A Supreme Court Ruling On Loans Against Pledged Shares May Come Handy For Reliance Capital

The apex court has clarified the law on pledge of securities which will impact transactions involving loans against shares.

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(Image: PxHere)

In an important ruling, the Supreme Court has clarified the law on pledge of securities which will impact transactions involving loans against shares.

Merely because the entity which has extended the loan has become the beneficial owner of pledged shares doesn't mean the debt has been discharged, the apex court held.

Loan against shares is a very common transaction structure specifically for NBFCs and the judgment will help bring clarity for them in line with the letter and spirit of the law, said Veena Sivaramakrishnan, partner at Shardul Amarchand Mangaldas.

The Issue

PTC India Financial Services Ltd. had extended a Rs 125 crore to NSL Nagapatnam Power and Infratech Ltd. NSL's parent—Mandava Holdings—pledged 26% shares of another subsidiary, NSL Energy Ventures Pvt. Ltd., to secure the loan.

Since the debt wasn't paid, PTC moved to get itself registered as the beneficial owner of the pledged shares of NSL Energy. But before the sale could happen, NSL Power went into insolvency.

PTC Financial filed its claim as the financial creditor of the company, which was contested by Mandava Holdings or MHPL. Since PTC Financial had become the beneficial owner of the pledged shares, the value of the shares must be deducted from their claim, MHPL argued.

The National Company Law Tribunal accepted this argument, saying MHPL was a financial creditor to the extent of the 26% shares transferred to PTC Financial. The appellate tribunal also came to the same conclusion, prompting an appeal by PTC Financial before the apex court

The Supreme Court's View

The court examined the interplay between law of pledge under The Contract Act,1872 and the Depositories Act,1996 as well as Securities and Exchange Board of India (Depositories and Participants) Regulations,1996.

It pointed out that just because the entity which has received the pledge—in this case PTC Financial—has become the beneficial owner does not have the effect of sale of shares by it. The pledge is not discharged or satisfied either in full or in part until the sale of shares happen, it said. And that the entity which has given shares as security—in this case MHPL—would continue to have the option of redeeming it until the actual sale of securities has happened.

Invocation of a pledge in shares by getting registered as the beneficial owner with a depository would not mean the end of the road for the one who had given the security, said the Supreme Court.

Getting recognised as a ‘’beneficial owner’’ would not mean ‘’final sale’’ as per contract law, the apex court held. The sale of the pledge, it explained, can take place only to a third person. Sale to itself would be conversion which is not the actual sale as per law of pledge and the right of redemption would continue to vest with the one who had given the security, the court pointed out while upholding PTC Financial's case.

The act of getting registered as a beneficial owner was only an additional procedural step in the process of sale of a pledge. The actual sale will only happen when the shares are transferred to a third person and until then there will be an option to redeem the pledge, noted the Supreme Court.

Commercial Impact

The ruling has clarified that there is no conflict between the provisions of the Depositories Act and the Indian Contract Act. Mere declaration as a beneficial owner does not tantamount to a sale of shares, said Nirav Shah, partner at DSK Legal

The Depositories Act only enables the pawnee (in this case PTC Financial) to get the shares registered in its own name so that it can take steps to sell the shares, Shah said.

The provisions of the Depositories Act are only to enable the pawnee to take the relief provided under the law of pledge in Contract Act. The substantive provisions are in the Contract Act and the provisions of the Depositories Act are in aid of exercising those rights.
Nirav Shah, Partner, DSK Legal

While the clarity this ruling brings is welcome, there are still some unanswered questions from a practical perspective, Sivaramakrishnan said.

And that's got to do with the economic loss from the time a pledgee has registered themselves as a beneficial owner and the final sale of shares she pointed out.

There are cases where the pledgee can hold invoked shares without selling it because of commercial and market consideration. At the end of the day the borrower doesn’t have the right to claim the shares back until the borrower pays for it to redeem it. Tomorrow, if the pledgee does not sell the shares for years for example and the share prices keep falling then who bears that loss? The answer probably lies in the contract of pledge itself.
Veena Sivaramakrishnan, Partner, Shardul Amarchand Mangaldas & Co.

Unanswered questions apart, the apex court's ruling will be relevant to determine the rights of parties in transactions involving pledge of shares.

Incidentally, the exact issue is alive in the insolvency proceedings of Reliance Capital Ltd.

Reliance Home Finance Ltd. had issued non-convertible debentures which it failed to redeem. As part of the restructuring terms of these NCDs in 2019, RHFL's promoter—Reliance Capital—had pledged its entire shareholding in Reliance General Insurance Co. in favour of IDBI Trusteeship Services—the debenture trustee.

Reliance Capital is now arguing before the insolvency tribunal that just because IDBI Trusteeship has ownership of Reliance General Insurance's shares doesn't mean "my custody and ownership of those shares has come to an end", senior counsel Ravi Kadam told the NCLT this week. And since IDBI Trusteeship hadn't sold the shares until Reliance Capital's insolvency commenced, the shares need to be returned to the administrator, Kadam said while relying on the apex court ruling in PTC Financial's case.