Author: Diya Parvati
Third-year law student at Gujarat National Law University (GNLU), Gandhinagar
In October 2023, the Ministry of Corporate Affairs (“MCA”) took a revolutionary step through notifying the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (“PAS Amendment Rules 2023”). It mandates all private companies, except small companies and government companies, to hold or transfer securities only in dematerialised form in accordance with the provisions of the Depositories Act, 1996. Dematerialisation of securities means the conversion of securities held in physical form to electronic format held in a centralised depository.
For the past decade, only public companies had to comply with such a requirement under Section 29 of the Companies Act, 2013. However, the addition of Rule 9B to the Companies (Prospectus and Allotment of Securities) Rules, 2014 (“PAS Rules 2014”) now brings private companies within this regulatory paradigm and puts an end to physical share certificates.
This article aims to decipher the intricacies of the PAS Amendment Rules 2023, explore the background and the reasons for the amendment, understand its impact on various stakeholders before highlighting certain concerns associated with it.
II. Understanding the amendment
The far-reaching compliances under the amended PAS Amendment Rules 2023 apply to both private companies and individuals holding securities of private companies, mandating compliance by September 2024.
a. Compliance for private companies
Every private company, is now required to (i) issue securities only in dematerialised form; (ii) facilitate dematerialisation of all its securities; and (iii) dematerialise the entire holding of securities of the company’s directors, promoters, and key managerial personnel before making any offer to issue or buyback any securities.
Notably, Rule 9B prescribe two exemptions. Firstly, small companies with maximum paid-up share capital of INR 4 crores and maximum turnover of INR 40 crores are exempted. Secondly, government companies are excluded.
b. Compliance for individuals holding securities of private companies
Starting September 2024, anyone who owns securities in private companies is required to convert them from physical to dematerialised form before making any transfers. Hence, post the deadline, securities can be transferred only in dematerialised form.
III. Context and purpose of the amendment
The enactment of Depositories Act, 1966 marked the advent of dematerialisation of securities in India. The process was pioneered by the National Securities Depository Limited and subsequently by the Central Depositories Service Limited.
Later, in 2004, the Securities Exchange Board of India (“SEBI”) attempted to understand the high operating cost of the demat environment in its “Report of the group on reduction of Demat charges.” While conducting a cost-benefit analysis, the report identified the risks involved in dealing with physical share certificates. Share certificates are lost in transit, forged, stolen and, in many cases, delayed in transfer due to logistical difficulties. The printing, RTA handling, and transit charges are additional expenses attributed only to physical share certificates. Hence, SEBI concluded that the dematerialisation would be cost-effective in the long run.
The Companies Act, 1956 had laid down traces of dematerialisation with a limited scope in Section 68B requiring every listed public company making initial public offer more than INR 10 crores only in dematerialized form. The Companies Act, 2013 expanded the scope via its Section 29, mandating every listed company and other class of companies as maybe prescribed to issue the securities only in dematerialised form.
In 2014, MCA fortified the dematerialisation regime by introducing the PAS Rules 2014 mandating promoters of a listed public company making a public offer of any convertible securities to hold such securities only in dematerialised form. Further, in 2018, the requirement was expanded to an unlisted public company, through Rule 9A of the PAS Rules, also to issue shares only in dematerialised form and facilitate the dematerialisation of all its existing securities. It also had to ensure that the entire holding of securities of its promoters, directors, and key managerial personnel had been dematerialised.
The PAS Amendment Rules 2023 further expands the scope by extending the same requirements to private companies, proposing a deep penetration of the concept of dematerialisation. From a broader perspective, the amendment aligns with prevailing shift towards digitisation and targets to curb long prevails hurdles in the corporate landscape.
Primarily, the amendment aims to fully institutionalise investor protection, transparency, and accountable corporate governance. Private companies often have shares registered under unidentifiable names raising concerns about money laundering and black money. Hence, the amendment falls in line with MCA’s attempt to increase corporate accountability.
