One of the most common forms of security obtained by banks / financial institutions for securing debts owed to them by borrowers is pledge over shares held by the borrowers in other companies. In current times, it is more common for a company's shares / securities to be in dematerialised form as opposed to physical form i.e. physical share certificates. A controversy that has arisen therefore is whether the law applicable to pledge of goods in the traditional sense applies to pledge of shares, particularly those held in dematerialised form. This note particularly attempts to analyse the judicial position with regards to the enforcement of pledge over dematerialised shares.
Pledge – in the traditional sense
Pledge is defined under Section 172 of the Indian Contract Act, 1872 ("Contract Act") to mean a bailment of goods as security for payment of a debt or performance of a promise. Section 173 of the Contract Act provides that the pawnee, i.e. the pledgee may retain the goods pledged, not only for the performance of the promise, but for the interest of the debt and all necessary expenses incurred by him in respect of the possession or for the preservation of the goods pledged.
Under Section 176 of the Contract Act, it is provided that if the pawnor, i.e. the pledger makes a default in payment of the debt, at the stipulated time, the pledgee is entitled to bring a suit against the pledger and retain the goods pledged as collateral security. The Pledger may also sell the pledged goods upon giving reasonable notice of sale to the pledger. Under Section 177 of the Contract Act, the defaulting pledger has the right to redeem the pledged goods at any time prior to the actual sale and after the default in payment.
As is clear from the language of Section 176 of the Contract Act, the pledgee is required to deliver a notice to the pledger prior to undertaking a sale of the pledged goods. The same was held applicable to enforcement of pledge over shares given as security for security due repayment of a financial debt. Therefore, the pledgee, would typically a notice of default along with a notice informing the pledger that the pledgee plans to invoke the pledge over the shares held as security in view of the said default.
However, the position vis-à-vis requirement of issuance of notice prior to undertaking sale of pledged shares remains different and somewhat unsettled with respect to dematerialised shares. This is primarily because pledge over dematerialised shares is governed inter alia by provisions of the Depositories Act, 1996 and the provisions framed thereunder. The same is set out herein below.
Pledge over Dematerialised Shares – Relevant Legal Provisions
Section 12 of the Depositories Act, 1996 ("Depositories Act") provides that subject to applicable regulations and bye-laws, a beneficial owner may, with the previous approval of the depository, create a pledge or hypothecation in respect of a security owned by him through a depository.
Under Section 25 of the Depositories Act, regulations have been framed by SEBI for regulating the manner of creating a pledge inter alia on dematerialised shares, in the form of Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018 ("Depositories Regulations"). The manner of creation of
pledge of hypothecation is stipulated under Regulation 76 of the Depositories Regulations, which is set out herein below:
Manner of creating pledge or hypothecation
- (1) If a beneficial owner intends to create a pledge on a security owned by him he shall make an application to the depository through the participant who has his account in respect of such securities.
(2) The participant after satisfaction that the securities are available for pledge shall make a note in its records of the notice of pledge and forward the application to the depository.
(3) Within fifteen days of receipt of the application, the depository shall after concurrence of the pledgee through its participant, create and record the pledge and send an intimation of the same to the participants of the pledger and the pledgee.
(4) On receipt of the intimation under sub-regulation (3) the participants of both the pledger and the pledgee shall inform the pledger and the pledgee respectively of the entry of creation of the pledge.
(5) If the depository does not create the pledge, it shall send along with the reasons an intimation to the participants of the pledger and the pledgee.
(6) The entry of pledge made under sub-regulation (3) may be cancelled by the depository if pledger or the pledgee makes an application to the depository through its participant:
Provided that no entry of pledge shall be cancelled by the depository without prior concurrence of the pledgee.
(7) The depository on the cancellation of the entry of pledge shall inform the participant of the pledger.
(8) Subject to the provisions of the pledge document, the pledgee may invoke the pledge and on such invocation, the depository shall register the pledgee as beneficial owner of such securities and amend its records accordingly.
(9) After amending its records under sub-regulation (8) the depository shall immediately inform the participants of the pledger and pledgee of the change who in turn shall make the necessary changes in their records and inform the pledger and pledgee respectively.
