Pledge of Shares- An Overview

Pledge of Shares- Law, Disclosures & ImplicationsMarch 2009

-Neha Gupta

Vinod Kothari & Company

[email protected]

Pledge of promoters’ shares has become an important way of private equity financing, andimportant tool for corporate India, as recent events have highlighted. This article considers sometricky issues regarding pledges, rights of pawnee and pawnor and the disclosure requirements.

Basic Law of Pledge:As distinct from liens or hypothecations, a pledge is a possessory security against debt orpromise. Section 172 of Indian Contract Act 1872 defines Pledge as “the bailment of goods as asecurity for the payment of a debt or performance of a promise”. A pawnee does not have theright of ownership, though he has the right of possession but not the right of enjoyment; apawnee has the right of disposition which is limited to disposition of pledgee’s rights only and ofa sale only after notice and subject to certain limitation- Shatzadi Begum Saheba v. GirdharilalSanghi AIR (1976) Andhra Pradesh 273.

Rights of Pawnee:As per section 176 of the Contract Act, if the pawnor makes default in payment of the debt, thepawnee has two distinct rights:

Ø Right to retain the pawn as a collateral security and sue for the claim, or

Ø Right to sell the pawn to realise his dues

While right to retain or sell are not concurrent, right to sue and sell are concurrent rights (KolkataHigh Court Judgement dated 17th July 1962 in Haridas Mundra v. National Grindlays BankLtd.). In case pawnee exercises right to sell, he may recover from the pawnor any deficiencyarising on the sale and hand over the surplus, if any, realised on the sale of the goods to thepawnor. A significant ruling of Company Law Board dated 7th Nov, 2001, in the matter ofMaruti Udyog Limited v. Pentamedia Graphics Limited, Pentafour Products Limited and ShriV.Ramakrishnan establishes that the pawnee has right to sue for the outstanding amount, enforcethe security by sale after due notice and file suit enforcing the security. And only in case ofmortgage of shares, the mortgagee can enjoy the shares and bring them in his name and not inthe case of pledge.

Rights of Pawnor:Section 177 of the Contract Act allows the pawnor to redeem his property even if he hasdefaulted. If a time is stipulated for the payment of a debt, and the pawnor makes default, he mayredeem the goods pledged at any subsequent time before the actual sale of that; but he must, in

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that case, pay, in addition, any expense which has arisen from his default. J Shelat in LallanPrasad v. Rahmat Ali (AIR) 1967 also observed this.

Why would pledge of shares be a special case?Shares are goods in law; hence, common law rules must be applicable to shares too. Shares areone of the most common forms of movable property used in pledges – the reasons are obviousas shares of a substantial value can be pledged to lenders without much of inconvenience. Thiswould not be possible with lots of other assets. Hence, pledge of shares has always been animportant form of commercial financing. To enable pledge of shares, laws have had provisionsof convenience – such as sec 108(1C)(B) of the Companies Act, 1956 avoiding the requirementfor pre-stamping of a transfer deed in case of pledge of shares to banks etc.

Of late, however, shares have been transformed from physical form into metaphysical form – inform of demat shares. This throws some new challenges.

Depositories Act contains some specific provisions about pledge, and there is a degree of conflictbetween the common law rules discussed above and the Depositories Act provisions.

Provisions in the Depositories Act and Regulation:Sec 12 of the Depositories Act, 1996 provides that a beneficial owner may with the previousapproval of the depository create a pledge or hypothecation in respect of a security owned byhim through a depository. Every beneficial owner should give intimation of such pledge orhypothecation to the depository participant and such depository is required to make entries in itsrecords accordingly. Any entry in the records of a depository should be evidence of a pledge orhypothecation.

