DEMATERIALISATION OF SHARES - THE CERTAINTY ON

TRANSFERS

SUBMISSION IN THE SUBJECT OF

CORPORATE FINANCE LAWS

By

SUPRIYO RANJAN MAHAPATRA

4th YEAR BA.LLB (Hons)

BA0140066

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 DEMATERIALISATION OF SHARES - THE CERTAINTY ON

TRANSFERS

ABSTRACT

Finance is the process of conversion of accumulated funds to productive usage. Finance helps
to direct the flow of economic & facilitate in the firm's smooth operations. Dematerialisation
is the process by which a client can get physical certificates converted into electronic balances.
An investor intending to dematerialise its securities needs to have an account with a DP. The
client has to deface and surrender the certificates registered in its name to the DP. After
intimating NSDL electronically, the DP sends the securities to the concerned Issuer/ R&T
agent. NSDL in turn informs the Issuer/ R&T agent electronically, using NSDL Depository
system, about the request for dematerialisation. If the Issuer/ R&T agent finds the certificates
in order, it registers NSDL as the holder of the securities (the investor will be the beneficial
owner) and communicates to NSDL the confirmation of request electronically. On receiving
such confirmation, NSDL credits the securities in the depository account of the Investor with
the DP. Depositories Act, 1996 provides for the establishment of depositories in securities with
the objective of ensuring free transferability of securities with speed, accuracy and security.
The depositories make securities of public limited companies freely transferable, subject to
certain exceptions. They dematerialise the securities in the depository mode and provide
maintenance of ownership records in a book entry form. The depository system comprises of
the depositary participant, beneficial owner/investor, the issuer and the depositary. A
depositary is a firm wherein the securities of an investor are held in electronic form in the same
way a bank holds money.
Keywords- Demat, Shares, Physical form, Share certificate.

Introduction

Demat signifies the conversion of a share certificate from its present physical form to electronic
form for the same number of holdings. It offers scope for paperless trading whereby share
transactions and transfers are processed electronically without involving any share certificate
or transfer deed after the share certificates have been converted from the physical to electronic
form. Demat attempts to avoid time consuming and complex process of getting shares
transferred in the name of buyer’s1.Dematerialised securities trading, settlement and custody

1
Arati Shetty, “The Paperless War of Depositories”, Treasury Management, ICFAI, October 2000, pg-21-23.

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has changed considerably the market microstructure of Indian stock exchanges.
Dematerialisation is the process by which "physical certificates of an investor are converted to
an equivalent number of securities in electronic form"2.The converted securities are owned,
traded and utilised like physical securities. Order routing, trading and settlement, that is
delivery and payment in demat form, changed the way markets started functioning. These
changes have brought tremendous impact on the behaviour of investors, stock exchanges,
depository participants and custodians. Generally, an investor would look for more liquidity to
less liquidity in a stock. Higher liquidity means lower transaction costs and easy entry and exit
options. Therefore, higher liquidity is preferred. Ownership transfer of demat shares is quite
fast. Investors would be able to churn their portfolio many a times over, contributing to the
increase in turnover and liquidity. Whenever a new product is made available, there will be an
additional demand for that particular product. Dematerialised shares are definitely superior to
physical (paper) form of shares. Physical form of shares are fraught with fake, forgery, stolen
and duplicate problems. Logically speaking, higher demand should emanate for demat shares,
which is expected to push up (pull down to a lesser extent) shares prices resulting in higher
returns (lesser losses) to the investors compared to pre demat period. This higher demand will
continue for sometime (adjustment period lasting, sometimes, a few months) only. Once all
investors understand the merits and value of demat shares or when all shares of all stocks are
demated, then the superior or higher returns will disappear or will not be there3. Some markets
are quite quick enough to discount the new information while some other markets take longer
time (a few weeks to a few months) to discount the new information.

