India: Dematerialization Mandate For Private Companies: Implications, Challenges, And Strategic Shifts

Introduction

On October 27, 2023, the Ministry of Corporate Affairs ("Ministry") amended the Companies (Prospectus and Allotment of Securities) Rules, 2014 ("Rules") vide the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 ("Amendment")¹ by introducing Rule 9B² ("Rule"). The Amendment has been carried out in pursuance to the power granted to the Central Government under Section 29(1)³ of the Companies Act, 2013 ("Act"). The said Rule necessitates all private companies to have all their securities in dematerialized form by September 30, 2024 ("Compliance Date") in accordance with provisions of the Depositories Act, 1996, and regulations made thereunder.

This article intends to dissect the nuances of the aforesaid Rule 9B focusing on the mandate for private companies to dematerialize their securities⁴. Additionally, the article will evaluate the potential effects and challenges that private companies might face in adhering to these revised regulations.

Implication

On or before the Compliance Date, and always thereafter, the private companies are to exclusively issue securities in dematerialized form and facilitate the dematerialization of all their existing securities.

In the event a private company intends to offer to (i) issue securities, (ii) buyback, (iii) issue bonus shares, or rights offers, the same can only be done after the dematerialization of securities held by the concerned private company's promoters, directors, and key managerial personnel.

Additionally:

1. for any person intending to transfer securities in a private company, the securities must be dematerialized before the transaction can take place, and the buyer must receive them in dematerialized form.
2. when a subscriber subscribes to securities in a private company through private placement, bonus shares, or rights offer, the private company must dematerialize all their held securities before such subscription.

Applicability

The Amendment applies to all private companies⁵, save and except for the below mentioned companies:

1. Small Company (not being a small company on or after March 31, 2023)⁶; and
2. Government Company⁷.

It is crucial to note that there is no explicit exemption provided for companies incorporated under section 8 of the Act under the Amendment. Section 8 companies are those formed for the promotion of commerce, art, science, sports, education, research, social welfare, religion, charity, etc. It is interesting to see how the Ministry takes a view regarding the applicability of the said Rule 9B on Section 8 companies, since Section 8 companies do not fall under the definition of a small company or Government companies.

Further, if a private company operates as a subsidiary or a holding company of another private company, despite meeting the financial criteria defining a small company, it will not be categorized as a small company. If it is a private company then consequently, it must adhere to the requirements outlined in the Amendment.

Furthermore, one needs to take into consideration that the said private companies for the purpose of dematerialization of its securities have to comply with Rule 9A(4) to Rule 9A(10)⁸ of the said Rules.

Potential effects

1. at the Amendment is in line with the government's growing efforts to curb various economic crimes like benami transactions, fraudulent share transfers including without limitation backdating the share transfers, and/or improper share pledges.
2. Dematerializing shares simplifies several aspects of shareholding. It reduces the likelihood of fraudulent activities associated with physical share certificates. By digitizing shares, it minimizes the risk of fake transfers and mitigates disputes related to them. This, in turn, decreases the volume of litigation concerning these matters.
3. Moreover, holding shares in dematerialized form brings operational efficiencies for shareholders. It streamlines processes for them, making transactions and ownership transfers more convenient and secure.
4. Financial institutions grappling with challenges in foreclosing pledges of physically held shares will benefit significantly from this move. Foreclosing dematerialized shares is a far more straightforward procedure compared to physical shares, which involves complex processes. The transition to dematerialization simplifies this aspect for financial entities, facilitating smoother foreclosure procedures.
5. Dematerializing of shares also substantially reduces the risk of share certificates being lost or being damaged.

From a broader perspective, this transition enhances transparency within the shareholding landscape. It assists governmental agencies in tracing shareholders of private companies more effectively. Additionally, it aids in ensuring proper payment of stamp duty on share transfers, contributing to greater regulatory compliance and transparency in financial transactions.

