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Pledge of shares – Interplay between the Indian Contract Act, 1872 and the Depositories Act, 1996

Premise

The Indian Contract Act, 1872 (“Contract Act”) governs the law of pledges. Where the property
being pledged is shares of a company, the Depositories Act, 1996 (“Depositories Act”) and the
Securities and Exchange Board of India (Depositories and Participants) Regulations, 20181 (“DP
Regulations”) may also apply.

The Supreme Court of India was recently seized of the question whether the Depositories Act
would override the Contract Act in determining the position of a pledgee of shares vis-à-vis the
pledgor2. The root of this controversy lay in Regulation 79 of the DP Regulations3 which allows a
pledgee of shares, upon the pledgor’s default, to unilaterally become the beneficial owner of the
pledged shares without any prior notice to the pledgor.

Facts

PTC India Financial Services Limited (“PIFSL”) had advanced a loan to NSL Nagapatnam Power
and Infratech Limited (“NNPIL”) under a Bridge Loan Agreement. The loan was, inter alia,
secured by a pledge of shares held by NNPIL’s holding company, Mandava Holdings Private
Limited (“MHPL”) in another of its subsidiaries, NSL Energy Ventures Private Limited
(“NEVPL”), in favour of PIFSL (“Pledged Shares”).

As NNPIL defaulted on repayment, PIFSL invoked the pledge, and communicated its decision to
the Depository, resulting in PIFSL becoming the ‘beneficial owner’ of the Pledged Shares. PIFSL
also wrote to MHPL intimating that it had invoked the pledge and was reserving its right to sell the
Pledged Shares to satisfy the debt. However, till the date of the Supreme Court’s judgment, no
shares had been sold by PIFSL to any third party.

In the meantime, pursuant to an application, the National Company Law Tribunal, Hyderabad
Bench (“NCLT”) initiated the corporate insolvency resolution process (“CIRP”) of NNPIL and
appointed an Interim Resolution Professional (“IRP”) under the provisions of the Insolvency and
Bankruptcy Code, 2016 (“IBC”). PIFSL filed its claim before the IRP in respect of the amounts
due and payable under the Bridge Loan Agreement. MHPL also filed a claim contending that upon
PIFSL’s invocation of the pledge, it (MHPL) was no longer the holder of the Pledged Shares and

  1. These Regulations repealed the erstwhile Securities and Exchange Board of India (Depositories and Participants)
    Regulations, 1996. Curiously, the Court refers to the provisions of the repealed 1996 Regulations in the judgment.
  2. PTC India Financial Services Limited v. Venkateswarlu Kari & Another, Civil Appeal No. 5443 of 2019 decided by
    the Supreme Court of India on May 12, 2022.
  3. For the purposes of laying down a mechanism for creation of pledge over securities, the provisions of Regulation 58
    of the erstwhile 1996 Regulations and Regulation 79 of the 2018 Regulations are analogous. Hence, any reference to
    the latter shall mean a reference to the former as used by the Court.

to that extent, it had become a financial creditor of NNPIL by subrogation. The IRP rejected the
claims of PIFSL and MHPL and declined to include them in the Committee of Creditors on the
ground that their claims could not be crystallized owing to uncertainty as to the valuation of the
Pledged Shares.

PIFSL and MHPL each challenged the IRP’s decision before the NCLT. PIFSL’s claim was
rejected by the NCLT on the ground that it had become the beneficial owner of the Pledged Shares
upon invocation of the pledge and to that extent, was no longer a financial creditor of NNPIL.
Simultaneously, it allowed MHPL’s application by holding that it had become a financial creditor
of NNPIL by subrogation.

In appeal, the National Company Law Appellate Tribunal (“NCLAT”) upheld the NCLT’s
decision. Aggrieved, PIFSL appealed to the Supreme Court.

Supreme Court’s findings

The Supreme Court, in its judgment dated May 12, 2022, has penned down a detailed analysis of
the law relating to pledge on all aspects under the Contract Act and the Depositories Act. Several
earlier judgments on the subject have been referred to and analysed in detail, and some have even
been overruled.

Clarifying a fundamental concept, the Court observed that under the Contract Act, a pledgee, upon
the pledgor’s default, has two options, one being to sue the pledgor for the debt while holding the
pledge as collateral, and the other being to sell the pledge after giving the pledgor reasonable notice
under Section 176 of the Contract Act. The Court further clarified that in a case where the pledgee
elects to sell, the pledgor has a right to redeem the pledge by discharging its debt at any point before
the ‘actual sale’ of the pledge takes place. Pertinently, the Court analysed various judgments and
the Contract Act to emphasise that ‘actual sale’ is different from sale to self, with the former
meaning a sale in favour of a third party and the latter being “conversion”. The Court also observed
that a pledge can get extinguished either by the pledgor redeeming it or by virtue of an actual sale
in favour of a third party.

The Court further observed that the Depositories Act and the DP Regulations lay down an elaborate
mechanism for creation and invocation of pledges of securities. Under the DP Regulations, a
pledgor, being the beneficial owner of a security, is required to intimate the Depository for a valid
pledge to be created thereon. Further, on the pledgor’s default, a pledgee can invoke the pledge and
intimate the same to the Depository, which will then register the pledgee as the beneficial owner
of the security.

Thus, before a pledgee can sell the pledged shares, it is required to give a reasonable notice to the
pledgor under the Contract Act and get itself registered as the beneficial owner of the shares under
the DP Regulations. In the Court’s view, to this extent, there is no conflict between the Contract
Act and the Depositories Act in as much as the latter only provides for a specific procedure for a
particular type of property without contradicting in any way, the general law laid down by the
former.

As the above conditions are mandatory, complying with them merely puts the pledgee in a position
to sell the pledged shares. This, however, cannot be equated with an actual sale of the pledge, as
there is no transfer of the shares to a third party. Consequently, merely by reason of the pledgee
becoming the beneficial owner of pledged shares, the pledge is not extinguished, and the pledgee’s
rights remain intact.

Applying the above principles, the Court set aside the NCLAT’s order and held that PIFSL
continued to be a financial creditor of NNPIL to the full extent of the outstanding debt, irrespective
of it being the beneficial owner of the Pledged Shares. Simultaneously, the Court also held that
MHPL was not a financial creditor of NNPIL to the extent of the Pledged Shares.

Conclusion

While the judgment has substantially clarified a pledgee’s position under a share-pledge agreement,
its impact on proceedings under the IBC could perhaps have been discussed in some detail to avoid
any controversy or confusion in the future. For instance, when a borrower (to secure whose loan,
shares are pledged with the creditor) goes into CIRP and a resolution plan is approved, the same
would bind the pledgee / creditor and in view of the ‘clean slate’ theory envisaged under the IBC,
the pledge would be rendered infructuous even though the beneficial ownership of the pledged
shares may have been transferred to the pledgee. In any event, the judgment certainly sets straight
the law relating to pledge of shares, particularly in view of divergent views taken by various courts
on the subject.

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