Company Law Project On:
Role And Functions Of Depositories In Securities Market
Submitted By,
B.Ananthu Roll No: 585 Vth SEM NUALS
ACKNOWLEDGEMENT
I wish to extend my heartfelt gratitude to The Almighty for helping me to complete my endeavour successfully. I would also like to express my sincere gratitude to my educational institution, The National University of Advanced Legal Studies for providing me with all the required support for the successful completion of my project. I also extend my heartfelt thanks to my Company Law Faculty, Mr Anil.R.Nair. I would also to thank my friends for their never ending support and cooperation. I also thank the NUALS library for its exhaustive resources which proved highly useful for my project.
INTRODUCTION
Securities market is an economic eco nomic institute institu te within which take place sale s ale and purchase purch ase transactions of securities between subjects of economy on the base of demand and supply. Also we can say that securities market is a system of interconnection between all participants (professional and nonprofessional) that provides effective conditions: to buy and sell securities, and also
To attract new capital by means of issuance new security (securitization of debt),
To transfer real asset into financial asset,
To invest money for short or long term periods with the aim of deriving profit.
India has adopted the Depository System for securities trading in which book entry is done electronically and no paper is involved. The physical form of securities is extinguished and shares or securities are held in an electronic form. Before the introduction of the depository system through the Depository Act, 1996, the process of sale, purchase and transfer of securities was a huge problem, and there was no safety at all.
The depository system
envisages a deposit of securities by the various investors with the depository. This would take the form of a transfer by the various investors with the depository. This would take the form of a transfer by the holder of securities in favour of depository. Once the shares are lodged with the depository, their transfer would be through book entry transfers in accounts maintained by the depository. Thus the main functions of a depository are to dematerialize the securities and enable their transaction in book entry form.
I.
Depositories: Definition, Role And Function:
According to Black‟s Law dictionary the word „depositary‟ is defined as “the party of the
institution receiving a deposit. One with whom anything is lodged in trust, as „depository‟ is the place where it is put. The obligation upon the depositary is that he keeps the thing with reasonable care and upon request restores it to the depositor.” A depository holds securities
(like shares, debentures, bonds, Government Securities, units etc.) of investors in electronic form. Besides holding securities, a depository also provides services related to transactions in securities. It acts as a trustee of the owner since the securities are entrusted with him in trust. He is also the agent of the owner of the securities.
As per the Bank for International Settlements (BIS), depository is “a facility for holding
securities transaction to be processed by book entry. Physical Securities may be immobilized by the depository or the securities may be dematerialized (so that they exist only as electronic records).” 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. In the absence of depositories, which provide for maintenance of ownership records in a book entry form, every share transfer is required to be accomplished by physical movement of share certificates to, and registration with, the company concerned. The process often involves long delays and a significant portion of transactions end up as „bad delivery‟ due to
faulty completion of paperwork. In many cases the process of transfer would take much longer than the two months stipulated in the Companies Act, and a significant proportion of transactions would end up as bad delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities were rampant. In addition, the issuer has the right to refuse the transfer of a security. All this added to costs and delays in settlement, restricted liquidity and made investor grievance redressal time consuming and, at
times, intractable. To obviate these problems, the Depositories Act, 1996 was enacted with the objective of ensuring free transferability of securities with speed, accuracy, and security, by a. Making securities of public companies freely transferable subject to certain exceptions by restricting company‟s right to use discretion in effecting the transfer securities and dispensing
with the transfer deed and other procedural requirements under the Companies Act. b. Dematerializing the securities in the depository mode c. Providing for maintenance of ownership records in a book entry form.
II.
Securities Market- Functions and Classifications:
The definition of 'Securities' as per the Securities Contracts Regulation Act (SCRA), 1956, includes instruments such as shares, bonds, sc rips, stocks or other marketable securities of similar nature in or of any incorporate company or body corporate, government securities, derivatives of securities, units of collective investment scheme, interest and rights in securities, security receipt or any other instruments so declared by the Central Government Securities. Markets is a place where buyers and sellers of securities can enter into transactions to purchase and sell shares, bonds, debentures etc. Further, it performs an important role of enabling corporates, entrepreneurs to raise resources for their companies and business ventures through public issues. Transfer of resources from those having idle resources (investors) to others who have a need for them (corporates) is most efficiently achieved through the securities market. Stated formally, securities markets provide channels for reallocation of savings to investments and entrepreneurship. Savings are linked to investments by a variety of intermediaries, through a range of financial products, called 'Securities'.
Functions of Securities Market:
Common market functions:
Commercial function (to derive profit from operation on this market)
Price determination (Demand and Supply balancing, the continuous process of prices movements guarantees to state correct price for each security (So, the market corrects mispriced securities)
Informative function (market provides all participants with market information about participants and traded instruments)
Regulation function (securities market creates the rules of trade, contention regulation, priorities determination)
Specific functions of the securities market:
Transfer of ownership (securities markets transfer existing stocks and bonds from owners who no longer desire to maintain their investments to buyers who wish to increase those specific investments. There is no net change in the number of securities in existence, for there is only a transfer of ownership. The role of securities market is to facilitate this transfer of ownership. This transfer of securities is extremely important, for securities holders know that a secondary market exists in which they may sell their securities holdings. The ease with which securities may be sold and converted into cash increases the willingness of people to hold stocks and bonds and thus increases the ability of firms to issue securities)
Insurance (hedging) of operations though securities market (options, futures, etc...)
Classifications of Securities Market:
Primary market:
Fresh issues of shares and other securities are effected though the Primary market. It provides issuers opportunity to issue securities, to raise resources to meet their requirements of business. Equity issues can be effected at face value or at discount/premium. Issues at
discounts are rare and almost unheard of. Issuers can issue the securities in domestic market and/or international market through ADR/GDR/ECB route.
Secondary market
Investors can buy and sell securities in secondary market from/to other investors. The securities are traded, cleared and settled through intermediaries as per prescribed regulatory framework under the supervision of the Exchanges and oversight of SEBI. The regulatory framework has prohibited trading of securities outside the exchanges. There are 24 exchanges (The Capital Stock Exchanges, the latest in the list, is yet to commence trading) today recognised over a period of time to enable investors across the length and breadth of the country to access the market.
Derivatives market
Derivatives are contracts that are based on or derived from some underlying asset, reference rate, or index. Most common financial derivatives are: forwards, futures, options and swaps, Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000 for trading in index futures, currently, the Indian markets provide equity derivatives of the following types: • Index Futures -Two Indices • Stock Futures-Twenty Nine stocks • Index Options -Two Indices • Stock Options -Twenty Nine Stocks
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. Corporations can keep the risks they are most comfortable managing and transfer those they do not want to other companies that are more willing to accept them. From a market-oriented perspective, derivatives offer the free trading of financial risks.
Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately, derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to best meet specific risk-management objectives. Moreover, under a marketoriented philosophy, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any business‟s risk management strategy to ensure that value-enhancing investment opportunity can be pursued.
III.
Depository System in India:
India has adopted the Depository System for securities trading in which book entry is done electronically and no paper is involved. The physical form of securities is extinguished and shares or securities are held in an electronic form. Before the introduction of the depository system through the Depository Act, 1996, the process of sale, purchase and transfer of securities was a huge problem, and there was no safety at all. Key Features of the Depository System in India:
1. Multi-Depository System: The depository model adopted in India provides for a competitive multi-depository system. There can be various entities providing depository services. A depository should be a company formed under the Company Act, 1956 and should have been granted a certificate of registration under the Securities and Exchange Board of India Act, 1992. Presently, there are two depositories registered with SEBI, namely:
National Securities Depository Limited (NSDL), and
Central Depository Service Limited (CDSL)
At present there are two depositories in India, National Securities Depository Limited (NSDL) and Central Depository Services (CDS). NSDL is the first Indian depository; it was inaugurated in November 1996. NSDL was set up with an initial capital of US$28mn, promoted by Industrial Development Bank of India (IDBI), Unit Trust of India (UTI) and National Stock Exchange of India Ltd. (NSEIL). Later, State Bank of India (SBI) also became a shareholder.
The other depository is Central Depository Services (CDS). It is still in the process of linking with the stock exchanges. It has registered around 20 DPs and has signed up with 40 companies. It had received a certificate of commencement of business from SEBI on February 8, 1999. These depositories have appointed different Depository Participants (DP) for them. An investor can open an account with any of the depositories‟ DP. But transfers arising out of
trades on the stock exchanges can take place only amongst account-holders with NSDL‟s DPs. This is because only NSDL is linked to the stock exchanges (nine of them including the main ones-National Stock Exchange and Bombay Stock Exchange). In order to facilitate transfers between investors having accounts in the two existing depositories in the country the Securities and Exchange Board of India has asked all stock exchanges to link up with the depositories. SEBI has also directed the companies‟ registrar and transfer agents to effect change of registered ownership in its books within two hours of receiving a transfer request from the depositories. Once connected to both the depositories the stock exchanges have also to ensure that inter-depository transfers take place smoothly. It also involves the two depositories connecting with each other. The NSDL and CDS have signed an agreement for inter-depository connectivity. 2. Depository services through depository participants : The depositories can provide their services to investors through their agents called depository participants. These agents are appointed subject to the conditions prescribed under Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996 and other applicable conditions. NSDL carries out its activities through various functionaries called business partners who include Depository Participants (DPs), Issuing corporates and their Registrars and Transfer Agents, Clearing corporations/ Clearing Houses etc. NSDL is electronically linked to each of these business partners via a satellite link through Very Small Aperture Terminals (VSATs). The entire integrated system (including the VSAT linkups and the software at NSDL and each business partner‟s end) e nd) has been named as the t he “NEST” [National Electronic Settlement & Transfer] system. The investor interacts with the depository through a depository participant of NSDL. A DP can be a bank, financial institution, a custodian or a broker. Just as one opens a bank account in order to avail of the services of a bank, an investor opens a depository account with a depository participant in order to avail of depository facilities.
3. Dematerialisation: The model adopted in India provides for dematerialisation of securities. This is a significant step in the direction of achieving a completely paper-free securities market. Dematerialization is a process by which physical certificates of an investor are converted into electronic form and credited to the account of the depository participant. Indian investor community has undergone sea changes in the past few years. India now has a very large investor population and ever increasing volumes of trades. However, this continuous growth in activities has also increased problems associated with stock trading. Most of these problems arise due to the intrinsic nature of paper based trading and settlement, like theft or loss of share certificates. This system requires handling of huge volumes of paper leading to increased costs and inefficiencies. Risk exposure of the investor also increases due to this trading in paper. Some of these risks are:
Delay in transfer of shares.
Possibility of forgery on various documents leading to bad deliveries, legal disputes etc.
Possibility of theft of share certificates.
Prevalence of fake certificates in the market.
Mutilation or loss of share certificates in transit.
The physical form of holding and trading in securities also acts as a bottleneck for broking community in capital market operations.
The introduction of NSE and BOLT has increased the reach of capital market manifolds. The increase in number of investors participating in the capital market has increased the possibility of being hit by a bad delivery. The cost and time spent by the brokers for rectification of these bad deliveries tends to be higher with the geographical spread of the clients. The increase in trade volumes lead to exponential rise in the back office operations thus limiting the growth potential of the broking members. The inconvenience faced by investors (in areas that are far flung and away from the main metros) in settlement of trade also limits the opportunity for such investors, especially in participating in auction trading. This has made the investors as well as broker wary of Indian capital market. In this scenario dematerialized trading is certainly a welcome move.
Dematerialization or “Demat” is a process whereby your securities like shares, debentures
etc, are converted into electronic data and stored in computers by a Depository. Securities registered in your name are surrendered to depository participant (DP) and these are sent to the respective companies who will cancel them after “Dematerialization” and credit your
depository account with the DP. The securities on Dematerialization appear as balances in your depository account. These balances are transferable like physical shares. If at a later date, you wish to have these “demat” securities converted back into paper certificates, the
Depository helps you to do this. 4. Fungibility: The securities held in dematerialized form do not bear any notable feature like distinctive number, folio number or certificate number. Once shares get dematerialized, they lose their identity in terms of share certificate distinctive numbers and folio numbers. Thus all securities in the same class are identical and interchangeable. For example, all equity shares in the class of fully paid up shares are interchangeable. 5. Registered Owner/ Beneficial Owner: In the depository system, the ownership of securities dematerialized is bifurcated between Registered Owner and Beneficial Owner. According to the Depositories Act, „Registered Owner‟ means a depository whose name is entered as such in the register of the issuer. A „Beneficial Owner‟ means a 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 remain with the beneficial owner. For the securities dematerialized, NSDL/CDSL is the Registered Owner in the books of the issuer; but ownership rights and liabilities rest with Beneficial Owner. All the rights, duties and liabilities underlying the security are on the beneficial owner of the security. 6. Free Transferability of shares: Transfer of shares held in dematerialized form takes place freely through electronic book-entry system.
IV.
Legal Frame Work:
Depositories Act, 1996:
The Depositories Act, 1996 was enacted to provide for regulation of depositories in
securities and for matters connected therewith or incidental thereto. It came into force from 20th September, 1995. The terms used in The Depositories Act,1996 are defined as under: (1) “Beneficial owner ” means a person whose name is recorded as such with a depository. (2) “Depository” means a company, formed and registered under the Companies Act, 1956
and which has been granted a certificate of registration under sub-section (1A) of section 12 of the SEBI Act, 1992. (3) “Issuer” means any person maki ng an issue of securities. (4) “Participant” means a person registered as such under sub -section (1A) of section 12 of
the SEBI Act, 1992. (5) “Registered owner ” means a depository whose name is entered as such in the register of
the issuer. Agreement between depository and participant
A depository shall enter into an agreement in the specified format with one or more participants as its agent. Services of depository
Any person, through a participant, may enter into an agreement, in such form as may be specified by the bye-laws, with any depository for availing its services. Surrender of certificate of security
Any person who has entered into an agreement with a depository shall surrender the certificate of security, for which he seeks to avail the services of a depository, to the issuer in such manner as may be specified by the regulations. The issuer, on receipt of certificate of security, shall cancel the certificate of security and substitute in its records the name of the depository as a registered owner in respect of that security and inform the depository accordingly. A depository shall, on receipt of information enter the name of the person in its records, as the beneficial owner. Registration of transfer of securities with depository
Every depository shall, on receipt of intimation from a participant, register the transfer of security in the name of the transferee. If a beneficial owner or a transferee of any security seeks to have custody of such security, the depository shall inform the issuer accordingly. Options to receive security certificate or hold securities with depository
Every person subscribing to securities offered by an issuer shall have the option either to receive the security certificates or hold securities with a depository. Where a person opts to hold a security with a depository, the issuer shall intimate such depository the details of allotment of the security, and on receipt of such information the depository shall enter in its records the name of the allottee as the beneficial owner of that security. Securities in depositories to be in fungible form
All securities held by a depository shall be dematerialised and shall be in a fungible form. Rights of depositories and beneficial owner
A depository shall be deemed to be the registered owner for the purposes of effecting transfer of ownership of security on behalf of a beneficial owner. The depository as a registered owner shall not have any voting rights or any other rights in respect of securities held by it. The beneficial owner shall be entitled to all the rights and benefits and be subjected to all the liabilities in respect of his securities held by a depository. Pledge or hypothecation of securities held in a depository
A beneficial owner may with the previous approval of the depository create a pledge or hypothecation in respect of a security owned by him through a depository. Every beneficial owner shall give intimation of such pledge or hypothecation to the depository and such depository shall thereupon make entries in its records accordingly. Any entry in the records of a depository under Section 12 (2) shall be evidence of a pledge or hypothecation. Furnishing of information and records by depository and issuer
Every depository shall furnish to the issuer information about the transfer of securities in the name of beneficial owners at such intervals and in such manner as may be specified by the bye-laws. Every issuer shall make available to the depository copies of the relevant records in respect of securities held by such depository. Option to opt out in respect respect of any security
If a beneficial owner seeks to opt out of a depository in respect of any security he shall inform the depository accordingly. The depository shall on receipt of intimation make appropriate entries in its records and shall inform the issuer. Every issuer shall, within thirty days of the receipt of intimation from the depository and on fulfillment of such conditions and on payment of such fees as may be specified by the regulations, issue the certificate of securities to the beneficial owner or the transferee, as the case may be. Depository to indemnify loss in certain cases
Any loss caused to the beneficial owner due to the negligence of the depository or the participant, the depository shall indemnify such beneficial owner. Where the loss due to the negligence of the participant is indemnified by the depository, the depository shall have the right to recover the same from such participant. Securities not liable to stamp duty
As per Section 8-A of Indian Stamp Act, 1899: a) An issuer, by the issue of securities to one or more depositories shall, in respect of such issue, be chargeable with duty on the total amount of security issued by it and such securities need not be stamped;
b) where an issuer issues certificate of security under sub-section (3) of Section 14 of the Depositories Act, 1996, on such certificate duty shall be payable as is payable on the issue of duplicate certificate under the Indian Stamp Act, 1899; c) Transfer of registered ownership of securities from a person to a depository or from a depository to a beneficial owner shall not be liable to any stamp duty; d) Transfer of beneficial ownership of shares, such securities dealt with by a depository shall not be liable to duty under Article 62 of Schedule I of the Indian Stamp Act, 1899; e) Transfer of beneficial ownership of units, such units being units of mutual fund including units of the Unit Trust of India, dealt with by a depository shall not be liable to duty under Article 62 of Schedule I of the Indian Stamp Act, 1899;
SEBI (Depositories and Participants) Regulations, 1996:
SEBI had circulated a consultative paper on the framework of the draft regulations for depositories and participants in October 1995. Extensive discussion were then held with the stock exchanges, market participants and investors on this issue. In addition to the views expressed at these meetings, SEBI also had the benefit of written comments on the Consultative Paper submitted by chambers of commerce and industry, market participants and investors. Based on the above, the SEBI (Depositories and Participants) Regulations, 1996 were notified in May 1996. These regulations provide for the following:
1. registration of depositories and participants under the SEBI Act 2. grant of certificate of commencement of business upon satisfaction that adequate safeguards and systems to prevent manipulation of records and transactions have been put in place, as required by the Depositories Act 3. the eligibility criteria for admission of securities to a depository
4. the specific rights and obligations of depositories, participants and issuers in addition to those specified in the Depositories Act 5. periodic reports to and inspections and enquiries by SEBI 6. penal action and procedure in case of default
In addition, the regulations contain the following provisions:
a. the minimum capital of the company that is to be registered as depository, has been set at Rs. 100 crore b. the eligibility criteria for the sponsors of a depository, who have been restricted to financial institutions, custodians, non-banking finance companies and stock brokers with a minimum net worth of Rs. 50 lakh and subject to a ceiling of 25 times their net worth on the value of the portfolios for which they act as participant c. provisions for the indemnification of beneficial owners including insurance cover for the depository and participants d. the adequacy of safeguards and procedures that are to be put in place before commencement of business is allowed to the depository e. the internal and external controls and audit mechanisms that are to be instituted by the depository in order to ensure the integrity of data processing systems and the adequacy of systems and procedures to prevent systemic failure, manipulation or loss of records
CONCLUSION
Advantages of the Depository System
The advantages of dematerialization of securities are 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.
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.
Disadvantages/Problems Disadvantages/Problems of the Depository System
Some disadvantages were about the depository system were known beforehand. But since the advantages outweighed the shortcomings of dematerialisation, the depository system was given the go-ahead.
Lack of control: Trading in securities may become uncontrolled in case of
dematerialized securities.
Need for greater supervision: 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.
Complexity of the system: 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. Besides the above mentioned disadvantages, some other problems with the system have been discovered subsequently. With new regulations people are finding more and more loopholes in the system. Some examples of the malpractices and fraudulent activities that take place are:
Current regulations prohibit multiple bids or applications by a single person. But investors open multiple demat accounts and make multiple applications to subscribe to IPOs in the hope of getting allotment of shares.
Some listed companies had obtained duplicate shares after the originals were pledged with banks and then sold the duplicates in the secondary market to make a profit.
Promoters of some companies dematerialised shares in excess of the company‟s
issued capital.
Certain investors pledged shares with banks and got the same shares reissued as duplicates.
There is an undue delay in the settlement of complaints by investors against depository participants. This is because there is no single body that is in charge of ensuring full compliance by these companies.
BIBLIOGRAPHY
Law relating to Depositories Depositories with Special Special Reference Reference to India: An Analytical Analytical Study -
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Atin Kumar Das
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www.wikipedia.com
Information collected from www.nseindia.com
The Company Law- C.R Dutta`
