MCA’s Directive for Dematerialization of Securities for Private Companies

[Shruti is a student at Gujarat National Law University.]

In a significant development, the Ministry of Corporate Affairs (MCA) has, through a notification dated 27 October 2023, introduced a pivotal amendment, particularly Rule 9B, into the Companies (Prospectus and Allotment of Securities) Rules 2014 (PAS Rules), via the Companies (Prospectus and Allotment of Securities) Second Amendment Rules 2023 (PAS Amendment Rules). Rule 9B mandates the dematerialisation of securities for private companies, marking a departure from traditional paper-based processes. This move aligns with the broader trend of digitisation within the corporate landscape and underscores the MCA’s commitment to enhancing transparency and efficiency in the securities market.

The Antecedent Position

The Companies Act 1956 had a provision under Section 68B for dematerialisation regarding the 'initial offer of securities to be in dematerialised form in certain cases'. However, it was Section 29 of the Companies Act 2013 which introduced the express mandate that public offers of securities by listed public companies and other entities, as stipulated, must be in a dematerialised form. The formal notification of Section 29 on 12 September 2013 emphasised the transition from physical to electronic records.

The subsequent promulgation of the PAS Rules on 1 April 2014 provided the detailed procedural underpinning for the implementation of Section 29. This framework outlined the processes and requirements for ensuring the dematerialisation of securities in public offers. A further expansion of the regulatory purview occurred When the PAS Rules were amended and brought into force on 2 October 2018 by the MCA notification dated 10 September 2018, where all unlisted public companies were brought under the ambit of Section 29. This extension aimed to standardise practices across both listed and unlisted public companies, aligning their operations with the evolving norms of dematerialisation.

Defining Dematerialisation

A crucial step is required before availing the benefits of a demat account, which is the process of dematerialization. Dematerialisation is the process that involves converting tangible share certificates into electronic records, a practice that enhances efficiency, security, and ease of trading. The dematerialisation process commences with the opening of a demat account. Demat accounts serve as electronic repositories for shares and securities, enabling investors to hold and manage their financial assets in digital form.

One must select a depository participant (DP) providing demat services to initiate this. The next step involves filling out a dematerialization request form, available with the DP, and submitting it along with the physical share certificates. Each certificate should be endorsed with ‘surrendered for dematerialization.’ The DP processes the request, forwarding it to the company, registrars, and transfer agents through the depository. Upon approval, the physical share certificates are destroyed, and confirmation of dematerialisation is sent to the depository. The depository, in turn, notifies the DP, resulting in an electronic credit of the shares in the investor's account.

At present, two depositories viz. National Securities Depository Limited and Central Depository Services (India) Limited are registered with SEBI. Following registration, depositories assign a unique International Securities Identification Number for each share, constituting a distinctive 12-digit code crucial for identifying various securities like shares and bonds. Notably, companies can access depository services solely through an intermediary. In the event an issuer wishes to transfer dematerialized shares, it becomes imperative to establish demat connectivity directly from the depositories.

MCA’s Mandate

The Companies Act 2013 underwent a significant amendment with the insertion of sub-section (1A) under Section 29, a provision that empowered the Central Government to delineate specific classes of unlisted companies mandating the exclusive holding and transfer of securities in dematerialised form. In consonance with this statutory empowerment, Rule 9B was introduced through the PAS Amendment Rules.

Rule 9B states that every private company shall '(a) issue the securities only in dematerialised form; and (b) facilitate the dematerialisation of all its securities, in accordance with provisions of the Depositories Act, 1996 (22 of 1996) and regulations made thereunder.'

The introduction of Rule 9B into the PAS Rules applies comprehensively to private companies as defined under Section 2(68) of the Companies Act 2013, encompassing a wide array of entities. However, two specific categories are exempted from its purview. First, the amendment does not apply to small companies, defined as private companies with a paid-up share capital of INR 4 crores or below and a turnover of INR 40 crores or below. Additionally, the amendment excludes government companies from its scope, acknowledging the distinct regulatory framework applicable to these entities.

Every private company engaging in activities such as issuing securities, conducting buybacks, or offering bonus shares or rights must adhere to the stipulation that the securities held by its (a) promoters, (b) directors, and (c) key managerial personnel, must be dematerialised prior to making such offers.

Regulatory Compliances for Private Companies

Rule 9B stipulates that private companies, as determined on the last day of the financial year ending on or after 31 March 2023, are obligated to issue securities exclusively in dematerialised form. This transition to dematerialisation is required to be completed within 18 months from the conclusion of the specified financial year, precisely by 30 September 2024. Sub-rules 4 to 10 of Rule 9A will be applied, with necessary modifications, to govern the dematerialisation process under the present regulatory framework.

Any individual holding securities in a private company who intends to transfer them is obligated to dematerialise these securities before proceeding with the transaction. Importantly, this regulatory requirement ensures that both parties involved in the transaction, the seller and the buyer, adhere to dematerialisation norms. Consequently, the buyer must receive the securities in dematerialised form. For individuals holding securities in a private company, engaging in private placement, bonus shares, or rights offers mandates a critical procedural step: the dematerialisation of all existing securities before subscribing to any new securities.

In adherence to regulatory obligations, every private company is mandated to ensure the punctual payment of fees to both the depository and the registrar to an issue and share transfer agent, as outlined in the agreement executed between the parties involved. Additionally, the company is required to uphold a continuous security deposit, the equivalent of not less than two years’ fees, with the depository and registrar to an issue and share transfer agent. The specific form of this deposit is determined through mutual agreement between the private company and the concerned parties. Further, due to the mandatory dematerialisation of securities in private companies in India, foreign investors would be required to open demat accounts with depositories in the country to facilitate their investments.

As part of the ongoing regulatory compliance framework, every private company is required to submit Form PAS-6, a half-yearly return designed particularly for reporting shares held in a dematerialised form. This submission must be made to the Registrar of Companies within 60 days from the conclusion of each half year. The submission should be accompanied by the relevant fee and must be duly certified by a qualified professional, either a company secretary in practice or a chartered accountant in practice.

Conclusion

The recent initiative to mandate the dematerialization of shares in private companies in India reflects a multi-faceted strategy aimed at enhancing the business environment and curbing illicit financial activities. The dematerialisation process will not only streamline the securities market but will also contribute significantly to the reduction of paperwork and the overall modernisation of India's corporate governance. Holding shares in a dematerialised form not only creates operational efficiencies for shareholders but also addresses challenges faced by financial institutions in the foreclosure of physical shares. The foreclosure process for dematerialised shares is notably more straightforward, presenting a positive shift for financial institutions. In sum, the dematerialisation mandate emerges as a comprehensive step towards fostering a more secure, efficient, and accountable landscape for private company transactions in India. This measure not only enables compliance but also contributes to the overall integrity and transparency of transactions involving private company securities.