[Mythri is a student at National Law University Jodhpur.]
In its consultation paper on crowdfunding in India dated 17 June 2014, the Securities and Exchange Board of India (SEBI) explained crowdfunding as a method of soliciting small financial contributions from individuals who may number in the hundreds or thousands for the purpose of funding a business venture, charitable or public-interest cause (such as a community-based social or cooperative initiative), or creative project (such as music, film, or book publication). These donations are requested via an online crowd-funding website, and the offer may also be advertised on social media.
In short, equity crowdfunding is an extremely novel method of raising capital for businesses. It is essentially a type of fundraising, where a company raises money from the public for its business in exchange for the public receiving a financial stake (equity) in the company.
However, in India, equity crowdfunding platforms are considered “unauthorised, unregulated and illegal”, since as per SEBI, only recognised stock exchanges are permitted to offer electronic platforms for the listing and trading of equity and other corporate securities. SEBI stated that equity crowdfunding contravenes the Securities Contracts Regulation Act 1956.
Existing Regulatory Framework in India
Crowdfunding models that rely on donations, rewards, or peer-to-peer loans are widely used in India. However, because of India’s tougher laws governing public share offerings, securities crowdfunding has not seen popularity.
As mentioned previously, in equity-based crowdfunding, using a web-based platform, equity interests in the company are sold to investors. Traditionally, some aspects of the company legislation or regulations governing angel investors are attracted if a firm wants to raise money by issuing securities.
Public offer
With the public offer approach, securities can be publicly issued to an unlimited number of investors. Early-stage firms may find it challenging to meet the stringent eligibility requirements for the method of acquiring capital through public offerings like an initial public offering. It only permits public issuance of shares via prospectus and adds the need of listing it on a recognised stock exchange. The entire procedure takes many months and ends up costing the businesses a lot of money. Small businesses trying to raise money through crowdfunding will therefore be unable to do so.
Private placement
Securities are privately issued to a limited number of investors using the private placement process. This technique does not require additional regulatory compliance, but it does have a cap on the total number of investors it can have in a financial year, which is 50, as well as a cap on the types of investors it can have. If crowdfunding is conducted through a private placement, its identity and purpose are lost since there is a cap on the number of investors. Additionally, if there are more than 50 offerees, the situation becomes a public matter, and the applicants must comply with its strict standards.
Venture capital fund (VCF) and alternative investment fund (AIF)
The SEBI (Venture Capital Funds) Regulations 1996 (VCF Regulations) in India previously governed VCFs. Although the VCF Regulations now stand repealed, SEBI, at the time when the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) were notified, clarified that the existing VCFs shall continue to be regulated by the VCF Regulations till the scheme is wound-up, provided that they do not launch any new scheme after the notification of the AIF Regulations.
According to the VCF Regulations, VCFs need to be registered, satisfy eligibility requirements, and follow investing regulations. VCFs are subject to several regulations, such as maintaining a corpus of at least INR 50 million, investing up to 25% of its corpus in a single project, and putting at least 66.67% of its corpus into unlisted equity instruments. Additionally, it needs an individual investor to contribute a minimum of INR 500,000, and it can only welcome investors through private placement. It prohibits the invitation of the public for investment.
The AIF Regulations also regulated angel funds, or AIFs, which solicit money from both domestic and international investors and then invest the combined sums in early-stage businesses. Additionally, they must register with SEBI and disclose their investment strategy and are required to maintain a minimum capital of INR 200 million and to receive INR 10 million at the very least from each investment. Moreover, it is unable to solicit public subscription and must conduct a private placement to issue its units.
An Analysis of Existing Regulations
By examining the current regulatory framework, it can be stated that India has strictly regulated equity-based crowdfunding by imposing onerous requirements on public offerings of securities. The regulatory framework is set up to safeguard investors by obscuring the requirement for crowdfunding platforms in India. Equity crowdsourcing is currently not possible.
Thus, it is challenging to categorise crowdfunding as either a “public offer” or “private placement,” as well as a VCF or AIF. A start-up or a small and medium-sized business cannot be classified to seek a public offer or a private placement if it seeks a significant number of investors who are members of the public on a crowdfunding platform but limits the number of investors to 50. Equity crowdsourcing is a fresh idea that stands between the extremes of a public offer and a private placement. Therefore, this novel manner of fundraising calls for a completely distinct legal structure.
When examining the legal framework for equity crowdfunding, it is important to consider whether the websites offering these securities need to be registered as intermediaries under the SEBI Act and be subject to the SEBI (Intermediaries) Regulations 2008.
