Penny Wise : A Crowdfunding Critique

[The
following guest post is contributed by Anantha
Krishnan Iyer
, a graduate of National Law University Lucknow (batch of
2008-2013) currently working with a leading law firm in Mumbai]
Introduction
Pooling as a concept that has existed for a while now, as it
is considered a useful solution to generate certain efficiencies. The advent of
pooling of funds by multiple persons to fund a project, otherwise known as
‘crowdfunding’, is a concept which has been making waves around the world. With
its inception in the early 2000s, crowdfunding has gained considerable momentum
in both developed and emerging markets.
In 2014, the Securities and Exchange Board of India (SEBI)
released a consultation
paper
on crowdfunding in India. While the securities market watchdog considered
the types that an entrepreneur could avail, there certainly have been
shortcomings in the points omitted to be addressed by SEBI in its paper. The
types of crowdfunding can be broadly split up into Community and Financial-return
based. While Community crowdfunding covers Donation-based and Reward-based
crowdfunding, Financial-return pertains to Peer-to-Peer Lending and Equity-based
crowdfunding. The concept provides a paradigm shift from traditional means of
funding such as venture capital and angel investments. However, it does not
provide a complete solution to providing funding to a startup company.
Dissecting SEBI’s Proposal
SEBI’s proposal recognizes crowdfunding as an innovative way
to provide ‘modest amount of funding’ to young entrepreneurs in need of early
stage capital to fuel their startup ventures. Proposing three routes namely
Equity, Debt and Fund-based crowdfunding, SEBI has crystallized the framework
proposed by specifying eligible investors, investment limits, conditions and
recognition of crowdfunding platforms associated with such investments.
Eligible Investors: While Qualified Institutional Buyers (‘QIB’) and High Net Worth Individuals (‘HNI’) have been made eligible based on
their net worth, the guidelines proposed for Eligible Retail Investors (‘ERI’) is quite hazy. Since the concept
of crowdfunding is pivoted around pooling of funds from multiple small-time
investors, it is quite likely that ERIs would form a majority of the investors.
By proposing an ‘Appropriateness Test’ which may be conducted by the
crowdfunding platform itself and placing dubious restrictions such as not
investing more than 10% of their net worth in all crowdfunding investments per
year or Rs.60,000 per investment, the framework for eligibility leaves a lot to
be desired in terms of clarity.
Investment Limits: As a potential source of funding, SEBI has
complied with international standards on its view on entities eligible for
crowdfunding and has limited the funding which could be raised by such
entities. With the United States allowing up to $1 million a year through
crowdfunding (approx Rs. 6 crores), SEBI has raised the bar to allow Rs. 10
crores per annum for Indian entities. With entities that are only up to 48
months old being considered eligible for crowdfunding under the proposal, the
SEBI has placed a time-cap on startups to realize their potential, which is a
welcome move considering the burgeoning pace at which companies are established
in India.
Disclosure by Issuers: With an increased risk forecast at stake, it
would be pertinent to tighten the bolts on disclosure requirements placed on
entities seeking crowdfunding. Following the United States model, which amongst
international jurisdictions, places stringent disclosures on such entities, SEBI
has listed a 13-point disclosure requirement. However, the inherent flaw with
the proposal stems from the fact that SEBI draws parallels with public offers
but fails to address the question of investors exceeding 200 in number in
crowdfunded entities.
The Public Offer Conundrum
The
Companies Act, 2013 (“Act”)
specifies that any offer/invitation which is not in compliance with the
provisions of Section 42 would be treated as a public offer. While the
consultation paper released by SEBI deals at length with crowdfunding
initiatives amounting to a private placement under Section 42 of the Act and
the necessary procedure to be followed in such cases, it does not cover a
scenario where the investors (apart from QIBs) exceed 200 in number.
The
concerns have been partly addressed in case of Small and Medium Enterprises (‘SME’). However, SMEs are not currently
required to make an initial public offer and are traded on the SME exchange,
Institutional Trading Platform (“ITP”).
Furthermore, one of the criteria for listing in the ITP is that such SMEs
should not have their securities listed on any recognized stock exchange. Such a
criterion put in perspective of the SEBI consultation paper effectively rules
out a public offer opportunity for SMEs and Startups. It may also be noted that
the paper rules out a secondary market to trade scrips of such companies
displayed on a crowdfunding platform.
The Curious Case of P2P Lending
Peer-to-peer lending is another source of crowdfunded money,
which can be traded through loans/promissory notes/contracts on a platform or a
secondary market. Primarily dealing with unsecured loans carrying interest
rates set by the platform which matches the borrowers with lenders,
peer-to-peer lending has been pegged to be more than £400 million in the United
Kingdom. While the SEBI paper recognized peer-to-peer lending to be a rapidly
growing concept in recent years, with data backing the claim that such lending
doubled year-on-year, it failed to take cognizance of the concept stating the
such lending would not fall within the regulatory purview of SEBI. Citing the
Reserve Bank of India to be the watchdog for such lending, the clarity over
peer-to-peer lending was left hanging by SEBI. The RBI, to its credit, has
recognized the concept of peer-to-peer lending in its Financial Stability
Report dated June 26, 2014 and opined in the report that such a form of lending
required regulatory attention. With the ball in the RBI’s court now, it would
be quite interesting to see how the concept shapes up in India.
Conclusion
SEBI has gone all out in analyzing the various facets of
crowdfunding in every other jurisdiction where the concept is prevalent. It has
taken due note of the shortcomings and pitfalls associated with the concept as
well. While it has countered some of these issues, there are still certain
gaping holes left open and to be clarified. With other regulatory bodies such
as the RBI are to be roped in to draft and finalize the set of regulations to
govern crowdfunding in India, it does seem to be headed in the right direction.
However, with a time crunch looming due to the breakneck pace at which startup
ventures are opening shop, swift and immediate attention to roll out necessary regulations
is the need of the hour.
Anantha Krishnan Iyer

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.

1 comment

  • Sporadic:
    “…….swift and immediate attention to roll out necessary regulations is the need of the hour.”
    ‘the need of the hour’ – instead, one would prefer to say ‘ the need of the
    ‘lost’ (past) hours’ , regrettably remaining over sighted/chosen to be ignored until this moment. The concept of ‘crowdfunding’, in a manner of critical viewing, as rightly cautioned, has all the inherent adverse potentials, likely to harm the ‘national economy’ in the long run. For a quick analogy, one can do no better than think of the proverbial , – ‘herd mentality’. In one’s conviction, that is seen to be the causa causans, at the grass root level, of the kind prevailing all around in most ‘material’ matters.

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