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Towards effective control of the capital market
July, 06th 2006

Analysis of SEBI's discussion paper on measures to check excess dematerialisation of securities

To ensure that unlisted securities are not put in circulation, securities must be created and allotted in demat only after obtaining listing approvals from stock exchanges.

Recently, the Securities and Exchange Board of India (SEBI) released a discussion paper proposing certain amendments to the Depositories and Participants Regulations which will have far-reaching implications in terms of how the depository system would work. The objective of the proposed measures to check excess dematerialisation and pre-listing grey market in securities in Initial Public Offers (IPOs) is certainly laudable.

A cursory glance at the proposed amendments reveals that the primary responsibility for excess dematerialisation and reconciliation of capital is sought to be shifted to the depositories. In the process, the reality that the company or its Registrar and Transfer Agent (RTA) are solely responsible for reconciliation of capital under regulation 55 has been ignored.

In fact, SEBI has taken certain bold measures by stipulating the requirement for obtaining in-principle approval from the stock exchanges before further issue of security by listed companies, single agency for handling matters relating to securities both in physical and demat forms, compulsory quarterly secretarial audit by independent agencies relating to reconciliation of capital, and the need to bring the discrepancy, if any, between the issued, listed and dematerialised capital to the notice of the stock exchange and the depository.

These steps have undoubtedly strengthened the mechanism for establishing the integrity of capital and the consequent risk management framework. SEBI has further directed that the International Securities Identification Number (ISIN) of any further issue of securities has to be deactivated from the date of allotment to the date of commencement of trading on the stock exchanges, thus taking away the possibility of off-market transfers before listing. The question therefore arises as to whether these measures have delivered and, if not, to what extent the various constituents of the demat universe are accountable for the non-compliance on their part.

Objectives accomplished?

As always, it is not the regulation per se but the manner or effectiveness of implementation which will ensure that the desired objective is accomplished. Despite all the controls, if the existing machinery has not delivered the desired results, it is mainly because the weakest link in the entire chain of activities is the RTA, through whom the companies establish electronic connectivity to the depository system.

The RTA happens to be a specialised entity which possesses the expertise and skills to maintain the records of a large number of investors and also service them. The operations of RTAs are also subject to registration and inspection of the capital market regulator.

In the structure of the depository functioning and the statutory framework, the role of the depository is to provide infrastructure for maintenance of records of allotment of securities in dematerialised form. The company that issues securities performs several critical functions relating to creation of securities, and its extinguishing if need be, whether in physical or dematerialised form.

Thus, even in the dematerialised set-up the issuer continues to undertake all the activities relating to issue, allotment, confirmation of dematerialisation after destruction of certificates and issue of new certificates on re-materialisation. The issuer is required to handle all the functions relating to securities both in physical as well as dematerialised form on an integrated basis, that is, either himself or through the RTA. Companies are required to obtain approvals from various authorities for issue and allotment of securities. A listed company is required to compulsorily list all further issue of securities from the stock exchanges concerned in order to provide liquidity to the investors.

In view of these factors, it is clear that the only entity which can be fastened with the responsibilities is the issuer or its RTA, as the case may be. Casting such obligation on any other entity like depository would may prove futile, as the depository is seized of the happenings within its functional jurisdiction and, obviously, does not have any control on the securities held in physical form. Holding the depository responsible would be like holding the Registrar of Births and Deaths responsible for the legitimacy or otherwise of the child. To stretch the analogy further, it would be similar to holding the hospital accountable for the credentials of the patient who had only used the facilities of the hospital for undergoing the treatment. The fact that one intermediary has failed to discharge its obligations should not be a ground for putting the responsibility on some other intermediary.

Physical still

Even when trading and settlement in demat form has been made compulsory for all the listed scrips, some of the companies are continuing the practice of issuing the physical share certificate to the allottees, especially in cases involving private placement, preferential allotments, and so on. Most of these cases do not satisfy the listing guidelines on the stock exchanges, especially the clauses such as minimum public offer or even the pricing guidelines stipulated by SEBI.

As a result, they fail to obtain the necessary approvals from stock exchanges or SEBI as they do not fulfil the criteria. However, when everything is fungible and pari passu, such unlisted securities used to be delivered in the market. Section 68 B of the Companies Act provides that if the listed company makes IPO of securities for a sum of Rs 10 crore or more, it shall issue securities only in demat form. This may prescribe issue of securities in physical form if the same is less then Rs 10 crore.

There is an urgent need to stop this practice by expressly providing that the listed companies can issue further securities, either by way IPO, rights, private basement, preferential allotment or in any other mode, only in dematerialised form and also obtaining the listing approval, irrespective of the amount of capital issued. This will ensure that further capital is not created in paper form in the system. .

There is a proposal that the depository should maintain the allotment of the distinctive numbers of the securities, be they in physical or demat form. This proposal will take the wheel of reform backwards, as the benefits of dematerialisation have arisen from the fact that the securities do not have distinctive numbers.

Even if the database of distinctive numbers in respect of the shares held in physical form as well as in demat form is jointly maintained by depositories and the stock exchange, it will have to be on the basis of the information received from the company. Unless the company has been made responsible for the information provided by it, the authenticity of such an exercise may not serve any purpose.

To ensure that the unlisted securities are not put in circulation, it must be stipulated that securities must be created and allotted in demat only after obtaining the listing approvals from the stock exchanges.

All listed securities and those proposed to be listed require the basis of allotment to be approved by the respective stock exchanges. This step will ensure that only leased capital enters the credit and settlement systems. Alternatively, to further tighten the system, every new series of security to be issued can be allotted in a separate ISIN.

Similarly, the issue of securities containing lock-in restrictions is also the function of the issuer in RTA and, currently, this is taken care in the depository system through separate corporate action before allotting securities in an IPO to the general investing public. The existing procedure needs to be continued. It is hoped that SEBI would modify the proposals accordingly.

Umesh P. Maskeri
(The author is Vice-President Legal and Company Secretary of Central Depository Services India Ltd. The views are personal.)

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