Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 19 Jan 2011

Complete that demat process

I have a column in today’s Financial Express on the need to complete the process of dematerialization of shares in India by abolishing physical share certificates completely.

The time has come to abolish physical share certificates completely and dematerialise all shares by eliminating the option that is currently given to the owner to hold shares either in physical form or in dematerialised form. Dematerialisation should be mandatory even if the owner has no immediate intention to trade the shares on the exchange.

When depositories were first created in India, it was well known that physical share certificates were prone to fraud and malpractices. However, since dematerialisation was a new concept in the country, it was thought that the ability to convert back and forth between paper and dematerialised form would give investors greater comfort and confidence. Today, after more than a decade, the depositories have established themselves as reliable and secure. There is now nothing to be lost and everything to be gained by eliminating paper completely.

Many of us believed that the risk of fraud and theft of physical certificates would induce a voluntary dematerialisation of large holdings, particularly after the exchanges shifted to trading exclusively in dematerialised mode. However, some large investors (including, unfortunately, some government entities) ignore these risks and hold on to paper certificates. More troublingly, one hears disconcerting (hopefully false) rumours of physical certificates being used to backdate or postdate transactions with the collusion of companies and their registrars.

Such alteration of dates may produce advantages under the takeover code and under the tax laws. For example, inter se transfer of shares between promoters is exempted from the requirements of the takeover code if the transferor and transferee have held the shares for at least three years. Similarly, purchases of shares during the previous six months are taken into account while deciding the open offer price. Under the tax laws, the lower tax rate on capital gains applies if the shares are held for a year.

All these could be facilitated by backdating or postdating transaction dates—something that would be impossible in the dematerialised environment. In fact, the more I think about it, the more I am convinced that some promoters and large operators hold on to paper certificates for unsavoury reasons.

Even if this were not so, there would still be reason to worry about these holdouts of paper certificates. As old timers retire, registrars are gradually losing the skill set required to verify the authenticity of physical certificates. I have seen airline check-in staff (and sometimes even their supervisors) fumble when they encounter the increasingly rare physical air tickets because they are all familiar only with e-tickets. Over a period of time, this lack of familiarity with the vestiges of a paper era will become a serious problem for registrars, and will provide a fertile opportunity for fraudsters.

It is, therefore, imperative to launch a time-bound action plan to achieve 100% dematerialisation. I think such a plan should have three elements.

First, we should stop creation of new paper certificates forthwith. The Depositories Act should be amended to prohibit rematerialisation of physical certificates. Furthermore, it must be mandatory to make all new allotments of shares in dematerialised form. Transfer or transmission of shares (even if it takes place outside the exchange) should be permitted only in dematerialised form.

Second, we must set a cutoff date (say, January 1, 2012), by which large and critical holdings must be dematerialised. This date should apply to:

An extended cutoff date (say, January 1, 2015) can be set for dematerialisation of other shares—small shareholdings by individual investors.

After the cutoff date (or the extended cutoff date for small holdings), physical shares that have not been dematerialised would become almost useless. However, in exceptional cases where genuine reasons can be demonstrated, dematerialisation of these shares may be permitted after issuing a public notice in a newspaper giving sufficient time for other claimants to dispute the claims of the holder. For tax purposes and for takeover code purposes, the date of dematerialisation would be deemed to be the date of acquisition of the shares.

Finally, we must set a cancellation date (say, January 1, 2020) on which all remaining physical share certificates would be deemed to be cancelled and forfeited, and the issuers would be required to record the forfeiture of shares in their books.

During this process of elimination of paper certificates, it would be useful to preserve samples of the old paper certificates for the historical record in an appropriate archive or museum. Regulations require dematerialised share certificates to be mutilated and cancelled, and in the absence of a conscious archival effort, these mutilated certificates are likely to be destroyed as a matter of course.

Posted at 10:52 on Wed, 19 Jan 2011     7 comments     permanent link


Sandeep Parekh wrote on Wed, 19 Jan 2011 11:12

Re: Complete that demat process

Unfortunately, there is a large cost attached to demat for both small players and large. Small because paying over a 1000 rupees per year for opening a DP account may be very expensive. Large holders who do not intend to sell for a long period may also not want to pay various charges - which they don't need to for physical certificates. If these issues can be solved, then the positives are of course overwhelming.

Kushankur, Doctoral Student, IRMA wrote on Wed, 19 Jan 2011 20:37

Re: Complete that demat process

Sir, I feel that it is very pertinent issue to make streamline the operations of capital market. Depositories (NSDL & CDSL) should put up necessary efforts to achieve the complete demat-process. For a while, we should think on commodity markets also, as the physical title of ownership, i.e., warehouse receipt is often facing a barrier to make it fully dematerialized. Hopefully, Warehouse Development (Regulation) Act, 2007 will pave teh way for complete clearance of physical forms into electronic forms. We should wait for a while to witness the occurrences, which will bring 'feel good' for spot as well as futures as a result of better 'integration'.

Sendil AB wrote on Thu, 20 Jan 2011 19:24

Re: Complete that demat process

Nice article. A powerful and pointed argument, Professor.

Akshay wrote on Thu, 20 Jan 2011 20:32

Re: Complete that demat process

Before this I want: a) A unique number for EVERY demat a/c across India. Like the core-banking A/c no. Why? : Because i can be confident in writing that number in applications (IPO's for example) so that the shares come directly into my a/c.

b) All such critical numbers like PAN, Bank A/C etc. should be converted to a 'check-summed' notation like a Credit Card number. In case people do not know, Credit Card number's are not given in serial order. An algorithm generates them, such that if you make a typing/writing mistake for 1-few digit(s) you will NEVER make another valid number. AND this can immediately be verified by simple software.

To validate this, try entering a wrong credit card number while purchasing online, it will get rejected BEFORE the password screen.

jagan wrote on Wed, 21 Sep 2011 10:04

Re: Complete that demat process

Sir, dont you also think that in the absence of dematerialisation, promoters would be able to pledge their holdings without anyone knowing about it? Please recall the fact that GTL shares fell 75 per cent in one week this year on fears that the promoters are unable to meet margin calls and lenders are selling them. Dematerialisation would make the SEBI requirement of declaration of all pledges made by promoters more effective as the depository can could be asked to make such material information public.