[Mihir Vashishtha is a final year B.A., LL.B. (Hons.) student at National University of Study and Research in Law, Ranchi]
With the rise of digitization in the capital market, there has been a notable surge in interaction between retail investors and the market, leading to increased investment activity. In turn, this increased digitization has incentivized market players to develop investment avenues customized for small-scale investors, breaking away from the traditional market model that predominantly served institutional investors. One notable aspect of these digitally influenced investment avenues is their focus on real-world assets, where ownership is fractionalized to facilitate crowdfunding and generate yields. These investment schemes are generally open-ended, i.e., investments are redeemable at any time without many restrictions.
Under Indian regulatory regime, instruments issued for the purposes of a scheme or arrangement are separately defined under section 2(h)(ib) of Securities Contracts (Regulation) Act, 1956 (“SCRA”) as units or any other instrument issued by any Collective Investment Scheme (“CIS”) and are considered as securities. In order to run a CIS, it is mandatory to operate only through a collective investment management company (“CIMS”) and the scheme must be approved by Securities and Exchange Board of India (“SEBI”). Mandatory prior approval along with discretionary power of Board to reject the same can be cited as one of the major reasons behind the fact that no CISM is registered with SEBI as per publicly available records despite the proliferation of these crowdfunding schemes. Instead, attempts have been made to evade this prior approval requirement by not offering these investment schemes as investment contracts but rather structuring them in the nature of fractional ownership or joint partnership. However, SEBI has clamped down on these attempts observing that since they inhere the character of a CIS, they will be treated as unregistered CIS.
Background – SEBI’s Order in Growpital
SEBI issued an interim order dated 29 January 2024 (“Interim Order”) against Agri investment platform-Growpital which offered a 11%-14% tax-free assured profit share against the investments. SEBI in its order, noted that the Growpital was running and promoting an unregistered CIS in violation of Collective Investment Scheme Regulation, 1999 (“CIS Regulation”). It is not for the first time that SEBI has clamped down an unregistered CIS platform, in fact since 1994-95 till 31 March 2020 a total of 1226 unregistered CIS platforms have been prosecuted.
The requirement for registration, coupled with various regulatory provisions outlined in the CIS Regulation such as scheme approval from SEBI and credit rating, serve as filters to identify Ponzi Schemes with illegitimate foundations, safeguarding against fraudulent practices. But scenarios have arisen wherein the unregistered CISs were genuinely operating with transparency and without any intent to cheat yet faced prosecution and closure as they were not approved by SEBI.
Determination of a Cis or an Investment Contract by SEBI-Howey’s Test
In SEC v. Howey, US Supreme Court introduced Howey’s Test which lays down four-factor analysis which is to be undertaken to determine if an instrument issued pursuant to an arrangement or scheme is in the nature of investment contract. In India, Dave Committee Report on Collective Investment Schemes was released in April 1999 which was first to come up with the definition of CIS and while doing so it relied on Howey’s Test. Soon after the report in December 1999, section 11AA was introduced vide Security Laws (Amendment) Act, 1999 which specifically provides that a scheme or arrangement will be a CIS if:
- Investor contributions are pooled for scheme purposes;
- Investors expect profits or property in return for their contributions;
- Property or investment is managed on behalf of investors;
- Investors lack day-to-day control over scheme management.
It is noteworthy that even in India this four-factor test is used to determine if an instrument is an investment contract or not, and the term CIS is a genus to which Companies, Mutual Funds, AIFs etc. are statutorily recognized species.
While examining the nature of schemes under section 11AA, SEBI has been very careful to adopt a technologically and structurally neutral approach.
Bypassing the Investment Contract Route while Crowdfunding
A share in profits made by business can be acquired either through investing money in the business or by becoming a partner or joint owner of that business. It is noteworthy that the term investment denotes asset acquired or money committed to generate profits. Thus, merely investing in the capital stands on a different pedestal than directly engaging in the operations of the business, and hence the former is treated as investment contracts bearing returns whereas the latter is reflective of joint ownership or partnership encompassing both profit and liability.
