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Introduction
The landscape for equity investments in start-ups has evolved drastically over the past few years. While traditionally such investments have been dominated by venture capitalists and angel investors, the emergence of fund-raising platforms are providing retail investors easy access to participate in start-up funding. Labelled as 'equity based crowdfunding' platforms, start-ups and small and medium sized enterprises ("SMEs") utilise such crowdfunding platforms to solicit small amounts of funds from many individual and organisational investors in consideration of equity instruments of such entities.
Such model of funding has its own unique characteristics and benefits. On one hand, not only does equity based crowdfunding provide for a new mode of financing and creatively utilise the advancements in technology to satiate the need for funding through alternative sources, it also allows start-ups and SMEs to raise capital in a more efficient and cost effective manner. On the other hand, equity based crowdfunding provides retail investors with new investment opportunities and in turn encourages competition in a space which has historically been restricted to only certain kinds of investors.1 However, the general sense of apathy towards provision of regulatory recognition and instances of rigorous intervention by authorities has ensured that crowdfunding as an alternate source of funding has failed to meet its potential.
Keeping the aforesaid in mind, this article seeks to highlight that the past attempts to introduce a regulatory regime as well as the current legal regime concerning such funding platforms is not appropriately suited to regulate the equity based crowdfunding industry and proposes broad principles that must be kept in mind to ensure that equity based crowdfunding is fully realised as a source of funding for start-ups and SMEs.
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The Shaky Road to Regulation:
As per a report commissioned by the World Bank ("World Bank Report"), it was found that Kickstarter, a donation based crowdfunding platform has been instrumental in raising billions of dollars till date.2 While the World Bank Report highlighted the rapid growth of this industry, the risks posed to small time retail investors also swiftly caught the eye of various securities regulators. Heightened financial risks associated with start-ups, fraud/money laundering/terrorist financing/cyber-attacks, platform failure, illiquidity of crowdfunded securities, information asymmetry amongst investors who may lack adequate experience and cross border implications were some of the special risks that became apparent and particularly associated with the crowdfunding model.3
In an attempt to address these risks, the Securities Board of India ("SEBI") released a consultation paper in 2014 ("Consultation Paper") which came in the wake of numerous securities regulators around the world seeking to bring the crowdfunding phenomenon within their ambit.4 This section of the article highlights the broad framework proposed by SEBI in its Consultation Paper.
Market Access and Eligibility Criteria for Fund Raising Companies
Since crowdfunding has evolved as a response to the need for funding by early-stage start-ups that have limited access to capital, the Consultation Paper laid down the criteria for companies looking to raise such funds. This was to ensure that companies which otherwise have access to other methods of fund raising are prohibited from utilising crowdfunding avenues.5
Accreditation of Investors and Investment Limitations
The Consultation Paper restricts participation in crowdfunding to mainly 'accredited investors'. Such accredited investors refer to companies having a net worth of at least INR 200 Million and individuals having a net worth exceeding INR 2 Million. Individuals who do not fall in the aforementioned category may still be eligible to partake in crowdfunding activities provided they fall within the criteria laid out in relation to 'eligible retail investors'. These are:
- a minimum gross annual income of at least INR 1 Million;
- having filed income tax returns for at least the last 3 preceding financial years; and
- are well versed and advised in investment matters (on the advice of professional investment and portfolio managers) or have passed the appropriateness test laid out by an accredited institution.
