Introduction
As per Section 172 of the Indian Contract Act, 1872 [ICA], pledge is a form of bailment where a debtor transfers their possession of an asset to the creditor as a security until the repayment of debt or fulfillment of promise. In India, it is a common practice for promoters of listed companies to pledge their shares in order take a loan, usually at a lower rate of interest.
Other than this, a lot of retail investors also pledge their shares to banks to take on a loan either for trading further or any other personal reason. Given the complexity of such a transaction, several laws, and regulations other than the ICA come into play. These rules and regulations are majorly looked after by the Reserve Bank of India [“RBI”] and the Securities and Exchange Board of India [“SEBI”]. This is because whenever a listed company undertakes any major transaction such as pledging shares to take on a loan, it may have an adverse effect on the economy of the whole country as it is the public who is a major shareholder of such a company. Hence, there is an added responsibility of disclosures and compliances which are governed by RBI and SEBI.
Relevant SEBI regulations for pledging dematerialized shares
There are certain regulations which the promoters of a public company need to keep in mind and read along with Section 172 of the ICA while making a pledge. One of the most important things to keep in mind is the difference between physical shares and dematerialized [“demat”] shares. Before 1996, in India, all the securities that were traded were backed by a certificate which acted as a proof of ownership. Post which, SEBI introduced the concept of demat account system where no transfer of papers was required, and the shares were ‘dematerialized’ into electronic form and could be transferred without physically handing over the certificate. In 2019, the physical shares were made illiquid by SEBI which meant that these shares could not be transferred without converting them into demat shares. This meant that they cannot be sold or pledged in the physical form. However, it still acted as a legal and permissible proof of ownership.
Next, according to Regulation 36 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, the promoters of a public company need to hold at least a minimum 20% of the shares for a lock-in period of three years. However, according to Regulation 39 of the same set of regulations, the promoters can pledge the shares in excess of 20% for any purpose they wish. However, that 20% can only be pledged for financing activities which will help the company to meet its objectives. This means when the promoter of a newly listed company plans to raise a loan for personal reasons, their right to pledge under the ICA is subject to certain other regulations of SEBI. Further, under Regulation 28 (3) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011, the term “encumbrance” includes all types of pledges and liens. This becomes extremely vital as SEBI requires all promoters to disclose any creation, invocation and release of encumbrance to the public under Regulation 31(1) of the same set of regulations. This shows that pledging shares of a listed company, in the capacity of a promoter is much more regulated when compared to a normal investor. The reason for the same lies in making all the information regarding the finances of a listed company readily available publicly. Usually, when the promoters of a company pledge their shareholding, it implies that the company has poor finances and lacks a robust cash flow. This significantly affects the reputation of the company amongst investors. Hence, making the knowledge of pledged promoter stock public is vital for the investors and something the promoters may not want the investors to be aware of.
In this case of retail investors, the regulations and compliances are much lesser in number. Other than Section 172 of the ICA, Section 10, 12, 20 of the Depositories Act, 1996 and Regulation 58 of the SEBI (Depositories and Participants) Regulations, 1996 lay down the procedure of creating a pledge and the penalty for contravention of these regulations. Other than these two SEBI rules, the bye-laws of the Depository Participant [“DP”] (which is either NSDL or CDSL in India) also lay down certain conditions and procedures which need to be followed while pledging demat shares.
