The prime issue addressed by the judgment of the Supreme Court in PTC India Financial Services Limited v. Venkateswarlu Kari and Ors. is whether, in the context of pledge over dematerialised shares, the Depositories Act, 1996 (“Depositories Act”) read with Regulation 58 of the SEBI (Depositories and Participants) Regulations, 1996 (“Depositories Regulation”) has the effect of overwriting the provisions relating to contract of pledge under the Indian Contract Act, 1872 (“Contract Act”) and the common law as applicable in India. The judgment, after considering a series of judgments on this issue which have we have dealt with in a previous article here, holds that provisions of the Contract Act and Depositories Act should be read harmoniously. Along with this finding, the Supreme Court has also clarified the legal position on certain other aspects which may have far reaching consequences in the context of the law of pledges.
Before summarising and analysing the said findings, set out below are the relevant facts before the Supreme Court:
The NCLT accepted the Pledgor’s claim relying on the provisions of the Depositories Act and the Depositories Regulations, essentially holding that the Pledgor is the financial creditor of the Borrower to the extent of the value of the invoked shares since the Pledgor’s shareholding in the subject company stood reduced by such number of shares post the invocation of pledge by the Pledgee. The NCLT also held that the relevant date for determining the extent to which the Pledgee and the Pledgor are financial creditors of the Borrower is the date of invocation of the pledge. The IRP was directed to appoint an independent valuer to assess the fair value of such shares.
The NCLT’s order was challenged by the Pledgee before the NCLAT. The NCLAT observed that pursuant to invocation of pledge, the pledged shares stood transferred in the name of the Pledgee and the fact that the Pledgee had not thereafter sold the shares would not matter. The NCLAT observed that as the Pledgee had become the 100% owner of the pledged shares, it could realize its dues in whole or part by sale and transfer of the shares according to the law. Further, it observed that once the Pledgee has exercised right to become the owner of the shares, it cannot take advantage of Section 176 of the Contract Act to ‘reclaim’ the debt.
The Supreme Court set aside the judgment of the NCLAT. It held that the Pledgee, and not the Pledgor, is a creditor of the Borrower. Therefore, the Pledgee was right in filing a claim with the IRP of the Borrower, without accounting for the value of the pledged shares. The Supreme Court held:
In arriving at the aforesaid finding, the Supreme Court made the observations on various issues including: (i) what is pledge and the legal difference between ownership, pledge and mortgage; (ii) right of the pledgee being a special and not general right in the pledged property; (iii) accretions on the pledged goods; (iv) notice of sale by pledgor and the pledgee’s right to sue for recovery and sell the pawned goods; (v) sale of the pledged goods by the pledgee to self; (vi) effect and purpose of Depositories Act and Depositories Regulations; (vii) effect of Depositories Act and Depositories Regulations on pledge under Contract Act.
Some of the interesting observations of the Supreme Court, which may have a far reaching effect on the legal position as it stood are set out below:
Section 176, elucidating on the rights of the pledgee, states that in case of default by the pledgor, the pledgee has: (a) a right to sue upon the debt and to retain the goods as collateral security, and (b) sell the goods after reasonable notice of the intended sale to the pledgor. Once the pledgee, by virtue of his right under Section 176, sells the goods, the right of the pledgor to redeem them under Section 177 of the Contract Act is extinguished. But, thereupon, the pledgee is bound to apply the sale proceeds towards satisfaction of the debt and pay the surplus, if any, to the pledgor. So long as the sale does not occur, the pledgee is entitled to redeem the goods on payment of the debt.
Under Section 176 of the Contract Act, the requirement of giving the pledgor reasonable notice of sale is mandatory and it is not open to parties to contract themselves out of this section. The notice that is to be given for the intended sale by the pledgee is a special protection that the Contract Act has given to the pledgor and the parties cannot agree that the pledgee may sell the pledged goods without notice to the pledgor. The right of redemption of the pledgor under Section 177 remains till the ‘actual sale’ of the pledged goods.
The object and purpose of the notice is to give an opportunity to the pledgor to redeem the pledged goods before “actual sale”. The Court, while considering the judgment of the Delhi High Court in Tendril Financial Services Pvt. Ltd. & Ors. v. Namedi Leasing & Finance Ltd. and Ors., observed that the requirement of reasonable notice under Section 176 would be satisfied once the pledgor is made aware and has knowledge of the pledgee’s desire / intention to sell.
A reading of Section 176 and 177 of the Contract Act reveals that a pledgor has the right to redeem by offering to pay the debt due and recovering his pledged goods. The dicta of the judgments referred and Section 177 of the Contract Act is that the defaulting pledgor has the right to redeem the pledged goods till ‘actual sale’ of the pledged goods. These dicta do not support sale of the pledged goods by pledgee to self.
