The Ministry of Corporate Affairs (“MCA”) on October 27, 2023^[1] notified the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, vide which a new rule, i.e. Rule 9B has been inserted in the existing Companies (Prospectus and Allotment of Securities) Rules, 2015 (“Allotment Rules”).

Requirement under the law

Under the said Rule 9B of the Allotment Rules, every private company which is not a small company^[2] as on March 31, 2023, has to ensure that all its shares are in dematerialised form by September 30, 2024^[3] (“De-Mat Last Date”). For all such other private companies which would qualify as a ‘small company^[4]‘as per the provisions of the Companies Act, 2013 (the “Act”), the requirement to dematerialise all their shares would become applicable within 18 (eighteen) months from the end of such financial year in which such company would no longer qualify as a small company.

Further, the Allotment Rules has specified that post the De-Mat Last Date, any new issuance of securities by the private companies has to solely be undertaken in a dematerialised form. Further, the private companies which plan to buyback its shares or issue bonus shares or undertake a rights issue, have to ensure that the holding of securities by their promoters, directors, key managerial personnel are in the dematerialised.

While the amendment does not prohibit the holding of shares of a private company in physical form, but any person(s) holding such shares in physical form, would have to ensure that these shares are converted into dematerialised form in case, they wish to transfer the same post the De-Mat Last Date. So, before seeking any transfer of any such shares after the De-Mat Last Date, the shares will have to be mandatorily dematerialised.

Rationale behind the move

While dematerialisation of shares is not a completely new phenomenon, this requirement comes in line with the amendment made to the Allotment Rules in October 2018, vide which issuance of securities by all public unlisted companies in dematerialised form were made mandatory. The idea behind the move seems to not only improve the ease of doing business in India but also to curb benami transactions, reduce litigations related to fake share transfers or improper share pledges. Holding shares in dematerialised form creates efficiencies for the holder of shares as well. As regards the financial institution, which are facing challenges in foreclosures pledges of shares in physical form, this will be a great move as the foreclosure of dematerialised shares is far simpler process. Further, this move would also ensure transparency and may aid the governmental agencies to better trace the shareholders of private companies and also seek payment of adequate stamp duty on share transfers.

Impact on private companies

The requirement of compulsory dematerialisation of shares may have additional compliance costs for the private companies, however, in the long run, this move would only improve the ease of doing business in India as this would ensure that any further issuance by private companies, share transfer, buyback, rights issues etc., would become a much faster and smoother process. Further, it must be seen that the MCA has specifically excluded ‘small companies’ from the ambit of this compulsory dematerialisation requirement, which can be seen as a move to exclude early-stage start-ups from the burden of additional compliance costs.

Compliance requirement for foreign investors

On account of compulsory dematerialisation, the foreign investors would need to open demat accounts with depositories in India for the purpose of making investments in private companies in India. This could lead to increase in the time period of deal closure as opening of demat account for foreign investors would involve obtaining a Permanent Account Number (PAN) with tax authorities in India, fulfilling of know your customer (KYC) norms of the depositories, payment of additional fees, apostille of documents etc.

However, this being a one-time requirement, this would provide much more benefits to the foreign investors than the hassles involved as it would provide benefits to the foreign investors such as consolidation of investments in various private companies in India under one demat account, smoother and faster process for share transfer in case of exit from investment, lesser risk of loss of share certificates like in the case of physical share certificates etc.

Adequate timeline

The market intermediaries i.e. depository participants, depositories, Registrar and Transfer Agents (RTAs) may have to overhaul their existing infrastructure and processes to be able to accommodate huge number of additional users in their network. Similarly, the private companies would also require some time to complete the dematerialisation of the shareholding of its promoters, directors and key managerial personnel. It seems the MCA has taken into consideration the time to be taken for all these actions to take place, hence, provided for timelines which almost a year away, which should be ample and adequate amount of time for undertaking all necessary changes by all the stakeholders.

Conclusion

The compulsory dematerialisation of the shares of the private company overall seems to be the move in the right direction and will lead to a more transparent and efficient system of share transfers, more financial inclusivity, better bankability of the shares (owing to ease of foreclosures of pledges shares in dematerialised form) and access for retail investors, reduction of frauds and cost, time effectiveness for investors, financial institutions and issuer companies alike.

Footnotes:

[1] Notification bearing no. G.S.R. 802 (E) dated October 27, 2023.

[2] A company for the purposes of this rule will be considered as a small company if it qualifies as a small company as per the audited financial statements of the period ended March 31, 2023.

[3] Rule 9B (2) of the Allotment Rules provides all private companies which is not a small company as on the financial year ended March 31, 2023, shall comply with the requirement of dematerialization within a period of 18 (eighteen) months from end of the financial year.

[4] As per Section 2(85) of the Act, a small company is a company, other than a public company, whose maximum paid-up capital is INR 4,00,00,000 (Indian Rupees Four Crores only) and maximum turnover is INR 40,00,00,000 (Indian Rupees Forty Crores only).