Every Transfer Or Sale Is Not 'Actual Sale': Clarifies Supreme Court

Facts:

• PTC India Financial Services Limited (PIFSL) by way of a Bridge Loan Agreement dated 10th March 2014 had advanced a loan of Rs. 125 crores to NSL Nagapatnam Power and Infratech Limited (NNPIL/Corporate Debtor).

• Mandava Holdings Private Limited (MHPL), executed a Pledge Deed in favour of PIFSL, thereby, pledging 31,80,678 shares, equivalent to 26% of the shares of NSL Energy Ventures Private Limited (NEVPL) to secure the loan the availed by NNPIL. NNPIL and NEVPL are subsidiaries of MHPL.

• On 17th November 2017, the Corporate Debtor filed a petition invoking Section 10 of the Insolvency and Bankruptcy Code, 2016 seeking for initiating the corporate insolvency resolution process (CIRP) which got admitted on 18.01.2018.

• On 28th December 2017, PIFSL issued a notice under the Pledge Deed apprising MHPL on the defaults on the part of Corporate Debtor and that if the debt due was not discharged within seven days, PIFSL would exercise the rights in terms of the Pledge Deed.

• On 16th January 2018, as the debt remained unpaid, PIFSL wrote to the Depository Participant invoking its rights in terms of Clause 6.1 of the Pledge Deed. Acting on the request, the Depository Participant has accorded PIFSL the status of 'beneficial owner' of 31,80,678 pledged shares of NEVPL.

• On 23rd January 2018, PIFSL wrote to MHPL informing that due to continued defaults in payment on the part of the Corporate Debtor, it had exercised the right under Clause 6.1, while reserving its right to sell the shares under Clause 6.2 of the Pledge Deed read with Section 176^[2] of the Contract Act.

• On 6th February 2018, MHPL made a claim before the IRP, inter alia, stating that PIFSL having been conferred status of 'beneficial owner', MHPL no longer has any title or right over 31,80,678 shares. Accordingly, MHPL had stepped into the shoes of PIFSL as a creditor of the Corporate Debtor to the extent of the value of 31,80,678 shares of NEVPL now owned by PIFSL.

• Contrarily, on 10th February 2018, PIFSL submitted Form C with a financial claim of Rs.169,19,17,637/-, being the amount due and payable to PIFSL by the Corporate Debtor as of 18th January 2018, the date on which the Adjudicating Authority admitted the Section 10 application of the Corporate Debtor. The value of 31,80,678 pledged shares was not accounted for or reduced.

• On 19th February 2018, IRP, by two separate emails, informed that MHPL's claim could not be crystalized as it was not possible to ascertain the value of 31,80,678 shares 'transferred' to PIFSL. Similarly, PIFSL's claim cannot be crystalized due to the settlement in whole/part of its claim and the need to arrive at the valuation at the time of 'transfer' of shares to PIFSL.

• PIFSL and MHPL preferred separate applications before the Adjudicatory Authority against the rejections of their claims.

• By a common order dated 6th July 2018, the Adjudicating Authority disposed of the applications filed by PIFSL and MHPL, accepting the MHPL's claim by primarily relying on the Depositories Act and Regulation 58^[3] of the 1996 Regulations. The Adjudicating Authority agreed with MHPL that PIFSL having exercised its right under the Pledge Deed to 'transfer' 31,80,678 pledged shares, MHPL's shareholding in NEVPL got reduced by 31,80,678 shares. Therefore, MHPL is a financial creditor of the Corporate Debtor to the extent of the value of 31,80,678 shares.

• PIFSL challenged the orders before Hon'ble National Company Law Appellate Tribunal, New Delhi, but the appeals were dismissed vide the impugned judgement dated 20th June 2019. The Appellate Authority has held that PIFSL had exercised its rights under Clause 6.1 of the Pledge Deed on 16th January 2018 and consequently, the pledged shares stood transferred in the name of PIFSL. Once PIFSL has exercised right to become the owner of the shares, PIFSL cannot take advantage of Section 176 of the Contract Act to 'reclaim' the debt. Aggrieved by the said orders, appeal was preferred before Hon'ble Supreme Court.

Issue:

Whether sale by pawnee to self is valid and recognized under the Indian Contract Act 1872?

Answering the question, Hon'ble Supreme Court observed the following:

i. Section 176 of the Indian Contract Act, 1872 requires that the pawnee may sell the thing pledged on giving the pawnor reasonable notice of the sale. It does not prescribe any fixed form of notice or specify any fixed period of notice.

ii. 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'.

iii. Whether or not a notice was given and the period of notice was reasonable would depend upon the facts of the case. The pawnor can communicate his willingness and desire to the pawnee that the pledged goods may be sold. In case any such request is made, a pawnee may well act upon the request without violating Section 176 of the Contract Act. However, a pawnee, unless he also agrees, cannot be compelled by the pawnor to sell the pledged goods.

