Dematerialisation of Shares for Private Companies in India

On October 27, 2023 the Ministry of Corporate Affairs introduced the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. A new rule, Rule 9B, has been added to the existing Companies (Prospectus and Allotment of Securities) Rules, 2015. According to Rule 9B, private companies (excluding small companies), as of March 31, 2023, must ensure that all their shares are in dematerialised form by September 30, 2024. Small companies, as defined by the Companies Act 2013, must comply within 18 months from the end of the financial year in which they no longer qualify as a small company.

Dematerialisation of shares, involving the conversion of physical shares into electronic form, significantly benefits directors, promoters, and key management personnel. This shift enhances efficiency, reduces the risk of loss or damage, facilitates quick and transparent transactions, ensures compliance with regulatory changes, and aligns with principles of good corporate governance. It also provides easy access to corporate actions, supports stock-based incentive schemes, and integrates well with modern financial systems, offering a more convenient and secure way to manage and trade securities.

This article serves as a comprehensive guide, encapsulating all essential information regarding the recent notification issued by the Ministry of Corporate Affairs on October 27, 2023. Detailing the Mandatory Demat for Private Companies under the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, the piece provides a thorough overview of the regulatory changes. Whether you seek a clear understanding of the timeline, criteria, or the broader impact on shareholding practices, this article aims to equip you with all the necessary insights into the significant developments outlined in the notification.

Background and Context

Dematerialisation– Revolutionizing Securities Ownership

Following the liberalisation of the Indian economy in 1991, the establishment of the Securities and Exchange Board of India (SEBI) in 1992 marked a pivotal moment in securities market regulation. As SEBI initiated transformative reforms, a significant milestone emerged — the dematerialisation of securities.

Dematerialisation of shares involves the conversion of physical share certificates into electronic book entries, akin to bank accounts. This revolutionary process addresses challenges such as the risk of bad deliveries, extensive paperwork, the potential loss and theft of share certificates, and transit delays. Dematerialisation of shares, therefore, has effectively consigned these issues to the annals of history.

Genesis of Demat Accounts – The Legislative Foundation

In 1996, the Parliament of India enacted the Depositories Act, providing a robust legal framework for dematerialisation process. National Securities Depository Limited (NSDL) played a pioneering role in spearheading dematerialisation in India. Subsequently, Central Depository Services (India) Limited (CDSL) emerged as the second SEBI-recognized and licensed depository.

As per the Depositories Act, 1996, the Depository assumes the role of the registered owner of shares in the company’s records and holds these shares in a fiduciary capacity for the shareholder. Depositories have, in turn, appointed intermediaries called Depository Participants to facilitate the opening and maintenance of Demat accounts for investors.

Underlying Motivation for the Mandate

The recent push for mandatory dematerialisation of shares finds its roots in the October 2018 amendment to the Allotment Rules. This pivotal change mandated that all public unlisted companies issue securities exclusively in dematerialised form. The essence of this move extends beyond mere regulatory compliance; it reflects a broader initiative aimed at transforming business practices in India.

Objectives:

1. Streamlining Business Practices: The primary objective is to streamline and modernise business practices, aligning them with global standards. The shift towards the dematerialisation of shares is a key step in this direction.
2. Combatting Illicit Transactions: By making the dematerialisation of shares mandatory, regulatory authorities seek to address issues related to benami transactions, fake share transfers, and improper share pledges. This move is a proactive measure to enhance the integrity of share transactions.
3. Operational Efficiency for Shareholders: Dematerialized shares offer shareholders a more efficient and secure means of managing their investments. This transition simplifies the processes associated with buying and selling securities.
4. Supporting Financial Institutions: Financial institutions, often challenged by complexities in foreclosing physical shares, stand to benefit significantly. The foreclosure of dematerialised shares is a more straightforward process, contributing to operational ease.
5. Transparency and Governance Enhancement: The move towards dematerialisation of shares contributes to increased transparency in the corporate sector. It enables governmental agencies to trace shareholders of private companies more effectively and ensures the proper enforcement of stamp duty on share transfers.

