[Payal Agarwal is a Partner at Vinod Kothari & Co]
The mandatory dematerialisation provisions under the Companies Act, 2013 require companies to issue their securities and facilitate transfer requests in dematerialised form. For private companies, the mandate has become effective since 30 June 2025. Hence, every private company (barring a small company) is now required to issue securities in dematerialised form. Not only do new securities need to be in demat form, but shareholders having existing shareholding in physical form are deprived of their shareholding rights in the form of participation in further rights issue, bonus issue, and other corporate accruals. The purpose of the mandatory demat rule is to bring shareholders and shareholding in companies within a transparent, tractable domain. However, can every person who has not dematerialised their holdings deserve to have their property rights defeated and redistributed to other shareholders? Can such a person be compelled to lose their rights entitlement offered by the private company? Even more stark, can such a shareholder lose their rights to the accumulated surplus in the company if the board of directors of the company decides to issue bonus shares? In simple words, can the mandate of dematerialisation, that is applicable on a company, have the unintended consequence of depriving shareholders of their property rights?
It is not that rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014 is new: since its original notification in October 2023, the applicability of the provision was deferred from the original applicability date of 30 September 2024 to 30 June 2025. However, it is necessary to consider that when it comes to private companies, there are minority shareholders who have not converted their shareholdings into demat form. Reasons could be internal family considerations, some issues with respect to holdings, or pure inertia. Let there be no mistake of assuming that private companies are small companies – they may be sitting on assets worth astronomical amounts – these may be family holding companies, joint venture companies, or even large companies with a restricted shareholding base. If the company is an old legacy company, for sure, the shares would have been in physical form, and may not have been converted into demat form. Now, suddenly, finding the law that has come into force, if the board of directors decides to come out with a bonus issue, the minority holding shares in physical form will be deprived of their right – which would mean, their share of wealth piled up over the years runs the risk of going to the other shareholders.
Mandatory dematerialisation prior to subscription to securities
Sub-rule (4) of rule 9B puts a condition on the securities holders to have the entire holding in demat form prior to subscription to the securities. The relevant extracts are as below:
(4) Every holder of securities of the private company referred to in sub-rule (2),-
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(b) who subscribes to any securities of the concerned private company whether by way of private placement or bonus shares or rights offer on or after the date when the company is required to comply with this rule shall ensure that all his securities are held in dematerialised form before such subscription
Thus, the provision explicitly forbids a shareholder from participation in a rights issue or bonus issue – corporate actions that are very much a part of the pre-emptive rights of a person as an existing shareholder.
Seeking mandatory dematerialisation: powers under section 29 of the Companies Act
Note that rule 9B has been issued in accordance with the powers contained in section 29 of the Companies Act, 2013. The title of section 29 reads as “Public Offer of Securities to be in Dematerialised Form”, indicating Parliament’s intent of requiring mandatory dematerialisation of “public offers”. Sub-section (1)(b) of the said section originally referred to “public” companies; however, the term “public” was subsequently omitted, and sub-section (1A) introduced, so as to require the notified classes of unlisted companies to “hold” and “transfer” securities only in dematerialised form. The amendment was brought in 2019, thus enabling the Government to bring private companies too within the ambit of mandatory dematerialisation.
Bonus issue and the unfair treatment to physical shareholders
Rule 9B(4) explicitly refers to “bonus issue”, and states that physical shareholders are ineligible to “subscribe to the bonus issue”. At the outset, the language of the provision is flawed in the sense that bonus issue is mere capitalisation of profits of the company – there is no “offer” on the part of the issuer, and no “subscription” on the part of the shareholder. The bonus shares are proportionally available to all shareholders in the ratio of their existing shareholding.
Since bonus issue leads to capitalisation of profits, there is an effective distribution of profits to the shareholders, though the company does not incur any cash outflow. Depriving a shareholder of their right to bonus issue does not only result in non-distribution of the profits to such shareholder, but also ends up in redistribution of the share of profits to other shareholders. There is a disproportionate distribution of profits, and the physical shareholders stand at a loss.
Unclaimed dividend: why should the treatment not be the same?
A parallel reference may be drawn from the provisions applicable to payment of dividend, through which distribution of profit occurs, with an immediate cash outflow. Section 124 of the Companies Act, 2013 requires that any unclaimed or unpaid dividend be transferred to a separate escrow account, and the details of the shareholders be placed on the website to provide notice to the shareholders for claiming the same. Even if the same is not claimed by the shareholders during the specified period, it is still not allowed to be re-distributed amongst the other shareholders; rather, it gets transferred to the Investor Education and Protection Fund (IEPF), and may still be claimed by the shareholders.
In a bonus issue, which is much similar to that of dividend, the rights of the physical shareholders should not be compromised and the bonus shares should ideally be set aside in a separate suspense account with any depository participant. Before keeping such shares in the suspense account the issuer company should send intimation letters to such shareholders at their latest known address.
Listed shares and Suspense Escrow Demat Account
Pending dematerialisation of holdings, any corporate benefits accruing on such securities are credited to the Suspense Escrow Demat Account, and may be claimed by the shareholder. Regulation 39 read with Schedule VI of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 require all such corporate benefits to be credited to such demat suspense account or unclaimed suspense account, as applicable for a period of seven years and thereafter transferred to the IEPF in accordance with the provisions of section 124 of the Companies Act read with the rules made thereunder.