Further, Regulation 58 of SEBI (Depositories and Participants) Regulation, 1996 lays down themanner of creating pledge or hypothecation:

o If a beneficial owner intends to create a pledge on a security he shall make an applicationto the depository through his participant.

o The participant shall make a note in its records of the notice of pledge and forward theapplication to the depository.

o The depository after confirmation from the pledgee shall within fifteen days of the receiptof the application create and record the pledge and send an intimation of the same to boththe participants.

o On receipt of the intimation, both the participants shall inform the pledger and the pledgerespectively of the entry of creation of the pledge.

o If the depository does not create the pledge, it shall send along with the reasons anintimation to the participants.

o The entry of pledge may be cancelled by the depository if pledger or the pledgee makesan application to the depository through its participant

Provided that no entry of pledge shall be cancelled by the depository without priorconcurrence of the pledgee.

o The depository on the cancellation of the entry of pledge shall inform the participant ofthe pledger.



o Subject to the provisions of the pledge document, the pledgee may invoke the pledge andon such invocation, the depository shall register the pledgee as beneficial owner of suchsecurities and amend its records accordingly.

o After amending its record, the depository shall immediately inform the participants of thechange who in turn shall make the necessary changes in their records and inform thepledger and pledgee respectively.

o No transfer of such security shall be effected by a participant without the concurrence ofthe pledgee.

Conflict between the Contract Act and the Depositories Act:A major conflict arises between the said Acts on the question: Can Pawnee sell pawn to himself?The Contract Act does not permit this. Upon default of the pawnor, the pawnee cannotappropriate the specific pawn, unless it be conveyed by way of mortgage, so as to pass the legaltitle. But he may sell it, and apply the proceeds of such sale to the liquidation of his claim. Hecannot, however, become the purchaser himself. Because, where pawnee sells the pawn tohimself, he is seller and buyer both but sale proceeds go to credit of the pawnor. Hence, it is aclear case of conflict between interests of the buyer and seller.

On the other hand, the Depositories Act provision that talks about pledgee getting the beneficialownership transferred in his own name effectively seems to enable a sale to the pawnee. In caseof shares with transparent market price, there is effectively no difference between a pawneeselling in the market, or selling to himself. However, pawnee cannot, for instance, choose a dateof sale when the price of shares is the least, thus clearly benefiting himself at the cost of thepawnor.

Invocation vis-à-vis Sale:Strictly the procedure of the Depositories Act provides for invocation of a pledge which istransfer of beneficial interest to the pawnee. Pawnee subsequently makes a sale of the shares inthe market. But, who is responsible for the change in price between the date of invocation andactual sale? On proper construction, it appears that there is no difference under Depositories Act,as under Contracts law, between invocation and sale. Invocation is for the purpose of sale.Pawnee may invoke pledge and cause sale directly, as beneficial owner. If he chooses to invokepledge, transfer beneficial interest to himself, and not sell in the market, it is a case of sale tohimself. Hence, any change in price after the date of invocation should belong to the pawnee.Generally, the practice of invoking pledge and not selling should be discouraged.

Recent Amendments:

Capital markets regulator Securities and Exchange Board of India (SEBI) has recently made itmandatory for promoters to disclose details of shares pledged by them in their listed entities.



SEBI Takeover Code- Event Based Disclosures:

The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 has beenamended on 28th January 2009 by inclusion of Regulation 8A, which reads out as follows:

• A promoter or every person forming part of the promoter group of any company shall,within seven working days of commencement of Securities and Exchange Board of India(Substantial Acquisition of Shares and Takeovers) (Amendment) Regulations, 2009,disclose details of shares of that company pledged by him to that company.

• A promoter or every person forming part of the promoter group of any company shall,within 7 working days from the date of creation of pledge on shares of that company heldby him, inform the details of such pledge of shares to that company.

• A promoter or every person forming part of the promoter group of any company shall,within 7 working days from the date of invocation of pledge on shares of that companypledged by him, inform the details of invocation of such pledge to that company.

• The company shall disclose the information received to all the stock exchanges, on whichthe shares of company are listed, within 7 working days of the receipt thereof, if, duringany quarter ending March, June, September and December of any year,:-

• aggregate number of pledged shares of a promoter or every person forming part ofpromoter group taken together with shares already pledged during that quarter bysuch promoter or persons exceeds twenty five thousand; or

• aggregate of total pledged shares of the promoter or every person forming part ofpromoter group along with the shares already pledged during that quarter by suchpromoter or persons exceeds one per cent of total shareholding or voting rights ofthe company, whichever is lower.

Amendments to Equity Listing Agreement- Periodic Disclosures:Capital market regulator SEBI has amended clause 35 and 41 in the Equity Listing Agreement toenhance disclosures regarding shareholding of promoters and promoter group including detailsof pledged shares.



Documents

Pledge of Shares- An Overview