[Nachiketh is a student at National Law School of India University.]
Crowdfunding is a method of soliciting funds from a large community, typically through the Internet, where project creators receive small contributions from many donors or investors. It represents the convergence of microfinance and crowdsourcing. Crowdfunding comes in four main types. Donation crowdfunding involves giving funds for charitable causes without expecting returns. Reward crowdfunding offers rewards like products or merchandise but no financial returns.
In equity-based crowdfunding, equity interests in a company are sold to investors via a web-based platform. Companies seeking to raise funds through securities must navigate regulations related to public offers or angel investors. Public offers allow securities to be issued to an unlimited number of investors, but require compliance with stringent eligibility criteria, including listing on a recognized stock exchange and issuing a prospectus. This process can be expensive and time-consuming, making it impractical for small businesses using crowdfunding. In contrast, private placements involve issuing securities to a limited number of investors, capped at 50 per year, which avoids extensive regulatory compliance but limits crowdfunding's reach.
Startups in India seek capital, while small investors aim to diversify by investing in new ventures. The rise of platforms connecting companies with investors has fueled crowdfunding opportunities. However, equity crowdfunding remains unregulated, leading platforms to create financial instruments like "community subscription offer plans" (CSOPs) that resemble equity but are not classified as securities. Instruments such as compulsorily convertible debentures (CCDs), compulsorily convertible preference shares, and non-convertible debentures are common, but CSOP funds are treated as revenue, with no shareholder rights. Regulatory loopholes, like the silent stance on stock appreciation rights, allow founders to retain equity without dilution while offering retail investors a chance to participate in the startup culture with potential returns. Additionally, any argument in favour of online crowdfunding platforms would be unsustainable since SEBI has outright banned equity crowdfunding in India.
The Tyke Case: Navigating Private Placement Violations and the Role of Crowdfunding Platforms
The judgment against Anbronica Technologies Private Limited (Tyke) highlights the company's violation of Section 42(7) of the Companies Act 2013, which prohibits companies from using public advertisements, media, or marketing channels to inform the public at large about a private placement offer. The company had raised funds by issuing CCDs through the Tyke platform, which was found to have acted as a media or distribution channel, thereby breaching this provision.
Section 42(7) is designed to ensure that private placement offers are made to a select group of individuals and not publicized widely, maintaining the private nature of such offerings. However, in this case, the use of the Tyke platform, which had a community of around 1.5 lakh members, effectively made the offer accessible to the public, violating the law's intent. The main argument taken by the company was that CSOPs are not a security and hence, it does not come within the ambit of Section 42 of the Companies Act 2013. However, the Registrar of Companies (RoC) rejected the said contention and held that CSOPs qualify as a 'security' under Section 2(81) of the Companies Act 2013 read with Section 2(h) of the Securities Contracts (Regulation) Act 1956 (SCRA).
The RoC adjudged that Tyke and its directors were liable for penalties under Section 42(10) of the Companies Act 2013. The order also pointed out that while Tyke facilitated the violation, the Companies Act 2013 did not permit the imposition of penalties on the platform itself, only on the company and its directors.
While these platforms may offer retail investors a valuable opportunity to participate, public investment in private limited companies is prohibited under Section 2(68) of the Companies Act 2013. Section 2(68) outlines the criteria for classifying an entity as a private company, which includes (a) a minimum paid-up share capital as prescribed, (b) restrictions on the transfer of shares, (c) a limit of 200 members, and (d) a prohibition on inviting the general public to subscribe to any of its securities.
One of the fundamental distinctions between a public and private company lies in the manner of raising capital for the company, wherein a public company can invite the general public to invest in it, private companies cannot. Amidst all this, platforms as mentioned above, have allowed retail investors to bypass such legal requirement, raising key issues on the regulation front to provide coverage for such usage of the loophole.
In this case, Tyke's website was clearly used by the company as a media, marketing, and distribution channel to inform the public about the issue of securities, violating the provisions of Section 42(7) of the Companies Act 2013. Tyke collected fees at various stages of the process, from onboarding services to commissions when the investors deposited funds into the company's escrow account. Tyke also collected money from investors who used the platform to invest in different companies. Therefore, Tyke's role extended beyond merely generating interest in the company; it acted as an active facilitator for raising investments, providing end-to-end services either directly or through its partners. It also raises critical questions about the role of platforms, suggesting that their involvement might blur the lines between private and public offerings, leading to potential regulatory breaches.
