Securities, Collaterals and Guarantees: Some Legalese & Some Anecdotes (Part 1)

Pawn shops are found across all economies and have existed for God knows how long. After all money lending is the second oldest profession in the history of mankind. In urgent need of money a person can walk up to a pawn shop with an heirloom or such family treasure and obtain some ready cash. The pawnbroker (also called pawnee) examines the treasure, assesses its value, subtracts a safety margin from that value and gives cash to the person who pawns the treasure (called pawner) with a piece of paper commonly called pawn ticket. But before giving the cash and pawn ticket the pawnee locks away the treasure in his safe and the pawner signs a standard contract, essentially recording that the pawner has pawned the article on his own free will to secure a cash advance against it. The treasure gives the pawnee the sense of security that the cash being lent will come back to him with interest. He is also confident that if the hapless pawner fails to repay the loan the pawned treasure will more than make good the loss. Since the pawned article ensures that the loan will be safe and secure, it is called “security”.

The pawner heads home with cash and the pawn ticket in his pocket. The pawn ticket is transferable. The pawner can transfer it to his friend or agent to collect the pawned article after making payment. He can even sell it. If the pawned article’s value is sufficiently more than the cash advanced against it, the pawner may find many a willing buyer. Such a buyer gets a right to claim the security after making required payment. From here the other meaning of security emerges – that of tradable claims.

While treasuries of banks deal in this kind of securities- the tradable financial claims, the credit operations of banks usually have the other security, assets securing repayment of loans, around the centre of their operations. I am concerned today with this second kind of security.

A security, in the credit business is any asset, the owner of which transfers a part of his ownership interests (in that asset) to a lender making loan to the transferor of the interest or to any other person at the request of the transferor. In the example of pawn the asset was the family treasure, the pawner had transferred a part of his ownership interest to the pawnee who had made a loan to the pawner. A pawn is called a pledge in the legal parlance; and the act of depositing the pledged articles with the pledgee is said to give rise of relationship of “bailment” between the two. Bailment is a common law term which expressly provides that though possession of the asset has been transferred the ownership remains with the transferor. (As you must have guessed when we talk in terms of bailment the transferor of the article becomes the bailor and the transferee bailee!)

By recognizing a pledge as a form of bailment, all the case laws of bailment spanning over hundred of years become applicable to pledge - a rich source of headache and glee to the parties concerned and their lawyers respectively. While general ownership remains with the pledgor, a special right passes on to the pledgee and the pledgor’s ownership becomes somewhat less than absolute, described as ownership subject to pledge. Pledgee is required to take ordinary care (as expected from a prudent man of business) of the assets, belonging to pledgor, but left in his possession. Pledgee also enjoys a right to sell the pledged asset if the loan secured by the pledge is in default.

Banks traditionally made loans against pledge of assets. While it was easy to create a pledge over high value assets which have manageable dimensions such as a brick of silver or some gold coins / ornaments, it was naturally not possible to accept, across the counter, pledge of high volumes of low value articles – for example four truck loads of skins and hides, 2000 kilograms of black pepper or say packets of undergarments filling a medium sized warehouse. Concept of constructive pledge evolved to enable the bankers to accept such assets as securities and to enable the merchants to meet their liquidity needs. In this arrangement the bank would put its padlocks on the warehouse where the goods are stored and by doing so the bank is said to have obtained constructive possession of all goods stored in that warehouse. The warehouse could well be within the premises of the borrower. The borrower would pledge goods by storing in the warehouse and secure loan against goods so pledged. When it wanted the goods for business purposes it would repay the bank the value of such goods (plus interests less whatever margin was stipulated) and bank would dispatch an employee with the keys of its padlock to effect the transfer of goods. Cumbersome and costly it appears to us today but some two hundred years back it was a revolutionary innovation. I last saw it in use in 1984. May be it is still in use somewhere!

