Questions arise over restricting ‘sale of pledged shares to self’

By Aniket Sawant and Aanchal Gujrani, SNG & Partners

In the recent case of PTC India Financial Services Limited v Venkateswarlu Kari and Anr, the Supreme Court delivered a landmark judgement settling key aspects of the law in relation to pledges and the interplay between the Depositories Act, 1996 (Depositories Act) and the Indian Contract Act, 1872 (Contract Act).

PTC India Financial Services Limited (PIFSL) had advanced a loan to NSL Nagapatnam Power and Infratech Limited (NNPIL), which was secured by a pledge in favour of PIFSL of dematerialised shares held by Mandava Holdings Private Limited (MHPL) in the share capital of NSL Energy Ventures Private Limited (NEVPL), a subsidiary, like NNPIL, of MHPL. A corporate insolvency resolution process was initiated in respect of NNIPL and PIFSL invoked its pledge. The resolution professional (RP) of NNPIL recognised PIFSL as the beneficial owner of the pledged shares but rejected the claim of PIFSL to be a financial creditor, arguing that the debt owed by NNPIL had been satisfied by the transfer of the pledged shares in favour of PIFSL.

Aniket Sawant, SNG & Partners, Questions arise over restricting ‘sale of pledged shares to self’
Aniket Sawant
Senior Associate
SNG & Partners

PIFSL’s challenges to the RP’s rejection of its claim were dismissed by the National Company Law Tribunal and the National Company Law Appellate Tribunal. In PIFSL’s appeal to the Supreme Court, it was held that the Contract Act does not recognise the concept of a sale of pledged goods by the pledgee to self. A sale to self is not an actual sale under section 176 of the Contract Act. Section 177 of the Contract Act, gives the defaulting pledgor the right to redeem the pledged goods up to the point of an actual sale and the pledgee’s sale to self does not supersede such right. Actual sale means the sale by a pledgee to a third party.

The acceptance of PIFSL as the beneficial owner of pledged shares could not be treated as an actual sale as it was merely a procedural requirement in regulation 58(8) of the SEBI (Depositories and Participants) Regulations, 1996 (DP Regulations), before PIFSL could undertake the actual sale. The pledge would be discharged only when the pledgee undertook an actual sale and applied the net proceeds towards the discharge of the debt. Sections 177 and 176 of the Contract Act applied to the pledge of dematerialised securities and the Depositories Act and the Depositories Regulations were not intended to allow the sale to self or to deny the right of the pledgor to redeem the pledged shares up to an actual sale. Accordingly, the court held that PIFSL’s claim to be a financial creditor without having to account for the value of the pledged shares was correct. The Supreme Court held that the general rights in the pledged property remained with the pledgor, the pledgee having only a right to sell the pledged property and to apply the proceeds towards the satisfaction of the debt.

Aanchal Gujrani, SNG & Partners, Questions arise over restricting ‘sale of pledged shares to self’
Aanchal Gujrani
SNG & Partners

The rights given by ownership of the shares are not transferred to the pledgee merely upon the invocation of the pledge and the pledgee’s admission as the beneficial owner. It is therefore important that lenders ensure that the pledge document expressly sets out that voting and other rights of the pledgor in the pledged shares will be exercised by the pledgee upon the invocation of the pledge. It remains to be seen how a pledgee will exercise its rights in the pledged shares if the pledgor has entered into an agreement with other shareholders. In such a case the parties to such an agreement may dispute the exercise by the pledgee of its rights in the pledged shares. As the pledgee is entitled only to restricted rights, it may be further questioned whether the thresholds imposed on banks when accepting pledges of shares as security are justifiable. Banks will merely hold the shares as beneficial owners until the actual sales to third parties are completed.

This judgment has shown the need for clarity on issues such as, whether the consent or notification requirements under regulations issued by the Securities and Exchange Board of India will be triggered upon the invocation of a pledge or only on the actual sale of pledged shares by the pledgee. Though this judgment seeks to protect the interests of lenders by allowing them to claim their entire debts without accounting for the value of pledged shares, it restricts the rights of the lenders with respect to the security of such shares to setting in motion the eventual actual sale to third parties.

Aniket Sawant is a senior associate and Aanchal Gujrani is an associate at SNG & Partners.

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