[Aryan Dhingra is a 4th-year student at Jindal Global Law School]
Introduction
In the aftershock of the 2008 global financial crisis, entrepreneurs and businesses found it increasingly difficult to raise funds due to the unwillingness of financial institutions to give loans. In such circumstances, crowdfunding arose as a new and innovative alternative for financing new business ventures. Although prevalent in several countries, it is a new concept being analyzed and introduced in India. As per SEBI, Crowdfunding is defined as “a solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause”.
Several countries such as the US, UK and Italy have passed legislations that exempt crowdfunding activities from traditional securities laws. Presently, the Indian regulations prohibit a fund-raising offer to more than 200 persons in a financial year. SEBI in its consultation paper in 2014 discussed an exemption for crowdfunding activities like the JOBS Act in the United States. However, this initial proposal which suggested the creation of a market for crowdfunding in India contained significant limitations which could effectively stifle crowdfunding rather than promote it in India. The essence of crowdfunding is in the ‘crowd’ which enables normal people to invest in new and innovative companies and imposing additional restrictions essentially removes the crowd from crowdfunding.
The author delves into (i) the existing regulatory framework for fundraising and the interplay with equity crowdfunding, (ii) the proposed regulation through the analysis of the consultation paper proposed by SEBI and whether SEBI possesses the adequate jurisdiction to regulate the crowdfunding market in India, along with a brief analysis of how SEBI’s approach has affected crowdfunding platforms. This article will help ascertain the need for a comprehensive legislation which can fulfill the inherent purpose of crowdfunding, which is to assist small companies to raise funds at ease while also maintaining investor security.
Regulatory Framework for Fundraising vis-à-vis Crowdfunding
The impediment raised through Section 2(68)(iii) of the Companies Act, 2013 which prohibits a private company from making invitations to the general public, raises the first issue towards crowdfunding in India. The basics of crowdfunding indicate that the number of contributors or investors will normally be in large numbers and will thereby violate Section 42 of the Companies Act, 2013 which provides that the number of subscribers to a private issue cannot exceed 50 persons. An issue with subscribers exceeding the provided limit would automatically be classified as a public offer and would be governed by SEBI Regulations.
SEBI Consultation Paper – Critical Analysis
SEBI in its 2014 consultation paper introduced crowdfunding as a completely new concept and failed to recognize the fact that there have been many developments in the field and various platforms are already operating around it. SEBI implied in the paper that the regulations if any would assist start-ups and small companies raise funds with ease. However, after a cursory reading of the paper, it can be observed that the proposals will fall short of this lucrative goal.
According to the consultation paper, a crowdfunding platform could only be established by
(i) Class I entities – SEBI recognized stock exchanges
(ii) Class II entities – Technology Business Incubators
(iii) Class III entities – Networks and Associations of angel investors.
This initial limitation itself would limit the establishment of new crowdfunding platforms. Another concerning proposal was the limitation on the credentials of the investors. According to the paper, investments could only be made by accredited investors which would include, qualified institutional buyers, companies with a net worth exceeding Rs. 20 Crore and high net worth individuals with a net worth exceeding Rs. 2 Crore. Retail investors would not be permitted to partake in the process. This essentially implies that the companies seeking investments would have to rely on institutional investors who are normally hesitant in investing in early-stage or pre-revenue companies. Additionally, 5% of the issue must be held by Qualified Institutional Buyers (QIB).
Mandate to purchase minimum offer value per person, net worth eligibility criteria, are amongst many such proposals which will inhibit the chances of a company to even qualify itself to be eligible for the funding, even before it has a chance to approach the public with the same. Additionally, the requirement that at least 5 percent of the issue was to be held by QIB would also be troublesome as, if a company is not able to attract a QIB, the issue would fail.
