Introduction
With its announcement on October 27, 2023, the Ministry of Corporate Affairs (MCA) has set in motion a major shake-up of the private corporate sector in India. The Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (hereinafter “Amendment Rules”) introduces a new Rule 9B that changes the very ways in which private companies handle their securities. The rule requires all private companies, except “small companies” and government companies, to not only dematerialise their securities already heldbut also any present as well as future securities should be transferred in dematerialised (demat) form only. This overhaul is definitely a step forward and quite bold as the limit for compliance is 30th April 2025, 18 months from the date of notification.
The benefits foreseen are beyond doubt and praiseworthy. What the MCA wants to achieve through this is to make the shareholding more transparent, eliminate the use of benami shares, lessen the chances of back-dated transfers, and at the same time improve corporate governance considerably through the creation of an easily auditable, electronic trail (Rule 9B,2023). This step intends to bring the private sector at par with the public market in terms of operational efficiencies, thus increasing investor protection and making dispute resolution less complicated.
Although Rule 9B’s mandatory dematerialisation is a well-meaning step to bring transparency to India’s private sector by global standards, its realization faces significant procedural and regulatory hurdles. This undertaking contends that in the absence of essential regulatory clarifications, most notably with regard to the execution of private agreements (in the Articles of Association), the complicated compliance requirements for cross-border investors, and operational issues at the depository side, the reform may just become another box to tick without bringing the business community the anticipated benefits. The paper will delve into the conflict between this instruction and the basic legal principles of private enterprises in India that are its focus.
The Legal Framework: From Act to Rule
The rule of dematerialisation is not a standalone regulation but a series of laws that follow one another and are based on the Companies Act, 2013 (“the Act”) and rules related to it, all governed by the Depositories Act, 1996. The Depositories Act, 1996, is the legal charter that grants dematerialisation the power to create the depositories like NSDLand CDSLand to equate the electronic records of the securities with the physical certificates in terms of the law (The Depositories Act, 1996).
This change is brought about bythe Act. The enabling provision is Section 29(1A) of the Act which is the source of the enabling provision and Central Government is given the power by this section to issue rules to the effect that “…such class or classes of unlisted companies… shall hold or transfer securities only in dematerialised form” (Section 29(1A), The Companies Act,2013).Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014, was created as a result of this authority.
Rule 9B is the central point of the command and it encloses a number of essential subsections:
- According to Rule 9B(1) the basic regulation is provided: “Every private company, other than a small company, shall… (a) issue the securities only in dematerialised form; and (b) facilitate dematerialisation of all its securities…”.
- Rule9B(4) defines the moment when non-compliance ends.It highlights the point that “if a security holder intends to transfer his shares or subscribe to any new issue (including rights issues or bonus shares), he has first to make sure that all his existing holdings are in dematerialized form” (Rule 9B(4), Companies (Prospectus and Allotment of Securities)Rules, 2014). In other words, the portfolio of a non-compliant shareholder is frozen.”
The biggest exception to this regulation is the “small company” within the meaning of Section 2(85) of the Act. The description was changed to cover companies that have a paid-up share capital of less than four crore rupees AND a turnover of less than forty crore rupees (Section2(85), The Companies Act,2013). Nevertheless, the exemption is quite limited.The Act specifies that “small company” shall not be a holding company or a subsidiary company.
thereby, thousands of private companies in bigger corporate structures are being pulled into the demat net.
The latest structure is a prelude to a big legal battle. According to Section 2(68)(i) of the Act, the definition of a “private company” is a company that, by its Articles of Association (AoA), “limits the right to transfer its shares” (Section 2(68)(i), The Companies Act, 2013).The basic idea of limited transferability, which was there for the protection of closely-heldcompanies, is now in the midst of an operational conflict with a demat system that is meant for free and instant transfers.
Critical Analysis: Procedural Gaps and Regulatory Hurdles
Although the Rule 9B policy goal is transparency, looking at its practical side, the rule introduces operational frictions exponentially. The main issue is the imposition of a public market mechanism (dematerialisation) generally used for a private market system, which, by law, is not freely transferable.
