CS Vikas Gupta

CS VIKAS GUPTAIt is a refined phrase for the colloquial term ‘girvi rakhna’. Banks and Financial Institutions provide loans against shares and the bank will call it ‘collateral’.

Pledging of shares in order to avail the loan is neither a new concept for promoters nor for investors. In brief, when the promoters want to raise the funds for the personal or the company’s needs, they pledge their shares with the financial or non-financial institution.

1. Existing legal frame work

Before examining the practical aspects of the issue, it is important to understand the legal provisions under various acts governing the pledging of shares.

Indian Contract Act, 1872

“Pledge is the delivery of goods by the pawnor to the pawnee by way of security upon a contract that they shall, when the debt is paid or the promise is performed, be returned or otherwise disposed of according to the directions of the pawnor.”

A pledge would, therefore, create a right of possession only. The title of the pledged property remains with the pawnor.

Now a days majority of the shares are held in demat form and it is therefore important to know that both the depositories in India namely NSDL and CDSL have adequate system in their software to create pledge and its invocation in such a way that the holding statement shows the share holding under two heads ‘Free and Pledged’. Further Regulation 58 of the Depository Participant Regulations 1996 reads as under:

“Subject to the provisions of the pledge document, the pledgee may invoke the pledge and on such invocation, the depository shall register the pledge as beneficial owner of such securities.”

Further, the Companies Act 2013 does not place any bar or restriction to the quantum or manner of pledging of shares. The Companies Act 2013 does not prescribe any minimum percentage to be held by the promoters or the directors. However, the Articles of Association of a company may prescribe the qualification shares of a director but practically this is a very nominal figure grossly immaterial for the movement of share price. Regulation 36 of The SEBI (Issue of Capital and Disclosure requirements) Regulations 2009 does provide that in case of a company making a public issue, there should be a minimum promoters holding of 20% which should be locked for a minimum period of three years. However, after three years the promoters are free to sell their shares. So if the invocation of pledge results into promoters holding falling below 20% after the said lock-in period, it does not violate the SEBI guidelines.

Banking Regulation Act, 1949

Under Section 19(2) of the Banking Regulation Act 1949, it is provided that no banking company shall hold shares in any company whether as pledgee, mortgagee or absolute owner of an amount exceeding 30% of the paid-up capital of that company or 30% of its own paid-up capital and reserves, whichever is less. The shares of any company are taken as security by the banks and financial institutions in following cases:

1. Overdraft facility against listed and approved shares of any public limited company.

2. Pledge of shares of listed companies as an additional or collateral security for a loan or overdraft given against some other prime security.

Further, in terms of the RBI instructions, it is necessary that the bank holding shares as a pledgee or mortgagee must get such shares transferred in its own name (refer to RBI circular no.DBOD.BC.90/13.07.05/98 dated 28th August, 1998). This means that promoter’s shares in excess of 30% cannot be accepted in pledge.

ECB (External Commercial Borrowing) Guidelines

Under the ECB guidelines, the choice of security to be provided to the overseas lender/ supplier for securing ECB is left to the borrower. However, creation of charge over immoveable assets and financial securities, such as shares, in favour of the overseas lender is subject to Regulation 8 of Notification No. FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA 20/RB-2000 dated May 3, 2000, respectively, as amended from time to time. Accordingly, proposals for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees, on behalf of the borrower in favour of the overseas lender, to secure the ECB under automatic/ approval route, are considered by the Reserve Bank.

As a measure of rationalisation of the existing procedures, it has been decided to allow AD (Authorised Dealers) Category – I banks to convey ‘no objection’ under the Foreign Exchange Management Act (FEMA), 1999 for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees in favour of overseas lender/ security trustee, to secure the ECB to be raised by the borrower. Before according ‘no objection’ under FEMA, 1999, AD Category – I banks may ensure and satisfy themselves that:

(i) the underlying ECB is strictly in compliance with the extant ECB guidelines,

(ii) there exists a security clause in the Loan Agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee,

(iii) the loan agreement has been signed by both the lender and the borrower, and

(iv) the borrower has obtained Loan Registration Number (LRN) from the Reserve Bank.

On compliance of the above conditions, AD Category – I banks may convey their ‘No objection’, under FEMA, 1999 for creation of charge on immovable assets, financial securities and issue of personal or corporate guarantee, subject to the conditions mentioned below:

Creation of Charge over Financial Securities

AD Category – I banks may convey their ‘no objection’ under FEMA, 1999 to the resident ECB borrower for pledge of shares of the borrowing company held by promoters as well as in domestic associate companies of the borrower to secure the ECB subject to the following conditions:

(i) The period of such pledge shall be co-terminus with the maturity of the underlying ECB.

