India has a vibrant market for financing promoters/primary owners against listed shares, either through loans or domestic bonds, being non-convertible debentures. The attraction for lenders is that the collateral is, relative to other asset classes such as immovable property, liquid, with transparent market pricing, that can be easily exited.
The "chink in the amour" however has been the question of whether the pledgee must issue prior notice to the borrower before sale of dematerialized pledged shares held in electronic form. For listed shares, hours let alone days can mean large swings downwards in share price, thereby impairing the lenders security value and recovery. The requirement (if any) for prior notice before sale of the pledged shares has been judicially considered by both the Bombay and Delhi High Courts.
Briefly put, the Courts had to reconcile and rationalise the requirements of Section 176 of the Indian Contract Act, 1872, as amended ("Contract Act") with Section 10 of the Depositary Participants Act, 1996, as amended ("DP Act") and Regulation 58 of the Depositary Participant Regulations 1996, as amended ("Regulations"). The requirement of prior "reasonable notice" in the Contract Act is not mirrored in the DP Act or Regulations.
The judgement creating the requirement of prior notice for sale of pledged shares, was given by the Delhi High Court in GTL Limited v. IFCI Ltd. 2011 (126) DRJ 394 ("GTL Case"). The Delhi High Court ruled that the provisions of prior notice at the time of sale of dematerialized shares were mandatory and could not be contracted out of. In the Court's view, the requirement of prior notice was meant to provide the borrower with an opportunity to repay the debt and therefore any agreement to the contrary was illegal and opposed to the letter and spirit of the Contract Act.
In contrast, the Bombay High Court in JRY Investments Pvt. Ltd. v. Deccan Leafine Services Ltd  56 SCL 339 (Bom), held that no prior notice was required when sale of dematerialized listed shares following pledge enforcement.
The Bombay High Court on analysing the provisions of the DP Act and Regulations held that the DP Act and Regulations constituted a self-contained code and procedure that prevailed over the Contract Act. In its view, a pledge of dematerialized shares could only be validly created under the DP Act and not the Contract Act, as the latter only regulated the pledge of physical shares. This reasoning and ruling was subsequently endorsed by a Division Bench of the Bombay High Court in Pushpanjali Tie Up Pvt. Ltd vs Renudevi Choudhary AIR 2015 Bom 1.
The GTL case made market participants weary about notice requirements. However there is good news for lenders in the Delhi High Court recent judgement Tendril Financial Services Pvt. Ltd. and Ors. v. Namedi Leasing & Finance Ltd. and Ors. 2018 SCC OnLine Del 8142 dated April 3, 2018 ("Tendril"), where it declined to follow its early ruling in GTL's case on the basis that the DP Act provisions had been not considered in its earlier judgement and therefore the ratio does not bind the Delhi High Court. The Delhi High Court instead adopted the approach of the Bombay High Court and ruled that the requirement for prior notice would only arise if the terms of the pledge expressly provided for it. In its view, the requirement for prior notice contemplated by the Contract Act was for the benefit of the pledgor and could be waived by it. There was no element of public interest or policy that prevented parties from dispensing with this requirement. The Court made it clear that the Regulations are beneficial as they introduce transparency and certainty in the securities market and there is no other discernible reason for the legislature having introduced these provisions.
This approach is also consistent with the Indian depositories rules which do not specify any notice requirement but leave the pledgor and pledgee to agree requirements in their agreement.
The judgments demonstrate a consistent and positive view now by both the Bombay and Delhi High Courts to the sale of dematerialized pledged shares, whether listed or unlisted. The jurisprudence on this topic has been sophisticated and commercial and suggests that: (i) physical share pledges are treated differently to dematerialised share pledges; (ii) Courts will uphold the terms of the pledge agreement and what the parties have contracted; (iii) the pledgor by dematting its shares and pledging through the depository system is specifically aware of the terms of the depository pledge mechanics and the terms it needs to comply with; (iv) the special procedure set out in the DP Act and Regulations must be followed; and (v) any requirement for prior notice under the Contract Act for dematerialised shares, will interfere with transparency and certainty in the securities market, frustrating the object of the enactment and impairing lender's security. The recent ruling lends comfort and certainty in ensuring that a sale of dematerialised listed shares without any notice on enforcement of a share pledge, will be valid and enforceable by the Indian courts. For the avoidance of doubt, lenders should ensure that the pledge agreement expressly permits the sale of pledged shares without notice and in addition provide an express waiver from the pledgor to raise any ground for objection of the sale in relation to timing, notice, price or process.
Posted on 13 July 2018 by Zarir Bharucha & Niloufer Lam
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