The history of online trading goes back to 1983, when the first online trade using e-trade
technology took place. What began with a single click over 28 years ago has now taken the
world by storm. The concept visualized by Bill Porter who provides online quotes and trading
services to many US firms like fidelity, Charles Schwab, and Quick and Reilly. Bill happened
to foresee that someday everyone would own computers and invest through them with
unprecedented efficiency and control. And today his dream has become a reality. The Indian
capital market witnessed an explosive growth between mid-Eighties and mid Nineties. The
total number of companies listed in the stock exchanges had grown by 72.3 per cent . The
market capitalization of the companies listed with stock exchanges had gone up from Rs.21,000
crores in 1985 to more than Rs.4,50,000 crores in 1995.The secondary market trading activity

2
Ariel R.A, “A Monthly Effect in Stock Returns”, Journal of Financial Economics, 1987, pg 161-174.
3
Baker. C Effective Stock Splits‟ Harvard Business Review, Vol 34, 1956. pg 101-10

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also gathered momentum. There has been tremendous growth in secondary market trading at
BSE and NSE. Other regional exchanges like Calcutta and New Delhi have also become active
players in the market. But the system used was not able to withstand the strain caused by the
tremendous growth in the securities market. The entire securities market started experiencing
a gridlock, posing obstacles in its growth. Moreover, this sudden growth has also magnified
the risks that have always been plaguing the Indian system, viz., credit risk and systematic risk.
The International institutional investors wanting to invest in India had become apprehensive
about the reliability of the trade settlement mechanisms used in the country, which did not
match international standards. Besides affecting the inflow of foreign capital, the lack of
efficient settlement systems had affected the institutional investors, individual investors and
brokers in the stock market4. The incidence of lost trading days (liquidity), lost scrips,
improperly paid dividends, mistaken registration, unnecessary financing cost, failure of counter
party and fraud were reported frequently5. The awareness about the immense potential for
growth made the Indian stock markets very dear to the global investors and the access to
internet facility virtually at every part of the country made its momentum so fast. But the
manual and paper based settlement system, caused series of problems for the purchaser as well
as the seller. Delayed settlements, long settlement periods, high level of failed trade, high cost
of transaction and bad deliveries are some among them6. Interestingly, the stipulations
contained in section 113 of Companies Act, 1956; section 22 A of the Securities Contracts
(Regulations) Act, 1956 failed to trace the delay as illegal. Large number of bad deliveries,
mismatch of signatures on transfer deeds, theft, forgery, multination of certificates and other
irregularities also had become rampant.

Research Questions

1. Whether the restrictions imposed upon the transfer of shares in a private company can
be adopted to transfer of shares in dematerialised form?
2. Whether the dematerialised form is advantageous to investors? If yes, whether SEBI
has been able to regulate this market?

OBJECTIVES OF THE PROJECT:

4
Baker, C Effective Stock Splits,’ Harward Business Review, Vol 34, 1956. pp 101-106
5
Campbell, John Y, Andrew W Lo, A Craig MacKinlay, The Econometrics of Financial Markets, Princeton
University Press, 1997
6
Fama, E, L. Fisher, M. Jensen, and R. Roll, ‘The Adjustment of Stock Prices to New Information,’
International Economic Review, Vol 10, 1969, pp1-21

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• To know the mechanism in the Demat and the activities in Primary Market and Secondary
Market in the context of Dematerialization

• To study the activities of Depository Participants and the process of Settlement

SCOPE OF THE STUDY: The scope of the study is confined to the process of
dematerialization of securities and its advantages. The scope of the project is limited to the
depository participant services through depositors.

METHODOLOGY OF THE STUDY: The study is based on both the primary and the
secondary sources of data. The source of primary data is from the unstructured interview of the
officials in the company. The secondary data is collected from the websites.

LIMITATIONS OF THE PROJECT: By not considering the entire depository participant's

implications relating to the pattern of trading may have been missed in the study. The study is
confined to only depository participant’s services through Depositories  NSDL. Exhaustive
analysis, problems of listing and management of trade and SEBI guidelines of relating there
lot are not covered due to limited & keep the study in manageable limit.