(10) If a beneficial owner intends to create a hypothecation on a security owned by him he may do so in accordance with the provisions of sub-regulations (1) to (9).
(11) The provisions of sub-regulations (1) to (9) shall mutatis mutandis apply in such cases of hypothecation:
Provided that the depository before registering the hypothecatee as a beneficial owner shall obtain the prior concurrence of the hypothecator.
(12) No transfer of security in respect of which a notice or entry of pledge or hypothecation is in force shall be effected by a participant without the concurrence of the pledgee or the hypothecatee, as the case may be." (emphasis supplied)
Conflict between provisions of the Contract Act and Depositories Act read with Depositories Regulations
As may be noted from the aforementioned provisions, i.e. Sections 172 and 176 of the Contract Act, provide for the creation of pledge and also stipulate the requirements for invocation or enforcement of pledge. One such requirement is the issuance of a notice under Section 176, under which, the pledgee is required to issue a notice to the pledger informing the pledger of the default and that a sale of the pledged goods will be undertaken if the default is not cured.
It may be noted from the provisions of Regulation 77 of the Depositories Regulations that there is no requirement for issuance of any notice to the pledger of dematerialised shares for invocation of the pledge. A questions therefore arises as to whether a notice contemplated under Section 176 of the Contract Act is required for pledge over dematerialised shares. This question along with other questions hinting at a possible conflict between relevant provisions on pledge under the Contract Act versus those under Depositories Act and Depositories Regulations arose before Courts. The present Article, on the basis of these decisions, seeks to analyse this conflict and determine the judicial trends on this issue.
JRY Investments Private Limited v. Deccan Leafine Services Limited and Others. (2004) 121 Comp Cas 12
- A single judge Bench of the Bombay High Court, in this matter, has held that since the shares in question were in dematerialized form and not in physical form, such shares cannot be pledged in accordance with the provisions of Section 172 of the Contract Act. The reason assigned to this by the High Court is that Section 172 of the Contract Act requires delivery of the goods pledged. The High Court held that it is therefore obvious from the provisions of Section 172 that for a valid pledge there must be delivery of goods, i.e. physical possession of goods. It would be impossible to hold that such goods in a dematerialized form are capable of delivery that it handing over by de facto possession.
- The High Court thereafter noted that provisions have been enacted in the Depositories Act, 1996 for the purpose of recording accurately the transfers and pledges of shares including those is dematerialized form. The High Court observed that it is, therefore, clear that the Depositories Act and the regulations framed thereunder contain a whole and self-contained procedure for the creation of pledges. The Court remarked that in any case, since it is not possible to physically deliver dematerialized shares and therefore pledge them in accordance with the Contract Act, it must be held that a pledge of such shares can only be validly created in accordance with the provisions of the Depositories Act.
Pushpanjali Tie Up Pvt Ltd. v. Renudevi Choudhary (2014) 6 Mah LJ 124
- A Division Bench of Bombay High Court, while ruling on the question of pledge over dematerialized shares considered the aforementioned judgment in JRY Investments by the Single Judge. The Division Bench refrained from expressing any opinion regarding the finding of the Single Judge in JRY Investments that it is impossible to hold that the goods in dematerialized form are capable of delivery that is by handing over de facto The Division Bench presumed that it is possible to do so. The Division Bench however expressed complete agreement with the Single Judge that the transfer of shares governed by Depositories Act must be in accordance with the provisions of the said Act and that the pledge of the shares can only be validly created in accordance with the provisions of that Act.
Tendril Financial Services Pvt. Ltd. v. Namedi Leasing and Finance Limited 2018 SCC OnLine Del 8142
- The Delhi High Court considered the issue of requirement of notice under Section 176 of Contract Act in case of dematerialized shares. The Delhi High Court referred to the aforementioned decisions of the Bombay High Court i.e. JRY Investments and Pushpanjali Tyres. The Learned Single Judge of the Delhi High Court in this matter held that a notice under Section 176 of the Contract Act is in derogation of the Regulation 58 framed under the Depositories Act (which is pari materia with the provisions of Regulation 77 of the Depositories Regulation referred to herein above).
