Explained: What's the new norm that increases transparency for 60% of India Inc, and why concerns were raised with MCA

It might make shares of private company freely transferable which is against provisions of Companies Act, according to the compliance expert.

From October 1, a directive that affects 60 percent of India Inc or shareholders of nearly 16 lakh companies came into force.

The government, by amending the Companies (Prospectus and Allotment of Securities) Rules, 2014, has mandated that private companies issue securities in dematerialised (demat) form only.

This increases transparency with regard to shareholder identity and helps in hassle-free transactions and fundraising. But it can also pose a difficulty for companies' boards by allowing the shares to be freely transferable. This makes it difficult for the board to track if the public shareholding is limited to the maximum of 200 members (under Section 2 (68) of the Companies Act), and if new shareholders will be compatible with their vision.

Makarand Joshi, a compliance expert and founder of MMJC and Associates, explains why this mandate was issued, how it benefits shareholders and why companies have made representations to the Ministry of Corporate Affairs (MCA) for a review on one of the outcomes.

Why was this mandate introduced?
The need for greater transparency was felt because 60 percent of the corporate ecosystem was functioning with the paper form of securities (share certificates). Securities in paper form are subject to manipulations in transfer, transmission, KYC or know your customer process and so on, leading to legal disputes. This leads to wastage of a lot of resources.

Securities in demat form are subject to a periodic KYC process which makes it easy to identify and trace the actual shareholder. A standardised transfer and transmission process makes the same quick, and brings transparency.

Demat shares can also be pledged through the demat system easily. This will bring ease of doing business, which would further help improve India's ranking at the Financial Action Task Force also. (The FATF is an international grouping formed to combat money laundering.)

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What is the exemption that is given to 'small companies'?
Small companies—those that have a paid up capital not exceeding Rs 4 crore and a turnover up to Rs 40 crore as on the last date of the previous financial year—are not covered by the mandatory provisions of dematerialising shares. Small companies do not include holding companies, subsidiary companies, Section 8 companies and companies or bodies corporate governed by any special act.

Will this mandate affect fundraising in the private market? If yes, how?
Fundraising would be affected till the time private companies that have not already done so implement the demat facility. Once the demat facility is activated, there will not be any challenge—rather, fundraising would become a quicker process. Persons who are shareholders will have to have a demat account.

 What will be the challenges for companies in implementing this?
Lack of awareness and being updated with the process of dematerialisation can pose challenges in implementing this process for the time being. This can be tackled with the help of guidance from professional experts.

Why would investors in the private market prefer to hold their shares in the physical form? Why haven't they asked for a demat form earlier?
Holding of shares in demat form comes with the cost of operating a demat account. It also requires adoption of advanced technology. This requires distancing oneself from the traditional paper form of holding securities, which used to give a sense of custody and security that one is in actual possession of shares.

What will be the biggest impact of this change?
Corporate actions, fundraising, securities transfer and so on will become far less problematic.

On the other hand, it makes shares of private company freely transferable, which could run afoul of certain provisions in the Companies Act. Under the Companies Act, there is restriction on transfer of shares of a private company. These restrictions are mentioned in companies' articles of association. Also, a maximum 200 members of the public can be members of private company.

Therefore, the transfer of shares of a private company requires its board's approval. When they are held in physical form, share transfer deeds must be submitted for such approval. But if the shares are held in demat form, they can be transferred from one account to another demat account easily without the board of directors being made aware of it.

Depositories NSDL and CDSL do have a facility of freezing and unfreezing the ISIN (the identification code for securities). By choosing to freeze the ISIN, companies can ensure that shares are not transferred from one demat to another unless the companies' board approves it. But freezing and unfreezing for share transfer every time costs Rs 10,000 to Rs 15,000. This is also a challenge. Therefore, representations have been made to the MCA in this regard.