The Corporate & Commercial Law Society Blog, HNLU

Month: January 2024

  • Mandatory Dematerialisation of Securities: Unveiling the new MCA Amendment

    Mandatory Dematerialisation of Securities: Unveiling the new MCA Amendment

    BY TARUN THAKUR, A SECOND-YEAR STUDENT AT NLUO, CUTTACK

    Introduction

    In an interesting move recently, the Ministry of Corporate Affairs (MCA) vide notification on 27 October 2023 introduced the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. Now, this amendment has inserted Rule 9B which stipulates that securities issued by private companies must be in a dematerialised form, and further mandates that both issue and facilitation of its existing securities should necessarily be in dematerialised form. This is a major leap as now securities can now only be in dematerialised form. After this amendment, with effect from 30 September 2024, a private company has to comply with the new rules.

    This amendment does not come as a huge surprise to the private companies as there were already discussions in the market from a long time that soon it will become mandatory that securities must be held in dematerialised form. Securities and Exchange Board of India (SEBI) in its report titled – Report of the Group on Reduction of Demat Charges that was released in early 2004 highlighted the risks involved when dealing with physical shares and SEBI also stated that it is playing an important role in in nurturing the growth of dematerialisation of securities in the country. So, from the report it is very coherent that even SEBI was in favour of dematerialisation at that time and was also working to achieve it. Moreover, the CLC working committee report was released last year in March 2022 which also hinted towards the new amendment that has been done to the Companies (Prospectus and Allotment of Securities) Rules, 2014 (PAS rules), as it noted the advantages of dematerialisation and also proposed that the Companies Act, 2013 (CA) should be amended and issue, transfer and facilitation of securities should be done only in dematerialised form.

    Tracing the origins of dematerialization

    Now before moving forward with the intricacies and challenges that this amendment poses it is crucial to know about dematerialisation and its inception. The term “dematerialisation” simply means converting physical shares and securities into electronic form and it was first introduced in the Depository Act, 1996 (DA 1996), as section 9(1) of the Act states that all securities pertaining to a depository shall be dematerialised.

    This was the inception point when securities facilitation and storage started in dematerialised form.  It is also noteworthy that Section- 29 of the CA broadened the scope of dematerilization as it mandates that the issuance of securities should only be in dematerialized form, thus complimenting the DA.  

     Understanding the rationale behind mandatory dematerilisation

    The main contention revolves around the rationale behind making dematerilisation mandatory for the private companies  Earlier in 2018, MCA amended the PAS Rules (2018 Amendment) which inserted Rule 9A and made it mandatory for the public companies to issue and facilitate existing securities in dematerialised form. The same Rules have been applied to the private companies via the new amendment with minor differences.

    Dematerialization combats back-dated transactions and improves transparency of the system. Backdating is the practice of changing a document’s date to an earlier one but when the documents pertaining to shares will be in an electronic form than backdating cannot be done, hence transparency will get bolstered.  Furthermore, dematerialization assists in real-time monitoring of any non-compliance of rules that has been done by any company due to its electronic nature and strict regulatory oversight.

    Challenges Ahead: Examining the Transition to Dematerialisation

    The current amendment exempts only small and government companies from mandatory dematerilisation in contrast to its previous 2018 Amendment, which in addition to small and government companies, also exempted Nidhi companies and wholly owned subsidiaries from mandatory dematerilisation. The reason cited for this was that these type of companies have limited number of shareholders. This gives rise to a pertinent question – why is there a diversion from the previous 2018 amendment, and what is the rationale behind not exempting Nidhi companies and wholly owned subsidiaries in the current amendment?

    One justification for non-exemption might be to fill in the gaps that existed in the 2018 amendment. An additional and more convincing rationale could be that the government is rapidly approaching dematerialization and any exemption granted to any company will eventually run its course. As a result, soon there will be no company that will be exempted from dematerialization. To maintain a cohesive framework, MCA must address the concerns of the stakeholders.

    Further, while extension of the dematerialized realm to private companies seems like a bold move, the compliance timeline given to the private companies is only 18 months i.e. till 30 September 2024, after which issuance and transfer of securities can only happen in demat form.  In India, there are 24,61,937 private companies that are currently registered. . All of these companies will be filing applications in the NSDL and CSDL for the conversion of securities. Consequently, the main concern is whether both these systems have the requisite digital infrastructure and technology to not only facilitate this conversion of securities, but also facilitate them in a fast and smoother way as massive amount of applications may pose operational challenges to both of them.

    Another  obstacle is that a private subsidiary company cannot qualify as a small company.  In case of subsidiaries of private foreign companies, they will also need to adhere to the new rules that have been notified. This will be cumbersome for both, the government and private foreign companies, as they will need to open a demat account with SEBI which requires them to complete a comprehensive Know Your Customer (KYC) process and also obtain a permanent account number (PAN).  This will be taxing for the government as there will be an influx of foreign entities trying to obtain PAN. Moreover, the private foreign companies will also face a challenge as even after obtaining PAN after a comprehensive process, they will have to incur a recurring cost to maintain their demat account.