When a 'Security' Is Not So Secure: The CSOP Conundrum in Crowdfunding
It is important to revisit the definition of 'security' under Section 2(h) of the SCRA, which encompasses a broad range of instruments. Since CCDs and similar instruments featured on these platforms fall under the category of 'security,' the relevance of CSOPs within this context becomes noteworthy. When an instrument is classified as a 'security,' regulatory authorities are empowered to interpret, intervene, and assert their jurisdiction over the company to address any potential irregularities. Therefore, if CSOPs are deemed 'securities,' their issuance would be prohibited under Section 2(68) in conjunction with Section 42 of the Companies Act 2013 and Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules 2014.
Given that CSOPs function as speculative contracts that derive their value from the company's future performance and growth, bearing all the characteristics of a 'security' in the form of a 'derivative,' it will be intriguing to observe whether SEBI maintains its current legal interpretation to extend its jurisdiction. This situation is reminiscent of the Sahara India Real Estate Corporation Limited v. SEBI (Sahara India) case, where optionally fully convertible debentures were classified as 'securities,' thus broadening the scope of applicability. The crucial point here is the enforcement of the two-hundred-member threshold limit set by the Act, treating it as a 'deemed public issue,' regardless of whether the entity is publicly listed or unlisted.
The RoC order, which focused on the issuance of CCDs, examined the relevant provisions of the Companies Act 2013, specifically Section 2(68) and Section 42(7). Section 42(7) of the Companies Act 2013 expressly prohibits private limited companies from inviting the public to subscribe to their securities through public advertisements or marketing, media, or distribution channels. Consequently, only companies that issued CCDs were penalized by the RoC for fundraising, allowing platforms and companies issuing other types of securities to evade regulatory scrutiny.
A key issue with equity crowdfunding is the lack of liquidity after funding. Platforms typically focus on raising capital by selling securities but rarely offer a secondary market. While some argue that crowdfunding’s goal is to generate capital, this ignores the importance of exit provisions for investor protection in cases of default or mismanagement. The broad definition of 'securities' under Section 2(h) of the SCRA includes 'derivatives', which are contracts deriving value from underlying securities. Indian courts have examined what constitutes 'underlying securities' in relation to derivatives, underscoring the need for clearer exit strategies to protect investors in equity crowdfunding.
The Madras High Court, in the case of Rajshree Sugars and Chemicals Limited v. AXIS Bank Limited, determined that derivatives can be based on a variety of financial assets, including shares, bonds, and foreign currencies. This interpretation was supported by the Bombay High Court in CIT v. Bharat R Ruia. Specifically, the Madras High Court noted that financial instruments like call and put options are derivatives because their value is linked to the underlying shares' value.
Conclusion and Beyond: Turning Derivatives into Directions—India’s Crowdfunding Crossroads
According to this ruling, any contract whose value depends on the value of underlying shares qualifies as a derivative. Reviewing the CSOP agreement on Tyke’s website reveals that the payout a subscriber receives upon exit is based on the company's equity share value. The CSOP agreement details how the value of stock appreciation rights is calculated, linking the payout to the company’s pre-money valuation, which is essentially the equity share value.
Interpreting the agreement considering the Madras High Court’s judgment indicates that the CSOP is a derivative. The ROC also observed that the value of CSOPs is tied to the company's equity securities at various stages and possesses characteristics of securities like transferability and registry maintenance. Thus, CSOPs are classified as derivatives. As a result, the issuance of CSOPs is subject to regulation under Section 42 of the Companies Act 2013. This regulatory stance might influence the availability of capital for startups and investment opportunities for retail investors.
In conclusion, the regulation of equity crowdfunding in India requires greater clarity, especially concerning instruments like CSOPs, which challenge traditional securities definitions. Judicial interpretations and regulatory actions have expanded the scope of derivatives, bringing such instruments under the scrutiny of securities law, with significant consequences for startups and retail investors. This regulatory stance may restrict access to capital and opportunities, making it essential to address ambiguities while balancing compliance with fostering innovation.
Other jurisdictions, such as the United States and the United Kingdom, have adopted different crowdfunding norms to address these challenges in a regulated manner. For example, the United States implemented the Jumpstart Our Business Startups Act, enabling equity crowdfunding, which allows startups to solicit up to USD 1 million annually from the public with lower reporting requirements. In the UK, the Financial Conduct Authority regulates loan- and investment-based crowdfunding, but imposes restrictions, allowing only high-net-worth individuals or those taking regulated advice to participate in such platforms.
In contrast, India’s SEBI has clearly disallowed any form of equity crowdfunding. Given the evolving market landscape, this regulatory approach must be revisited and revised to support capital formation while ensuring investor protection. The challenge for India lies in balancing the need for investor protection with enabling growth in the crowdfunding sector. Clearer guidelines will be essential to address the regulatory loopholes.
コメント