Supreme Court clarifies the interplay between pledge under Contract Act and Depositories Act: PTC India Financial Services Ltd. vs. Venkateswarlu Kari (12 May 2022)

Date of the Judgment: 12 May 2022
Citation: (2022) INSC 479
Judges: M.R. Shah, J., Sanjiv Khanna, J.

Can a pawnee (lender) automatically become the owner of pledged shares by simply recording themselves as the beneficial owner in the depository records? The Supreme Court of India addressed this critical question in a recent case, clarifying the relationship between the Indian Contract Act, 1872, and the Depositories Act, 1996, particularly regarding the pledge of dematerialized securities. The court’s decision has significant implications for lenders and borrowers in the financial sector. This judgment was authored by Justice Sanjiv Khanna.

Case Background

The case involves PTC India Financial Services Limited (PIFSL), a financial institution, and Mandava Holdings Private Limited (MHPL), which had pledged shares of NSL Energy Ventures Private Limited (NEVPL) as security for a loan taken by NSL Nagapatnam Power and Infratech Limited (NNPIL). NNPIL defaulted on the loan, leading PIFSL to invoke the pledge. PIFSL, through its Depository Participant, got itself recorded as the ‘beneficial owner’ of the pledged shares in the depository records. Subsequently, insolvency proceedings were initiated against NNPIL, and a dispute arose regarding whether PIFSL could claim the full debt amount or if the value of the pledged shares should be deducted from their claim.

Timeline:

Course of Proceedings

The National Company Law Tribunal (NCLT), Hyderabad, initially ruled in favor of MHPL, stating that PIFSL’s action of recording itself as the beneficial owner was equivalent to a transfer of ownership, thus reducing MHPL’s shareholding and making MHPL a creditor to the extent of the value of the shares. The National Company Law Appellate Tribunal (NCLAT) upheld this decision, stating that once PIFSL exercised its right to become the owner of the shares, it could not use Section 176 of the Contract Act to reclaim the debt. PIFSL then appealed to the Supreme Court.

Legal Framework

The Supreme Court examined the following key legal provisions:

• Sections 172, 176, 177, and 179 of the Indian Contract Act, 1872: These sections define pledge, the rights of a pawnee (lender) upon default by the pawnor (borrower), the pawnor’s right to redeem the pledged goods, and the validity of a pledge when the pawnor has limited interest.
  
  Section 172: ‘Pledge’, ‘pawnor’ and ‘pawnee’ defined – The bailment of goods as security for payment of a debt or the performance of the promise, is called a ‘pledge’. The bailor is in this case called the ‘pawnor’. The bailee is called ‘pawnee’.
  
  Section 176: Pawnee’s right where pawnor makes default. — If the pawnor makes default in payment of the debt, or performance; at the stipulated time or the promise, in respect of which the goods were pledged, the pawnee may bring a suit against the pawnor upon the debt or promise, and retain the goods pledged as a collateral security; or he may sell the thing pledged, on giving the pawnor reasonable notice of the sale. If the proceeds of the sale are greater than the amount so due, the pawnee shall pay over the surplus to the pawnor.
  
  Section 177: Defaulting pawnor’s right to redeem. – If a time is stipulated for the payment of the debt, or performance of the promise, for which the pledge is made, and the pawnor makes default in payment of the debt or performance of the promise at the stipulated time, he may redeem the goods pledged at any subsequent time before the actual sale of them, but he must, in that case, pay, in addition, any expenses which have arisen from his default.
  
  Section 179: Pledge where pawnor has only limited interest.– Where a person pledges goods in which he has only a limited interest, the pledge is valid to the extent of that interest.
• The Depositories Act, 1996: This act governs the dematerialization of securities and introduces the concepts of ‘registered owner’ (the depository) and ‘beneficial owner’ (the actual owner). Section 12 allows for the pledge of securities held in a depository.
  
  Section 12: Pledge or hypothecation of securities held in a depository: (1) Subject to such regulations and bye-laws, as may be made on this behalf, a beneficial owner may with the previous approval of the depository create a pledge or hypothecation in respect of a security owned by him through a depository. (2) Every beneficial owner shall give intimation of such pledge or hypothecation to the depository and such depository shall thereupon make entries in its records accordingly. (3) Any entry in the records of a depository under sub-section (2) shall be evidence of a pledge or hypothecation.
• Regulation 58 of the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996: This regulation outlines the procedure for creating and invoking a pledge of dematerialized securities.
  
  Regulation 58(8): 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 emphasized that the Depositories Act and its regulations are meant to facilitate the smooth transfer of securities in a dematerialized form and do not override the fundamental principles of contract law, particularly the law of pledge. The court also highlighted that Section 28 of the Depositories Act states that its provisions are in addition to, and not in derogation of, any other law relating to the holding and transfer of securities.

Arguments

Submissions by the Appellant (PIFSL):

• PIFSL argued that recording itself as the beneficial owner was merely a procedural step to enable the sale of pledged shares and did not extinguish the debt.
• They contended that the right to sell the pledged shares under Section 176 of the Contract Act remained intact, and they had reserved this right in their notice to MHPL.
• PIFSL submitted that the Depositories Act and its regulations were not intended to override the provisions of the Contract Act relating to pledge.

Submissions by the Respondent (MHPL):

• MHPL argued that PIFSL, by getting itself recorded as the beneficial owner, had effectively taken ownership of the shares, thus extinguishing the debt to the extent of the share value.
• MHPL contended that the Depositories Act and its regulations provide a complete code for the transfer of dematerialized securities, and the Contract Act provisions are not applicable.
• They submitted that PIFSL could not claim the full debt amount without accounting for the value of the shares.

