DEMATERIALIZATION OF SHARES AN

OVERVIEW

PROJECT IN COMPANY LAW - I

Submitted in Partial Fulfillment of the B.B.A, LL.B (Hons.)
Course

SUBMITTED

TO:

SUBMITTED BY:
Mr. Anurag Kumar Srivastava

Vivek

Sriram
Faculty Company Law I

Roll No.

260
Semester
V

DATE OF SUBMISSION : 14TH October, 2006

NATIONAL LAW UNIVERSITY

TABLE OF CONTENTS

S. No.

Title

Pg. No.

1
2
3
4
5
6

Dematerialization A Prelude
Depository System
Process of Dematerialization
Excess Dematerialization
Conclusion
Bibliography

3
7
10
11
16
18

Dematerialization A Prelude
The traditional method of possessing shares involved holding a physical share certificate.
Dematerialized securities are securities that are not on paper and a certificate to that
effect does not exist. They exist in the form of entries in the book of depositories. 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.
The Companies Act, 1956 makes it mandatory for any Company making an Initial Public
Offer of Rs. 10 crore or more to issue shares in a dematerialized form alone.1
Thus, it is clear that Dematerialization refers to conversion of a share certificate from its
physical form to electronic form.
The Depositories Act, 1996 enacted by the Indian Parliament has now facilitated
paperless trading by way of dematerialisation of shares. Securities and Exchange Board
of India (SEBI) and the Government of India together have endeavored from time to time
to ensure that the concept of paperless trading is effectively implemented for the benefit
of the investors at large.
1

Section 68B, Companies Act, 1956

The process involved in dematerialization of shares is as follows:

The physical share certificates of an investor are taken back by the Company and an
equivalent number of securities are credited in electronic form at the request of the
investor. An investor will have to first open an account with a Depository Participant and
then request for the dematerialisation of his share certificates through the Depository
Participant so that the dematerialised holdings can be credited into that account. This is
very similar to opening a Bank Account.
Why Dematerialization?
An interesting question which will be analyzed in this Section is what induced the methid
for introducing the new method of dematerializing the securities. Investors can be
broadly classified into 2 categories. Those who are allotted shares in the primary capital
market and the second those being investors who trade in recognized stock exchanges
(secondary market).
The SEBI identified certain fundamental problems which arose in dealing with physical
shares. They are listed below:2

Share certificates were sometimes lost in transit. In that scenario, the investors
had to give an indemnity bond to the Company, which involved a cost to the
investor, besides depriving him of the opportunity to sell the shares at the
opportune time.

Time taken to receive the shares was also quite long compared to the present
dematerialized environment.

Secondary market operations were fraught with bad paper due to signature
differences, forged and fake certificates, stolen certificates and delayed transfer
resulting in low confidence in the market place.

Apart from the above problems which were faced by the Investors, there was another
problem which was identified from the Issuers perspective. In public issues, Companies
were / are incurring several costs in distributing the share certificates to the investors.
2

Shri. V.S. Sundaresan, Report of the Group on reduction of Demat charges,

www.sebi.gov.in/commreport/dematrep.pdf, visited on 11th October, 2006

In case of investors purchasing the shares from the secondary market, there are certain
costs incurred by the companies. After the shares are transferred into the investors name,
the expenses on corporate benefits distribution will be same for all shareholders owning
the shares in physical form.
In the new system, the ownership of records is kept in electronic form and the physical
movement of securities is replaced by a book entry system. This system was seen as a
solution to the problems associated with the process of physical movement, such as, long
delays in transfer, bad deliveries due to faulty completion of paper work, signature
difference with the specimen on record with the listed companies and other procedural
lapses.

Advantages of Dematerialization
Thus, the advantages of dematerialization can be summed up as follows:

Share certificates, on dematerialization, are cancelled and the same will not be
sent back to the investor. The shares, represented by dematerialized share
certificates are fungible and, therefore, certificate numbers and distinctive
numbers are cancelled and become non-operative. The depository system and
dematerialized securities offer paperless trading and transfer of shares through the
use of technology.

