Saturday, January 17, 2009

Satyam Update 3 - is pledge of shares insider trading?

The Economic Times reports today (17th January 2009) that SEBI is examining whether, in law, pledge of shares amounts to Insider Trading. The SEBI Committee, as the report importantly adds, will also consider whether the law should be amended whereby pledge of Promoters shares would now be required to be disclosed.

A crisis and major scandal such as Satyam often has the good effect of speeding up improvements in law that otherwise may take a longer time. Reports that some institutions sold shares in Satyam some of them selling shares of Promoters held under pledge well ahead of the disclosures and steep market fall has rightly caused outrage. However, the pressure to take quick action may also result in ill considered amendments, making rules out of exceptions, and also interpretations of “spirit” that otherwise may come to haunt later on.

I find it a little surprising when the report implies that even bonafide pledge of shares may be held to be Insider Trading apparently by taking an extended meaning of “dealing” in “securities”. I wonder whether the existing law is broad enough to include even such bonafide pledge of shares. The existing definition of “dealing in securities” in the SEBI Insider Trading Regulations is quite specific and exhaustive though a bit clumsy. It says that “dealing in securities” means “an act of subscribing, buying, selling or agreeing to subscribe, buy, sell or deal in any securities by an person either as a principal or an agent”. Pledging of shares is not subscribing or buying or selling of securities, nor is it agreeing to do so.

The definition has some clumsiness in terms of being circumlocutory when it uses the word “deal” again in the latter part of the definition but I doubt whether even this would be sufficient to cover bonafide pledge of shares.

Consider also the intention of these Regulations prohibiting Insider Trading. It is obviously to restrict insiders from dealing ahead of material disclosures, at a time when the price is significantly different from what may be if these disclosures were made. In Satyam, it is being alleged that the Promoters pledged shares when prices were high and thus obtained monies based on valuations that did not reflect the reality and which reality was disclosed much later. The lenders allegedly sold shares when market price started falling and Promoters could not meet margin calls. However, this, by itself only, cannot make bonafide pledge of shares insider dealing.

When a person pledges shares, he keeps the risks and rewards in the shares with himself. When the lender sells the shares on default or margin calls, he sells at a time when the prices may have already fallen but then it is the borrower who has to bear such fall. He would be credited obviously only to the extent of the amount realized by sale. If the borrower bears the risk of such fall, then this goes against the very concept of Insider Trading where the dealer profits from a fall in price that may be the result of adverse information published later.

In furthering the argument that pledge of shares is “dealing in securities” a cue also seems to be taken in the report from the fact that the definition of “securities” Insider Trading involves dealing in “securities” under the Securities Contracts (Regulation) Act, 1956 includes “rights or interest in securities”. Since, and it is rightly stated, pledge of shares may involve, to some extent, grant of right or interest in securities, a suggestion apparently made is that in that case dealing in “securities” would cover pledge of shares (a contrary view is also quoted, which I agree to, but since the report does discuss the law further, it is being discussed here).

One possible answer to this is that what is covered under Insider Trading is “dealing” in securities i.e., the process and action itself. It is the word “securities” that has been given an extended meaning under SCRA to cover “rights or interest”. The word “dealing” has not so been artificially extended and in fact, as discussed above, is quite specific and exhaustive (except for the quirk, also discussed). If pledge of shares is held to be Insider Trading, then Insider Trading is being interpreted to mean “dealing in (dealing in securities)”!

Interestingly, the Takeover Regulations exempts acquisition of shares by “banks and public financial institutions as pledgees".  One may wonder whether, therefore, pledge was thus understood to be acquisition since otherwise there was no need to specifically give this exemption. However, this conclusion may not be correct since, even here, what is really exempted is “acquisition of shares” as “pledgees" and not the pledge itself. In other words, the pledge has to be an acquisition first possibly as, e.g., in the case where the pledgee actually transfers the shares in its name and also does further acts. Also, there are decisions (of SAT, etc., not discussed here) that have held that pledge does not amount to acquisition of shares. 

The above discussion though applies to bonafide pledge of shares and the moot question of course is whether the pledge of shares in Satyam was bonafide. Obviously, no one knows this yet and it may take a long time before the truth is established. However, clearly, if a pledge is not a bonafide pledge and is actually a sale in disguise, then it would be sale of securities and in that case the Insider Trading Regulations would squarely apply. But this would be by applying the regular and plain interpretation of Insider Trading and not by a crisis-driven, extended meaning.