- The Conflict between ‘Private Agreement’and’Demat’:
The legal identity of a private company under Section 2(68) is based on its Articles of Association (AoA) that limit share transfers, e.g. by Rights of First Refusal (ROFR) or requiring board approval. These are not only the contractual foundations of joint ventures and family businesses but also essential elements. However, the demat ecosystem (NSDL/CDSL) is designed for easy and unrestricted transfers. At present, there is no operational method in the depository system to programmatically enforce these complicated private AoA restrictions. This legal space leads to a situation where a momentary demat transfer may violate the company’s own AoA, thus forcing shareholders having to resort to expensive litigation to defend their rights.
- Cross-border Investors Face Obstacles:
The rule entails serious problems for foreign investors, thus working against the FDI objectives. The first obstacle is a KYC one, as demat accounts require a PAN, causing foreign entities (that are allowed to hold shares under FEMA)to deal with Indian tax authorities in order to complete their KYC. The second problem is that it causes unharmonious reporting in terms of FEMA.Themomentofdemattransferisnotlinked
with the RBI’s Form FC-TRS submission, which is necessaryfor confirming the transfer. This “harmonisation gap” leads to a situation where a transfer can be done electronically and then canceled by the RBI, thus creating a legal and logistical nightmare.
- OperationalandCostBurden:
The threshold for exemption of a “small company” (₹4 Cr capital / ₹40 Cr turnover) is quite high, which is why a large number of non-holding or non-subsidiary MSMEs have been subjected to this directive. These companies are now experiencing new significant recurrent financial and administrative burdens because of this, e.g., the necessity to appoint an RTA and pay annual fees to depositories for an ISIN. For a great number of such companies, this “progressive reform” merely equals a costly compliance exercise.
Judicatory Examination: The Supremacy of the AoAVs. Procedural Mandates
Rule 9B’s contention with the law is depicted through the hierarchy of the legal system that is revealed by the case law discussed. The Supreme Court’s landmark decision in V.B.Rangaraj vs. V.B. Gopalakrishnan is the most important one, declaring the Articles of Association (AoA) as the supreme constitutional document for a private company. Accordingly, the precedent sets that Rule 9B as only a procedural rule cannot override the substantive rights granted in the AoA such as rights of first refusal (ROFR) or other restrictions on the transfer of shares. This conflict is deepened by the case of John Tinson & Co. Pvt. Ltd. vs. Mrs. Surjeet Malhan, which referred the board’s fiduciary duty and authority to the power to approve or disapprove transfers as provided by the AoA.
The instantaneous demat operation under Rule 9B creates a situation where the board has no legal means to carryout this court-affirmed right, thus putting the directors in an unresolvable legal predicament. Although the similar NCLT case of Arvind Parasramka v. The Jaipur Udyog Limited indicates that the only way to respond to a breach is to file a reactive petition to the NCLT under Section 59, this course of action is very inefficient. The argument here is that by not offering a proactive method to ensure the implementation of the AoA, the regulation converts the shortcoming of regulatory foresight intoa litigation burden thus older shareholders will have to take part in the costly post-facto legal battles in order to rectify invalid transfers.
Conclusion
Redrawing shares of private firms on electronic platforms by the MCA is, in essence, a forward-looking reform. The goals of making things more transparent, lessening the chances of fraud, and enhancing corporate governance are very clear and beyond dispute. Nevertheless, this study has pointed out that the current uniform application of Rule 9B in its procedural aspects is the fundamental structure of a private company.
The rule change bybringing a public market mechanism (instant transferability) into a system that is legally defined as having certain restrictions(theAoA)is creating quite a few legal issues, thus it is imposing additional burdens on the cross-border investors without offering them a corresponding benefit and therefore there is the risk that it will simply be a compliance exercise rather than a business-friendly enabler. Besides, such a market would be a good place for cross-border investors to meet new issuers and open up a dialogue, which would be an excellent opportunity to do business and much better than meeting in an awkward and cold compliance environment
Author Name- Shivani Sharma, B.A. LL.B. (Hons.) student, Institute of Law, Nirma University (ILNU), Ahmedabad.
