Borrowing against security of equity shares particularly by Promoters of listed companies is common. Security of the Promoters’ shares is often also given even for the borrowings of the listed company. Security of equity shares for certain reasons is often found preferable even to more substantial assets like land, buildings, etc. Listing and dematerialisation of shares has to some extent made this even easier, particularly with certain special provisions in law relating to pledge, etc. of shares.
However, the Takeover Regulations, made with a different object in mind, created serious consequences in the process of creation of the pledge, its invocation and when the shares are retransferred if the loans are eventually repaid.
This problem arises if the holdings of the borrower/ lender at any stage increase by more than prescribed percentage. For example, if the lender enforces the security and acquires the shares that result in his holding crossing, say, 15%, he is required to make an open offer. If the borrower is required to reacquire the shares from the lender on repayment of the loan and if this triggers the requirements of the Takeover Regulations, then again, the issue of open offer arises. The Regulations further contain restrictions on transfer of the shares till the open offer is complete and this delays the re-transfer of shares. It may be recollected that the open offer requirements would mean that a further 20% of the shares are to be acquired from the public. Even the very act of pledge of shares, if it involves transfer of shares in the name of the lender, may create similar complications, except where it is covered by a specific exception.
Earlier, in case of paper shares, it was not uncommon for the lender to get the shares transferred in its name to get total control over the shares. In other cases, blank transfer documents were lodged. However, in case of such blank transfers, the limited validity of the transfer documents created a problem. The system of dematerialisa-tion, however, resolved this problem to a substantial extent. As will be explained later, the security of the shares is recorded by the depository itself in a legally recognised manner and for practically an unlimited period of time.
A recent decision of the Securities Appellate Tribunal (‘SAT’) dealt in fair detail with the implications of the Takeover Regulations to a case where shares were retransferred to the pledger after the loan was repaid. This is in the case of Liquid Holdings Private Limited v. SEBI, (Appeal No. 83 of 2010, dated 11th March 2011).
The facts of that case are fairly simple (and simplified further here to bring focus on a few essential issues). Promoters of a listed company gave security to a lender against a loan given by the lender to a listed group company (‘the Company’). The security was given in the manner specified under the Depositories Act whereby the pledge against the shares is recorded in the demat account containing such shares.
The Company defaulted in repayment of the loan. The lender enforced the pledge and got the shares transferred to its name. However, after some time, the loan was fully repaid and the shares were reacquired from the lender. Because of such acquisition, however, the holding of the Promoters increased by such a percentage that would require the making of an open offer. The question was whether such an open offer was warranted when the Promoters merely re-acquired the shares.
The Takeover Regulations require an open offer to be made when shares are acquired whereby certain specified limits are crossed. This may be when the shareholding crosses 15% or when it crosses so-called creeping acquisition limits, etc. There are more situations when the open offer requirements are attracted. However, there is a special feature of these provisions. And that is that there is no netting off of purchase and sales. This can be explained as follows.
Say, a person holds 14% and acquires another 4% shares in a listed company. He is required to make an open offer. Now, let us say he sells 5% shares whereby his holding reduces to 13% but again buys 5% whereby he is back at 18%. Still, he is required to make an open offer when he crosses the milestone of 15% again. This point though a fundamental feature of the Regulations right from their formulation in 1997, is often forgotten or otherwise not appreciated.
So, this provision hits a borrower who is required for some reason to give up his shares because of his default. When he is able to raise the finance and he re-acquires the shares, he has to make an open offer. This is despite the fact that the control over the Company would not have changed at all.
It is worth emphasising that the ‘creeping acquisition limits’ of 5% would sound very low in context of a re-acquisition of shares from a lender after a default.
The expensive consequences of open offer hardly need emphasis. The acquirer is required to acquire another 20% shares from the public.
Interestingly, the banks and financial institutions are given exemption from the open offer requirements if they acquire shares, as pledgees. However, strangely, there is no reverse exemption if the shares are reacquired if the default is cured and even if the reacquisition is from the banks/financial institutions. Further, the exemption is given only to banks/financial institutions and not to other parties who may be lenders.
Normally, a pledge does not amount to transfer of shares even under the mechanism provided under the depositories regulations. It is a mere recording of a charge that disables the pledger from selling the shares, but does not make the pledgee the acquirer or owner of the shares. It is only if the pledge is exercised and the shares transferred in its name that the pledgee lender can be said to have acquired the shares. Though not stated in express terms, the intention seems to be that this acquisition by banks/financial institutions of shares on account of exercise of pledge is exempted from open offer requirements.
The provisions of Regulation 58 of the SEBI Depositories Regulations lay down the procedure for recording of the pledge in respect of the shares being held in the name of the pledger. The said Regulation also facilitates easy invocation of the pledge in accordance with the pledge document whereby the shares would be transferred from such account to the pledgee.
In the present case, the lender had invoked the pledge and transferred the shares in its name. Later on, the borrower could arrange for the funds and thus the shares were re-acquired by the Promoters. However, in this process, the open offer requirements were triggered since they acquired in excess of what is permitted without requiring an open offer.
