Introduction

The Supreme Court of India (‘Supreme Court’), in the case of PTC India Financial Services Limited v. Venkateswarlu Kari and Another[1] (‘PTC Ruling’), resolved the conundrum pertaining to the pledge of shares in dematerialized form and its enforcement thereof.  The judgment sought to resolve the tangled relationship between the Depositories Act, 1996 (‘Depositories Act’) read with the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 (‘Depositories Regulations’) and the Indian Contract Act, 1872 (‘Contract Act’). 

In this article, we delve into the ramifications of the PTC Ruling and shed light on the overlapping of the Depositories Act and Contract Act, providing clarity on the enforcement of pledged shares in dematerialized form.

Brief Facts

PTC India Financial Services Limited (‘PIFSL’) extended a secured loan of INR 125 crores to NSL Nagapatnam Power and Infratech Limited (‘NNPIL’).  Mandava Holdings Private Limited (‘MHPL’) (a holding company of NNPIL), pledged 26% of the shares of NSL Energy Ventures Private Limited (‘NEVPL’), another subsidiary of MHPL for securing the above loan.  The shares pledged by MHPL were in dematerialized form.  Pursuant to default by NNPIL in payment of the loan amount, PIFSL wrote to the depository participant invoking its rights in terms of the pledge deed and became the ‘beneficial owner’ of the pledged share of NEVPL.

Simultaneously, the National Company Law Tribunal (‘NCLT’) admitted the petition of NNPIL (the borrower) for the corporate insolvency resolution process.  MHPL and PIFSL had submitted the claims as the financial creditors of NNPIL.  The interim resolution professional rejected both claims, citing that there was absence of a valuation for the pledged shares at the time of their ‘transfer’.  The NCLT and the National Company Law Appellate Tribunal (‘NCLAT’) determined that MHPL had become a financial creditor to the extent of the pledged shares’ value after the invocation of pledge by PIFSL.

Relevant provisions of pledge under the Contract Act

Chapter IX of the Contract Act deals with ‘Contracts of Bailment’.  Sections 148 to 171 provides general law pertaining to bailments and Sections 172 to 179 deals with specific provisions concerning pledges, which are subsets of bailment. 

A pledge is a contract made by the pledgor and the pledgee to secure a debt.  It allows the pledgee to hold on to the pledged good(s) as a security but with the responsibility to give them back once the debt is paid. Section 176 of the Contract Act deals with the pledgee’s rights when the pledgor fails to meet its obligation. In such an event, the pledgee can (a) take legal action against the pledgor to recover the debt and keep the pledged good(s) as collateral; or (b) even sell them to third party on giving a reasonable notice of the sale to pledgor.  Further, if the proceeds from the sale of the pledged good(s) are less than the debt owed, the pledgor must pay the remaining balance to the pledgee.  On the contrary, if the proceeds from the pledged good(s) are more than the debt, the excess must be returned to the pledgor.

Notably, there is no set standard format of a pledge, and the terms of a pledge agreement may vary as per circumstances.  Any term in the pledge agreement which is mutually agreed by the parties is valid if it is not inconsistent with any provision of the Contract Act.

Relevant provisions of pledge under the Depository Act

To pave the way for smooth, fast and constancy in the transfer of securities and to promote and deal with an increase in trading of stocks and shares in a transparent manner, the Depositories Act was enacted. It lays down process and rules for the dematerialization of securities by converting them into electronic data stored in the computers of ‘the depository’. 

The Depositories Act establishes the depository eco-system and introduces the concepts of a ‘registered owner’ and ‘beneficial owner’.  Section 2(1)(a) of the Depositories Act defines the term ‘beneficial owner’ as a person whose name is recorded as such with a depository whereas Section 2(1)(j) defines ‘registered owner’ as a depository whose name is entered as such in the register of the issuer/company. 