    Course of Action for Private companies

    In order to comply with the new regulations, private enterprises will need to take a few steps as a result of this amendment. Initially, in order to facilitate the dematerialisation of securities, a private company must get the International Securities Identification Number (ISIN) for each security. Subsequently, the company must notify its shareholders of this information. A private company’s securities should only be issued and transferred in dematerialised form once its share capital has been dematerialised. Additionally, the dematerialisation of the securities held by the company’s directors and promoters should be required. The amendment does not provide for any penal sanctions for non-compliance but on non-compliance a private company will not be able to facilitate transfer of securities and if a there is any grievance a security holder has then it will be resolved by the Investor Education and Protection Fund Authority (IEPFA).

    Concluding thoughts

    This amendment though has some issues but this is a major transformation from the conventional system where the transfer and issuance of securities was done in physical form. Dematerialization shall help in  bringing more efficiency and transparency into the system. Further, from the regulators point of view, this will help them in tackling and mitigating benami transactions and theft by incorporating this new technology driven digital system. It is still debatable whether there is adequate infrastructure to sustain this paradigm shift. The government has to ensure that intact systems are placed so as to regulate and facilitate changes that this new amendment will bring.

    Electronic form of securities also helps in tracking real time market movements and see if there is any suspicious activity which cannot be done in the case of physical securities. While a company has to bear printing expense in case of physical securities, a much lower cost is involved in managing electronic securities. Also, the stringent KYC norms posed by this amendment give an overriding benefit to the government as it will help them to maintain a comprehensive database which would further help in bringing more transparency in the system and make it more robust.

    In the end, it can be stated that this is a major progressive reform but there are some concerns that needs to be addressed by the MCA.

  • Regulating Through Litigating: Quandary of SEBI

    Regulating Through Litigating: Quandary of SEBI

    BY ANSH CHAURASIA, A THIRD-YEAR AT RMLNLU, LUCKNOW

    Introduction

    Recently, the securities market regulator Securities and Exchange Board of India (‘SEBI’), equipped with broad powers, had difficulty defending its quasi-judicial orders. For instance, the Supreme Court (‘SC’) rejected SEBI’s appeal against the order of the Securities Appellate Tribunal (‘SAT’) in the matter of Apollo Tyres. SEBI was reprimanded by the SC for imposing a penalty for violation of SEBI (Buy Back of Securities) Regulations, 1998, but only after the show cause notice was issued to the respondent after more than a decade in 2014 for a cause of action that arose way back in 2003. SEBI passed the order imposing the maximum penalty in 2016, which was set aside by the SAT on grounds that it was not justified in imposing the maximum penalty. Subsequently, the revised penalty was quashed by SAT, against which SEBI approached the apex court. The SC affirmed the decision of SAT on the grounds of inordinate delay, a point of law entirely overlooked by the SEBI during the whole proceedings, right from the commencement of the investigation in 2014 to its appeal before the court on 4 December 2023. Although the SEBI Act has no limitation period per se for the issuance of show cause notice or the completion of the adjudication proceedings, the court’s earlier decision settled the position that such exercise of power must be done within a reasonable time.

    The aforementioned failure of SEBI in appealing before SC is part of a larger trend. At the heart of this regulatory struggle lies the legally untenable orders of SEBI and consequential litigation before SAT and SC. The redundancy of SEBI’s regulatory role resulting from such orders being litigated and decided against affects its credibility and has far-reaching implications for the key market regulator.

    The detrimental litigation

    The legislative history and precedent of the SC lucidly point to the cases appropriate for the appeal. The unamended Section 15Z, the appellate remedy to the High Court, was provided on any question of law or fact. After the amendment in 2002, the appellate court was changed from the High Court to the Supreme Court, and the grounds for appeal were limited to only questions of law, making it the current position. The SC interpreted the phrase ‘question of law’ in the backdrop of Section 15Z to arise when there is either erroneous construction or interpretation of the legal provisions of the statute or the general principles of law. The court also held that the power under Section 15Z has to be exercised while keeping in mind the sectorial laws and policy evolved by the tribunal acting under Section 15T through its interpretation of the Acts, Rules and Regulations. Therefore, the scope of the appeal and criteria of the cases appropriate for appeal are settled propositions of law.

    In its attempt to enforce its order, SEBI has appealed multiple times to the apex court despite a clear scope. In WhatsApp leaks case, SEBI imposed a penalty upon noticees for forwarding messages containing information about financial results. However, the order lacked any finding with respect to the originator of the message. SEBI’s order completely overlooked the fact that noticees merely forwarded the messages with sensitive information, which resulted in SAT overturning the order and vindicating SAT’s finding by the SC.