Chapter - II

THE DEPOSITORY SYSTEM

A depository is a file or set of files in which data is stored for the purpose of safekeeping or
identity authentication. In general, a depository is a physical site where data is kept in the form
of hard copies, magnetic disks, magnetic tapes, compact disks (CDs), and similar media. The
concept of Depository is known to the world since 1949 when the first depository was set up
in Germany. The depository model in India is a competitive multi depository system. In India
the system of dematerialisation is followed, wherein the securities will be cancelled as against
the system of immobilization in which the securities are kept in custody.

LEGAL FRAMEWORK OF DEPOSITORY SYSTEM

The operations of the depositories are primarily governed by the Depositories Act, 1996, SEBI
(Depositories & Participants) Regulations, 1996, Bye- Laws approved by SEBI, and Business
Rules framed in accordance with the Regulations and Bye-Laws. The Act enables the setting
up of multiple depositories in the country to see that there is competition in the service and

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there is more than one depository in operation7. Only a company registered under the
Companies law and sponsored by the specified category of institutions can set up a depository
in India. Before commencing operations, depositories should obtain a certificate of registration
and a certificate of commencement of business from SEBI. Every depository must have
adequate mechanisms for reviewing, monitoring and evaluating the depository's controls,
systems, procedures and safeguards. It should conduct an annual inspection of these procedures
and forward a copy of the inspection report to SEBI. The depository is also required to ensure
that the integrity of the automatic data processing systems is maintained at all times and take
all precautions necessary to ensure that the records are not lost, destroyed or tampered with. In
the event of loss or destruction, sufficient back up of records should be available at a different
place. Adequate measures should be taken, including insurance, to protect the interests of the
beneficial owners against any risks. Every depository is required to extend all such co-
operation to the beneficial owners, issuers, issuers' agents, custodians of securities, other
depositories and clearing organisations, as is necessary for the effective, prompt and accurate
clearance and settlement of securities transactions and conduct of business. The depository
should indemnify beneficial owners of securities for any loss caused to them due to the
negligence of the DP. However, where the loss is caused due to the negligence of a DP, the
depository shall have the right to recover it from such DPs. Generally, the following securities
are eligible for dematerialisation:

(a) Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of
a like nature in or of any incorporated company or other body corporate.

(b) Units of mutual funds, rights under collective investment schemes and venture capital
funds, commercial paper, certificates of deposit, securitised debt, money market instruments,
government securities, national saving certificates, kisan vikas patra and unlisted securities.

(c) Securities admitted to NSDL depository are notified to all DPs through circulars sent by
email.

DEPOSITORY PARTICIPANTS

NATIONAL SECURITIES DEPOSITORY LIMITED (NSDL)

7
Raju, M.T. ‘Transaction Cost for Equity Shares in India (Revised)’, Working Paper Series No.3, Securities and
Exchange Board of India, November 2000.

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In a span of about nine years, investors have switched over to electronic [demat] settlement
and National Securities Depository Limited (NSDL) stands at the centre of this change. In order
to provide quality service to the users of depository, NSDL launched a certification programme
in depository operations in May 1999. This certification is conducted using NCFM
infrastructure created by NSE and is called "NSDL - Depository Operations Module". The
programme is aimed at certifying whether an individual has adequate knowledge of depository
operations, to be able to service investors. National Securities Depository Limited is the first
depository to be set-up in India. It was incorporated on December 12, 1995. The Industrial
Development Bank of India (IDBI) - the largest development bank in India, Unit Trust of India
(UTI) - the largest Indian mutual fund and the National Stock Exchange (NSE) - the largest
stock exchange in India, sponsored the setting up of NSDL and subscribed to the initial capital.
NSDL commenced operations on November 8, 1996.

OWNERSHIP

NSDL is a public limited company incorporated under the Companies Act, 1956. NSDL had
a paid-up equity capital of Rs. 105 crores. The paid up capital has been reduced to Rs. 80 crores
since NSDL has bought back its shares of the face value of Rs. 25 crores in the year 2000.
However, its net worth is above the Rs. 100 crores, as required by SEBI regulations.