In 1978 I was looking after credit portfolio of a major bank at a small centre when I learnt of this interesting episode which had occurred some five years before I had joined. One of the bank’s borrowers, manufacturer of men’s undergarments had credit limits under what was called “Lock & Key facility” - constructive pledge and all that. Account was quite regular. One night the bank’s warehouse within the factory premises of the borrower caught fire and was totally gutted. Insurance claim was filed in due course. Insurers carried away truckloads of ash for chemical tests and it turned out that the ash was of burnt paper and not of burnt cotton fabrics! Apparently the borrower in collusion with the bank’s employee who carried the keys to the warehouse had removed all garments and pledged old newspapers to the bank before setting the warehouse ablaze.

We had another very interesting development around late seventies. The bank had among its borrowers a silver refining firm. This firm bought old silver ornaments, which had up to 20% impurities. The ornaments were smelted in a crucible to get silver with 99.9% purity. This was called 999 silver. There was ready export market in 999 silver. Its price was rising on daily basis. India does not have any silver mines but has huge quantities of silver, most of it as ornaments worn by not too well off ladies. It was a good way of keeping the family wealth safe for people with no access to or no trust in banks, women being largely immune from highway violence. Our refiner would bring to the bank silver bricks weighing around 30 kilograms which we promptly locked in the vault after weighing and made “drawing power” available in the borrower’s account as per the terms and conditions of sanction of the loan. Over two years the price of 999 silver rose from INR 2000 (then USD 240) a kilogram to INR 5500 a kilogram. Most of the sales were taking place at Zurich, where 30 kilograms was apparently the typical “deal size”. Bank allowed the borrower to withdraw and airlift the bricks to Zurich on receiving confirmation of the sale from our correspondent bank by telex. Payments came from Zurich within a week by telex.

The goods were removed from the pledge without deposition of value under a mechanism called Trust Receipt. It essentially created a legal myth that the borrower was accepting the goods on behalf of the bank in trust and shall sell the same and bring the sales proceeds to the bank for credit to his loan account! This was a very convenient arrangement. With borrowers inspiring more confidence bankers used this small legal myth to its utmost limit. After all if you can let the borrower keep one brick for some time why can't you allow him to keep all the bricks all the time, strictly in trust for and on behalf of the bank, of course. After a credit facility is sanctioned, secured with pledge of current assets of the borrowing firm, the firm would give a statement of its current assets to the bank with a request to take possession. The bank would send an employee with its padlocks to the firm's works / show room, who would put the locks on all entry ways, at least on the major entry ways. The bank would then solemnly confirm to the borrower that it has taken effective possession of all the current assets and then handover the keys to the borrowing firm with a request to hold the current assets in trust for the bank!

We get back to late 1970s of booming silver prices. These were rather exciting times for that sleepy little town in eastern India. The rising price of silver had taken everybody by surprise. There were features on BBC about silver prices and there were as many theories as there were analysts. Towards the end of the boom it became known that two Hunt brothers of the USA (where else) were trying to corner the whole world’s supply of silver. Hunts were among the richest families in the USA at that time. They had joined hands with some Arab Sheiks but even such a formidable cartel could not corner more than 50% of the world’s supply. By that time Comex increased the margin on silver (which had peaked at almost $1500 a kg!) and the highly leveraged operation of Hunts came a cropper.

However, quite a while before Hunts collapsed, Indian government banned export of bullion silver. At that time 999 silver was trading at around INR 5500 a kilogram. Our bank had been sort of marking to market i.e. the price of silver was rising and so were our borrower’s credit limits which were essentially fixed with his refining capacity in kilograms of silver. With ban on export silver prices in India crashed. It was nothing compared to what was to happen in the rest of world after about one year when Hunts’ operations unraveled, but enough to give us all sleepless nights. The borrower himself was worried but confident that if we did not call the loan immediately or asked him to make good the shortfall with silver valued at new prices (which he was in no position to do at the time) he would make enough money to liquidate the account in a year or so by trading the daily fluctuations in silver prices. And this he did!

So much about pledge. Pledge can obviously be created only on movable properties i.e. on movable chattels as lawyers are so fond of saying to confuse the innocents. The legal process to secure a loan with immovable property is mortgage. This I shall dwell on in next part.