Pledge is a bailment made as security for payment of a debt or performance of a promise1. As per the law of contract, pledge means delivery of goods by the pawnor to the pawnee by way of security upon a contract with a promise that when the debt is repaid or the promise is performed, the security shall be returned or disposed of according to the directions of the pawnor2. Moreover, Section 176 of the Indian Contract Act, 1872 ("Contract Act") provides that the pawnee has the following three rights in case the pawnor commits a default: (a) bring a suit upon the debt; and (b) retain the pawn as a collateral security; or (c) sell it giving the pawn or reasonable notice of sale....
Pledging of shares is increasingly being used as a mode of creation of security. Many Indian companies have a large part of their shareholding controlled by their founders and promoters. Since raising funds by way of pledging of shares is considered to be an easy method of creation of security, many promoters pledge their securities3 in the company with banks, non-banking financial institutions or other financial institutions to get loans against them.
However, in 2019, the Reserve Bank of India in its Financial Stability Report4 has expressed concerns over a high level of pledging by promoters. Many times, pledging of shares is seen as a warning signal, indicating the company's poor health where the company is unable to access funding through other options. It is believed that an increased pledging activity is risky for any company as focus on debt repayment leaves no room for the company's growth5.
Therefore, in case of a default in the repayment of the loan amount, the lender usually invokes the pledged securities in the market to realize the amounts outstanding against the debt especially if the pledged securities are listed, and therefore easily transferable. This article seeks to analyze the requirement of a notice in case of invocation and sale of pledged securities in dematerialized form and whether and to what extent the same is governed by the requirements of Section 176 of the Contract Act. It further delves into the question of whether 'invocation' and 'sale' of pledged securities in dematerialized form are two separate events or not.
I. Requirement of Notice for Invocation and Sale of Pledged Securities
The requirement of prior reasonable notice under Section 176 of the Contract Act in cases involving dematerialized securities has been a subject of dispute and has been interpreted differently by various Indian courts. One of the first cases in this line of jurisprudence is JRY Investments Private Limited v. Deccan Leafine Services Ltd. and Ors.6, wherein the Bombay High Court held that pledge of dematerialized shares is not and cannot be in accordance with the Contract Act, which requires delivery of the goods pledged. The Court held that pledging of securities in dematerialized form is directly governed by the provisions of Depositories Act, 1996 ("Act") and Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 ("Regulation, 1996") as existing then7. Thus, the Act and the Regulation contains a whole and self-contained procedure for the creation of such pledges. The Court emphasized on the exhaustive nature of the Act by citing Section 10 of the said Act which begins with a non-obstante clause thereby providing that ownership and transfer of shares must be in accordance with the Act. Moreover, Section 12 of the Act specifically provides for pledge or hypothecation of the security and Section 20 therein renders anyone who acts in contravention of the Act or any Regulation or bye-laws, punishable with imprisonment8.
In contrast, the Hon'ble Delhi High Court in the matter of GTL Limited &Ors. v. IFCI Ltd. &Anr.9 held that the notice under Section 176 of the Contract Act is mandatory prior to sale so that the pledger has a reasonable opportunity to redeem the securities pledged and any agreement to the contrary would be illegal. Thus, the right to sale accrues only when the notice for sale is given. The Court opined that the notice requirement comes into play only at the time of sale and not at the time of invocation of pledge.
Subsequently, the decision of the Division Bench of the Bombay High Court in the matter of Pushpanjali Tie Up Pvt. Ltd v. Renudevi Choudhary10, the Court held that if a pledge could be created in any manner, there was no reason for the legislature to have provided for a particular manner alone for creating a pledge of shares in a dematerialized form. Thus, for a pledge to be valid, it is mandatory that the pawnor creates it in the manner prescribed by the Act and the Regulation. The Court further stated that the provisions of the Act, in particular Section 12 and Regulation 58, are salutary as they introduce transparency and certainty in the securities market. The Court believed the Contract Act does not specify the manner in which a pledge is to be created. However, the Act prescribes the manner of creating a pledge. The Court considered the fact that even if owing to Section 28 of the Act11, the provisions of the Contract Act are not excluded, the provisions of the Act and the Regulation are not in derogation of the provisions of the Contract Act but in addition thereto.
