Wisdom Crux

Crowd funding: A modern day framework to expand start-up capital

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[Volume 2, Issue 6] – June, 2017

Author – Mrudula Sarampally, B.A.LL.B (Hons.), Symbiosis Law School, Pune.

ABSTRACT

The mechanism of “Crowd funding” is a new concept that is currently evolving in India. The first milestone in this regard was reached by Securities and Exchange Board of India (SEBI) by releasing a Consultation Paper in 2014 and encouraging opinions of the people for the same. Crowd funding is aimed at aiding various start-up firms and Small and Medium Enterprises (SMEs) to raise their capital, through the digital media mostly internet. The main objective behind this paper is to understand and comprehend crowd funding as a concept in relevance to India and analyze the proposed regulations that SEBI has put forth.

The author through this paper would like to discuss as to whether crowd funding would be accepted in India, secondly, the jurisdiction of SEBI to enact regulations and thirdly, a detailed analysis and suggestions for the consultation paper released by SEBI in 2014. The conclusion includes analysis of the validity of SEBI in releasing these guidelines and success rate of SEBI in drafting such regulations for crowd funding activities as well as propose certain amendments that could be made along with certain substantial issues which has been left out of the draft released by SEBI.

INTRODUCTION:

Crowd funding is a method that is used to raise funds or investments from various individuals over the social media for a project or a venture with a common interest. This technique is practised in developed countries like US and UK, but is in a very initial stage in India. The recent development in  India has took its shape in 2008 when the country faced a major financial crisis and was helpless. The Securities Exchange Board of India (SEBI), which released a report on the issue has defined crowd funding 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.”((SEBI Consultation Paper on Crowd funding in India, Para 2.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf [Last seen October 7, 2016])) Prior to the recognition by SEBI, Dhirubhai Ambani has already introduced the concept and was successful in establishing Reliance Industries. Crowd funding is carried out in four ways:

  1. Donation Crowd funding
  2. Reward based crowd funding
  3. Peer to peer crowd funding
  4. Equity Crowd funding

Donation Crowd funding is investment without any expectation on its returns.((C. S. Bradford, Crowd funding And The Federal Securities Laws, Columbia Business Law Review 1, 15 [2012] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184 [Last seen on September 20, 2016])) Any small rewards that act like return gifts may be an incentive for its participants called “Thank you gifts”,((E. Burkett, A crowd funding exception? Online Investment Crowd funding and U.S Securities Regulation, 3 Transactions: The Tennese Law Journal of Business Law 63, 64 (2011),http://heinonline.org/HOL/Page?handle=heinjournals/transac13&div=6&g_sent=1&collection=journals [Last seen on September 19, 2016])) for which kick starter serves as a best example. Reward based crowd funding involve investments that receive rewards on the terms that are agreed upon. Peer to peer crowd funding is providing funds to those small enterprises for which interest is charged and the main platform would be the internet. In Equity crowd funding, the returns are the equity shares((A. V. Chirputkar, S. Saxena and J. Tarkas, Crowd Funding as a Tool of Business Transformation to Micro Enterprises in India – A Conceptual Framework, 8(S4) Indian Journal of Science and Technology 115, 116 [2015])) and such ventures are prevalent in the United States.((K. Stanberry and  F. Aven, Crowd funding and the Expansion of Access to Start up Capital, V(12) International Research Journal of Applied Finance 1382, 1389 [2014], https://www.irjaf.com/uploads/IRJAF_Vol _V_ Issue_12_-4_Kurt_Stanberry_-_Crowdfunding_and_the_expansion_of_access_to_startup_Captial.pdf, [Last seen on September 19, 2015]))

CROWD FUNDING IN INDIA:

In any domain, crowd funding is an emerging trend in India, though the process of accessing it online would pose a major challenge as the country has not yet completely attained a crime free cyber network. This in turn has developed a very low trust level among the citizens. Also, the industry is not investor friendly. E-commerce also has a very less utilization in India though it is prevalent in the today’s generation because of lack of internet security and awareness.((R. Pawha, P. Pranjal, and A.Mohan, Crowd funding: Is India Ready?, January Company Law Journal 50, 54 [2015], http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2605329, [Last seen on September 17, 2016])) Other drawback in introducing this concept is the increasing amount of corruption among the public officials.((G.P.Krishna An Empirical Overview of Crowd Funding – An Emerging Trend in India, 2 International Journal of Research 893, 895 [2015]))

In spite of all these problems, developed countries have taken a step forward to make it legal by enacting various laws like the Jumpstart Our Business Start-ups (JOBS) Act, 2012 in United States. This act is one of the international equivalent to the crowd funding regime.((G. Gupta and S. Vij, Note on Institutional Trading Platform, Notified by SEBI (Listing of Specified Securities on Institutional Trading Platform) Regulations, 2013, Practical Lawyer, 78, 82 [January 2015]))  Even the developing country like India is in a dire need to make it an essential part of the secondary and service sectors for the benefit of the stakeholders so that there is a balance between protection of investors and promotion of entrepreneurship. The SEBI has to take an effort by specifying in its regulations the importance of this type of funding and also by giving an assurance that the implementation would be credible and transparent in nature.

