In India, out of the over 5000 listed companies, promoters of 4274 companies had pledged all or

some of their shares, according to an analysis by Securities and Exchange Board of India as
quoted in the recent RBI Financial Stability Report. Of these, promoters of 286 companies had
pledged more than 50% of their shareholding. Pledge of shares has increasingly become a
common practice resorted to by the corporate world to raise finances. Shares may be offered as
security to the lenders either by the promoter or the borrower itself. Ordinarily, shares of the
borrower company are offered, but depending upon the mode of transaction, shares of affiliate
companies may also be accepted by the lenders. Like in case of project based financing, to ensure
some degree of control over the project lenders stipulate pledge of shares of the borrower
company only. Pledge of shares as concept, act and process, is amenable to various laws,
principles, and rules and regulations that have evolved over a period of time.

Pledge as a legal concept

One of the fundamental statutes dealing with the principles of pledge is the Indian Contract Act,
1872, which defines pledge as the bailment of goods as security for payment of a debt or
performance of a promise *(Section 172, Indian Contract Act, 1872). The bailor is referred to as
the “pawnor/pledgor” and the bailee as the “pawnee/pledgee”. Bailment means delivery of
goods by one to another for some purpose, upon a contract that they shall, when the purpose is
accomplished, be returned or otherwise disposed of according to the directions of the person
delivering the them *(Section 148 of the said Act). So in order to constitute a valid pledge, what
is essential is that there must be a delivery of the article, either actual or constructive, to the
pledgee. Constructive delivery applies to all those cases where the pledgor remains in possession
of the goods under specific authority of the pledgee, or for limited purposes. The essential test is
not the purpose for which the pledgor is permitted to retain possession, but whether the
dominion of the pledgee over the goods is retained, and the physical possession or handling of
the goods by the pledgor is under delegated authority of the pledgee, or is independent. The
pledgee may retain the goods pledged not only for payment of the debt or performance of the
promise, but for the interest of the debt, and all necessary expenses incurred by him in respect of
the possession or for the preservation of the goods pledged *(Section 173).

The essential distinction between a pledge and a mortgage is that unlike a pledge a mortgagee acquires a
general property in the thing mortgaged subject to the right of redemption the mortgagee. In
other words, the legal estate in the mortgaged property passes on to the mortgagor and as a legal
corollary, the right to enjoyment of the mortgaged property vests with the mortgagee. Unlike a
mortgage, a pledge does not have the effect of transferring any “interest” in the property in
favour of the pledgee, who has only the special property in the goods pledged. The special
property is the right of the pledgee to keep possession of the pledged goods and to dispose them
of for the realisation of the debt after a reasonable notice of the intended sale to the pledgor. As
observed by Supreme Court *(Lallan Prasad v Rahmat Ali, AIR 1967 SC 1322), the two
ingredients of the pledge are:

“(1) that is essential to the contract of pawn that the property pledged should be actually or
constructively delivered to the pawnee, and (2) a pawnee has only a special property in the pledge
but the general property remains in the pawnor and wholly reverts to him on discharge of the
debt. The right to property vests in the pledgee only so far necessary as is necessary to secure the
debt……..The pawnor, however, has a right to redeem the property pledged until the sale.”
*(Balkrishna Gupta vs. Swadeshi Polytex Ltd. AIR 1985 SC 520)

Though pledge creates a special property in the goods in favour of the pledgee, the general property
therein remains with the pledgor. It is interesting to note that in cases of pledge of shares, it is by
virtue of this general property that any accretion by way of dividends, bonus or right shares in
respect of the rights shares, in the absence of any contract to the contrary, becomes the property
of the pledgor.

Where the pledgor makes default in payment of the debt within a stipulated time, in respect of
which the goods were pledged, the pledgee may institute a suit against the pledgor upon the debt
and retain the goods pledged as a collateral security; or he may sell the pledged goods on giving
the pledgor reasonable notice of the sale. The pledgee has a right to sell the pledged goods
without reference to the court. But that does not affect the pledgee’s right to sue the pledgor on
the debt or bring a suit for sail of the goods pledged. If the proceeds of the sale are less than the
amount due in respect of the debt or promise, the pledgor is still liable to pay the balance. If the
proceeds of the sale are greater than the amount due, the pledgee shall pay over the surplus to
the pledgor *(Section 176 of the Indian Contract Act, 1872). So long as the sale does not take
place, the pledgor is entitled to redeem the goods on payment of the debt *(Section 177, Indian
Contract Act, 1872). It follows therefore, that where a pledgee files a suit for recovery of debt,
though he is entitled to retain the goods, he is bound to return them on payment of the debt.