Key Highlights of the Notification

1. Applicability:

The Ministry of Corporate Affairs (MCA) introduced provisions for the dematerialisation of shares by private companies through a notification dated October 27, 2023. These provisions are delineated in Rule 9B, which became applicable on the same date.

2. Scope and Exemptions:

The regulations apply to all private companies, with the exception of small companies. Notably, government companies are exempted from the mandate.

3. Compliance Filing Requirement:

A crucial aspect of adhering to these regulations is the mandatory filing of E-Form PAS-6, ensuring transparency and regulatory compliance.

4. Rule 9B Overview:

Private companies falling under the purview of Rule 9B are obligated to issue securities exclusively in dematerialised form. Furthermore, these companies are required to facilitate the dematerialisation of all their securities.

5. Compliance Deadline:

Private companies are required to complete the dematerialisation of shares or issue new shares in dematerialised form within eighteen months from the conclusion of the financial year ending on March 31, 2023. Consequently, the compliance deadline is set for September 30, 2024.

6. Pre-Offer Compliance Requirements:

Prior to making any offer for issue, buyback, bonus issue, or right issue after the compliance date, a private company must ensure that the entire holding of securities belonging to its promoters, directors, and key management personnel has been dematerialised.

7. Securities Holder Obligations:

Securities holders of private companies falling under the Rule 9B criteria are subject to specific obligations. Those intending to transfer securities after the compliance date must ensure the dematerialisation of shares before the transfer. Similarly, those subscribing to securities after the compliance date, whether through private placement, bonus shares, or rights offer, must hold all their securities in dematerialised form before such subscription.

8. Application of Rule 9A Provisions:

The provisions of Rule 9A (sub-rules 4 to 10) are applicable to Rule 9B with necessary adjustments. This ensures consistency and conformity in compliance, extending the regulatory framework for effective implementation.

9. Issue and Buyback of Securities:

Prior to making any offer for the issue, buyback, or bonus shares or rights offer, a Private Company must confirm that the securities held by its promoters, directors, and key managerial personnel have been dematerialised. This prerequisite underscores the move towards the dematerialisationof shares before new investments are sought.

10. Transfer of Securities:

Individuals intending to transfer securities to a private company must dematerialise these securities before executing the transaction. This requirement extends to the buyer, necessitating the receipt of securities in dematerialised form.

11. Private Placement, Bonus Shares, or Rights Offer:

Individuals subscribing to securities in a private company through private placement, bonus shares, or rights offers are obligated to dematerialise all held securities before participating in such subscriptions.

12. Compliance with Relevant Laws:

To ensure the dematerialisation of shares, Private Companies must comply with key regulations, including the Depositories Act, 1996, the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018, and the Securities and Exchange Board of India (Registrars to an Issue and Share Transfer Agents) Regulations, 1993.

13. Obligation to Submit Form PAS-6:

Additionally, every Private Company is required to submit Form PAS-6, a half-yearly return reporting shares held in demat form, to the Registrar of Companies (ROC) within 60 days from the conclusion of each half-year. This submission, duly certified by a company secretary in practice or a chartered accountant in practice, reinforces transparency and adherence to the dematerialisation of shares norms.

Exemptions from dematerialisation Requirement: Under the recent notification, certain categories of companies are exempted from the obligation to dematerialise their shares. This includes Nidhi Companies, Government Companies, Wholly Owned Subsidiary Companies of Public Companies, and Small Private Limited Companies.

Definition of “Small Company” under the Companies Act, 2013: Financial Criteria and Recent Amendments

The Companies Act, 2013, in Section 2(85), provides the definition of a “small company,” establishing financial parameters for its classification as a non-public entity. The criteria include a paid-up share capital not exceeding INR 50,00,000 or a prescribed higher amount (up to INR 10,00,00,000) and a turnover not surpassing INR 2,00,00,000 or a prescribed higher limit (up to INR 100,00,00,000), based on the profit and loss account for the preceding financial year.

