Supreme Court holds that (i) Sections 176 and 177 of the Indian Contract Act, 1872 (viz., rights available to a pawnee and a defaulting pawner) apply equally to pledged dematerialized securities as they would apply to other pawned goods; and that (ii) mere registration by a pawnee as a ‘beneficial owner’ of dematerialized shares (within the meaning of the Depositories Act, 1996) does not have the effect of discharge of debt.
In a landmark and significant judgement rendered by the Supreme Court of India on 12 May 2022 (in the matter of PTC India Financial Services Limited v Venkateswarlu Kari and Another, CA No. 5443 of 2019), the Supreme Court has settled some key aspects of the law relating to pledge and the interplay between the Depositories Act, 1996 and the Indian Contract Act, 1872.
The primary legal issue before the Court was whether the Depositories Act, 1996 (“Depositories Act”) read with Regulation 58 of the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 (“1996 Regulations”) has the effect of overwriting the provisions relating to contracts of pledge under the Indian Contract Act, 1872 (“Contract Act”) and the common law as applicable in India.
Brief facts leading to the case
PTC India Financial Services Limited (“PIFSL”) had advanced a loan of INR 125 Crores to NSL Nagapatnam Power and Infratech Limited (“NNPIL”) by way of a Bridge Loan Agreement dated 10 March 2014. This loan was secured by a Pledge Deed executed by Mandava Holdings Private Limited (“MHPL”), wherein MHPL had pledged certain shares of NSL Energy Ventures Private Limited (“NEVPL”) (a subsidiary of MHPL) in favour of PIFSL.
As the debt remained unpaid, PIFSL wrote to the Depository Participant, invoking its right under the Pledge Deed. Acting on the request, the Depository Participant accorded PIFSL the status of ‘beneficial owner’ of the pledged shares of NEVPL.
Subsequently, an order for commencement of corporate insolvency resolution process of NNPIL was passed by the National Company Law Tribunal (“NCLT”) and an interim resolution professional (“IRP”) was appointed. PIFSL submitted its financial claim before the IRP for the amount being due and payable by NNPIL. MHPL too submitted its claim before the IRP stating inter alia that once PIFSL has been conferred the status of ‘beneficial owner’ of the pledged shares, MHPL no longer had any title or right over such shares; and that it is MHPL which now had a claim against NNPIL (and not PIFSL). The IRP rejected PFS’s claim on the ground that the same stood satisfied by transfer of the pledged shares in the depository participant account of PIFSL. Against the IRP’s rejection of PIFSL’s financial claim, PIFSL preferred an application before the NCLT; and being dissatisfied with NCLT’s decision also, a further appeal to the NCLAT. Both NCLT and NCLAT held that PIFSL’s settled the dues by way of transfer of pledged shares in its depository participant account. PIFSL challenged these decisions before the Supreme Court.
Supreme Court examines in detail the law relating to pledge
What is pledge and the legal difference between ownership, pledge and mortgage
The Supreme Court noted that the distinction between a ‘pledge’ and a ‘mortgage’ of movable property is that under a pledge, there is only a bailment, whereas under a mortgage, there is transfer of the right of the property by way of security. Therefore, unlike a pledgee, a mortgagee acquires general rights in the things mortgaged, subject to the right of redemption of a mortgagor. In other words, the legal estate in the goods mortgaged passes on to the mortgagee. In comparison, a pawnee has only the special right in the goods pledged, namely, the right of possession as security and in case of default, he can bring a suit against the pawnor as well as sell the goods after giving a reasonable notice.
Notice of sale and pawnee’s right to sue for recovery and sell the pawned goods
The Supreme Court noted the decisions of various High Courts holding that while the pawnee has a right to sell the goods after giving notice to the pawnor, he is not bound to sell at any particular time. The power of sale conferred on the pawnee is expressly for his benefit, and it is his sole discretion to exercise the power of sale or otherwise. If the pawnee does not exercise that discretion, no blame can be put on him.
The Court also observed that Section 176 of the Contract Act requires that the pawnee may sell the thing pledged on giving the pawnor reasonable notice of the sale. The object and purpose of giving notice is to make the pawnor know about the pawnee’s intent to sell the pawn and give him an opportunity to exercise his statutory right of redemption, which, as per Section 177, can be exercised till the date of ‘actual sale’.
Effect and purpose of the Depositories Act, 1996 and the 1996 Regulations
The Depositories Act establishes the depository eco-system and introduces the concepts of a ‘registered owner’ and ‘beneficial owner’. The Court noted that while the Depositories Act distinguishes between the ‘registered owner’ and the ‘beneficial owner’ (i.e., the de facto owner), however, this does not contradict or lay down a rule which is contrary to Sections 176 and 177 of the Contract Act. These sections, as per the Court, would still apply to any pledge deed and do not get diluted or overridden by the provisions or requirements of the Depositories Act.
The Court then analysed Regulation 58(8) of the 1996 Regulations, which provides that “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.”