iv. Several judgements and Section 177 of the Contract Act, which confers on the defaulting pawnor the right to redeem the pledged goods till 'actual sale', does not support pawnee's sale to self. Sale to self would in terms of the judgement in Madholal Sindhu's case is a case of conversion and not 'actual sale', and therefore, would not affect the pawnor's right to redemption under Section 177 of the Contract Act. 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 pawnor is bound by the resale duly effected by the pawnee to third persons. However, where the pawnee has erroneously represented to the pawnor before such resales that the securities have been sold and, therefore, no longer available for redemption, the pawnee becomes liable for the value as conversion.

v. The Hon'ble Supreme Court while analysing various case laws had occasion to deal with the following other aspects:

a) Pledge and the legal difference between ownership, pledge and mortgage: A contract of pledge should satisfy the following conditions: (i) there should be a bailment of goods as defined in Section 148 of the Contract Act, that is, delivery of goods; (ii) the bailment must be by way of security; and (iii) the security must be for payment of debt or performance of a promise. There is no standard format and incidents in a contract of pledge can be different. A term mutually agreed by the parties is valid as long as it is not contrary to or inconsistent with any provision of the Contract Act. A pledge creates an estate or a right that vests with the pawnee. An owner has: (a) right of possession; (b) right of enjoyment; and (c) the right of disposition. A pawnee does not have the right of ownership, but has limited right to retain possession till debt is paid or promise is performed. A pawnee's right of disposition is limited to disposition of the pledge rights only, and the right to sell after reasonable notice. Even when the pawnor makes default in payment of debt or performance of the promise, the pawnor has the right to redeem the pawn till 'actual sale' of the pawn by the pawnee.

b) Pawnee has a special and not general right in the pledged property: Section 173 of the Contract Act provides that the pawnee may retain the goods pledged only for payment of the debt, performance of the promise and also for interest on the debt, etc. The pawnee has a special property or interest in the thing pledged while the general property therein continues in the owner. The special interest exists in the pawnee so that the pawnee can compel payment of the debt or sell the goods when the right to do so arises. This special interest is distinguished from mere right of detention that the holder of lien possesses, since the pawnee may assign or pledge his special property or interest in the goods.

c) Accretion on pawned goods: Referring to Section 163 of the Contract Act, it is observed that in the absence of a contract to the contrary, the bailee is bound to deliver to the bailor, or according to his directions, any increase of profit that may have accrued from the bailed goods. An example in this Section states that if a calf is born to the cow, then the bailee is bound to deliver the calf as well as the cow to the bailor. In other words, the pledge extends to accretions and additions, and therefore, when the pawnee returns the pledged goods, the accretions and additions must be returned to the pawnor. It also follows that the pawnee's right to retain and sell the pledged goods stretches to the right to retain and sell any increase and accumulations to the pledged goods.

d) Notice of sale by pawnor and his right to sale: 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. Even where the value of the goods deteriorates due to time, no relief can be granted to the pawnor against the pawnee as the pawnor is legally bound to clear the debt and obtain possession of the pawned goods.

e) Effect and Purpose of the Depositories Act, 1996: The Depositories Act is enacted to lay down a process and Rules for the dematerialization of securities by converting them into electronic data stored in the computers of 'the depository'. Every owner of a physical share has to enter into an agreement with 'the depository' for availing its services. 'The depository' becomes the 'registered owner' in respect of the security, whereas the person who surrenders the physical shares is recorded as 'the beneficial owner'. 'The depository', as the registered owner, does not have any voting right or any other right in respect of the securities held by it. 'The beneficial owner' shall be solely entitled to all rights, benefits, and liabilities attached to the securities held by 'the depository'. Further every 'depository', on receipt of intimation from a participant, is required to transfer the security in the transferee's name. Further, on registration of transfer of security in the transferee's name, the transferee is registered as the 'beneficial owner'.

f) Effect of the Securities and Exchange Board of India (Depositories and Participants) Regulation, 1996 ("DP Regulations") on the pledge under the Indian Contract Act, 1872: The special rights of the pledgee/pawnee in the pawn remain intact under the Depositories Act and the 1996 Regulation. However, the right to sell dematerialized securities is conferred and given to the 'beneficial owner', who exercises this right through the participants. Consequently, if a pawnee wants to exercise his right to sell dematerialized security it is mandatory for the pawnee 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. The expression 'actual sale' used in Section 177 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', 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. Every transfer or sale is not 'actual sale' for the purpose of Section 177 of the Contract Act. To equate 'sale' with 'actual sale' would negate the legislative intent. The 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.

This judgement will have positive impact on creditors and financial markets and is also likely to end and discourage frivolous legal proceedings by pledgor(s). The Supreme Court clarified that registration of the pawn as a beneficial owner does not have the effect of sale of shares by the pawnee while reiterating that such pledges continue to be governed by relevant provisions of the Indian Contract Act, 1872; Depositories Act, 1996 and DP Regulations.

Authors: Ravi Charan Pentapati (Partner) and Ayushi Verma (Intern) at Link Legal. Views Are personal.