If in the heat and pressure of action, to somehow find the Promoters of Satyam guilty of Insider Trading, a stretched interpretation is taken that any pledge of shares should also be deemed to be Insider Trading, it can cause a serious crisis to the whole corporate world generally. Firstly, Promoters of numerous other companies would also be deemed to have committed Insider Trading through pledge. Secondly, this process may bring out the real picture of the status of finances of Promoters in India post stock market meltdown!

It is then that the second issue raised by the ET report can be discussed and that is whether Promoters should be required to disclose the pledge of their shareholdings. I think this is a sensible suggestion and it would be valuable information for shareholders and the markets in general to know to what extent the Promoters are vulnerable and what is their real, net and clear holding and stake. Not that there is anything per se wrong in pledging shares or that it is “disclosure” of Insider Trading,  Pledge may be for many reasons for raising of finance for persons or corporate purposes or even further acquisition of shares, etc. In fact, if funds are raised by Promoters for financing further acquisitions of shares, then this may be even indicative of their own confidence in the Company. Of course, in some cases, this disclosure may help initiating investigation of the bonafide nature of the pledge.

However, as stated earlier, making Promoters to disclose, at this juncture, the pledge of their holding would also result in the discovery probably shocking of the reality as suggested by the oft-quoted statement of Warren Buffet “You only find out who is swimming naked when the tide goes out”. We may thus find out how many Indian Promoters are swimming dressed very skimpily and how many are swimming stark, bare-assed naked!

- Jayant Thakur


Renu Gupta said...


In a public company, minutes of meetings are available for inspection (including electronically on MCA website on payment of certain amount of money). These minutes would include (in the resolutions passed and also the general description) minutes for any loan approved by the board, including securities which have been provided by the company/promoters for the loan.

Should this not take care of the discloure requirement, if any?

Renu Gupta said...

Please see this newsreport at

the relevant paragraph is "It is interesting to note that a provision in this regard already exists under the Depositories Act, where promoters have to disclose their pledged holding separately to the depository, on which a third party charge exists. This becomes necessary in order to avoid banks from selling shares without the consent of the original owner (promoter in this case)."

I have independently checked and Section 12 of Depositories Act, provides for the said provison.

It is reproduced below.

12. Pledge or hypothecation of securities held in a depository

(1) Subject to such regulations 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 to the depository and such depository shall thereupon make entries in its records accordingly.

(3) Any entry in the records of a depository under sub- section (2) shall be evidence of a pledge or hypothecation.

Let me know your views?

Renu Gupta said...


Please also see the post by Professor Jayanth Verma at

Relevant portion is :

"The model code on insider trading in the UK listing rules states that “dealing” in shares includes “using as security, or otherwise granting a charge, lien or other encumbrance over the securities of the company;”. Thus pledge of shares is subject to the same disclosure requirements as other dealings in shares."

Jayant Thakur, CA said...

Thanks, Renu, for your useful inputs and references.

There are, as you rightly pointed out, some provisions of law, that do require disclosure of pledge to the company/depository. However, the real challenge and concern would be whether the law makers would make specific disclosure requirement of such pledge or other charges on the Promoters' shares to the general public. Howsoever desirable it may be and howsoever widely followed it may be worldwide, there woulld, as the learned author of the Financial Express article points out, resistance to it and eventually the demand may be forgotten. The underlying skeletons are too horrifying perhaps!!

- Jayant

Anonymous said...

It would also be interesting to see the need for disclosure under the takeover code for pledge of shares where Banks FI are not a party.

Jayant Thakur, CA said...

Anonymous said:-

"It would also be interesting to see the need for disclosure under the takeover code for pledge of shares where Banks FI are not a party."

Probably the position is the same but in the meantime, SEBI has announced its decision. See my post on the Press Release. Maybe we can consider these and other issues in the light of the actual amendment as and when announced.

- Jayant

Renu Gupta said...


Would you be aware whether there is any view by SEBI or any other regulatory authority on "pledge of shares amounting to insider trading". Except the ET report on which your post is based, is there anything which points in the same direction? Thanks.

Anonymous said...

Will Pledge of Shares by a promoter amount to financial assistance under Section 77(2) of the Companies Act? If not, why?

V. Umakanth said...

@ Anonymous. Pledge of shares by promoters does not violate the rules against financial assistance. Those rules apply only when the company provides financial assistance for purchase of its own shares.

Anonymous said...

@V. Umakanth-

Thank you for your reply. However, if the Promoter pledge shares to a company as security for the company buying shares for the promoter's company. will that fall under financial assitance under 77?

Eg- X promoter of company Y, pledges shares to Z to secure Z's investment into equity shares of Y. Is this banned under Section 77?