1. What is Substituted Collateral

Original Security: e.g. Residential flat in Mumbai, listed shares, machinery
Borrower says: "Let me sell Mumbai flat, I will give you Pune land / unlisted shares / corporate guarantee of sister company"

Substitution is allowed only under conditions:

• RBI Master Circular on Loans & Advances - Bank must obtain fresh valuation from empanelled valuer, legal title search, ensure LTV not breached, ensure substituted collateral is not correlated to borrower's own business (wrong-way risk)
• Loan agreement must have substitution clause - usually Clause: "Lender may at its sole discretion allow substitution subject to credit approval and fresh security creation"
• SARFAESI: Substitution requires fresh mortgage deed, filing with CERSAI within 30 days

Failure types:

1. No fresh valuation: Accepts valuer's old report
2. No title verification: Accepts land which is already mortgaged / agricultural / disputed
3. Liquidity risk: Accepts shares of illiquid group company instead of listed blue-chip
4. Deterioration in custody: Takes custody but does not maintain - property loses value
5. Consent failure: Uses collateral for another loan without borrower consent

2. Legal Duties of Lender

a) Duty to maintain collateral in good condition:
Supreme Court Online - Pushpa Builders Ltd v The Vaish Cooperative Adarsh Bank Ltd 2021 PLRonline 9096:
Banking - Auction - Mortgage - Receiver has responsibility to maintain property in good condition and prevent its deterioration. Creditor cannot later claim property lost value while in their custody, will be accountable for any loss in property value. When collaterals and securities provided by borrowers are available to creditors for sale and transfer to recover dues, creditor must preserve.

If bank allows substitution and new collateral deteriorates because bank did not insure / monitor, bank bears loss.

b) Duty to assess value at time of substitution - Valuer Negligence:

Titan Europe v Colliers - English High Court - Landmark securitisation issuer claim against valuer:
Held for first time that securitisation issuer was able to bring claim against valuer who had been negligent when providing valuation for property used as collateral for loan which was subsequently securitised. Judgment in Titan Europe v Colliers will be of interest to investors, issuers. Principle: If valuer overvalues substituted collateral, lender and even SPV can sue valuer for negligence. Failure to assess risk = lender liable to investors.

Lowick Rose LLP v Swynson Ltd [2017] UKSC 32 - Supreme Court overturns assessment of damages in accountants' negligence:
Lender relied on negligent due diligence report to give loan against collateral. Loan repaid by borrower using money borrowed from lender's owner. Supreme Court held loss extinguished when loan repaid - repayment not collateral. Shows that collateral assessment negligence claim must show actual loss, not notional.

c) Consent for collateral use:

Delhi HC - L&T Finance and Edelweiss vs State of NCT Delhi - Loan Dispute over Gurugram Project - Collateral Use Without Consent:
Delhi High Court dealt with petitions by L&T Finance and Edelweiss ARC seeking to set aside CJM Saket order directing FIR registration. Complainants alleged Raheja Developers in collusion with L&T Finance used licensed land as collateral for multiple loans without consent. HC examined whether using same land as substituted collateral for another project without consent amounts to cheating / breach of trust. Held use of collateral without consent is illegal.

Return of title deeds after closure - N Anji Reddy v SBI WP 14685/2020 dated 18.08.2022 + Appeal No 93 of 2022:
When loan account closed and satisfied from auction proceeds, guarantor has to be discharged and his properties released. Holding title deeds against closed loan is illegal. If bank substitutes collateral and retains old title deeds, it is illegal retention.

d) Invocation of pledge on substituted shares:

• Liquid Holdings Pvt Ltd vs SEBI 11 March 2011 - IndianKanoon:
  Appellants pledged shares with two banks as collateral security when Morepen availed loan facilities. When Morepen defaulted, pledges invoked by banks. Issue - whether invocation without proper risk assessment of substituted collateral (shares instead of property) violated SEBI Takeover Regulations. Held pledge invocation valid if loan agreement allows, but bank must assess market risk - if shares illiquid, bank cannot claim deficiency later without assessing.

e) General Lien vs Specific Collateral:

• Karnataka HC Writ Appeal No 679 of 2023 (GM-RES) 29 Nov 2024 - Bank exercised general lien over deposits:
  Bank cannot exercise general lien over deposits when specific substituted collateral was agreed. If agreement says substituted collateral is Pune land, bank cannot hold back fixed deposits as additional collateral without clause.

f) Borrower protection against low-price sale of substituted collateral:

• Delhi HC - If Banks have to survive, borrowers must exist - Protection against arbitrary disposal of mortgaged properties at low prices:
  Court expressed that since petitioner defaulted, suit filed with sale of mortgaged property. Question: Whether borrowers have no protection against arbitrary disposal at low prices? Held there cannot be free run for banks at cost of borrowers who mortgaged valuable property as security. Banks must obtain proper valuation before sale of substituted collateral, follow SARFAESI Rule 8/9 procedure - valuation by approved valuer, reserve price, notice.

g) Substitution of unsecured loan:

• Sunil Sharma Vs Hero Fincorp Ltd - Supreme Court - FIR Set Aside Because Loan Default Lacked Entrustment:
  Third loan of Rs 15 cr converted into unsecured / corporate loan - Hero did not object till 2018. Supreme Court held loan default and contract breach not criminal breach of trust - no entrustment, no mens rea. Bars criminalising commercial disputes where collateral substituted from secured to unsecured without proper risk assessment.

3. How to Assess Risk Correctly - Checklist

Under RBI and IBA guidelines, before allowing substitution:

1. Legal: Fresh title search 13 years, CERSAI search, ROC search for company, ensure no prior charge
2. Valuation: Two independent valuations - one by empanelled valuer, LTV must be <= original LTV + 5% buffer. For shares, take 50% haircut on illiquid.
3. Correlation: If borrower is real estate developer, do not accept real estate of same project as substituted collateral - wrong-way risk. Accept liquid FD / government security.
4. Documentation: Fresh mortgage deed, hypothecation, pledge agreement, filing with CERSAI, ROC Form CHG-1 within 30 days, else charge void vs liquidator.
5. Insurance & Maintenance: If property, obtain insurance, ensure property tax paid, receiver duty to maintain per Pushpa Builders judgment.
6. Consent: Borrower and guarantor written consent for substitution and release of old collateral. Else illegal retention as per N Anji Reddy.

4. Remedies if Bank Failed to Assess

• Borrower: File complaint to Banking Ombudsman under Sec 8(m) - levying charges / holding collateral without assessment. Claim compensation for loss in value as per Pushpa Builders.
• Bank vs Valuer: Sue valuer for negligence per Titan Europe v Colliers - claim difference between negligent valuation and actual market value.
• Bank vs Borrower: Cannot recover deficiency if it accepted insufficient substituted collateral without due diligence - estopped.