[Viti Bansal is a fourth year student of B.A. LL.B. (Hons) at Gujarat National Law University]
The Insolvency & Bankruptcy Code, 2016 (“IBC”), under section 21(2), provides that a related party to the corporate debtor who is also a financial creditor of the corporate debtor will have no right of representation, participation or voting in a meeting of the committee of creditors (“CoC”). The intent behind section 21(2) in denying related parties voting rights is to ensure that external creditors drive the corporate bankruptcy resolution process. Irrespective of the fact that related parties may have claims and may even petition for corporate insolvency resolution, such parties cannot drive the insolvency resolution process since it would be fraught with conflicts of interest. Sections 5(24) and 5(24A) of the IBC provide an exhaustive definition of ‘related party’. The present discussion pertains to the related parties as stipulated under section 5(24)(j), i.e., persons who control more than 20% of the voting rights in the corporate debtor on account of ownership.
Consistent with the aim of the IBC, financial institutions were subsequently exempted from being treated as a related party on account of holding equity in the corporate debtor undergoing insolvency if the equity has been obtained solely through conversion of a debt instrument. This is by way of section 5(24A), as amended by the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018. This is because their acquisition of equity stems from the debt itself and, therefore, there is an absence of vested interest in the corporate debtor. In this context, it is pertinent to take of note of a class of financial creditors who are very similarly placed – those that are pledged equity shares of the corporate debtor and attain over 20% ownership on account of invocation of those pledged shares. In this post, the author aims to discern whether such financial creditors would be disqualified from having any actual rights in the CoC on account of having attained beneficial ownership on invocation of pledged shares.
Legal effect of invocation of pledged shares
At the outset, one must understand the legal effect of invocation of shares. The courts in India had in earlier cases such as Balakrishna Gupta v. Swadeshi Polytex and Lallan Prasad v. Rahmat Ali, in light of section 176 of the Indian Contract Act, 1872, found that the pledgee may invoke the pledged shares, but the same does not grant the pledgee an absolute right to sell the shares. The shares may be redeemed by the pledgor prior to sale to third party. The cases held that sale of shares by the pledgee to itself would be a void contract. Thus, sale of share to itself was found to be illegal and was therefore separate from invocation of pledged shares.
This position does not stand in the light of dematerialised shares as provided under the Depositories Act, 1996. The Delhi High Court in Tendril Financial Services Pvt. v. Namedi Leasing & Finance Ltd. has, in concurrence with the decisions of the Bombay High Court in JRY Investments Pvt. Ltd. v. Deccan Leafine Services Ltd. and Pushpanjali Tie Up Pvt. Ltd. v. Renudevi Choudhary IV, held that, drawing a distinction between ‘sale’ and ‘invocation’ would be incorrect and contrary to regulation 79(8) of the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018.
Regulation 79(8) provides:“Subject to the provisions of the pledge document, the pledgee may invoke the pledge and on such invocation, the depository shall register the pledgee as beneficial owner of such securities and amend its records accordingly.” On such an invocation, the title on the shares does not remain with the pledgor. This is because, as found in the Tendril case, “the only title in dematerialised shares, under the Depositories Act, is as beneficial owner in the records of the participant and the depository and which beneficial ownership changes on invocation of pledge in terms of Regulation 58.” Therefore, the moment the shares are transferred to the demat account of the beneficiary after invocation of pledge shares, such transfer amounts to sale and transferee became the beneficial owner of the shares.
Effect of invocation on rights in the CoC
It is evident from the above discussion that invocation of pledged shares results in transfer of beneficial ownership to the pledgee. If this beneficial ownership exceeds 20%, then the financial creditor would come within the ambit of ‘related party’ and would not have any real rights in the CoC. However, the jurisprudence on the issue indicates that the challenge to position of financial creditor in the CoC following the invocation of pledged shares has been on the ground of satisfaction of debt and not in terms of its conversion to a related party of the corporate debtor. The question has been restricted to payment of financial debt.
In India Power Corporation Ltd. v. Meenakshi Energy Ltd. , Meenakshi Energy Ltd. borrowed a loan from SBI and certain associate banks for two phases of a project and pledged its shares held by the creditors of India Power Corporation Ltd. Subsequent to the default, the share pledge agreement for phase 1 creditors was invoked by SBI CAP Trustee, who became owner of 95.2% shares of the Meenakshi Energy Ltd.. The National Company Law Appellate Tribunal (“NCLAT”) agreed that the financial creditor gains beneficial ownership, but did not agree that it loses the status of financial creditor by becoming a shareholder. Although after invocation of the pledge, Meenakshi Energy Ltd. issued more shares with differential voting rights thereby reducing the voting rights of SBI CAP Trustee from 97.58% to 3.75% and the shares were transferred to the demat account of the SBI CAP Trustee and not the financial creditors, the arguments of parties and reasoning of the tribunal were restricted to its continued status as a financial creditor to whom a financial debt was owed. There was no argument discussed pertaining to related party considerations.
Similarly, in PTC India Financial Services Ltd. v. Venkateswarlu Kari, the NCLAT or parties did not concern themselves with the shareholding that the pledgee obtains in the corporate debtor. The discussion was confined to position as financial creditor after invocation of pledged shares. The NCLAT upheld the decision of the National Company Law Tribunal that the difference between the dues and the value of shares transferred to the account of the financial creditor would determine if dues still subsist and thereby whether the status as financial creditor remains. However, the case did clarify that the financial creditor was the owner of the shares.
While there is no case that explicitly discusses the aspect of pledgee being the related party, the insistence on the pledgee invoking the shares, being the sole owner of the shares, indicates towards a control over the corporate debtor, which may be argued upon to constitute it as a ‘related party’ if it falls within the definition of section 5(24)(j) of IBC.
Although the possibility of treating financial creditors invoking pledged shares and thereby becoming ‘related party’ on account of beneficial ownership has not been explored by the courts and tribunals so far, following dematerialisation, this issue is likely to arise before the courts of law. Allowing holders of pledged shares on mere invocation to be brought under the ambit of ‘related party’ on a mere technicality of law would be inconsistent with the aims of the IBC. It would therefore be trite on part of the legislature to bring forth a clarification in this regard, excluding pledgee from the definition under section 5(24)(j) of IBC, along the lines of exclusion of equity holders having obtained equity solely through conversion of a debt instrument.
– Viti Bansal