Taking the ‘Crowd’ Out of Crowdfunding: SEBI Regulations on Equity Crowdfunding
The author is Nidhi Agrawal, second year student at National Law School India University, Bangalore.
Equity Crowdfunding (“EC”) is a FinTech business funding model which acquires equity capital in smaller sums from a varied number of investors through online platforms. The 2008 financial crisis led to the application of Basel III Capital adequacy norms on banks. This constrained investment lending by banks highlighted the need for alternative modes of capital funding for small and medium-sized enterprises (“SMEs”) and start-ups which do not meet these capital adequacy norms. Therefore, EC becomes pertinent for early-stage funding for SMEs and start-ups as it allows capital raising at a lower cost and through less rigorous procedures. EC remains prohibited in India due to the absence of a regulatory framework. However, this came to the regulatory forefront in 2014 when the Securities and Exchange Board of India (“SEBI”) released a consultation paper. This paper proposed a robust regulatory mechanism for early-staged EC that balanced investor protection and access to additional channels of capital funding. Although its regulatory framework remained unimplemented, the paper did highlight the inadequacy of the extant regulation of Fintech-based ECs.
The broad outcomes of FinTech regulation focus on maintaining (i) Market Integrity (ii) Financial Stability and (iii) Fair Competition. To achieve these outcomes, broadly three principles are followed. First, Legal Certainty, which includes a robust definition of regulatory mechanisms with a transparent application of the law through redressal mechanisms. Second, Technology Neutrality, which focuses primarily on the functionality of the service allows for extant regulations to subsume the new FinTech services. Third, Proportionality allows for lower compliance requirements for FinTech services to prevent heavy regulatory burdens which could stifle innovation. In pursuance of these, mainly three approaches are undertaken by the regulators. First, ‘Ignore: Keep it unregulated’ leaves FinTech completely unregulated and the service remains inaccessible to the crowd; Second, ‘Duck Type: Same risk, same rules’ allows for the 'technology neutral’ stance as the application is based on economic functions rather than technology; Third, ‘Code: New Functionality, New Rules’ allows for expansion of the existing regulatory framework to specifically cater to the new functionality arising out of these innovations.
In this paper, I rely on regulatory theory to argue against the restrictive approach of SEBI towards regulating EC. I will do this through the following steps: First, analysing the SEBI regulations in the consultation paper (“SRCP”) to argue that the ‘duck-type’ method proposed falls foul of the proportionality principle; Second, evaluating the inadequacy of the SRCP to be subsumed in ‘duck-type’ regulations due to the lack of consideration of cross-sectoral regulations.
The Proportionality Conundrum
In this section, I analyse the SRCP to highlight two issues (i) the inability of retail investors to be a part of the EC due to the requirements of the regulatory framework and (ii) the inability of the nascent crowdfunding platforms to comply with the regulatory requirements. Through this, I aim to prove that these regulations fall foul of the proportionality requirements as they stifle the growth of the nascent EC industry.
The purpose of EC crowdfunding is to allow a large number of investors to invest in small amounts. This allows (i) companies that are not listed on the stock exchange to raise equity capital and (ii) investors outside the stock exchange to be a part of this funding. The SRCP restricts participation in EC to Accredited Investors or Qualified Institutional Buyers (“QIB”), companies registered in India worth INR two hundred million or more, and individuals with a net worth over INR two million (excluding primary residence). Individuals who do not meet this criterion are allowed to participate if they have a gross annual income of INR one million. It is pertinent to highlight that if these qualification requirements are not undertaken then Information Asymmetry would lead to several inexperienced small investors investing in highly volatile companies. While this classification is important to ensure financial stability, it can exclude retail investors who might not fall into these categories. Moreover, the basis of investment for Accredited investors is done through an analysis of the company’s social and financial standing, which might not be available for risk-based start-ups. This could lead to the inability of many start-ups and SMEs to avail credit through EC. Moreover, following the Companies (Prospectus and Allotment of Securities) Rules, 2014, the SRCP allow for the maximum number of investors (excluding QIBs, companies, and employees) involved in an EC company to be limited to two hundred. The Private Placement Offer Letter submitted by the issuer is circulated online only to selected accredited investors who are registered with the crowdfunding platform and can contribute at least twenty thousand to the company. This prevents the dissolution of power in a company but could create a hierarchy of retail investors who could subscribe to equity shares based on their income.