Pledge in the era of demilitarization

With the enactment of the Depositories Act, 1996, pledging of shares of the listed companies
began to be governed by it as the shares of listed companies are compulsorily required to be held
in dematerialized form. Section 12 of the Depositories Act, 1996 which prescribes the manner of
creation of pledge held in a depository, reads as under:

(1) Subject to such regulation and bye-laws, as may be made in 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 in respect of a
security owned by him through a depository.
(3) An entry in the records of a depository under sub-section (2) shall be evidence of a pledge or
hypothecation.

Pledge of shares in dematerialized form cannot be done involving the delivery of the shares in
question as the same are maintained otherwise than in physical form. The mode and manner of
creation of pledge of dematerialized shares have been provided for in the Regulation 58 of the
Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996. (Refer
the Box)

The pledgor submits an instruction to its DP to initiate a pledge/hypothecation request with

requisite the details. If the form is complete in all respects, the DP will accept the form for
processing and issue an acknowledgment for the same to the pledgor. The DP will enter the
details of the request, generate a pledge/hypothecation instruction number for the request and
release the request to NSDL. The securities pledged are moved from 'Free balances' to 'Pledged
balances' account. Thus the securities pledged will not be available to pledgor for any other
purpose. The DP shall write the pledge/hypothecation instruction number on the
pledge/hypothecation form and intimate the same to the pledgor.

The details of the pledge/hypothecation are electronically communicated to pledgee's DP for

confirmation. The pledgee's DP will furnish the details of the pledge/hypothecation requests
received for confirmation to the pledgee. The pledgee will submit an instruction to its DP to
accept/reject the pledge/hypothecation request by indicating the option 'confirm the creation of
pledge/hypothecation' in the pledge/hypothecation form.

Pledge and the disclosure regime

Disclosure of encumbrances on the assets of publically traded companies has been the
cornerstone of market regulators’ drive to usher in more transparency as it allows shareholders
and investors to better understand and analyse the liquidity and solvency profiles of such
companies. To enhance the disclosure requirements in India, the Securities and Exchange Board
of India (“SEBI”) has, vide SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,
2011, made it mandatory for promoters (including promoter group) to disclose the details of
pledge of shares of the listed companies promoted by them and likewise, any invocation or
release of shares also has to be disclosed *[Regulation 31 of the Takeover Regulation]. The
obligation of disclosure is cast on the pledgee as well if the pledgee acquires in a target company
shares or voting rights aggregating to five per cent or more of the shares of such target company
*[Regulation 29 (1) of the Takeover Regulation]. However, such disclosure requirement does not
apply to a scheduled commercial bank or public financial institution as pledgee in connection
with a pledge of shares for securing indebtedness in the ordinary course of business *[Proviso to
Regulation 29 (4) of the Takeover Regulation]. The said disclosures have to be done both at the
level of every stock exchange where the shares of the target company are listed; and the target
company at its registered office.

Applicability of the Takeover Regulations on the pledge of shares may, at first instance, be
looked upon with an element of surprise but one has to understand that creation of pledge is a
stepping stone to indirect acquisition of shares or voting rights in, or control over the target
company. The Takeover Regulations, thus, expressly treats shares taken by way of encumbrance
as an acquisition and the shares given upon release of encumbrance as a disposal *[Regulation 29
(4) of the Takeover Regulation]. The Listing Agreement also stipulates disclosure of the shares
pledged or encumbered *(Clause 35 of the Listing Agreement).