A proper regulatory framework has to be brought into place, after considering that it will regulate crowd funding and also taking into consideration the way it has to be regulated. The risks and advantages that are involved have to be thoroughly interpreted before enacting a law. In the words of Dam Moram, a crowd funding expert, “Without adequate regulation, fraud is one major concern for investors. With regulation, influence of strong investors on the organisation and its management can be levelled.”((SEBI Consultation Paper on Crowd funding in India, Para 2.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf, [Last seen October 7, 2016]))

ANALYSIS AND RECOMMENDATIONS OF THE CONSULTATION PAPER PRESENTED BY SEBI:

The consultation paper published in 2014 whose main aim was towards start ups and medium enterprises, recognised crowd funding as the best alternative for raising the funds. It not only puts forward the risks and advantages that are involved in the crowd funding in India like the Companies Act, 2013, existing SEBI regulations etc,((SEBI Consultation Paper on Crowd funding in India, Para 2.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf, [Last seen October 7, 2016])) but also various laws enacted for the same in other countries. SEBI guidelines regulates the issuers who raise the funds, the investors and the entities.((S. Jain and  P. Pandya,  SEBI Consultation Paper On Crowd funding In India: Key Takeaways,Taxmann.com 53, 59 (2015), https://www.taxmann.com/filecontent.aspx?Page=ART&isxml=Y&id=105010000000011822&PageType=1&search=crowdfunding&tophead=true, [Last seen at September 19, 2016])) The maximum amount of capital raised by a company should not be more than INR 100 million and the sponsorships should not exceed INR 25 crores. As per the analysis of the paper, crowd funding is limited to those who have the capacity to bear the losses and also only accredited investors are officially recognized to invest.((T.L. Hazen, Crowd funding or Fraudfunding? Social Networks and the Securities Laws-Why the Specially Tailored Exemption must be Conditioned on Meaningful Disclosure, 90 North Carolina Law Review 1735, 1738 [202]))

The entities are divided into several classes. Class I Entities are those which are recognized stock exchanges and SEBI Depositories. Apart from these SEBI has also proposed other entities. Class II includes Technology Business Incubators and Class III includes Associations and Networks of Private Equity or Angel Investors.((SEBI Consultation Paper on Crowd funding in India, Para 9.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf, [Last seen October 7, 2016]))

The major difficulty involved in the regulations made by SEBI includes the eligibility criteria for crowd funding being arbitrary as it is available only to the unlisted public companies. The small enterprises are generally listed under private companies because of lack of huge capital. Therefore, this pre-condition levied on crowd funding platforms shall act as a detriment to the investments thereby, discouraging further investors to invest in business. The solution for this could be the inclusion of the private companies also into the SEBI directions for crowd funding. The companies can be allowed to display their profits and losses so that the investors can choose in which company the investment is to be made. Acknowledgement of only the accredited investors and not retail investors is another drawback of the report. So, SEBI should give a broader meaning to the term “Investors” including more number of people to invest, which can fall under the category of crowd funding. Further, a platform to display the status of a company including their profits and losses making it flexible for the investors to invest in a business of their choice without any hindrances can be provided by SEBI.((K.Reinier, J.Armour, P.Davies, L.Enriques, H.B. Hansmann, G. Hertig, K.J. Hopt, H. Kanda and E. B. Rock, The Essential Elements of Corporate Law: What is Corporate Law, 14, [2nd ed., 2009]))

The very essential part of the concept of crowd funding by SEBI is restricting the investors to accredited investors only who would be investing in small amounts.((D.M. Ibrahim, Equity Crowd funding: A Market for Lemons?, Minnesota Law Review, [2016]))  The maximum limit of funds that can be raised through the crowd funding is INR 10 crores, in the period of 12 months which is way less when compared to some of the developed countries like in US it is INR 6 crores, in UK it is fixed at INR 20 crores and so on. Keeping in mind the Indian scenario, the amount setup by SEBI can be reduced because it is not possible for such big investments.((E. Kirby and S. Worner, Crowd-funding: An Infant Industry Growing Fast, Staff Working Paper of IOSCO Research Department, 20, No. [SWP3/2014], IOSCO [2014])) As per the rules SEBI, a company that follows crowd funding has to disclose all the truthful and appropriate information pertaining to the company and also a compulsory rating regarding the practicability and feasibility of the venture of the company which ensures the investors to make an informed decision about their investment. ((A.B. Majumdar, When three is a company, The Hindu (07/07/2015), http://www.thehindu.com/opinion/op-ed/securities-and-exchange-board-of-india-sebi-guidelines-when-three-is-a-company/article7392530.ece, [Last seen on September 20, 2016])) This authority has to keep in mind, that the investor protection is the sole responsibility of its regulations.

