Share pledges are an extremely popular method of security creation amongst promoters seeking to raise capital in India. In transactions secured by share pledges, if the value of the shares falls below a certain threshold, lenders are usually entitled to ask borrowers to furnish additional collateral to cure the shortfall (margin calls), and/or liquidate the shares before their value declines further. In this context, the Bombay High Court recently passed two interim orders temporarily staying pledge invocation, citing the coronavirus-induced market crash.
The first order (confirmed by the Supreme Court) restrained IDBI Trusteeship from selling the Future Group’s pledged shares to repay debenture holders until further orders. The second restrained ICICI Home Finance from selling pledged shares that secured a term loan, subject to certain conditions. Given the ubiquity of share-backed financing in India, such litigation could become common in the coming weeks, with borrowers seeking to temporarily prevent lenders from selling pledged shares due to their fall in value. How courts respond to such litigation is important and merits some analysis.
The RBI moratorium: The Reserve Bank of India (RBI) has, in its Covid-19 relief package, provided banks and financial institutions with the option to impose a moratorium on instalments of term loans and working capital facilities falling due between March 1 and May 31, 2020. The moratorium is both transaction-specific (term loans and working capital facilities) and time-bound (instalments falling due between March 1 and May 31). While both interim orders concern debts not covered by the moratorium (the ICICI case involved a default in January 2020), they also embody a common principle—that the sale of pledged shares can be temporarily stayed if their market value falls. This principle, if accepted as precedent, could jeopardise a wide range of transactions critical to the functioning of financial markets, including various kinds of securities contracts and margin calls.
Systemic risk: When courts injunct transactions not covered by the moratorium, they effectively widen its scope to include situations deliberately excluded by RBI. This could set a dangerous precedent. For instance, payment obligations arising from transactions on stock exchanges are excluded from the moratorium, and for good reason. It is widely accepted that the continuous functioning of financial markets is better for risk management, as market forces operate in real time and allow for better price discovery. Financial markets require a synergy between numerous market intermediaries connected to one another by a web of transactions. Interim orders that prevent these transactions from happening could have a cascading effect on third parties and even undermine the stability of the market.
A good example of this cascading effect was seen last year when an order of the Economic Offences Wing (EOW) of the Delhi Police froze certain demat accounts, pending its investigation into a possible scam. Consequently, the securities in these accounts became unavailable as collateral for certain trades on the National Stock Exchange. These trades could not be settled for months, leaving innocent investors in the lurch. The Supreme Court was forced to intervene with emergency measures.
The broader impact of such interim orders on the economy has been acknowledged by the Supreme Court in United Bank of India v. Satyawati Tondon in 2010, where it was observed that “in cases relating to the recovery of dues of banks, financial institutions and secured creditors, stay granted by the High Court would have an adverse impact on the financial health of such bodies/institutions which ultimately prove detrimental to the economy of the nation. Therefore, the High Court should be extremely careful and circumspect in exercising its discretion to grant stay in such matters.”
Way forward: It is a settled principle of law that courts must ensure their interim orders do not cause more inconvenience to one party than they alleviate for the other (known in legal parlance as the ‘balance of convenience’ test). It is possible that an interim order staying pledge invocation could harm the lender more than it helps the borrower. Its continued operation could result in the complete loss of capital advanced by the lender. Large defaults, if allowed to continue, could even create systemic risk. Balancing convenience in the facts of each case is therefore, crucial.
It is also settled law that public interest must be considered while passing interim orders. Courts must therefore take into account the systemic impact their orders might have. They may, in this regard, examine factors such as the systemic importance of a party (whether it is ‘too big to fail’), its market exposure, its financials and the potential consequences of default. Taking more informed decisions in some cases could require the expertise of accountants, market analysts and economists. In such cases, courts may even consider expeditiously hearing an expert before passing orders, especially when systemic impact appears likely.
Courts must resist the tendency to treat the pandemic as a factor that excuses the performance of all contractual obligations. The principle of force majeure does not automatically apply to all contracts and its application will depend on the terms of each contract. Contract law does not excuse performance on grounds of commercial inconvenience either. Contracts must, therefore, be enforced as a general rule, and such interim orders must only be passed in extraordinary circumstances. Courts must ensure that injunctions against pledge invocation do not become a routine phenomenon. The short-term relief is not worth the long-term risk.
Vishnu Sumanth
The author is a corporate lawyer
(vishsumanth@gmail.com)