It enables processing of share trading and transfers electronically without

involving share certificates and transfer deeds, thus eliminating the paper work
involved in scrip-based trading and share transfer system.

Transfer of dematerialized securities is immediate and unlike in the case of

physical transfer where the change of ownership has to be informed to the
company in order to be registered as such, in case of transfer in dematerialized
form, beneficial ownership will be transferred as soon as the shares are transferred
from one account to another.

The investor is also relieved of problems like bad delivery, fake certificates,
shares under litigation, signature difference of transferor and the like.

There is no need to fill a transfer form for transfer of shares and affix share
transfer stamps.

There is saving in time and cost on account of elimination of posting of

certificates.

The threat of loss of certificates or fraudulent interception of certificates in transit

that causes anxiety to the investors, are eliminated.

The biggest advantage that maintaining shares in a fungible format is the cost
effectiveness that it has provided to the Issuing Companies.

Disadvantages of Dematerialization
Though the advantages of Demat shares outweigh the disadvantages, there are a few
disadvantages which exist with respect to Demat shares which have to be looked into
with caution.

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.
Cost Analysis Demat Shares

Prior to the introduction of the De-mat form Companies had to incur the following costs
with regard to physical shares.
Variable expenses

Share Transfer

Maintenance of folio records

Custody of physical shares, etc

Dividend and other corporate actions

Event Specific Expenses

Issue of duplicate certificates

Adhoc reports, etc.

Apart from the risks entailed with holding and dealing with physical share certificates the
above costs were major burdens for the Organizations and they have been able to do
away with the same by switching to the Demat format.
Individual investor/Institutional investor was required to pay 0.5 percent of purchase
value of share as stamp duty under physical environment which has been totally removed
under demat conditions. Further, issues pertaining to bad paper like, signature difference,
fake or forged certificate, etc. besides delay in transfer, are eliminated and thus investor is
a direct beneficiary. The price risk faced by the investor has also been eliminated. As per
some unofficial estimates, the cost related to the bad paper was to the extent of about 20
per cent of the market value of shares. Currently this figure is estimated to be almost nil.3

Depository system
A Depository system facilitates holding of shares in an electronic form and enables
transaction of such shares by a Depository Participant (DP). The DP acts as the link
between the investor and the Depository. The DP is the representative of the investor and
the agent of the Depository.
Thus, a Depository is essentially an organisation like a Central Bank where the securities
of a shareholder are held in the electronic form at the request of the shareholder through
3

Supra note 2

the medium of a Depository Participant.

In India, there are two Depositories viz.,

National Securities Depository Limited (NSDL)4

Central Depository Services India Limited (CDSL)5

Types of Depository Systems

Dematerialization, wherein, by operation, there is no physical scrip in existence as

neither the individual who owns the shares nor the depository keeps scrips. The
depository maintains the electronic ledger of the securities under his control.

Immobilization, wherein the physical scrips are held in the depository vaults,
supporting the book entry records kept on the computer.

Depository Participants
The Depository Participants are the link between the Shareholder, the Company and the
Depository. Banks, Financial Institutions, Custodians, Stock Brokers etc. can become
DPs subject to their meeting certain requirements prescribed by the Depositories and
SEBI. An investor can open his/her account with one or more DPs as he/she likes. The
procedure for opening an account with the Depository Participant is similar to opening a
Savings Bank Account with the Bank. After having opened the account, an investor can
hold shares of any number of companies in his/her account, provided all such companies
have entered the depository system.
In a Depository System, there is a possibility of 2 kinds of ownership. They are:6
Registered Owner: A registered owner is the depository who holds the securities in his
name.