Amendments through the Companies (Specification of Definition) Amendment Rules, 2022: Revised Financial Limits

In accordance with the Companies (Specification of Definition) Amendment Rules, 2022, Rule 2(1)(t) of the Companies (Specification of Definition Rules), 2014 has been amended. The amendment introduces new financial limits for small companies, restricting their paid-up capital to INR 4,00,00,000 and turnover to INR 40,00,00,000. Importantly, these revised limits do not apply to companies acting as holding or subsidiary entities.

Impact on Holding and Subsidiary Companies: Exemption from Small Company Status

The revised definition implies that a private company operating as a holding or subsidiary entity will not be categorised as a ‘small company,’ irrespective of its paid-up capital and turnover falling below the stipulated thresholds. This distinction underscores the nuanced application of the “small company” classification within the amended financial framework.

Compliance Requirements

The Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, introduced by the Ministry of Corporate Affairs (MCA), bring about a significant change with the addition of Rule 9B after Rule 9. Effective September 30, 2024, non-small private companies must comply with two pivotal mandates: issuing securities only in dematerialised form and ensuring the dematerialisation of all existing securities.

Major Impact of dematerialisation on Companies:

1. Since October 2, 2018, unlisted companies must ensure that the entire holding of securities belonging to promoters, directors, and key managerial personnel is in dematerialised form. Failure to meet this requirement restricts the company from engaging in various activities, including issuing securities, buy-back of securities, issuing bonus shares, and rights issues.
2. Starting from September 30, 2024, all new issuances or transfers of securities for non-small private companies must be exclusively in dematerialised form.

Impact on Security Holders (Transfer/Subscription of Securities):

According to Sub Rule 4 of Rule 9B, the amendment specifies that every securities holder:

1. Individuals intending to transfer securities on or after September 30, 2024, must ensure the dematerialisation of shares before initiating the transfer.
2. Those looking to subscribe to securities of the relevant private limited company should confirm that all existing securities are held in dematerialised form before proceeding with the transfer or subscription.

Compliance Process Overview:

First Step

According to Rule 9B, effective from September 30, 2024, the transfer of shares for every holder of securities in a Non-Small Private Limited Company is permitted only in the Demat Form. To facilitate this transition, shareholders need the company’s ISIN (International Security Identification Number). Rule 9B places the company’s responsibility to allow shareholders to convert their shares into Demat. Therefore, every Non-Small Private Limited Company is required to apply for ISIN before the specified date.

Additionally, Rule 9B(5) and Rule 9A(4) stipulate that every Non-Small Private Limited Company must initiate the dematerialisation process for all existing securities. This involves making the necessary applications to a depository under the Depositories Act, 1996, securing an ISIN for each type of security, and informing all existing security holders about this dematerialisation of shares facility.

Subsequent Compliance

Following the mandatory ISIN application for Non-Small Private Limited Companies, the second step involves specific compliance requirements:

In accordance with Rule 9A(8), every Non-Small Private Limited Company falling under this rule must submit Form PAS-6 to the Registrar. This submission, along with the requisite fee as stipulated in the Companies (Registration Offices and Fees) Rules, 2014, is mandatory within sixty days of each half-year’s conclusion. The submission should be duly certified by either a practising company secretary or a practising chartered accountant.

Post-ISIN Allocation

In the third phase of compliance subsequent to ISIN allocation, Non-Small Private Limited Companies must adhere to the following obligations:

1. Timely Fee Remittance: Ensure the timely and regular payment of fees, encompassing both admission fees and annual fees.
2. Security Deposit Maintenance: Comply with the terms of the agreement by maintaining a security deposit equivalent to two years’ fees. This agreement typically involves entities such as the depositor, registrar of an issue, and share transfer agent.
3. Adherence to Regulatory Directives: Consistently adhere to the regulations, guidelines, or circulars issued by the Securities and Exchange Board or the Depository. Stay vigilant about any updates or modifications communicated by these regulatory authorities.

Compliance Procedures for Form PAS-6 and Reporting Capital Discrepancies to Depositories

Private companies are mandated to submit Form PAS-6 to the Registrar, accompanied by the stipulated fee as outlined in the Companies (Registration Offices and Fees) Rules, 2014. This submission is required within 60 days of each half-year’s conclusion and must be duly certified by a practising Company Secretary or a practising Chartered Accountant. Simultaneously, any disparities identified between the company’s issued capital and the capital held in the dematerialised form must be promptly communicated to the depositories.

Impact of the Amendment:

The Ministry of Corporate Affairs (MCA) has implemented this measure to fortify transparency, investor protection, and governance within the corporate sector. The amendment extends the significant advantages of dematerialisation of shares to private companies. These advantages include eliminating risks associated with physical certificates, such as loss and theft, streamlining the transfer of securities, exemption from stamp duty on transfers, and enhancing the corporate governance system through increased transparency and the prevention of malpractices.

Furthermore, any grievances arising from the dematerialisation of shares will be addressed by the Investor Education and Protection Fund (IEPF) Authority. This proactive step is anticipated to simplify the resolution of issues related to dematerialised securities, fostering greater investor confidence in the overall process.

Compliance Requirements for Share Warrants Issued by a Public Company Pre-Companies Act, 2013

An additional sub-rule has been incorporated into the existing Rule 9 of the Companies (Prospectus and Allotment of Securities) Rules, 2014. According to this newly introduced sub-rule, every public company that issued share warrants before the initiation of the Companies Act, 2013 and has not yet converted them into shares must adhere to the following compliance measures:

1. Informing the Registrar of Companies (ROC):

Public companies are obligated to furnish details of outstanding warrants to the ROC within a period of 3 months from the date of this notification. This information should be submitted through Form PAS-7.

2. Surrender of Warrants and dematerialisation:
   • The company is required to prompt bearers of share warrants to surrender them within a period of 6 months from the notification date.
   • Simultaneously, these bearers must ensure the dematerialisation of shares into their respective accounts.
   • The company is further mandated to publish a notice for the bearers of share warrants, utilising Form PAS-8, on the company’s website.

Non-Surrender of Share Warrants within 6 Months

If a bearer fails to surrender share warrants within 6 months, the company must convert them into a dematerialised form and transfer them to the Investor Education and Protection Fund (IEPF), as per the new sub-rule. This promotes transparency, streamlines conversion processes, and strengthens corporate governance, reducing risks associated with unconverted physical certificates. The amendment modernises corporate practices and establishes a clear framework for converting and transferring share warrants.

Key Implications of the Amendment

1. Scope and Impact on Companies:
   • The Amendment affects over 14.45 lakh active private companies in India, constituting about 95% of the total incorporated companies.
   • The compliance burden is expected to increase, and ongoing subscription and share sale transactions remain unaffected until compliance is required by September 30, 2024.
2. Challenges for Foreign Investors:
   • Foreign companies face increased complexity due to the need for extensive Know Your Customer (KYC) information and obtaining a Permanent Account Number (PAN) with Indian tax authorities.
   • This may extend the lead time for first-time foreign investors looking to invest in Indian companies.
3. Resource Requirements and Compliance Costs:
   • To facilitate the dematerialisation of shares, depositories, depository participants, and share transfer agents must allocate resources and undertake capacity-building measures.
   • Compliance costs for private companies are anticipated to rise.
4. Awareness Programs and Timely Compliance:
   • The Ministry of Corporate Affairs (MCA) and corporate governance professionals will need to conduct awareness programs across the country to ensure compliance with Rule 9B of the Prospectus and Allotment of Securities Rules.
   • The September 30, 2024, deadline is considered fair for companies to comply with the new rule.
5. Benefits of dematerialisation:
   • The move towards dematerialisation of shares and digitisation is expected to weed out benami shareholders, expedite transactions, and establish an effective ownership tracking mechanism.
   • The MCA’s amendment aligns with the goal of institutionalising transparency and corporate accountability on a national scale.
6. Dematerialisation Mandate:

While the Amendment mandates the dematerialisation of shares, it allows security holders to continue holding securities in physical form. However, the dematerialisation of shares becomes mandatory for any transactions post-September 30, 2024.

