Introduction
With the Ministry of Corporate Affairs (‘MCA’) mandating the dematerialization of securities for private companies, India’s corporate landscape is witnessing a digital transformation. The provisions of the Companies Act, 2013 (‘Act’) provide that every private company (other than the small companies[1] and government companies) is required to facilitate the dematerialisation of all its securities and issue the securities only in dematerialised form.
The mandate aims to strengthen corporate governance, protect investor interests, reduce risks associated with physical certificates such as loss, theft or fraud, enhance transparency and to simplify electronic processes for share transfer and stamp duty collection. However, it also presents new challenges in managing shareholder rights traditionally enforced in a physical framework by a private company. By requiring shares to be held in demat form, it may limit the flexibility private companies have typically enjoyed in governing shareholder rights and controlling ownership structures like restrictive rights on share transfers.
In this article, we will delve into the implications, the challenges for enforcing shareholder agreements, and the solutions available to preserve shareholder rights in the digital age.
Legal Framework for Dematerialization
The dematerialization requirement, initially applicable to unlisted public companies, now extends to private limited companies. This shift was brought into effect last year by the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. Through the incorporation of Rule 9B in the Companies (Prospectus and Allotment of Securities) Rules, 2014, effective from 27 October 2023, the MCA mandates that all securities of private companies must be dematerialized within an 18-month window, ended on 30 September 2024.
To facilitate the dematerialisation of securities to its shareholders, the company is required to approach the depository (NSDL and/or CDSL) to obtain International Security Identification Number (‘ISIN’) for each type of security issued by it.
The Role of Shareholders’ Agreements in Safeguarding Rights
A private company has always been subject to statutory restrictions on share transfers. For instance, Section 2(68) of the Act provides that a private company means a company which by its articles of association (‘AOA’) restricts the transfer of its shares.
Further, Section 10 of the Act provides that the restrictions imposed by the AOA are applicable on all the shareholders of a company, while Section 58(1) of the Act empowers a private company to refuse the transfer of its shares, whether exercised through a specific power outlined in its AOA or otherwise.
The AOA, as a charter document of a company, provides the governing provisions for the management of the company. Further, it is a well-settled principle that the AOA of a company constitutes a binding contract between the company and its shareholders, as well as among the shareholders themselves[2]. Similarly, a shareholders’ agreement (‘SHA’) is also pivotal in defining shareholder rights and obligations and provides the mechanism for the management of a company. Once agreed upon in the SHA, the enforceability of these rights, however, depends on their subsequent incorporation into the company’s AOA.
Indian courts, in various judicial decisions, have held that unless restrictions contained in the SHA are incorporated into the AOA, they are not binding on the company. Thus, even with contractual agreements in place, companies must embed these restrictions in their governing documents for effective enforcement.
Typically, the restriction on the transfer of securities in a private company originates from the terms set out in the SHA (which are then incorporated in the AOA). SHA’s often contain detailed clauses regarding share transferability such as the right of first refusal (ROFR), right of first offer (ROFO), tag-along rights, drag along right, restriction on transfers to competitors, lock-in periods, other pre-emptive rights etc. designed to ensure control over share transfers.
Transfer of Securities and Shareholder Rights in Physical Regime
In the physical mode of transfer of securities, a company is obligated not to register any transfer unless a proper instrument (form SH-4) of transfer, duly stamped, dated and executed by both buyer and seller, accompanied by the share certificate(s) or letter of allotment, has been delivered to the company and the same has been approved by the board of directors (‘Board) in accordance with the Act and the AOA of the company. The approval from the Board becomes critical for the shareholders, where multiple covenants are outlined in the SHA and incorporated within the company’s AOA in relation to the restrictions on transfer of securities.
Thus, the approval of the transfer of securities by the Board has been essential in case of transfer of securities in physical form. This measure provided the Board with a level of control over securities transfer, allowing it to deny transfers that did not align with the SHA or AOA.
Implication of Dematerialisation on Governance of Shareholder Rights
The shift to dematerialized securities introduces fresh challenges in enforcing shareholder rights traditionally protected in a physical framework. In the automated demat transaction, securities are electronically transferred without the need for Board approval, which increases the risk of bypassing critical restrictions under the SHA or AOA. This issue is compounded by the standardized tri-partite agreements used by registrars and transfer agents (RTAs) and the depositaries that often lack the flexibility to accommodate company-specific governance requirements.
The move to dematerialized securities could potentially lead to a rise in legal conflicts if restrictive covenants are not properly enforced within the electronic framework. As electronic transfers occur swiftly and with less manual oversight, there is a risk that essential restrictions—such as rights of first refusal/ offer or prohibitions against transferring shares to competitors—may be inadvertently bypassed. If these covenants are not consistently upheld within the digital system, disputes may arise between shareholders seeking to enforce their rights and those initiating or completing transfers, resulting in increased litigation to address breaches and clarify enforcement of these critical shareholder protections.
The primary option available to parties affected by an unauthorized securities transfer is to pursue a rectification of the company’s register of members through the National Company Law Tribunal, as outlined in Section 59 of the Act, in addition to a suit for contractual breach against the defaulting party.
Potential Solutions to the Challenges
Depositories, such as NSDL and CDSL, offer the option to freeze the ISIN of securities to prevent unauthorized transfers. This can be used by private companies or their shareholders to control or halt transfers that do not meet agreed-upon restrictions. The frozen status would require shareholder or board approval to unfreeze, creating an added layer of oversight and enhancing control over security transfers within the dematerialized system.
The adopting for a default “Freeze for Debit” facility by a company upon the payment of the fees could reduce risks related to internal conflicts or disputes among shareholders, as it limits transfers until shareholder or board approval is granted.
Additionally, private companies may consider amending their SHAs and/or AOA to accommodate the specific requirements of dematerialization with respect to the restrictive covenants. For instance, companies may incorporate an additional layer of pre-authorization from the Board for transfers of securities, ensuring it align with the restricted covenants contained in the SHA and the AOA.
Further, the government could consider mandating depositories to automatically enforce transfer restrictions for private companies, similar to the physical restrictions historically in place.
Conclusion
The transition to dematerialized securities represents a transformative step towards modernizing India’s corporate landscape, bringing enhanced transparency and reducing risks associated with physical certificates. However, with this transition, the private companies face a double-edged sword: increased transparency, yet new vulnerabilities in upholding shareholder rights. Without proactive adjustments to governance and safeguards, the shift to digital environment could mean the job remains half-done, with unintended consequences for shareholder control.
By Nidhi Arora (Partner) and Binny Chopra (Senior Associate)
[1] The Act defines a small company as a company that is not a public company and has: (i) a paid-up share capital equal to or below INR 4 crore or such a higher amount specified not exceeding more than INR10 crores; or (b) a turnover equal to or below INR 40 crore or such a higher amount specified not exceeding more than INR100 crore.
[2] Borland’s Trustee v. Steel Brothers and Co. Ltd., (1901) 1 Ch 279; Inland Revenue Commissioners v. Crossman, (1937) AC 26.