Such eligible retail investors' investment is capped to INR 60,000 in one issue and an overall cap of 10% of the individual's net worth was proposed. Therefore, it becomes apparent that SEBI's Consultation Paper proposed to restrict crowdfunding activities to investors who were (i) experienced in making investments, have access to professional advice, and (ii) have the ability to absorb losses arising from such investments.6
Classification of Crowdfunding Platforms
The Consultation Paper classified crowdfunding platforms in three categories, namely Class I entities (recognized stock exchanges with nationwide terminal presence), Class II entities (technology business incubators) and Class III entities (associations and networks of PE or angel investors). Additionally, since there is a high possibility of fundraising companies concealing information that may be relevant to investors, crowdfunding platforms have also been tasked with conducting basic due diligence, review and filtering of business plans and conducting a series of checks and reviews.7
Laying Out of Crowdfunding Procedures
The Consultation Paper lays out the manner in which crowdfunding and associated disclosures are to be undertaken. While such proposed procedure lays down the manner in which the initial introduction between fund raising companies and interested investors shall take place, the procedure post the initial introduction reflects the same set of rules contained in Section 42 of the Companies Act, 2013 ("Companies Act").8
Illiquidity of Crowdfunded Securities
A unique risk associated with crowdfunded equity is that, only the issuer company is allowed to sell its securities and is in most scenarios, responsible for providing a secondary market for the same. Lack of clear exit options may result in investors not having adequate remedies in case of default or mismanagement. Recognising this risk, the Consultation Paper proses that trading of crowdfunded equity may be undertaken by: (i) buyback as provided under the Companies Act; (ii) transfer to another accredited investor; and (iii) transfer to a family member/relative/friend of the existing investor.9
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Analysis of the Consultation Paper
It has been broadly observed that 'accredited investor' constitutes a very small percentage of investors. In fact, the thresholds laid out to qualify as an 'eligible retail investor' has been considered to be high.10 This means that only high net-worth investors with investment experience and knowledge shall qualify to participate in such crowdfunding. This eligibility criteria in fact takes the 'crowd' out of the crowdfunding and restricts the pool size of eligible investors.11 Additionally, allowing only accredited investors to participate falls foul of the whole concept of crowdfunding as, such accredited investors may already have access to existing avenues that create a connection between start-ups and SMEs and interested investors.12
The disclosures required to be made by issuer companies pursuant to private placement provisions contained in the Companies Act may prove to be cumbersome in relation to the model of the crowdfunding industry. The detailed requirements and disclosures may not be readily available with many nascent companies looking to fund raise through crowdfunding. Excessive disclosures may also prove to be harmful to early-stage start-ups. Thus, it may not be wise to apply the same onerous obligations to such start-ups and SMEs which are applicable to traditional public and private companies.13 Further, the non-provision of a secondary market for crowdfunded securities limits the ability of the investor to part with the said securities and is in fact contrary to the best interests of the investors. Additionally, the illiquid nature of such securities may also act as a deterrent to many investors.
The screening and due diligence processes of the issuer company by crowdfunding platforms will most likely increase the transaction costs associated with using crowdfunding platform. This may take away from the cost-effective nature of such platforms.14 It is essential to understand that the very nature of crowdfunding is a hybrid of private placement and public offer.15 The Consultation Paper does not provide for a specialised regime that fits the unique characteristics of crowdfunding. In fact, it equates equity crowdfunding to private placement and places stricter restrictions due to the online nature of crowdfunding platforms. This, in turn makes, equity crowdfunding difficult for all parties involved.16
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Aftermath of the Consultation Paper
The release of the Consultation Paper indicated that regulatory authorities were acknowledging the unique benefits and risks associated with crowdfunding, and were amenable to introducing a regime to regulate the same. However, after the release, no further action was taken by SEBI. Reports in 2015 suggested that SEBI was of the opinion that introducing crowdfunding regulations would be premature as, other jurisdictions had not made a move to regulate the crowdfunding market either.17
Another factor that played a role in the shelving of any crowdfunding regulations was, the difficulty such platforms introduced in regulating cross-border investments. It seems that SEBI may introduce crowdfunding norms once it has some guidance from analysing how other advanced economies look to regulate this industry.18
While the Reserve Bank of India (the "RBI") has introduced guidelines governing debt-crowdfunding in the nature of peer-to-peer lending, SEBI has been agonisingly slow in bringing adequate regulation after acknowledging the need for introducing regulation governing equity crowdfunding almost 10 years ago. In the meantime, the Ministry of Corporate Affairs, through the Registrar of Companies, has come down heavily on certain companies that have raised funds through equity based crowdfunding platforms.
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Recent Events
A recent order passed by the Registrar of Companies, NCT of Delhi and Haryana ("RoC') against Anbronica Technologies Private Limited ("Anbronica") sheds some light on the way regulatory authorities view the crowdfunding model since the release of the Consultation Paper almost 10 years ago.
Anbronica used Tyke, a technology based crowdfunding platform to float a fund raising campaign and connect with potential investors registered on the platform as members of Tyke. Such members have access to knowledge content on investing in start-ups and can also attend pitch sessions targeted to advance start-up investments. Fund raising companies can also avail numerous services on Tyke such as, inter alia, setting up of escrow accounts, KYC verification and assistance in compliance with private placement as required under the Companies Act.19
Pursuant to interest generated by the Anbronica's campaign on Tyke, Anbronica issued and allotted its compulsorily convertible debentures ("CCDs") to 28 identified subscribers on a private placement and preferential basis. However, the RoC issued a show cause notice to Anbronica stating that such issue and allotment of the CCDs was in fact in contravention of the Companies Act.
