How to Create, Cancel and Invoke a Pledge of Dematerialised Securities
A lender taking shares as collateral is relying on an entry in a depository's records rather than on possession of a certificate. A pledge of dematerialised securities is created, cancelled and enforced by a sequence the regulations set out step by step, and the security interest exists only once the entry does.
Step 1: Start From Section 12 and the Previous Approval
Section 12 of the Depositories Act, 1996 permits a beneficial owner to create a pledge or hypothecation in respect of a security owned through a depository, subject to the regulations and bye-laws made in that behalf and with the previous approval of the depository.
Sub-section (2) requires the beneficial owner to give intimation of the pledge or hypothecation to the depository, which then makes entries in its records accordingly. Sub-section (3) makes any such entry evidence of the pledge or hypothecation. That is the whole evidentiary basis, so the entry is the security and the paperwork is the route to it.
Step 2: Apply Through the Participant That Holds the Account
Under regulation 79(1) of the SEBI (Depositories and Participants) Regulations, 2018 the beneficial owner applies to the depository through the participant with which the account is held. There is no direct route to the depository.
This matters where the pledgor and the pledgee bank with different participants, which is the ordinary case. The application travels through the pledgor's participant, and the pledgee's participant enters the sequence later.
Step 3: Expect the Availability Check
Regulation 79(2) requires the participant, after satisfying itself that the securities are available for pledge, to note the notice of pledge in its records and to forward the application to the depository.
The check is on availability, not on the merits of the underlying loan. Securities already subject to an entry, or otherwise not free, will not clear it, which is why a lender should settle the state of the account before documenting the facility rather than after.
Step 4: The Pledgee Must Concur, and Fifteen Days Run
Regulation 79(3) gives the depository fifteen days from receipt of the application to create and record the pledge, and it is to do so after the concurrence of the pledgee communicated through the pledgee's participant. It then intimates the participants of both the pledgor and the pledgee.
Two things follow. The pledgee is not a bystander: without its concurrence the entry is not made. And the fifteen days are the depository's, not the parties', so a facility drawn down on the assumption that the entry exists on the day of application is drawn down unsecured.
Step 5: Watch for the Intimation, and for Reasons
Regulation 79(4) requires each participant, on receiving the depository's intimation, to inform its own client that the pledge has been created. That is the confirmation to rely on.
Regulation 79(5) deals with the other outcome. Where the depository does not create the pledge, it is to send the reasons to the participants of the pledgor and of the pledgee. Both sides are named, and a pledgee that has heard nothing should treat silence as unresolved rather than as refusal, because the provision contemplates that it be told why. SEBI has treated a failure to pass those reasons on as a breach of a statutory obligation.
Step 6: Cancellation Needs the Pledgee's Prior Concurrence
Regulation 79(6) allows the depository to cancel the entry on an application by the pledgor or the pledgee through a participant, and provides that it shall not do so without the prior concurrence of the pledgee. Regulation 79(7) requires the depository, after cancellation, to inform the pledgor's participant.
So a pledgor cannot release its own collateral, and a release negotiated outside the depository has no effect until the entry goes. On the other side, a pledgee that has given concurrence should check that the cancellation has in fact been recorded, since the intimation after cancellation runs to the pledgor's participant.
Step 7: Invocation Changes Who Owns the Securities
Regulation 79(8) provides that, subject to the provisions of the pledge document, the pledgee may invoke the pledge, and that the depository shall then register the pledgee as the beneficial owner and amend its records accordingly. Regulation 79(9) requires the depository to inform both participants immediately, who amend their records and inform their clients.
The words subject to the provisions of the pledge document are the operative limit. What the pledgee may do on invocation is what the document allows, and the regulation supplies the mechanism rather than the right. A document silent on the circumstances of invocation leaves the mechanism without a trigger.
Step 8: Hypothecation Follows the Same Route, With One Difference
Regulations 79(10) and 79(11) allow a beneficial owner to create a hypothecation by the same procedure, applying sub-regulations (1) to (9) with the necessary modifications. The difference is at the end: the depository is to obtain the prior concurrence of the hypothecator before registering the hypothecatee as the beneficial owner.
That is the reverse of the pledge position, where invocation by the pledgee does not require the pledgor to concur again. Choosing between the two forms therefore decides who holds the last word at enforcement, which is a drafting decision and not a labelling one.
Step 9: Remember the Transfer Restriction
Regulation 79(12) provides that a participant shall not transfer a security subject to a notice of pledge or hypothecation without the concurrence of the pledgee or the hypothecatee. The restriction attaches to the notice, so it bites from the point the entry is in the participant's records.
The Explanation to the regulation records that pledge includes a re-pledge of securities for margin or settlement obligations, or for such other purposes as the Board may specify. A re-pledge in the course of settlement is therefore inside this framework and not outside it.
Common Pitfalls to Avoid
Treating the documents as the security: The entry in the depository's records is the evidence of the pledge under sub-section (3) of section 12.
Going direct to the depository: The application is made through the participant with which the account is held.
Drawing down on the day of application: The depository has fifteen days from receipt to create and record the pledge.
Forgetting the pledgee's concurrence: The entry is created after the concurrence of the pledgee through its participant.
Reading silence as refusal: Where the pledge is not created, the reasons are to be sent to the participants of both the pledgor and the pledgee.
Assuming a pledgor can release collateral: Cancellation requires the prior concurrence of the pledgee.
Relying on the regulation instead of the document: Invocation is subject to the provisions of the pledge document.
Confusing pledge with hypothecation at enforcement: Registering the hypothecatee as beneficial owner requires the prior concurrence of the hypothecator.
Key Statutory Provisions
Section 12 of the Depositories Act, 1996: Pledge or hypothecation of securities held in a depository. Sub-section (1) permits it with the previous approval of the depository and subject to the regulations and bye-laws; sub-section (2) requires intimation to the depository, which makes entries in its records; sub-section (3) makes any such entry evidence of the pledge or hypothecation.
Regulation 79 of the SEBI (Depositories and Participants) Regulations, 2018: The procedure. Application through the participant; the availability check; creation within fifteen days after the pledgee's concurrence; intimation to both participants and by them to their clients; reasons to both participants where the pledge is not created; cancellation only with the pledgee's prior concurrence; invocation subject to the pledge document, with registration of the pledgee as beneficial owner; hypothecation by the same route with the hypothecator's prior concurrence before registration; and no transfer of a security subject to a notice without the concurrence of the pledgee or hypothecatee. The Explanation brings a re-pledge for margin or settlement obligations within the term.
Sources and References
Depositories Act, 1996, section 12, and SEBI (Depositories and Participants) Regulations, 2018, regulation 79
Disclaimer: This article is for informational purposes only and does not constitute legal advice. Readers should consult a qualified legal professional for advice specific to their circumstances.
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