Issues Framed by the Supreme Court

The primary legal issue before the Supreme Court was:

1. Whether the Depositories Act, 1996, read with Regulation 58 of the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996, has the legal effect of overwriting the provisions relating to the contracts of pledge under the Indian Contract Act, 1872, and the common law as applicable in India.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issue

Authorities

The Supreme Court relied on several cases and provisions to clarify the law of pledge and its interplay with the Depositories Act:

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• The Court relied on Lallan Prasad v. Rahmat Ali [CITATION] and Bank of Bihar v. The State of Bihar [CITATION] to reiterate that a pawnee has a special right in the pledge, but the general property remains with the pawnor.
• The Court affirmed that the pawnee’s right to sell the pledged goods after giving reasonable notice under Section 176 of the Contract Act remains intact, as held in Balkrishan Gupta v. Swadeshi Polytex Ltd. [CITATION].
• The Court followed the principle laid down in The Official Assignee of Bombay v. Madholal Sindhu [CITATION] that the right to redeem remains until a lawful sale to a third person.
• The Court overruled the decision in Dhani Ram and Sons v. The Frontier Bank Ltd. [CITATION], which held that a sale by a pawnee to itself is valid, stating that it is contrary to the established principles of pledge.
• The Court held that the Depositories Act and the 1996 Regulations are to facilitate the smooth transfer of securities and not to rewrite the provisions of the Contract Act, as stated in Section 28 of the Depositories Act.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the need to maintain a balance between the Depositories Act and the Contract Act. The Court emphasized that the Depositories Act was enacted to streamline the process of trading in dematerialized securities, but it was not intended to override the substantive law of contracts, especially the law of pledge. The court recognized that the pawnee’s right to sell and the pawnor’s right to redeem are fundamental aspects of pledge law that must be upheld. The court also considered the commercial implications of its decision, aiming to ensure that lenders are not unjustly deprived of their security and that borrowers are not deprived of their right to redeem.

Logical Reasoning:

The Court rejected the argument that the Depositories Act and its regulations provide a complete code for the transfer of dematerialized securities, thereby overriding the Contract Act. It held that the two statutes operate in separate spheres and that the Depositories Act supplements the Contract Act rather than replacing it.

The Court clarified that the expression ‘actual sale’ used in Section 177 of the Contract Act should be read as ‘the sale by the pawnee to a third person made in accordance with the Depositories Act and applicable by-laws and rules’. It also means and requires compliance with Section 176 of the Contract Act. Mere exercise of the right by the pawnee to record himself as the ‘beneficial owner’ is not ‘actual sale’ and would not affect the rights of the pawnor of redemption under Section 177 of the Contract Act.

The Court also addressed the issue of sale by the pawnee to self, reiterating that such a sale is not a valid sale under the Contract Act and does not extinguish the pawnor’s right to redeem. However, the Court carved out an exception for listed dematerialized securities sold to third parties in accordance with the Depositories Act, stating that in such cases, the pawnor does not have a right to redemption against the third party.

The Court also addressed the issue of waiver of the right to reasonable notice under Section 176 of the Contract Act. The Court held that the requirements of Section 176 are mandatory and that, even if there is a term in the contract of a pledge to waive notice, still, the pledgee is not relieved of his obligation to give notice before the sale.

Key Takeaways

• Recording as Beneficial Owner: A pawnee (lender) does not become the owner of pledged dematerialized shares merely by recording themselves as the beneficial owner in the depository records. This is only a procedural step to facilitate the sale.
• Section 176 Compliance: Pawnees must still comply with Section 176 of the Contract Act, which requires them to give reasonable notice to the pawnor (borrower) before selling the pledged goods.
• Right to Redeem: The pawnor’s right to redeem the pledged goods continues until the ‘actual sale’ to a third party. A sale by the pawnee to self is not considered a valid sale.
• Depositories Act and Contract Act: The Depositories Act and its regulations do not override the fundamental principles of contract law, particularly the law of pledge. They operate in separate spheres.
• Exception for Listed Securities: In cases of sale of listed dematerialized securities to third parties in accordance with the Depositories Act, the pawnor does not have a right to redemption against the third party.

Directions

The Supreme Court set aside the orders of the NCLAT and NCLT, holding that MHPL is not a secured creditor of NNPIL to the extent of the value of the pledged shares. PIFSL was allowed to claim the full debt amount as a financial creditor of NNPIL without accounting for the value of the pledged shares. The insolvency proceedings against NNPIL will proceed accordingly.

Development of Law

This judgment clarifies the interplay between the Depositories Act and the Contract Act, specifically in the context of pledge of dematerialized securities. The ratio decidendi of the case is that the Depositories Act is not intended to override the Contract Act and that the pawnee must comply with the provisions of the Contract Act, especially Section 176, while exercising its right to sell the pledged goods. The judgment also clarifies that the right of redemption of the pawnor continues until the actual sale to a third party. This judgment has overruled the ratio in Dhani Ram and Sons v. The Frontier Bank Ltd. [CITATION].

Conclusion

The Supreme Court’s judgment in PTC India Financial Services Ltd. vs. Venkateswarlu Kari provides critical clarity on the law of pledge in the context of dematerialized securities. The court emphasized that while the Depositories Act streamlines the trading of securities, it does not override the fundamental principles of contract law. This decision ensures that the rights of both pawnees and pawnors are protected, promoting fairness and stability in the financial market. The judgment clarifies that the pawnee must comply with Section 176 of the Contract Act, which requires reasonable notice before selling pledged goods, and that the pawnor retains the right to redeem until the actual sale to a third party. The judgment also provides an exception for listed dematerialized securities sold to third parties in accordance with the Depositories Act, stating that in such cases, the pawnor does not have a right to redemption against the third party.