(ii) In case of invocation of pledge, transfer shall be in accordance with the extant FDI policy.

(iii) A certificate from the Statutory Auditor of the company that the ECB proceeds have been / will be utilized for the permitted end-use/s.

Issue of Corporate or Personal Guarantee

The ‘no objection’ to the resident ECB borrower for issue of corporate or personal guarantee under FEMA, 1999 may be conveyed after obtaining –

(i) Board Resolution for issue of corporate guarantee from the company issuing such guarantees, specifying names of the officials authorised to execute such guarantees on behalf of the company or in individual capacity.

(ii) Specific requests from individuals to issue personal guarantee indicating details of the ECB.

(iii) Ensuring that the period of such corporate or personal guarantee is co-terminus with the maturity of the underlying ECB.

2. Provisions relating to disclosure of pledge

SEBI has come out with disclosure, in a bid to protect the interest of existing and potential shareholders, as pledging of shares could result in a change of ownership if the promoter is unable to redeem those shares by repaying the loan.

Disclosure-related provisions – Regulation 28(3) of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011

For the purposes of this Chapter, the term “encumbrance” shall include a pledge, lien or any such transaction, by whatever name called.

Disclosure of acquisition and disposal – Regulation 29 of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011

(1) Any acquirer who acquires shares or voting rights in a target company which taken together with shares or voting rights, if any, held by him and by persons acting in concert with him in such target company, aggregating to five per cent or more of the shares of such target company, shall disclose their aggregate shareholding and voting rights in such target company in such form as may be specified.

(2) Any person, who together with persons acting in concert with him, holds shares or voting rights entitling them to five per cent or more of the shares or voting rights in a target company, shall disclose the number of shares or voting rights held and change in shareholding or voting rights, even if such change results in shareholding falling below five per cent, if there has been change in such holdings from the last disclosure made under sub-regulation (1) or under this sub regulation; and such change exceeds two per cent of total shareholding or voting rights in the target company, in such form as may be specified.

(3) The disclosures required under sub-regulation (1) and sub-regulation (2) shall be made within two working days of the receipt of intimation of allotment of shares, or the acquisition of shares or voting rights in the target company to,—

(a) every stock exchange where the shares of the target company are listed; and

(b) the target company at its registered office.

(4) For the purposes of this regulation, shares taken by way of encumbrance shall be treated as an acquisition, shares given upon release of encumbrance shall be treated as a disposal, and disclosures shall be made by such person accordingly in such form as may be specified:

(5) Provided that such requirement shall not apply to a scheduled commercial bank or public financial institution as pledgee in connection with a pledge of shares for securing indebtedness in the ordinary course of business.

Disclosure of encumbered shares – Regulation 31 of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011

(1) The promoter of every target company shall disclose details of shares in such target company encumbered by him or by persons acting in concert with him in such form as may be specified.

(2) The promoter of every target company shall disclose details of any invocation of such encumbrance or release of such encumbrance of shares in such form as may be specified.

(3) The disclosures required under sub-regulation (1) and sub-regulation (2) shall be made within seven working days from the creation or invocation or release of encumbrance, as the case may be to,—

(a) every stock exchange where the shares of the target company are listed; and

(b) the target company at its registered office.

3. Purposes of pledge

The underlying purposes for which the shares are pledged is very important in taking a view of the intention of the promoters. From the empirical study, it is found that the promoters generally pledge their shares for the following purposes:

a) To create a security for the loan borrowed by the same company.

b) To raise money for conversion of warrants of the same company into it’s shares.

c) To create a security for their personal loans or loans taken by their other business ventures.

d) To raise funds for purchasing further shares of the same company from the secondary market.

While (a) and (b) above have a justification in the sense that the pledge is for the purpose of strengthening the position of the company or consolidation of the holding of such promoters. But the purpose specified in (c) above may imply an ulterior motive or speculative intentions of the promoters to jack up the price artificially. However, pledging of shares for the purpose specified in (d) above looks to be totally unreasonable and gives a smelling of the bad intentions of the promoters.

4. Conclusion

Functions related to Pledge of shares may appear to be routine but it is beyond filling of forms since more of better understanding of practical nuances and nitty-gritties, helps avoidance of pitfalls, ensuring compliance and makes the task easier. A promoter is a person who is in ultimate control of the company and formulates its operating plans and he is the first to be aware of its good or bad future. The SEBI guidelines prescribe restrictions on increase in promoters holding after certain limit, but contain no prescription of minimum promoters holding. This leaves a scope for promoter to sell or pledge even its 100% shares with an ordinary disclosure. Such companies are always vunerable to sudden crash on a particular sunny day which leaves the investors awestruck.

(Author can be contacted for further details at vks.gupta29@gmail.com)

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