Dematerialization of shares: Mandatory for Private Limited Companies

Introduction

The Ministry of Corporate Affairs (MCA) has introduced a significant change with the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (PAS Amendment Rules) as notified by notification no. GSR 802(E) dated 27^th October 2023. This mandates private companies, excluding small ones, to convert physical securities into dematerialized (demat) form within eighteen months of their financial year ending March 31, 2023. This article explores the key parameters, compliance timelines, and consequences of this dematerialization mandate.

Under Rule 9B of the PAS Amendment Rules, private companies that are not classified as “small companies” under the Companies Act, 2013, as of the end of the financial year ending on or after March 31, 2023, are mandated to convert their existing physical securities into dematerialized (demat) form within eighteen months of the conclusion of that financial year.

Key parameters of dematerialization mandate as implemented under the PAS Amendment Rules

1. Class of Companies that are required to abide by the dematerialization provisions

Rule 9(B) of the PAS Amendment Rules enlists the prescribed classes of companies that are required to comply with the provisions:

• Private Company, other than a small company, as of the financial year ended on or after 31^st March 2023;

Small Companies[1] as defined under section 2(85) of the Companies Act, 2013 are excluded from the ambit of PAS Amendment Rules

Note – For the sake of brevity, “private company other than small company” shall be referred to as “Applicable Company” in this Article.

2. Obligation for Dematerialization of securities

An Applicable Company is required to comply with the following conditions:

• Issue of securities in dematerialized form: Applicable Company must issue securities solely in dematerialized form within the timeframe specified in point no. 3.
• Dematerialization of existing securities: Applicable Company must facilitate the dematerialization of all existing securities in accordance with the provisions of the Depositories Act, 1996 read with any other applicable regulations.

3. Compliance Timeline

Applicable Company is required to comply with the provisions of this rule within eighteen months of the conclusion of the financial year ending on March 31, 2023 i.e., latest by September 30, 2024 (“Due Date”).

Consequences in case of non-dematerialization of the securities on or before the Due Date

 1. On the Applicable Company

In the event an Applicable Company fails to undertake dematerialization of its securities on or before the Due Date, it shall not be able to make any offer for the issue of any securities or buyback of securities or issue of bonus shares or rights offer after such Due date unless entire holding of securities of its promoters, directors, key managerial personnel has been dematerialized in accordance with the provisions of the Depositories Act, 1996 (22 of 1996) and regulations made thereunder

 2. On the Security Holders

In the event, security holders of the Applicable Company fail to undertake dematerialization of its securities on or before the Due Date, and who intends to transfer such securities on or after the Due Date shall not be able to transfer, purchase, subscribe to any securities of the Applicable Company whether by way of private placement or bonus shares or rights offer, unless such securities are dematerialized before transfer, purchase or subscription, as the case may be.

In a nutshell, the Applicable Company and/ or the security holders are mandated to dematerialize the securities either on or before the Due date or after the Due Date but before undertaking of any transaction as contemplated in (a) and (b) above.

Procedure for Dematerialization of securities

 1 Procedure to be followed by the Applicable Company

The following procedure is to be followed by the Applicable Company for the purpose of dematerialization of securities:

Step 1: Pass a Board Resolution

The Applicable Company’s board of directors shall pass a resolution to authorize the dematerialization of its securities. However, it shall be ensured that the power of dematerialization must emanate from the Articles of Association of the Applicable Company.

Step 2: Select Depository Participant (“DP”) and Open Demat Account

The Applicable Company will be required to finalise a Depository Participant (“DP”) from a list of registered DPs, who will facilitate the entire dematerialization process. A list of registered DPs shall be available on the website of National Securities Depository Limited (“NSDL”) at https://nsdl.co.in/dpsch.php or Central Depository Services (India) Limited (“CDSL”) at https://www.cdslindia.com/DP/dplist.aspx.

The DP shall assist the Applicable Company in opening its demat account for the purpose of dematerialization upon obtaining the necessary documents as mentioned under point no. 6 and further facilitate the electronic transfer of securities between Demat accounts during trading and settlement processes.

Step 3: Appoint Registrar and Share Transfer Agent (“RTA”)

The Applicable Company will be required to appoint an RTA from a list of registered RTAs, who will facilitate the dematerialization process. They play a significant role in managing the administrative and record-keeping aspects of securities held in electronic form and ensure smooth operations in the demat system.

