Resolüt Audio is our initiative to present to you our analysis on legal and tax issues in a simple and de-jargonized manner through free-flowing conversations.
In the first episode of Resolüt Audio, host Raina Mitra talks with Ruchir Sinha on the recent Supreme Court Judgement in the PTC India case. They talk about the regulation of pledged dematerialized shares and the implications of the PTC judgement while providing a broad overview on the law of pledge and the challenges of reconciling the statutory requirements to dematerialized shares.
Raina: Hi, my name is Raina and in today's episode, Ruchir and I will be discussing the Supreme Court judgment in the PTC case. The judgment in many ways has redefined the way a pledge of demat shares operates, a position which has anyway undergone significant changes over the course of the past few years. In fact, we're already seeing instances of pledgors trying to regain control over their pledged shares, much like the Yes Bank-Dish TV scenario. And really there are quite a few questions that remain to be answered. So, let's get right into it.
Raina: So, what exactly has the Supreme Court done in the PTC case?
Ruchir: I think the Supreme Court has probably given the most logical interpretation to the law of pledge. And before we understand what the Supreme Court has done, I think it's very important to understand what is a pledge. Okay?
Many people have misconstrued that pledge, becomes, is a form of ownership upon invocation. And I think that is exactly what the Supreme Court has tried to clarify.
But let's go back and understand what's a pledge. So, a pledgor can pledge his property in the form of shares. The classic example used to be that of oranges or mangoes to somebody, to a pledgee, to get, as a form of security for the payment he may have, for the cash proceeds that he may have, received.
The pledgee then sits in trust over the pledged property. It is the duty of the pledgee to hold the pledged property in order, take care of the pledged property as his own.
And, if there is a default in payment of the dues by the pledgor only then the pledgee can sell the pledged property. And before, and section 176 very clearly says that before you have to sell the, before you sell the pledged property, or before the actual sale of the pledged property, you must give a reasonable notice of sale to the pledgor.
Now, why is this important? The idea is that the pledgor pledged some property of his own which could be possibly precious to him. You do not dispossess him of that property without even giving him a chance to redeem or to take his asset back from you.
So therefore, I think there are three aspects which are very important in a pledge. First, is the role of a pledgee. He never becomes the owner. He's only holding this in capacity as a trustee, in other words, a pawnee or a bailee under Contract Act.
Second concept that becomes important is that of actual sale. What is actual sale? Taking possession of the pledged property is not ownership. He is only holding again as trust, holding the property in trust. So, actual sale has always meant, historically also meant that when you are selling off to a third party.
Third aspect that becomes important is that of reasonable notice of sale. So, this is where I think it was getting convoluted because if you remove the idea of actual sale or if you look at the idea of actual sale as a sale to your own self or sale to pledgee, then naturally there can be no concept of reasonable notice also.
So, effectively what Tendril and all the previous High Court rulings did was that they said that once you invoke- and this so happened because of the way the depositories regulations work because under depositories regulations, the depository is the registered owner or the legal owner and the beneficial owner is the holder of the securities
So, until the pledge is invoked, the pledgor remains the beneficial owner. When the pledge is invoked, the pledgee becomes the beneficial owner. Now what happens is, the beneficial owner is the pledgee. So, Tendril held that because the beneficial owner has changed and there is no record of pledgor and therefore it is an act of actual sale that has happened. And that's what the, I think it was a misplaced interpretation because the Depositories Act somehow trumped the substantive law of the Indian Contract Act.
And I think Tendril held that there is no other way to look at it because when beneficial owner changes, the pledgee becomes the owner. When pledgee becomes the owner, there's no need for reasonable notice for sale. So, it totally redefined the idea of actual sale. So, this invocation by pledgee, that the change of name in the beneficiary records became the idea of actual sale.
So, I think that's where the gap is. Supreme Court has relooked at the entire scheme again and said, look, even if the beneficial owner is changing in the books of the depository, this is not an actual sale. This is only a procedural requirement because a pledgee also needs to sell. And you can't sell something which you don't own, so you can't sell a title which you don't have. So, only to facilitate the ownership in favour of pledgee, the change of beneficial owner is fine in the name of pledgee, but it doesn't really change the role of a pledgee from a trustee to the owner.
And the idea of actual sale is again when the pledgee sells to a third party. So, it's again taken the goalpost back to where it was originally supposed to be. That means a sale to a third party. So, I think that is the genesis of what the Supreme Court has done.
Raina: So, what were the practical challenges post-Tendril and how have they been resolved?
Ruchir: I don't think they've been resolved. I think there's more confusion now, but not that there was less confusion earlier. I think what's happened after Tendril was really this - that I think the court relied on rulings of the past and held that a sale to self was not void.
What was happening was that upon the invocation, when the beneficial owner changed to the pledgee, a sale to self technically happened and that was an absolute sale. So, now what happens is the pledgor relinquished his property, he sold his property technically to the pledgee, but he hasn't received the consideration for it yet.
And Tendril went on to say that this sale cannot be reversed. The only claim that the pledgor will have against the pledgee is that of claiming a fair compensation. If he gets lesser compensation, you can go for damages, but your property cannot come back to you.
Now, if you look at it, it's actually quite counterintuitive because this kind of sale has helped no one. From a pledgor's perspective, he's lost his right to redeem because the sale has happened, pledge property is gone. No matter what he does, he cannot get the pledge property back because the sale is absolute.
From a pledgee's perspective, pledgee now owns, let's say, the property is a share. Now pledgee owns the pledged shares. He has to make good the compensation for these pledged shares. If he's able to down sell it to some third party, then great.
But if he can't, in most cases these might be unlisted shares as well. What does he do? He would have to do a fair valuation of shares and to that extent, the outstanding dues of the pledgee that the pledgor has to pay will stay discharged.