Further, Section 12 of the Depository Act allows a beneficial owner to create a pledge or hypothecation in respect of a security owned by him/her through the depository and Regulation 58 of Depository Regulations (now Regulation 79 of the SEBI (Depositories and Participants) Regulations, 2018) provides the procedure by which a pledge or hypothecation of dematerialized shares can be created.  Regulation 58(9) of the Depository Regulations also provides that the depository has to notify the pledgor and the pledgee once it amends its records on the invocation of a pledge and a transfer of the beneficial ownership of the shares.

Notably, the Depositories Act does not provide any explicit definitions for terms like pledge or hypothecation and thereby accepts and adapts their meaning as known in the commercial sense to people in the trade.  Thus, this approach effectively aligns the Depositories Act with the principles concerning pledges outlined in the Contract Act and the common law.

Supreme Court Observations

Based on the above broad statutory contours of pledge, the Supreme Court analyzed the law related to the pledge under the Contract Act & the Depository Act and allowed PIFSL appeal to set aside the decision of NCLT and NCLAT.  The Supreme Court affirmed that the pledging of dematerialized shares remained subject to the pertinent provisions of the Contract Act, the Depositories Act, and the Depositories Regulations, and hence ought to be interpreted in a complementary and harmonious manner. 

The Supreme Court held that the act of PIFSL becoming a beneficial owner (within the meaning of the Depositories Act) does not equate to the actual sale/ transfer of shares.  It is only a pre-condition before the ‘actual sale’ of shares takes place under Section 176 of the Contract Act.  Thus, it becomes evident from the Supreme Court’s judgment that if a pledgee wants to sell the dematerialized shares, then it becomes essential for him/ her to first become a beneficial owner and only then exercise its right to sell further to a third party.

Additionally, the Court distinguished between MHPL and PIFSL, stating that MHPL cannot be considered as a secured creditor of NNPIL with respect to the pledged shares and had not stepped into the shoes of PIFSL as a creditor of NNPIL.  Whereas PIFSL will be considered as a financial creditor to NNPIL and is entitled to claim the entire debt owed without factoring in the value of the pledged shares of NEVPL.

The Supreme Court has arrived the above conclusion by considering various judicial precedents and dealt with the following aspects:

• Distinction between ownership, pledge and mortgage:  With respect to distinction between pledge and mortgage, the Supreme Court clarified that a pledge implied a temporary transfer of possession of goods as security for a debt or promise, with the pledgor retaining the general ownership.  On the other hand, a mortgage goes further by transferring the legal ownership of the property to the mortgagee as security. In a pledge, the pledgor can redeem the goods upon fulfilling their obligations, whereas in a mortgage, the mortgagor also has the right of redemption, but the property’s legal ownership lies with the mortgagee until the debt is repaid.

• Pledgee has a special and not general right in the pledged property:  Section 173 of the Contract Act specifies that the pledgee may retain the goods pledged only for repayment of the debt, performance of the promise, and for interest on the debt, etc.  The pledgee has a special right in the pledged property while the general rights in the pledged property therein continues with the pledgor.  The special right exists with the pledgee so that it can compel payment of the debt or sell the goods when the need to do so arises. 

This principle aligns with the Supreme Court’s ruling in Lallan Prasad v. Rahmat Ali and Another[2] which established that “a pledgee has only a special right in the pledged property but the general property therein remains in the pledgor and wholly reverts to him on discharge of the debt”.

• Accretion on pledged goods: The pledge encompasses not only the original items but also any accretion/ additions of the pledged goods.  Consequently, when the pledgee returns the pledged goods, it is incumbent upon him to also return any accretions or additions to the pledgor. 

