From Physical to Digital: Rule 9B and the Dematerialization of Securities of Private Companies. - MMJC

• Introduction

Among the Diverse efforts undertaken by the Ministry of Corporate Affairs (MCA) to enhance the ease of doing business, the mandate for dematerialization of securities stands out as a paramount initiative. Dematerialization, in simple terms, involves the conversion of physical securities into a digital or electronic format. As per the FAQs on dematerialisation issued by SEBI in 2008, Dematerialisation is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited into the BO’s account with his DP Originally implemented for listed companies, this provision was introduced to address challenges associated with the physical transfer and transmission of securities, aiming to streamline and expedite these processes. Recognizing its success and efficiency, the scope of dematerialization was progressively expanded to include unlisted public companies, and notably, it has now been extended to encompass private companies as well.

The said provisions relating to dematerialisation (‘demat’) of securities is made applicable to private companies through MCA notification dated 27^th October 2023 in this article we shall try to deliberate upon the crucial aspects of rule 9B of Companies [Prospectus and Allotment of Securities] Rules 2014, which talks about applicability of demat provisions to private companies.

• Background.

As discussed above, the provisions relating to demat of securities were previously applicable only to listed public companies. Thereafter, in October 2019, a new rule called rule 9A was inserted in prospectus and allotment of securities rules. By the effect of this rule, the demat related provisions were made applicable to unlisted public companies as well. Post insertion of this rule, the unlisted public companies are required to issue securities in demat mode only. Also, as per this rule, the companies cannot allow the transfer of such securities which are in physical mode. The security holders must first get their securities dematerialised and only then can they transfer such securities. Also, the existing security holders cannot subscribe to any fresh issue of securities including bonus issue made by company, without getting the existing securities dematerialised.

Through MCA notification dated 27^th October 2023, rule 9B was inserted in prospectus and allotment of securities rules 2014, by which the demat provisions were made applicable to private companies which are not small companies. The provisions of rule 9B are largely like that of rule 9A, however, there are some differences as well which we shall see hereinafter.

• Applicability.

The applicability of rule 9B to companies is discussed in sub-rule 1 of the said rule. As per this sub-rule, this provision is applicable to those private companies which are not small companies as at the financial year ending on or after 31^st March 2023. For example, if any private company is not a small company as per the balance sheet dated 31^st March 2023, then it will have to comply with demat provisions whereas, if the company is a small company as per the balance sheet dated 31^st March 2023, then it need not comply with these provisions till the time it remains a small company.

However, there is one point worth noting regarding applicability of this provision. Once this provision relating to demat becomes applicable to private company, it becomes applicable to all the securities issued by that private company because, the text of rule 9B uses word ‘securities’ and not shares. Therefore, once demat provisions are applicable, the private company must dematerialise all the types of securities issued by it and not just equity shares. For example, if the private company has issued preference shares and non-convertible debentures in addition to equity shares, then it will have to facilitate demat of all securities including debentures.

• Applicability to wholly owned subsidiaries of private companies.

Rule 9B exempts only the government private companies from demat requirements. Whereas rule 9A which talks about demat of unlisted public companies, exempts wholly owned subsidiaries of public companies from this requirement. Therefore presently, wholly owned subsidiaries of public companies are exempt from demat requirement but wholly owned subsidiaries of private companies are not. Also, one point to be noted is that, even if any wholly owned subsidiaries of public company is a private company by its articles of association, then also it will be considered as deemed public company for compliance purpose and hence will be exempt from requirement of dematerialisation despite being a private company as per its articles of association.

• Compliance due dates.

The notification introducing rule 9B clearly says that the notification shall come into effect from the date of its publication in the official gazette i.e. from 27^th October 2023. Therefore, the compliance is applicable to all private companies who are not small companies from immediate effect. Also, sub-rule 2 of rule 9B prescribes the timeline by which the compliance with these provisions shall be completed. However, with respect to last date for compliance, there are 2 different situations. The rule basically provides a timeline of 18 months from the end of financial year to comply with the provisions. but the two different situations arise out of the fact that whether the company is making any fresh issue of any securities before expiry of said 18 months.

• In case of no fresh issue.

The first of the two situations is that the private company is not proposing to make any fresh issue of any securities within 18 months from the end of financial year 2022-23. In such circumstances, sub-rule 2 of rule 9B says that, if any private company is not a small company as per the balance sheet as at the financial year ended 31^st March 2023 or thereafter then it should facilitate demat within 18 months from such financial year end.

That means, if any private company is not a small company as per balance sheet dated 31^st March 2023, then demat should be facilitated within 18 months, that is, up to 30^th September 2024 and if the company is not a small company as per balance sheet dated 31^st December 2023, then, demat should be facilitated up to 30^th June 2025.

• In case of proposed fresh issue within 18 months

The second situation is that, when the private company is proposing to make a fresh issue of any securities within the said period of 18 months.  In that case, if we refer to opening language of sub-rule 1 along with clause A thereof, it says that the private company within time specified in sub-rule 2 (that is, 18 months from end of financial year), shall, issue the securities only in dematerialised form. reading of opening words of sub-rule 1 with clause (a) thereof creates some confusion.

Clause (a) of sub-rule 1 says that if private company is making any kind of fresh issue of securities after this amendment becoming effective, that is after 27^th October 2023, then such issue should be made in demat mode only even if it is done before expiry of time limit of 18 months. That means, if company is planning to make fresh issue of any securities before end of 18 months, then it does not have time up to 18 months for complying with demat related provisions. instead, it will have to do the same before making offer for fresh issue of securities.