The non-existence of any secondary market for the investors which denies the provision to transfer the securities to anyone other than issuer and also the unavailability of the option to quit, creates a detriment amongst the investors to engage in activities like crowd funding. Amendment to this provision should be permitted so as to remove any disabilities to the investors.

The concept of cross-border crowd funding which involves a foreign investor investing in India and also a foreign company investing through Indian investors, also has to be analysed by the consultation paper.  Many questions like insolvency, difficulty in the application of laws to a foreign citizen, problems of regulation and so on might arise in this process. So, proper guidelines are to be established to solve the ambiguity that is involved.

JURISDICTION OF SEBI:

Crowd funding being a recent development, there are several defects involved in introducing the concept which have to be identified and fixed.((P.Kaushik, SEBI Opens Windows; Will Crowd funding shine through?, Business Insider (June 20, 2014), http://www.businessinsider.in/SEBIOpens-WindowsWill-Crowdfunding-ShineThrough/articleshow/37260011.c ms, [Last seen on September 19, 2016])) Few of them include, lack of regulations for such activities has given rise to concerns of defrauding the investors.((SEBI floats “crowd funding” rules; restricts investor access, Indian Express (17/06/2014), http://indianexpress. com/article/business/market/sebi-floats-crowdfunding-rules-restricts-investor-access/#sthash.D2UwEsk8.dpuf, [Last seen on September 19, 2016])) The consultation paper released by SEBI did not entirely concentrate on the objectives and needs of the Small and Medium enterprises, thereby it assumed the regulatory jurisdiction. The assumption of this responsibility by SEBI has not included the consideration of actual characteristics of crowd funding and other laws like the Income Tax laws((U. Varotill, SEBI consultation Paper on Crowd funding, (2014) [Last seen on September 18, 2016])), Companies Act, 2013 and RBI rules((Sahara India Real Estate Corporation Ltd. v. SEBI (2012) 10 SCC 603)). As the problem is a manifold one, if crowd funding platforms are assumed to be private, then according to the sections 42(2) and 42(4) of the Companies Act, any private company shall not exceed  50 investors which will make it a deemed company. But, the same is not a requirement of SEBI which explains another instance of assumed jurisdiction.((J.Soni, K. Bagchi, Crowd funding in India: A Tale of misplaced regulations, 48 Economic and Political Weekly 14, 15 [2014])) If these provisions are implemented crowd funding can be carried out in the Indian context, without any legislative amendment and with mere intervention of SEBI.((A. Patnia, Crowd funding- An Indian Perspective [2013])) Further, funding through debt would again lead to a difficult situation, since the Companies Act makes it ineffectual for small private companies to perform this through debt irrespective of whether it is convertible to equity. However, in the absence of any legislative support, the authority of SEBI stands certainly against all the other authorities created by legislations.((SEBI Consultation Paper on Crowd funding in India, Para 2.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf., [Last seen October 7, 2016])) The uncertainty can be resolved by differentiating between public offer and private placement which would require a prospectus and other compliances((Section 23(1)(a) of Companies Act, 2013)) and would be difficult for the crowding platforms and start-ups as it would defeat the purpose of crowd funding if a private company wants to make a public offer.