Since the acquisition was made without making an open offer, SEBI levied a penalty on the acquirers. On appeal, SAT confirmed the penalty and did not agree to the argument of the Promoters on the facts that the re-acquisition of shares after invocation of the pledge did not trigger the open offer requirement. Thus, it confirmed that the acquirers had indeed violated the Takeover Regulations and the penalty levied was justified in law.
The following are some extracts of the decision that are relevant.
The Promoters argued that “the object of transferring the shares in the names of the banks was only to provide a certain comfort level to them so that they feel confident that they would be able to recover the amount without going back to the pledgers if and when a default in payment occurs.”. Thus, there was no real transfer or re-transfer. The SAT, however, did not accept this argument and held as follows.
First, they explained the nature of the pledge as under the new scheme of depositories as follows:
“The pledges were created and recorded in the records of the depository and the pledgors and the pledgees were informed of the entry of creation of the pledges through their participants. As long as the shares remained under pledge, the pledgors (the appellants) were their beneficial owners and the only effect of the pledge was that the shares under pledge could not be transferred any further or dealt with in the market without the concurrence of the pledgees i.e., the banks. The pledge by itself did not bring about any change in the beneficial ownership of the shares pledged and there was no question of the provisions of the takeover code being attracted.”
Then it explained what happened when the pledge was invoked. Thereby they also explained why the lenders were not required to make an open offer.
“It was somewhere in the year 2004 that default was committed in the repayment of the loans as a result whereof the banks invoked the pledges and got the shares transferred from the demat accounts of the appellants (pledgers) to their own demat accounts. On such invocation, the depository cancelled the entry of pledge in its records and registered the banks as beneficial owners of the shares in its records and made the necessary amendments therein. The depository then immediately informed the participants of the pledgers and the pledgees of the change and the participants also recorded the necessary changes in their records. Upon the banks being recorded as beneficial owners of the shares in the records of the depository, they became members of the target company and they acquired not only the shares but also the voting rights attached thereto. But for the exemption granted to them under Regulation 3(1)(f)(iv) of the takeover code, they would have been required to comply with the provisions of Regulation 11(1) by making a public announcement to acquire further shares of the target company as envisaged therein.”
And the third and final stage of the chain of events took place when the borrower settled the loan and the shares got retransferred to the Promoters. The consequences of this were explained as follows:
“The shares acquired by the banks ceased to be the security for the loans as the banks had become the beneficial owners thereof. In December 2007, Morpen paid the entire loan amounts to the banks and settled the loan accounts. It was then that the banks issued a ‘no dues certificate’ to Morepen, the principal borrower and simultaneously executed DIS requiring their participants to debit their accounts and transfer the shares in the names of the appellants. Accordingly, the shares got transferred from the demat accounts of the banks to the demat accounts of the appellants in the records of the depository. On this transfer being made by the banks, the appellants acquired the shares and became their beneficial owners as their names were entered in the records of the depository.”
Hence, since the shares were actually re-acquired, the requirements of disclosure as well as open offer were attracted. The SAT observed as follows:
“Admittedly, the shares which the appellants acquired in December 2007 were in excess of the threshold limit(s) prescribed by Regulation 11(1) of the takeover code and, therefore, the said regulation got triggered. The appellants were required to come out with a public announcement to acquire further shares of the target company as envisaged in this Regulation. This was not done. Not only this, the appellants having acquired the shares from the banks were also required to make the necessary disclosures in terms of Regulation 7 of the take-over code to the target company and the stock exchanges where the shares were listed. This, too, was not done. We are, therefore, satisfied that the provisions of Regulations 7 and 11(1) stood violated and the adjudicating officer was right in recording a finding to this effect.”
The final argument of the appellants that the legal effect of the transaction was that there was no real transfer of shares to the lender was also rejected. It was held that the title did transfer to the lender on the shares and there was a retransfer too.
Thus, SAT upheld the penalty for not making the open offer.
To conclude, to a fair extent, clarity has been obtained on the implications of the Takeover Regulations when shares are transferred on invocation of pledge and shares are retransferred on satisfaction of the default. At the time of invocation of pledge, if the pledgee is a bank/financial institution, the transfer would not attract the open offer requirements of the Regulations. Further, where shares are retransferred, the retransfer would attract the open offer requirements.
A possible way out of this is to apply to the Take-over Panel for exemption for such re-acquisition. However, it would be up to the discretion of the Panel whether or not to recommend such exemption and of SEBI to finally grant it.
However, the decision obviously does not cover many other situations of pledge and their consequences. Pledge of shares that are not dematerialised may remain an issue, though the above decision should apply if the shares are transferred in the name of the lender. The exemption on transfer on invocation of pledge is not available if the lender is not a bank/financial institution. The general unfairness of the consequences of such reacquisition is apparent and it is clear that the law needs a change to provide for exemption with clear conditions to avoid misuse.
