Concept of Demat Shares - banking laws and Finance law

Dematerialized securities ('Demat' in short) are securities that are not on paper and a certificate to that effect do not exist. They exist in the form of entries in the book of depositories. Essentially, unlike the traditional method of possessing a share certificate to the effect of ownership of shares, in the demat system, the shares are held in a dematerialized form. This system works through a depository who is registered with the Securities and Exchange Board of India (SEBI) to perform the functions of a depository as regulated by SEBI. Under Section 68 B of the Companies Act, inserted by the Companies (Amendment) Act, 2000, it is mandated that every Initial Public Offer (IPO) made by a listed company in the excess of Rs. 10 Crores has to be issued in dematerialized form by complying with the requisite provisions of the Depositories Act, 1996.

Background
Indian capital market has seen unprecedented boom in its activity in the last 15 years in terms of number of stock exchanges, listed companies, trade volumes, market intermediaries, investor population, etc. However, this surge in activity has brought with it numerous problems that threaten the very survival of the capital markets in the long run, most of which are due to the large volume of paper work involved and paper based trading, clearing and settlement.

Until the late eighties, the common man kept away from capital market and thus the quantum of funds mobilized through the market was meager. A major problem, however, continued to plague the market. The Indian markets were drowned in shares in the form of paper and hence it was problematic to handle them. Fake and stolen shares, fake signatures and signature mismatch, duplication and mutilation of shares, transfer problems, etc. The investors were scared and were under compensated for the risk borne by them. The century old system of trading and settlement requires handling of huge volumes of paper work. This has made the investors, both retail and institutional, wary of entering the capital market. However, lack of modernization become a hindrance to growth and resulted in creation of cumbersome procedures and paper work.

However, the real growth and change occurred from mid-eighties in the wake of liberalization initiatives of the Government. The reforms in the financial sector were envisaged in the banking sector, capital market, securities market regulation, mutual funds, foreign investments and Government control. These institutions and stock exchanges experienced that the certificates are the main cause of investors` disputes and arbitration cases. Since the paper work was not matching the rapid growth so there was a need for a better system to ensure removal of these impediments.

Government of India decided to set up a fully automated and high technology based model exchange that could offer screen-based trading and depositories as the ultimate answer to all such reforms and eliminate various bottlenecks in the capital market, particularly, the clearing and settlement system in stock exchanges.[1] A depository in very simple terms is a pool of pre-verified shares held in electronic mode which offers settlement of transactions in an efficient and effective way.

Meaning of Dematerialization

Dematerialization is a process by which physical certificates of an investor are converted into electronic form and credited to the account of the depository participant. Dematted securities do not have any certificate numbers or distinctive numbers and are dealt only in quantity, i.e., the securities are replaceable.
Investors can dematerialize only those certificates that are already registered in their names and are in the list of securities admitted for dematerialization. These are: shares, scrips, stocks, bonds, debentures, stock or other marketable securities of a like nature in or of any incorporated company or other body corporate, units of mutual funds, rights under collective investment schemes and venture capital funds, commercial paper, certificate of deposit, securities debt, money market instruments and unlisted securities, underlying sharing of American Depository Receipts and Global Depository Receipts issued to non-resident holders.[2] Dematerialization is the process of converting physical holdings into electronic form with the depository wherein the share certificates are shredded and corresponding entry of the number of shares is done in the opened with the depository.

The securities held in dematerialized form are fungible; that is, they do not bear any notable feature like distinctive number, folio number or certificate number. Once shares get dematerialized, they lose their identity in terms of share certificate distinctive numbers and folio numbers.

Following requisites are necessary for dematerialization of securities:

1. Investors should have a depository account.
2. Securities should be from the eligible list of securities issued by the depository.[3]
3. Securities must be in the name of the account holders and owned by him.
4. Separate demat requisition form is required for each issuer company.
5. DRF[4] should be signed by all the holders so as to match specimen signature.

Object of Demat System

India has adopted this system in which book entry is done electronically. It is the system where no paper is involved. Physical form is extinguished and shares or securities are held in electronic mode. Before the introduction of the depository system by the Depository Act, 1996, the process of sale, purchase and transfer of shares was a huge problem and the safety perspective was zero.

Demat has the following advantages:

Demat system not only provides smooth and hassle-free way of dealing in shares, it also does away with all the associated tensions.
Bad deliveries are minimized
Postal delays and loss of shares in transit is prevented
Immediate transfer of shares
No stamp duty on transfer
Less paper work (reduction in huge volumes).
Faster settlement cycles and payouts.
The demat system totally avoids the associated heartburns arising from theft of shares, mutilation, forgery, counterfeit shares and loss of shares during a natural calamity.