Subsequently, in the year 2018, the Delhi High Court in the case of Tendril Financial Services Pvt. Ltd. and Ors. v. Namedi Leasing & Finance Ltd. and Ors.12, concurred with the view of the Bombay High Court in JRY Investments Pvt. Ltd.13 and Pushpanjali Tie Up Pvt. Ltd14 and held that the shares in dematerialized form cannot be pledged in accordance with Section 176 of the Contract Act. The Court observed that the provisions of the Contract Act require delivery of the goods pledged i.e. a physical possession of the goods. However, the dematerialized shares are not capable of delivery by handing over de facto possession. Since, the goods in such cases are invisible and intangible, it would be impossible to fix the time and place of delivery. Hence, the requirement for sending a reasonable notice to the pledger under Section 176 of the Contract Act prior to the actual sale is not required in case of sale of dematerialized securities because the provisions of the Contract Act will not be applicable for enforcing a share pledge. The provisions of the Act and Regulation therein shall apply.
A closer look at the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018 ("Regulation 2018") would help us analyze if there is any requirement of sending a notice prior to effecting sale of securities. Section 79 (8) of the Regulation 201815 states that a pledge shall be invoked subject to the provisions of the pledge document and upon such an invocation, the depository shall register the pledgee as the beneficial owner of such securities. Therefore, on the one hand, if the agreement between the parties specifies that a prior notice before invocation or sale of the securities is required, then such terms have to be necessarily complied with. On the other hand, if the agreement does not specify for any notice for enforcement of the pledge and subsequent sale of the securities or more importantly waives such a requirement, then the pledgee in accordance with the Act and the Regulation 2018 will not be obligated to send a notice to the pledger. The parties are free to waive the notice requirement as any provision in law, for personal benefit, if not in public interest can always be waived by an agreement between the parties to the contract.16
II. Is there a difference between 'invocation of pledged securities' and 'sale of pledged securities'?
Interestingly, the Act has changed the mode in which the pledge operated traditionally as per the contract law as opposed to the securities pledged in a dematerialized form. In case of dematerialized shares, upon invocation the lien marked shares in the pledger's account are transferred to the account of the pledgee. Hence, invocation and transfer to the pledgee's account, in dematerialized shares are largely simultaneous. In Tendril Financial Services Pvt. Ltd. and Ors. v. Namedi Leasing & Finance Ltd. and Ors.17, the Delhi High Court held that upon invocation, beneficial ownership of pledged shares changes from the pledger to the pledgee and this is equivalent to sale. Further, the distinction sought to be drawn between 'invocation' and 'sale' is not in consonance with Regulation 58. The difference between invocation of pledged securities and sale of pledged securities in the case of Tendril Financial Services (supra)arose pursuant to the agreement between the parties in the said case, i.e. the Letters of Pledge wherein the distinction was present only for the purposes of determining the amount which has to be offset from the debt on the day of sale of the securities.
It is important to note that neither the Act and the Regulation 1996/ Regulation 2018 nor the Contract Act talk about 'invocation' and 'sale' as two separate events. However, in Tendril Financial Services18>, the Court referred to the letters of pledge executed in that case which stated that invocation of pledge would not amount to the sale of shares to the lender. The Court observed that the distinction between "invocation" and "sale" is not in consonance with either Section 58(11) of the Regulation, 1996 or Section 176 of the Contract Act.
Consequently, upon invocation or enforcement of the pledge, the pledgee becomes the beneficial owner and holds the pledged securities. Section 47 (1)(a) of the Companies Act, 2013, inter alia states that every member of a company limited by shares and holding any equity share capital therein shall have a right to vote on every resolution placed before the company. Further, the expression 'member' has been defined in Section 2 (55) of the Companies Act, 2013 which includes every person holding equity share capital of a company and whose name is entered as beneficial owner in the records of the depository. Thus, upon invocation the pledgee becomes the beneficial owner and member of the company and it acquires not merely shares but also the voting rights attached thereto.