How physical shareholders are deprived of their rights to proportionate holding
Under a rights issue, an opportunity is given to the existing shareholders, in proportion to their existing shareholding, to subscribe to the further issue of shares by the company. Thus, any dilution in the voting rights and towards the value of the company is avoided. The alternative to rights issue is through a preferential allotment, where the securities may be offered to any person – whether an existing shareholder or otherwise – in any proportion. Since this may lead to a dilution in the rights of the existing shareholders, the same requires: (a) approval of the shareholders through a special resolution and (b) a valuation report from the registered valuer.
Both of the aforesaid are meant to protect the interests of the existing shareholders. On the other hand, in case of a rights issue neither shareholders’ approval nor a fair valuation requirement applies, on the premise that there is no dilution of rights of the existing shareholders. In fact, rights issue of shares can be, and in practice are, fairly underpriced, since there is no mandatory valuation requirement under the Companies Act. While some court rulings contradict each other on whether section 56(2)(x) of the Income Tax Act applies on disproportionate allotment under a rights issue, the valuation may be based on historical values and therefore, may not reflect the fair value of the shares.
Not being entitled to rights issue is like losing the shareholder’s proportional wealth in a company, resulting in re-distributing the property of the physical shareholders to the demat shareholders. This effectively steals a physical shareholder of its existing holding in the company, which gets diluted to the extent of the disproportionate allotment, and a loss in value on account of the underpriced share issuance.
Listed companies and the approach followed for rights issue
For listed entities, there is no blanket prohibition on subscription of shares by physical shareholders; rather, necessary provisions are created to facilitate subscription to the rights issue by such shareholders as well.
- Where the demat account details are not available or is frozen, the right entitlements (REs) are required to be credited in a suspense escrow demat account of the company and an intimation to this effect is sent to such shareholder.
- Physical shareholders are required to provide their demat account details to the issuer or registrar for credit of REs at least 2 working days prior to the issue closing date.
- The REs lapse in case the demat account related information is not made available within the specified time.
Thus, there is no automatic deprivation of the rights of the physical shareholders to apply in a rights issue; rather, a systematic process is given to facilitate dematerialisation and subscription of shares.
The problem is bigger for private companies: necessitating additional measures
A listed entity has a large number of retail shareholders, although with very small individual holdings. In contrast is a private company, where the number of shareholders is small and each shareholder would be holding a rather significant share. The larger the share of an individual shareholder, the more it is impacted by the deprivation of participation in a rights issue. The technical requirement of securities being dealt with only in dematerialised form cannot give a private company the right to arbitrarily bring up corporate actions to deprive the existing physical shareholders from their rights over the company.
An ideal approach towards preventing companies from taking an unfair advantage of the non-dematerialised holdings of some shareholders vis-a-vis dematerialised holdings of other shareholders would be by requiring them to keep the corporate actions attributable to the physical shareholders in abeyance, pending dematerialisation of securities. Therefore, for instance, in case of rights issue, along with the circulation of offer letter to the shareholders, a dematerialisation request form may be circulated, requiring the shareholders holding shares physically to apply for such dematerialisation. Pending dematerialisation of the securities, shares may be held in a suspense account or may be reserved for the shareholders in any form, and may be credited to the demat account of such shareholders, once the same is available.
In the absence of any measures for protection of interest of the physical shareholders, the disproportionate treatment to such shareholders pursuant to a corporate action may carry the potential for use of the law with a mala fide intent, one carried out with the intent of differentiating between shareholders of the same class – which could not have been possible otherwise, if the shares were held in demat form. Thus, one may contend that the “right” is used for a “wrong”, thus challenging the legal validity of such law.
Failure to dematerialise: can there be genuine reasons or mere inertia?
One may argue that shareholders bear the responsibility to ensure their holdings are dematerialised, and hence a physical shareholder rightfully suffers the consequences of its own lethargic attitude. However, that argument should not justify depriving a shareholder of the rights to property legally owned and held by it.
Practically speaking, there may be various reasons for which a shareholder may not be able to dematerialise its existing shareholding in a company, thus becoming ineligible for participation in rights and bonus issues. For instance, the title of a shareholder might be in dispute, pending which dematerialisation would not be possible. Another practical issue might be due to loss of share certificates, and the investee company, pending issuance of duplicate share certificates and dematerialisation thereof, may come up with a bonus issue.
Concluding Remarks
The dematerialisation provisions, brought to do away with bogus shareholders, might be used to fritter away the rights of validly existing shareholders, on the pretext of non-fulfilment of a technical requirement. In view of the mandatory issuance in demat form, a physical shareholder might not be able to “hold” the shares pending dematerialisation. However, the same does not snatch away the “entitlement” of the shareholder to such rights, and cannot, at all, be re-distributed to other shareholders. This does not seem to have been the intent of law although, in the absence of clear provisions requiring the company to hold such rights in abeyance for the physical shareholders, this may lead to inefficacy.
– Payal Agarwal