Pursuant to the issuance of the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, with effect from September 30, 2024, both public and private limited companies are required to convert the existing shares and issue new shares exclusively in dematerialised form, bringing an end to physical share certificates. While this seems like a small change, this post seeks to trace the transformation of ‘dematerialisation’ from a progressive and secure option for security holders to a compliance requirement, signifying an increased and progressive threshold of regulation. The post also highlights the key challenges that companies and investors may face with this change.
History of dematerialisation in India
The concept of dematerialisation was introduced with the passing of the Depositories Act, 1996 (“DA, 1996”). Thereafter, the government formed the National Securities Depository Limited (“NSDL”) in August 1996 and Central Depositories Services Limited (“CSDL”) in February 1999 for facilitating fast transfers and storage of securities in an electronic form. The DA, 1996 under Section 9(1) stipulated that “All securities held by a depository shall be dematerialised and shall be in a fungible form”. i.e., all securities held by the NSDL and CSDL are required to be in dematerialised form. This was the start of trading of securities in dematerialised form.
In its ‘Report of the Group on Reduction of Demat’ issued in 2004, SEBI identified inter alia certain risks associated with physical shares such as costs of printing share certificates, costs of RTA handling registered post dispatches, theft of share certificates in transit, delays in receiving share certificates, forged and fake certificates and signature differences. This led SEBI to conclude that moving to dematerialisation was the way forward.
Evolution of the regulatory regime governing dematerialisation – enforcing progressive compliance
In 2014, the requirement of holding securities in dematerialised form was extended to unlisted public companies in India by the Ministry of Corporate Affairs (“MCA”), which introduced the Companies (Prospectus and Allotment of Securities) Rules, 2014 (“PAS Rules”). The PAS Rules, provided under rule 9, state that “The promoters of every public company making a public offer of any convertible securities may hold such securities only in dematerialised form: Provided that the entire holding of convertible securities of the company by the promoters held in physical form up to the date of the initial public offer shall be converted into dematerialised form before such offer is made and thereafter such promoter shareholding shall be held in dematerialized form only”.
The MCA amended the PAS Rules on September 10, 2018, to impose a mandatory obligation on unlisted public companies under Rule 9A of the PAS Rules: “Every unlisted public company shall – (a) issue the securities only in dematerialised form; and (b) facilitate dematerialisation of all its existing securities in accordance with provisions of the Depositories Act, 1996 and regulations made there under. (2) Every unlisted public company making any offer for issue of any securities or buyback of securities or issue of bonus shares or rights offer shall ensure that before making such offer, entire holding of securities of its promoters, directors, key managerial personnel has been dematerialised in accordance with provisions of the Depositories Act, 1996 and regulations made there under”. Further the amendment also imposed a similar mandatory obligation on all securities holders in unlisted public companies. However, it should be noted that Nidhi companies, government companies and wholly owned subsidiaries (“WOS”) that are public companies are exempted from complying with the mandatory dematerialisation requirements.
It is pertinent to note that post the DA, 1996, listed entities were required to accept physical certificates of securities for transfer requests up until April 1, 2019, after which the securities regulator amended the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. Following the amendment listed companies were barred from accepting request for transfer of securities held in physical form.
Recent amendments – widening the regulatory net
To harmonise the regulatory framework governing dematerialisation, the Ministry of Corporate Affairs (“MCA”) released the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 on October 27, 2023, thereby amending the PAS Rules (“PAS 2023-Amendment”).
The PAS 2023-Amendment inter alia introduced Rule 9B, which pertains to the issue of securities in dematerialised form by private companies. With regards to private companies it mandates that they shall “(a) issue the securities only in dematerialised form; and (b) facilitate dematerialisation of all its securities, in accordance with provisions of the Depositories Act, 1996 (22 of 1996) and regulations made thereunder” and further that any such company making any “offer for issue of any securities or buyback of securities or issue of bonus shares or rights offer, after the date when it is required to comply with this rule, shall ensure that before making such offer, entire holding of securities of its promoters, directors, key managerial personnel has been dematerialised in accordance with the provisions of the Depositories Act, 1996 (22 of 1996) and regulations made thereunder”. Similar to the obligations imposed on securities holders of unlisted public companies, the PAS 2023-Amednment also places a mandatory obligation on all securities holders of private companies “(a) who intends to transfer such securities on or after the date when the company is required to comply with this rule, shall get such securities dematerialised before the transfer; or (b) who subscribes to any securities of the concerned private company whether by way of private placement or bonus shares or rights offer on or after the date when the company is required to comply with this rule shall ensure that all his securities are held in dematerialised form before such subscription”.