So, to sum up, we can say that, if company is not going to make any fresh issue of securities within 18 months from end of financial year 2023, then it has time of 18 months for facilitating demat of securities. But if it is going to make any issue of securities, then it must facilitate demat before making such issue without waiting up to 18 months.

• Demat compliances WRT promoters.

As per the general requirement of rule 9B the private company is simply required to facilitate demat of securities and it is at the desire of the security holder that whether and when does he want to dematerialise his holdings. However, this is not the case in case of members who are promoters, directors, or key managerial personnel (‘KMP’) of the company. As far as these persons are concerned, sub-rule 3 of rule 9B states that, if any private company is making any fresh issue or any buy back of any securities after the date when it is required to comply with this rule, then before making offer for such issue or buyback, private company should ensure that all types of securities held by promoters, directors and key managerial persons should be dematerialised.

In other words, if the company is not going for any fresh issue or buyback of securities before 18 months from end of financial year 2023, then the shareholding of promoters, directors, KMP can be dematerialised till the end of 18 months or even thereafter, but before the company makes any new issue or buy back of securities after the end of the said 18 months. But if the company is planning to make any issue of securities before end of 18 months, then a confusion arises. This is because the wordings used in Rule 9B (3) is “after the date when it is required to comply with this rule, shall before making the offer, ensure that shareholding of promoters, directors, KMP is in demat mode.”

The conjoint reading of words  “within the period referred to in sub-rule 2” used in sub-rule 1 and the words “after the date when it is required to comply with this rule” used in sub rule 3 create confusion that whether it means for any offer done after the expiree of said 18 months as per sub-rule 2 OR for any offer done after the date of commencement of notification even if it is within the period of 18 months. For example, if A private limited is not a small company as per Balance sheet dated 31^st March 2023, then it will be required to facilitate demat of its securities by 30^th September 2024, in this case the confusion is that, the requirement of dematerialisation of promoter’s security holding should become applicable in case of issue of securities done before completion of 18 months, say in January 2024, or in case of issue of securities done after expiry of 18months, say in October 2024?

Till the time MCA clarifies on this, to avoid any interpretation issues, it is recommended and advised that before making any issue of securities being done post the date of this notification and even before the completion of the said 18 months, it is better to ensure that the shareholding of promoters, directors and KMP is held in dematerialised mode before making offer for such issue. That is, in case of above-mentioned example, dematerialisation of promoter’s security holding shall become applicable in case of issue of securities done in January 2024.

• Demat compliances with respect to non-promoter members.

As far as non-promoter shareholders are concerned, the demat provisions relating to them are discussed in sub-rule 4 of rule 9B. As discussed above, in case of non-promoter members the company is required only to facilitate the demat of securities, that is obtain International Securities Identification Number (ISIN) for each type of securities issued by the company, so that members can demat their security holding. But whether to demat the securities and when to do so is the call of the member himself.

In other words, the company is required only to facilitate demat of shares by obtaining ISIN. Whether or not to demat the securities is the choice of the security holder. As per sub-rule 4, the shareholder will have to get his shares dematerialised before subscribing to any fresh issue of securities made by the company or before transferring the said securities, whichever is earlier.

The timeline of 18 months is not applicable to members. It is only for the companies to facilitate demat of securities. Members are at liberty to demat their securities as per their own wish, and even after the completion of the timeline of 18 months but before transfer or subscription of fresh issue. In fact, if the member so desires, he can keep his securities in physical mode for lifetime. But this will mean that he cannot subscribe to any private placement or rights issue or even to bonus issue of securities made by the company thereafter and cannot transfer any of his securities to anyone.

• procedure for facilitating demat/obtaining ISIN.

In case of compliance with rule 9B, the first step is obtaining ISIN so that the securities held by the promoter as well as non-promoter members can be dematerialised. To obtain ISIN, the company must first select Registrar and share transfer Agent (RTA)and a depository and pass a board resolution for obtaining ISIN. Thereafter the company should enter into a tripartite agreement between company, RTA, and depository. Thereafter an application accompanied with all the relevant documents is filed with depository, which if found in order, ISIN is allotted to the company. Subsequently the company is expected to inform the members about having obtained an ISIN.  

• Conclusion

So to summarise the demat related compliances, we may say that, this rule 9B says that, all private companies who are not small companies as per the balance sheet as at the financial year ended 31^st March 2023 or thereafter, shall facilitate mandatorily dematerialisation of its securities within 18 months from the end of financial year and if the company is making any fresh issue of securities before such 18 months, then such facilitation of demat should be done before making offer for issue.

Further, it is recommended that security holding of promoters, directors and KMP should be dematerialised before making any fresh issue even if such issue is being made before expiry of timeline of 18 months. In case of other members, company must facilitate demat within 18 months, but it is at the discretion of the member whether he wants to demat his securities unless he wishes to transfer the securities or wants to subscribe to fresh issue of securities made by the company.

Despite being new for private companies, dematerialisation is not a new concept all together. In fact, it is a tried and tested concept in case of public companies. The experience with dematerialisation is that it saves time, money, and energy of all the parties and enhances the ease of handling securities. Despite initial problems, the private companies shall also benefit from the same. Also, this move of MCA is in line with eventually doing away with physical holding of securities.

This article is published in Taxmann. The link to the same is as follows: –

https://www.taxmann.com/research/company-and-sebi/top-story/105010000000023646/from-physical-to-digital-rule-9b-and-the-dematerialization-of-securities-of-private%C2%A0companies-experts-opinion

This article is written by: –

CS Deepti Jambigi Joshi – Partner – QA and RND – deeptijambigi@mmjc.in