Regulatory challenges faced by Equity based Crowd-funding Platforms. 

The author is a 5th year student of B.A.LLB (Hons.) of ILS Law College, Pune.

What is Crowdfunding?

With the rise of the Internet, a new method of fund raising has emerged- Crowdfunding. Crowdfunding is the solicitation of funds from multiple investors through web-based platforms.[1] Different kinds of organisations including NGOs, small companies and business ventures use Crowdfunding to raise funds for different activities, expansion, diversification etc. Crowdfunding can be broadly classified into two kinds- donation based and reward based. Donation based crowdfunding involves grants and donations with no expectation or obligation of returns. Reward based crowdfunding can be further classified into- debt based or equity based. In debt based crowdfunding if it is in the form of loans, it is called peer to peer lending and should come under the banking regulator, whereas if it is debt securities based then it would come under the purview of the securities regulator.

The subject matter of this article is equity based crowdfunding in which equity shares of the company are issued in lieu of funds raised from investors. It is a popular method of fund raising by start-ups. There are web based platforms which facilitate information exchange and advertising of companies as well as act as intermediaries for fund and equity share transfer. In web-based platforms for equity crowdfunding, investors and companies looking to raise capital through equity have to register with the platforms and pay a registration fee for the same. Start-ups advertise and solicit funding on these platforms and therefore the web-based platforms act as intermediaries or a marketplace for investors and start-ups.  Social media platforms are also often used by start-ups to solicit funds from multiple investors.

The need for regulation

Traditionally, start-ups raise funding through Venture Capital funds and Private Equity investors who have a high risk appetite. The funding is also at a later stage, after the product/ service becomes commercially viable. However with the advent of crowdfunding platforms, multiple investors with smaller individual investment are tapped into, usually at an early stage. The benefits of crowdfunding are that it is easier, faster and cheaper method of fund raising, requires no mandatory disclosures, and possesses easier and wider access to funding and investors. While the benefits of crowdfunding are manifold for the start-ups, the risk to the investors is high. There is an information asymmetry in the functioning of these crowdfunding platforms as there are no straight jacket regulations on mandatory disclosures which apply to them. These are also characterized as high risk investments and involve a high exposure to retail investors which makes the regulators uneasy. Start-up companies also offer less liquidity and therefore might not be viable for retail investors who do not have the required skills and assessment of risk to invest in such securities. There is a lack of regulatory certainty due to absence of regulations in which these crowdfunding platforms function.

Current regulatory framework

The applicable laws to Equity based crowdfunding are-

1) Companies Act, 2013- Any issue of securities by a company would come under the purview of the Companies Act, 2013. In relation to issue of securities, there are two recognised modes available to companies under Section 23 of the Companies Act, 2013- Public offer through prospectus and Private placement through an offer letter[2].

2) Securities Contract (Regulation) Act, 1956, Securities and Exchange Board of India Act (SEBI Act) and Regulations- Under Section 24 of the Companies Act, 2013, Securities Exchange Board of India (SEBI) shall regulate the issue and transfer of securities of listed companies and those companies which intend to get their securities listed.

A public offer requires a ‘prospectus’ and there is a list of matters to be disclosed in the prospectus. The prospectus also needs to be filed with the Registrar of Companies (RoC) and SEBI.[3] A private placement offer under Companies Act, 2013 cannot be made to more than 200 people in a financial year.[4] The newly amended Section 42 also stipulates that private placement shall be made only to persons identified by the Board and prohibits public advertisements or utilisation of any media, marketing or distribution channels or agents to inform the public at large about such an issue.[5] Explanation III to Section 42 dealing with offer or invitation for subscription of securities on private placement reads-

“If a company, listed or unlisted, makes an offer to allot or invites subscription, or allots, or enters into an agreement to allot, securities to more than the prescribed number of persons, whether the payment for the securities has been received or not or whether the company intends to list its securities or not on any recognised stock exchange in or outside India, the same shall be deemed to be an offer to the public and shall accordingly be governed by the provisions of Part I of this Chapter”. Therefore the modus operandi of crowdfunding platforms[6] of raising funding through issue of equity shares through the medium of electronic platforms with a number of registered/ member investors would neither meet the stringent regulations for a public offer nor qualify as a private placement under the Companies Act, 2013. There is more similarity to a public offer than a private placement which is on a one-to-one basis. The decision of the Supreme Court in the Sahara judgment[7] concluded that an offer to 50 or more persons constitutes a public issue and will come under the regulatory oversight of SEBI even in case of unlisted companies. In case of crowdfunding, there is no filing of prospectus with the RoC and the disclosures to be made are not complied with, therefore there is a violation of public offer norms. Private Placement under Section 42 (7) specifically bars the utilisation of any media to market and distribute to the public at large about such an issue. The solicitation made to more than 50 persons also makes crowdfunding beyond the scope of private placement.