BUSINESS RULES OF NSDL

Based on the functions, NSDL enables the surrender and withdrawal of securities to and from
the depository (dematerialisation and re-materialisation). It maintains investor holdings in the
electronic form and effects settlement of securities traded on the exchanges. It carries out
settlement of trades not done on the stock exchange (off-market trades).Moreover, the transfer
of securities, Pledging/hypothecation of dematerialised securities, electronic credit in public
offerings of companies or corporate actions, receipt of non-cash corporate benefits and Stock
Lending and Borrowing comes under the purview of this.

DISTRIBUTED DATABASE

Each of the computer systems connected to NSDL system has its own database relating to its
clients. This helps in giving prompt and accurate service to the clients. However each of the
databases is reconciled with the data at the central system every day in order to ensure that the
data in the distributed database tallies with the central database.

COMMON SOFTWARE

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NSDL develops software required by depository participants, companies, R&T Agents and
clearing corporations for conducting depository operations. Thus, the computer systems used
by all the entities will have common software given by NSDL. However, depending on the
business potential, branch networks and any other specific features, DPs may develop software
of their own for coordination, communication and control and provide service to their clients.
Such exclusive software is called "back office software".

CENTRAL DEPOSITORY SECURITIES LIMITED (CDSL)

A Depository facilitates holding of securities in the electronic form and enables securities
transactions to be processed by book entry by a Depository Participant (DP), who as an agent
of the depository, offers depository services to investors. According to SEBI guidelines,
financial institutions, banks, custodians, stockbrokers, etc. are eligible to act as DPs. The
investor who is known as beneficial owner (BO) has to open a demat account through any DP
for dematerialisation of his holdings and transferring securities. The balances in the investors
account recorded and maintained with CDSL can be obtained through the DP. The DP is
required to provide the investor, at regular intervals, a statement of account which gives the
details of the securities holdings and transactions. The depository system has effectively
eliminated paper-based certificates which were prone to be fake, forged, counterfeit resulting
in bad deliveries. CDSL offers an efficient and instantaneous transfer of securities. CDSL was
promoted by Bombay Stock Exchange Limited (BSE) jointly with leading banks such as State
Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank, Union
Bank of India and Centurion Bank.

CDSL was set up with the objective of providing convenient, dependable and secure depository
services at affordable cost to all market participants.

Process of dematerialization

Dematerialization starts with opening a Demat account. For demat account opening, you need
to shortlist a Depository Participant (DP) that offers Demat services.

To convert the physical shares into electronic/demat form, A Dematerialization Request Form
(DRF), which is available with the Depository Participant (DP), has to be filled in and deposited
along with share certificates. On each share certificate, 'Surrendered for Dematerialization'
needs to be mentioned. The DP needs to process this request along with the share certificates
to the company and simultaneously to registrars and transfer agents through the depository.

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Once the request is approved, the share certificates in the physical form will be destroyed and
a confirmation of dematerialization will be sent to the depository .The depository will then
confirm the dematerialization of shares to the DP. Once this is done, a credit in the holding of
shares will reflect in the investor's account electronically. This cycle takes about 15 to 30 days
after the submission of dematerialization request. Dematerialization is possible only with a
Demat account8.

Chapter - III

Trading and Settlement of dematted shares

Meaning of transfer of shares

One of the most important functions of the depositories is to provide the facility of transfer of
shares9. It basically means transfer of ownership from the seller to the buyer at the instruction
of the account holder. Both the buyer (transferee) and the seller (transferor) have to give
instructions to their respective depository participants regarding the transfer of ownership. A
transferee is allowed to give Standing Instructions (SI) to the DP regarding the credit. But a
beneficiary account can be debited only if the beneficiary owner has given the Delivery
Instructions (DI) in the prescribed form10.

Transfers can arise out of off-market Trades or Market Trades. Any trade carried out without
the participation of the clearing corporation is called off-market trade, i.e. trades cleared and
settled without the intervention of NSCCL. Generally, bulk deals between institutions; trades
between private parties, transfer of securities between a client and a sub-broker are off-market
trades. On the other hand, a market trade is one which is settled through the clearing
corporation. All the trades done in a regular manner on the exchange are a part of market trade.
Even the negotiated trades done with the intervention of the clearing corporation are a part and
parcel of market trades11.