The Depository system has the following benefits to different groups:

Benefit to the Country
The depository system helps the capital market to be more liquid, attracting more foreign investors and is in compliance with international standards, as it creates efficient and risk-free trading environment.
It minimises the settlement risks and frauds in carrying out transactions in capital markets and thus can restore faith of investors in capital markets.
It helps to reduce delay in trading practices creating investor friendly atmosphere in the capital markets.

Benefit to the Company

The depository system helps in reducing the cost of new issues due to less printing and distribution cost.
It increases the efficiency of the registrars and transfer agents and the Secretarial Department of the company.
It provides better facilities for communication and timely services with shareholders, investor etc.

Benefit to the Investor

The depository system reduces risks involved in holding physical certificated, e.g., loss, theft, mutilation, forgery, etc.
It ensures transfer settlements and reduces delay in registration of shares.
It ensures faster communication to investors.
It helps avoid bad delivery problem due to signature differences, etc.
It ensures faster payment on sale of shares.
No stamp duty is paid on transfer of shares.
It provides more acceptability and liquidity of securities.

Benefit to Brokers

The depository system reduces risk of delayed settlement.
It ensures greater profit due to increase in volume of trading.
It eliminates chances of forgery – bad delivery.
It increases overall of trading and profitability.
It increases confidence in investors.

Agency in Depositories

India has chosen the concept of multi-depositories.[5] Presently, there are two depositories registered with SEBI;
National Securities Depository Limited (NSDL)
Central Depository Service (India) Limited (CDSL)

National Securities Depository Limited (NSDL)

Both agencies are linked with each other. NSDL is a public limited company incorporated under the Companies Act, 1956. Four renowned institutions participate in it. Unit Trust of India (UTI), Industrial Development Bank of India (IDBI), National Stock Exchange of India (NSE), State Bank of India (SBI).UTI is the largest mutual fund of India and IDBI is the largest development bank, NSE is the largest stock exchange of India and SBI is the largest commercial bank of India having clearing facility. HDFC and Citibank also share in this system.[6] NSDL is managed by Board of directors headed by a managing director. It is governed by its bye-laws and its business operations are regulated by business rules. NSDL interfaces with the investors through players or business partners. Constituents of depository compromise of clearing corporation, brokers, clearing member, registrar and transfer agents, company or issuer, stock exchange, bank depository participant and investors. All are electronically linked to the main depository for the settlement of trades and to perform a daily reconciliation of all accounts held with NSDL.

Central Depository Service (India) Limited (CDSL)

Second agency is CDSL - Central Depository Service (India) Limited. Main functions of this agency are centralized database and accounting. Major participant in CDSL[7] are LIC, GIC and BSE. This agency is set up with the object to keep in mind to accelerate growth of scripless trading, with major thrust of individual participation and creating competitive environment, responsible to the users interests and demands to enhance liquidity. CDSL aims to retain the entire data of the investors in the central database of CDSL. It has opted for it with the following objectives:
Within time information is available to issuers/registrar's and share transfer agents.
Companies can monitor critical holdings, e.g., holding of FIIs and FIs, investment companies, etc., by using up the parameters through their front-end terminals.
There is no other database in the system to reconcile.

No additional security or storage cost of data or critical database residing at the front-end terminals with the issuers/registrars.

Recover only the annual maintenance charges.

CDSL signed a memorandum of understanding with NSDL for inter-depository connectivity. Presently, more than half the business of depositories is handled by this agency. Role of both these agencies has become very vital after SEBI's declaration that there would be no deals in physical form and only dealing to happen in market through demat accounts.

Depository Participant
Similar to the brokers who trade on your behalf in and outside the Stock Exchange; a Depository Participant (DP) is the representative (agent) in the depository system providing the link between the Company and the investor through the Depository. Depository Participant maintains investor's securities account balances and intimates him the status of your holding from time to time. According to SEBI guidelines, Financial Institutions like banks, custodians, stockbrokers etc. can become participants in the depository. A DP is one with whom you need to open an account to deal in electronic form. While the Depository can be compared to a Bank, DP is like a branch of bank with whom one can have an account.

Process of Demating Shares

The process of opening an account with a Depository Participant is similar to the opening of a bank account.

One has to open an account with a Depository Participant (DP) by filling up an Account Opening Form and signing a “Participant-Client Agreement”. Then a unique client ID number will be given, which must be quoted in all correspondence with the DP.

Thereafter, one has to fill up and submit a Dematerialization Request Form (DRF) provided by the DP duly signed by all the holders and surrender the physical shares intended to be dematted to the DP.

The DP upon receipt of the shares and the DRF will issue an acknowledgement and will send an electronic request to the Company/ Registrars and Transfer Agents of the Company through the Depository for confirmation of demat. The DP will simultaneously surrender the DRF and the shares to the Company / Registrars and Transfer Agents of the Company with a covering letter requesting the Company to confirm demat.