Sale to self is conversion and not ‘actual sale’. Therefore, it would affect the pledgor’s right to redemption under Section 177 of the Contract Act. The Court referred to prior decisions to observe that the sale of goods by the pledgee to itself is unauthorised but did not entitle the pledgor to have the goods back. The pledgor would be required to pay back the debt for which the goods were pledged as security to redeem the goods. If the loan remains unpaid after the demand, the pledgee is entitled to sell the goods and credit the proceeds towards the outstanding debt. The pledgee may be liable in such cases for damages for converting the goods for his use, subject to the terms of the contract.
Sale by pledgee to self does not defeat the right of redemption of the pledgor. It may amount to conversion in law. Other provisions of Contract Act enumerated in Chapter IX (which contains Section 176, 177 etc.) may well apply. The term ‘actual sale’ used in Section 177 of the Contract Act should be read as ‘the sale by the pawnee to a third person made in accordance with the Depositories Act and applicable by-laws and rules’. It also requires compliance with Section 176 of the Contract Act.
Mere exercise of the right by the pledgee to record himself as the beneficial owner , which is a necessary precondition before the pledgee exercises his right to sell, is not actual sale. Such exercise would not affect the right of the pledgor of redemption under Section 177 of the Contract Act. The right of redemption can be exercised by the pledgor even after the pledgee has been registered as the beneficial owner but this right of redemption ceases on actual sale, i.e. when the shares are sold to a third person.
In the context of dematerialised shares, the pledgor’s right of redemption does not operate against third parties even if the pledgee has not given reasonable notice under Section 176 of the Contract Act. If the Pledgor’s case was to be accepted, it would mean that the entire dues of the Pledgee stand paid without a single penny coming to the coffer of the Pledgee. Since the shares of the subject company are unlisted it is unclear whether the Pledgee will be able to find a willing buyer to purchase the shares.
The pledge extends to accretions and additions. Therefore, when the pledgee returns the pledged goods, the accretions and additions must be returned to the pledgor. It also follows that the pledgee’s right to retain and sell the pledged goods stretches to the right to retain and sell any increase and accumulations to the pledged goods.
The Contract Act is the substantive and general law relating to contracts. Depositories Act is the law relating to securities. The two should be interpreted harmoniously and should be read together. This does not mean that any provisions of one enactment could nullify the provisions of the other.
The Depositories Act (except for Section 12) and the Depositories Regulations do not state that their provisions prevail over the Contract Act. To the contrary, Section 28 of the Depositories Act states that the provisions of the 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.
Section 12 of the Depositories Act, which deals with pledge or hypothecation of shares does not define pledge or hypothecation, and thereby accepts and adapts their meaning as known in the commercial sense to people in trade. This means the Depositories Act recognises the principles relating to pledge prescribed by the Contract Act and the common law.
Section 12 of the Depositories Act is not ex-facie inconsistent with the pledgee’s and pledgor’s contractual rights and obligations under the Contract Act and common law. It recognises the concept of legal and beneficial owner but does not in any manner contradict or lay down a rule which is contrary to provisions of Section 176 and 177 of the Contract Act.
Regulation 58 of the Depositories Regulations, which deals with manner of creation of pledge, also does not nullify any provision of the Contract Act. The non-obstante part of Regulation 58 (i.e. Regulation 58(8)) does not circumscribe or limit the contractual rights and obligations of the parties. It serves a limited purpose, i.e. the pledgee must record itself as a beneficial owner before he proceeds to sell the pledged shares. Without such status being accorded, the pledgee cannot proceed to sell the shares; and it cannot proceed to exercise its rights to sell the pledge and retrieve the monies by taking recourse to the rights under Section 176 of the Contract Act.
The ratio decidendi of the Delhi High Court in Tendril Financial that there is a conflict between Regulation 58 of the Depositories Regulations and Section 176 of the Contract Act has been set aside by the Supreme Court. The Court has observed that Regulation 58 entitles the pledgee to register itself as the beneficial owner – this does not automatically result in actual sale. This is because the pledgee does not receive any money from such registration which it can adjust against the debt due.
Further, object of pledge is not to purchase security. Purchase by self is conversion and does not extinguish the pledge or the right of the pledgor to redeem the pledge.
Implications of the Supreme Court’s observations on rights of pledgors and pledgees of the dematerialised shares:
 Civil Appeal No. 5443 of 2019, Judgment dated 12 May 2022
 2018 SCC OnLine Del 8142
 Neikram Dobar v. Bank of Bengal (Privy Council) ILR (1892) 19 Cal 322; Haridas Mundra v. National and Grind-Lays Bank Ltd, AIR 1963 Cal 132
 While coming to this conclusion, the Supreme Court has overruled the decision of the Haryana High Court in Dhani Ram and Sons v. The Frontier Bank Ltd. and Another (AIR 1962 P&H 321) which holds that the sale of the pledged goods by the pledgee to himself is not void, and the pledgee was held to be the legal owner of the pledged shares.
This article was originally published in Mondaq on 18 June 2022 Co-written by: Ameya Gokhale, Partner; Vaibhav Singh, Counsel; Radhika Indapurkar, Principal Associate. Click here for original article
Contributed by: Ameya Gokhale, Partner; Vaibhav Singh, Counsel; Radhika Indapurkar, Principal Associate
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