One of the most common forms of security obtained by banks / financial institutions for securing debts owed to them by borrowers is pledge over shares held by the borrowers in other companies. In current times, it is more common for a company’s shares / securities to be in dematerialised form as opposed to physical form i.e. physical share certificates. A controversy that has arisen therefore is whether the law applicable to pledge of goods in the traditional sense applies to pledge of shares, particularly those held in dematerialised form. This note particularly attempts to analyse the judicial position with regards to the enforcement of pledge over dematerialised shares.
Pledge is defined under Section 172 of the Indian Contract Act, 1872 (“Contract Act”) to mean a bailment of goods as security for payment of a debt or performance of a promise. Section 173 of the Contract Act provides that the pawnee, i.e. the pledgee may retain the goods pledged, not only for the performance of the promise, but for the interest of the debt and all necessary expenses incurred by him in respect of the possession or for the preservation of the goods pledged.
Under Section 176 of the Contract Act, it is provided that if the pawnor, i.e. the pledger makes a default in payment of the debt, at the stipulated time, the pledgee is entitled to bring a suit against the pledger and retain the goods pledged as collateral security. The Pledger may also sell the pledged goods upon giving reasonable notice of sale to the pledger. Under Section 177 of the Contract Act, the defaulting pledger has the right to redeem the pledged goods at any time prior to the actual sale and after the default in payment.
As is clear from the language of Section 176 of the Contract Act, the pledgee is required to deliver a notice to the pledger prior to undertaking a sale of the pledged goods. The same was held applicable to enforcement of pledge over shares given as security for security due repayment of a financial debt. Therefore, the pledgee, would typically a notice of default along with a notice informing the pledger that the pledgee plans to invoke the pledge over the shares held as security in view of the said default.
However, the position vis-à-vis requirement of issuance of notice prior to undertaking sale of pledged shares remains different and somewhat unsettled with respect to dematerialised shares. This is primarily because pledge over dematerialised shares is governed inter alia by provisions of the Depositories Act, 1996 and the provisions framed thereunder. The same is set out herein below.
Section 12 of the Depositories Act, 1996 (“Depositories Act”) provides that subject to applicable regulations and bye-laws, a beneficial owner may, with the previous approval of the depository, create a pledge or hypothecation in respect of a security owned by him through a depository.
Under Section 25 of the Depositories Act, regulations have been framed by SEBI for regulating the manner of creating a pledge inter alia on dematerialised shares, in the form of Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018 (“Depositories Regulations”). The manner of creation of pledge of hypothecation is stipulated under Regulation 76 of the Depositories Regulations, which is set out herein below:
Manner of creating pledge or hypothecation
Provided that the depository before registering the hypothecatee as a beneficial owner shall obtain the prior concurrence of the hypothecator.
Conflict between provisions of the Contract Act and Depositories Act read with Depositories Regulations
As may be noted from the aforementioned provisions, i.e. Sections 172 and 176 of the Contract Act, provide for the creation of pledge and also stipulate the requirements for invocation or enforcement of pledge. One such requirement is the issuance of a notice under Section 176, under which, the pledgee is required to issue a notice to the pledger informing the pledger of the default and that a sale of the pledged goods will be undertaken if the default is not cured.
It may be noted from the provisions of Regulation 77 of the Depositories Regulations that there is no requirement for issuance of any notice to the pledger of dematerialised shares for invocation of the pledge. A questions therefore arises as to whether a notice contemplated under Section 176 of the Contract Act is required for pledge over dematerialised shares. This question along with other questions hinting at a possible conflict between relevant provisions on pledge under the Contract Act versus those under Depositories Act and Depositories Regulations arose before Courts. The present Article, on the basis of these decisions, seeks to analyse this conflict and determine the judicial trends on this issue.
JRY Investments Private Limited v. Deccan Leafine Services Limited and Others. (2004) 121 Comp Cas 12
Pushpanjali Tie Up Pvt Ltd. v. Renudevi Choudhary (2014) 6 Mah LJ 124
Tendril Financial Services Pvt. Ltd. v. Namedi Leasing and Finance Limited 2018 SCC OnLine Del 8142
“While Section 176 entitles the pledgee/pawnee to, on default by the pledgor/pawnor, sell the thing pledged, “on giving the pawnor reasonable notice of the sale”, Regulation 58(8) entitles the pledgee to, “subject to the provisions of the pledge document”, “invoke the pledge” and mandates the depository to “on such invocation” i.e. by the pledgee, “register the pledgee as beneficial owner of such securities” i.e. the securities pledged and further mandates the depository to “amend its records accordingly”. There is no place for a prior notice under Section 176, in the scheme of Regulation 58(8). On the contrary, Regulation 58(9) requires the depository to, after so amending its records under Regulation 58(8), inform the participants of the pledgor and the pledgee of the same and mandates the said participants to inform the pledgor and the pledgee. Thus, (a) while Section 176 provides for a notice to pledgor prior to effecting sale, Regulation 58 provides for notice post invocation and on which invocation beneficial ownership of pledged shares changes from that of the pledgor to that of the pledgee and which is equivalent to sale under Section 176. To hold that a prior notice under Section 176 of Contract Act is also required in the case of pledge of dematerialised shares would interfere with transparency and certainty in the securities market, rendering fatal blow to the Depositories Act and Regulations and the object of enactment thereof.” (emphasis supplied) (para E, page 12)
The High Court thereafter discussed the distinction if any between “sale” of pledged shares and “invocation of pledge”. It was held that:
Conclusion – What emerges from the aforementioned decisions?
From the aforementioned discussion, it may be noted that the Bombay High Court and the Delhi High Court have clarified the conflicting position with respect to the application of provisions of Contract Act versus the provisions of Depositories Act and Depositories Regulations. Courts have held that Depositories Act and the regulations framed thereunder specifically provide for the manner of creation of pledge. The scheme framed therein also provides the manner of invocation of pledge or the sale of the pledged shares at the instance of the pledgee.
Further, with regard to the requirement of issuance of notice as contemplated under Section 176 of the Contract Act, the Delhi High Court has categorically held that issuance of such notice is not required, since the same is not provided for in the provisions of Section 12 of the Depositories Act and Regulation 77 of the Depositories Regulations. It is however important to note that the aforesaid provisions, specifically, the provision governing invocation of pledge clearly provides that the invocation shall be subject to the document governing the pledge.
This article was originally published in Mondaq on 20 May 2022 Co-written by: Ameya Gokhale, Partner; Vaibhav Singh, Counsel; Radhika Indapurkar, Senior Associate. Click here for original article
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