Pledge invocation and the Takeover Code in India: time for a change?
The Indian Supreme Court’s judgment in PTC India Financial Services Limited v. Venkateswarlu Kari & Another (May 2022) (the ‘Judgment’) sets out to clarify contentious issues surrounding the invocation of pledges. This post does not seek to add to the fairly extensive body of literature that has built up on the judgment: instead, it examines a stray observation in the Judgment calling for an amendment of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the ‘Takeover Code’).
The Supreme Court’s decision in the Judgment
The primary issue considered was whether there is a distinction in law between invocation of a pledge and sale of pledged shares.
Four parties are significant: PTC India Financial Services Limited (‘PTC’), Mandava Holdings Pvt. Ltd. (‘Mandava’), NSL Nagapatnam Power and Infratech Limited (‘NNPIL’), and NSL Energy Ventures Pvt. Ltd. (‘NEVPL’)
PTC had advanced a loan to NNPIL against a pledge by Mandava of its shareholding in NEVPL. Following a default, PTC invoked the pledge. Following the pledge invocation, PTC was registered as the ‘beneficial owner’ of the pledged shares of NEVPL on the books of the depository participant. In such circumstances, the pledgee can choose to sell the pledged shares and recover the amounts due, but the pledged shares in the case at hand were never sold. Rather, PTC continued to claim the entire debt from NNPIL following the invocation of the pledge. Questions arose as to PTC’s entitlements as a creditor of NNPIL and whether its invocation of the pledge affected the amounts due to it from NNPIL. Traveling up the judicial pipeline, the issues reached the Supreme Court.
The Court held (amongst other findings) that:
- the rights of a pledgee are narrower than those of an owner. A pledgee did not have the right of ownership. A pledgee simply had a limited right to retain possession of the goods until the debt was paid;
- the pledgee is not bound to sell the pledged goods at any particular time. The pledgee remains entitled to sue on the debt concurrently with their right to retain the pawn;
- the pledgee cannot sell the pledged goods to itself.
It follows that the recording of the pledgee as ‘beneficial owner’ is simply a legal sleight of hand, allowing the pledgee to sell the shares onwards to a third party without any further requirement of consent or active participation by the pledgor. But until the time of actual sale to a third party, the pledgor remains entitled to redeem the shares on payment of the debt to the pledgee.
Overlap with the Takeover Code
The Takeover Code regulates direct and indirect acquisitions of shares or voting rights in a target company. It mandates that all acquisitions of shares beyond certain defined thresholds trigger the requirement for the acquirer to make an open offer to acquire other shareholders’ shares at a determined price. The objective is to ‘provide an exit route to the public shareholders when there is substantial acquisition of shares or a takeover’.
Pledge invocations are covered by the Takeover Code on account of Regulation 58 of the Securities & Exchange Board of India (Depositories and Participants) Regulations, 1996. It specifies that on invocation of the pledge, the depository modifies its books to record the pledgee as the beneficial owner of pledged shares. Acquiring status as a beneficial owner is the ‘acquisition’ which triggers the application of the Takeover Code.
There is a limited exception: Regulation 10(2)(b)(viii) of the Takeover Code states that in case of an invocation of a pledge by Scheduled Commercial Banks or Public Financial Institutions as pledgees, there is an exemption from the obligation to make an open offer. This implies that every time a pledgee other than banks or public financial institutions invokes a pledge, the pledgee is required to make an open offer.
This open offer requirement ensures that when new entities acquire significant shareholding in a company, existing shareholders who do not want to stay invested (on account of the acquisition) are able to exit.
The Judgment makes clear that the pledgee acquires no general ownership rights over the shares. The pledgee enjoys no rights of governance or management or control (or even ownership as commonly understood) of the company on the basis of those shares. It can simply hold on to the pledged shares as ‘beneficial owner’ until the debt is discharged.
Given that the pledgee is recorded as a ‘beneficial owner’ but in fact acquires no rights in the target company, there is no change requiring any shareholder to be afforded an exit opportunity. Nevertheless, the pledgee is required under the Takeover Code to make an open offer, unless covered by the exception in Regulation 10(2)(b)(viii).
This exception is needlessly narrow. There was no reason to restrict the exception to public financial institutions and scheduled commercial banks. The report which formed the basis of the Takeover Code notes that loans backed by pledges are routine, and these pledges do get invoked on default. On this basis, the report ‘considered it appropriate to exempt acquisition of shares by a consortium of banks pursuant to invocation of a pledge’. It backs this up with an unsupported assertion that ‘normally the shares so pledged with an individual bank would be well within the enhanced threshold specified’. Essentially, the exemption was withheld from individual banks because the committee felt it would not be necessary, and not based on any principled reason. It is hard to sustain this logic and continue to keep the exception limited. The logical next step would be to make the exception cover all instances of pledge invocation.
In making this recommendation, a caveat is in order: each pledge agreement differs. The Judgment specifies that pledge invocation by itself does not confer any general ownership rights on the pledgee. However, certain pledge agreements do contain provisions that confer on pledgees voting rights and other management rights. Logically, pledge invocations in these cases could constitute acquisitions.
The simplest way would be to call on the pledgee to determine whether the pledge documentation gives the pledgee voting or management rights (this is a determination that the pledgee can make prior to invocation). If yes, then the pledgee proceeds with the open offer requirement process. If no, then the invocation is exempt. While questions may arise as to potential conflicts of interest in this process, there are some mitigating factors. The pledgees are not legally permitted to sell the shares to themselves or appropriate them as repayment of the debt. Moreover, under the Takeover Code, the pledge documents themselves are always disclosed to the market regulator, which may determine that there has been a change in control that has not been disclosed and choose to proceed against the pledgee for wrongful disclosure.
The amendments above would not be entirely unexpected. The Court observed in the Judgment that the Securities and Exchange Board of India (‘SEBI’) ‘may’ re-examine the takeover code to ‘avoid discord or ambiguity resulting in instability or confusion’. Elaborating on the need for SEBI’s review, the Court stated:
‘The takeover regulations may have its own impact and in a given case, may be a detriment and a negative factor for the creditor who wants to secure himself by a deed of pledge. The pertinent question is, should takeover regulations apply when the pawnee exercises his right to be recorded as a ‘beneficial owner’, while reserving his right to sell the pledge’.
SEBI ought to take this stray observation as impetus for long needed reform, and align the Takeover Code with the position of law following the Judgment. This is low-hanging fruit, and will go a long way in simplifying needlessly complex securities regulations.
Neeraja Balakrishnan is an India-qualified lawyer, specialising in commercial disputes. She also consults for Lextel Partners.
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