[By Anubhav Patidar & Sarthika Singhal]
The authors are students of Narsee Monjee Insititute of Management Studies.
INTRODUCTION
The Indian financial market has witnessed tremendous growth anchored on the principles of transparency and ease of doing business promoted by the Government of India. Historical inefficiencies in the physical aspect of the trading system of the securities market have come to light. Securities and Exchange Board of India (“SEBI”) in its 2004 report titled ‘Report of the Group on Reduction of Demat Charges’1 highlighted the risks associated in dealing with physical shares, i.e., theft, forgery, loss and damage.
Pursuant to the threats posed by physical certificate trading in private, regulators mandated compulsory dematerialization for private companies. In accordance with the powers granted by Section 292 read with Section 469 of the Companies Act, 20133 (“Act”), the Ministry of Corporate Affairs (“MCA”) introduced this amendment to the to the Companies [Prospectus and Allotment of Securities (“PAS Amendment”)] Rules, 2014 on October 27, 2023.
Dematerialization refers to the process through which tangible share certificates of an investor are converted into an equivalent number of securities in electronic format.
This article deals with the intricacies of the PAS Amendment Rules 2023, analyze the background and the rationale behind the amendment, understand its impact on market players and then highlighting certain concerns associated with it.
MCA Notification
Under the amended rules, every private company must compulsorily dematerialize all its securities with immediate effect. The companies are granted an 18 month-timeline from the closure of the financial year in which they cease to be a non-small private company to adhere to this amendment.4 For instance, if a company seizes to be a small company at any time during the financial year 23–24, 18 month-timeline triggers from 31 March 2024, and be complied is required by 30 September 2025.
Two specific categories are exempted from this mandate. First, the amendment does not apply to small companies5, 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, government companies are excluded6, acknowledging the distinct regulatory framework applicable to these entities.
RATIONALE BEHIND MANDATORY DEMATERIALIZATION
The rationale to implement dematerialization for private companies is to unveil the opaque realms of asset ownership in the private sector. This initiative aims to enhance efficiency, transparency, and security within the private sector, ultimately benefiting both companies and investors.
Private companies, characterized by a restricted shareholder base and minimal regulatory scrutiny owing to their absence from public markets, have long operated under a shroud of secrecy. This opacity has provided fertile grounds for various illicit practices, spanning from tax evasions to financial deceit, often facilitated by the presence of shell companies – with no significant assets or operations.
Transitioning to dematerialization requires a private company to register with one of India’s two depositories and be allocated a securities identification number (“ISIN”) that will be used to track shares and other securities issued by the company. Shareholders will need to open a ‘demat account’ showing identification proof. Demat accounts would have to be compulsorily linked to permanent account numbers (“PAN”), and bank account.7 Any sale or purchase of shares of a private company will reflect in the demat account records. With shares held and exchanged through depository accounts, ownership rights become unequivocally clear, rendering it significantly challenging to engage in fraudulent activities such as clandestine ownership or fabricated transfers.
Further, private company ownership information will come handy to market regulators like SEBI. Regulators can effectively track and scrutinize transactions, facilitating prompt detection and prevention of non-compliance. This heightened level of regulatory scrutiny will act as a deterrent to illicit activities, fostering a more compliant and transparent securities market environment.
Impact on Companies
The financial burdens on the private companies are expected to get fortified since there is a fee component associated with demat accounts. Moreover, Private companies have to hire additional people to look after the compliance of dematerlialization process. Opening these accounts is merely the tip of the iceberg; ongoing expenses like annual maintenance fees add to the burden. Additionally, complying with regulatory requirements, such as upgrading technology and infrastructure, for dematerialization entails additional costs. This requires companies to allocate significant resources to ensure seamless compliance and effectively manage the financial implications of dematerialization.
While the wholly-owned subsidiaries (WoS) of unlisted public companies received exemptions from dematerialization requirements in the 2018 Amendment Rules exempted, the same leniency doesn’t extend to WoS of private companies under the Amended PAS Rules. If a private company subsidiary falls under the umbrella of another private entity, it must adhere to dematerialization regulations. However, if the subsidiary operates under a public company, thereby retaining its status as a deemed public company, it remains exempt from the 2018 amendment to the Rules.
Impact on Foreign Investors
The impact of dematerialization on foreign investors in Indian private companies presents both short-term challenges and long-term benefits. This documentation and procedural requirements may lengthen investment timelines and incur additional costs, posing a potential deterrent to foreign investment. Moreover, shareholders must furnish extensive details regarding their constitution, ownership, and stakeholder agreements, which could raise concerns for foreign funds. Once the demat account is established, the administrative burdens associated with traditional paper-based transactions are eliminated. Dematerialization ensures smoother, safer, and faster transactions for foreign investors, enhancing the efficiency and attractiveness of investing in Indian private companies. Therefore, while the initial setup may pose challenges, the transition to dematerialization ultimately enhances the investment landscape for foreign investors in the Indian market.
AFTERMATH OF AMENDEMENT: CHALLENGES AND WAY FORWARD
Navigating the transition towards mandatory dematerialization in private limited companies presents considerable hurdles, requiring strategic solutions for effective implementation.
Firstly, the technical complexities encountered by shareholders, often acts as a deterrent to the adoption of dematerialization. However, by providing intuitive interfaces and dedicated technical assistance, companies can empower shareholders to navigate the process with enhanced ease and assurance, thereby facilitating a smoother transition.
Moreover, the cybersecurity concerns presents yet another formidable challenge, and the Karvy scam8 is a prime example of the consequences of inadequate cybersecurity measures. In this scam, Karvy Stock Broking misused their client’s dematerialized securities by creating additional pledges on them in clear violation of their legal rights. This was made possible due to inadequate cybersecurity measures that allowed hackers to manipulate or gain unauthorized access to the client’s securities. Therefore, effective cybersecurity measures are an ongoing process that requires constant vigilance and measures to update and upgrade systems to strengthen them. Proper implementation of security measures, multi-level authentication, and artificial intelligence (AI) systems can help address these challenges and improve the security of the dematerialized share system.
CONCLUSION
The amendment stands as a beacon for transparency and accountability to the often-opaque world of private ownership. At the initial stage, it poses several challenges, necessarily requiring investors and companies to undertake additional compliance costs and market regulators to indulge in capacity building measures and robust cybersecurity measures to aid the dematerialization process. However, the overall trajectory towards increased efficiency and robustness in the Indian capital market would outweigh temporary disruptions. This essay sought to map the legal and practical landscape in India with regard to compulsory dematerialization for private companies.
However, realizing the full potential of dematerialization demands a concerted effort from market regulators, intermediaries, and stakeholders. The recommendations and suggestions of the authors through the analysis can be summarized and concluded as follows:
- Given the heightened state of cybersecurity concerns in India, a powerful IT-based monitoring mechanism is required to be developed by the regulator along with the depository participant to ensure constant vigilance over integrity of the demat procedure.
- Adequate systems should be implemented at the depository level to uphold the fundamental characteristics of a private company- restricted ownership. This includes implementing filters to scrutinize and approve any transfer of securities.
While the idea of compulsory dematerialization is revolutionary and is the need of the hour, the abovementioned issues need careful consideration by the concerned authorities to ensure that the real objective of introducing the amendment is actually achieved and is not proved to be futile.