No intermediary in the securities market may buy, sell, or deal in securities without a certificate of registration. A crowdfunding site must meet the criteria of an intermediary and adhere to registration requirements. Therefore, a company issuing securities via a crowdfunding website may be seen as an intermediary and need SEBI registration. Additionally, such intermediaries must comply with regulations, including timely disclosures and maintaining books. This may not be acceptable to many service providers.
Why is SEBI against Equity Crowdfunding?
First, its biggest concerns are the possibility of frauds and scams while soliciting money from a huge public online. The public is not able to conduct adequate due diligence to confirm the credentials of the fundraising organisations, which could result in organisations dissolving after receiving funding.
Second, due to crowdfunding platforms’ lack of adoption of stringent security measures, the possibility of cybercrimes occurring increases. Indians have historically had their doubts about what happens on online platforms. Even the e-commerce platform only attained widespread acceptance when the “cash-on-delivery” option, which allowed customers to pay only after receiving the product, was made accessible. India has been unable to make online platforms safer, and cybercrime is still a problem there. Additionally, there is a chance that individuals will get involved in money laundering schemes.
Third, the risk associated with early-stage company failure is another worry that led SEBI to outlaw equity-based crowdfunding. According to studies, more than 50% of new businesses fail within the first 5 years. SEBI, which has been tasked with protecting investors, does not want to place investors in a situation where they have no option to retrieve their investment in the event of a company going out of business.
Fourth, the securities issued through crowdfunding are illiquid due to the lack of a secondary market. In contrast to public offerings of securities that are freely marketable on stock exchanges, such investors do not have the option of recovering their investment by selling their assets on the crowdfunding platform. This also eliminates the investors’ right to an immediate exit if the issuing company defaults or engages in fraud, placing them at a disadvantage.
SEBI does not permit unregulated securities crowdfunding because of two significant scandals in India.
First, there was the Sahara scam, where two Sahara Group businesses raised USD 3 billion from 30 million investors without submitting a prospectus or listing on a stock exchange as required by law.
Second, the Saradha group of companies was engaged in the scandal. An amount of INR 20-30 billion rupees had been raised from 1.7 million persons. When it was discovered to be a Ponzi scheme, members of the organisation were arrested. This might also be referred to as crowdfunding that the Indian judiciary forbade.
It seems reasonable for SEBI to declare the platforms participating in securities crowdfunding illegal based on the analysis of the hazards associated with uncontrolled securities-based crowdfunding. The regulators had to create stronger regulations because of the 2 scandals and numerous more. As a result, genuine start-up fundraising was portrayed as fraudulent activity carried out by Saradha and Sahara, severely restricting crowdfunding in India.
Recommendations
Only registered investors granted access to the platform should receive offers through a recognized web-based crowdfunding platform. Crowdfunding platforms must register with SEBI and meet all regulatory and intermediary requirements.
Companies seeking to raise money must register with a crowdfunding site by uploading their business model or projected business plan, along with incorporation documents and other relevant papers. This helps businesses showcase themselves and assists investors in understanding the firm before investing.
The crowdfunding website will maintain a list of registered investors permitted to access the platform for investments. Registered investors must meet all requirements, including submitting proof of net worth or income and signing a risk acknowledgment document.
Companies raising capital can approach registered investors individually, limiting the offering to a private placement. According to Section 42 of the Companies Act 2013, this invitation must be extended to a group of no more than 50 investors.
To make the Companies Act 2013 and the associated rules more accommodating of crowdfunding, SEBI, in cooperation with the government, should remove the cap on offerings, simplify procedures, and widen the investor base. It should also offer a secondary market to clarify its position on cross-border crowdfunding.
Regulatory organizations should study crowdfunding, its significance, and governance in different countries. Conducting an Impact Assessment Study of regulatory frameworks in other jurisdictions will help formulate a unique regulation for securities-based crowdfunding in India. Hence, a separate legislation piece is essential to oversee securities-based crowdfunding in India.
Conclusion
Equity crowdfunding is a novel and intriguing concept in corporate finance, presenting new challenges for regulators and policymakers. It has both benefits and drawbacks that will be incorporated into Indian legislation, with most risks being internet-related. This concept can help entrepreneurs achieve their goals by acting as a financing channel. SEBI should initiate awareness campaigns to educate business owners, issuers, and stakeholders about the fundamentals of this method, aiming to build confidence in business owners to pursue their projects.
Currently, SEBI is taking a cautious approach to crowdfunding, prioritizing investor safety. While the regulation of equity-based crowdfunding in India remains uncertain, with the right regulations, it could become extremely popular in the rapidly growing start-up industry.