Further, it eliminates risks associated with physical certificates, such as loss and theft and also prevents any kind of mutilation of the physical records. It also curbs the risk of fake share certificates, delays, and other malpractices to a major extent. In addition, digitisation of securities assures manifold ease in transfer of securities and in turn contributes to the ease of doing business in India.
IV. Impact of the amendment on various stakeholders
From an investor perspective, the amendment makes holding and transferring shares more convenient as shares (even a single share) can be transferred instantly on authorisation. It also saves stamp duty on transfers and reduces other transaction and legal costs. The move will also boost investor confidence as any grievance arising from the dematerialisation of securities will be dealt with by the Investor Education and Protection Fund (“IEPF”), which puts the investor’s interest first on the priority list.
From a regulatory perspective, this move fortifies transparency and efficiency in the securities market. Since all transactions are recorded electronically in one place (the demat account) it creates a transparent and auditable account. Hence, dematerialisation compels individuals to maintain a transparent account of the ownership in different companies. The step aids regulatory efforts to mitigate benami transactions, identify beneficial ownership and control money laundering significantly.
In addition, it can also be construed as an effort to curb hindrances in deducing angel tax from both Indian and foreign investors. Angel tax is imposed when the shares of a company are sold at a premium to their fair market value. Such premium is considered as an “income from other sources” and thus subjected to taxation under Section 56 of the Income Tax Act, 1961.
The Annual Budget 2023-24 proposed bringing foreign investors within the ambit of angel tax. However, its collection faced hindrances even with resident investors. An accurate picture of each start-up’s shareholding and the proportion of shares held by each shareholder is difficult to obtain. Dematerialisation of shares would bring ground-breaking transparency into the picture with respect to the shareholding of both resident and non-resident investors. The Income Tax department can compare the shareholding details of a company and those provided by the shareholders to find discrepancies.
V. Possible consequences of the amendment
Firstly, in order to comply with the current amendment, private companies will have to undertake additional compliance costs and indulge in capacity building measures to aid the dematerialisation process. However, it is also expected that dematerialised securities will ensure faster and smoother transfer of securities in the long run.
Secondly, considering the huge number of existing private companies in line to dematerialise their securities, the preparedness of its facilitators comes into question. Hence, is essential to ensure that the depositories and depository participants will not be overwhelmed by this mammoth task.
Thirdly, opening a demat account inter alia requires obtaining a Permanent Account Number (“PAN”) with tax authorities of India and carrying out Know Your Customer (“KYC”) norms of the depositories. The same may impede foreign investment in Indian private companies by making the process lengthier and costlier for foreign investors. However, again, in the long run, once the securities are dematerialised, every further transaction will be smoother, safer and faster for foreign investors as well.
In addition, the PAS Rules 2014 notably exempted Nidhi companies, Section 8 companies and wholly-owned subsidiaries of public companies from the requirement for dematerialisation. The same is not reflected in PAS Amendment Rules 2023, as it exempts only small companies and government companies leading to unnecessary confusion. Hence, it is pertinent that MCA harmonises the exceptions carved out in both amendments to reconcile these exemptions.
Above all, the digitisation of securities raises concerns about data privacy and security. The private and sensitive information of the stakeholders may be vulnerable to cyber threats, resulting in unauthorised access or breach. Hence, robust cybersecurity measures should be implemented to ensure the reforms under the amendment do not backfire.
The current amendment encompasses the issuance, transfer and holding of securities in electronic form, aligning private companies with public counterparts. The mandatory dematerialisation is undoubtedly a transformative step to fortify transparency and bolster investor protection in congruence with worldwide shift towards transparency. Though the amendment poses additional financial burden and compliance challenges, majority of them are one-time requirements that assure efficiency and reduction of fraud in the corporate landscape of India. However, the bigger question of how equipped the existing infrastructure is to facilitate this change still lingers. Hence, carefully navigating implementation challenges is imperative to ensure a smooth transition without stifling investor interest or overwhelming regulatory infrastructure.