MCA notifies mandatory dematerialisation for securities of private companies

• Payal Agarwal, Senior Manager | corplaw@vinodkothari.com

Two major amendments have been notified by MCA on 27th October, 2023 impacting all companies, and majorly the private companies. These include the Companies (Management and Administration) (Second Amendment) Rules, 2023 introducing the concept of “designated person” with respect to beneficial interest in shares of a company^[1] and the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (“PAS Amendment Rules”). The PAS Amendment Rules encompass two major amendments: (i) with respect to the bearer share warrants under the erstwhile Companies Act, 1956, and (ii) mandatory dematerialisation for all private companies excluding small companies. In this write-up, we briefly discuss the amendments with respect to mandatory dematerialisation of securities for the private companies and the implications thereto.

Regulatory basis of present amendment

Sub-section (1A) was inserted under Section 29 of the Companies Act 2013 (“the Act”) facilitating the Central Government to prescribe such class or classes of unlisted companies for which the securities shall be held and/ or transferred in dematerialised form only. In exercise of the powers conferred under the said section, Rule 9B has been inserted vide the PAS Amendment Rules specifying the requirement of mandatory dematerialisation of securities issued by private companies.

Applicability of mandatory dematerialisation on private companies

The mandatory dematerialisation requirement is applicable on all securities of every private company, excluding small companies^[2] and government companies. The provisions are applicable with immediate effect, and a timeline of 18 months is provided from the closure of the financial year in which a private company is not a small company for the compliance with the mandatory dematerialisation requirements.

For example, a private company (other than a company that is a small company as on 31st March, 2023) is required to comply with mandatory dematerialisation of securities within a period of 18 months from the end of FY 22-23, i.e., on or before 30th September 2024.

In case a company ceases to be a small company after 31st March, 2023, the timeline of 18 months triggers from the close of the financial year in which it ceases to be a small company. Therefore, if a company ceases to be a small company at any time during FY 23-24, the timeline of 18 months will trigger from 31st March, 2024 and therefore, shall be complied with by 30th September 2025.  

Applicability on a wholly-owned subsidiary

Rule 9B of the PAS Rules, enforcing mandatory dematerialisation of the securities of private companies, is applicable on all private companies other than the following: 

1. Small company, and  
2. Government company

In case of unlisted public companies, sub-rule (11) of Rule 9A extends a similar exemption from dematerialisation requirements. The said sub-rule covers the following public companies – 

1. Nidhi company, 
2. Government company, and 
3. A wholly owned subsidiary. 

It is important to note that a wholly owned subsidiary, though exempt from the dematerialisation requirements under Rule 9A, similar exemption does not extend to a private company under Rule 9B. Therefore, currently it seems that a wholly-owned subsidiary, incorporated in the form of a private company, is not exempt from dematerialisation requirements. 

Further, for a private company that is a wholly-owned subsidiary of a public company, and therefore, a deemed public company, it remains an open question as to whether it will be exempt under sub-rule (11) of Rule 9A or the provisions of Rule 9B will apply.

The position may be summarised as below – 

Nature of wholly-owned subsidiary	Nature of holding company	Applicability of dematerialisation provisions
Public company	Public company	Exempt under Rule 9A(11)
Public company	Private company	Exempt under Rule 9A(11)
Private company	Private company	Covered under Rule 9B as of now
Private company	Public company	The same being a deemed public company, there is no clarity on whether Rule 9A applies or Rule 9B.  If considered to be a private company – covered under Rule 9B  If considered to be a public company – exempt in terms of Rule 9A(11)

Compliances applicable to private companies

A private company, covered under the provisions of mandatory dematerialisation shall –

1. Issue all securities in dematerialised form only;
2. Facilitate dematerialisation of all existing securities (as and when request is received from the holder of such securities);
3. Ensure that the entire holding of its promoters, directors and KMPs are held in dematerialised form only, prior to making any offer for issuance or buyback of securities

Apart from the aforesaid, the compliances applicable to an unlisted public company under sub-rule (4) to (10) of Rule 9A are also applicable to private companies. These include –