Now, even a pledgee is not benefited because pledgee is now left with shares which are non-marketable, he may not be able to sell. So, let's say the pledged property was $100 on the date the property was pledged, on the date of invocation, the fair value comes to about $80, now it's $80. But the pledgee never wanted, pledgee wanted $80 cash, not shares.
Pledgor had faith in the pledged property that if we perform well with the company, et cetera, the value would have gone way above from $80 to $200 to $1000. He cannot get the property back.
Pledgee, who may well be a financial investor, is left with shares which are no good for him. So, it didn't really solve any purpose. And I think that was a big challenge that Tendril placed.
Which is also the genesis of what happened in Supreme Court, because I think courts started to take the view after Tendril, and which is how this matter came up, is that, now the lender has certainly become the owner.
And the lender is like - I never wanted to be the owner, I only wanted to hold this property in trust for me to be able to down sell. But unfortunately, courts then started to hold the lender as the owner.
And I think that's where, I think the dichotomy sort of erupted and it had to be settled.
Raina: So how does this ownership issue intersect with other regulations like the takeover code?
Ruchir: So, I think Tendril was possibly a more logical way to look at takeover code.
I think from a securities law perspective, IRDA perspective; I think it was possibly more logical because you see, when the invocation of pledge happens, the beneficial owner changes.
Today there are no, in demat shares as you know there is no, shareholder register and all that. The depository records are like the shareholder register.
So, the very entity of pledgor is destroyed or taken away the moment invocation happens and the pledgee is known as the beneficial owner and the owner for all practical purposes and he gets, therefore, all the rights and accretions from those shares - right to vote, right to dividend and everything.
From a very simplistic or a purist perspective, I think Tendril was making sense because - let's say you invoked the pledge on listed shares and the pledgee becomes the owner.
And for that purpose, I think that the takeover code also prescribed that other than financial institutions like Banks and FI's, anybody else would have to possibly trigger the code, and which is what happened in Karvy and in many other cases.
That was logical. What the Supreme Court has now done, is actually, it has convoluted in the hope of making it simple. So, I think what's happened now is Supreme Court is saying that - you are the beneficial owner. In the books of the depository and for all practical purposes, let's say the shareholder register, will reflect the pledgee as the owner of those shares and therefore the voting rights will be exercised because that's the only way of exercise because whenever a shareholder meeting happens the depository will simply reflect the pledgee as the owner of those shares.
So, the pledgee has voting rights, dividend rights and all of it. But what Supreme Court is saying is, even though that may practically be the case, conceptually and philosophically and keeping the principles of the Contract Act - a pledgee is not the owner.
So, therefore I think this question has to be debated and thought through a lot more carefully - that who holds the voting rights? And I think that is the crux of this whole judgment that it has, in a way, clarified that the pledgee is like a trustee because if you make him the owner, the pledgor at that very moment forfeits his right to redeem the security.
And under the Contract Act also, a pledgee has the ability to invoke the shares and yet continue to claim for outstanding dues because if you make him the owner there is no due.
So Supreme Court has settled this part, that you don't become the owner. But what it has not settled is that okay, if you don't become the owner but the Depositories Act says you are the owner, then who votes during this time? That's in a limbo.
And I think it is, the Supreme Court has also kindly acknowledged that a holistic review of the takeover code and the entire securities law framework has to be undertaken now, in light of the findings of the Supreme Court.
So, I think, either you change the Depositories Act now to say that okay, whenever pledge invocation happens - the pledgee is only trustee and doesn't hold voting rights.
Some kind of change in the framework overall has to happen. Otherwise, I don't know how practically and administratively the entire securities law framework, etc will work, where some person is being reflected as the owner of the shares, but yet is not the owner.
Raina: So, going forward, what are some of the practical solutions that can mitigate some of these issues?
Ruchir: I think in my mind it should still be possible for the parties to contractually agree on how should the voting rights and the economic entitlements vest and accrue.
I think people need to be more careful while drafting the pledge documents on trying to determine what will happen upon invocation.
So, I think the period is really between invocation and actual sale. And I think you can sort of define the conduct of the parties during this period in the contract. Even that time, even if you look at the Depositories Act, it actually says that the pledge and the ownership and everything is actually subject to the pledge document. If the pledge document is saying something, it generally prevails.
Now, go back to even the principles. Let's say, I think divide this into voting and economics. On the economic part, I think the Supreme Court has also been very clear that the economic entitlements will actually vest with the pledgor. In fact, it goes on to say that let's say you are taking a cow in pledge and now there's a calf as well. If the debt has been discharged, then both the cow and the calf are now the property of the pledgor.
So, the economic entitlement, dividends, et cetera, whatever you keep on getting, you're only holding them in position of a trust. Extend the same logic to voting rights. It's like a trust which is holding certain shares for the benefit of the beneficiary. Here, the beneficiary technically should be the pledgor, right? Now, the trustee or the trust can vote, but there can obviously be an arrangement where the trustee will only vote on the instructions of the beneficiaries, right?
So, very simply here also there can be an embedded voting rights arrangement in the pledge agreement itself which says that - okay, during the period of invocation to actual sale to a third party, all the voting rights, et cetera, shall only be exercised on the instructions of the pledgor.
I think that can easily be achieved, but you have to be careful because if you do not have it, then unfortunately, in my mind, the way the scheme will work is that everything will stand at the discretion of the pledgee.
And while the economic rights might still vest on you, but during that time - the pledgee will end up exercising the voting rights for all practical purposes.
Then you can go on arguing that - no, the Supreme Court order says this and all of that. But practically, I think it will be difficult to say that you're not the owner.
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