In the matter of Standard Chartered Bank and another v. Custodian and Another[3], the Supreme Court had held that “bonus shares, dividend and interest were accretions to the pledged stock and have to be regarded as forming part of the pledged property which could not be ordered to be handed over unless redemption takes place”

• Notice of sale and pledgee’s right to sue for recovery and sell the pledged goods: The Supreme Court observed that Section 176 of the Contract Act requires that upon default, the pledgee may sell the pledged good(s) on giving the pledgor a reasonable notice of the sale.  It is pertinent to note that the power of sale conferred on the pledgee is expressly for his benefit, and it is his sole discretion to exercise the power of sale or otherwise.  The object and purpose of the notice is to give an opportunity to the pledgor to redeem the pledged goods before “actual sale” as provided under section 177 of the Contract Act. 

The Bombay High Court, in The Official Assignee v. Madholal Sindhu[4], ruled that regardless of what’s written in a pledge agreement, a notice must be provided before selling the pledged item.  This means that parties cannot make a contract that goes against the rules stipulated in Section 176 of the Contract Act.

• Sale of pledged items to self: Sale of a pledged good to oneself does not qualify as an ‘actual sale’ under Section 177 of the Contract Act.  The Supreme Court, based on previous High Court decisions and the rules in the Contract Act, determined that if the pledgee sells the pledged item to itself, it is considered a conversion and does not cancel the pledge. 

It is evidently clear that the pledge remains intact until the item is legitimately sold to a third party. It is only after the sale to a third party that the right of a pledgor to redeem is extinguished.  This interpretation by the Supreme Court has fortified the rights of pledgors to seek redemption until such third-party sale occurs.

• Interplay between the Depositories Act and Depositories Regulations with the Contract Act: The interplay has been a subject of extensive discussion and consideration by the Supreme Court in this case. To navigate this conflict, the Supreme Court has underscored the importance of interpreting these statutes harmoniously. The Contract Act governs the substantive aspects of contracts, while the Depositories Act focuses on the sphere of securities.  These two legal frameworks must coexist and complement each other without nullifying the provisions of either.

Section 12 of the Depositories Act, 1996 provides for pledge or hypothecation of securities held in a depository but that is not to say that the Depositories Act alone governs the pledge and hypothecation of dematerialized securities.  Section 28 clarifies that provisions of this 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.

The Supreme Court further held that Regulation 58 of the Depositories Regulations does not override the Contract Act.  Instead, it sets a prerequisite for the pledgee to record themselves as a beneficial owner before selling the pledged dematerialized shares to the third party.  Without the said exercise, the pledgee cannot exercise its rights to sell the pledge and retrieve the monies due by taking recourse to its rights under Section 176 of the Contract Act.

Thus, based on the PTC Ruling, it has been held that there is no legislative intent in the Depositories Act and the Depositories Regulations to change the law of pledge requiring issue of reasonable notice; or as allowing sale to self or abolishing the right of the pledgor to redeem the pledged goods till ‘actual sale’.  Sections 176 and 177 are not obliterated, in so far as they would equally apply to pledged dematerialized securities as they apply to other pledged goods.

Conclusion

The PTC Ruling carries significant implications for enforcing pledges on dematerialized shares, which can have a profound impact on lending transactions in India. This decision not only addresses the enforcement of pledges on dematerialized shares but also has the potential to establish a precedent for how such transactions are managed in the country. It may also have a noteworthy impact on the way borrowers use shares as collateral in debt deals.

The PTC Ruling also sets a crucial precedent for the intricate intersection of legal frameworks i.e., Contracts Act and Depositories Act, which govern such transactions. By providing clarity and setting forth precise interpretations, the ruling acts as a lodestar for all parties involved in pledge transactions, lending transactions and securities markets.

Written by Nidhi Arora (Partner), Binny Chopra (Senior Associate) and Amiya Krishna Upadhyay (Associate)

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[1]            PTC India Financial Services Limited v. Venkateswarlu Kari and Another (Civil Appeal No. 5443 OF 2019).

[2]            Lallan Prasad v. Rahmat Ali and Another (1967 AIR 1322).

[3]            Standard Chartered Bank and Another v. Custodian and Another (Civil Appeal No. 762 of 1999).

[4]            The Official Assignee v. Madholal Sindhu ((1946) 48 BOMLR 828).