Pledges in the Context of Insider Trading Regulations – Part 2

following guest post is contributed by Vinod
and Abhirup Ghosh of
Vinod Kothari & Co.
is the continuation of a previous post available here]
Whether a pledge is a
case of “dealing”?
As discussed in the previous post, the use of
the term “deal” or “dealings” in the definition of the term “trading” has
actually expanded its meaning beyond the usually understood meaning of
“trading”. Further, SEBI’s legislative Note to the definition of “trading”, as
stated below, makes it even clearer –
Under the parliamentary mandate, since the
Section 12A (e) and Section 15G of the Act employs the term ‘dealing in
securities’, it is intended to widely define the term “trading” to include
dealing. Such a construction is intended
to curb the activities based on unpublished price sensitive information which
are strictly not buying, selling or subscribing, such as pledging etc when in
possession of unpublished price sensitive information.
Not only has the Note expanded the meaning of
the term “dealing”, but has also clarified that for the purpose of the
Regulations, dealing in securities would also include pledging of securities.
Further, the same has been dealt with in the
Answer to Question 6 of the Guidance Note, as stated below –
6. (a) Whether SEBI’s intent is to prohibit
creation of pledge or invocation of pledge for enforcement of security while in
possession of UPSI?
(b)Whether creation of pledge or invocation of
pledge is allowed when trading window is closed?
Guidance: Yes.
However, the pledgor or pledgee may demonstrate that the creation of pledge or
invocation of pledge was bona fide and prove their innocence under proviso to
sub-regulation (1) of regulation 4 of the Regulations.
In the above guidance, SEBI has very clearly
expressed its intent to curb the practice of pledging of securities/ invocation
of pledge on securities while in possession of unpublished price sensitive
information (“UPSI”) as well.


What, in case of a
pledge, is “dealing”?
Given that, as we discussed above, a pledge is a
transfer of specific interest in goods, a pledge may be regarded as a form of
“trading”, the question is which of the several aspects of a pledge will be
regarded as “trading”.
(a)       Creation of a pledge:
As stated in the Note to the definition of
“trading”, dealing includes pledging of shares. So, there is no ambiguity to
the fact that creation of pledge will be regarded as “trading” for the purpose
of these Regulations.
Now let us understand as to why be SEBI might be
interested in controlling the pledge of securities. Assuming a case where a
promoter has access to UPSI and expects the price of the shares of the company
to fall on publication of the UPSI. In all likelihood, the promoter  would like to pledge the shares before the
publication of the UPSI and raise money from the market. It is as sensitive an
issue as buying and selling of securities at based on UPSI. Thus, it is very
logical to include pledging of securities in the definition of “trading”.
(b)       Invocation of a pledge and sale of
property by the pledge:
Here, at the very outset, we must understand
that the right to invoke a pledge remains with the pawnee of the property and a
pledge can be invoked only when there is a default on the part of the pawnor. On
invocation of the pledge, the pawnee attains the right to cause a sale of the
property as per Section 176 of the Contract Act, 1872. Note that generically
under the law of pledges the pawnee does not become absolute owner of the
property on invocation of the pledge – he simply acquires the right to cause a
sale of the pledged article.
Such a sale, caused by the pawnee, is certainly
a sale in normal parlance, and is hence, a “trading”. One has to see whether
the pawnee (and not the pawnor) is in possession of UPSI at this stage. If the
pawnee has an UPSI, the sale by the pawnee will attract the provisions of the
Regulations. If the pawner is an insider, and the pawnee is not, but the pawnee
is causing the sale at the instructions of the pawner, once again, there is a
use of UPSI, and therefore, the pawnee may also be regarded as “insider” within
the meaning of Para 2(g) of the Regulations.
(c)        Invocation of a pledge and assumption of
ownership interest by the pawnee:
In furtherance to the discussion in point (b)
above, where the terms of the pledge empower the pawnee to acquire title to the
goods on invocation of the pledge, and the pawnee decides to acquire the
ownership of the pledged securities, there is a change in the designation of
the pawnee, i.e, from being a mere holder of a security interest over a
property, it is becoming an owner of the property. This is undoubtedly a
transaction, where the outstanding debt is being settled in exchange of the ownership.
This is also a case of a “trading”. Actual sale of the pledged article by the
pawnee at a subsequent stage will also be a trading. Therefore, the meaning of
the term “deal” is being satisfied, so is the term “trading” for the purpose of
these Regulations.
(d)       Release of a pledge
Release of the pledge is, truly speaking, a
satisfaction of the pledge. The specific property that the pawnee had expires
on satisfaction of the purpose for whicih the pledge was created. Neither does
the pawnee, on satisfaction, have the right to retain the goods (Section 174 of
the Contract Act, 1872) nor does he have any right to cause a sale. Hence, this
amounts to an automatic termination of the rights contractually conferred by
the pawner. One cannot contend that on release of the pledge, there is a
retransfer of the specific property back to the pledgor. To begin with, the
property was specific and not absolute – it was granted for the purpose of
securing a debt. When that purpose becomes extinct, the specific property
expires by redemption of the purpose or debt. Therefore, it is incorrect to
contend that at this stage, there is a “trading” of any kind.
However, SEBI, in its Guidance to Question 7 of
the Guidance Note, has expressed the view that revocation of pledge also amounts
to a trade. While the use of the word “revocation” is, humbly, incorrect and
inappropriate, even if this is taken to refer to a release of the pledge, it is
wrong to contend that there is any transfer back of property, and therefore,
there is no question of any “trading” at this stage. More so in context of the
Regulations, because the Regulations are not intended to provide for a
generalised public record of pledges, as in case of registration of charges
under the Companies Act. The purpose of the Regulations is to ensure that there
is no insider taking advantage of UPSI. Surely enough, if the pawnor is
releasing his property by satisfying the debt, he cannot be intending to do so
to gain an advantage merely by release. If he at all were to cause a sale of
the released securities, that in any case will constitute a trade, but it is
wrong to contend that a mere release is a trade at all.
SEBI’s Guidance Note creates an unwarranted
confusion about pledges, and this series of posts has tried to align
understanding pertaining to pledges in different scenarios.
– Vinod Kothari & Abhirup Ghosh

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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