In Liquid Holdings Private Limited v. the Securities and Exchange Board of India, the Securities Appellate Tribunal, Mumbai (SAT) held that in the specific facts of the case, the pledge was invoked and the banks became beneficial owners of the shares and thereafter on repayment of the loan, the shares were transferred back to the pledger on the basis of an agreement between the parties. The Hon'ble Tribunal observed that the pledger did not get back the shares by redeeming the pledge. Once the pledgee invoked the pledged securities, the pledger cannot continue to hold the shares as collateral security and the shares transferred back to the pledger were not redeemed on account of repayment of loan, rather it resulted in fresh acquisition of shares.19>
It is pertinent to note here that the Delhi High Court relying on the decision of Neikram Dobay v. Bank of Bengal20 has observed that the sale effected by the pledgee to himself is unauthorized and the liability of such a pledgee would only be for damages.21 In Dhani Ram & Sons v.The Frontier Bank Ltd. & Ors., reliance was placed on Neikram to hold that a sale of the pledged securities by a bank to itself cannot be held to be void.22 In Ramdeyal Prasad v. SayedHasan23, it was held that such an act of the pledgee does not put an end to the pledge so as to entitle the pledger to recover the pledged goods without payment of the amount thereby secured and the pledger is bound by the re-sales duly effected by the pledgee to third persons. Neikram, Dhani Ram and Ramdeyal Prasad are relating to non-dematerialized securities
The anomalous position which emerges is that on the one hand, the sale and transfer of the pledged securities by the pledger to the pledge itself is unlawful. The pledger in such cases has a right to sue for damages though bound by any subsequent sale made by the pledgee to any third party. On the other hand, the Act and the Regulation provides for invocation of dematerialized pledged securities resulting in transfer of securities from the Demat account of the pledger to the Demat account of the pledgee. This would amount to transfer of securities by the pledger to the pledgee itself. Thus, the Act and the Regulation treats such transfers as lawful and in the author's view, the principles laid down in Neikram Dobay and Ramdeyal Prasad, referred above will not be applicable in case of dematerialized securities.
As discussed above, invocation of dematerialized securities would amount to sale to the pledgee unless there is a contract to the contrary, which would consider sale as a separate event relevant for the purpose of adjustment of the amount due against the loan advanced by the lender.
It is observed that both the Delhi High Court and the Bombay High Court are inclined to abide by the provisions of the Act and the Regulations while dealing with the pledge of dematerialized securities. The courts agree that the requirement of a reasonable notice mentioned in Section 176 of the Contract Act would not be applicable on the sale of dematerialized pledged securities unless the pledge document specifies otherwise. Considering this line of reasoning, invocation is a step towards the sale of the pledged securities resulting in the pledgee becoming the beneficial owner in whom all the rights vest and who takes up all the rights of the members of a company. A separate agreement requiring the pledgee to transfer the invoked securities back to the pledger upon repayment of the loan would amount to fresh acquisition of shares as the pledge ceases to exist and the securities do not continue to remain as a collateral security.24>
On a reading of the above case laws, the authors believe that the following position emerges:
Pledge of dematerialized securities is primarily governed by the Act and extant SEBI Regulations. While the application of the Contract Act cannot be ruled out completely, yet the method/process by which a pledge of dematerialized securities is created is different than that contemplated under the Contract Act.
Notice requirement for invocation of the securities and sale thereof are primarily dependent upon the terms of the pledge document. The pledge document could (i) provide for a separate notice period; or (ii) not mention the notice period/requirement; or (iii) specifically waive the notice requirement.
Invocation of a pledge leads to the pledgee becoming the beneficial owner of the pledged securities with, inter-alia, the right to vote thereon, where applicable. The pledge, upon invocation, comes to an end.
Invocation could be construed as a transfer of the securities to the pledgee, however, upon a reading of the Act and extant Regulations, the same may not be unlawful or void.
The position in (d) above could be buttressed if the pledge document treats "invocation" and "sale" as separate events, with the latter taking effect upon transfer to third parties and the adjustment to the debt upon such sale being effected at that period of time.
Courts would, in view of the language of the Regulation 2018, give effect to the terms of the pledge document-especially the effect of invocation, as also set-off to the debt taking place upon sale to a third party.
In the event that the sale to a third party does not happen post invocation, and the debt is paid, any reversal of the securities to the pledger would amount to a transfer, and not an act which is consistent with an existing pledge.