In cases where a company had limited itself to 200 members and approached the public for investment, it would neither be called a private placement or a public offer. This dilemma has led to confusion as to the jurisdiction of both SEBI and Ministry of Corporate Affairs, therefore, this can be referred as a hybrid transaction having an overlapping control over each other. The Supreme Court in Sahara India Real Estate Corporation Ltd. v. SEBI,((A. B. Majumdar, Regulating Equity Crowd funding in India – A Response to SEBI’s Consultation Paper, Draft Paper for International Symposium on Corporate Governance and Capital Markets 20, (2015) , http://dx.doi.org/10.2139/ssrn.2621488, [Last seen on September 18, 2016])) has held that as per provisions specified under Section 55A of the Companies Act, so far as in matters relating to issue and transfer of securities and failure to pay dividends, SEBI has the power to administer the case of listed public companies and in the case of those public companies who anticipate to make their securities get listed on a recognized stock exchange in India. This judgment has covered the grey areas which were present in regards to jurisdiction of SEBI and Ministry of Corporate Affairs. However, in the absence of any legislative backing, any purported and administrative authority of SEBI regulating crowd funding stands against any delegated legislation and the appropriate solution for the same being granting of residuary rule-making power under the Companies Act.((Nishith Desai, Crowd – Get Ready To Fund!!! SEBI Proposes A New Framework, http://www.nis hithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/crowd-get-ready-to-fund-sebi-proposes-a-new-framework.html?no_cache=1&cHash=ba6faea21bee5d30450465b332c6fb10, [Last seen at September 17, 2016]))

RISKS IN INTRODUCING CROWD-FUNDING IN INDIA:

SEBI has clearly indicated in its regulations that no company can encourage funds from the public, unless their rules are followed.((Crowd funding, social media, investment scheme under SEBI lens, Starlive24, http://www.starlive24.in /business/markets/crowdfunding-social-media-investment-schemes-under-sebi-lens/55386.html, [Last seen on September 15, 2016])) These complex rules include the entry barriers like minimum capital, years of operation and so on. However, SEBI being an uncertain regulatory body, the dilemma can be concluded by determining answers to the following two questions. Firstly, whether crowd funding has the characteristics of a public offer or a private placement, which essentially requires a differentiation between these two phrases to issue securities. This differentiation has been discussed under section 23 of the Companies Act as, public offer can be made only by a public company, which would require a prospectus and other compliances.((Crowd funding in India: A response to the SEBI Consultation Paper, Vidhi- Centre for legal policy, http://static1.squarespace.com/static/551ea026e4b0adba21a8f9df/t/55702567e4b02d3071c80513/1433412967 379/Vidhi+Crowd funding+Paper.pdf, [Last seen on September 19, 2016])) The option of private placement is available to both, a public company((U.N. Securities and Exchange Commission, Press Release, SEC Adopts Rules to Facilitate Smaller Companies’ Access to Capital, U.N. Document RIN 3235-AL39,http://www.sec.gov/news/pressrelease/2015-49.html, [Last seen on September 18, 2016])) and a private company((Crowd funding needs to be regulated, The Hindu(April 6, 2015), http://www.thehindu.com/news/national/telangana/crowdfunding-now-needs-toberegulated/article7072476.ece, [Last seen on September 19, 2016])). Further, public offer to issue securities has been denied to the private companies by section 2(68)(iii). Hence, it’s difficult for a private company to invite crowd funding by the investors, as a private company would not be eligible to make a public offer which defeats the whole purpose of crowd funding. Secondly, Section 42(2) of the Companies Act, 2013 had proposed that the number of people subscribing to the securities in a company shall not be more than 50, which otherwise would make it a public offer. As has been presented by SEBI in its consultation paper, the number of investors and the category of investors((Proposed Regulatory Framework For Crowd funding In India: Legal & Financial Analysis, Academia, http://www.academia.edu/11998619/Crowd funding_in_India, [Last seen at September 15, 2016])) in a public offer has been made limited, as in the case of internet entities, which are totally ignored((SEBI Consultation Paper on Crowd funding in India, Para 2.1 (2014), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf, [Last seen October 7, 2016])). Also, introduction of this concept may make the start-ups dependent on large institutional investors.((M.Chanchani, Startups see dark clouds over Sebi’s crowd funding plan, Economic Times(20/06/2014),http://articles.economictimes.indiatimes.com/2014-06-20/news/50739107_1_crowd funding-platforms-angellist, [Last seen on September 17, 2016]))

CROWD FUNDING IN OTHER COUNTRIES – COMPARATIVE VIEW:

In the United States, in order to accord recognition to crowd funding activities, proper regulatory framework was brought into place,((D.M. Ibrahim, Equity Crowd funding: A Market for Lemons?, Minnesota Law Review, [2016])) namely The Jumpstart Our Business Startups Act (JOBS Act) which includes a provision that allows small business owners to offer a limited amount of stock to private citizens through online platforms((The Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306, [2012])). Similarly, in the United Kingdom crowd funding activities are governed by the Financial Services Authority under the guidance of the Financial Services Markets Act, 2000((London Funding Conference, Crowd Funding, Staying on the Right Side of the FSA Part 2, YOUTUBE (Apr. 6, 2011), http://www.youtube.com/watch?v=qWgKbewv7FY; Financial Services and Markets Act, 2000, 1 (Eng.), [Last seen September 29, 2016])), which contains regulations that have been adapted to crowd funding activities.((Financial Services Markets Act, Ch. 8 [2000])) This act lays down that any invitation or inducement to get involved in any investment activity is considered to be a financial promotion,((Financial Services Markets Act, Ch. 8 [2000])) and also limits the number of people who can invest with a set of rules and regulations.((London Funding Conference, Crowd Funding, Staying on the Right Side of the FSA Part 2, Youtube (Apr. 6, 2011), http://www.youtube.com/watch?v=qWgKbewv7FY; Financial Services and Markets Act, 2000, 1 (Eng.), [Last seen September 29, 2016])) Italy is more on the lines of United States((Daniela Castrataro & Ivanapais, Analysis Of Italian Crowdfunding Platforms, 3 (2012),
http://twintangibles.co.uk/wp-content/uploads/2012/12/CrowdfundingInItaly1.pdf, [Last seen September 25, 2016])) and the most accepted form of crowd funding activity being micro lending, has accounted for many successful projects. In cases where a company is looking to raise equity through crowd funding portal it should first raise money through traditional sophisticated practices, which favours the less knowledgeable shareholders and protects them from potential abuse is one of the most remarkable practice in Italy’s crowd funding scenario.((Anton Root, A Closer Look at Italy’s Crowdfunding Law, Crowd Sourcing ( 2012), http://www.crowdsourcing.org/editorial/a-closer-look-at-italys-crowdfunding-law/20096, [Last seen September 28, 2016])) However, crowd funding laws of the European Union are ambiguous and are mostly conducted without explicit regulatory approval or disapproval.((Kristof De Buysere Et Al., A Framework For European Crowdfunding 21 (2012), http://www.europecrowdfunding.org/Resources/Documents/FRAMEWORK_EU_CROWDFUNDING.pdf, [Last seen September 25, 2016]))

Keeping in view the background of people in India of which 70% of  population practice agriculture, SEBI should be deemed to provide for traditional way of investments prior to online crowd funding, which protects farmers from rural background. Further, it should consider the “Collective Investment Model”,((Financial Services Markets Act, Ch. 8 [2000])) in the context of the UK crowd funding regulation which deals with the purpose of investments to be made when funds from large number of individuals are collected.((Justin Aronson, Lessons For The United Kingdom: How Registration And Prospectus Requirements Have Inhibited Condo-hotel Investment Offerings, 35 Syracuse J.Int’l.. L. & Com. 95, 114 [2007])) This arrangement is similar to that of an “Investment Contract”  under the Securities Act and Exchange Act in the United States.((Financial Services Authority, The Collective Investment Scheme Information, Guide 4,www.fsa.gov.uk/pubs/foi/collguide.pdf, [Last seen September 20, 2016]))

CONCLUSION:

To conclude, introduction of crowd funding in a country like India leads to a complicated scenario because of the increasing number of cyber crimes. Effective steps in this regard by conducting certain mandatory training sessions to build confidence among people especially the managers, owners of Small and Medium enterprises who are to be involved in this business are to be taken. The flaws in the cyber laws are also to be retreated. In implementation, the SEBI rules should neither be too stringent nor should be very mild and should be capable of striking a balance between regulations and provisions and also between protection of investors and promotion of entrepreneurship. However, keeping benefit of the stakeholders in mind, stringent regulations in collaboration with Reserve Bank of India, Finance Ministry, Ministry of Corporate Affairs and others who have the capacity to act as an agency for such activities should be undertaken.((P.Pandey, Analysis of the Consultation Paper on Crowd funding in India by SEBI, [2015])) Encouraging the investors in order to improve the funds, thus, contributing to the economic development of the country should be the ultimate motive.

Further, the regulating authority over the crowd funding activities in India, is still in a state of dilemma as to whether the SEBI or the Ministry of Corporate Affairs holds it. In Sahara India Real Estate Corporation Ltd. V. SEBI, it is stated that SEBI has the power of administration in issues relating to transfer of securities and failure of payments in the public companies. This case has marked a line in determining the jurisdiction, but since crowd funding has characteristics of both public offer and private placement, it can come under the purview of both SEBI as well as Ministry of Corporate Affairs which leads to an overlap in the jurisdiction. Hence, there should be an enacted law that clears the confusion in the jurisdiction.

In order to proceed with this project, the first and foremost step to be taken is to develop confidence which helps them to trust this policy  and get involved for the same. However, implementation requires extremely cautious approach with appropriate regulations which are simple and organised. Therefore, SEBI can try and adopt cross border companies’ investment styles as it is a new concept and help the start-ups make their own identity for themselves.