Insights

Law of Pledges applicable to Dematerialized Securities: Clarified by the Supreme Court of India

Smriti Mehta

The Supreme Court (“SC”) in its recent judgment in PTC India Financial Services Limited v. Venkateswarlu Kari and Ors. dated May 12, 2022 (“PTC Judgment”) opined on aspects relating to a pledge of dematerialized securities highlighting Sections 176, 177 of the Contract Act, 1872 (“Contract Act”) and Regulation 58(8) of the Depositories and Participants Regulation, 1996 (“DP Regulation”), as follows:

  1. The pledged property is subjected to a specific right, not a generic right, of the pledgee.
  2. A pledge extends to all accretions and additions attached to the pledged property. 
  3. Issuance of a reasonable notice of sale by the pledgee to the pledgor is a prerequisite for any sale of the pledged property, even if the pledge agreement provides the pledgee with an unconditional power of sale.
  4. The pledgor can redeem the pledged property until actual sale of the pledged property.
  5. Any gains made by the pledgee upon redemption or actual sale of the pledged property must be returned to the pledgor.
  6. The sale of pledged property to self is not conceived by the Contract Act. Such sale to self is a conversion and not an actual sale, and therefore does not affect the right of the pledgor to redeem the pledged property.
  7. The SC clarified the long-standing dispute regarding the contradiction between Sections 176, 177 of the Contract Act and Regulation 58(8) the DP Regulation. It concluded that both laws work harmoniously with each other. It stated that, upon invocation of the pledge, the pledgee is first required to be registered as a “beneficial owner” as per the DP Regulation, and only after this step the pledged property can be sold to a third party or redeemed as per the Contract Act. It further stated that the mere act of the pledgee registering itself as a beneficial owner shall not constitute an actual sale or result in discharge of debt.
  8. The SC further clarified that where the pledge is on dematerialized securities, the pledgor shall not be entitled to redeem the dematerialized securities from the third party on the ground that reasonable notice of sale was not given to the pledgor for the pledged property. This is because, as per the DP Regulation, both the pledgor and the pledgee are notified about the change in status with the pledgee making a request and being accorded a status of the beneficial owner, and to this extent the SC accepted that there is a conflict between Section 176 of the Contract Act and Regulation 58(8) the DP Regulation.

In furtherance to the PTC Judgment, the Bombay High Court (“BHC”) adjudged in the case of World Crest Advisors LLP v. Catalyst Trusteeship Ltd, and Ors. dated June 23, 2022 (“World Crest Judgment”), that the pledgee acquires the fullness of rights in the pledged property which includes voting rights in respect of securities and that the pledgee can further transfer the pledged property and/or its rights in the pledged property to its nominee/(s) without affecting the pledgor’s right to redeem the pledged property. Such transfer of the pledged property and/or rights in the pledged property to nominee/(s) of a pledgee does not amount to actual sale or sale to self. The BHC further opined that a contract of pledge allowing such rights would not be forbidden by law.

The PTC Judgment will serve as a landmark order in all matters pertaining to pledges for the benefit of the creditors. It is evident from the reading of the PTC Judgment and the World Crest Judgment that once a pledge of dematerialized securities is invoked upon a default in the debt and the pledgee becomes a beneficial owner of the pledged property, the pledgor can neither exercise its rights including voting rights in respect of the pledged property nor can it make a claim as a creditor in case of proceedings against the principal debtor under the Insolvency and Bankruptcy Code 2016. The only right available with a pledgor in such case would be that of redemption of the pledged property by discharging the debt. The PTC Judgment and the World Crest Judgment have restated and clarified the long-standing legal principals applicable to pledge. They have abetted in filling the gaps which on which the law was perhaps ambiguous, however, they do not serve as a modification of the law governing pledges. It would be imperative for the pledgors and pledgees to consider these principles while negotiating the terms of the contract governing their pledge.