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The Ministry of Corporate Affairs of India (MCA) introduced the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (PAS Amendment Rules) on October 27, 2023. These rules mandate the compulsory conversion of securities of private companies into electronic form, excluding small and government companies, encompassing stocks, bonds, debentures, share warrants, and preference shares. Dematerialization is the process of converting physical security certificates into electronic format. Previously, only public companies, with certain exceptions, were obligated to have their securities in dematerialized form.

Key Provisions of the PAS Amendment Rules:

  1. Private companies, not falling under the small company category as per audited financial statements post March 31, 2023, must facilitate the dematerialization of all securities within 18 months from the end of their financial year (i.e., by September 30, 2024, if the financial year ended on March 31, 2023). After this specified date, such private companies are mandated to issue securities only in dematerialized form.
  2. Post the specified date, any private company making offers for the issue, buyback, bonus shares, or rights offers of securities must ensure that the entire holding of securities by promoters, directors, and key managerial personnel has been dematerialized.
  3. Security holders intending to transfer securities after the specified date must ensure dematerialization before the transfer.
  4. Security holders subscribing to securities through private placement, bonus shares, or rights offer after the specified date must ensure that all their securities are held in dematerialized form before subscription.

Key Takeaways:

  • Dematerialization applies to all securities, not just equity shares, of the concerned private company.
  • Although private companies can issue securities in physical form before the specified date, issuing them in dematerialized form is advisable, even if issuance occurs before this date.
  • Transfer of securities in physical form is allowed before the specified date, but for transfers on or after this date, dematerialization is mandatory.
  • Relevant private companies may need to amend their articles of association to accommodate the issuance of securities in dematerialized form.

Exception: Above provisions on mandatory dematerialisation of securities by private companies are not applicable to small companies and Government company.

Small company means a company, other than a public company, whose paid-up share capital is less than or equal to (<=) Rs. 4 Crores and turnover as per the last financial year is less than or equal to (<=) Rs.40 Crores.

Following are not considered as small company viz.

• Holding company or a subsidiary company

• Section 8 company

• Company/ body corporate governed by any special Act

Rationale behind the move:

While the concept of dematerializing shares isn't entirely new, this requirement aligns with the amendment to the Allotment Rules in October 2018. This amendment mandated the issuance of securities by all public unlisted companies in dematerialized form. The rationale behind this change appears to be twofold: to enhance the ease of doing business in India and to address concerns regarding benami transactions and fraudulent share transfers or pledges.

Holding shares in dematerialized form offers advantages for shareholders. It streamlines processes and reduces the risk of litigation associated with fake share transfers or improper pledges. Additionally, for financial institutions grappling with challenges related to foreclosing pledges of shares in physical form, this requirement represents a significant improvement. Foreclosing dematerialized shares is a much simpler process.

Moreover, this shift towards dematerialization promotes transparency and facilitates governmental agencies in tracing shareholders of private companies. It also facilitates the collection of adequate stamp duty on share transfers.

Other Considerations:

  • Indian companies are primarily classified as public or private, with a majority being private due to fewer compliance requirements. The practice of issuing or holding securities in dematerialized form offers no advantage, but with the PAS Amendment Rules, all securities, including shares of private companies, must be held in dematerialized form.
  • Opening a demat account and completing the dematerialization process may take some time.
  • In M&A transactions involving share transfers, compliance with dematerialization rules is a condition precedent to closing, impacting both transferring shareholders and acquirers.

Consequences and Penalties for Non-Compliance:

 

In case the company or the security holders do not comply with the requirement to dematerialize their securities by 30 September 2024, the following consequences will apply:

  • The company will not be able to issue/allot any type of securities
  • The security holder will not be able to transfer or subscribe for any type of security
  • Monetary penalties on company and every officer in default:
    • On the company: Rs.10,000 + Rs.1,000 for each day violation continues. Maximum limit is Rs.2,00,000
    • Every officer of the company who is in default – same as above. Maximum limit is Rs. 50,000

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.

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