Step 4: Execute Tripartite Agreement

The Applicable Company shall enter into a tripartite agreement with the depository (e.g., NSDL or CDSL in India, as the case may be) and RTA which shall interalia govern the relationship among the parties and the outline scope of services to be undertaken by each of them. This agreement shall also outline the terms and conditions of the dematerialization process.

Step 5: Activate International Securities Identification Number (“ISIN”)

Upon verification and submission of all the documents with the DP and RTA, the depository will issue/activate the International Securities Identification Number (“ISIN”), i.e., a unique code to distinguish one security from another, facilitating trading, settlement, and record-keeping in the financial markets. These are essential for accurate and efficient tracking of securities on a global scale.

Step 6: Inform the shareholders

The shareholders of the Applicable Company must be informed about the decision to dematerialize its shares and the process involved. Such company should provide instructions and assistance to shareholders to open Demat accounts with DPs.

Step 7: Ensure the completion of process

The Applicable Company must ensure that all shares are successfully dematerialized and update its records to reflect the change. Once the shares are in Demat form, the company can facilitate electronic trading and transfer of shares.

1. Procedure to be followed by the shareholders of Applicable Company

Step 1: Select a Depository Participant (“DP”)

The first step is to select a registered Depository Participant (“DP”). A list of registered DPs shall be available on the website of National Securities Depository Limited (“NSDL”) at https://nsdl.co.in/dpsch.php or Central Depository Services (India) Limited (“CDSL”) at https://www.cdslindia.com/DP/dplist.aspx.

Step 2: Open a demat account

The shareholders shall provide their Know Your Customer (“KYC”) documents to their selected DPs along with other specific documents as may listed out by the DP in this connection for the purpose of opening a demat account.

Step 3: Submit Dematerialization Request

The shareholder shall submit the Dematerialization Request Form (“DRF”) to the DP along with the physical share certificate and other supporting documents as may be required.

Step 4: Verification of DRF

The DP shall verify the information as provided in the DRF and the documents submitted along with it to ensure they are authentic and meet regulatory requirements. Once the verification is complete, the DP will forward the dematerialization request to the respective depository (e.g., NSDL or CDSL in India).

Step 5: Confirmation and Record Update

Once the depository verifies and approves the dematerialization request, the physical shares are cancelled, and the equivalent electronic shares are credited to the shareholders’ Demat accounts.

 Documentation

1. For Applicable Company:

• Certified True Copy of Board Resolution for dematerialization of securities along with the list of authorized signatories and request letter for dematerialisation;
• Application for admission as Issuer of Eligible Securities as per the format provided by the DP;
• Details of shares to be converted into demat form;
• Net Worth Certificate issued by a Chartered Accountant;
• Certified true copies of the Memorandum of Association and Articles of Association along with the Certificate of Incorporation of the Company;
• Certified true copy of audited annual report for the last financial year;
• GST Certificate
• If Applicable Company has issued equity shares after latest balance sheet in that case, such company shall provide certified true copy of PAS-3.
• If there is any variation in the face value of shares or reduction in the capital after the last balance sheet date in that case, the Applicable Company shall provide a certified true copy of form SH-7;
• Undertaking by the Applicable Company in the prescribed format.
• Any other additional document as may be required by the DP

2. For shareholders of the Applicable Company:

• Know Your Customer (“KYC”) details;
• Original Share Certificates;
• Other documents as per the specific requirement of the selected DP.

Conclusion

As detailed hereinabove, the recent amendment makes it imperative for Applicable Company to convert its physical shares into electronic form. This will simplify the task of tracking investments, managing and transferring securities, reducing transaction costs, and enabling quick settlement. This transformation will eliminate the paperwork and the risk of loss or damage of physical share certificates leading to a more transparent transaction and eco-friendly environment.

Further, the regulatory bodies of various countries require securities to be held in Demat form for transparency and to prevent fraud. This mandatory dematerialization shall streamline the process of record keeping, reporting, and management of the securities.

[1] small company’’ means a company, other than a public company—

(i) paid-up share capital of which does not exceed fifty lakh rupees or such higher amount as may be prescribed which shall not be more than ten crore rupees; and

(ii) turnover of which as per profit and loss account for the immediately preceding financial year does not exceed two crore rupees or such higher amount as may be prescribed which shall not be more than one hundred crore rupees

Provided that nothing in this clause shall apply to—

(A) a holding company or a subsidiary company;

(B) a company registered under section 8; or

(C) a company or body corporate governed by any special Act;

Note – By virtue of notification no. GSR 700(E) dated 15^th September, 2022, the paid up capital and turnover of the small company shall not exceed rupees four crore and rupees forty crore, respectively