The prime issue addressed by the judgment of the Supreme Court in PTC India Financial Services Limited v. Venkateswarlu Kari and Ors.1 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:
- PTC India Financial Services Limited (Pledgee) is an NBFC classified as an infrastructure finance company. The Pledgee advanced a loan of Rs. 125 crores to NSL Nagapatnam Power and Infratech Limited (Borrower). The Borrower is a subsidiary of Mandava Holdings Private Limited (Pledgor), Respondent No. 2. The loan was secured by a pledge created by Pledgor over 26% dematerialised shares held by it in NSL Energy Ventures Private Limited (subject company), another subsidiary of the Pledgor. The shares of the subject company were unlisted.
- The Pledgee issued a notice under the pledge deed informing the Pledgor about defaults of the Borrower. The notice also stated that if the debt due was not discharged within 7 days, the Pledgee would exercise its rights in terms of the pledge deed. As the debt remained unpaid, the Pledgee invoked the pledge in terms of the pledge deed by writing to the Depository Participant (DP). The DP acted on this request of the Pledgee and accorded status of 'beneficial owner' to the Pledgee in respect of the shares. On the very next day, the Pledgee filed an application under Section 7 of the Insolvency and Bankruptcy Code, 2016 (IBC) against the Borrower. On the next day thereafter, the Borrower was admitted into insolvency, although, on its own application filed under Section 10 of the IBC. The NCLT subsequently permitted the Pledgee to withdraw its own application filed under Section 7 of the IBC against the Borrower with liberty to file proof of claim with the Interim Resolution Professional (IRP) of the Borrower, Respondent No. 1 in the present matter.
- In the interregnum, the Pledgee wrote to the Pledgor informing that it has invoked the pledge while reserving its rights to sell the shares under the pledge deed read with Section 176 of the Contract Act.
- Subsequently, the Pledgor filed a claim with the IRP in accordance with the provisions of the IBC stating that (i) since the title of beneficial owner has been conferred on the Pledgee, the Pledgor does not have any right or title on the pledged shares anymore; (ii) the Pledgor had stepped into the shoes of the Pledgee as a creditor of the Borrower to the extent of the valuation of the pledged shares of the subject company now held by the Pledgee.
- Interestingly, the Pledgee also filed a proof of claim with the IRP of the Borrower for the amount due and payable to the Pledgee as on 18th January, 2018 (which was the date of admission of the Borrower into insolvency). Importantly, the value of the shares on which the pledge was invoked was not accounted for or adjusted by the Pledgee while making its claim with the IRP.
- The IRP communicated that the Pledgor's claim could not be crystallised as it was not possible to ascertain the value of the shares transferred to the Pledgee. Simultaneously, the IRP communicated that the Pledgee's claim also cannot be crystallised because of the settlement in whole or part of its claim and the need to arrive at the valuation of the shares at the time of their transfer to the Pledgee. Since claims of both the Pledgor as well as the Pledgee were rejected, independent applications were filed by both before the NCLT.
- It is important to note that there was a dispute between the parties about the valuation of the pledged shares, particularly, value of the pledge shares and the date of which the value should be considered.
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.
Supreme Court's observations:
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:
- On becoming beneficial owner in the records of the depository, the Pledgee had complied with the procedural requirement under Regulation 58(8) of the Depositories Regulations. Thereafter, sale should be made in accordance with Section 176 of the Contract Act.
- The Pledgor is entitled to redeem the pledge before the actual sale to a third party is made.
- The registration of the Pledgee as beneficial owner does not have the effect of sale of shares by the Pledgee. The pledge has not been discharged or satisfied in part or in full.
- The Pledgor is not a secured creditor of the Borrower. The Pledgee has rightly made a claim as a financial creditor of the Borrower without accounting for the subject shares for arriving at its claim.
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:
- On rights of the pledgee generally:
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.
- On the requirement of notice:
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.2, 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.
- On right of redemption of pledgor:
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.
- On sale to self by the pledgee:
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 decisions3 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'.4 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.
- On accretions:
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.
- On apparent conflict between Depositories Act r/w Depositories Regulation and Contract Act:
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:
- In the PTC Financial, the Supreme Court has observed that the registered owner of the pledged shares continues to be the Depository and the beneficial ownership transfers from the pledgor to the pledgee upon invocation. The Supreme Court thus observed that a pledgee, upon invocation of the pledged shares, becomes the 'beneficial owner' of the shares.
- The Supreme Court has emphasised on the concept of 'actual sale' for the purpose of Sections 176 and 177 of the Contract Act. It was held that actual sale means sale of the invoked shares to a third party and not to self. Till the time such actual sale does not take place, the pledgor's right of redemption of the shares as per the Contract Act remains alive. Once the actual sale takes place and third party rights are created on the shares, the right of redemption of the pledgor comes to an end.
- The Supreme Court has observed that, even upon becoming the 'beneficial owner' of the pledged shares, the pledgee-lender continues to be a financial creditor of the corporate debtor. The Supreme Court came to this finding on the basis that even upon invoking the pledge and becoming the beneficial owner of the pledged shares, the Pledgee had not recovered its debt from the corporate debtor.
- The effect of the Supreme Court's ruling is that while the pledgee has become the legitimate owner of the shares (which it can sell whenever it deems fit), pledgee's claim as a creditor in the borrower's insolvency for the same has also been admitted. At the same time, the pledgor's right has been curtailed completely because its right over the pledged shares has come to an end post invocation and it has been unable to make a claim in the borrower's insolvency since the actual sale of the pledged shares has not taken place. In such a situation, it appears that the only right available with the pledgor is the right of redemption of shares by paying the due amounts.
1 Civil Appeal No. 5443 of 2019, Judgment dated 12 May 2022
2 2018 SCC OnLine Del 8142
3 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
4 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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.