National Securities Depository Ltd (NSDL) was the first Indian Depository; promoted by the Industrial
Development Bank of India, the Unit Trust of India and the National Stock Exchange to provide electronic
depository facilities for securities traded in the equity and the debt market
5
Central Depository Services India Ltd (CDSL) is the other Indian Depository; promoted by the Stock
Exchange, Mumbai in association with Bank of India, Bank of Baroda, State Bank of India and HDFC
Bank.
6
Trinath Tadakamalla, Dematerialized Securities,
http://www.legalserviceindia.com/articles/dematerialized_securities.htm, visited on 10 th October, 2006

Beneficial Owner: A beneficial owner is the person whose name is recorded as such with
the depository. Though the securities are registered in the name of the depository actually
holding them, the rights, benefits and liabilities in respect of the securities held by the
depository vest in the beneficial owner.
The depository model is based on the deposit of securities by the owner of the securities
with a certified depository. Subsequently, an entry is made in the name of the said owner,
manifesting his ownership of the securities upon which the person depositing the
securities becomes the beneficial owner in respect of the said securities. The service
provided in relation to this by the depository is that of recording of allotment of securities
or transfer of ownership of securities in the record of the depository.
Thus, the Depository System works very much like the banking system. A bank holds
funds in accounts whereas a Depository holds securities in accounts for its clients. A
Bank transfers funds between accounts whereas a Depository transfers securities between
accounts. In both systems, the transfer of funds or securities happens without the actual
handling of funds or securities. Both the Banks and the Depository are accountable for
the safe keeping of funds and securities respectively.
Charges Levied by the DP
Depository participants (DPs) impose various charges on the institutional as well as on
individual clients under various heads for providing services. The services available in
dematerialised environment that are extended to the clients are as follows:7

Dematerialisation

Rematerialisation

Custodial services

Debit or Credit facility

Hypothecation

Speed-e along with smart card

Corporate benefits like bonus, stock split, dividend payment, etc.

Supra note 2

This is an illustrative list of services available. The system of charging a fee for the
services extended to an investor is in two-layers. The Depository charges the DPs and
DPs in turn collect fee/charges from the investor. Each DP uses different norms to
classify charges depending on the extent of services rendered. NSDL has a provision for
collecting a one-time fee of 0.05 percent of market capitalization of the company, as
custody fees for life. For these companies, no custody charge is supposed to be charged
from the investors for life.

Process of Dematerialization
Open Account with a DP: The process of opening an account with a Depository
Participant is similar to the opening of a bank account. First, the investor will have to
open an account with a Depository Participant (DP) of his/her choice by filling up an
Account Opening Form and signing a Participant-Client Agreement. The Investor will
be then given a unique client ID number, which must be quoted in all correspondence
with the DP.
Submission of DRF8: Thereafter, the investor will have to fill up and submit a
Dematerialisation 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 the investor 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
8

Dematerialisation of Shares, www.syngenta.co.in/media/data-files/Dematerialisation of shares.doc,

visited on 12th October, 2006

10

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 the investors
account. After receiving this confirmation from the Depository, the DP will credit the
investors account with the number of shares dematerialized. The DP will hold the shares
in the dematerialized form thereafter on behalf of the investor. The Investor then becomes
the beneficial owner of these dematerialized shares.
Defacing Share Certificate: When the shares are submitted for dematerialisation, the DP
will

deface

the

share

certificates

with

the

stamp

SURRENDERED

FOR

DEMATERIALISATION. This ensures that the shares are not lost in transit or misused
till credit is received by the investor in his/her demat account.

