Shashank Shekhar and Utkarsh Sharma
The concept of fractional shares has been gaining momentum in the global stock market, and India is no exception. With the potential to break down the barriers to entry for retail investors, the Company Law Committee has proposed an amendment to the Indian Companies Act, 2013, to make fractional share investing a reality in the country. This article delves into the benefits and drawbacks of fractional shares and explores the regulatory framework required for its implementation. It also draws comparisons with the US market and provides recommendations for policymakers to make fractional share investing a game-changer for India’s retail investors.
Fractional shares are partial shares of a company’s stock. Fractional share investing allows investors to purchase fractional shares, i.e., a portion of a unit of stock rather than a whole unit. This is possible by purchasing stock shares via a fractional share program or a marketplace that provides this service. An individual share of stock may be broken down into a larger number of smaller units using this platform, and then those fractional shares can be purchased by investors. Consider, for instance, that a share of MRF company is now selling for Rs. 80,000. In the conventional investment model, the investor would have to pay that much for one share of the company. With fractional share investment, however, the investor would be able to purchase a piece of the share, such as 1/10th or 1/20th of the share, at a price proportional to that fraction. This may open the door for people with as little as Rs. 100 or Rs. 200 to become involved in the stock market.
In India, Section 4(1)(e)(i) of the Indian Companies Act, 2013 (hereinafter referred to as CA-13) restricts the ability of investors to hold fractional shares, it states that:
“the amount of share capital with which the company is to be registered and the division thereof into shares of a fixed amount and the number of shares which the subscribers to the memorandum agree to subscribe, which shall not be less than one share.”
However, the possibility of fractional shares seems to be rapidly approaching reality in India. The Company Law Committee (CLC), which was set up in 2019 by the Ministry of Corporate Affairs (MCA), published its third report in April 2022. The report proposed that the government amend the CA-13 to make it possible for businesses to issue, hold, and trade fractional shares in India.
This article aims to illustrate how implementing fractional share investing in India could be advantageous for retail investors in the country. It also analyses the potential drawbacks of fractional share investing, as well as how the United States (US) has handled the legislative side of enabling such investments, and whether or not India could adopt such regulations. Finally, it concludes with some suggestions and recommendations on how to move forward with fractional share investing in India.
The Good, The Bad, and The Ugly Side of Fractional Share Investing
In recent years, there has been a rise in retail investors in the Indian stock market. The number of retail investors who entered the market increased to over 1.42 crore in FY 2021. With more and more individuals looking to diversify their financial portfolios, fractional share investing has taken off as a convenient entry point into the stock market. However, like all forms of investing, fractional share investing has its advantages and disadvantages.
One of the key benefits of fractional share investing is its ability to provide access to expensive stocks. Many popular stocks in India can be prohibitively expensive for small investors to buy. By allowing investors to purchase a portion of a share, fractional share investing can make it easier for investors to access these stocks and diversify their portfolios. Fractional shares would thus help investors achieve diversification at lower investment amounts while also improving liquidity and depth that will grow equity culture and retail participation. This can help investors to build a more balanced investment portfolio that reduces risk and potentially improves returns over time. In addition, investors benefit from increased liquidity because they can more easily purchase and trade fractional shares. This can be particularly useful in volatile market conditions where investors want to enter or exit a position quickly.
However, fractional share investing is not without its potential downsides. One major disadvantage is the potential for market fragmentation. When investors buy fractional shares, it can make it more challenging to determine the true ownership of a company because fractional shares represent a smaller piece of ownership in a company. For example, if a company has 10,00,000 outstanding shares and 5,00,000 of those shares are owned by investors with fractional shares, it can be challenging to determine who has a controlling interest in the company. Additionally, some brokers and custodians may not allow fractional shares to be voted, meaning that even if a fractional shareholder has the right to vote, they may not be able to do so due to the brokerage firm’s policy (more on this later).
An additional drawback of dealing in fractional shares is the possibility of lower dividends. Companies may not pay dividends on fractional shares because the quantity of payouts may be insufficient to warrant overhead expenses. This can result in lower dividend income for investors who choose to invest in fractional shares. Lastly, investing in fractional shares may not in all cases be viable for investors. When investors purchase or trade fractional shares, they may be required to pay a brokerage fee to their broker. Since fractional shares involve the purchase or sale of lesser amounts of shares, the brokerage fees associated with these transactions can be comparatively expensive as a proportion of the expenditure.
Navigating India’s Complex Legislative and Compliance Terrain for Fractional Share Investing
Fractional share investing faces certain legal and regulatory challenges in India that investors must navigate to ensure compliance. The absence of a well-defined regulatory structure for purchasing fractional shares in India is a significant obstacle. The Securities and Exchange Board of India (SEBI) has not yet released definitive rules for purchasing fractional shares. This causes buyers to question whether or not the practice is lawful and raises questions about the necessary level of compliance. One of the primary legal restrictions on fractional share investing in India is Section 4(1)(e)(i) and paragraph 4 of Table F – Schedule 1 of the CA-13. As noted above, this section limits investors’ ability to hold fractional shares by requiring that the amount of share capital to which the investors agree to subscribe must not be less than one share.
While it is true that fractional shares may also be created through corporate actions such as stock splits, mergers, and acquisitions, in most cases, stockholders are not given fractional shares as a consequence of such actions. For instance, if a business experiences a 2-for-1 stock split, a stockholder who previously owned 10 shares will now own 20, but they will still possess whole shares. After a merger, an investor’s stock is exchanged for shares in the combined company, and the new company’s share price is determined by free markets. In such instances, fractional shares are changed into whole shares or repurchased by a trustee designated by the board of the company.
The CLC, which proposed the amendment in CA-13, recommended permitting the issuing, ownership, and transfer of fractional shares for a class or classes of companies. It was also proposed that such recommendations could be made for publicly listed companies in collaboration with SEBI. It was also made clear that this suggestion only applies to situations in which the business would be issuing new fractional shares, and not to situations in which fractional shares are temporarily produced as a result of any corporate action.
The International Financial Services Centre Authority (IFSCA) recently authorized the dealing of fractional shares in India under its regulated sandbox system. As a result of the proposed framework, Indian retail investors will be able to participate in transactions on the National Stock Exchange’s (NSE) IFSC platform in US equities within the limits set by the Reserve Bank of India’s (RBI) Liberalized Remittance Scheme (LRS), which allows permanent citizens to send up to $2,50,000 per financial year for any allowed current or capital account transaction. Zerodha also recently tried to introduce fractional share investing to India through the SEBI regulatory sandbox, but their application was denied. Requests made in the Sandbox sought modifications to the present practices of intermediaries with regard to the handling of customer funds and assets, as outlined in Sections 25.1 and 25.3 of the SEBI Master Circular for stockbrokers.
The legal framework and regulatory challenges surrounding fractional share investing in India pose significant obstacles for investors. However, if the CLC report is accepted, the suggested changes can put Indian company law in line with internationally acknowledged best practices and enhance the quality of life for corporates and customers.
Fractional Share Investing in the United States: Regulations, Rules, and Realities
Fractional share investing has become an increasingly popular investment option, especially for new investors who may not have the funds to purchase entire shares of expensive stocks. However, the regulations, rules, and realities of fractional share investing can vary by country and region. It is necessary to examine the US in the context of fractional shares because the concept of fractional shares emerged in the US. More importantly, the CLC’s recommendation that India adopt fractional shares is grounded in the peculiarities of the American stock market. This overlooks important differences between the two countries. Let’s proceed to examine how Indian stockbrokers vary from their American counterparts.
Brokers in the US can serve as For example, in the US, stockbrokers can hold the investor’s shares in the investor’s name (dealer) or in the “street name,” which is the name of the brokerage firm (broker). Therefore, sometimes brokerage firms will buy a single high-value share and then split it up among the investors in proportion to their investment. It is the responsibility of the agent or broker to keep track of the investor’s identity in the ledgers even if the majority of the shares are registered in the agent’s or broker’s name. As a result, brokers in the US frequently provide investors with the option to purchase fractional shares. With agents’ ability to adapt to changing market conditions, investors face a greater potential for both loss and gain.
However, in India, brokers serve as the investors’ agents. They gather orders from clients and transmit them to markets for implementation. So, in the current setup, depositories like Central Depository Services Limited (CDSL) and National Securities Depository Limited (NSDL) hold securities instead of brokers. Since brokers act only as agents for their clients and securities are held by depositories such as CDSL and NSDL, it is impossible for brokers to hold fractional shares on behalf of investors because they are not the custodian of the securities. This is in contrast to the United States, where brokers are the custodians.
The findings of the CLC overlooked these crucial differences between the Indian and US stock markets. As a result, their recommendation for the issuance of fractional shares in India to be based on US practices may not be entirely applicable or suitable. It is important to emphasize the relevance of this distinction in order to ensure that any recommendations or actions taken are tailored to the specific context of the Indian stock market.
Consider also that the US takes an unusual tack when it comes to dealing in fractional shares. The U.S. Securities and Exchange Commission (SEC) has determined that for purposes of securities laws and regulations, fractional share transactions are considered the same as a full share purchase. This indicates that fractional shares are liable to all rules and laws as a full share, including insider trading rules and transparency requirements. Presently in India, fractional shares can only be created through corporate actions, such as stock splits, mergers, and acquisitions. The fact that India does not recognize fractional share investments as full share purchases justifies different regulations because it creates unique market conditions that require specific rules to address potential risks and protect investors. This unique market condition can create different risks for investors, such as liquidity risk, valuation risk, and price impact risk.
For instance, the lack of a direct market for fractional shares in India means that investors may have difficulty finding buyers or sellers for these shares. This can create liquidity risk, where investors may not be able to buy or sell their fractional shares when they need to. Additionally, the valuation of fractional shares may be more difficult in India, as there may be less information available on the underlying assets or companies that make up these shares. This can create valuation risk, where the true value of the fractional shares may not be clear.
Also, in the US, the offer and sale of fractional shares is not considered an offer and sale of a new or distinct asset. This opinion is supported by judicial and SEC decisions and common market practice and knowledge. To be considered a ‘purchase’ of a new security under Section 10(b) and Rule 10b-5, the Second Circuit held in Abrahamson v. Fleschner that “there must be such significant change in the nature of the investment or in the investment risks as to amount to a new investment.” If the shift in the character of the transaction or the dangers connected with it is negligible, no new asset is purchased or sold. Shareholders can retain and engage in fractional shares through standard dividend reinvestment plans (DRIPs) and direct stock purchase programs (DSPPs) managed by stock transfer brokers, who do not consider the fractional shares to be new assets. There is currently no specific law or regulation that addresses the treatment of fractional shares, even by corporate actions, as a distinct asset in India. This lack of clarity could create ambiguity and confusion in the Indian stock market, making it difficult for investors to understand the implications of fractional share transactions and for regulators to enforce any rules or regulations.
According to the investor bulletin issued by the SEC’s Office of Investor Education and Advocacy, the brokerage firm may disclose the availability of fractional shares, the type of assets available for trading, trade execution, order types and trading restrictions, dividends, and other corporate actions, voting rights, fees, liquidity, and the non-transferability of the same. It is pertinent to note that the proxy voting rights of the shareholders will depend upon the brokerage firm. Different brokerage firms have different policies regarding this. Furthermore, brokerage firms do not ensure the availability of fractional shares, even if the company’s complete shares are liquid. There is a risk of financial loss associated with investing in fractional shares if the company in which they are invested becomes illiquid. This could make it difficult, if not impossible, to sell fractional shares. Finally, the bulletin stresses that transferring an account with fractional shares to a new brokerage firm is impossible and that selling the fractional shares first is the only choice.
The Way Forward
It is clear now that fractional shares provide an accessible and convenient means for investors to purchase a portion of a stock without having to buy the complete share, making it an attractive investment option for retail investors. However, the current regulatory environment in India restricts the issuance of fractional shares. Though the recommendation of CLC to amend the CA-13 to allow the issuance, holding, and transfer of fractional shares brings a ray of optimism, there is a loophole in this report insofar as it does not acknowledge and distinguish the stock broker system of the US from India and proceeds to make recommendations based on the US Law.
In India, fractional shares can only be created through corporate actions, but there are no specific laws governing their treatment as distinct assets, similar to the US. Therefore , Indian lawmakers should consider differences with the US when making regulations and tailor these to suit the Indian market. Clarity on the treatment of fractional shares as a distinct asset, for example, is important to avoid confusion among investors and regulators.
Furthermore, in terms of proxy voter rights, India could have a different approach than the US. The latter gives the liberty to the brokerage firm to allow it or not, but India can make it mandatory by bringing an amendment under Section 105 of CA-13. The section states that “a member of a company entitled to attend and vote at a meeting and entitled to appoint another person as a proxy to attend and vote at the meeting on his behalf.” This would ensure that investors have a say in important corporate decisions and can participate in voting on matters that affect the company’s direction and strategy. To implement this solution, companies could work with brokers and investing platforms to enable fractional share investors to appoint a proxy to vote on their behalf. It may however be argued that handling a large volume of fractional investors would be a significant challenge for the voting system, as it would require setting up an efficient and secure mechanism to collect, verify, and count the votes cast by each investor or their appointed proxies. One possible approach to addressing this issue could be to allow for the aggregation of votes, whereby a group of fractional investors could appoint a single proxy to vote on their behalf. This would reduce the administrative burden on both the investors and the companies and brokers responsible for managing the voting process.
As it stands, investing in fractional shares is not a well-established practice in India, and the Indian government needs to provide a more specific set of rules before this can become a viable option for investors .
The authors are undergraduate students at HNLU, Raipur.
Categories: Commercial Law, Corporate Law, Economic Affairs and Policy