Sale to self of pledged securities not legal

By Karthik Somasundram and Khyati Mehrotra, Bharucha & Partners
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In PTC India Financial Services Limited v Venkateshwarlu Kari and Anr., the Supreme Court ruled on the exercise of rights under a pledge of dematerialised shares. The issue was whether the re-classification of the pledgee as the beneficial owner in the register and index of a depository is a conversion or sale to self of the pledged securities. If it is, the consequential issue is whether the secured debt had been satisfied, in part or whole.

Following default on the financial debt owed by NSL Nagapatnam Power and Infratech (NSL), PTC India Financial Services (PTC) exercised its rights over the securities pledged by NSL’s holding company to be registered as the beneficial owner. In subsequent corporate insolvency resolution proceedings against NSL, PTC made a claim for the financial debt owed to it. The resolution professional (RP) rejected the claim on the ground that, as the beneficial owner of the pledged securities in the records of the depository, it had acquired those securities and had realised its debt.

Karthik Somasundram, Bharucha & Partners, Sale to self of pledged securities not legal
Karthik Somasundram
Partner
Bharucha & Partners

PTC challenged the RP’s decision, arguing that the classification as the beneficial owner was not comparable to an actual sale and the realisation of value. The National Company Law Tribunal and the National Company Law Appellate Tribunal upheld the RP’s decision. PTC appealed to the Supreme Court.

The issuing and holding of securities in electronic form and the concepts of registered and beneficial ownership of electronic securities were introduced by the Depositories Act, 1996. Depositories are the registered owners of dematerialised securities but have no rights, such as voting, sale or pledge, over those securities. The substantive rights in the securities vest in the beneficial owners, who are able to purchase and trade the dematerialised securities.

Section 12 of the Depositories Act read with regulation 58 of the SEBI (Depositories and Participants) Regulations, 1996 (regulations) permits beneficial owners to pledge and hypothecate securities, subject to the prior approval of the relevant depository. The pledgor and the pledgee must be notified of the creation and cancellation of pledges, and, on the exercise of pledge rights, the depository must register the pledgee as the beneficial owner. The pledgor and pledgee must be notified of the change in the beneficial ownership of the securities.

The Supreme Court held that the notification of a pledgee becoming a beneficial owner is akin to the mandatory prior notice under section 176 of the Indian Contract Act, 1872 (act), which must be given before the sale of the pledged goods. Section 176 allows a pledgee either to retain the goods and sue the pledgor for the amount or sell the goods with reasonable notice to the pledgor. Only after such notice is given can the pledgee exercise its right of sale of the pledged security.

In deciding whether the exercise of the pledge itself amounted to a sale and consequent satisfaction of the debt, the court relied on the Privy Council ruling in Nekram Dobay v Bank of Bengal, that a sale to self or conversion is not permissible under the act. Section 177 of the act allows the pledgor to redeem the pledge up to the time of the actual sale by the pledgee, which right would be nullified if sale to self were permitted. The court ruled that the expression actual sale in section 177 of the act, in the context of the Depositories Act, meant a sale to a third party. Once the actual sale occurred, the pledgor’s right to redemption under section 177 of the act was extinguished.

The mere recording of the pledgee as the beneficial owner in the records of the depository, a necessary step in exercising the right of an actual sale, is not itself a sale and does not affect the pledgor’s right of redemption under section 177 of the act. Sections 176 and 177 of the act apply equally to dematerialised securities as to other pawned goods.

The court ruled that the registration of PTC as the beneficial owner did not have the effect of an actual sale. The debt was neither discharged nor satisfied. There were no sale proceeds that could be applied for the satisfaction of the debt in full or in part. As the financial debt due to PTC had not been discharged, PTC was held to be a financial creditor of the corporate debtor.

Karthik Somasundram is a partner and Khyati Mehrotra is an associate at Bharucha & Partners.

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