DEMYSTIFYING DEMATERIALIZATION: MCA's PARADIGM SHIFT IN PRIVATE COMPANY SECURITIES

In the fast-evolving landscape of Indian corporate finance, the Ministry of Corporate Affairs (“MCA”) in a significant stride towards digitizing the corporate landscape, introduced an amendment - mandating the dematerialization of securities for private companies. The paradigm shift was declared through anotification by the MCA on October 27, 2023, through the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (“Amended PAS Rules”) and marks a significant departure from the status quo, extending a practice that was hitherto exclusive to public companies. This article navigates through the historical evolution, the legislative milestones and the transformative implications for private entities.

DEMATERIALIZATION'S EVOLUTION IN INDIA: A TRYST WITH DIGITAL FINANCE

The roots of dematerialization in India can be traced back to 1996, a pivotal year when the landscape of securities trading underwent a profound transformation. This transformation aimed to enhance efficiency, security, and accessibility in the Indian capital market. The National Securities Depository Limited (“NSDL”) and Central Depository Services Limited (“CDSL”) were established in 1996 to oversee this transition. The dematerialization process necessitates investors to establish demat accounts with Depository Participants ("DPs"), serving as intermediaries between them and the depository. The transition from physical to electronic securities, facilitated by depositories such as NSDL and CDSL, has introduced a new era although initially introduced solely for the public listed companies, the move aimed to mitigate risks associated with physical certificates and streamline the entire trading process via electronic records. Over the years, dematerialization became the norm for the public listed entities, bringing in efficiency, security, and accessibility to the Indian capital market.

THE 2018 AMENDMENT: EXTENDING THE DIGITAL REACH

Introduced over a decade ago, Section 29 of the Companies Act, 2013 (the successor to Section 68B of the Companies Act, 1956) established the necessity for a dematerialized form when conducting a public offer of securities by listed public companies and other specified companies. The notification for Section 29 of the Companies Act was made on September 12, 2013, while the PAS Rules were enacted on April 1, 2014. A precursor to the current mandate was the Companies (Prospectus and Allotment of Securities) Third Amendment Rules, 2018 (“2018 Amendment Rules”) released by the MCA which came into effect on October 2, 2018 brought every unlisted public companies within the purview of Section 29 of the Companies Act. This amendment cast its net wide, encompassing all the unlisted public companies including the private companies acting as subsidiaries of a public company with the exception of nidhi or government companies into the dematerialization fold thereby obligating such companies to issue securities exclusively in dematerialized form and support the dematerialization of all its existing securities. Notably, the wholly-owned subsidiary (“WoS”) of an unlisted public company received an exemption from this obligation under the 2018 Amendment Rules, however, the intention was clear – going forward, no company, irrespective of its public or private nature, should be left behind in the digital transformation of securities.

2023 PAS RULES: DEMOCRATIZING DIGITAL SECURITIES FOR PRIVATE COMPANIES

The Amended PAS Rules bring about significant transformations, with two key focal points. Firstly, public companies are now required to relinquish share warrants issued before the initiation of the Companies Act, 2013, and convert shares into dematerialized mode. Secondly, the mandate extends to private companies, excluding small companies, compelling them to issue securities exclusively in dematerialized form and emphasizing the facilitation of dematerialization for all existing securities. The term 'securities' within the Amended PAS Rules, referencing the Securities Contracts (Regulation) Act (“SCRA”), encompasses a broad spectrum of instruments, including equity shares, preference shares, debentures, warrants, and more. This signifies a notable evolution from the 2018 Amendment Rules, broadening its reach to encompass private companies, thereby advancing the universality of dematerialization in the Indian corporate landscape. The Amended PAS Rules are applicable to all private companies, barring small and government companies. Importantly, the exemption does not extend to companies incorporated under section 8 of the Companies Act, ensuring comprehensive coverage. This move represents a significant stride towards a more digitized and streamlined securities management system in India, affirming the commitment to modernize and standardize practices across various sectors of the corporate domain.

DIVING INTO THE AMENDED PAS RULES: KEY REQUIREMENTS AND ITS EFFECTS

A. Surrendering of Share Warrants by Public Entities

Timelines and Compliance Instructions: The Amended PAS Rules introduce crucial obligations for public entities concerning share warrants. These directives apply specifically to share warrants issued before the commencement of the Companies Act, 2013, which haven't been converted into shares up to the initiation of the Amended PAS Rules.

1. Submission of Details to RoC (Form PAS-7): Within a three-month window from the initiation of the Amended PAS Rules, these entities are mandated to provide details of such share warrants to the Registrar of Companies (RoC) using Form PAS-7.
2. Notice and Publication (Form PAS-8): Within six months of the commencement of the Amended PAS Rules, public entities must display a notice in Form PAS-8 on their websites and publish it in both a vernacular and English newspaper. This notice is aimed at holders of such share warrants, urging them to surrender the warrants and dematerialize the corresponding shares.
3. Ramifications of Non-Compliance: Failure to comply with the surrendering of share warrants leads to the transfer of non-converted share warrants to the Investor Education and Protection Fund (IEPF).
4. B. Dematerialization of Securities for Private Entities

Compliance Framework and Deadlines: Private entities, excluding those falling under the small company category, face an extensive set of requirements concerning the dematerialization of securities, impacting various facets of their securities management.

