Explore whether penal action resulting in the freezing of shares amounts to encumbrance under SEBI (SAST) Regulations, 2011. Understand the definition, implications, and disclosure obligations for better compliance.
Encumbrance is defined under Regulation 28(3) of Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (‘SEBI SAST’). The definition reads as follows:
[(3) For the purposes of this Chapter, the term “encumbrance” shall include, –
(a) any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly;
(b) pledge, lien, negative lien, non-disposal undertaking; or
(c) any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.]
The term ‘Encumbrance’ in defined in an inclusive manner. Hon’able Rajasthan High Court in the matter of Aditya Cement Staff Club vs Union of India and Ors, RLW 2004 (1) Raj 396, 2003 (4) WLC 663 has stated that, “The scope of an inclusive definition cannot be restricted to those categories only which occur in the definition, but an inclusive definition will extend to so many other things ordinary falling within the parent expression, which are not talked of in the section”. It means inclusive definition cannot be restricted to events or categories mentioned in the definition.
Definition of Encumbrance provides for certain events but it also provides for certain characteristics that may amount to Encumbrance viz. any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly.
This definition of Encumbrance is referred under Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) , Regulations 2015 [‘SEBI LODR’] for the purpose of disclosure of Encumbrance under shareholding pattern as per Regulation 31 of SEBI LODR in the format prescribed thereunder. . .
Now if we further dwell deep into this subject, we would get some precedents wherein regulatory authorities and judiciary have thrown light on this subject. SEBI in its Adjudication Order dt: March 31, 2020 had stated as follows, ” Under Regulation 28(3) of SAST Regulations which is any way an inclusive provision to take into its ambit all kinds of restrictions on transferability of shares, the words, “by whatever name called” assume much significance when seen in light of inclusivity of the provision. These words are intended to include all encumbrances and restrictions and not to limit the applicability of the obligations only with regard to pledge, lien or other similar transactions. If the intent of regulation was to limit the scope of ‘encumbrance’ to pledge, lien and similar transactions only, then the words “by whatever name called” would not be necessary in regulation 28(3). “. This again reiterates the principle of encumbrance as stated above. So, it means that any restriction on free transferability and marketable title of shares would be considered as Encumbrance as per SEBI SAST
To further get some insight on this question let us read Reg. 31(4) of SEBI SAST
Regulation 31(4) of SEBI SAST, “The promoter of every target company shall declare on a yearly basis that he, along with persons acting in concert, has not made any encumbrance, directly or indirectly, other than those already disclosed during the financial year” (Emphasis supplied)
Reg 31(4) states that promoter on behalf of PAC shall declare that they have not made any encumbrance which is not disclosed too public.
On perusing these wordings, it can be inferred that encumbrance created/initiated by the Promoter or Promoter Group or Persons Acting in Concert voluntary would be covered under the term Encumbrance.
If we read the above two inferences jointly it can be seen that any restriction on free transferability and marketable title of shares and which is created voluntarily by the shareholder would be considered as Encumbrance. We would get another aspect of Encumbrance of Shares if we refer the disclosure obligations and formats pertaining to that notified under SEBI SAST. Formats for disclosure of Encumbrance was notified by SEBI vide its circular dt: August 5, 2015. SEBI further vide its circular dt: August 7, 2019 had stated certain additional formats if encumbered holding of promoter exceeds certain specified limits. On conjoint reading of formats provided by SEBI Circular dt: August 5, 2015 with August 7, 2019 it can be seen that encumbrance is generally done for raising funds.
Now if we again read conjointly above three conclusions it can be inferred as follows;
1. Encumbrance is voluntary in nature
2. It is restriction on free and marketable title.
3. It is done for raising funds for business or personal use.
Question now arises is that whether freezing of shares pursuant to non-compliance with provision of SEBI LODR whereby penal action of freezing of shares is done pursuant to SEBI circular dt: January 22, 2020 on Non-compliance with certain provisions of SEBI (Listing Obligations and Disclosure Requirements), Regulations, 2015 and Standard Operating Procedure for suspension and revocation of trading of specified securities [‘SEBI SOP Circular’]can be considered as encumbrance?
Let us understand this with an example. ABC Ltd fails to have composition of board of directors as per SEBI LODR for one quarter. As it was a continuous non-compliance, stock exchanges initiated penal action against ABC Ltd. Company failed to pay the penalty and rectify the non-compliance within the time specified. Stock exchanges pursuant to exercise of powers under SEBI SOP Circular freezed promoters demat account including shareholding of company held by them. Whether this kind of freezing would be termed as encumbrance?
