Difference between first charge, second charge and pari-passu charges explained

Charge creation means the establishment of the lender’s right over specified assets of the borrower in order to recover principle and interest in default from the borrower. The charge can be created against the same assets by more than one lender.

The lender in whose favour charge is first created is called the holder of ‘First Charge’. If a Subsequent charge is created in favour of a different lender against the same assets on which the first charge already exists, the subsequent charge holder is called the holder of the second charge.

First Charge:

When the capital assets like land building, plant, machinery, etc., of the borrower, are normally funded by a term lending institution(s) that will have the first charge over the property so acquired by the borrower. The bank which releases working capital finance will have the first charge over working capital (stocks of raw material, work-in-progress, finished goods, and receivables) funded by it.

Second charge:

The lender in whose favour charge is first created is called the holder of ‘First Charge’. If a Subsequent charge is created in favour of a different lender against the same assets on which the first charge already exists, the subsequent charge holder is called the holder of the second charge. Normally bank which finances the working capital limit would stipulate a condition that the company should offer collateral security by way of the creation of the second charge on the properties against which term lenders have the first charge. The second charge is usually created when the capital assets like land building, plant, machinery, etc., of the borrower, are normally funded by a term lending institution(s) that will have the first charge over the property so acquired by the borrower. The bank which releases working capital finance will have the first charge over working capital (stocks of raw material, work-in-progress, finished goods, and receivables) funded by it. Normally bank which finances the working capital limit would stipulate a condition that the company should offer collateral security by way of the creation of the second charge on the properties against which term lenders have the first charge.

Rights of second charge holder(s)

The second charge is also a legal charge but it will rank behind the first charge. When the first charge is satisfied by the company after liquidating the term loans, the second charge holder is automatically promoted as the first charge holder against those specified assets.

In case, when the first charge holder disposes of the assets charged in its favour in order to recover its dues from the borrower, the second charge holder is entitled to receive the residual value of the assets if any available in the hands of the first charge holder. This is possible only when the first charge holder’s dues are fully liquidated.

Pari-Passu charge:

Pari-passu is a Latin phrase used in contract law that means “equal footing”.  Thus pari passu charge means, having equivalent charge/ rights or say charge-holders have equal rights over the asset on which pari-passu charge is created.

Most of the large borrowers are financed by multiple banks in a consortium or under Joint Lending Arrangement (JLA). Each bank that participates in the joint lending program takes a share of a certain percentage of the total amount of finance under uniform terms and conditions including the rate of interest. The loan program of multiple banks will be under common loan documentation and common asset classification for the combined limits sanctioned by them. For this purpose, participating banks enter into an inter-se agreement that allows these banks to hold common security against their advances. 

The Pari-Passu Charge provides an equivalent right to the share of specified assets of a borrowing company to all the lenders under the arrangements. In the event of default of repayment from the borrower, the joint lenders may decide to dispose-off the security held by them in order to recover their dues. The realization proceeds of the assets disposed of would be shared among joint lenders in proportion to the balances outstanding in their accounts.

For example, Bank A, Bank B, and Bank C are financed to a single borrower D  on certain common assets like stocks, book debts, and other currents under a consortium arrangement. The working capital finance of Bank A is Rs.50 crore, Bank B is 30 crore and bank C is 20 crores having pari-passu charge on the current assets borrowed by company D. In case of default of D, bank A, Bank B, and Bank C will have the right to recover the amount from the realization of the charged security in the ratio of 5:3:2.

Other Related Posts:

Mode of charge registration under the companies act
How to get a ‘Satisfaction of Charge’ certificate from the Registrar of companies?
Effects of non-registration of charge
Effects of charge registration under the companies act
Difference between first charge and second charge
Meaning of fixed charge, floating charge, and crystallization of charge

The condonation route: After a delay in filing of registration of the charge: