Issue of securities in dematerialised form by private companies

By Juhi Roy

1. MCA notification mandating private companies to dematerialise its shares. 

The Ministry of Corporate Affairs  vide notification no. G.S.R. 802(E) dated 27^th October, 2023 has notified the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, which introduced rule 9B. Rule 9B now mandates the private companies to dematerialise the share certificates by September 30, 2024. As the D day is approaching let us quickly look at the amendment and also understand its implications on the private limited company and holders of securities. Rule 9B  states that a private company, which as on last day of a financial year, ending on or after 31st March, 2023, is not a small company as per audited financial statements for such financial year, is required to within eighteen months of closure of such financial year, comply with the provisions of this rule. 

Small companies has been defined to mean a company (i) whose paid-up share capital does not exceed fifty lakh rupees or such higher amount as may be prescribed which shall not be more than  ten crore rupees; and (ii) turnover of which  as per profit and loss account for the immediately preceding financial year  does not exceed two crore rupees or such higher amount as may be prescribed which shall not be more than one hundred crore rupees. However, the following entities are excluded from being classified as a “Small Company”:

• Holding or Subsidiary Companies: Any company that is a holding company or a subsidiary company does not qualify as a small company.
• Section 8 Companies: Companies that are registered under Section 8 of the Companies Act, are not considered small companies.
• Companies Governed by Special Acts: Any company or body corporate governed by any special Act is also excluded from the definition of a small company.

Let us quickly look at the categories of private limited companies which will now have to comply with Rule 9B: 

Nature of company	Whether it will have to comply or not
Private Limited Company	Yes
Section 8 companies	Yes
Government companies	No
Small companies	No
Deemed public company	Yes
Subsidiary of a private limited company	Yes  *  this will be applicable even in case where the subsidiary company on a standalone basis is considered to be a small  company.
Holding company of a private limited company	Yes. *  this will be applicable even in case where the holding company on a standalone basis is considered to be a small  company.

2. Requirements under Rule 9B

As per Rule 9B a private limited company will have to comply with the following within the prescribed timelines: 

1. issue the securities only in dematerialised form; 
2. facilitate dematerialisation of all its securities; 
3. every private company planning to issue any securities, or buy back securities, or issue bonus shares, or make a rights issue after the prescribed deadline must ensure that, before making the offer, entire holdings of securities held by its promoters, directors, and key managerial personnel are dematerialised  as per the Depositories Act, 1996.

As per Rule 9B the following are the obligations on the holders of securities of private limited company:

1. who intends to transfer such securities on or after the date when the company is required to comply with this rule, shall get such securities dematerialised before the transfer; or

2. who subscribes to any securities of the concerned private company whether by way of private placement or bonus shares or rights offer on or after the date when the company is required to comply with this rule shall ensure that all his securities are held in dematerialised form before such subscription. 

It’s pertinent to note that the requirement to dematerialise securities only applies when an eligible private company plans to issue securities, buy back shares, or offer bonus or rights issues after September 30, 2024. If a company intends to undertake any of these activities, it must ensure that entire holdings of securities held by its promoters, directors, and key managerial personnel are dematerialised. However, if the company does not engage in these activities, it will not face penalties for not dematerialising its shares. Meaning holding physical share certificates has not been prohibited by Rule 9B. What has been intended is that post September 30, 2024, any issuance of securities, buy back of securities, transfer of securities can only happen if the securities has been dematerialised. 

3. Key Reasons for Requiring Dematerialisation:

The government’s push for private companies to dematerialise securities stems from several important considerations. This move for private companies is part of a broader strategy aimed at improving the ease of doing business in India and also curbing frauds and benami transactions.

Following are the key reasons for requiring dematerialisation:

1.       Curbing Benami Transactions:

• Physical share certificates historically provided a level of anonymity, allowing for the easy registration of shares under proxies or nominees, thereby facilitating benami transactions. These transactions involve assets being purchased in one person’s name while the actual financial ownership belongs to another. The shift to dematerialized shares is a strategic government initiative aimed at curbing such practices. By eliminating physical certificates, dematerialization ensures that true ownership is transparently recorded in electronic form within a centralised system managed by depositories. This system keeps an accurate and up-to-date record of the actual owners, significantly reducing the possibility of concealing true ownership and thus tackling the issue of benami transactions more effectively.

2. Reduction in Litigation:

• Dematerialisation helps minimize disputes related to fake share transfers and improper share pledges. Electronic records are more secure and harder to forge, reducing the chances of fraudulent activities.

3. Improved Efficiency for Shareholders:

• Holding shares in dematerialised form streamlines the process for shareholders, making it easier to manage, transfer, and pledge shares without the need for physical certificates.

4. Simplification of Foreclosures for Financial Institutions:

• Financial institutions benefit from dematerialised shares, as the process of foreclosing on shares held as collateral becomes much simpler compared to dealing with physical share certificates, which can be cumbersome and prone to legal complications.

5. Increased Transparency and Traceability:

• Dematerialisation enhances the ability of government agencies to trace the ownership of securities in private companies. This transparency is crucial for ensuring compliance with regulatory requirements and preventing fraudulent activities.

6. Efficient Collection of Stamp Duty:

• The shift to dematerialised securities also aids in the accurate collection of stamp duty on security transfers, issuance of security, as electronic records are easier to monitor and audit, ensuring that the government receives the appropriate revenue.

4. Certain interpretations of Rule 9B

Let us now look at some of the interpretation issues in Rule 9B. 

Firstly, the word used in Rule 9B is ‘securities’ and not shares. Therefore, the notification will be applicable to physical certificates related to shares and also securities like NCDS, debentures etc. 

Secondly, rule 9B stipulates that a private company, which is no longer classified as a small company as of the last day of a financial year ending on or after March 31, 2023, based on its audited financial statements, must comply with the provisions of this rule within eighteen months of the close of such financial year, i.e., by September 30, 2024. This raises the question of whether Rule 9B will apply to small companies incorporated after September 2024. Furthermore, if such a small company subsequently loses its small company status, what would be the applicable timeline for complying with the requirements of Rule 9B?

For example, let us assume that Apple Private Limited is incorporated in October 2024 and it qualified as a small company for the year 2024. However, in the following year 2025, the company’s financials and operations expand, and it ceases to qualify as a small company.

Now one interpretation can be that Rule 9B specifically refers to companies incorporated prior to September, 2024 and not companies incorporated post September, 2024, since the compliance needs to be completed within September 2024. However, this interpretation maybe a bit farfetched. Since, the rule specifically states that a private company, which as on last day of a financial year, ending on or after 31st March, 2023, is not a small company as per audited financial statements for such financial year, is required to within eighteen months of closure of such financial year. Thus, it can be inferred that companies incorporated after September 2024, upon ceasing to qualify as small companies, will be required to comply with the relevant requirements within 18 months of the end of the financial year in which they lose their small company status.

Third question that arises is if the holder of the securities are required to dematerialise all his securities post September, 2024. Let us assume that Mr A is a holder of equity shares in Apple Private Limited and also holder of compulsorily convertible debentures (CCDS) in Orange Private Limited. All of these securities were issued in the year 2018 and are held in physical form. Now Apple Private Limited wants to do a rights issue on December, 2024 and Mr A wants to purchase the shares in the rights issue. The question that arises is whether Mr A would also have to dematerialise the CCDs held in Orange Private Limited. If we read the language of Rule 9B it says: who subscribes to any securities of the concerned private company whether by way of private placement or bonus shares or rights offer on or after the date when the company is required to comply with this rule shall ensure that all his securities are held in dematerialised form before such subscription. 

Thus, a literal interpretation will mean Mr A will not only have to dematerialise his shares in Apple Private Limited but also in Orange Private Limited. However, this might be too cumbersome on the holders of securities and was probably not the intention of the government. So, in my considered view Mr A will only have to dematerialise his securities held in Apple Private Limited. Thus, if Mr A was holding equity shares and CCDs in Apple Private Limited, in physical form, then prior to the rights issue Mr A will have to convert all this securities held in physical form in Apple Private Limited i.e. the equity and the CCDS in dematerialised form, irrespective of the fact that he is only purchasing equity shares in Apple Private Limited. 

5. How to dematerialise securities?

To dematerialise physical securities, an investor must first open a demat account and complete a Dematerialisation Request Form (DRF), which is available with the Depository Participant (DP). A Depository Participant (DP) is a financial institution, bank, or stockbroker that acts as an intermediary between investors and depositories in India. DPs are registered with depositories. Depositories hold securities of the investors in dematerialised form as per the Depository Act. In India there are two depositories- (a) Central Depository Services (India) Ltd. (CDSL), and (b) NSDL (National Securities Depository Limited).  

The DRF, along with the physical certificates to be dematerialised, must be submitted to the DP. A separate DRF must be completed for each ISIN. As per SEBI Faqs “ ISIN (International Securities Identification Number) is a unique 12 digit alpha-numeric identification number allotted for a security (E.g.- INE383C01018). Equity-fully paid up, equity-partly paid up, equity with differential voting /dividend rights issued by the same issuer will have different ISINs. ”

The process involves the following steps:

1. The investor who holds the physical certificates is required to surrender the respective physical certificates to their DP.
2. The DP then notifies the respective depository of the request of the holder of the physical certificate.
3. Then the DP is required to forward the physical certificate to the Registrar of the issuing company.
4. On receiving the certificates the Registrar confirms the dematerialisation request with the respective depository.
5. The Registrar dematerialises the certificates, updates the records, and informs the respective depository.
6. The depository updates its accounts and notifies the DP.
7. Then the DP updates the investor’s demat account with the electronic securities.

6. Compliance by private companies

Private limited companies will now have to comply with the following: 

1. Every private limited company is required to facilitate dematerialisation of all its existing securities by making necessary application to a depository i.e. CSDL or NSDL and is required to secure ISIN for each type of security. It is also obligated to inform all its existing security holders about such facility  being available.
2. Every private limited company is required to ensure that-

1. it makes timely payment of fees (admission as well as annual) to the depository and registrar to an issue and share transfer agent in accordance with the agreement executed between the parties;
2. it maintains security deposit at all times, of not less than two years, fees with the depository and registrar to an issue and share transfer agent in such form as may be agreed between the parties; and
3. it complies with the regulations or directions or guidelines or circulars, if any, issued by the securities and Exchange Board or Depository from time to time with respect to dematerialisation of shares.

3. No private company which has defaulted in making the required payment can make offer of any securities or buyback its securities or issue any bonus or right shares till the payments to depositories or registrar to an issue and share transfer agent are made.
4. The provisions of the Depositories Act 1996 the securities and Exchange Board of India (Depositories and participants)  and the securities and Exchange Board of India (Registrars to an Issue and share Transfer Agents) Regulations, 1993 shall apply mutatis mutandis to dematerialisation of securities of private limited companies.
5. Every private limited companies governed by this rule is required to submit Form PAS-6 to the Registrar with adequate fees within sixty days from the conclusion of each half year duly certified by a company secretary in practice or chartered accountant in practice.
6. The company is required to immediately bring to the notice of the depositories any difference observed in its issued capital and the capital held in dematerialised form.

7. Implications and way forward

Increase in Cost and Compliance: Dematerialising shares involves several upfront costs, such as fees for opening demat accounts, charges from Depository Participants (DPs), and compliance with regulations set by the Securities and Exchange Board of India (SEBI). Moreover, ongoing compliance with the regulatory framework, such as updating records with depositories and ensuring the maintenance of electronic records, adds to the administrative burden and costs.

Impact on Foreign Investors: The process of dematerialisation could lead to delays in closing deals, particularly in transactions involving foreign investors. Since foreign investors are often involved in complex cross-border transactions, the additional steps of converting physical shares to electronic form may extend the time required to close deals. 

One-Time Bane for a Longer-Term Gain: Although the initial costs and compliance requirements may seem burdensome, dematerialisation is a one-time challenge that ultimately leads to a more efficient and transparent system. Once shares are dematerialised, companies and investors benefit from faster transactions, reduced paperwork, and enhanced security against fraud and loss. Over time, these advantages outweigh the initial difficulties, leading to a more streamlined and reliable process.

By embracing the process and planning effectively, private companies can turn the challenges of dematerialisation into opportunities for improved corporate governance and stronger investor relations.