To understand the nature of the contravention, the RoC studied and analysed the fundraising model adopted by Tyke. In its defence, Anbronica stated that Tyke was mainly used as a platform to generate interest in its campaign from members of Tyke. It contended that neither was Tyke used as a platform to invite the public to subscribe to its CCDs nor did such campaign inform the public of the private placement offer that was to be issued by Anbronica. Pointing at its 'Terms of Use', Tyke too argued that it has mechanisms built in its system to restrict the number of investors that may view a campaign to 200 so as to ensure compliance with the Companies Act. Additionally, the platform's terms of use clearly indicated that nothing on the website is intended to constitute an offer or solicitation of an offer to purchase or sell any security.20
Not convinced by any of the points raised and clarifications provided by representatives of Tyke and Anbronica, the RoC found that the relevant provisions of the Companies Act and Companies (Prospectus and Allotment of Securities) Rules, 2014 ("Rules") were violated. Accordingly, the RoC held that the relevant provisions explicitly mandates that in private placement, an offer can be made to only 200 persons. The RoC pointed out that the explanation to Section 42(3) of the Companies Act makes it clear that the process of private placement comprises of 3 constituents, namely, (i) the offer; (ii) the invitation to subscribe; and (iii) issue of securities to a select group of persons. In RoC's view, this makes it abundantly clear that while the 200 person restriction is applicable to the number of persons who ultimately subscribed to the CCDs, it was also applicable at the time an offer or invitation to offer were made on Tyke. Relying on the answers provided by Tyke's representative, it was found that the invitation to offer to subscribe to Anbronica's CCDs was accessible to roughly 1.5 lakh members of Tyke and thus Anbronica was in clear contravention of the Companies Act. Additionally, while explaining the concept of over-subscription on Tyke, its representative also admitted that interest shown by community members may exceed 200 persons.
In addition to the above, the RoC also found that Anbronica was also in contravention of Section 42(7) of the Companies Act which provides that a company issuing securities under Section 42 is prohibited from releasing any public advertisements and cannot utilise any media/distribution channel/agents to inform the public regarding its issue. In this particular fact scenario, it is apparent that Tyke was being utilised as a media/marketing/distribution channel/agent to particularly inform the public of the proposed issue of CCDs. This was evidenced by the fact that the actions of Tyke showed that it played the role of an active facilitator.
Accordingly, the RoC found Anbronica to be in contravention of Section 42 of the Companies Act and imposed penalties on the company, its directors and promoters under Section 42(10) of the Companies Act owing to the fact that Anbronica fell under the definition of 'small company' under the Companies Act. It is, however, interesting to note that even though the RoC held that Tyke was in fact a facilitator to the contravention of Anbronica, no penalty has been imposed on Tyke as Section 42 only provides penalties for the relevant company, its directors and promoters.
This goes to show that the Companies Act is not designed or suitable to deal with the transgressions of all parties involved in an equity crowdfunding transaction and highlights the desperate need for regulatory intervention. While many such crowdfunding platforms follow models similar to Tyke, the lack of a regulatory framework is stifling the growth of the crowdfunding industry. It is therefore important that any regulatory regime in relation to crowdfunding strikes a balance between investor protection as well as providing easy access to private capital to start-ups and SMEs without creating rigorous entry barriers or substantial compliance burden on the parties involved.
Footnotes
1. http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf
2. https://fortune.com/2014/04/17/why-investors-are-pouring-millions-into-crowdfunding/
5. ibid
6. Supra, footnote 1
7. ibid
8. ibid
9. ibid
10. P.M. Vasudev & Susan Watson, Global Capital Markets: A Survey of Legal and Regulatory Trends (2017)
11. https://www.minnesotalawreview.org/wp-content/uploads/2016/01/Ibrahim_4fmt.pdf
12. https://www.law.ox.ac.uk/business-law-blog/blog/2016/07/regulating-equity-crowdfunding-india
14. Supra, footnote 13
15. https://www.jstor.org/stable/24481069
16. Supra, footnote 11
18. ibid
19. https://www.mca.gov.in/bin/dms/getdocument?mds=I4whIqT0vI2s3pZZHS8PiQ%253D%253D&type=open
20. https://www.mca.gov.in/bin/dms/getdocument?mds=I4whIqT0vI2s3pZZHS8PiQ%253D%253D&type=open
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