Settlement of Off–market Trades

8
Report of the Committee constituted by SEBI on „reduction in the Cost for the Investors relating to demat
operations
9
Shiv Kedia‟ “Dematerialisation of Shares”, SEBI and Corporate Laws, 20th May 1999, pg-141-144.
10
Raju.M.T and Prabhakar Patil, “Dematerialisation: A Silent Revolution in the Indian Capital market” March
2001, SEBI working paper.
11
Kaushal .H, “Investor Friendly Demat Trade Needed”, Business Standard, 26th May 1999

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Step: 1 Seller gives delivery instructions to his DP to move securities from his account to the
buyer’s account. Step: 2 Buyer automatically receives the credit of the securities into his
account on the basis of standing instruction for credits. Step: 3 Buyer receives credit of
securities into his account only if he gives receipt instructions, if standing instructions have not
been given. Step: 4 DP needs to be extra careful in verifying the signature of the client if large
quantities of securities are being debited to the account. Step: 5 Funds move from buyer to
seller outside the NSDL system12.

In case of Off-market trades, all the funds related settlements are made outside the system of
NSDL and NSCCL. Only the transfer of securities is done through the NSDL channel.
Therefore, NSCCL is not responsible for the timely payment of funds.

Settlement of Market Trades

Market trades include all the trades done through the NSE system. Even the trades done
through negotiation, wherein the buyers and sellers fix a deal on their own but want that the
securities should move through the NSDL system, and the clearing and settlement through the
NSCCL will also be a part of market trades.

Step: 1 Seller gives delivery out instructions to his DP to move securities from his account to
his broker’s account. Step: 2 Securities are transferred from broker’s account to CC on the basis
of a delivery out instruction. Step: 3 on the pay-out day securities are moved from CC to buying
broker’s account. Step: 4 Buying broker gives instructions and securities move to the buyer’s
account.

Transaction done on person-to-person basis without going through stock exchange mechanism
is labelled as off market transactions. Trades done by investors through stock exchange
mechanism and settled by using same stock exchange mechanism is reckoned as on market
transactions. Transfer of securities through Demat Account is possible for the execution of Off
Market Transactions or for settling On Market Transactions or for Inter depository transactions.
SEBI (Depository and Participants) Regulations, 1996 requires depositories to be inter-
connected and the Securities be available for dematerialization on both Depositories. The debit/

Kendall M.G, “The Analysis of Economic Time Series”, Journal of the Royal Statistical Society (Series A),
12

XCVI, pg 11-25.

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credit instructions have to be given on inter-depository delivery or receipts forms to the DP’s
of seller and the buyer and the instructions are exchanged online for each day between the
depositories.

Chapter - IV

Conclusion

Dematerialisation of shares was a major change in the Indian securities markets and it has wide
ramifications on various sectors of the capital markets. In order to rightly understand and
appreciate the implications, there is a need to make a scientific study of the impact that
dematerialisation generated on the market microstructure of Indian stock exchanges. To
classify a stock market either as a matured market or emerging market one of the important
parameters is liquidity13. Higher liquidity provides opportunity for easy entry and exit options
to the investors. Dematerialisation definitely increased volumes traded thus providing higher
liquidity. At the same time, control group recorded negative growth or lesser growth in the
number of shares traded, definitely suggesting the positive impact of dematerialisation on
liquidity. More number of shares traded per trade is yet another sign to indicate better liquidity.
More and more institutional players appear to be participating in a bigger way in post-demat
period in the market indicating increased level of confidence in the Indian stock market. The
Ultimate test of any stock market is the returns to the investor. Generally, always though not
possible, investors expect to earn abnormal returns on their investments. Dematerialised shares
by and large provided in most cases abnormal returns in short-run. Not only did they earn
abnormal returns but also they are statistically significant. The abnormal returns taper off over
a period. This abnormal returns are a phenomenon of a short term in nature due to any event in
the capital markets. Non-demat (control group) companies, in fact, mostly posted negative
returns in the study period.

13
.Rajiv Goel, “The New Rules in a Dramatized Era”, The Economic Times, 21st January 1998.

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