Under the Companies Act, 2013 joint-stock companies are of two categories: public companies and private companies. Public companies have greater than 200 members/shareholders and are heavily regulated by the authorities.
Further, if these companies are listed on the stock exchange, they have to follow strict corporate governance norms and comply with listing and other regulations. Unlisted companies, whether public or private have not been as regulated as listed companies.
Trading of shares in unlisted companies is through PE (private equity) funds and private placements.
In September 2018, the Government came with a new regulation related to shares issued by unlisted public companies. They have been mandated to issue new shares only in dematerialized form. Besides the issue of new shares, even the transfers of existing shares have been mandatorily shifted to the demat route after this regulation.
Investors can open demat account online with a simple registration process with the broker. The demat account operations are regulated by SEBI and applicants can open a demat account by following KYC norms through proper channels.
Listed companies are advised to have shares traded through the demat account, as per legal requirements, though it is not compulsory for traders to open demat account online for listed share trading. With the latest regulation, even unlisted companies have been regulated to shift to the demat route. Here are some of the reasons why this move is required in the Indian stock market:
Illicit fund transfers: Companies that trade off the demat route can transfer funds illegally, as there is no electronic trail of transactions. Having unlisted companies to mandatorily trade their shares by demat accounts would bring higher accountability regarding fund transfers to and from the company to auditors and other authorities.
Illegal shell companies: Companies in large Groups tend to have shell companies to carry on subsidiary activities in-house. This could be a strategic plan to either integrate operations forward or backwards. Demat trading of shares would regulate these shell companies and prevent illicit funds transfers. It would also aid the regulators to identify illegal shell companies, formed for the purpose of black money generation or transfers.
Greater transparency: Ownership of companies and management accountability would be clearer when unlisted companies are under the dematerialised trading environment. Investors in unlisted companies are often unaware about the true owners and whom to approach in case of grievances or other investor issues.
Grievance handling: Investors would have a specific portal to raise grievances to the unlisted company issuing shares. Demat accounts have a unique ID which can be quoted as proof of purchase or sale of any security. It provides an electronic backup of all transactions made by the investor and is useful to quote past trades accurately.
More regulation: When unlisted companies issue demat forms for fresh share issue, they become more accountable to the authorities. The electronic trading environment and stock markets are monitored and regulated by SEBI (Securities and Exchange Board of India). A thorough regulatory framework ensures fair trading, and high standards of corporate governance for the investing community.
Cut benami transactions: ‘Benami’ property or security is that which is bought under someone else’s name to store untaxed income or black money. Investors often use shares purchased off the record/ offline for benami transactions. The dematerialisation of shares for unlisted companies would aid to drastically cut benami transactions.
Better record keeping: The demat account provides for investors to complete KYC norms, submit the relevant documents and keep their information updated with the authorities. Listed companies shares are in this net at present. When unlisted companies join the bandwagon, it would lead to better record keeping for traders, brokers, issuing companies and the regulatory bodies as well.
Prevent backdated issues: Traders or their brokers often backdate the share purchase contracts in case of physical share trades of unlisted companies. Backdating is done to reduce or nullify tax liabilities and other costs associated with trading. This is unethical and illegal and cannot be controlled unless there is demat trading. Dematerialised trading facilitates online record keeping and also leaves a definite trail where frauds such as backdating can be prevented.
Unlisted firms have been out of the regulatory net to some extent, as their shares were privately placed or sold to investment funds or retail buyers through offline media. However, this brought many issues for the authorities such as illegal fund transfers, benami transactions and poor governance. Even genuine investors had a low level of confidence in investing in these companies.
With the latest regulation pertaining to the mandatory shift to demat accounts for investors of shares of unlisted companies, there would be many advantages to both the investors and regulators. There would be higher accountability, prevention of frauds by the company, clarity of ownership of the company and better grievance handling for investors.