- On the question as to whether a separate notice is required to be issued prior to sale of dematerialized shared by virtue of invocation of pledge on shares. The High Court expressed agreement with the aforementioned decisions of the Bombay High Court and held thus:
"While Section 176 entitles the pledgee/pawnee to, on default by the pledgor/pawnor, sell the thing pledged, "on giving the pawnor reasonable notice of the sale", Regulation 58(8) entitles the pledgee to, "subject to the provisions of the pledge document", "invoke the pledge" and mandates the depository to "on such invocation" i.e. by the pledgee, "register the pledgee as beneficial owner of such securities" i.e. the securities pledged and further mandates the depository to "amend its records accordingly". There is no place for a prior notice under Section 176, in the scheme of Regulation 58(8). On the contrary, Regulation 58(9) requires the depository to, after so amending its records under Regulation 58(8), inform the participants of the pledgor and the pledgee of the same and mandates the said participants to inform the pledgor and the pledgee. Thus, (a) while Section 176 provides for a notice to pledgor prior to effecting sale, Regulation 58 provides for notice post invocation and on which invocation beneficial ownership of pledged shares changes from that of the pledgor to that of the pledgee and which is equivalent to sale under Section 176. To hold that a prior notice under Section 176 of Contract Act is also required in the case of pledge of dematerialised shares would interfere with transparency and certainty in the securities market, rendering fatal blow to the Depositories Act and Regulations and the object of enactment thereof." (emphasis supplied) (para E, page 12)
- The High Court thereafter discussed the distinction if any between "sale" of pledged shares and "invocation of pledge". It was held that:
"The distinction sought to be drawn by the senior counsel for the plaintiffs between "invocation" and "sale" is also not in consonance with Regulation 58. I may notice that there is no such distinction in Contract Act either. While Section 176 of Contract Act entitles pledgee to, on default of pledgor, sell the pledged thing i.e. transfer title and possession thereof to purchaser, Regulation 58 entitles the pledgee to, on default on pledgor, invoke the pledge by intimating to the depository and mandates the depository to in its records record the pledgee in place of the pledgor as the beneficial owner of pledged shares, thereby transferring title as beneficial owner, from the pledgor to pledgee. The only condition imposed on invocation of pledge by the pledgee, under Regulation 58 (8) is of the same being required to be "subject to the provisions of the pledge documents" i.e. of creation of pledge in the manner provided in Regulation 58(1) to 58(6)-of which the participant of the pledgee and the depository have been made aware and with which they are thereby required to comply with. ..... The only title in dematerialised shares, under the Depositories Act, is as beneficial owner in the records of the participant and the depository and which beneficial ownership changes on invocation of pledge in terms of Regulation 58." (para F, page 13)
- The High Court thereafter observed on the aspect of issuance of notice under Section 176 of the Contract Act.
"Provision of notice under Section 176 of the Contract Act, even is were to be held to be required to be given, is for the benefit of the pledger and has no element of public law or public interest. A provision, even in law, for personal benefit, if not in public interest, can always be waived by that person." (para I, page 14)
Conclusion – What emerges from the aforementioned decisions?
From the aforementioned discussion, it may be noted that the Bombay High Court and the Delhi High Court have clarified the conflicting position with respect to the application of provisions of Contract Act versus the provisions of Depositories Act and Depositories Regulations. Courts have held that Depositories Act and the regulations framed thereunder specifically provide for the manner of creation of pledge. The scheme framed therein also provides the manner of invocation of pledge or the sale of the pledged shares at the instance of the pledgee.
Further, with regard to the requirement of issuance of notice as contemplated under Section 176 of the Contract Act, the Delhi High Court has categorically held that issuance of such notice is not required, since the same is not provided for in the provisions of Section 12 of the Depositories Act and Regulation 77 of the Depositories Regulations. It is however important to note that the aforesaid provisions, specifically, the provision governing invocation of pledge clearly provides that the invocation shall be subject to the document governing the pledge.
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.