The Registrars and Transfer Agents of the Company, after necessary verification of the documents received from the DP, will cancel the physical shares and confirm demat to the Depository. This confirmation will be passed on by the Depository to the DP which holds investor's account. After receiving this confirmation from the Depository, the DP will credit investor account with the number of shares dematerialized. The DP will hold the shares in the dematerialized form thereafter on behalf of the investor. And hence one becomes the beneficial owner of these dematerialized shares.

When the beneficial owner submits the shares for dematerialization, his DP will deface the share certificates with the stamp “SURRENDERED FOR DEMATERIALISATION”. This ensures that shares are not lost in transit or misused till credit is received in demat account.

SEBI Guidelines [8]

SEBI has taken various policy initiatives to popularize the demat concept. One of them is delivery of demat shares compulsorily for institutional investors and OCBs. However, these investors have been allowed to buy shares in physical form, get them transferred in their names and thereupon get them dematerialized.

The implementation of the guidelines is subject to the condition that the company shall get a certificate of practice that the company has followed the procedure mentioned in the scheme and to affect that:
The company has followed the necessary procedures for effecting the original transfer;
The register of members of the company was, accordingly, amended and the shares were transferred in favour of the transferee;
The company has adequate procedures and has satisfied itself that the transferee and the entity requesting dematerialization are one and the same and before confirming the dematerialization request; company has further amended its register of members to indicate the transfer from the transferee to any agency;
The company has defaced and cancelled/mutilated all the certificates.
The company has adequate system to ensure that the investor does not lose his corporate benefits on account of the transfer entries in favour of the agency.

Re-materialization
Rematerialisation is a process, by which a client can get his electronic holdings converted back into the physical holdings, i.e., he can get back the physical form of share certificates. To get the certificate back, he has to fill up a remat request form and submit it to its depository with whom he has an account. The new certificates may not necessarily bear the same folio or distinctive numbers as previously existed. The facility to rematerialise again is offered to all those scrips which are eligible for demat in the depositories` list of securities available for dematerialisation.The whole process of rematerialisation is completed within 30 days from the receipt of request. This shows how speedy the electronic system works – that being the essence of today's business where the prices of scrips change many times a day.

Disadvantages of Demat

The disadvantages of dematerialization of securities can be summarised as follows:
Trading in securities may become uncontrolled in case of dematerialized securities.
It is incumbent upon the capital market regulator to keep a close watch on the trading in dematerialized securities and see to it that trading does not act as a detriment to investors. The role of key market players in case of dematerialized securities, such as stock-brokers, needs to be supervised as they have the capability of manipulating the market.

Multiple regulatory frameworks have to be confirmed to, including the Depositories Act, Regulations and the various Bye Laws of various depositories. Additionally, agreements are entered at various levels in the process of dematerialization. These may cause anxiety to the investor desirous of simplicity in terms of transactions in dematerialized securities.

However, the advantages of dematerialization outweigh its disadvantages and the changes ushered in by SEBI and the Central Government in terms of compulsory dematerialization of securities is important for developing the securities market to a degree of advancement. Freely traded securities are an essential component of such an advanced market and dematerialization addresses such issues and is a step towards the advancement of the market.

Conclusion
Over the last decade, the Indian capital market has been growing by leaps and bounds. India has the largest number of listed companies in the world today. It also boasts of a large number of shareholders, about 32 million. Paradoxically, the problems associated with transactions, clearing and settlement were also on the rise. Simultaneously, they expose the investors to greater risks.
Indian market thus required a new system that would eliminate all problems of investors and would give them healthy environment, and would strengthen their faith in the capital market, which was very low due to scams. Inordinate delay in investigation of these scams and escape of wrongdoers from law – created doubts in the minds of investors. The position has substantially improved after the introduction of the depository system.

Bibliography
Taxman,Company Law & Practice, Majumdar A K. & Dr. Kapoor G. K.,Taxman Publication Pvt. Ltd., (2003)
Ramaiya A., Guide to Company Law, 16th Edn., Wadhwa Publication.
Singh Avtar, Company Law, 13th Edn., Eastern Book Company, Lucknow, 2001.
[1] Depositories Act, 1996: also in (19996) 3 Comp LJ 261 (St.) and SEBI (Depositorries and Participants) Regulations, 1996: (1996) 3 LJ 13 (St.) [1-19]
[2] SEBI (Depositories and Participants) Regulations, 1996: see (1996) 3 Comp LJ 13 (St.)
[3] NSDL/CSDL agencies
[4] Demat Requisition Form
[5] Depository Act passed by Parliament in August, 1996: see (1996) 3 Comp LJ 261 (St.)
[6] Hindustan Development and Finance Corporation – Participate from 1990-2000
[7] Certificate of Commencement of Business from SEBI 8 February, 1999
[8] SEBI (Depositories and Participants) Regulations, 1996: see (1996) 3 Comp LJ 13 (St.)

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