Conversion Vs. Actual Sale : Pledge Over Dematerialised Shares

On May 12, 2022, the Supreme Court considered the interplay between the Indian Contract Act, 1872 (“Contract Act”) and the Depositories Act, 1996 (“Depositories Act”) in relation to the pledge of shares and held that the Contract Act does not recognise the sale of the pledged goods by the pawnee to himself in the event of default of payment by the pawnor.

These observations were made in the case of PTC India Financial Services Limited vs. Venkateswarlu Kari and Another1. Mandava Holdings Private Limited (MHPL) had pledged its shares with the appellant PTC India Financial Services Ltd (PIFSL) company as a guarantee for a secured loan. After the pledge, those shares were registered with the depository with the appellant as the “beneficial owner”. The issue before the Court was whether such registration as a beneficial owner of shares would amount to the sale of shares.

Pledge under the Contract Act

Chapter IX of the Contract Act deals with ‘Contracts of Bailment’. Sections 148 to 171 lay down the general law pertaining to bailments, while Sections 172 to 179 delineate specific provisions concerning pledges, which are a subset of bailments.

Section 172 of the Contract Act defines the ‘pledge’, ‘pawnor’ and ‘pawnee’ as follows: the bailment of goods as security for payment of a debt or the performance of the promise, is called a ‘pledge’. The bailor is in this case called the ‘pawnor’. The bailee is called ‘pawnee’.

As per Section 172 of the Contract Act, creating a valid pledge requires delivery of the possession of goods by the pawnor to the pawnee by way of security upon the promise of repayment of a debt or the performance of a promise, thereby, creating an estate that vests with the pawnee.

As per Section 176 of the Contract Act, when a pawnor makes a default in payment of debt or performance of a promise, the pawnee may bring a suit against the pawnor upon such debt or promise and retain the goods pledged as collateral security, or he may sell the goods pledged upon giving the pawnor reasonable notice of the sale. If the pledged goods are sold, and the proceeds of such sale are less than the amount due in respect of the debt or promise, the pawnor is still liable to pay the balance amount to the pawnee. If the proceeds of such sale exceed the amount due, the pawnee will be liable to pay the surplus to the pawnor.

Under Section 177 of the Contract Act, the defaulting pledgor has the right to redeem the pledged goods at any time prior to the actual sale after the default in payment.

Pledge under the Depositories Act 

Pledge over dematerialized shares is governed by provisions of the Depositories Act and the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018 (“Depositories Regulations“). The manner of creation of pledge of hypothecation is stipulated under Regulation 79 of the Depositories Regulations. According to the Depositories Regulations, subject to the provisions of the pledge document, the pledgee may invoke the pledge and on such invocation, the depository shall rgister the pledgee as the beneficial owner of such securities and amend its records accordingly. It may be noted that the Depositories Regulations do not require issuance of any notice to the pledgor of dematerialised shares for invocation of the pledge.

The question before the Court therefore, was whether a notice contemplated under Section 176 of the Contract Act is required for pledge over dematerialised shares.

Relevant Case Law

In the case of JRY Investments Private Limited v. Deccan Leafine Services Ltd. and Others2, it was held that since the shares in question were in dematerialized form and not in physical form, such shares cannot be pledged in accordance with the provisions of Section 172 of the Contract Act.

Further, in Pushpanjali Tie Up Pvt Ltd. v. Renudevi Choudhary3, the Court ruled that the transfer of shares governed by the Depositories Act must be in accordance with the provisions of the Depositories Act and that the pledge of shares can only be validly created in accordance with the provisions of the same. 

The Delhi High Court examined the same issue in Tendril Financial Services Pvt. Ltd. v. Namedi Leasing and Finance Limited4 and held that “there is no place for a prior notice under Section 176 of the Contract Act, in the scheme of Regulation 58(8). On the contrary, Regulation 58(9) requires the depository to, after so amending its records under Regulation 58(8), inform the participants of the pledgor and the pledgee of the same and mandates the said participants to inform the pledgor and the pledgeeThus, (a) while Section 176 provides for a notice to pledgor prior to effecting sale, Regulation 58 provides for notice post invocation and on which invocation beneficial ownership of pledged shares changes from that of the pledgor to that of the pledgee and which is equivalent to sale under Section 176To hold that a prior notice under Section 176 of Contract Act is also required in the case of pledge of dematerialised shares would interfere with transparency and certainty in the securities market, rendering fatal blow to the Depositories Act and Regulations and the object of enactment thereof. 

The Apex Court examined the rulings passed in the abovementioend cases and noted that there exists a distinction between a pledge (which creates an estate or right that vests with pawnee) and wider general rights of an owner. The owner has: (a) right of possession; (b) right of enjoyment; and (c) right of disposition. A pawnee does not have the right of ownership, but a limited right to retain possession till the debt is paid or a promise is performed. The Court further noted that a pawnee’s right of disposition is limited to disposition of the pledge rights only, and the right to sell after reasonable notice. Even when the pawnor makes a default in payment of debt or performance of the promise, the pawnor has the right to redeem the pawn till the ‘actual sale’ of the pawn by the pawnee.

