Private companies (other than a ‘small company’) are required to take steps towards dematerialization of all its securities with effect from 27 October 2023. The requirement applies to fresh issuance of securities and securities already issued by the relevant private company. This is the latest diktat from the Ministry of Corporate Affairs, which notified the ‘Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023’ (the “Amendment Rules”) on 27 October 2023 (the “Notification Date”).

Among other things, the Amendment Rules have inserted a new rule, i.e., Rule 9B, to the Companies (Prospectus and Allotment of Securities) Rules, 2014. The new Rule 9B and what it means to private companies has been examined below:

  • Within eighteen (18) months from the close of a “financial year” (the “Cut-off Date”), every private company other than a “small company” that intends to issue securities must issue securities only in a dematerialized form. Further, every private company must “facilitate” the conversion of securities held in physical form into a dematerialized form. Such efforts must be undertaken with immediate effect. “Financial Year” for the purpose of Rule 9B means a financial year ending on or after 31 March 2023, in respect of which audited financial statements are available.  
  • Before embarking on a fresh issuance of securities, or buyback of securities, or issue of bonus shares, after the Cut-off Date, a private company must ensure that shares held by the promoters, directors and key managerial personnel has been dematerialized. Without dematerialization of the securities held by such persons, a private company cannot proceed with the corporate actions described in this paragraph.
  • Further, the private company cannot register / record any transfer in its books or offer fresh securities after the Cut-off Date if the securities are not held in a dematerialized form.
  • Rule 9B also provides that the provisions of sub-rules (4) to (10) of Rule 9A shall mutatis-mutandis apply to the dematerialization of securities under Rule 9B. Rule 9A was inserted in 2018 and deals with issue of securities in a dematerialized form by unlisted public companies. Among other things, Rule 9A(8), which, by reference would also apply to private companies requires every company to file a half-yearly return showing compliance of the dematerialization norms with the MCA.

The definition of “small company” is contained in Section 2(85) of the Companies Act, 2013. Accordingly, “small company’’ means a company, other than a public company:

  1. paid-up share capital of which does not exceed INR 50,00,000 (Indian Rupees Fifty Lakhs) or such higher amount as may be prescribed which shall not be more than INR 10,00,00,000 (Indian Rupees Ten Crores); and
  2. turnover of which as per profit and loss account for the immediately preceding financial year does not exceed INR 2,00,00,000 (Indian Rupees Two Crores) or such higher amount as may be prescribed which shall not be more than INR 100,00,00,000 (Indian Rupees One Hundred Crores).

Pursuant to the Companies (Specification of definition) Amendment Rules, 2022, Rule 2(1)(t) of the Companies (Specification of definition rules), 2014 provides that the paid-up capital and turnover of a small company shall not exceed INR 4,00,00,000 (Indian Rupees Four Crores) and INR 40,00,00,000 (Indian Rupees Forty Crores) respectively. However, the above limits do not apply to a company that is a holding company or a subsidiary company. This means a private company that is also a holding company, or a subsidiary company will not be considered a ‘small company’ even if its paid-up capital and turnover does not exceed the thresholds mentioned in the above definition.

A few scenarios in the context of a private company that is not a ‘small company’ as per audited financial statements dated 31 March 2023 are examined below:

Impact and implications of the Amendment Rules

The impact of the Amendment Rules on private companies is expected to be significant, both from a process perspective and cost perspective. As per estimates, India has about 15 Lakh companies out of which 12-13 lakh are private companies and approximately 50,000 are qualify as a ‘small company’. Given the sheer number of private companies that are otherwise not small companies, the dematerialization requirement covers a large universe of companies and the implications for them are substantial.

From a regulatory standpoint, the move is expected to bring in much needed transparency in share transfers. It would help track transfers and reduce the room for shareholder disputes. It could also prevent fraud when it comes to transfers as the process of transfer will now be professionally managed through a depository. It would also mitigate ‘benami’ transactions.

The immediate implication for a private company is that it must commence the process of putting in place the relevant systems and processes before embarking on any fresh issuance of securities post the Cut-off Date. Also, it must “facilitate” dematerialization of securities held by its shareholders on an immediate basis. Dematerialization of securities held by its directors, key managerial personnel and promoters is a priority as any fresh issuance, bonus issue or buy-back cannot take place after the Cut-off Date if the securities held by such persons are not dematerialized. While the expression “facilitate” is not defined, it would entail the private company undertaking reasonable efforts to cause its completion.

From a cost perspective, the private company and the shareholders must execute relevant custodian agreements and open demat accounts with depositories. This will entail significant paperwork and costs. It must also be ensured that the share certificates must be stamped as per the relevant state stamp law prior to dematerialization.