In the opinion of the author equity based crowdfunding platforms are currently not only functioning in a regulatory lacuna but is illegal in India till proper regulations are introduced. The regulatory action by SEBI in cautioning investors against web-based platforms in reference to crowdfunding platforms[8] and questioning LinkedIn Corp and 30 other online platforms regarding violation of Companies Act to raise funding[9] is also in tandem with this conclusion.

Tracing regulatory developments with respect to Crowdfunding in India

The need to amend the Companies Act, 2013 and SEBI Act and Regulations to allow crowdfunding was realised in 2014 when SEBI issued a consultation paper on the regulation of crowdfunding.[10] The paper laid down a framework to regulate crowdfunding. Some of the proposed regulations are-

• It allows only unlisted public companies to be eligible under the framework

• A minimum investment of 5% by Qualified Institutional Buyers (QIB) is mandatory

• Retail Investor contribution is capped: Minimum- INR 20,000 and maximum- INR 60,000

• Only start-ups less than two years old eligible to participate

• Maximum number of retail investors capped at 200

The consultation paper has proposals which are against the very idea of crowdfunding. Most start-ups are registered as private companies and if the maximum number of retail investors is any way capped at 200, then keeping out private companies will be a restriction barring many start-ups from utilising crowdfunding as a means to raise capital. The mandatory minimum investment of QIB is counter-productive as QIBs tend to invest in companies that are more than two years old, which have proved their business models and have comparatively dependable projections.

However there was no further action taken on the proposed framework apart from specific instances of SEBI asking for clarifications from web-based platforms.[11] Exemptions need to be made in the current Companies Act and SEBI regulations to allow crowdfunding and a light regulatory approach in disclosures and capping of maximum investment amount is required to facilitate and encourage crowdfunding. Keeping a minimum ticket size of investment and cumbersome compliance requirements on the issuing company would be counter-productive and will take the charm out of crowdfunding.

Conclusion

An analysis of the Company law provisions makes it clear that crowdfunding platforms as they function today with visibility, soliciting to more than 200 investors[12] are not only in a regulatory grey space but illegal and subject to clamp down by the regulators. A dialogue between the crowdfunding platforms and SEBI has to fructify into amendments to the law in order to facilitate crowdfunding.

[1] SEBI Consultation Paper on Crowd-funding in India, June 17, 2014, Available at https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf.

[2] Section 23 of Companies Act, 2013.

[3] Section 26 of Companies Act, 2013; Companies (Prospectus and Allotment of Securities) Rules, 2014.

[4] Rule 14 (2) (b) of Companies (Prospectus and Allotment of Securities) Rules, 2014.

[5] Section 42 (2) and (7) of Companies Act, 2013 substituted by Section 10 of the Companies (Amendment) Act, 2017.

[6] Are online funding platforms for start-ups breaking the law, Live Mint, September 23, 2016 http://www.livemint.com/Opinion/I2TA2BTAK7H1wZ90xfBMRO/Are-online-funding-platforms-for-startups-breaking-the-law.html.

[7] Sahara India Real Estate Corporation Limited & Ors. V. Securities and Exchange Board of India & Anr., order dated August 31, 2012 in Civil Appeal No. 9813 and 9833 of 2011.

[8] PR No.: 137/2016, August 30th, 2016 https://www.sebi.gov.in/media/press-releases/aug-2016/sebi-cautions-investors_33094.html.

[9] SEBI questions fundraising on LinkedIn, Anirudh Laskar, Aug 25, 2017, Live Mint http://www.livemint.com/Companies/dvQTX1PpiAsUZj3gOTJtbM/Sebi-questions-fundraising-on-LinkedIn.html.

[10] SEBI Consultation Paper on Crowd-funding in India, June 17, 2014 available at https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf.

[11] SEBI questions fundraising on LinkedIn, Live Mint, Aug 25, 2017, available at  http://www.livemint.com/Companies/dvQTX1PpiAsUZj3gOTJtbM/Sebi-questions-fundraising-on-LinkedIn.html.

[12] Are online funding platforms for start-ups breaking the law, Live Mint, September 23, 2016 http://www.livemint.com/Opinion/I2TA2BTAK7H1wZ90xfBMRO/Are-online-funding-platforms-for-startups-breaking-the-law.html.