Treatment of 'pledge' transactions under SEBI Prohibition on Insider Trading Regulations

 The Supreme Court, in a landmark judgment, has clarified several long-standing issues surrounding the pledge of dematerialized (“demat”) shares. Most importantly, it held that the invocation of a pledge under the Depositories Act and DP Regulations does not constitute an “actual sale” of shares.

How does a pledge work?

·       A pledge is a security arrangement under which a borrower provides securities as collateral.

·       Upon creation of a pledge, the securities in the borrower’s demat account move from the ‘free balance’ to a ‘locked-in/encumbered’ status in favour of the lender.

·       Once the loan is fully repaid, the pledge is released and the encumbrance is lifted.

·       If the borrower defaults, the lender may either sue for recovery and retain the pledged shares as security, or invoke the pledge and—after giving reasonable notice of sale—sell the shares to a third party.

·       The invocation process involves instructing the Depository Participant to transfer the pledged shares from the borrower’s demat account to the lender’s account to enable a lawful third-party sale.

Supreme Court’s landmark ruling clarifying legal position on pledge of shares
The Supreme Court (in the case of PTC India Financial) held that there is no conflict between the Depositories Act, 1996 (“DP Act”), SEBI (Depositories and Participants) Regulations, 1996 (“DP Regulations”), and the provisions of the Indian Contract Act, 1872 (“Contract Act”) in the context of a pledge of demat shares. The Supreme Court overruled earlier High Court decisions that treated DP Regulations as inconsistent with the Contract Act in the context of the pledge of demat shares.

Key principles emerging from the ruling

·       A lender has only a special property right in the pledged shares—not full ownership

·       A lender may retain the pledged shares or sell them after giving reasonable notice, but becoming the “beneficial owner” upon invocation is merely a procedural step under depository law

·       It does not amount to an actual sale or transfer of ownership, which remains with the borrower until a genuine third-party sale is completed

·       Registration of the lender as “beneficial owner” is required only to enable a lawful sale; it does not transfer substantive ownership

·       The borrower’s right to redeem the shares continues even after invocation and is extinguished only upon such third-party sale

·       Importantly, the lender cannot sell the pledged shares to itself

Treatment under SEBI Prohibition of Insider Trading (PIT) Regulations
Under the SEBI PIT Regulations, creation, release and invocation of a pledge are treated as “trades” to prevent abusive practices. As a result, these transactions may trigger pre-clearance requirements, disclosure obligations and trading-window restrictions.

Key Takeaways
While the Supreme Court holds that creation, release and invocation of pledge do not transfer ownership, the PIT Regulations treat these steps as “trades” for regulatory purposes. Thus, (i) Creation and Release of Pledge, though legally not a transfer of ownership, attract PIT compliances; (ii) invocation of pledge, though merely procedural in law, continues to be treated as a trade under PIT Regulations; and (iii) both the Supreme Court and SEBI PIT Regulations recognize actual sale to a third party as the point at which ownership truly changes.

Given the divergence between legal principles and regulatory treatment, companies and designated persons should exercise enhanced diligence in all pledge-related transactions to ensure both legal and regulatory compliance.