SEBI introduces recording on non-disposal undertaking
In a bid to ensure further transparency and adequate disclosures by promoters, the Securities and Exchange Board of India (“SEBI”) has issued a circular requiring non-disposal undertakings to be recorded in the depository system.
The Depositories Act, 1996 introduced the concept of dematerialized securities in India. In addition to the other advantages of dematerialization of securities, a notable feature of this legislation was the mechanism that was put in place for the creation of a pledge of shares. Traditionally, a pledge of shares involves passing of the ‘constructive possession’ of the pledged shares in favour of the pledgee upon execution of the deed of pledge. Upon the creation of a pledge of dematerialised shares, the same is notified to the depository participant, and the pledged shares are frozen by the depository participant. The freezing of pledged shares by the depository restricts the beneficial owner (i.e. the shareholder in the records of the depository) from transferring or otherwise dealing with the shares for as long as the shares are pledged. However, no such mechanism existed for non-disposal undertakings (“NDU”). NDUs are undertakings given by a shareholder to another person (generally a lender) undertaking not to transfer or otherwise alienate the securities held by such shareholder in a company. Considering that dematerialized shares are fungible, tracking NDUs were practically impossible.
As per the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Code”) promoters are required to disclose details of ‘encumbered’ shares. Under the Takeover Regulations1 ‘encumbrance’ includes any “pledge, lien, or any such transaction, by whatever name called.” Thus, the term ‘encumbrance’ does not merely mean a simpliciter pledge or lien, but also includes, any other transaction, which may entail a risk of the shares held by promoters being appropriated by a third party and thus covers within its definition a ‘NDU’. However, due to lack of mechanism to monitor creation of NDU on dematerialized shares, a depository would be unable to track shares which are subject of an NDU, and NDUs would go undisclosed in a depository’s system. It is in this light that SEBI has, on June 14, 2017 issued a circular to the depositories (i.e. NSDL and CDSL) (“Circular”) directing the depositories to implement the contents of the Circular within 4 months from the date of the issuance of the Circular.
Provision and analysis
(i) Provision: To record the NDU, both the beneficial owner (“BO”) and the person in favour of whom the NDU is being created (“Beneficiary”) are required have a demat account with the same depository. Once the NDU is created, the BO and the Beneficiary are required to make an application to the depository through the depository participant (“DP”) to record the NDU.
(ii) Provision: Once the NDU is recorded (which implies that the shares are frozen in the system), the depository shall not facilitate or effect any transfer, pledge, hypothecation, lending, rematerialisation or alienation in any manner or otherwise dealing in such shares, till receipt of instruction from both parties for the cancellation of the NDU. In case the entry of the NDU is required to be cancelled, the parties to the NDU are required to make a joint application requesting cancellation of NDU and unfreezing of shares.
Although the Circular has put in place a mechanism for recording NDU in depository system, the Circular does not completely preclude creation of NDUs outside the depository system. However, the Circular is only one step towards furthering the recording of NDUs.
Having said the above, it is likely that banks2 and other persons in favour of whom such NDUs are created would require all NDUs to be recorded, since recording of such NDUs offer better protection to the lenders as security. Further, while the intent was to further recording of shares of listed companies, it is likely that unlisted companies (including private companies) having their shares held in the dematerialized form would also benefit from the Circular.
– Swati Sharma, Abhinav Harlalka & Simone Reis
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2Banks are the most common beneficiaries of NDUs since they are not permitted to take a pledge over 100% of the shares of any borrower under the extant banking laws. Accordingly, a 30:70 split, being pledge of 30% of the shares of the company and NDUs over 70% shares are quite common.