Excess Dematerialization
In terms of section 9 (1) of the Depositories Act, 1996, all securities held by a depository
shall be dematerialised and shall be in a fungible form. In the past, SEBI had come across
some cases where the listed companies had dematted more securities than their
listed/issued capital. As the securities in the dematerialized environment are fungible,
once these fungible securities enter the market, it has been found to be almost impossible
to distinguish these securities from the other securities. This has enabled duplicate or fake
securities to find way into the system. This is a matter of concern for the regulator and
therefore, has been engaging the attention of SEBI9 for quite some time.
The SEBI has identified two types of excess securities in the system:

V.S. Sundaresan, Discussion paper on measures to check excess dematerialisation of securities and prelisting grey market in securities issued in initial public offers (ipos) proposed amendments to the sebi
(depositories and participants) regulations 1996, http://www.sebi.gov.in/commreport/discussion.pdf,
visited on 14th October, 2006

11

Excess of Listed Capital: One is where the dematerialisation is in excess of listed

capital of a listed company. This may be a temporary phenomenon arising out of
the fact that the company has made further issue of securities and dematerialised
such fresh capital without having received the listing approval from one or more
or all of the stock exchanges where the securities of the company are listed. The
allotment of this excess capital could be in demat or physical form. This
excess dematerialisation may get regularized once the final listing approval/s
are granted by all the stock exchanges. However, till the listing approval is
granted, these securities are technically unlisted and therefore, could not be
delivered in the stock exchanges. But due to the fungibility, if these securities are
delivered, it would not be possible to distinguish them from the original listed
securities.

Excess of Issued Capital: The other kind of excess securities is where the
securities in existence (physical and demat) are in excess of issued capital of a
listed company. This would imply that duplicate securities are in existence.
Measures Taken by SEBI to address the aforesaid problems

Excess of Listed Capital: In order to address the concerns arising out of

dematerialisation of securities in excess of listed capital, SEBI had issued a circular on
March 8, 2001 advising the stock exchanges to amend the listing agreement, stating,
inter-alia, that the company agrees to obtain in-principle approval for listing from the
exchange before issuing further shares or securities. It was also mandated in the said
circular that the stock exchanges shall inform depositories the grant of in-principle
listing approval immediately. The stock exchanges having connectivity with the
depositories would upload this information electronically. This circular was modified by
a Circular dated September 29, 2003, stating that if a company is listed on any stock
exchange which is having nationwide trading terminals, it would be a sufficient
compliance of the SEBI circular (dated March 8, 2001), if it obtains in-principle
approval from such stock exchange(s) for further issue of shares or securities. Where the
company is not so listed on any stock exchange having nationwide terminals, it shall

12

continue to obtain in-principle approval from all the exchanges where it is listed as was
provided in the aforesaid circular dated March 8, 2001.10
Further, in September 2003 vide Regulation 54(5) of the SEBI (D&P)(second
Amendment) Regulations, 2003, it was provided that within 15 days of receipt of the
certificate of security from the participant, the issuer shall confirm to the depository that
securities comprised in the said certificate have been listed on the stock exchange or
exchanges where the earlier issued listed securities are listed and shall also after due
verification immediately mutilate and cancel the certificate and substitute in its record the
name of the depository as the registered owner and shall send a certificate to this effect to
the depository and to every stock exchange where the security is listed. These efforts
have resulted in considerable reduction in the number of cases where the dematerialized
capital was in excess of the listed capital of a listed company. However, a blanket ban on
dematerialization of any unlisted securities of a listed company was not feasible in view
of the provisions of section 8 of the Depositories Act, 1996, in terms of which the
investor has the option to receive security certificate or hold securities with depository in
a dematerialised form.
Excess of Issued Capital: In order to address the problem arising out of
dematerialisation of securities in excess of issued capital of a listed company, SEBI
issued a circular dated December 31, 2002, mandating all companies to subject
themselves to secretarial audit on a quarterly basis. With the objective of strengthening
the regulatory framework to address the aforesaid problem, SEBI brought in changes in
the manner of handling share registry work by inserting regulation 53A in SEBI (D&P)
Regulations, 1996 with effect from September 2, 2003. This regulation provides that All
matters relating to transfer of securities, maintenance of records of holders of securities,
handling of physical securities and establishing connectivity with the depositories shall
be handled and maintained at a single point i.e. either in-house by the issuer or by a Share
Transfer Agent registered with the Board. Further, with the insertion of Regulation 55A
in SEBI (D&P) Regulations, 1996, on September 2, 2003, the requirement of submission
10

