Supreme Court on Pledge of Shares: Insider Trading Regulations May Require Review

[Vinita Nair is a Senior Partner at Vinod Kothari & Co.]

Recently, in PTC India Financial Services Limited v. Venkateshwar Kari, the Supreme Court held that ‘beneficial ownership’ in the context of the Depositories Act should not be confused with beneficial ownership under general law as it is merely a procedural precondition to sale by the pledgee. Further, the Court found that there is no concept of ‘sale to self’ by the pledgee and that the pledgee is bound by the two options provided under section 176 of the Indian Contract Act, 1872, viz., the right to bring a suit against the pledgor and retain the goods pledged as collateral security, or to sell the thing pledged on giving reasonable notice to the pledgor and sue for the balance, if any.

In the author’s view, there is a need to examine the applicability of SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’) in the context of pledges, for reasons discussed in the later part of this post.

Different Stages in a Pledge

Stages in a pledge transaction

Impact

Creation of pledge

The securities are moved from ‘free balances’ or ‘lock-in’ as applicable to ‘pledged balances’ account. There is no change of hands or a transfer of ownership at this stage and the pledgor continues to remain the legal and the beneficial owner. The pledged goods are, however, now encumbered.

Release of pledge

The securities are moved from ‘pledged balances’ to ‘free balances’ or ‘lock-in’ as applicable.  There is no change of hands or transfer of ownership at this stage, similar to the above stage. The encumbrance is removed.

Notice of invocation of pledge

No impact.

Invocation of pledge

In terms of regulation 79 (8) of the SEBI (Depositories and the Participants) Regulations, 1996, the depository registers the pledgee as the “beneficial owner” and the securities move to the demat account of the pledgee. It is important to note at this stage that while there is change of hands or transfer of securities from one demat to another, in view of the rationale provided in the PTC India ruling, the registration of the pledgee as a beneficial owner is only to enable the pledgee to exercise the right under section 176 of the Contract Act.

Redemption of pledged goods

This results in transfer of securities from the pledgee’s account to the pledgor’s account. However, it cannot be regarded as a sale or transfer given the rationale provided in the PTC India ruling, as the earlier transfer of demat shares to  the beneficial account of the pledgee was not a case of transfer in law. If the pledgee was not the transferee of the shares, the release of the pledge does not amount to a transfer from the pledgee to the pledgor.

Sale of pledged goods

The third-party purchaser becomes the legal and beneficial owner. It would appear from the movement in demat accounts as if the shares have been transferred from the demat account of the pledgee to that of the buyer; however, in legal parlance, the sale has occurred effectively from the pledgor to the buyer.

Impact of Pledge under PIT Regulations

The Securities and Exchange Board of India (‘SEBI’), in its Guidance Note of 2015 regarded a pledge as covered within the definition of ‘trade’. Moreover, in the Comprehensive FAQS on PIT Regulations, SEBI clarified further that ‘trading’ would include the creation, invocation, or revocation of a pledge.

Consequently, every restriction and compliance requirement applicable to a trade undertaken by a designated person (‘DP’) is equally applied in case of pledge of listed securities. The PIT Regulations only provide a carve out from the applicability of trading window restrictions in respect of pledge of shares for a bona fide purpose such as raising of funds, subject to pre-clearance by the compliance officer and compliance with the respective regulations. The onus to demonstrate bona fide intention behind such transactions lies with the pledgor or the pledgee, as the case may be. Apart from this, the requirement of seeking pre-clearance, disclosure requirement, and contra-trade restrictions are all made applicable in case of creation, invocation and release of pledge, which seems quite counterintuitive for reasons explained hereunder. The ICSI Guidance Note on PIT Regulations (in page 145) also provides that if a DP pledges its shares, it cannot de-pledge the shares in the next six months and that it cannot even change the banker with whom the shares are pledged, as it will amount to de-pledge of shares and a further re-pledge of shares. This is obviously impractical, as there is no reason for a DP who has pledged its securities for taking a loan not to release the pledge having repaid the loan within six months.

Applicability of PIT Regulations to Various Stages of Pledge

Creation of pledge: There is no change of beneficial owner upon creation of pledge. In case the DP has sold certain securities, the contra-trade restrictions should not get attracted upon creation of pledge within six months from last sale transaction as it is merely the creation of a security interest. The requirement of pre-clearance for creation of pledge also seems a perfunctory requirement, especially where the law permits the creation of a pledge even during the trading window closure period. The disclosure requirement is anyways system driven and will get captured pursuant to the record of the depository.

Release of pledge: The release of a pledge is, truly speaking, a satisfaction of the underlying purpose for which it was created. The specific property right that the pledgee had expires on satisfaction of the purpose for which the pledge was created. Neither does the pledgee, on satisfaction, have the right to retain the goods (section 174 of the Contract Act) nor does it have any right to cause a sale. Hence, this amounts to an automatic termination of the rights contractually conferred by the pledgor. One cannot contend that on release of the pledge, there is a re-transfer of the specific property back to the pledgor. If the DP was 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 of pledge is a trade. Therefore, the requirement of seeking pre-clearance as well as contra trade restrictions should not apply in this case.

Notice of invocation of pledge: There is no ‘dealing’ in securities at this stage and no compliance requirement under PIT Regulations is involved as it results in neither acquisition nor disposal.

Invocation of pledge: The right to invoke a pledge remains with the pledgee of the property and a pledge can be invoked only when there is a default on the part of the pledgor. This certainly cannot attract contra-trade restrictions as the pledgor cannot control the invocation of a pledge and, therefore, the requirement of seeking a pre-clearance from the compliance officer seems a perfunctory requirement. On invocation of the pledge, the pawnee attains the right to cause a sale of the property according to section 176 of the Contract Act. The pledgee does not become the absolute owner of the property on invocation of the pledge and is simply registered as a beneficial owner under the depository laws in order to cause a sale of the pledged article. The disclosure requirement is anyway system driven and will get captured pursuant to the record of the depository.

Redemption of pledged securities: Section 177 of the Contract Act gives the pledgor a right to redeem even after the stipulated time for payment and before the sale of the invoked securities. Naturally, upon settlement of entire dues, it will result in a re-transfer of the pledged securities to the pledgor. In the author’s view, the restriction of contra trade and the requirement of pre-clearance should not apply even in that case as the re-transfer is consequential to the settlement of outstanding amounts by the pledgor and has similar effect as the release of a pledge.

Sale of pledged securities: This is the stage that results in disposal of the securities by the DP. However, it can be contended that the individuals who were in possession of such unpublished price sensitive information (‘UPSI’) were different from the individuals taking trading decisions and such decision-making individuals were not in possession of such UPSI when they took the decision to trade. Accordingly, the requirement of pre-clearance and contra-trade restrictions should not apply even in the instant case as the sale is carried out by the pledgee in the course of enforcement of security interest. Ideally, the disclosure requirement should also get triggered at this stage as the transfer to the demat account of the pledgee is merely to enable the pledgee to cause a sale.

Conclusion

In view of the PTC India ruling, SEBI needs to revisit PIT Regulations in view of the concept of pledge and rights of pledgee and pledgor under the Contract Act to ensure that contra-trade restrictions and other perfunctory compliances discussed above are done away with.

Vinita Nair

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