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The author is Unnati Sinha, third year student at Narsee Monjee Institute of Management Studies.
Introduction
The Ministry of Corporate Affairs (MCA) has made an intriguing step by introducing the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 by notification on October 27, 2023. Rule 9B, which was included in this amendment, now requires that private companies’ securities be issued in a dematerialized form. It also requires that the company issue new securities and facilitate the issuance of its current securities in a dematerialized form. This is a significant advance as securities may now only exist in dematerialized form. Following this modification, which takes effect on September 30, 2024, a private company must abide by the new regulations.
The private companies are not too surprised by this modification, since there have been conversations in the market for some time about the impending need that securities be stored in dematerialized form. In an early 2004 report titled “Report of the Group on Reduction of Demat Charges,” the Securities and Exchange Board of India (SEBI) emphasised the dangers associated with dealing in physical shares. SEBI further stated that it is actively promoting the dematerialization of securities in the nation. Therefore, it is very clear from the report that even SEBI supported dematerialization at the time and actively worked to bring it about. Furthermore, the March 2022 release of the CLC working committee report also hinted at the recent amendment to the Companies (Prospectus and Allotment of Securities) Rules, 2014 (PAS rules), noting the benefits of dematerialization and suggesting that the Companies Act, 2013 (CA) be modified to require the issuance, transfer, and facilitation of securities only in dematerialized form.
Following the inception of dematerialization
Now that we are getting into the nuances and difficulties this amendment presents, it is important to understand the history of dematerialization. Since section 9(1) of the Act mandates that all securities related to a depository be dematerialized, the word “dematerialization”—which essentially refers to transforming physical shares and securities into electronic form—was first used in the law by the Depository Act, 1996 (DA 1996).
This was the inception point when securities facilitation and storage started in dematerialised form. It is also noteworthy that Section- 29 of the CA broadened the scope of dematerialization as it mandates that the issuance of securities should only be in dematerialized form, thus complimenting the DA.
Recognising the reasoning behind mandatory dematerialization
The primary point of argument centres on the reasoning for requiring dematerialization for private companies. The PAS Rules (2018 Amendment) were modified earlier in 2018 by MCA, adding Rule 9A and requiring public companies to issue and facilitate their current securities in dematerialized form. With a few minor modifications, private companies are now subject to the same rules.
Dematerialization enhances system transparency and fights backdated transactions. Backdating is the technique of altering a document’s date to an earlier one; however, as backdating is not possible for papers referring to shares that are electronically stored, transparency will be strengthened. Furthermore, since dematerialization is based on stringent regulatory control and is electronic in nature, it helps in real-time monitoring of any non- compliance conducted by any company.
Challenges Ahead: Examining the Transition to Dematerialisation
The current amendment exempts only small and government companies from mandatory dematerialisation in contrast to its previous 2018 Amendment, which in addition to small and government companies, also exempted Nidhi companies and wholly owned subsidiaries from mandatory dematerialisation. The reason cited for this was that, these kind of companies have limited number of shareholders. This gives rise to a pertinent question – why is there a diversion from the previous 2018 amendment, and what is the rationale behind not exempting Nidhi companies and wholly owned subsidiaries in the current amendment?
One justification for non-exemption might be to fill in the gaps that existed in the 2018 amendment. An additional and more convincing rationale could be that the government is rapidly approaching dematerialization and any exemption granted to any company will eventually run its course. As a result, soon there will be no company that will be exempted from dematerialization. To maintain a cohesive framework, MCA must address the concerns of the stakeholders.
Further, while extension of the dematerialized realm to private companies seems like a bold move, the compliance timeline given to the private companies is only 18 months i.e. till 30 September 2024, after which issuance and transfer of securities can only happen in demat form. In India, there are 24,61,937 private companies that are currently registered. All of these companies will be filing applications in the NSDL and CSDL for the conversion of securities. Consequently, the main concern is whether both these systems have the requisite digital infrastructure and technology to not only facilitate this conversion of securities, but also facilitate them in a fast and smoother way, as a massive amount of applications may pose operational challenges to both of them.
Another obstacle is that a private subsidiary company cannot qualify as a small company. In case of subsidiaries of private foreign companies, they will also need to adhere to the new rules that have been notified. This will be cumbersome for both, the government and private foreign companies, as they will need to open a demat account with SEBI which requires them to complete a comprehensive Know Your Customer (KYC) process and also obtain a permanent account number (PAN). This will be taxing for the government as there will be an influx of foreign entities trying to obtain PAN. Moreover, the private foreign companies will also face a challenge as even after obtaining PAN after a comprehensive process, they will have to incur a recurring cost to maintain their demat account.
Course of Action for Private companies
In order to comply with the new regulations, private enterprises will need to take a few steps as a result of this amendment. Initially, in order to facilitate the dematerialisation of securities, a private company must get the International Securities Identification Number (ISIN) for each security. Subsequently, the company must notify its shareholders of this information. A private company’s securities should only be issued and transferred in dematerialised form once its share capital has been dematerialised. Additionally, the dematerialisation of the securities held by the company’s directors and promoters should be required. The amendment does not provide for any penal sanctions for non-compliance but on non-compliance a private company will not be able to facilitate transfer of securities and if a there is any grievance a security holder has then it will be resolved by the Investor Education and Protection Fund Authority (IEPFA).
Concluding thoughts
This amendment though has some issues but this is a major transformation from the conventional system where the transfer and issuance of securities was done in physical form. Dematerialization shall help in bringing more efficiency and transparency into the system. Further, from the regulators point of view, this will help them in tackling and mitigating benami transactions and theft by incorporating this new technology driven digital system. It is still debatable whether there is adequate infrastructure to sustain this paradigm shift. The government has to ensure that intact systems are placed so as to regulate and facilitate changes that this new amendment will bring.
Electronic form of securities also helps in tracking real time market movements and see if there is any suspicious activity which cannot be done in the case of physical securities. While a company has to bear printing expense in case of physical securities, a much lower cost is involved in managing electronic securities. Also, the stringent KYC norms posed by this amendment give an overriding benefit to the government as it will help them to maintain a comprehensive database which would further help in bringing more transparency in the system and make it more robust.
In the end, it can be stated that this is a major progressive reform but there are some concerns that needs to be addressed by the MCA.