Let us apply the conclusions drawn above to this situation.
Whether encumbrance is voluntary: no
Whether it is for raising funds: no
Whether it is restriction on free and transferable title: yes.
So, if we see above freezing of shares does not fulfil all conditions of encumbrance. It only fulfils one condition that is it is restriction on free and marketable title. So, as we had seen above to be termed as Encumbrance under SEBI SAST, it is necessary that all conditions shall be fulfilled. But as checked above freezing of shares is not complying with all conditions. So, it can be inferred that freezing of shares is not encumbrance.
So now question arises is that whether this would require disclosure under Reg. 31(1) states as follows:
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:
Provided that the aforesaid disclosure requirement shall not be applicable where such encumbrance is undertaken in a depository.
Securities Appellate Tribunal vide its various orders have been mentioning about importance of disclosures under various SEBI Regulations.
Hon’ble SAT in the matter of Coimbatore Flavors & Fragrances Ltd. vs SEBI (Appeal No. 209 of 2014 order dated August 11, 2014), has also held that “Undoubtedly, the purpose of these disclosures is to bring about more transparency in the affairs of the companies. True and timely disclosures by a company or its promoters are very essential from two angles. Firstly; investors can take a more informed decision to invest or not to invest in a particular scrip secondly; the Regulator can properly monitor the transactions in the capital market to effectively regulate the same.” Further in the matter of Appeal No. 66 of 2003 -Milan Mahendra Securities Pvt. Ltd. vs. SEBI–the Hon’ble SAT, vide its order dated April 15, 2005 held that, “the purpose of these disclosures is to bring about transparency in the transactions and assist the Regulator to effectively monitor the transactions in the market.” Disclosure plays a very important role in securities market. Timely disclosures of all relevant information are essential for creating a level playing field in securities market.
In this regard let us try and understand the background for introduction of 1st proviso to reg 31(1) SEBI Board Meeting dt: August 6, 2021 stated that, “Sub-regulations (1) and (2) of Regulation 31, inter-alia, requires promoter/promoter group to disclose details of encumbrance, release and invocation of shares in the target company. 4.4. Since, disclosures of creation, invocation and release of encumbrance registered in depositories are also now system driven, thus obligation of promoter/promoter group for these disclosures is also proposed to be done away with.” The reason for doing away disclosures pertaining to encumbrance was that the disclosures have become system driven. As per 1st proviso to Reg. 31(1) of SEBI SAST, all encumbrances that are marked in demat need not be disclosed to stock exchange as they already get displayed on stock exchange through system driven disclosure. So, it can be inferred that disclosure either manual or automated form is necessary.
But as discussed ‘freezing of shares’ is not encumbrance. So, 1st proviso to Reg 31(1) of SEBI SAST wouldn’t be of any help to us. It will not be voluntarily marked in demat account by Promoters of the company.
But if we see the background with which this proviso is inserted it can be seen that pursuant to system driven disclosure encumbrances once marked in demat account becomes available to public at large on stock exchange platform. Accordingly, it needs to be seen whether information relating to freezing of shares is made available on website of stock exchanges? Details of SEBI SOP Circular non-compliance are also made on the website of stock exchanges. So, it can be inferred that they need not be disclosed under Reg. 31(1) of SEBI SAST.
Further if we see the other leg of disclosure under Regulation 31(4) of SEBI SAST it states as follows, “The promoter of every target company shall declare on a yearly basis that he, along with persons acting in concert, has not made any encumbrance, directly or indirectly, other than those already disclosed during the financial year”
This disclosure is much wider in scope that disclosure of encumbrance under Reg. 31(1). Regulation 31(4) of SEBI SAST asks the promoter to declare that no encumbrance is created other than those disclosed to stock exchange. So, it is confirmation from promoter on behalf of promoter group and Persons acting in Concert that there is no encumbrance created other than those disclosed to stock exchange. As we have seen that freezing of shares is not encumbrance.
Taking this understanding if promoter declares under Reg. 31(4) of SEBI SAST that there is no encumbrance would this declaration be correct? Even if the provision does not expressly mention about such kind of disclosures and also it does not mention about what can be done in such scenarios it is recommended that on freezing of shares a note may be inserted in declaration given under Reg. 31(4) of SEBI SAST giving details of freezing of shares of Promoter.
So, on freezing of shares of promoter even if no express disclosure is required under Reg. 31(1) but a mention about the same under Reg. 31(4) of SEBI SAST is recommended. Further any clarity in this regard from regulator would be welcome.
The article is written by Deepti Jambigi Joshi – Partner and Vallabh Joshi – Senior Manager RnD Team!
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