This article has been written by Mr. Vedant Parakh, a 3rd year student of Institute of law, Nirma University college, Ahmedabad.

 

Abstract: 

The financial world has undergone a significant transformation with the dematerialization of securities. Dematerialization is the conversion of physical shares into electronic form. Dematerialization gives numerous advantages to both investors and companies whereas in a country like India where the economy is growing at a sound pace, it is complex to keep securities in physical form. The dematerialization requirement aligns with the October 2018 amendment to the Allotment Rules, which mandated the issuance of securities in dematerialized form by all public unlisted companies along with it The Ministry of Corporate Affairs of India (“MCA”) issued the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (“PAS Amendment Rules”) on 27 October, 2023 which mandates compulsory dematerialization of securities of private companies, excluding small companies and government companies (including stocks, bonds, debentures, share warrants, preference shares). 

The article examines section 29 of the Companies Act which mandates dematerialization for specific entities and scenarios, such as public companies making public offers or private companies exceeding certain capital and turnover thresholds. The article seeks to clarify Investors’ understanding of their rights and obligations regarding dematerialized securities.

 

Introduction:

Dematerialization involves the conversion of physical certificates into digital or electronic forms, facilitated by unique codes assigned by issuers and managed through depositories. Similar to depositing cash in a bank account, dematerialization allows securities to be held electronically, with the depository acting as the registered owner while the certificate holder becomes the beneficial owner. This process offers several advantages such as reducing fraud risk, eliminating the loss of physical certificates, enhancing transparency among securities holders, and maintaining proper records of issuance, transfer, and disposal of securities.

 

The dematerialisation requirement comes in line with the amendment made to the Allotment Rules in October 2018, vide which issuance of securities by all public unlisted companies in dematerialized form was made mandatory. The idea behind the move seems to not only improve the ease of doing business in India but also to curb benami transactions, and reduce litigations related to fake share transfers or improper share pledges. Holding shares in dematerialized form creates efficiencies for the holder of shares as well. As regards the financial institution, which is facing challenges in foreclosure pledges of shares in physical form, this will be a great move as the foreclosure of dematerialized shares is a far simpler process.

 

On October 27, 2023, the Ministry of Corporate Affairs (MCA) introduced the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. This amendment included the addition of Rule 9B to the existing Companies (Prospectus and Allotment of Securities) Rules, 2015 which mandates compulsory dematerialization of securities of private companies, excluding small companies and government companies (including stocks, bonds, debentures, share warrants, preference shares).

 

Procedure:

 

For Public Companies

The dematerialization process begins with the opening of a De-mat account, typically through a Depository Participant (DP) offering De-mat services. To convert physical shares into electronic or De-mat form, a Dematerialization Request Form (DRF) available with the DP must be completed and submitted along with the share certificates. Each share certificate should be marked ‘Surrendered for Dematerialization’.

 

Subsequently, the DP processes the request along with the share certificates, forwarding them to the company and registrars/transfer agents via the depository. Upon approval, the physical share certificates are destroyed, and confirmation of dematerialization is relayed to the depository.

 

The depository then confirms the dematerialization to the DP, resulting in an electronic credit of shares to the investor’s account. This entire process typically takes around 15 to 30 days from the submission of the dematerialization request.

 

For private companies

To enable the dematerialization of securities and offer De-mat securities, a company needs to approach depositories like NSDL and/or CDSL to obtain an ISIN (International Security Identification Number) for each type of security it issues. A private company may engage a registrar to an issue and share transfer agent (“RTA”) to handle registrar to an issue (RTI) and share transfer agent (STA) activities. The PAS Amendment Rules impose several obligations on private companies regarding depositories and RTAs. These include timely payment of fees to both entities as per the agreement, maintaining a security deposit equivalent to at least two years’ fees with the depository and RTA, and compliance with regulations, directions, guidelines, or circulars issued by SEBI or the depository. Failure to fulfill these obligations can result in the company being prohibited from offering securities until payments to depositories or RTAs are made.

 

To convert physical securities into dematerialized form, a security holder must appoint a depository participant (DP), such as an Indian stockbroker, to open a De-mat account in their name. The DP acts as an intermediary between the depository and the security holder. The security holder then needs to complete and sign a de-mat request form provided by the DP, along with submitting certain documents like a self-attested PAN card, board resolution for opening and operating the De-mat account, proof of address, bank account details, and relevant securities certificates (marked as “SURRENDERED FOR DEMATERIALISATION”). If executed outside India, these documents may require notarization, apostilling, or consularization.

 

The PAS Amendment Rules outline crucial requirements as follows:

 

Private companies, excluding small companies based on audited financial statements from March 31, 2023, must facilitate the dematerialization of all securities within 18 months from the end of their financial year (i.e., by September 30, 2024, if the financial year ended on March 31, 2023). From the specified date onwards, such companies must issue securities exclusively in dematerialized form.

After the specified date, any private company proposing to issue securities, conduct buyback, issue bonus shares, or rights offers must ensure that the holdings of its promoters, directors, and key managerial personnel are dematerialized before making such offers.

Security holders intending to transfer securities after the specified date must ensure that the securities are held in dematerialized form before transfer.

Security holders intending to subscribe to securities of a private company, whether through private placement, bonus shares, or rights offers after the specified date must ensure that all their securities are held in dematerialized form before subscription.

 

Foreign investment

Due to the mandatory dematerialization, foreign investors will be required to open De-mat accounts with depositories in India to invest in private companies. This could potentially extend the time needed to finalize deals as the process for foreign investors includes obtaining a Permanent Account Number (PAN) from Indian tax authorities, complying with Know Your Customer (KYC) norms of depositories, paying additional fees, and apostilling documents.