Pledge and the Companies Act, 2013

With the enactment of the Companies Act, 2013, the companies creating pledge over shares are
compulsorily required to register the charge, which was not the case with its predecessor. No
pledge created by any company can be enforced against it by any creditor unless and until the
pledge is registered as per the provisions the Companies Act, 2013 *[Section 77 (3) of the
Companies Act, 2013] and hence the mandatory requirement to register the charge. The
Companies Act casts a duty on the company to register with the Registrar of Companies, the
particulars of creation as well as modification of pledge along with the instrument within a
stipulated time period. The mode and manner of registration is provided in the Companies
(Registration of the Charges) Rules, 2014.

But before a company proceeds with the creation of pledge, it must have the special resolution
authorising the creation of charge on the shares proposed to be pledged *[Section 180 (1) (a) of
the Companies Act, 2013] and failure to do so wil strike at the root of the transaction. Also, if a
company other than parent company intends to offer pledge of shares as security in connection
with any loan taken by another company, the former has ensure that the mischief of Section 185
of the Companies Act, 2013 is not attracted.

Pledge and cap on the Banking Companies

The banking companies are also not left untouched by the regulations applicable to pledge of
shares. The lending banks cannot hold shares in any company whether as pledgee, mortgagee or
absolute owner of an amount exceeding 30% of the paid-up capital of that company or 30% of
its own paid-up capital and reserves, whichever is less *[Section 19(2) of the Banking Regulation
Act 1949]. The main object of the provision is to ensure that a banking company may not enter
into non-banking business by means of any company in which it is to be largely interested. The
said cap of 30%, however, does not apply to the NBFC`s or non-banking companies acting as
lenders. The restriction regarding the holding of shares do not apply when they are held as
trustee, agent or otherwise than as pledgee. It is thus practically possible for the banking
companies to have the benefit of pledged shares above the stipulated cap as security by way of
settling trust with the security trustee and authorizing them to hold shares for their benefit.

Conclusion

Though pledging of shares is considered relatively one of the easiest ways to raise money and it
works fine in a bull market, there are latent risks in the pledging of shares of listed companies as
the stocks of even the fundamentally strong companies may fall to trigger default or potential
default under the financing instruments upon falling of the share prices, if the mood in the
market turns negative or bearish. The various legal and regulatory requirements of registration of
charge and disclosures at multiple fora in respect of pledge of shares is, inter alia, aimed at
offering safeguards to the shareholders and investors from the risks posed by the volatility in the
company’s share price
NEW LINK

Legal Understanding of Pledging of Shares

Before understanding the concept of pledging of shares we have to understand it legally. It is

mainly covered under three laws, i.e., the Indian Contract Act, 1872, the Banking Regulation Act,
1949 and External Commercial Borrowing Guidelines.

Indian Contracts Act, 1872

Section 172 of the Indian Contract Act, 1872 gives us the definition of a Pledge. It states that the
bailment of goods as security for payment of a debt or performance of a promise is called
‘pledge.’ The bailor is in this case called the ‘pawnor.’ The bailee is called ‘pawnee.’[1]”

According to this definition, a pledge creates only the right of possession while the pawnor has
the title of the property.

The Companies Act, 2012 does not place any restriction on amount or manner of pledging of
shares. The Act has not prescribed any minimum percentage of share to be held by the directors.
But the Article of Association of a company can prescribe the qualification shares of a director.
It is a very nominal figure which is immaterial to the movement of the share price.

Regulation 36 of the SEBI Regulations, 2009 provides

that when a company is making a public issue, the promoters or directors should be holding at
least 20% of the shares with a lock in period of minimum three years. After the lock-in period of
3 years, the promoters or directors are free to sell their shares. So if the holding of promoters is
below 20% after the lock-in period, it will not violate the norms of SEBI.

Banking Regulations Act, 1949

Section 19(2) of the Banking Regulations Act, 1949 provides that no banking company should
hold the shares of any other company whether in the form of pledge, mortgagee or absolute
ownership that is more than 30% of the paid up capital of the respective company or 30% of the
company’s paid-up capital and reserves, whichever happens, to be less. The shares of a company
are taken by a bank or any other financial institution as security in the following cases:
  Overdraft facility against recorded and affirmed shares of any open restricted
organization.

 Overdraft of shares of a listed company against recorded and affirmed shares of any
open restricted organization.

