Contract Act Does Not Recognize Sale Of Pledged Goods By Pawnee To Self : Supreme Court

The Supreme Court has held that the Indian Contract Act 1872 does not recognize the sale of the pledged goods by a pawnee to himself in the event of default of payment by the pawnor.

The Court noted that as per Section 176 of the Contract Act, in the event of default by the pawnor, the pawnee may bring a suit or sell the pledged items on giving the pawnor reasonable notice of the sale.

As per Section 177, the pawnor has right to redeem the pledged goods before the actual sale of them.  The Court further noted that a pawnee has only special rights over the pledged goods - to retain them as security for the debt- and no general rights over them.

Referring to various precedents, and analyzing the differences between "ownership", "pledge" and "mortgage",  a bench comprising Justices MR Shah and Sanjiv Khanna observed that the law does not recognize the pawnee's sale to self. Sale to self is regarded as a case of "conversion" and not "actual sale" in terms of Section 177.

"Several other High Courts have similarly opined and we agree that the Contract Act does not conceive of sale of the pawn to self and consequently, the pawnor's right to redemption in terms of Section 177 of the Contract Act survives till 'actual sale'", the bench observed.

The bench also overruled the solitary judgment of the single judge of the Punjab and Haryana High Court Dhani Ram and Sons v. The Frontier Bank Ltd. and Another AIR 1962 P&H 321 which held that the sale of the pawned goods by the pawnee to himself is not void, and the pawnee was held to be the legal owner of the pledged shares. The bench said that this decision proceeds on the incorrect understanding of precedents and is to be overruled.

The bench made these observations in the case PTC India Financial Services Ltd versus Venkateswarlu Kari and another, in which it was considering the interplay between the Contract Act and the Depositories Act, 1996 in relation to the pledge of shares.

One company(MHPL) had pledged its shares with the appellant PTC India Financial Services Ltd (PIFSL) company as guarantee for a loan. After the pledge, those shares were registered with the depository with the appellant as the "beneficial owner". The issue was whether such registration as "beneficial owner" of shares would amount to sale of shares. 

This question arose in the insolvency proceedings of the debtor company. When PIFSL raised a claim as a financial debtor, MHPL(the guarantor company which pledged the shares) objected.MHPL argued that the PIFSL has sold the pledged shares and has thereby realized its debts and therefore, it is MHPL which will step into the shoes of the financial creditor.

It is in this context that the bench examined the issue if sale to self by the pawnee is recognized by the Contract Act.

Depositories Act permits pledge

The Court noted that Section 12 of the Depositories Act permits pledge and hypothecation of securities held by a depository.

"Clearly, Section 12 of the Depositories Act is not ex-facie inconsistent with pawnee and pawnor's contractual rights and obligations under the Contract Act and the common law", the judgment authored by Justice Khanna stated.

On an analysis of the provisions of the Depositories Act, it was held that they "do not in any manner contradict or lay down a rule which is contrary to the provisions of Sections 176 and 177 of the Contract Act".

"These sections(176 and 177), given the objective and purpose behind them, would still apply to any pledge deed and do not get diluted or overridden by the provisions or requirements of the Depositories Act", the judgment added.

Sections 176 and 177 apply to pawned dematerialised securities as they apply to other pawned goods

"Given the nature and requirements under Section 12 or Regulation 58 of the SEBI (Depositories & Participants) Regulations 1996, do not by implication or due to conflict over-write and undo the legislative mandate of Sections 176 and 177 of the Contract Act. We do not read any legislative intent in the Depositories Act and the 1996 Regulations to change the law of pledge requiring issue of reasonable notice; or as allowing sale to self, or abolishing the right of the pawnor to redeem the pledged goods till 'actual sale'. Sections 176 and 177 are not obliterated, in so far as they would equally apply to pawned dematerialised securities as they apply to other pawned goods".

Recording of pawnee as beneficial owner in depository is not "actual sale"

The Court held that action on the part of the 'depository' recording the pawnee as the 'beneficial owner' is not 'actual sale' for the purposes of Section 177. The right of redemption would cease on the 'actual sale', that is, when the 'beneficial owner' sells the dematerialised securities to a third person.

"In The Official Assignee versus Madholal Sindhu AIR 1947 Bom 217 and several other decisions, the expression 'actual sale' in Section 177 of the Contract Act has been interpreted to mean lawful sale to a third person and not conversion or unlawful sale contrary to Section 176 of the Contract Act. According to us, 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".

Principle that pawner has right to redeem on failure of reasonable notice will not apply to pledge of shares

The Supreme Court however held that the general principle that pawner has right to redeem on failure of reasonable notice will not apply to pledge of shares.

"We, however, accept that the Depositories Act, by-laws and rules relating to sale of dematerialised securities would be gravely undermined in case the pawnor is entitled to redeem the dematerialised shares from the third party on the ground that reasonable notice, as postulated under Section 176 of the Contract Act, was not given to the pawnor. To this extent, we would accept that there is a conflict between the Depositories Act and the interpretation given in Madholal Sindhu (supra), which has been followed in other cases, including the judgment of the Delhi High Court in Nabha Investment (supra). If this principle is applied to dematerialised securities that have been transferred to the third parties in accordance with the provisions of the Depositories Act, by-laws and rules, it would materially impact certitude in the transaction in listed dematerialised securities which would become vulnerable to challenge even when the arm's length purchasers are innocent third-party buyers for valuable considerations. Open market operations would be affected.

To this extent, therefore, we do hold that the dictum in Madholal Sindhu (supra) and Nabha Investment (supra), that the pawnor has a right to redemption against third parties when the pawnee does not give reasonable notice under Section 176 of the Contract Act, would not apply to listed dematerialised securities which are sold by the pawnee in accordance with the provisions of the Depositories Act, by-laws and rules". 

Applying the above principles to the instant case, the Court held that registration of the pawn, that is 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. MHPL is entitled to redeem the pledge before the sale to a third party is made.

The Court allowed the appeal of PIFSL and set aside the orders of the NCLT and NCLAT which held MHPL as a secured creditor of the corporate debtor. The two options available to PIFSL as the pawnee under Section 176 of the Contract Act remain and are not exhausted and it has rightly made a claim as financial creditor of the Corporate Debtor, the Court held.

Case Title : PTC India Financial Services Ltd versus Venkateswarlu Kari and another

Citation : 2022 LiveLaw (SC) 475

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Head Notes

Indian Contract Act, 1872- Sections 176 & 177 - Pledge, Pawnee & Pawnor -Contract Act does not conceive of sale of the pawn to self and consequently, the pawnor's right to redemption in terms of Section 177 of the Contract Act survives till 'actual sale' (Para 8.2)

Depositories Act 1996 - Section 12 of the Depositories Act is not ex-facie inconsistent with pawnee and pawnor's contractual rights and obligations under the Contract Act and the common law (Para 10.2)

Depositories Act 1996 - 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'-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. (10.4)

Depositories Act 1996 -Principle that pawner has right to redeem on failure of reasonable notice will not apply to pledge of shares -We, however, accept that the Depositories Act, by-laws and rules relating to sale of dematerialised securities would be gravely undermined in case the pawnor is entitled to redeem the dematerialised shares from the third party on the ground that reasonable notice, as postulated under Section 176 of the Contract Act, was not given to the pawnor (10.5)