Guest Post: Comments on SEBI’s Crowdfunding Paper

[The following post is
contributed by Debanshu Mukherjee, a
Senior Resident Fellow at Vidhi Centre for Legal Policy, New Delhi]
Last
month, SEBI had issued a
Consultation Paper on regulating Crowdfunding in
India. Vidhi Centre for Legal Policy,
a New Delhi based independent and not-for-profit think-tank prepared a detailed
response to the Paper and submitted it to SEBI earlier this month.
Crowdfunding,
if regulated appropriately can provide an excellent funding alternative for
early-stage ventures and cash-strapped small businesses. However, given its
vulnerability to ‘regulatory arbitrage’ and fraud, the regulatory framework
needs to strike the right balance between protection of investors and promotion
of entrepreneurship.
Here’s
a summary of some of the key arguments advanced in the Vidhi response:

Eligible Investors: The consultation paper proposes to allow only a
limited class of investors (‘Accredited Investors’) to participate in
crowdfunding. Crowdfunding, by definition, is typically aimed at raising funds
through relatively small contributions from a large number of people (the
‘crowd’), and not from a small group of sophisticated investors. Since most ‘Accredited
Investors’, particularly the Qualified Institutional Buyers (QIBs), are
unlikely to invest in early stage ventures (given their exhaustive screening
and diligence related requirements), many of those investors may not be
interested in crowdfunding at all. The proposed definition of eligible
investors should be modified to allow greater participation from retail
investors.

Number of Investors: Limiting the number of potential investors to 200 could
severely limit a venture’s fundraising attempts. Given that most QIBs are
unlikely to invest through the crowdfunding route, the other categories of
investors need to be sufficiently large in number to raise any substantial
amount.
While allowing a large number of investors to participate in
crowdfunding may increase the transaction costs and cause administrative
difficulties for the issuer company, such issues can be dealt with by
restricting the rights given to shareholders through issuance of shares with
differential voting rights and providing for a trustee/nominee to represent the
shareholders’ interests. Appropriate amendments to the Companies Act, 2013 and
the relevant rules thereunder will be required to facilitate this.

Disclosure Requirements: A typical venture resorting to crowdfunding is
likely to be at a very early stage of its operations and may not have the
resources to produce (on its own or by hiring external advisors) the necessary
information required for enabling the investors to make an informed decision.
Moreover, in the absence of proper legal advice at the time of making
disclosures, the issuer company may be at the risk of disclosing intellectual
property which could otherwise be legally protected under the laws of patent, etc.
It is here that the role of the crowdfunding portal becomes crucial. The
crowdfunding portal could hire specialists to enable the issuer to make the
necessary disclosures without undermining its legal interests (especially   in
relation to product-details and business methods). The portal could then factor
the cost of generating this information in its fee (to be recovered after the
funding is complete).

Rating: Though not specifically addressed in the SEBI paper, the
crowdfunding regulations may require issuers to obtain a ‘compulsory rating’
from a registered financial analyst about the financial viability of the
venture. The regulations may prescribe the methodology for the rating service
and require the service providers to be registered with SEBI. In the absence of
other traditional intermediaries (investment banks, underwriters, etc.) it is
important that independent analysts or business specialists lend their
reputation to the issuer company to signal the investors about the viability of
the venture. Alternatively, the start-up community could be urged to organise
itself voluntarily and develop a self-regulatory system for rating issuers on
crowdfunding platforms. Given that many ventures may not have the financial
resources to obtain such rating, the cost should be initially borne by the
portal (and factored in its fee).

Funding Portals:  Whilst SEBI
understandably proposes extensive regulation of platforms that facilitate
crowdfunding, some requirements might be potential deterrents for
competitiveness and efficiency in crowdfunding. For instance- limiting the
category of entities that can establish funding portals to stock exchanges,
depositories, technology business incubators (TBIs) and association of private
equity/angel investors is counter-productive. Given that internet and
technology companies have defined the crowdfunding experience so far and
increased regulations would only require enhanced innovation, capabilities and
systems to manage risk control and data protection, the aforesaid entities
should qualify as eligible entities for establishing funding portals. Further, networks
of entities with past experience and expertise in identifying, funding and
incubating potentially successful social ventures/SMEs, should also be
permitted. Finally, in order to promote
diversification, enhanced
capital flows and greater resilience in crowdfunding, SEBI should examine
additional measures, including, inter
alia
, promoting investor education, ensuring inter-operability of funding
portals, centralizing the verification of accredited investors and addressing
moral hazard concerns.  

Secondary Sales: In conventional capital markets, it is the existence of
a robust secondary market (a stock exchange) that encourages investors to
invest in the primary market, i.e., the initial offer. In the absence of an
‘informationally efficient’ secondary market (where the prices of the
securities reflect their fair value), investors may not be able to exit at a
desired time.  Retail investors are
particularly prone to facing personal exigencies, which may require them to
liquidate their holdings at any time and exit the venture. Any uncertainty
about exit options may discourage investors from making the initial investment
in the first place. While a full-fledged secondary market for securities issued
through crowdfunding may not be permissible given the regulatory framework for
stock exchanges, the discussion forums/ social networks on the funding portal
may be used as a platform to facilitate information exchanges between potential
buyers and sellers. Any transfer of shares facilitated through such forums may
be subjected to separate pricing and anti-manipulation guidelines to ensure
that the prices are not manipulated.
As
long as the regulatory regime provides for sufficient safeguards to prevent
frauds, raising equity capital through crowd-funding may go a long way in
unlocking the true potential of early-stage ventures. Having said that,
crowdfunding transactions are susceptible to frauds and regulatory arbitrage.
Regulatory arbitrage occurs when the regulated entities take advantage of the
variations between two or more regulatory regimes by subjecting themselves to a
system that involves lesser costs or compliances. Allowing companies to raise
funds through crowdfunding may create such arbitrage opportunities for
transactions which could otherwise be subjected to SEBI (Issue of Capital and
Disclosure Requirements) Regulations, 2009, SEBI (Collective Investment Scheme)
Regulations, 1999, the AIF Regulations or the Foreign Contribution (Regulation)
Act, 2011. In view of the above, issuance of securities through crowdfunding
may be introduced in a phased manner to gauge its suitability for the Indian
markets. Companies in sectors with dynamic entrepreneurial activity could be
allowed to raise money through crowdfunding on a pilot basis (for instance, in
the technology sector), before introducing this on a wider scale.
Vidhi’s detailed response to the SEBI
paper can be downloaded from its website:
http://vidhilegalpolicy.in/Crowdfunding%20Report%20-%20Vidhi.pdf  (the report is prepared by a Vidhi team
comprising Debanshu Mukherjee, Shubhangi Bhadada, Aditi Singh and Ketan Paul).

Debanshu Mukherjee

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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