Interestingly, the PAS 2023-Amendment creates an exception for small private companies and government companies but does not create any exemption for Nidhi companies, Section 8 companies or for WOS. This creates an unnecessary and unjustified differential treatment, which is noteworthy because it deviates from the exceptions afforded to unlisted public companies that extend to Nidhi, government companies and WOS. The rationale and justification for this deviation and differential treatment is unclear and will hopefully be clarified by the regulator in due time.
Evaluating stakeholder readiness for the increased threshold of regulation and compliance
While there was no pre-legislative consultation prior to the PAS 2023-Amendment, there have been two primary instances where stakeholders’ views on the subject of ‘dematerialisation’ were recorded. The first was the ‘Report of the Group on Reduction of Demat Charges’, prepared on January 27, 2004, where the SEBI had set up an internal group to evaluate several representations it had received from investors. The second was the March 2022 ‘Report by the Company Law Committee’ where the committee noted the benefit of dematerialisation in passing, and proposed that the Companies Act, 2013 should be amended to ensure that the issuance, holding, transfer of fractional shares is done only in dematerialised form. It is pertinent to note that neither of the above made any recommendations to the effect that dematerialisation should be implemented for all classes of securities/ companies.
Below are some of the challenges/ issues that different stakeholders might face in light of the PAS 2023-Amendment:
First, it should be noted that the PAS 2023-Amendment is in effect increasing the threshold of compliance required for holding securities but providing a mere 18 (eighteen) month window to comply with the same. Given that there are 24,61,937 registered companies in India, it also needs to be assessed whether the NSDL and CSDL systems and their corresponding IT infrastructure are ready to deal with an increased influx of applications for conversions of physically-held securities to the demat form.
Second, since for opening of a demat account requires completing the account holder’s KYC, there would be an increased requirement for non-residents to obtaining PANs and also verify PAN details of the resident account holders, which could become challenging.
Third, physical securities have acquired a legacy status for (i) some families who hold them as legacy securities that have been passed on from one generation to the next; (ii) those some individuals who now treat the physical certificates as a legacy and bear a certain degree of affinity towards these that might be hard to let go off.
Fourth, the KYC and following dematerialisation process is bound to slow down the overall process for transfer of securities that are currently held physically, which could in turn impact the timelines of mergers and acquisitions and private equity transactions. The impact will be felt by specifically those investors who are investing in India for the first time, as they have to obtain a PAN, complete their KYC and also open a demat account.
Last, the dematerialisation requirement may also impose logistical challenges for securities holders who might have changed their names, addresses, or their residential status or where the securities were jointly held by people who have since died, with no nomination or paperwork to claim the securities in question. Further, where physical certificates have been locked away or are not traceable, companies would have to issue duplicate share certificates to complete the demat process, paving the way for a one-time clean up exercise. Conversely, it may also lead to different investors trying to claim ownership based on physical share certificates in their possession, which may potentially give rise to shareholder disputes. Additionally, based on past trends, it is likely that the companies are only going to make efforts towards complying with the PAS 2023-Amendment towards the end of the 18-month period. Therefore, it is essential that in the interim, attention is given towards updating the IT infrastructure, so that implementation of the mandatory dematerialisation requirement under the PAS 2023-Amendment is successful.
The PAS 2023-Amendment is a progressive shift but, as discussed above, not necessarily a stakeholder-friendly shift. It is progressive to the extent that it would lead to increased protection for security holders by reducing the risk of disputes and litigation, theft, forgery, etc., by bringing in a digitalised mechanism. The move towards a transparent and more efficient format would aid regulatory bodies to track and maintain protection of the securities. However, the bigger concern is whether the existing infrastructure can facilitate and handle such a drastic change.
The regulator also needs to harmonise in due course the exemptions that have been carved out to the mandatory dematerialisation requirement across different classes of companies and further needs to reconcile these exemptions with its desire for creating a fully digitalised system.
For further information, please contact:
Bharath Reddy, Partner, Cyril Amarchand Mangaldas
 Report of the Group on Reduction of Demat Charges’ (January 27, 2004); https://www.sebi.gov.in/sebi_data/commondocs/dematrep_p.pdf.
 Rule 9A(3), PAS Rules.
 Rule 9A(11), PAS Rules.
 The amendment was introduced with effect from April 1, 2019.
 9B(1), PAS 2023-Amendment.
 9B(3), PAS 2023-Amendment.
 9B(4), PAS 2023-Amendment.
 As of March 31, 2023 per Rule 9B(2), PAS 2023-Amendment.
 9B(6), PAS 2023-Amendment.
 This refers to companies that are incorporated under section 8 of the Companies Act, 2013.
 Rule 9B(2), PAS 2023-Amendment.
 This number includes all the companies registered in India as of January, 2023. The breakup as recorded from the Monthly Information Bulletin of the MCA; accessible at https://www.mca.gov.in/bin/dms/getdocument?mds=txTYdsRdDC%252BtNEfohyF1SQ%253D%253D&type=open