We had last month discussed the ex parte ad interim order passed by the Securities and Exchange Board of India (SEBI) wherein the regulator found that Karvy Stock Broking Limited (KSBL) had wrongfully pledged securities belonging to its clients to various lenders in exchange for funds borrowed. Since then, four lenders, (i) Bajaj Finance Limited, (ii) ICICI Bank Limited, (iii) HDFC Bank Limited and (iv) IndusInd Bank Limited approached the Securities Appellate Tribunal (SAT) with a request to set aside SEBI’s order. The SAT found that in the interim the disputed securities in KSBL’s position were already transferred to their clients. Hence, the lenders sought to reinstate their status as pledgees and asked for other forms of relief. However, the SAT directed them to approach SEBI, and requested SEBI to consider the lenders’ submissions and pass an order by 16 December 2019.
On Friday, 13 December 2019, a whole time member of SEBI passed an order denying relief to the lenders, who therefore no longer have access to the pledge of securities. The lenders’ claim is that KSBL pledged the disputed securities in their favor in accordance with the provisions of the Depositories Act, 1996, the SEBI (Depositories and Participants) Regulations, 2018 and relevant rules of intermediaries such as the depositories and the stock exchanges. However, SEBI rejected this stance on the ground that both the legislation as well as the regulations permit persons to create a pledge only in respect of securities “owned” by them. In the present case, since KSBL never “owned” the disputed shares in the first place, but rather its clients did, it did not have the ability in law to create the pledge in favour of the lenders. As SEBI observes (by referring to the lenders as “Representors”):
18. In the present case, in respect of impugned securities which have been unauthorisedly removed/transferred by KSBL to the demat account no. 11458979, were belonging to the clients who had paid in full against these securities and there was no further instructions to act upon them (hereinafter referred to as “fully paid clients”). Therefore, KSBL was not at all authorized to pledge securities owned by its fully paid clients. The unauthorized transfer of securities of fully paid clients by KSBL, is misappropriation of clients’ securities by KSBL. These securities were subsequently unauthorisedly pledged by KSBL to the Representors for availing the loans. Thus, the pledge created by KSBL of the securities owned by its clients, was unauthorized and in law, not treated as a valid pledge.
19. As can be noted from Section 12(1) of the Depositories Act, 1996, a beneficial owner can create pledge on the securities “owned” by him. Similarly, Regulation 58 of DP Regulations, 1996 and Regulation 79 of DP Regulations, 2018, further reiterates that a beneficial owner can create pledge of securities “owned” by him. As noted above, in the present case, securities lying in the demat account no. 11458979 which were unauthorisedly pledged by KSBL with the Representors, were owned by the clients of KSBL and the clients continued to be entitled to all the benefits attached to such securities in terms of Section 10(3) of the Depositories Act, 1996. These securities were not at all owned by KSBL. Therefore, in terms of the provisions of the Depositories Act, 1996 and DP Regulations, KSBL could not have pledged these securities. Accordingly, such unauthorized pledge was not in accordance with law and hence, did not create any right in favour of the Representors.
As one reviews the order and, in particular, the extracted portion above, it becomes clear that the dispute at hand is one under the law relating to contract law and sale of goods, as the solution essentially relates to a determination of who had the title to the shares. This part of the dispute is no longer one relating to securities law, and one wonders what role SEBI might have to play in these circumstances. In these circumstances, SEBI rightfully refused to intervene in the matter, and stated that the remedy for these matters lies before a civil court of competent jurisdiction.
No matter what the next steps are, this set of events gives rise to important legal issues pertaining to pledge of dematerialized securities. While general principles of contract law and sale of goods ought to apply, the special nature of the property involved, viz. dematerialized securities, compounds matters. The treatment of the property and its dealings would also have to be determined in the light of the Depositories Act and SEBI’s regulations thereunder. Although the lenders may very well appeal to SAT, the appellate body too is likely to be operating under the same constraints that SEBI faced, i.e., regarding the nature of the dispute and the extent of the role of the securities regulator in resolving that dispute.
That said, given that the demat account 11458979 on which the pledge was made was Karvy’s, the pledge is legally valid. Further, it is the responsibility of NSDL to ensure that the securities on which pledges are registered are actually owned by the concerned entity. Hence, NSDL makes a specific commitment that it will not transfer any pledged securities without approval of the pledgees. Failure to do, is indeed an criminal act of fraud/collusion –
What is most concerning of this case, is that NSDL allowed Karvy to transfer of shares belonging to investors into demat account 11458979 – furthermore, registered the pledge. Given the huge volumes of transfers, and the fact that pledges of large sums of money were made on the securities, this would only be possible with active or tacit complicity of NSDL.
While SEBI should definitely impose a huge fine on NSDL and also order it to compensate all impacted parties, it should also ask EOW to investigate these – and in the interim, suspend the current management of NSDL to ensure that a fair inquiry is held in this huge scam.
I do not find that the substantive law governing ‘Pledge of shares’ is any different for dematerialized shares. The provisions of Indian Contract Act and The Sale of Goods Act will still be the substantive provisions governing ‘Pledge of Shares’. The applicability of Depositories Act and the regulations framed thereunder would be limited and relevant to the extent of governing the procedure for creation, revocation and invocation of pledge on demat shares.
Another, important point of contention by the lenders was the irrefutable presumption being created by section 10(3) and section 2(1)(a) of the Depositories Act. It was the case of the lenders that once a person is identified as ‘Beneficial Owner’ under the depository system, its ownership of such shares cannot be disputed and it is this irrefutable protection being offered by Law that has facilitated and enabled the development of modern day electronic trading in shares. However, SEBI did not accept this contention of the lenders, stating that merely because the name is reflected as ‘BO’ in depository system, does not make a person the title holder of such shares. According to SEBI, when a broker is holding clients shares in his Pool Account/Unpaid Shares Account/Client Beneficiary Account, he is merely holding such shares ‘in trust’ on behalf of his clients. He is not entitled to any benefits or enrichment attached to such shares.