    In Tata Steel case, SEBI appealed to SC after its order to impose a penalty was set aside by SAT. SC refused to interfere because the order of SAT clearly established that the show-cause notice did not impute any charge upon the noticees. Consequently, the penalty was set aside. SC also remarked whether SEBI appealed only because their ‘ego was hurt’.

    In NSE Dark fibre case, SEBI appealed to SC after a setback from SAT when the disgorgement order for Rs 625 crore with interest was quashed due to a lack of nexus between the disgorgement order and the wrongdoing as required under Section 11B. Another order of fine was set aside by SAT in this case due to inadequate reasons to impose a maximum fine under Section 15J. Consequently, SAT reduced the quantum of the penalty. The move of SEBI demanding a stay on SAT’s order delineates an approach centred on recourses to enforce its orders rather than introspecting on its quasi-judicial adjudication process. Frequent dismissals in appeals whose fate could have been easily determined pinpoints the obdurate nature of the regulator.

    The ramifications of SEBI donning a litigator’s mantle

    The inefficiency of the adjudicatory process becomes apparent when shortcomings in SEBI’s order are pointed out by SAT and vindicated by SC. This directly dents the investor confidence that SC regards to be directly dependent upon the effectiveness of the regulatory mechanism. In SEC v Zandford, investor confidence was held to be the key objective behind the introduction of the Securities Exchange Act. Investors should not perceive the market as a system stacked against them. The Sisyphean undertones in SEBI’s approach to taking the case to the apex court, which has now been frequently falling to the ground, negate the fundamental credibility that the legislature intended to imbibe in the eyes of the investors.

    The SC interpreted the statutory right of appeal incorporated under Section 15T as scrutiny of SEBI’s broad power and emphasised the crucial role of the tribunal in the structural and consistent evolution of sectorial laws. Overlooking the shortcomings pinpointed by the order of SAT or requesting a ‘stay’ on its order before the apex court erodes the parliamentary intent and development of sectorial law.

    Against this backdrop, the problem of complying with basic technicalities is also a glaring issue. A lackadaisical approach in passing orders without providing adequate and sound reasons and bypassing the jurisprudence enunciated by SAT decisions is concerning.

    However, at the outset, SEBI incurs a financial burden every time it decides to go against an order of SAT, and the imposition of a similar burden on the opposite party is problematic. Justice Madan B. Lokur lamented this approach of government agencies litigating for the sake of litigating in a 2018 judgment. SEBI itself passed a proposal in 2019 mandating the appellants before SAT to deposit 10 per cent of the penalty so it could curb the appeals solely aimed at delaying the execution of its order. Therefore, SEBI does acknowledge the hardened mindset to resort to appeal, if not within itself yet among the parties aggrieved by its order, and it rightly points to the consequences of such an approach.

    The ripple impact of this approach is now perceptible as affecting institutional integrity. The SC reprimanded SEBI in the Suzlon case, asking the regulator to ‘regulate rather than litigate’. Although the SC granted the relief to SEBI, clarifying that the contested order would not be treated as precedent, it proceeded to remark. In Apollo Tyres case, SEBI was criticised for appealing against every order that went against them and directed to submit an affidavit of appeals they have filed.

    Conclusion

    The SEBI is a unique statutory body that has the role of regulating, investigating, adjudicating, and deterring the offender. We see an amalgamation of executive, legislative, and quasi-judicial functions within the SEBI. The broad powers conferred upon it have to be exercised to protect the interest of the investors and inspire confidence among the public. SEBI ought to weigh the above considerations before moving to the apex court. SEBI brought itself into this position where it has been reprimanded multiple times for ascertaining the cases only to meet the on-paper requirements. However, the situation requires adherence in spirit. This obstinacy on the part of SEBI is a Faustian bargain where it is giving up institutional credibility for no change in consequences and further losing an opportunity to look into regulatory mechanisms. Any decision to appeal must pass the muster of the requirements of appeal irrespective of the fact that SEBI has been aggrieved at the hands of the SAT.

    The striking similarity in all cases challenged before SC and quashed before SAT is SEBI’s failure to substantiate its allegations and insistence on enforcing its order. Changes in its regulatory and investigatory mechanism can lower the recurrence of these defects. Recently, the SC expert committee constituted to investigate the Adani-Hindenburg made significant suggestions for the prudent and effective exercise of the broad power at SEBI’s disposal. It suggested an ‘effective enforcement policy’ to lay down criteria by which SEBI must decide whether to initiate the proceeding either to impose a monetary penalty, to take a remedial action, or to take a punitive action. Such criteria should be clear and non-arbitrary. Laying down criteria would delineate an objective requirement of specific conditions to initiate proceedings, consequently leading to a proportionate exercise of regulatory powers.