Advertising or showcasing the company on a fundraising platform is a precursor to the entire crowdfunding process. However, companies are prohibited from advertising themselves, directly or indirectly to the public. This seems like an effort to limit public participation and distance crowdfunding from a public issue. Subsequently, issues can be observed in the implied jurisdiction that SEBI has assumed over crowdfunding and the reaction of the authority towards crowdfunding platforms in the country.
i. Jurisdiction
SEBI has been authorized through the securities laws to protect the interest of investors and regulate public dealing of securities, while on the flip side, it is under the ambit of the Ministry of Corporate Affairs to regulate private placement.
It is a contentious proposal that SEBI would have jurisdiction over crowdfunding as usually unlisted and private companies would raise funds through crowdfunding.
It was opined in the Sahara case that SEBI only has jurisdiction on matters pertaining to the issue and transfer of securities of publicly traded companies. Additionally, the Ministry of Corporate Affairs also enjoys residual powers to formulate rules for matters specifically mentioned in the Companies Act including private placement.
It is proposed that crowdfunding is a unique model for fundraising which does not fall within the conventional contours of a public offer or private offer. It stands balanced in the middle of the fundraising spectrum. Crowdfunding transactions possess hybrid qualities of both private placement as well as a public offer and therefore would fall under the jurisdiction of both the SEBI and the Ministry of Corporate Affairs. It is therefore contended that neither of the two authorities would possess outright complete jurisdiction over the mechanism.
ii. Crowdfunding Platforms in India
Many crowdfunding platforms were established in the previous decade in India which facilitated crowdfunding and online sale of securities. Subsequently, in 2016 the SEBI released a press note which issued a clarification and cautioned investors that the platforms were not authorized by it and investors would not be eligible for any benefits under the SEBI rules. The board chose to proceed with a restraining approach which would declare the platforms as illegal instead of promoting the format.
Platforms in India such as ‘termsheet’ and ‘letsventure’ which aimed to promote this method of fundraising and were operating in a grey area of law and claimed they were abiding by all possible regulations and that SEBI took an “amateurish, ill-informed and irresponsible” decision which would disrupt and hamper the possibility of crowdfunding in the country.
Furthermore, in 2019, SEBI compelled these online platforms to register themselves as Alternate investment funds. Reportedly notices were sent to platforms like ‘AngelList’ and ‘letsventure’ for not adhering to norms for private placement.
All of this has put significant restrictions on the operation of the platforms and puts a damper on the sources of funds for investment. While the consultation paper was released in 2014, the only development so far has been a consultation with the government in 2015 where it was decided that India was not ready for crowdfunding yet.
Conclusion
While equity crowdfunding has several advantages for businesses and provides them with the ability to raise funds without complying with complicated regulations, what cannot be overlooked are the various risks associated. There could be cases of fraud or cyber-crime or a situation where the portal itself stops existing after collecting funds. This could pose threats to both businesses as well as investors. Investors also carry the additional risk of investing in companies that may go belly-up anytime. In 2011, Bubble and Balm, a soap manufacturing company in the UK raised funds through crowdfunding and shut shop a year after the funds were raised. This rendered the 82 investors without any remedy. There also exist systemic risks such as the lack of a secondary market to sell the securities and information asymmetry due to the limited information available on the crowdfunding platforms about the companies seeking investments.
In line with the associated risks, the regulator has erred on the side of caution and has stifled any growth that could have been seen in this funding format. This however does not seem uncharacteristic for the regulator considering the numerous scandals witnessed by the country. It can be argued that SEBI could relax certain proposed norms and facilitate the inclusion of a wider variety of investors and lower the threshold for investor qualification. This could allow crowdfunding to grow in a controlled manner. One that could be observable and regulatable. Increasing the number of investors to more than 200 could also fairly divide the risk amongst investors.
However, SEBI does not have the jurisdiction to amend the Companies Act and change the regulations of private placement. What is required is a proper regulatory sanction and separate legislation such as the JOBS Act and CROWDFUND Act in the US. India has shifted towards an approach that is tightening its noose on the offering of securities by companies in the fear of fraud. It is time to gradually drift away from that direction towards one which promotes the growth of startups and provides readily available investment opportunities for people who do not have access to the securities market.