1. Application with depository for dematerialisation of all existing securities and securing ISIN for each type of security;
2. Inform the existing security holders about the facility of dematerialisation;
3. Make timely payment and maintenance of security deposit with the depository, RTA and STA as may be agreed between the parties;
4. Complies with all applicable regulations, directions and guidelines with respect to dematerialisation of securities of a private company;
5. File a return in form PAS-6 with ROC on a half yearly basis within 60 days from conclusion of each half of the financial year, with respect to reconciliation of the share capital of the company;
6. Bring to the notice of the depositories, any difference in the issued capital by the company and the capital held in dematerialised form;
7. The grievances of any security holders under this rule (Rule 9B) to be filed with IEPF Authority, and the same, in turn, shall initiate any action against a depository or depository participant or RTA or STA, as may be required, after prior consultation with SEBI.

Compliances applicable to the holders of securities of a private company

As for persons holding securities of a private company, while the mandatory dematerialisation cannot be enforced by the private company, the same is expected to be taken care of by way of sub-rule (4) of Rule 9B that requires –

1. Dematerialisation of securities by the securityholder, before the transfer of such securities; and
2. Subscription to the securities issued by a private company, in dematerialised form only

Therefore, the mandatory dematerialisation of securities of a private company is ensured through placing restrictions on both a private company and the holders of securities issued by the same.

Consequences of non-compliance 

There are no specific penal provisions governing the non-compliance with the provisions of section 29 of the Act read with Rule 9B of the PAS Rules, and therefore, general penal provisions under section 450 of the Act should apply. 

Section 450 specifies the following: 
“If a company or any officer of a company or any other person contravenes any of the provisions of this Act or the rules made thereunder, or any condition, limitation or restriction subject to which any approval, sanction, consent, confirmation, recognition, direction or exemption in relation to any matter has been accorded, given or granted, and for which no penalty or punishment is provided elsewhere in this Act, the company and every officer of the company who is in default or such other person shall be liable to a penalty of ten thousand rupees, and in case of continuing contravention, with a further penalty of one thousand rupees for each day after the first during which the contravention continues, subject to a maximum of two lakh rupees in case of a company and fifty thousand rupees in case of an officer who is in default or any other person.”

Implications of the present amendment

The existence of shell companies and personification of shareholders is not a rare scenario, and such a situation is likely to be more common in case of a private company, unlike a public company. Historically, dematerialisation of shares is looked upon by the government as a means to curb black money^[3]. As for listed companies and unlisted public companies^[4], the dematerialisation of securities is already a mandatory requirement. With the present amendments being notified, the private companies have also been covered by the mandatory dematerialisation requirements.

As on 31st January, 2023, more than 14 lac companies registered with MCA comprising 95% of the total active companies are private companies, out of which approximately 50,000 companies are small companies^[5]. Thus, with the mandatory dematerialisation for private companies coming into existence, a large number of companies will be forced to move towards dematerialisation of shares. Further, while the company can be held accountable for the mandatory dematerialisation of securities held by promoters, directors and KMPs, given the closely held nature of private companies, barely any securityholder (particularly shareholders) will remain outside the purview of the same.

Further, it is clarified that, in no way such a mandatory dematerialisation for private companies can be taken to mean that the restriction on transfer of shares of such a company is relaxed, and adequate systems can be implemented at the depository’s level to ensure compliance with the basic distinguishing characteristic of a private company and thereby have filters before executing any transfer of securities.

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^[1] Read our article on the same here – https://vinodkothari.com/2023/10/companies-to-disclose-designated-person-with-respect-to-beneficial-interest-in-shares/

^[2] As per the definition under the Act read with the rules made thereunder, a small company means a company, other than a public company, having paid up share capital not exceeding Rs. 4 crores and turnover not exceeding Rs. 40 crores. Further, the following cannot be a small company –

(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.

^[3] https://www.moneycontrol.com/news/trends/legal-trends/government-looking-to-dematerialise-shares-of-unlisted-cos-to-curb-black-money-2382347.html

^[4] https://vinodkothari.com/wp-content/uploads/2018/09/Physical-to-demat-a-move-from-opacity-to-transparency.pdf

^[5] As per MCA Monthly Information Bulletin – January, 2023