Before August 2020, the process for an investor to pledge securities was extremely straightforward where all the essential ingredients of a pledge were met. The pledge (i) took place in pursuance of a contract and (ii) the demat shares were transferred to the pawnee’s demat account by the pawnor. However, in February 2020, SEBI came out with a circular which stated that from June 2020 (which was later extended to August 2020), the pledged shares would not be transferred to the broker’s account but would remain in the demat account of the pawnor only. However, it would technically be in a different demat account which could not be used by the pawnor to trade the pledged securities. This process of pledging goods without delivering the possession of the goods to the pawnee is known as hypothecation. This concept of hypothecation came into existence in the case of Reeves v Capper (132 E.R. 1057). Post which, this concept has been widely used in Indian courts and is defined under Section 2(n) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
Invocation of pledged demat shares
Till now, we discussed the process of how an individual or a group of individuals can pledge their shares in order to secure a loan. Now let us look into to the rights of the pawnee when the pawnor defaults in the payment of his debt. For the same, the main statute that comes into play is Section 176 of the ICA. This section gives the pawnee the right to (i) sue the pawnor, (ii) retain the pledged goods or (iii) sell them after providing the pawnor a reasonable notice. The relevant SEBI regulation which governs the invocation of a pledge is Regulation 79 (8) of the SEBI (Depositories and Participants) Regulations, 1996. However, this regulation does not state that any sort of prior notice needs to be served to the pawnor before invoking the pledge. All it states that the same should be done in accordance with the pledge document. Since there is a clear contradiction in terms of the requirement of a notice in the two statutes, the same has been brought up in different High Courts for which rulings have sometimes been contradictory in nature.
Firstly, in 2004, a single judge bench of the Bombay High Court [“Bombay HC”] in the case of JRY Investments Pvt. Ltd. v. Deccan Leafine Services Ltd held that there was no duty upon the pawnee to serve a notice to the pawnor when pledged demat shares were being enforced. The reasoning for the same was that the Depositories Act, 1996 and the relevant SEBI provisions prevailed over the ICA. This was because in the Bombay HC’s view, a pledge of demat shares can only be created under the Depositories Act, 1996 and not the ICA. The ICA could only regulate pledges relating to physical shares as in the context of demat shares, no physical delivery of goods takes place. The same ruling and reasoning was later affirmed by a division bench of the Bombay HC in the case of Pushpanjali Tie Up Pvt. Ltd vs Renudevi Choudhary.
On the contrary, in 2011, in the Delhi High Court [“Delhi HC”] in the case of GTL Limited v. IFCI Ltd. & Others held that a reasonable notice for selling demat securities under Section 176 of the ICA is mandatory. Otherwise the contract would be illegal as the pawnor would not have the opportunity to redeem the pledged shares. Further, it was held that the requirement of a notice only comes when the pawnee plans on selling the share and not when they plan on invoking the pledge and transfer the securities into their own demat account. However, later on in 2018, the Delhi HC in the case of Tendril Financial Services Pvt. Ltd. and Ors. v. Namedi Leasing & Finance Ltd. and Ors. declined its previous ruling of the GTL Limited v. IFCI Ltd. & Others case and held that a notice was not required. The Delhi HC stated that the provisions of the Depositories Act, 1996 were not taken into account in the previous judgement. Now, the court agreed with the decision of the Bombay HC and held that the requirement of furnishing a notice to the pawnor will only arise if the pledge agreement has a provision for the same in the contract. For now, the settled law in Delhi and Bombay HC for pledging shares is that only the pledging of physical shares will be governed by the ICA. However, If the pledging of demat shares is in question, the relevant SEBI regulations and the pledge agreement will be considered. Given that SEBI has now made it compulsory to deal with securities only in the dematerialised form. This means that the ICA cannot be used to handle issues relating to pledged shares anymore.
Conclusion
Now even though two High Courts of the country agree upon how the pledge of demat shares should be treated, it is important that the Supreme Court also rules upon the same in order to ensure a nationwide uniformity for dealing with the same. Till then, it is important for the parties of a pledge of demat shares to ensure that they have a very robust pledge agreement. If the pawnor does want a notice of sale or invocation, the same should be made expressly clear in the pledge agreement. It is also an interesting case to see that even though pledge has always been regulated by the ICA, and the courts have recognized hypothecation as form of delivery of goods in the past. The same was not extended to pledges consisting of demat shares. At the same time, it would make sense not to add the extra burden of a notice as when it comes to the volatility of the stock market, there is usually a very limited time window in which the pawnee will be able to recover the debt by selling the pledged securities.
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