IV Checklist prior to and upon invocation (not exhaustive!)
1) Check that the pledge has been duly created in accordance with the Act and the Regulation. 2) Read the terms of the pledge document carefully. Check for the following: a) Notice period for invocation/sale, if any; b) Waiver of any notice requirements prior to invocation and sale; c) Does the document treat invocation and sale as two different events? 3) Make sure the notice requirements under the pledge documents are met. It may be prudent to send a notice (albeit a short one) even if the notice requirement is absent in the pledge document. Ensure that the notice specifies that the invocation is for the purposes of sale. Specific waiver of notice may stand on a different footing. 4) Invoke only upon expiry of the notice period. 5) File a caveat if it is perceived that the pledger would seek court/tribunal intervention to prevent invocation. 6) Check if the pledge document specifically provides for release/transfer of the pledged securities to the pledger's dematerialized account if the debt is repaid after invocation and before sale to any third party. 7) Check if the pledge document states that if the securities pledged are sold to third parties, the amount received shall be adjusted against the loan due from the borrower. Intimate the pledger too in this regard.
1 Section 172, Indian Contract Act, 1872. 2 Pollock &Mulla, The Indian Contract and Specific Relief Acts, 15th Edition, 2017, p.1489. 3 Security is defined in Section 2(h) of The Securities Contracts (Regulation) Act, 1956. (h) "securities" include— (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; (ia) derivative; (ib) units or any other instrument issued by any collective investment scheme to the investors in such schemes; (ic)security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;
(id) units or any other such instrument issued to the investors under any mutual fund scheme; (ii) Government securities; (iia) such other instruments as may be declared by the Central Government to be securities; and (iii) rights or interest in securities; 4 Financial Stability Report, Issue No. 19, Reserve Bank of India, June 2019, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/FSRJUNE2019E5ECDDAD7E514756AFEF1E71CB2ADA2B.PDF, p. 47. 5 Ibid. 6 JRY Investments Private Limited v. Deccan Leafine Services Ltd. and Ors., 56 SCL 339 (Bom). 7 The Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 was repealed and replaced by Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018. 8 Supra, fn.6. 9 GTL Limited &Ors.v. IFCI Ltd. &Anr., 2011 (126) DRJ 394. 10 Pushpanjali Tie Up Pvt. Ltd v.RenudeviChoudhary, AIR 2015 Bom 1. 11 28. Application of other laws not barred. The provisions of this Act shall be in addition to, and not in derogation of, any other law for the time being in force relating to the holding and transfer of securities. 12 Tendril Financial Services Pvt. Ltd. and Ors.v.Namedi Leasing & Finance Ltd. and Ors.,2018 SCC OnLine Del 8142.
This judgement differs from GTL Limited in as much as it holds that Section 176, Contract Act requirement is not mandatory. 13 Supra, fn.6. 14 Supra, fn.10. 15 Section 79. Manner of creating pledge or hypothecation (8) Subject to the provisions of the pledge document, the pledgee may invoke the pledge and on such invocation, the depository shall register the pledgee as beneficial owner of such securities and amend its records accordingly. 16 Supra, fn.12. 17 Supra, fn.12. 18 Ibid. 19 Liquid Holdings Private Limited v. the Securities and Exchange Board of India, Appeal No. 83 of 2010 dated 11.03.2011 before the Securities Appellate Tribunal, Mumbai. 21 In NeikramDobayv. Bank of Bengal, 1891 LR 60, the Privy Council held as under: "It would be inequitable to allow the bank, after this transaction, to treat the securities, which it had sold to itself, and then had in its hands, as still subject to the pledge. In their Lordships' opinion, the bank should be held to be no longer a pledgee of these notes, and to have converted them to its own use, and to be liable in damages for the value of them including the interest thereon." 21 Supra, fn.12. 22 Dhani Ram & Sons v. The Frontier Bank Ltd. &Ors, AIR 1962 P&H 321. 23 Ramdeyal Prasad v. SayedHasan, AIR (31) 1944 Patna 135. 24 M/s. Andhra Cement Limited, Securities and Exchange Board of India, Adjudication Order No. AK/ AO-59-69/2015 dated July 31, 2015.
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