Control Without Ownership A Legal Conundrum on Pledge of Shares

CONTROL WITHOUT OWNERSHIP A LEGAL CONUNDRUM ON PLEDGE OF SHARES

“Bar on sale of pledged goods to self - Pledgor’s right to redeem the goods survives till actual sale to a third party”

A popular collateral for banks and financial institutions, while granting loans and other advances to borrowing entities, is to obtain a pledge over the shares of the borrowing entity or on a significant holding of promoters of the borrowing company in other group companies, depending on its credit worthiness. The idea behind this is that in case of default or inability to pay, the lender can gain control over the concerned entity by exercising voting rights attached to the shares, transfer the ownership of the concerned entity and utilise the sale proceeds to set-off dues of the borrowing entity.

While traditionally, pledge of physical shares was taken by executing necessary documents and pre-signed share transfer forms/endorsements on share certificates, nowadays, with the introduction of the depository mechanism, banks and financial institutions are mandated to take pledge of only dematerialised securities as there is a well-defined process for creation and invocation of pledge/hypothecation over demat securities as prescribed by the depositories and the pledge/hypothecation is clearly reflected in the records of the depository participants.

The legal aspect of pledge is governed, inter-alia, by Sections 176-177 of the Indian Contract Act, 1872. Some of the important provisions regarding invocation of pledge, in case of default of the promisor/pledgor, are as follows:

(i) The pledgee may bring a suit for recovery of debt and retain the pledged shares as collateral security; or

(ii) The pledgee may sell the pledged shares on giving the pledger reasonable notice of sale, and appropriate the proceeds thereof towards the unpaid debt; and

(iii) Till the sale of the pledged shares, the pledger may redeem the pledged shares by making payment of the debt.

An interesting point which had arisen for consideration of the Hon’ble Supreme Court of India in the matter of PTC India Financial Services Limited v. Venkateswarlu Kari & Another1, was the aspect of ‘sale to self’ in case of invocation of pledge (“PTC Judgement”).While citing various decisions of the Indian judicial authorities, the Hon’ble Supreme Court of India held that the Indian Contract Act, 1872, does not conceive of sale of the pledged goods to self and consequently, the pledgor’s right to redeem the pledged goods survives till ‘actual sale’ to a third party.The court further held that while upon invocation of the pledged shares, the pledgee becomes the ‘beneficial owner’ of the shares for the purpose of satisfying the procedural requirements prescribed under the Depositories Act, 1996, the actual sale of such shares occurs only when invoked shares are sold 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 Indian Contract Act, 1872, remains alive.

The aforesaid judgement has made it clear that in case a pledgee invokes the pledge and the shares are transferred to the demat account of the pledgee as a part of the prescribed process, there is no ‘actual sale’ of the pledged shares; and that till the time the pledgee sells the shares to a third person, the pledger has the right to redeem the shares by making payment of the debt. It is important to understand that the ‘sale to self’ of the pledged securities is treated by the Hon’ble Supreme Court merely as a conversion, which though makes the sale void however, recognises the continuation of contract of pledge even in such situation. It implies that while sale to self by a lender will be considered as void, the pledgor is still bound by contract of pledge and will have to make payment to pledgee for release of pledged goods.

The aforesaid judgement, while in line with the provisions of Section 176 of the Indian Contract Act, 1872, does throw up some questions around inability of a lender to acquire the pledged shares itself. The said section nowhere explicitly states that the pledgee cannot sell the shares to itself - in this case, the pledgee will wear two hats and could act in two capacities - one as a pledgee and the other as an acquirer of the shares. If the lender sees value in the pledged shares and wishes to acquire them at the prevailing market price, thereby setting off the dues owed to that extent, why should there be another requirement of finding a buyer and selling to a third party? It should however be ensured that the pledged shares are acquired at marked value and not at a distressed valuation. The courts have interpreted Section 176 strictly so as to give the pledger time to redeem the shares before sale thereof, and thereby enable it to effectively exercise its right of redemption under Section 177. However, the counter to this could be that, as there is no specific time prescribed for a lender to sell the pledged shares after invocation, a sale after a significant time gap, where the value of the pledged shares could also be depleted, is also a valid concern from the pledgor’s perspective. In this regard, reference may also be made to the decision of the High Court of Bombay, in the matter of World Crest Advisors LLP v. Catalyst Trusteeship Limited &Ors.2, where the court held that while the pledgee may not be a true owner of the invoked pledged shares, however, as a beneficial owner it would be entitled to exercise all voting rights and other rights available to it as a beneficial owner of shares. This leads to a peculiar situation where a lender can exercise control over all major decision-making in a company, while at the same time, is not treated as the owner of shares. It is the need of the hour for the lawmakers to address this aspect and give some clarity on the rights of the pledgers and pledgees, especially where the pledgee can take over the control of the company as a ‘beneficial owner’.

The aforesaid decision also throws up certain questions which would need clarity, such as impact in case of pledge of physical shares, trigger of Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, stage of seeking regulatory approvals for change in ownership and other connected issues. A crucial aspect in regard to the invocation of pledge is the giving of a reasonable notice of sale to the pledger. While the section does not specify what amounts to a ‘reasonable notice’, the PTC Judgement provides that whether the notice is reasonable or not would depend on the facts of the case3. Any sale of pledged shares without giving a reasonable notice to the pledger is treated as invalid and does not take away the right of the pledger to redeem the pledged shares by making payment of the debt. Further, parties cannot contract out of this requirement of notice for sale under the instrument of pledge or otherwise as this is a special protection that the statute has given to the pledger to redeem the shares by paying the debt.4

Keeping in view the PTC Judgement, a question could be raised whether the reasonable notice is to be given for the purpose of invocation of pledge or at the time of actual sale to a third party. While the PTC Judgement could suggest that the reasonable notice for sale requirement is only at the time of actual sale and not necessarily prior to invocation, it would be in the best interest of the pledgee to give a prior reasonable notice both for invocation of pledge and at the stage of actual sale, as there could be a considerable gap between the two events.

Accordingly, a pledgee needs to be cautious and diligent, both at the time of invocation of pledge as well as at the time of sale of pledged shares to a third party, so that it doesn’t fall foul of the requirements mentioned under the Indian Contract Act, 1872, and the evolving judicial pronouncements on this subject.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.