India’s Supreme Court clarifies the law on pledge of dematerialised shares

In PTC India Financial Services Limited v. Venkateswarlu Kari, 2022 SCC OnLine SC 608(the “PTC Ruling”), India’s Supreme Court (“SC”) has held that the law on enforcing a pledge of dematerialized shares is not distinct from that applicable to enforcing a pledge of physical shares or other movable assets.  The SC has emphasized on the harmonious interpretation of the Depositories Act, 1996 (the “Depositories Act”) and the Indian Contract Act, 1872 (the “Contract Act”) in this regard.

Fact summary

In 2014, PTC India Financial Services Limited (“PIFSL”) granted a loan of INR125 crores (~US$16 million) to a subsidiary (the “Corporate Debtor”) of Mandava Holdings Private Limited (“MHPL”).  The loan was secured by a pledge by MHPL of the shares of another subsidiary company (not the Corporate Debtor) in favor of PIFSL.

The Corporate Debtor initiated voluntary insolvency proceedings under Section 10 of the Insolvency and Bankruptcy Code, 2006 (the “IBC”).  Aggrieved by this, PIFSL invoked the pledge and procured the status of “beneficial owner” under the Depositories Act from the Depository Participant.  PIFSL also filed an application under Section 7 of the IBC before the Interim Resolution Professional (“IRP”) for initiation of insolvency resolution, which was challenged by MHPL.  MHPL claimed that it substituted PIFSL as a creditor of the Corporate Debtor to the extent of the value of the pledged shares.  PIFSL’s and MHPL’s claims were turned down by the IRP, which prompted PIFSL and MHPL to individually approach the National Company Law Tribunal (the “NCLT”).  The NCLT held that MHPL was the financial creditor to the extent of the value of the pledged shares.

PIFSL challenged the NCLT’s order before the National Company Law Appellate Tribunal (the “NCLAT”).  PIFSL’s appeal was dismissed by the NCLAT, inter alia, because PIFSL had exercised its rights under the pledge deed and the shares pledged to PIFSL stood transferred in its name.  Consequently, PIFSL approached the SC against the decision of the NCLT and the NCLAT.

Analysis of the Supreme Court’s ruling

The SC allowed the appeal and overturned the ruling of the NCLT and NCLAT.  It held that a transfer of pledged shares in the name of the nominee does not discharge the debt until the actual sale of the pledged shares.  The SC observed that there is a clear distinction between a mere transfer of the pledged shares in the name of the pawnee as a “beneficial owner” and the “actual sale” of the pledged shares, and a pawnor retains his/her right to redeem the pledged shares until the actual sale of the pledged shares.  The SC highlighted that, under Section 176 of the Contract Act, the pawnee has the right to take the pawnor to court, retain the pledged shares, or sell them subject to notifying the pawnor of the sale.

Once the “actual sale” has been effected by the pawnee, the pawnor forfeits his/her right under section 177 of the Contract Act to seek redemption of the pawned shares.

The SC overruled the decision of the Bombay High Court in the case of JRY Investments Private Limited v. Deccan Leafine Services Ltd. and Others, (2004) 121 Comp Cas 12, under which it was held that dematerialized securities cannot be made the subject matter of a pledge under the Contract Act as it is not possible to transfer their physical possession.  According to the SC, the Contract Act deals with the pledging of “goods,” and the definition of “goods” under the Sale of Goods Act, 1930, covers every kind of movable property including stock and shares.  

In the PTC Ruling, the SC referred to the decisions of the High Court of Andhra Pradesh in Md. Sultan and Others v. Firm of Rampratap Kannayalal, AIR 1964 AP 201, and Sri Raja Kakarklhpudi & Ors. v. The Andhra Bank Ltd. Vijayawada & Ors., AIR 1960 AP 273.  In these cases, it was observed that a hypothecation and mortgage of movables, though not specifically mentioned in the Contract Act, is valid and enforceable in India as the Contract Act is not an exhaustive law on the subject. 

It should be noted that Regulation 58 of SEBI (Depositories and Participants) Regulations, 1996 (the “1996 Regulations”) and Regulation 79 of the SEBI (Depositories and Participants) Regulations, 2018, clearly specify the manner in which a pledge or hypothecation of dematerialized shares can be created.  Additionally, sub-regulation 9 of the 1996 Regulations requires the depository to notify the pledgor and pledgee once it amends its records on the invocation of a pledge and a transfer of the beneficial ownership of the shares.  However, the Depositories Act does not require a pawnee to notify the pawnor prior to the sale of pledged shares.  As can be seen, although the Contract Act does not specifically cover the pledging of goods without delivery of possession, the concept of pledging and hypothecation of dematerialized shares is well covered under the Depositories Act and its regulations.

Conclusion

Since the introduction of the dematerialized account system by the Securities Exchange Board of India, the dematerialization of shares into electronic form has been well regulated under the Depositories Act and its regulations, and unlike the Contract Act, the Depositories Act contains provisions for accurately recording transfers and pledges of shares.

In the PTC Ruling, the SC has avoided any conflicting interpretations between the provisions of the Contract Act, which is the substantive and general law relating to contracts, and the Depositories Act, which is primarily a law concerning securities.  As a result, the PTC Ruling will serve as a landmark decision in all matters relating to the invocation of a pledge of dematerialized shares and the rights of the pledgor and pledgee.

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