However, despite these initial hurdles, this requirement offers significant benefits to foreign investors. It allows them to consolidate their investments in various Indian private companies under a single De-mat account, facilitates smoother and faster share transfers when exiting investments, and reduces the risk of losing share certificates compared to physical certificates. Thus, while the process may involve some challenges initially, it offers long-term advantages for foreign investors.

The requirement for dematerialization extends to all securities, encompassing stocks, bonds, and debentures, not limited solely to equity shares of the respective private company.

Before the Specified Date, a private company has the option to issue securities in physical form. However, post the Specified Date, any issuance of securities must be in dematerialized form. Thus, it’s advisable for private companies to consider issuing securities in dematerialized form even before the Specified Date.

While transfers of securities of a private company can occur in physical form before the Specified Date, after this date, all securities must be dematerialized before transfer.

To comply, relevant private companies might need to amend their articles of association to accommodate the issuance of securities in dematerialized form.

 

Regarding its applicability, the Companies (Prospectus and Allotment of Securities) Rules, 2014, outline the requirements:

 

Rule 9 mandates dematerialization for all public companies from April 1, 2014.

Rule 9A extends this requirement to unlisted public companies from October 2, 2018.

Rule 9B, introduced by the Ministry of Corporate Affairs on October 27, 2023, mandates dematerialization for private companies (excluding Small Companies and one-person companies) by September 30, 2024.

 

The benefits of dematerialization of securities are as follows:

 

1. When shares are dematerialized, their certificates become obsolete and are not returned to the investor. This means that certificates and distinctive numbers are nullified, allowing for paperless trading and transfer of shares through technological means within the depository system.

 

1. Dematerialization makes share trading and transfers easier by allowing for electronic processing, eliminating the need for physical share certificates and transfer deeds. This reduces the amount of paperwork associated with traditional scrip-based trading and share transfer processes.

 

1. Dematerialized securities can be transferred instantaneously, as beneficial ownership changes hands as soon as shares are transferred between accounts. Unlike physical transfers, there is no need to register ownership changes with the company.

 

Here are some drawbacks associated with the dematerialization of securities:

 

1. Unregulated trading of dematerialized securities could pose a risk to the market.

 

1. To safeguard investors, it’s crucial for the capital market regulator to effectively oversee the trading of dematerialized securities. This involves closely monitoring key market players, such as stockbrokers, who have the potential to manipulate the market.

 

1. To ensure compliance, multiple regulatory frameworks, including the Depositories Act, Regulations, and various Bylaws of different depositories, must be followed. Additionally, investors may find the dematerialization process complex and experience anxiety, despite seeking simplicity in their transactions with dematerialized securities.

 

Conclusion:

In conclusion, Indian businesses are primarily categorized into public and private corporations, with the latter being more prevalent due to their less stringent compliance requirements. Traditionally, private corporations haven’t seen significant benefits in issuing or holding securities in dematerialized form, leading to physical issuance of securities. However, the recent PAS Amendment Rules mandate that all securities, including those of private corporations, must now be held in dematerialized form.

 

Security holders have to open de-mat accounts with Depository Participants (DPs), follow stringent KYC procedures, submit documents, and have their documents notarized in order to comply with these laws. This process can take several months, as might the dematerialization process itself. In addition, if the securities are kept outside of India, compliance with foreign legislation, including customs approvals, is required, and the physical certificates of securities must be given to the DP throughout the dematerialization process.

 

In merger and acquisition deals when share transfers are involved, the significance of complying with dematerialization requirements is particularly apparent. The completion of dematerialization by moving shareholders and the opening of de-mat accounts by transferees or acquirers are frequently prerequisites for closing. The influence of these procedures on transaction deadlines needs to be carefully evaluated since they are time-consuming.

 

References:

1. Mandatory dematerialization of shares for non-small private companies – securities – India Mandatory Dematerialization Of Shares For Non-small Private Companies – Securities – India, https://www.mondaq.com/india/securities/1385036/mandatory-dematerialization-of-shares-for-non-small-private-companies.
2. FAQ-Dematerialisation, https://www.sebi.gov.in/sebi_data/docfiles/20618_t.htm
3. India Infoline, What is Dematerialization and its process?, India Infoline (Aug. 17, 2020), https://www.indiainfoline.com/knowledge-center/demat-account/what-is-dematerialization-and-Its-process.
4. Dematerialisation of shares of private companies Khaitan & Co, https://www.khaitanco.com/thought-leaderships/Dematerialisation-of-Shares-of-Private-Companies (last visited Feb 8, 2024) 
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6. https://vinodkothari.com/2023/10/diktat-of-De-mat-for-private-companies/.
7. Dematerialisation of Securities, (Nov. 10, 2023), https://www.lawrbit.com/article/dematerialisation-of-securities/.
8. legal Service India, Dematerialized Securities, https://www.legalserviceindia.com/articles/dematerialized_securities.htm.
9. Tadashi Yamamoto, Compulsory Dematerialisation of Securities of Private Companies, Lexology (Dec. 26, 2023), https://www.lexology.com/library/detail.aspx?g=1cd0af77-c312-4b1d-8503-f8953d7b0012.
10. Shweta Gupta, Mandatory norms for shareholders holding shares in physical form, (Jan. 5, 2023), https://timesofindia.indiatimes.com/blogs/voices/mandatory-norms-for-shareholders-holding-shares-in-physical-form/.