Supra note 8

13

of secretarial audit by listed companies to stock exchanges, with effect from September
30, 2003, has been made a regulatory requirement. A circular was also issued on March 3,
2004 re-emphasizing the need to comply with the provisions of Regulation 55A.
Proposed Measures by the SEBI11
Despite the various measures initiated by SEBI as enumerated above, the problems
arising out of excess demat have not been completely resolved. Therefore, it is felt that
certain further preventive steps would be necessary, in the interest of securities market, to
tackle this issue. While the measures taken in the past include casting a responsibility on
the listed company and the stock exchanges, the issue now needs a fresh look from the
point of systemic issues with the depositories. One of the preventive steps could be to put
certain responsibilities on the depositories to ensure that the securities are not dematted in
excess of listed/issued capital.
Section 23F of the Securities Contracts (Regulation) Act, 1956 as inserted
by Securities Laws (Amendment) Act, 2004 provides for the following:
Penalty for excess dematerialisation or delivery of unlisted securities
23F. If any person dematerialises securities more than the issued securities of a
company or delivers in the stock exchanges the securities which are not listed in
the recognised stock exchange or delivers securities where no trading permission
has been given by the recognized stock exchange, he shall be liable to a penalty
not exceeding twenty-five crore rupees.
The aforesaid section deals with two distinct things, and provides for
imposition of deterrent penalty of upto Rs.25 crores.:
i. dematerialization in excess of issued capital; and,
ii. Delivering unlisted securities or securities for which no trading
permission has been given in the stock exchanges.

11

Supra note 8

14

As far as improper dematerialization is concerned, the person referred to above could

mean those who are involved in the process, i.e. the issuer, its registrar, the depository
participant and the depository, apart from the investor who holds the securities. As such,
it is felt that the responsibility would be on each such person to ensure that
dematerialization is not done in excess of issued capital. For this purpose, a system of
tracking distinctive numbers of securities admitted to a depository system seems to be a
sine qua non to ensure that certificates which have already been dematerialized are not
again tendered and dematerialized. This provision needs to be clarified further in the
SEBI (D&P) Regulations, 1996, by defining the responsibility of each such person in this
regard.
As regards delivery of unlisted securities on a stock exchange, though in terms of the
section every person who has so delivered is liable for monetary penalty, it is felt that
innocent parties such as clients or brokers, who may not be in the know, should not suffer
penalty. The way to ensure that such securities are not delivered on the stock exchange
would be to ensure that they are not dematerialized or allotted without blocking unlisted
securities allotted in demat form in the first instance and by making suitable provisions to
prevent or lessen the possibility of fraudulent demat of physical securities which are
unlisted or which are forged. The modalities for ensuring this have been discussed in the
subsequent paragraphs. Any person who manipulates and circumvents even the new
system (modalities) and delivers unlisted securities could then be punished.
The Securities Laws (Amendment) Act, 2004 also inserted Section 19E in the
Depositories Act, 1996 which reads as follows:
Penalty for failure to reconcile records.
19E. If a depository or participant or any issuer or its agent or any person, who
is registered as an intermediary under the provisions of Section 12 of the
Securities and Exchange Board of India Act, 1992 (15 of 1992), fails to
reconcile the records of dematerilaised securities with all the securities issued
by the issuer as specified in the regulations, such depository or participant or
issuer or its agent or intermediary shall be liable to a penalty of one lakh

15

rupees for each day during which such failure continues or one crore rupees,
whichever is less.
In terms of the aforesaid provision, the primary responsibility for correct reconciliation of
total issued securities with those dematerialized is on the depository. In the absence of
further clarification, there would be indiscriminate liability to penalty under this section
on all concerned, while there would be no system whereby the other players would be
able to ensure proper reconciliation. In such a case, levy of penalty on any innocent
person other tha n the depository may not be justified. There is a need for correctly
identifying the respective responsibilities of the depository, depository participant, issuer,
share transfer agent and the investor in the dematerialization process and casting an
obligation on the depository to develop the systems. This would require suitable
amendments to SEBI (D&P) Regulations, 1996. Once the system is established by the
depository, each of the other persons will be responsible to fulfill his part of the duty
properly and will be liable for any lapse in his sphere of duty.

