The New Amendment

The process of dematerialisation of shares of unlisted private companies has changed since the new amendment.  To ensure the greater good of all stakeholders, it is imperative that laws are amended in a way that retains the control mechanisms that are already in place, especially when digitization or technology is at play in the modern world. According to the Ministry of Corporate Affairs, the Companies Act, 2013 (CA13) was amended on September 10, 2018 in an effort to improve transparency, investor protection, and corporate governance. This regulation stipulated the dematerialization of existing securities as well as issuing and transferring of securities in the dematerialized form of an unlisted public company in India on October 2, 2018. Therefore, these shares have technically become illiquid after October 2nd, 2018, unless they are dematerialized. In the event of a death, shareholders can transfer their shares to their heirs. This is possible due to the inheritance process, but even new owners will have to dematerialize the shares in order to sell or transfer them.

In this blog, we have explained the dematerialization of shares process of an unlisted private company, how to dematerialize shares, how to transfer shares of unlisted public company, and which company shares can be freely transferable.

Provisions and problems in dematerializing shares

There is a restriction on transfer of shares in private company., which is important to remember. Nevertheless, private companies can provide this facility to their shareholders without any restrictions. In the response to this amendment, this article focuses on the potential impact on Indian unlisted companies as well as the possible way forward. 

It is not new to India to embrace the concept of dematerialization. electronic certificates, or dematerialized certificates. They were introduced in 1996 for private companies listed on Indian stock exchanges. In contrast to unlisted public companies, such a mandate was not present until October 2nd, 2018, resulting in fraudulent share transfers and other disputes, which lead to unnecessary litigations and troubles for shareholders.

If there are transfer restrictions applicable for an unlisted public company it can be enforced through contracts and dematerialization of securities. Under CA13, it is expressly stated that shares of public companies are freely transferable, which may raise questions as to whether they can have transfer restrictions at all. A provision to Section 58(2) of CA13, however, provides an exception to mentioned general provisions, which allow share transfer restrictions to be implemented through contracts or arrangements.

Foregoing provisions of the CA13 support guidelines that are laid down in a Bombay High Court judgment which states that a shareholder has a right to sell shares of a public company to another party with the right of first purchase at the prevailing market price which is not affected in any way by the shareholder’s expressed willingness to sell shares. There can be no violation of the act or Articles of Association of a company as long as the member pays the prevailing market price. The buyer and seller must both agree on the terms of the sale that are in order for the sale to be free of transferability restrictions. In a public company, shares are available for subscription to and the public. A public company’s shareholder has a right to agree to a consensual transaction that is unaffected. A company does not need to sign a share transfer agreement for its shares to be transferred, the High Court states. The free transfer of shares is not impaired by any consensual agreements between shareholders regarding their shares, which can be enforced in the same manner as any other agreement.

 Supreme Court has ruled restrictions on the right to contract that can only be made when they are necessary for the benefit of a community. As a provision to Section 58(2) of CA13 specifically mentions that shareholder contracts can be enforced as contracts. It is logical to assume that shareholder agreements can be enforced against the company as well as against the shareholders if they are included within the company’s Articles of Association.

Implementing this in a dematerialized shareholding environment is the interesting part. Traditional transfers cannot be registered by a company unless the transfer instrument form SH-4 mca is in physical form, dated, duly stamped, and executed by all parties. It has to be accompanied by the share certificates or letters of allotment, as applicable. The company shall receive the transfer and shall be approved by the board in conformity to the law and the company’s agreement. A joint venture company or one where an external investor is involved, they would consider this process. It is extremely important if there are multiple covenants in the Shareholders Agreement, which are also incorporated into the company’s AoA. SHA/AoA covenants are usually related to managing the business and protecting the shareholders’ wealth, while others are related to governance. It is common for the latter type of transfer to use preemptive rights, such as ROFOs, ROFRs, Tag-alongs, Drag-alongs, and Put and Call options. These rights all affect the transfer of shares by a shareholder. It may be the shareholders themselves who are most responsible for complying with these conditions. In addition to the board’s responsibility to comply after these obligations, they are incorporated into the AOA, which is also subject to the Memorandum of Association and Bylaws. Share transfers involving paper shares have the opportunity to be enforced by the board because requests for share transfers must be handled by the board in paper share cases. A caveat-emptor shall be placed on the share certificate itself if the transaction advisors are meticulous in listing the restrictions on transfers.

 However, not all share transfers are straightforward when it comes to Demat shares. The transfer of shares between Demat accounts is the main use of this type of account. A registrar and transfer agent (RTA) can assist companies who wish to dematerialize their securities by connecting them electronically to either the National Securities Depository Ltd (NSDL) or the Central Depository Services India Ltd (CDSL). In regard to the securities admitted by the companies, these depositories are the company’s records and accounting offices. Centralized database architecture is used by CDSL and NSDL, and a connection with RTAs is provided online. Transferors need to provide the RTA with a printed copy of their “Delivery Instruction Slip” (DIS). As soon as the transfer is accepted, the transfer will be done in 2-4 working days without the involvement of the company’s board. Once the transfer has been completed, the RTA will record the transaction in its computerized records. You need compulsory Demat of shares circular 

 The Takeaway

In the case of unlisted companies with various covenants enforced by their AoA. As long as the company’s securities exist in Demat form, the board will not be able to review shares transferred to ensure they are in compliance with the company’s operating agreements. Unlike traditional methods of transfer such as those discussed above, Demat forms do not require approval from the board, which is the case when securities are held duly stamped, in Demat accounts. In addition, in a Demat situation, such restrictions on transfer would also be difficult to enforce since NSDL and CDSL have standard tripartite agreements that can’t be negotiated. It has been reported that RTAs have refused to include contractual clauses in the agreement that could require the RTA to obtain prior permission from the companies before executing any transfer. As a consequence, companies in such a situation are unable to take any preventive measures to regulate share transfers and, as a result, fulfill their responsibilities under the Act. A company’s board or shareholders can always pursue post-facto remedies, such as applying to the tribunal and court.

In addition to removing instances of duplication, reducing the risk of loss of physical share certificates for investors, improving corporate governance, and increasing transparency in the share ownership structure, holding securities in dematerialized form has also improved shareholder relations. Benami shareholdings and other practices similar to them were also discouraged. If, however, any of the shareholder groups feel that the dematerialization compromises their ability to enforce the shareholders’ agreement in a preventive manner, all these benefits can potentially be overshadowed. In these cases, it may be time to explore alternative mechanisms to balance stakeholder protection with benefits brought by technology-based security.

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