I. INTRODUCTION
The primary objective of the Insolvency and Bankruptcy Code 2016 (“IBC”) has always been to provide equilibrium to the interests of all the concerned stakeholders. The IBC code since its very beginning has been emerging in order to safeguard the concerns of the creditors during the corporate insolvency resolution process (“CIRP”). However, this emergence has sometimes resulted in a collision where the provisions of this act collides with the provisions of the some other acts and laws of this country.
In recent times, a significant clash regarding the rights of the financial creditors (“FC”) vis-à-vis Pledgee has been spotted under the purview of IBC and The Indian Contract Act 1872. The concern is that when a pledgee or a beneficial owner of the pledged invoked the said shares then their seat and rights in the committee of creditors (“CoC”) as a FC may be impugned on the basis that they are a ‘related party’ to the corporate debtor (“CD”) under the IBC. This substantial concern has been discernible from the conjunctive readings of the established precedents of the different tribunals and the Supreme Court (“SC”).
The authors through this blog aim to highlight the various concerns of the Pledgee as beneficial owner under the IBC and argue rather that the established insolvency jurisprudence of India while safeguarding the various rights of the FC during CIRP should not end up sabotaging the contractual rights of the Pledgee at the time of invoking the pledged shares.
II. SCRUTINIZING BENEFICIAL OWNER VIS-À-VIS ACTUAL OWNER
The distinction between the terms ‘registered owner’ and ‘beneficial owner’ is laid under the Depositories Act 1996. The Regulation 58(8) of the SEBI (Depositories and Participants) Regulations , mentions that “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.” In the case of PTC India Financial Services Limited v. Venkateswarlu Kari and Another (2022) , the Court observed that if a financial company invokes its shares which are pledged by a creditor, then the company becomes the beneficial owner of the shares. Further, it was noted that, in the situation when the pledgee invokes his shares with an intention to accord himself the title of beneficial owner, it does not amount to actual sale. The actual sale takes place when the ‘beneficial owner’ sells the dematerialized securities to a third person. Thus, the beneficial owner converts into the actual owner upon the transfer of the pledged shares to the third party.
a-Right to sell or transfer
The Sections 176 and 177 of the Indian Contract Act 1872, bestow the pledgee with the right to sell the dematerialized security. There has been a link drawn between the Depositories Act and the Contract Act. In order for a pledgee to exercise his right to sell, he needs to get registered as a beneficial owner under the Depository Act. However, when the pledgee invokes the pledge to become a beneficial owner, the sale of shares to oneself does not amount to actual sale. Therefore, the pledgor reserves the right for the redemption of the pawned goods. The time when the actual sale takes place, the pledgor loses his right for redemption of pawned goods.
b-Right to retain voting rights
There has been a conflict pertaining to a situation where the pledged shares are not sold to the third party under Section 176 of the Contract Act. In the case of World Crest v. Yes Bank (2022) , the question arose whether the bank had voting rights because the actual sale of pledged shares had not taken place. It was noted that the pledgee had voting rights under this case since the pledgee is still a beneficial owner and the actual sale has not taken place. If the pledgee had exercised his right to vote by transferring the pledged shares to itself, he would not lose his right to vote even if he is a beneficial owner.
III. CURTAILMENT OF RIGHTS OF THE PLEDGEE UNDER IBC REGIME
Upon careful examination of the aforementioned judgments from both the SC and the High Court, it becomes apparent that invoking the pledged shares of a CD can result in the FC becoming a ‘related party’ as defined in the IBC. This situation arises due to the combined reading of Section 5(24)(j) and Section 21(2) of the IBC. According to these provisions, any individual or entity, including a company or body corporate, holding more than 20 percent of voting rights in a CD, whether through share ownership or a voting agreement, is disqualified from holding a seat in the CoC of that CD. Typically, a standard share pledge agreement grants the pledgee all the voting rights associated with the pledged shares once the pledge is invoked. Consequently, a share pledge agreement is considered a voting agreement within the definition of a ‘related party’ under the IBC.
Consequently, it follows logically that when a FC invokes over 20 percent of the pledged shares of a CD, they also acquire proportional voting rights. As a result, the FC would technically be considered a ‘related party’ of the CD and, accordingly, would be ineligible to hold a position in the CoC of the CD, as stipulated by Section 21(2) of the IBC. This situation puts the FC in a challenging position, as they must choose between occupying a seat on the CoC and exercising their contractual rights to invoke the pledge on the shares.
IV. FINANCIAL CREDITORS AT MERCY
The aforementioned contentions unequivocally highlights the concerns of not only the pledgee or the beneficial owner but various other financial entities such as Commercial Banks, NBFCs, Mutual Fund Companies, Foreign investors etc. who lend money or give credit facilities to the debtor through pledged shares as collateral. In order to safeguard and secure their lending these financial institutions attain collateral through the pledged shares so that they can invoke the pledged shares whenever there is a default by the debtor. However, if they invoke more than 20% of the shares of the CD who is under CIRP then they will lose their voting rights as a FC under the COC as they will become the related party to the CD. This situation creates a state of trepidation among the above the financial entities while securely lend the money to the CD by taking the pledged shares as collateral. This apprehension of the financial institutions losing their contractual rights as pledgees under the Contract Act 1872, or their voting rights as FCs in the CoC under the IBC when invoking shares is likely to have a detrimental impact on the credit supply in the market. This concern is expected to impede the lending rate in India.
V. THE NEED FOR A HARMONIOUS CONSTRUCTION BETWEEN THE IBC AND CONTRACT ACT
The Indian Contract Law 1872 protects the rights of the FC by giving him the right to invoke the pledge in case of default. On the other hand, the IBC provides a seat for the FCs in the CoC. The recent conflict between the two laws have affected the rights of the FCs. It is determined that every legislation has to be read in totality so that, one doesn’t override the other. In the case of Phoenix Arc Private Limited vs Spade Financial Services Limited , the Court opined that the term ‘related party’ needs to be understood as a whole including its purpose and objects. The object of exclusion of related party from CoC is to remove the conflict of interest with the CD. The aim is that CIRP should be taken in charge by the external creditors.
In the present case, if the FC invokes more than twenty per cent of his pledged shares then, it should be addressed whether the act genuinely creates a conflict of interest. If the interest is not created, he should be treated as an external creditor. Moreover, he should inherit the right to be a part of CoC along with the rights of a pledgee. This is to ensure that the FC does not lose his rights under both the provisions. Thus, both the legislations need to be harmoniously construed to protect the rights of the FCs under the statutes.
VI. CONCLUDING REMARKS
Despite the fact that the literal reading of the provisions of the IBC may initially appear to work against the rights of a FC, the SC has firmly established that all courts must be bound by its precedents. This is to ensure that the FC’s rights, both as a pledgee under the Contract Act and as a member of the CoC of the CD under the IBC, are upheld and considered legally valid. The intention is to prevent any inadvertent gap or oversight resulting from a literal interpretation of the IBC provisions from undermining the rights purposely granted to FCs by the law.