Conclusion
Dematerialization has almost been made a compulsion by enacting the Depositories Act,
1996 and various Rules and Regulations as provided by the SEBI from time to time.
Though, possessing physical shares is still allowed, it had becomes mandatory for shares
to be dematerialized for the purpose of trading. Further, most brokers prefer their
investors to deal in Demat shares considering the cost efficiency, relatively lower risk and
lesser time taken with these shares. Demat shares have helped do away with the
disadvantages faced by all with physical shares like theft, tearing, etc
The advantages of dematerialization seem to outweigh its disadvantages and the changes
ushered in by SEBI and the Central Government in terms of compulsory
dematerialization of securities are important for developing the securities market to a
degree of advancement. Freely traded securities are an essential component of such an

16

advanced market and dematerialization addresses such issues and is a step towards the
advancement of the market.
With the introduction of DPs, investors do not have to travel long distances to their
brokers to provide them the share certidicates and information for the purposes of trading.
Coupled with the fact that now it takes a much lesser time for the transaction to take
place, Demat becomes a definite necessity.
Caution and due diligence are the two key words in the stock market today and
dematerialization of shares is a step forward towards establishing a relatively investor
friendly market. The advantages of dematerialization have been enumerated in the above
chapters. It is noticed that Dematerialization is a much faster and efficient method of
trading in shares. It is pertinent to note that it is not only an investor friendly system, the
issuing company is also benefited in certain ways like reduction of costs by dealing in
dematerialized securities. Further, apart from establishing a relatively safer trading
system with respect to the dematted securities, the SEBI is constantly regulating the
working of the Depository system and looking to establish a full proof system with
respect to trading in the Stock Exchange in the electronic environment.
Thus, Dematerialization of shares is definitely a positive move, a step which is still being
contemplated in countries like the UK, Hungary, Australia etc.. 12 with the spurt in
technological advancement India is witnessing today it becomes necessary for us to use
the electronic securities system to trade in a full proof system.

12

The Dematerialization of Shares and Share Transfers, www.icsa.org.uk/demat/pdf/Condoc-processFinalDraft1.pdf, visited on 13th October, 2006

17

BIBLIOGRAPHY
[DISCUSSION PAPERS - SEBI]

Shri. V.S. Sundaresan, Report of the Group on reduction of Demat charges,

www.sebi.gov.in/commreport/dematrep.pdf, visited on 11th October, 2006

V.S. Sundaresan, Discussion paper on measures to check excess dematerialisation

of securities and pre-listing grey market in securities issued in initial public offers
(ipos) proposed amendments to the sebi (depositories and participants)
regulations 1996, http://www.sebi.gov.in/commreport/discussion.pdf, visited on
14th October, 2006
[ARTICLES]

Dematerialisation of Shares, www.syngenta.co.in/media/datafiles/Dematerialisation of shares.doc, visited on 12th October, 2006

18

Trinath Tadakamalla, Dematerialized Securities,

http://www.legalserviceindia.com/articles/dematerialized_securities.htm, visited
on 10th October, 2006
[DISCUSSION PAPERS]

The

Dematerialization

of

Shares

and

Share

www.icsa.org.uk/demat/pdf/Condoc-process-FinalDraft1.pdf,

visited

Transfers,
on

13th

October, 2006
[STATUTES]

Securities Contracts (Regulation) Act, 1956

The Companies Act, 1956

The Depositories Act, 1996

19