Saturday, September 12, 2015

Pledges in the Context of Insider Trading Regulations – Part 2

[The following guest post is contributed by Vinod Kothari and Abhirup Ghosh of Vinod Kothari & Co.

This is the continuation of a previous post available here]


Whether a pledge is a case of “dealing”?

As discussed in the previous post, the use of the term “deal” or “dealings” in the definition of the term “trading” has actually expanded its meaning beyond the usually understood meaning of “trading”. Further, SEBI’s legislative Note to the definition of “trading”, as stated below, makes it even clearer –

Under the parliamentary mandate, since the Section 12A (e) and Section 15G of the Act employs the term 'dealing in securities', it is intended to widely define the term “trading” to include dealing. Such a construction is intended to curb the activities based on unpublished price sensitive information which are strictly not buying, selling or subscribing, such as pledging etc when in possession of unpublished price sensitive information.

Not only has the Note expanded the meaning of the term “dealing”, but has also clarified that for the purpose of the Regulations, dealing in securities would also include pledging of securities.

Further, the same has been dealt with in the Answer to Question 6 of the Guidance Note, as stated below –

6. (a) Whether SEBI's intent is to prohibit creation of pledge or invocation of pledge for enforcement of security while in possession of UPSI?

(b)Whether creation of pledge or invocation of pledge is allowed when trading window is closed?

Guidance: Yes. However, the pledgor or pledgee may demonstrate that the creation of pledge or invocation of pledge was bona fide and prove their innocence under proviso to sub-regulation (1) of regulation 4 of the Regulations.

In the above guidance, SEBI has very clearly expressed its intent to curb the practice of pledging of securities/ invocation of pledge on securities while in possession of unpublished price sensitive information (“UPSI”) as well.

 

What, in case of a pledge, is “dealing”?

Given that, as we discussed above, a pledge is a transfer of specific interest in goods, a pledge may be regarded as a form of “trading”, the question is which of the several aspects of a pledge will be regarded as “trading”.

(a)       Creation of a pledge:

As stated in the Note to the definition of “trading”, dealing includes pledging of shares. So, there is no ambiguity to the fact that creation of pledge will be regarded as “trading” for the purpose of these Regulations.

Now let us understand as to why be SEBI might be interested in controlling the pledge of securities. Assuming a case where a promoter has access to UPSI and expects the price of the shares of the company to fall on publication of the UPSI. In all likelihood, the promoter  would like to pledge the shares before the publication of the UPSI and raise money from the market. It is as sensitive an issue as buying and selling of securities at based on UPSI. Thus, it is very logical to include pledging of securities in the definition of “trading”.

(b)       Invocation of a pledge and sale of property by the pledge:

Here, at the very outset, we must understand that the right to invoke a pledge remains with the pawnee of the property and a pledge can be invoked only when there is a default on the part of the pawnor. On invocation of the pledge, the pawnee attains the right to cause a sale of the property as per Section 176 of the Contract Act, 1872. Note that generically under the law of pledges the pawnee does not become absolute owner of the property on invocation of the pledge – he simply acquires the right to cause a sale of the pledged article.

Such a sale, caused by the pawnee, is certainly a sale in normal parlance, and is hence, a “trading”. One has to see whether the pawnee (and not the pawnor) is in possession of UPSI at this stage. If the pawnee has an UPSI, the sale by the pawnee will attract the provisions of the Regulations. If the pawner is an insider, and the pawnee is not, but the pawnee is causing the sale at the instructions of the pawner, once again, there is a use of UPSI, and therefore, the pawnee may also be regarded as “insider” within the meaning of Para 2(g) of the Regulations.

(c)        Invocation of a pledge and assumption of ownership interest by the pawnee:

In furtherance to the discussion in point (b) above, where the terms of the pledge empower the pawnee to acquire title to the goods on invocation of the pledge, and the pawnee decides to acquire the ownership of the pledged securities, there is a change in the designation of the pawnee, i.e, from being a mere holder of a security interest over a property, it is becoming an owner of the property. This is undoubtedly a transaction, where the outstanding debt is being settled in exchange of the ownership. This is also a case of a “trading”. Actual sale of the pledged article by the pawnee at a subsequent stage will also be a trading. Therefore, the meaning of the term “deal” is being satisfied, so is the term “trading” for the purpose of these Regulations.

(d)       Release of a pledge

Release of the pledge is, truly speaking, a satisfaction of the pledge. The specific property that the pawnee had expires on satisfaction of the purpose for whicih the pledge was created. Neither does the pawnee, on satisfaction, have the right to retain the goods (Section 174 of the Contract Act, 1872) nor does he have any right to cause a sale. Hence, this amounts to an automatic termination of the rights contractually conferred by the pawner. One cannot contend that on release of the pledge, there is a retransfer of the specific property back to the pledgor. To begin with, the property was specific and not absolute – it was granted for the purpose of securing a debt. When that purpose becomes extinct, the specific property expires by redemption of the purpose or debt. Therefore, it is incorrect to contend that at this stage, there is a “trading” of any kind.

However, SEBI, in its Guidance to Question 7 of the Guidance Note, has expressed the view that revocation of pledge also amounts to a trade. While the use of the word “revocation” is, humbly, incorrect and inappropriate, even if this is taken to refer to a release of the pledge, it is wrong to contend that there is any transfer back of property, and therefore, there is no question of any “trading” at this stage. More so in context of the Regulations, because the Regulations are not intended to provide for a generalised public record of pledges, as in case of registration of charges under the Companies Act. The purpose of the Regulations is to ensure that there is no insider taking advantage of UPSI. Surely enough, if the pawnor is releasing his property by satisfying the debt, he cannot be intending to do so to gain an advantage merely by release. If he at all were to cause a sale of the released securities, that in any case will constitute a trade, but it is wrong to contend that a mere release is a trade at all.

Conclusion

SEBI’s Guidance Note creates an unwarranted confusion about pledges, and this series of posts has tried to align understanding pertaining to pledges in different scenarios.

[Concluded]

- Vinod Kothari & Abhirup Ghosh


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