1. Compliance Deadline:

Private entities not qualifying as small companies as on the last day of financial year closure as of or after March 31, 2023 must adhere to the new requirements within 18 months from the completion of Financial Year. Consequently, for all the private entities concluding their financial years on March 31, 2023, the compliance deadline is set for September 30, 2024.

2. Steps for Adherence:

• Amendment of Articles of Association (“AoA”): The entity needs to amend its AoA to empower shareholders to hold securities in dematerialized form.
• Engagement of SEBI-Registered RTA: The entity must appoint a Securities and Exchange Board of India (“SEBI”) registered Registrar and Transfer Agent (“RTA”).
• ISIN Procurement: Obtain an International Securities Identification Number (“ISIN”) from NSDL or CDSL, with a separate ISIN required for each distinct type of existing security within 18 months.

3. Obligatory Dematerialization: After the 18-month period, private entities are mandated to issue securities solely in dematerialized form.

4. Application of 2018 Amendment Rules: Private entities are subject to the conditions outlined in sub-rules (4) to (10) of the 2018 Amendment Rules. While specific consequences for non-compliance are not detailed under Section 29 of the Act, the penalties outlined in Section 450 of the Act shall be applicable as a general rule.

C. Handling Securities Across Transactions

Issue and Buyback: Before initiating an offer or buyback of securities, a private entity must ensure the dematerialization of securities held by its promoters, directors, and key managerial personnel.

• Transfer of Securities: Individuals involved in transferring securities must dematerialize them before the transaction, a requirement applicable to the seller as well as the buyer since the buyer is required to retrieve such securities only in demat form.
• Private Placement, Bonus Shares, or Rights Offer: Individuals subscribing to securities in a private entity, whether through private placement, bonus shares, or rights offer, are obligated to dematerialize all held securities before subscribing.

Compliance with Laws and Interaction with Depository:

• Adherence to Laws: Private entities must conform to the Depositories Act, 1996, SEBI D&P Regulations, 2018, and SEBI's Regulations for Registrars to an Issue and Share Transfer Agents, 1993.
• Submission of Form PAS-6: Every half-year, private entities must submit Form PAS-6, reporting shares held in demat form, to the Registrar of Companies. This submission, certified by a company secretary or chartered accountant, is due within 60 days of each half-year's conclusion.
• Depository Interaction Protocols: Private entities must ensure timely fee payments, maintain a security deposit, and comply with SEBI or depository regulations. Failure to comply results in restrictions on the private entity from making various securities-related offers until outstanding payments are settled.

Handling Grievances:

• Grievance Resolution: Grievances related to dematerialization or transactions in dematerialized form will be addressed by the Investor Education and Protection Fund Authority (“IEPFA”). The IEPFA retains the authority to initiate actions against depositories, depository participants, registrars, or share transfer agents after consulting with SEBI.

KEY TAKEAWAYS

1. Foreign Investment Dynamics: The recent Amendment significantly impacts over 14.45 lakh active private companies in India, introducing complexities for foreign entities navigating Know Your Customer (“KYC”) requirements and obtaining a permanent account number. The compliance deadline of September 30, 2024, adds to the lead time for foreign investors.
2. Operational Challenges and Compliance Costs: Implementing the dematerialization process on a massive scale necessitates substantial efforts from depositories, depository participants, and share transfer agents. Beyond logistical challenges, the initiative amplifies compliance costs for private companies. Rule 9B of PAS Rules triggers awareness programs led by the MCA and corporate governance professionals.
3. Dematerialization for Enhanced Transparency: The Amendment aims at digitizing the entire share capital and shareholders' data nationwide, facilitating identification of benami shareholders and establishing an effective ownership tracking mechanism. This move demonstrates the commitment to institutionalizing transparency and corporate accountability.
4. Future of Securities Transactions: While mandating dematerialization, the Amendment preserves the option for security holders to retain physical securities until transacting post-September 30, 2024. Depositories and depository participants emerge as crucial players, bearing responsibility for any errors and resultant losses.

CONCLUSION

In conclusion, the recent Amendment marks a transformative phase for the active private companies in India. From a regulatory perspective, the MCA's initiative aligns with the global trend of enhancing transparency and streamlining securities transactions. It reduces the risk associated with physical certificates, deters fraudulent activities, and establishes a business-friendly ecosystem. The involvement of the IEPFA in addressing grievances related to dematerialized securities enhances investor confidence. As India embraces digitization in the securities market, the pivotal role played by depositories and participants sets the stage for a more transparent, accountable, and efficient securities market. While operational and compliance costs are inevitable, the overall benefits of dematerialization—transparency, security, and efficiency—outweigh the challenges. The stringent KYC requirements contribute to a robust centralized database, simplifying the process of determining beneficial ownership and enhancing tax collection efficiency.

In essence, the MCA's digital leap through the Amended PAS Rules signifies a proactive step towards modernizing corporate governance, fostering investor confidence, and aligning with global best practices. The journey towards a fully dematerialized securities landscape reflects a commitment to innovation and transparency in India's corporate ecosystem.