It was recently reported that a leading depository participant (DP) has misused the Power of Attorney provided by clients and pledged the clients’ shares with banks without their authorisation. As directed by the Securities and Exchange Board of India, some of these unauthorised pledges have been reversed. However, reports say that the banks have sought ownership of the pledged shares.

While SEBI is reviewing a large number of complaints from said clients for misuse of securities and unauthorised pledging of shares, another stockbroker has also come under scanner for similar charges. It is quite possible that more complaints may trickle in, as there seems to be a lack of effective control in this area by SEBI and the Reserve Bank of India.

Analysing the modus operandi suggests that though the culprit may be the DPs, there seems to be negligence on the part of financing banks. The basic tenet of ‘who can create a charge’ appears to have been ignored by the financing banks.

Types of charge creation

Banks do take securities for loans and advances, and generally, the charge is created by way of pledges, hypothecation, mortgages and assignments. Mortgages are created for immovable properties, while an assignment is made wherever there is an actionable claim, such as life insurance policies, fixed deposits etc. A pledge or hypothecation is applicable for movable goods.

Section 172 of the Indian Contract Act, 1872 gives us the definition of a pledge. It states that the bailment — or transfer — of goods as security for payment of a debt or performance of a promise is called a ‘pledge’. For all practical purposes, shares or share certificates are also treated as goods here.

Although charge on a company share can be created by way of pledge or hypothecation for dematerialised securities, banks practically allow only pledge of shares.

Validity of pledge

There are some basic conditions for creation of valid pledge. A pledge has to be created only by the owner or his authorised agent; and in some cases, by a mercantile agent. Pledging of shares by the DP without authorisation cannot be considered valid, and hence the financing banks cannot make a claim over the securities.

When the DP is holding shares under a demat account, it acts only as a trustee — it must take care of such shares diligently and cannot part with them. The scenario here is unlike that in a bank, where depositors’ money can be lent.

Only in the case of negotiable instruments — like cheques, bills of exchange or promissory notes — can the transferee acquire title over the instrument even if the transferor’s title is defective, provided there is proper consideration and the transaction is done in good faith without negligence. This is not applicable for shares transferred from demat accounts to the banks. When the DP does not own the shares, it cannot pass on any title/ownership to the banks.

In the absence of valid pledge, the banks cannot make any claim over the securities.

What next for banks?

In the ongoing cases, banks should have verified who is the owner of the shares before accepting the shares as security. There seems to be negligence on their part here.

However, banks generally take insurance coverage for frauds perpetrated on them. If a DP has defrauded the banks, they can make a claim with the insurance company as per policy terms. Criminal action should also be initiated against the fraudster.

The writer is a retired banker

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