7. Depositories’ Role and Responsibilities:
   • Depositories and depository participants play a crucial role in the securities market, ensuring effective, prompt, and accurate clearance and settlement of transactions.
   • The Depositories Act holds depositories accountable for any errors in securities transactions and requires indemnification for losses caused to beneficial owners due to negligence.
8. Preservation of Private Company Characteristics:
   • The basic features distinguishing private companies from public ones, such as restrictions on share transfer and limited number of members, remain unaffected by the Amendment.
   • Private companies must inform depositories about charter document restrictions during dematerialisation of shares, preserving their inherent characteristics.

Scope of Coverage

Applicability of Rule 9B on Wholly-Owned Subsidiaries:

Rule 9B of the PAS Rules mandates the dematerialisation of shares for private companies, with exemptions granted to small companies and government companies. However, it is crucial to note that this exemption does not extend to wholly-owned subsidiaries incorporated as private companies.

In contrast, Rule 9A, under sub-rule (11), provides exemptions for unlisted public companies, including Nidhi companies, government companies, and wholly-owned subsidiaries. Notably, the exemption under Rule 9A does not automatically apply to private companies under Rule 9B.

The current scenario indicates that wholly-owned subsidiaries, structured as private companies, are not exempt from the dematerialisation of shares requirements stipulated in Rule 9B. Additionally, there is ambiguity regarding the status of a private company acting as a wholly-owned subsidiary of a public company (thus deemed a public company). It remains uncertain whether such entities will be exempt under sub-rule (11) of Rule 9A or if Rule 9B provisions will be applicable.

This raises the need for further clarity on the dematerialisation of shares requirements for wholly-owned subsidiaries, particularly those falling within the private company framework.

Implications for foreign shareholders in private companies:

Compulsory dematerialisation of shares introduces specific compliance steps for foreign investors seeking to invest in private companies in India. This includes the following:

Foreign investors must open demat accounts with Indian depositories, necessitating the acquisition of a Permanent Account Number (PAN) from Indian tax authorities. Strict adherence to the Know Your Customer (KYC) norms set by the depositories is mandatory. Additional compliance requirements may include paying extra fees, apostille of documents, and other necessary steps.

While the initial compliance process may extend deal closure timelines, the long-term benefits for foreign investors are substantial. These include the consolidation of investments in various private companies in India under a single demat account, a smoother and faster process for share transfers, especially during exits, and a significant reduction in the risk associated with the loss of physical share certificates. While the compliance process involves certain challenges, the enduring advantages make it a valuable and necessary endeavour for foreign investors.

Consequences of Non-Compliance

Failure to comply with the provisions, constituting a breach of Section 29, triggers the application of general penalty provisions outlined in Section 450. In the absence of explicitly prescribed penalties in Rule 9A, Section 450 of the Companies Act comes into effect. As per this section, when no specific penalties are outlined in a Rule or Section, the following penalty structure is applied:

• The COMPANY, along with EVERY OFFICER in default or any other accountable individual, is subject to punishment by fine.
• The fine may extend to ten thousand rupees for the initial contravention.
• In the case of a continuing contravention, an additional fine, which may extend to one thousand rupees for each day after the first violation, is applicable.

Conclusion

The recent MCA notification, effective from September 30, 2024, imposes the imperative of dematerialising shares for private companies. This move is aligned with the evolving financial landscape, emphasising transparency and compliance. Although this transition may present challenges, a thorough comprehension and adherence to the regulations are pivotal to sidestep penalties and facilitate a seamless shift to dematerialised securities. For additional information or assistance, feel free to reach out to us.

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