07-Feb-2024 MANDATORY DEMATERIALIZATION FOR PRIVATE COMPANIES

INTRODUCTION:

The Ministry of Corporate Affairs (MCA) has recently introduced a significant amendment, through a notification dated 27 October 2023, to the Companies (Prospectus and Allotment of Securities) Rules, 2014. This amendment mandates the dematerialization of securities for every private company, excluding small companies and government companies. Previously, only public companies were subject to this requirement.

BACKGROUND:
Section 29 of the Companies Act, 2013, and rules made there under, initially mandated the dematerialization of securities for listed public companies and was later extended to include unlisted public companies in 2018. With the recent amendment, private companies (other than small companies and government companies) are now also brought within the purview of Section 29, as outlined in Rule 9B of the PAS Rules (issue of securities in dematerialized form by private companies).

APPLICABILITY AND TIMELINE:
The amendment applies to all private companies (including section 8 companies limited by shares)  except small companies* and government companies. Private companies falling under this ambit must comply with the new dematerialization requirements within 18 months from the closure of their financial year as of 31 March 2023. Therefore, the compliance date for most private companies is set for 30 September 2024.

COMPLIANCE REQUIREMENTS:
Companies covered under this provision are now obligated to issue and facilitate the dematerialization of all securities. Additionally, any offer for the issuance or buyback of securities, issue of bonus shares, or rights offer must ensure that the securities held by promoters, directors, and key managerial personnel are in dematerialized form. Additionally, companies will have to adhere to the Depositories Act, 1996, SEBI (Depositories and Participants) Regulations, 2018, and SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993.
 

A Small Company is defined as a private company with a paid-up share capital of INR 4 crores or below, and a turnover of INR 40 crores or below but excluding a subsidiary and holding company irrespective of its turnover / paid-up capital

• In terms of action items, pursuant to the Amendment, every Private Company is required to:

1.  
2. 1. Amendment of Articles of Association ("AoA") of the company to authorize shareholders to hold securities in dematerialized form;

2. Appointment of a Securities and Exchange Board of India ("SEBI") registered Registrar and Transfer Agent ("RTA");

3. Obtaining an International Securities Identification Number ("ISIN") from NSDL or CDSL by following the required procedure and documentation.
 

4. The ISIN should be obtained strictly within 18 (eighteen) months timeline. It is pertinent to note that a separate ISIN needs to be procured for all the existing different types of securities issued by such private companies.
 

5. Post the completion of 18 (eighteen) months time period, such a private company is required to mandatorily issue securities only in dematerialized form. Further, if any existing shareholder of a private company intends to transfer its securities, such shareholder will have to first dematerialize all such securities before executing the share transfer.
 

6. Apart from the above, Amended PAS Rules clarify that the conditions contemplated under sub-rules (4) to (10) of 2018 Amendment Rules shall equally apply to a private company as well. They are required to submit Form PAS-6, a half-yearly return, to the Registrar of Companies, certifying shares held in demat form within 60 days from the conclusion of each half-year.

NON-COMPLIANCE:
In case of any non-compliance of requirements under the Amended PAS Rules, there are no specific penal provisions stipulated under Section 29 of the Act read with Amended PAS Rules, as a general rule, the penalties under Section 450 of the Act would apply.
 

Penalty as per Section 450: The company and every officer of the company who is in default or such other person shall be liable to a penalty of Rs.10,000/-. and in case of continuing contravention, with a further penalty of Rs.1000/- for each day after the first during which the contravention continues, subject to a maximum of Rs.2,00,000 in case of a company and Rs.50,000/- in case of an officer who is in default or any other person.

NO EXEMPTION GRANTED TO WHOLLY OWNED SUBSIDIARY (WOS) OF PRIVATE COMPANIES: 
Under the 2018 Amendment Rules, a WoS of an unlisted public company has been exempted from complying with the requirement of dematerialization of securities. However, it is interesting to note that such an exemption has not been extended to a WoS of a private company under Amended PAS Rules. Resultantly, a private company which is a WoS of another private company would still have to comply with the dematerialization requirement. However, in the case of a private company which is a WoS of a public company, considering such WoS is a deemed public company, the exemption granted under 2018 Amendment Rules for such WoS would continue to be available. 
 

Also, there is no exemption for Section 8 companies incorporated as limited by shares. This should effectively address the major concerns of lack of ownership identification in Section 8 companies and any fraudulent activities using such structures.

MECHANISM FOR DEALING WITH GRIEVANCE(S) OF SECURITY HOLDER: 
 

Any grievance(s) with respect to dematerialization of securities or transactions in dematerialized form will be adjudicated by the Investor Education and Protection Fund Authority (IEPFA). IEPFA shall have the right to initiate any action against a depository, depository participant, registrar to an issue, or the share transfer agent, after prior consultation with the SEBI.

CONCLUSION:
The move towards dematerialization and digitization of share capital aims to enhance transparency, expedite transactions, and establish a robust ownership tracking mechanism. While this amendment doesn't alter the basic structure of private companies, it necessitates their adaptation to modern practices. The MCA's initiative aligns with the broader goals of institutionalizing transparency and corporate accountability in India.
 

This Amendment does not impact ongoing subscription and share sale transactions, as this Amendment will require compliance by 30th  September 2024. This will create further complexity for foreign companies as opening a dematerialized shares' account in India requires significant Know Your Customer (KYC) information, and also obtaining a permanent account number with Indian tax authorities. This will therefore increase the lead time for first-time foreign investors to invest in Indian companies.

Key Takeaways: Mandatory Dematerialization for Private Companies:

1. Recent Mandate: The Ministry of Corporate Affairs (MCA) now requires the dematerialization of securities for private companies, extending the rule from public companies.
 

2. Background: Companies Act, 2013, initially applied to listed public and later unlisted public companies in 2018. The recent change includes private companies, excluding small and government ones.

3. Applicability and Timeline: All private companies, except small and government ones, must comply by 30 September 2024, within 18 months from their financial year closure in March 2023.

4. Compliance Requirements: Private companies (except small and government) must dematerialize all securities, including those of promoters and key personnel.

5. Regulatory Framework: Adherence to key regulations, including amending articles, appointing a SEBI-registered agent, and obtaining an ISIN.

6. Non-Compliance: No specific penalties, but general penalties under Section 450 of the Act apply for non-compliance.

7. No WOS Exemption: Wholly Owned Subsidiaries (WOS) of private companies must comply, unlike WOS of unlisted public companies.

8. Grievance Mechanism: Investor Education and Protection Fund Authority (IEPFA) adjudicates grievances related to dematerialization.

Conclusion: Move towards dematerialization aims for transparency. Compliance required by 30 Sep 2024; may pose challenges for foreign companies due to increased lead time and regulatory hurdles.

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