Since the investors in investment contracts are not directly engaging in operations of the business, the investment contracts naturally require higher degree of compliance, disclosures and transparency for investor protection. These onerous requirements do not exist in partnership or joint-ownership, and hence there have been several attempts made to give investment schemes the color of partnership or joint ownership. Here are some notable structures examined by SEBI lately:
LLP Structure – Growpital
Taking advantage of the absence of a cap on the maximum number of partners in an LLP, a framework was devised where investors were onboarded as partners in the LLP. Their investment amount was designated as a capital contribution, determining their proportionate share of profits. However, upon examination of the agreement among members, SEBI identified it as a veiled pooled investment scheme operating under the guise of an LLP.
SEBI observed that the pooling of funds was done pursuant to farm projects and these projects were managed by one entity, Farm Tech Silo LLP on the behalf of all the investors. All the rights conferred to the LLP partners / investors emanating from LLP Agreement were transferred to one administrative entity by signing consent letter keeping them bereft of day-to-day control and management over the operations of LLP in which they were partner.
Another important feature considered by SEBI was that the partners in LLP / investors except the designated partner were exonerated from any liability to indemnify LLP due to losses that might arise. In the Interim Order at Paragraph 6.1(ii), SEBI concluded that the arrangement was purposely kept limited only as far as profits or returns are concerned and partners in LLP / investors were not actually in position of joint owners, thus LLP structure and agreement thereof were devised to operate as an investment contract.
Joint Ownership Structure – MSM REITs Consultation Paper
CIS structures which involve investment in real world assets also try to introduce the concept of joint ownership of asset pursuant to which investment is pooled. The Consultation Paper released by SEBI on Regulatory Framework for Micro, Small and Medium REITs (“Consultation Paper”) also provided that some fractional ownership platforms facilitate direct joint ownership of the real estate among a large number of individuals, creating complexity and future challenges for the investors who are joint owners. It was also noted that in case of a dispute, the regulatory oversight of RERA is quite limited as it does not provide for investor protection for those who are investing in fractional ownership schemes.
Although the joint ownership structures are not explicitly recognized as CIS in the Consultation Paper, however, even joint ownership of real-world asset is most likely to be treated as a CIS if the operations of scheme qualify the four-factor test laid down under section 11AA. Moreover, in UK, a similar situation arose in Asset Land v. FSA where money was pooled to purchase land. Despite the fact the land was divided in different plots and the investors were made the joint owners of the land, the UK Supreme Court observed that irrespective of the joint ownership structure, only sole entity- Asset Land is authorized to oversee management and take steps to augment the development value of the land, which then deprived other joint owner the day-to-day control and participation in management, thus making it a collective investment scheme.
Conclusion
Keeping a check on proliferation of investment schemes masqueraded as joint ownership or partnership, SEBI has commendably looked at the substance over form of these schemes while examining the parameters provided under section 11AA(2) of SEBI Act. It is also true that by clamping down on these schemes, SEBI has acted to protect investors.
However, the fact that no schemes have been approved by SEBI since last 15 years should give us pause. SEBI has even been very reluctant to approve and register the schemes which sought registration after SEBI prosecuted them. For instance, in Asurre Agrowtech Limited v. SEBI, after receiving notice from SEBI, the promoters of the unregistered CIS applied for approval with SEBI. However, SEBI contended that it would entertain fresh registration only after directions issued in its notice are adhered with and after the set fine is paid for operating as an unregistered CIS. Perhaps it is time to re-examine the registration requirements for a CIS.
Investor protection regime in India is well encapsulated in statutes and rules made thereunder, and in order to operate an investment avenue, be it Company, Mutual Funds, AIF, etc., the promoter is required to comply with the set of necessary conditions as mandated by law. However, in case of CIS, the process to commence business has been made very challenging in the name of investor protection as unlike other investment vehicles, in addition to the pre-requisite compliances, the commencement of a CIS is also dependent on approval from SEBI. This distinction makes CIS business a grant or privilege given at the discretion of SEBI and not a right that can be exercised by complying the necessary investment protection mandates. This is different from what is required in jurisdictions like USA wherein a Collective Investment Funds are exempt from registration and regulation if they qualify for exemption provided under section 3(C) of Investment Company Act and rule 506 of regulation D of the Securities Act if they comply with certain specific exemptive conditions.
The rise in frequency of friction between SEBI and unregistered CIS must be taken into consideration by SEBI and the challenges in the process to register and approve a CIS must be revisited and addressed.
– Mihir Vashishtha