Commercial lending in India involves a complex suite of documents, each serving a specific legal and commercial purpose. A defect in one document can undermine the enforceability of the entire security structure, as lenders discover when they attempt to enforce years after disbursement. This article examines the key documents in a commercial lending transaction and identifies the common errors that create problems at enforcement.
The lending process begins with a sanction letter (also called a term sheet), the bank’s offer to extend credit on specified terms. This document typically sets out:
- Loan amount
- Purpose of the loan
- Interest rate (fixed or floating, and if floating, the benchmark: MCLR-linked or repo rate-linked)
- Repayment schedule
- Security to be created
- Conditions precedent (documents to be provided before disbursement)
- Special conditions
The sanction letter is binding on the lender when accepted by the borrower, but it is not the full loan agreement. However, if a borrower acts in reliance on a sanction letter and the bank subsequently withdraws it without reasonable cause, courts have found this actionable.
Borrowers must review the sanction letter with care before acceptance, subsequent loan documents must align with the sanction letter terms. Discrepancies between the sanction letter and the executed loan agreement create ambiguities that benefit neither party.
The Loan Agreement
The loan agreement is the primary contract between lender and borrower. It should address:
Interest rate mechanics: For floating rate loans, the agreement specifies the benchmark rate (Marginal Cost of Funds-based Lending Rate, MCLR, or the RBI repo rate for external benchmark-linked loans) and the spread. RBI regulations require all floating rate loans to retail and MSME borrowers to be linked to external benchmarks (repo rate) since October 2019. The reset mechanism (how often the rate resets) and the effective date of each reset must be specified.
Repayment schedule: Monthly, quarterly, or half-yearly instalments. The schedule should be attached as an annexure, not merely described as “to be agreed.”
Prepayment: Whether the borrower can repay early; prepayment charges (RBI guidelines prohibit prepayment charges on floating rate loans to individual borrowers; for corporate loans, prepayment charges are negotiable).
Representations and warranties: The borrower’s statements of fact as at the date of the agreement, that the borrower is duly incorporated, that no material litigation is pending, that financial statements are accurate, that no default exists under other agreements. These representations, if false, trigger a default.
Events of default: A comprehensive list of events that trigger the lender’s right to accelerate the loan (demand immediate repayment of the entire outstanding amount), non-payment, breach of financial covenants, insolvency, MAC, cross-default to other borrowings, change in control.
Financial covenants: In commercial loans, lenders typically include financial ratio covenants (Debt to EBITDA ratio, interest cover ratio, current ratio) that must be maintained throughout the loan tenure. Breach of a financial covenant is a default even if payments are current.
Security Documents
Mortgage of Immoveable Property
A mortgage is the most common form of security for property-backed lending. Section 58 of the Transfer of Property Act, 1882 defines different types of mortgage:
- Simple mortgage: the mortgagor personally undertakes to pay, and in default the mortgagee can cause the mortgaged property to be sold; no transfer of possession
- Usufructuary mortgage: possession of property is delivered to the mortgagee, who receives rents and profits in lieu of or on account of interest; no personal covenant
- English mortgage: the mortgagor transfers the property to the mortgagee, with an obligation to re-transfer on repayment; the mortgagee has the right to sell without court order in case of default
English mortgage is the form most commonly used by banks in commercial lending because it gives the lender SARFAESI enforcement rights, the ability to take possession and sell without court proceedings.
Registration requirement: Section 17 of the Registration Act, 1908 requires compulsory registration of all documents creating rights in immoveable property where the value exceeds INR 100. Every mortgage of immoveable property must be registered at the Sub-Registrar of Assurances in the district where the property is situated. Stamp duty is payable at registration, rates vary by state.
Hypothecation Agreement
Hypothecation creates a security interest over moveable assets (plant and machinery, stock in trade, book debts, receivables, vehicles) without transfer of possession. Section 2(19) of the SARFAESI Act includes hypothecation within the definition of “security interest.”
A hypothecation agreement must: (a) describe the assets hypothecated (with sufficient specificity); (b) state the obligation secured; (c) grant the lender the right to take possession and sell the assets upon default.
CERSAI registration: Under Section 26B of the SARFAESI Act (as amended), a security interest in moveable property created by way of hypothecation must be registered with the Central Registry of Securitisation Asset Reconstruction and Security Interest (CERSAI) within 30 days of its creation. Failure to register within the prescribed period means the security interest is not enforceable against third parties and the lender loses priority to the hypothecated assets.
Pledge
A pledge under Sections 172-179 of the Indian Contract Act, 1872 requires actual or constructive delivery of the pledged asset to the pledgee. Pledge is used for: shares and securities, gold and jewellery, fixed deposits, and warehouse receipts (for commodities).
For listed shares, pledge is created through the depository system (CDSL/NSDL) under the SEBI (Depositories and Participants) Regulations. No separate registration is required, but the depository records the pledge and any invocation of pledge must go through the depository system.
Guarantee
A guarantee creates a secondary obligation, the guarantor is liable if the principal debtor defaults. Section 128 of the Indian Contract Act, 1872 provides that the guarantor’s liability is co-extensive with that of the principal debtor: if the borrower owes principal + interest + penal interest + costs, the guarantor owes the same.
For a corporate guarantee from a holding or group company: board resolution (and shareholder approval where required under Sections 185 and 186 of the Companies Act, 2013 for related party guarantees or guarantees beyond prescribed thresholds) is required before execution.
For a personal guarantee from a promoter: the promoter’s personal assets are exposed to recovery action, including DRT execution. Post-IBC, personal guarantors can also be proceeded against under the IBC, discussed separately.
CERSAI Registration: The Most Common Compliance Failure
CERSAI registration of security interests in moveable and immoveable property is mandatory under the SARFAESI Act. Failure to register within the prescribed timeframe is the single most common documentation compliance failure in commercial lending.
The consequences:
- The security interest is not enforceable against third parties (including a subsequently appointed insolvency resolution professional) who had no notice of it
- In IBC proceedings, an unregistered security interest may be treated as unsecured debt, dramatically reducing the lender’s recovery prospects
- SARFAESI enforcement may be challenged on the ground that the security interest was not properly perfected
Key Takeaways
- English mortgage is the most commercially effective form of immoveable property security for lenders because it creates SARFAESI enforcement rights, the ability to take possession and sell without court proceedings, and must be registered under Section 17 of the Registration Act, 1908.
- CERSAI registration of hypothecation, mortgage, and other security interests in moveable property is mandatory under the SARFAESI Act; failure to register within 30 days of creation means the security is unenforceable against third parties, including an insolvency resolution professional in IBC proceedings.
- A personal or corporate guarantee creates co-extensive liability under Section 128 of the Indian Contract Act, 1872; for corporate guarantees above specified thresholds or given to related parties, board resolutions and shareholder approvals under Sections 185-186 of the Companies Act, 2013 are required.
This article is for informational purposes only and does not constitute legal advice. Readers should seek appropriate professional counsel for their specific circumstances.
META TITLE: Loan Documentation India: What Lenders and Borrowers Must Know