The Court observed that sub-regulation (8) to Regulation 58 uses the expression “subject to the provisions of the pledge document” with a specific purpose and objective, i.e. it does not seek to curtail or restrict, but on the other hand respects party autonomy and freedom to decide the terms of the pledge, including the event of default that would entitle the pawnee to invoke the pledge and sell the pawn. The sub-regulation does not expressly nullify any provision of the Contract Act. However, the stipulation that the pawnee may invoke the pledge, and on such invocation, the pawnee is to be recorded as the ‘beneficial owner’ of the pledged securities is mandatory. Without the pawnee being accorded the status of a ‘beneficial owner’, a pawnee cannot proceed to sell the pledged dematerialized securities.
At the same time, the Court also cautioned that while the contractual terms are fundamental and determine the rights and obligations inter se the parties, including when the pawnee would be entitled to get his name substituted as a ‘beneficial owner’, however, the contractual terms are not permitted to override the Contract Act in so far as it regulates the rights and obligations of the pawnee and pawnor, and the requirement of compliance with Regulation 58(8).
Effect of the Depositories Act, 1996 and the 1996 Regulations on the pledge under the Contract Act
The Supreme Court made pertinent observations on the interplay between the Depositories Act and the Contract Act. The Court noted that if a pawnee wants to exercise his right to sell dematerialized security, it is mandatory first to get himself recorded as a ‘beneficial owner’ in the ‘depository’s records. Without the said exercise, the pawnee cannot exercise its rights to sell the pledge and retrieve the monies due by taking recourse to its rights under Section 176 of the Contract Act.
However, exercise of right on the part of the pawnee and consequent action on the part of the ‘depository’ recording the pawnee as the ‘beneficial owner’ is not ‘actual sale’. The pawnor’s right to redemption under Section 177 of the Contract Act continues and can be exercised even after the pawnee has been registered and has acquired the status of ‘beneficial owner’. The right of redemption would cease on the ‘actual sale’, that is, when the ‘beneficial owner’ sells the dematerialised securities to a third person. Once the ‘actual sale’ has been affected by the pawnee, the pawnor forfeits his right under Section 177 of the Contract Act to ask for redemption of the pawned goods.
The Court also held that the Depositories Act is in addition to other laws relating to the holding and transfer of securities, and its provisions and/or the provisions of the 1996 Regulations are not in derogation or conflict with Sections 176 and 177 of the Contract Act. Regulation 58(8) entitles the pawnee to record himself as a ‘beneficial owner’ in place of the pawnor. However, mere exercise of the right by the pawnee to record himself as the ‘beneficial owner’, which is a necessary precondition before the pawnee can exercise his right to sell, is not ‘actual sale’ and would not affect the rights of the pawnor of redemption under Section 177 of the Contract Act.
Application of the law to the facts of the case at hand
In the facts of the case, the Court noted that the clauses of the Pledge Deed draw a clear distinction between a mere transfer of the pledged shares in the name of the pawnee or its nominee as a ‘beneficial owner’ and the ‘actual sale’ of the pledged shares. Thus, there are two stages before the pledge can be enforced by a sale. At the first stage, the pawnee must give notice to the pawnor to exercise the rights to have the pledged shares transferred in its name or its nominees. This does not result in the discharge of the debt equal to the value of the shares. The discharge of debt in whole or part occurs when the pawnee exercises his right to sell the shares after giving notice to the pawnor and sells the pawn. Upon the actual sale, the pawnee can apply the net proceeds of the sale or disposition.
The Supreme Court further held that the law of pledge is dynamic and must adapt itself in the context of the current commercial environment; and that while interpretating the law relating to commercial matters and commerce, the court must consider the real-world impact and consequences.
The Supreme Court, therefore, held as follows:
- On becoming the ‘beneficial owner’ in the records of the ‘depository’, the pawnee had complied with the procedural requirement of Regulation 58(8) to enforce the right to sell the shares. Thereafter, such a sale should be made according to Sections 176 and 177 of the Contract Act. Recording change in the register of the ‘depository’, whereby PIFSL (as the pawnee) has become the ‘beneficial owner’, was only to enable the pawnee to sell and transfer the shares in accordance with the Depositories Act and the 1996 Regulations.
- Registration of the pawn i.e. the dematerialised shares in favour of PIFSL as the ‘beneficial owner’ does not have the effect of sale of shares by the pawnee. The pledge has not been discharged or satisfied either in full or in part. PIFSL is not required to account for any sale proceeds which are to be applied to the debt on the ‘actual sale’. The two options available to PIFSL as the pawnee under Section 176 of the Contract Act remain and are not exhausted.
In the above background and analysis, the Supreme Court allowed PIFSL’s appeal and set aside the judgments and orders passed by the NCLT and the NCLAT.
PIFSL was represented in these proceedings by JSA (team comprising Sidharth Sethi, Partner and Pallavi Kumar, Senior Associate). The matter was argued on behalf of PIFSL by Mr. Maninder Singh, Senior Advocate and Sidharth Sethi, Advocate.
 Civil Appeal No. 5443 of 2019