Holding of the Court

The Court held that the dictum in the judgments on the subject matter and Section 177 of the Contract Act, which confers on the defaulting pawnor the right to redeem the pledged goods till the ‘actual sale’, does not support the pawnee’s sale to self. The Court also overruled the judgment of the single judge of the Punjab and Haryana High Court in Dhani Ram and Sons v. The Frontier Bank Ltd.5 which held that the sale of the pawned goods by the pawnee to himself is not void, and the pawnee was held to be the legal owner of the pledged shares. The bench said that this decision proceeds on the incorrect understanding of precedents and is to be overruled.

The Court held that action on part of the ‘depository’ recording the pawnee as the ‘beneficial owner’ is not ‘actual sale’ for the purpose of Section 177 of the Contract Act. The right of the pawner to redeem the pledged shares would cease on the ‘actual sale’, i.e., when the beneficial owner sells the dematerialised securities to a third person.

The Court noted that Section 12 of the Depositories Act permits pledge and hypothecation of securities held by the depository. The Court also noted that a ‘beneficial owner’ can create a pledge or hypothecation regarding the security owned by him through the depository, subject to prior approval of the depository. Section 12 or for that matter, the Depositories Act does not define pledge or hypothecation, and thereby accepts and adapts their meaning as known in the commercial sense to people in the trade. This implies that the Depositories Act recognises the principles relating to pledge prescribed by the Contract Act and the common law. Such a pledge or hypothecation should be made in accordance with the regulations and by-laws made under the Depositories Act. A ‘beneficial owner’ as the pawnor is required to intimate such pledge or hypothecation to the depository, which thereupon makes entries in its records. This entry, made by ‘the depository’, is evidence of pledge or hypothecation.

The Court concluded that Section 12 of the Depositories Act is not ex-facie inconsistent with pawnee and pawnor’s contractual rights and obligations under the Contract Act and the common law. On the other hand, the Depositories Act expressly concedes that the securities held by the depository can be pledged and hypothecated by the ‘beneficial owner’.

Further, mere exercise of the right by the pawnee to record himself as the ‘beneficial owner’, which is a necessary precondition before the pawnee can exercise his right to sell, is not ‘actual sale’ and would not affect the rights of the pawnor of redemption under Section 177 of the Contract Act. Every transfer or sale is not ‘actual sale’ for the purpose of Section 177 of the Contract Act. To equate ‘sale’ with ‘actual sale’ would negate the legislative intent.

The Court elaborated further on the subject and held that the Depositories Regulations do not entitle the pledgor/pawnor to sell the pledged/pawned securities. The special rights of the pledgee/pawnee in the pawn remain intact under the Depositories Act and the Depositories Regulations. However, the right to sell dematerialized securities is conferred and given to the ‘beneficial owner’, who exercises this right through the participants. Consequently, if a pawnee wants to exercise his right to sell dematerialized security, it is mandatory for the pawnee first to get himself recorded as a ‘beneficial owner’ in the depository’s records. Without the said exercise, the pawnee cannot exercise its rights to sell the pledge and retrieve the monies due by taking recourse to its rights under Section 176 of the Contract Act. Right to sell the pledge after reasonable notice is one of the options, albeit, both under the common law and under the Contract Act, the pawnee has the choice even after issue of notice for sale to sue for the debt due while retaining possession of the pledged goods. Similarly, the pawnor under the Contract Act and the common law has the right to redeem the pledged goods till ‘actual sale’. Sale by the pawnee to self does not defeat the right of redemption of the pawnor. It may amount to conversion in law. Other provisions of the Contract Act enumerated in Chapter IX may well apply.

While putting the inconsistency to an end, the Court also highlightd that interpretation of statutes must depend on the text and the context. To resolve a debate when two views are evident, it is best to interpret the provisions when we know why the statute is enacted. If a statute is looked at, in the context of its enactment, with the glasses of the statute maker provided by such context, its scheme, the sections, clauses, phrases and words may take colour and appear different than when the statute is looked at without the glasses provided by the context. The provisions of the Contract Act, which is substantive and general law relating to contracts, and the Depositiories Act, which is a primary law relating to securities, must be interpreted harmoniously. This does not mean that any provision of one enactment could nullify the provisions of the other.

In view of the aforesaid findings, it was held by the Apex Court that registration of the pawn, that is the dematerialised shares, in favour of PIFSL as the ‘beneficial owner’ does not have the effect of sale of shares by the pawnee. The pledge has not been discharged or satisfied either in full or in part. PIFSL is not required to account for any sale proceeds which are to be applied to the debt on the ‘actual sale’. The two options available to PIFSL as the pawnee under Section 176 of the Contract Act remain and are not exhausted.

1 Civil Appeal No. 5443 of 2019

2 (2004) 121 Comp Cas 12

3 (2014) 6 Mah LJ 124

4 2018 SCC OnLine Del 8142

5 AIR 1962 P&H 321