Challenges

1. Although this Amendment does not aim to alter the private company's structure, operationally it will have to be seen how the private company, along with the depository and depository participant conduct themselves so as to preserve and honour the restrictions as imposed on a private company under the Act.
2. Market intermediaries such as depository participants, depositories, and Registrar and Transfer Agents will likely need to restructure their existing infrastructure and operational processes significantly. This restructuring is essential to accommodate the substantial influx of additional users into their networks resulting from the dematerialization initiative.
3. Private companies also face a considerable task in completing the dematerialization process for the shareholding of their promoters, directors, key managerial personnel and other shareholders. This involves a meticulous transition from physical shares to dematerialized form, necessitating adequate time and resources.
4. Compulsory dematerialization necessitates foreign investors in private Indian companies to open demat accounts in Indian depositories. The mandatory dematerialization introduces various procedural requirements, including PAN (permanent account number) acquisition, KYC (know your customer) compliances, potential financial charges, and document authentication, collectively impacting the time frame for foreign investors in finalizing deals involving investments in private Indian companies.

Implications of non-compliance

As no specific penalty has been provided for non-compliance, Section 450 of the Act automatically becomes applicable to punish for any contravention of the new Rule 9B. Thus, in the event of any non-compliance of Rule 9B, the company and every officer of the company in default shall be liable to a penalty of Rs. 10,000/- (Rupees Ten Thousand Only) and in case of a continuing default then a further penalty of Rs. 1,000/- per day, subject to a maximum penalty of (a) Rs. 2,00,000/- (Rupees Two Lakhs Only) in case of a company and (b) Rs. 50,000/0 (Rupees Fifty Thousand Only) in case of any officer in default.

Conclusion

The Amendment brings forth a pivotal shift for private companies in India. This mandate compelling dematerialization of shares has far-reaching implications, with a strategic aim to modernize the shareholding landscape and address pressing issues of fraud, transparency, and operational inefficiencies.

The dematerialization requirement, effective until the specified Compliance Date, underscores a fundamental transformation in how securities are issued, traded, and managed. While exempting small and government companies, this rule imposes a significant obligation on private entities (considering that there are more than 14 lakh private companies⁹), irrespective of the fact that some of these private companies may be the subsidiaries of foreign companies, urging them to align with the digitization trend. This strategic move anticipates a reduction in fraudulent activities associated with physical certificates, easing dispute resolutions, and lowering litigation volumes. Simultaneously, it promises streamlined processes, improved security, and operational convenience for shareholders in managing their investments.

However, the transition isn't devoid of challenges. Market intermediaries face the arduous task of overhauling their infrastructures to accommodate the surge in users. Private companies, too, confront a meticulous conversion process from physical to dematerialized shares, demanding substantial time and resources. The mandate's impact extends beyond national borders, necessitating foreign investors in private Indian companies to navigate additional procedural requirements, potentially elongating deal closure timelines.

Nonetheless, this strategic move towards dematerialization marks a pivotal step in enhancing transparency, fortifying regulatory compliance, and fostering a modernized, digitized ecosystem within private companies, especially with respect to eliminating fraudulent transactions and benami shareholders. It's a transformative directive aiming to align India's corporate landscape with contemporary global standards, albeit with inherent challenges that necessitate a carefully orchestrated transition.

Footnotes

1. https://egazette.gov.in/WriteReadData/2023/249772.pdf

2. Rule 9B of the Rules states as follows:

3. Section 29(1A) of the Companies Act, 2013 states as follows:

4. Section 2(81) defined securities as follows:

Further, Section 2(h) of Securities Contracts (Regulation) Act, 1956 defined securities as follows:

5. Section 2(68) of the Companies Act, 2013 defines private company as follows:

6. Section 2(85) of the Companies Act, 2013 defines a small company as follows:

7. Section 2(45) of the Companies Act, 2013 has defined Government Company as follows:

8. Sub-rule (4) to (10) of Rule 9A of Companies (Prospectus and Allotment of Securities) Rules, 2014 states as follows:

9. https://www.mca.gov.in/bin/dms/getdocument?mds=txTYdsRdDC%252BtNEfohyF1SQ%253D%253D&type=open

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.