from the date of documents
Promissory note
Cash credit pledge: Goods pledged has to be sold. For balance of loan if any
Promissory Note three years
Bill discounting Three years from the date of bill

Loan secured by mortgage 12 years from the date of mortgage

Bill purchasing Three years from the date of bill

7.1 Extension of period of limitation

According to Section 3 of Limitation Act, a suit cannot be filed for recovery on the
strength of a time barred document. Hence, if the documents are time barred, the bank’s
right of legal remedy for recovery is lost. Therefore, if a loan is not repaid within the
period of limitation the bank must get fresh document/s for extending the period of
limitation. However, according to Section 18 of the Act, when the borrower
acknowledges the debt in writing under the signature of the borrower or makes a part
payment under his/her signature before the expiry of period of limitation, then the
period of limitation is extended by one more period i.e. 3 years in case of promissory
note and 12 years in the case of mortgage or term loan from the date of such
acknowledgement document or such part payment.

8. Summary

Documentation is a very important stage in the lending process. Without relevant

documents banks cannot provide evidence for the loan given and hence cannot enforce
their rights over the borrower. Documents also fulfill certain objectives of the
borrowers including a confirmation that the bank will make the loan available and the
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terms and conditions for repayment of the loan. Important documents to be made and
executed are promissory note, loan agreement, inter-creditor agreement, security
agreement, mortgage deed, and disclosure and authentication forms. In addition,
adequate security for the loan should be obtained and charges on the securities must be
created. The bank should also ensure that securities are insured by the borrowers. The
documents should also be stamped as per the prevailing regulations after paying the
stamp duty. Though the documents provide certain rights to the banks for recovery of
loans the Limitation Act 1963 has limited the validity period of the documents.
Therefore, the banks must exercise their rights within the period of limitation or should
get fresh documents made.

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