In the past few years, across various measures by the Government of India, we have seen a push for both transparency and ease of doing business in India. While these objectives often go hand in hand, there may be some instances where the push towards increasing transparency in transactions may result in additional compliance burden for entities operating in India. One such move which has garnered a lot of attention is the requirement that all private limited companies (except small companies or government companies) must ensure that their shares are held by their shareholders in dematerialised form. This article specifically seeks to analyse the consequences of this move for start-ups and foreign investors (particularly early stage foreign investors).
On October 27, 2023, the Ministry of Corporate Affairs (MCA) notified the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023 (Rules) which among other things, requires every private limited company other than small companies or government companies (Subject Company) to issue securities only in dematerialised form and facilitate the dematerialisation of all its securities on or prior to September 30, 2024 (Compliance Deadline). Notably, Indian subsidiaries of foreign companies would not be considered small companies. Whether a private limited company is a small company for the purpose of the Rules will be determined based on the audited financial statements of such company as at the end of the financial year of such company ended on or after March 31, 2023.
As per the Rules, every Subject Company should ensure that before any offer for issue of any securities or a buyback of securities or a bonus issue or a rights issue made by it after the Compliance Deadline, all the securities held by its promoters, directors, and key managerial personnel have been dematerialised. Further, the Rules require every holder of securities of a Subject Company who intends to transfer such securities on or after the Compliance Deadline to get such securities dematerialised before the transfer, and a person who intends to subscribe to any securities of a Subject Company (whether by way of private placement, bonus issue or rights issue) on or after the Compliance Deadline to ensure that such securities are dematerialised prior to such subscription. It is not clear at this stage if this requirement of dematerialization will have any further implications, for instance, on the ability of a shareholder in a private company which has not complied with this requirement, to be able to receive dividends or bonus shares etc.
Relevant legal provisions
The inter se rights and obligations of the depository, the depository participant and the beneficial owner are governed by the Depositories Act, 1996, the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018, the byelaws of the depository, the agreement executed between the depository and the participant, and the agreement executed between the participant and the beneficial owner.
Once the securities of a company are dematerialised, the relevant depository shall be deemed to be the registered owner of such securities. The security holder will be deemed to be the beneficial owner of the security and will be recorded as such in the register and index of beneficial owners maintained by the depository. The depository is not entitled to any voting rights or any other rights in respect of the securities of which it is a registered owner — the beneficial owner/security holder will be entitled to all the rights and benefits and be subject to all the liabilities in respect of the securities held by a depository.
Further, in case of a company whose securities are dematerialised, the register and index of beneficial owners maintained by a depository as stipulated by the Depositories Act, 1996 will be deemed to be the register of members or register of debenture holders or the register of other security holders, as the case may be, for the purposes of the Companies Act, 2013. Once the depository receives an intimation from a depository participant to transfer a security from a beneficial owner of such securities to a transferee, the depository shall register such transfer. 
Under the Companies Act, 2013, the transferability of the shares of a private limited company is restricted by its articles of association. Accordingly, in order to give effect to the transfer of securities of a private limited company, the board of directors of such company would have to be provided with the duly stamped, dated, executed and complete instrument of transfer along with the certificate or letter of allotment relating to such securities. However, these provisions do not apply to transfers of dematerialised securities — the articles of association of a company which has dematerialised holding will contain enabling provisions to permit such dematerialisation and transfer of shares electronically.
Impact on foreign investors
The current process of opening a demat account for investors is quite onerous because of the associated documentation and procedural requirements. A Permanent Account Number (PAN) is a prerequisite for the know-your-customer standards of Indian depositories for the opening of a demat account, which is typically a time-consuming process. This alone could significantly increase timelines for investment by first-time investors into Indian companies, unless planned for. Shareholders may also be required to provide extensive details of their constitution, ownership and the agreements amongst their respective stakeholders/partners, etc. One may expect that this may be a concern especially for foreign funds.
That said, once the demat account has been opened, the administrative hassles associated with the preparation and maintenance of share certificates, statutory registers etc. will be obviated, though replaced to a limited extent by the requirement of providing transfer instructions duly signed by authorised signatories of the transferor and transferee of the shares.
Impact on start-ups
The holders of securities of venture capital- or private equity-backed companies are typically subject to restrictions on transfers of securities, such as consent requirements, rights of first refusal/offer, tag-along rights, bars on transfers to competitors etc. pursuant to the provisions of the shareholders’ agreements executed between such companies and their security holders. These provisions are also incorporated in the company’s articles of association so that in case of a breach of the provisions of the articles of association, the rights of the security holders may be enforced as against the company before the National Company Law Tribunal, in addition to a suit for contractual breach against the defaulting party.
Before the notification of the Rules, the boards of companies that maintained their securities in physical form were required to approve transfers of its securities in accordance with the provisions of the Companies Act, 2013. This step ensured some degree of control by the board over transfers of securities of start-ups since the board could reject transfers that were not compliant with the shareholders’ agreement and the articles of association of the company. However, unlike transfers of securities in their physical form, the board of directors of a private limited company would not be required to approve the transfers of securities in dematerialised form — once the beneficial owner submits an instruction slip to its depository participant with the details of the transferee, the depository would give effect to such transfer without regard to the contractual provisions or the articles of association governing transfers of shares of the issuer company. In practice, the issuer company many not even be made aware of the transfer until the depository or the depository participant issues the statement on beneficiary positions (BENPOS) to the issuer company on a weekly basis post the transfer.
Even before the notification of the Rules, there have been instances where the protections accorded by the shareholders’ agreement and the articles of association of a company have been ineffective in preventing the transfer of dematerialised securities by bad actors in a manner that is not compliant with the shareholders’ agreement and the articles of association. The notification of the Rules may pave the way for abuse of this loophole by disgruntled shareholders on a larger scale. As it stands, in the absence of any statutory or contractual protections for beneficial owners or the issuer of the securities, the only recourse available to aggrieved parties in case of an unauthorised transfer appears to be to seek a rectification of the register of members before the National Company Law Tribunal under the provisions of section 59 of the Companies Act, 2013. However, the protracted litigation that may be required to achieve the rectification may result in the very value erosion that the transfer restrictions intend to prevent in the first place.
 “small company’’ means a company, other than a public company,—
(i) paid-up share capital of which does not exceed fifty lakh rupees or such higher amount as may be prescribed which shall not be more than ten crore rupees; and
(ii) turnover of which as per profit and loss account for the immediately preceding financial year does not exceed two crore rupees or such higher amount as may be prescribed which shall not be more than one hundred crore rupees:
However, the following types of companies shall not be considered as small companies:
(A) a holding company or a subsidiary company;
(B) a company registered under section 8; or
(C) a company or body corporate governed by any special Act.
 Section 10 of the Depositories Act, 1996
 Section 88 of the Companies Act, 2013
 Section 7 of the Depositories Act, 1996
 Section 2(68) of the Companies Act, 2013.
 Section 56 of the Companies Act, 2013
 Section 56 of the Companies Act, 2013
This article is authored by partner – Archana Tewary and principal associate – Nikhil P. Joseph, published in Lexology.