Nowadays most of the shares are held in the form of Demat. There are two main depositories in
India – NSDL and CDSL and both have equally competent software’s to create a pledge and its
invocation that are listed in the statement as two columns named “Free” and “Pledged.”

For many years now, lending against shares was a common practice amongst promoters. As
prices were rising, there was no or rather a little risk. NBFC’s and banks were comfortable in
lending such type of loans. These types of loans were lent for one to three years and carried a
margin of two to three times, which means that the value of shares pledged was 2-3 times the
amount of the loan. For banks and NBFC’s, it is a low-risk business as they can charge a mark –
up of 3-4 % over the Prime Lending Rate (Prime Lending is the interest rate at which banks lend
to favored customers—i.e., those with good credit—but this is not always the case). Hence, the
lender has to ensure that his market risk is covered as the shares being pledged should be liquid
enough to ensure the timely recovery from the borrower.

Before the Satyam debacle, there were no disclosure norms made by SEBI (Securities Exchange
Board of India) for the promoters to disclose their pledged shares. In developed countries like
USA, directors as well as promoters are required to disclose their pledged shares. There the
pledging of shares by promoters, or insiders, as collateral for a loan is equivalent to a sale of the
stock to the pledge. In the UK this is covered under Insider Trading Regulations.

As banks or NBFC’s give loan taking the shares as collateral, the promoters are required to make
some payment or pledge some more shares whenever the price of the share comes down to a
certain level in the secondary market. (A secondary market is a market where investors purchase
securities or assets from other investors, rather than from issuing companies themselves. The
national exchanges – such as the NSE and BSE are secondary markets in India.)

The lender of the loan keeps the right to sell pledged shares in the market. As a result of this,
promoters always have the risk of hostile takeover. Hence, certain disclosures were necessary
regarding the pledging of shares by promoters as pledging of shares could result in a change of
ownership if the promoter is unable to redeem those shares by repaying the shares. This is
critical, as many investors consider promoter holding and management structure of the company
as a critical aspect of their investment decision. When promoters of big companies raise money
by pledging their shares, they pledge away their voting right, and hence it becomes a risk factor.
This reduction in shareholding deteriorates the company’s valuation. Beside this, in the event of
promoters not being able to repay the loan on time, the lenders dump the shares in the market in
huge quantities to recover their dues which have a cascading effect on the price of shares.

Pledging of Shares by General Shareholders

Whenever an investor or a shareholder needs a loan from a bank or financial institution, he/she
can pledge the shares to the lender for availing the loan. Unlike a promoter, a small investor is
not required to disclose that he has pledged his shares. For taking a loan against shares, the
investors have to collateralize the shares (in DEMAT FORM) to the bank.

Guidelines for Pledging of Shares under the Banking Regulation Act, 1949

Under Section 19 (2) of the Banking Regulation

Act 1949, it is provided that no banking company shall hold shares in any company whether as
pledge, mortgage, or absolute ownership of an amount exceeding 30% of the paid up capital of
that company or 30 % of its own paid-up capital and reserves, whichever is less . The shares of
any company are taken as security by the banks and financial institutions in following cases:

1. Overdraft facility against listed and approved shares of any public limited company.

2. Pledge of shares of listed companies as an additional or collateral security for a loan or

overdraft given against other prime security.

Availment of Loans by NRIs through Pledging of Shares

NRIs can take a loan by pledging shares, though they have to take the permission of the RBI.
The application has to be made through the same bank in which the NRO/NRI account is
opened[2] or being held.
Conclusion

Consequences relating to the pledging of shares may appear to be routine paperwork, but it is
beyond filling of forms since a better understanding of practical fundamentals helps the person
to avoid risks, ensures better compliance and makes the task easier. A promoter is a person who
is in ultimate control of the company and formulates its operating plans, and he is the first to be
aware of its good or bad future. The SEBI guidelines prescribe restrictions on the increase in
promoters holding after a certain limit but contain no prescription of minimum promoters
holding. This leaves the promoter with the scope to sell or pledge even 100% of his shares with
an ordinary disclosure. Such companies are always at risk of a sudden crash which leaves the
investors awed3.