In other countries seeking to regulate nascent EC like the UK, along with income requirements for certain retail investors, there is also scope for small investors to be a part of the EC. This is possible through a screening process undertaken by Crowdfunding platforms to ensure solvency and knowledge requirements of the investors. I argue that this model would serve to be a better form of regulation because it allows for flexibility in the determination of a potential retail investor rather than restricting a large segment of the population based on their income requirements. This also allows for new and unreputed start-ups to attract investors while ensuring that investors do not subscribe to highly volatile shares. Although many different jurisdictions have models similar to the one proposed by SEBI, the UK model suits India better because (i) the goal of financial inclusion in FinTech regulation and (ii) ensuring the regulation remains proportional to the risk posed by the financial service. This model is more flexible and better meets the goal of proportionality by checking the potential risks case-by-case instead of implementing a blanket ban.
The SRCP divides crowdfunding platforms into three categories (i) Class-I Entities, comprising recognised stock exchanges with a nationwide presence, (ii) Class-II Entities, having a minimum net worth of INR one hundred million and promoted by the state and (iii) Class-III Entities, which must have a net worth of twenty million and a hundred active members. These high capital requirements exclude many crowdfunding platforms from entering the EC industry. Instead of a blanket ban on certain crowdfunding platforms, a distinction can be created between Class III entities and platforms dealing with small issues to allow the upcoming platforms to facilitate EC. However, there should be a requirement for a macroprudential screening layer for these non-Class III entities by the regulatory authorities to prevent fraud and money laundering concerns. This would balance the regulatory requirement of maintaining market integrity without stifling nascent FinTech EC platforms with capital lesser than 20 million.
The Foreign Exchange Management Act 1999 (‘FEMA’) has divided accounts into two categories (i) capital account comprising transactions which alter assets and liabilities for any Indian resident in a foreign country and (ii) current account which handles the non-capital transactions. FEMA also gave the RBI the authority to regulate capital account transactions through the FEMA 2000 Regulation. This prohibits people from selling or drawing foreign currency unless they are so authorised by the RBI. However, because of the blurring of the lines between territories due to the global nature of the Internet, it would be increasingly difficult to ensure the identity of the investor. Moreover, there would be ambiguity about the jurisdiction of these regulatory authorities (RBI and SEBI) in regulating these transactions. Although, the current model followed in donation crowdfunding platforms like Milaap which disallows foreign donations, is a disproportionate form of regulation. Therefore, there is a requirement for (i) expansion in the definition of authorised individuals by the RBI to accommodate EC investors and (ii) cross-sectoral collaboration to ensure that foreign institutional investment along with retail investors is allowed in the EC industry in India.
The proposed regulations on equity crowdfunding in India merely reinforce the rule in Section 42 of the Companies Act, 2013. The SRCP merely serves to introduce the fund-seeking company to the already registered accredited investors. However, after this introduction, companies would be required to perform the same process as required in a standard private placement of securities. This leads to the entrenchment of the existing ‘duck-type’ regulations to ensure market integrity. However, due to the high capital requirements for both investors and crowdfunding platforms, it falls foul of the proportionality principle by disallowing financial inclusion which is a key goal of FinTech regulation. Moreover, there is a general lack of cross-sectoral regulation in India which is exacerbated through an intersection of FEMA and EC in India. This could lead to financial instability if not regulated, however, the current model of a complete ban on foreign investors is a disproportioned response. There is a need to modify the existing securities regulation to make space for EC while ensuring the regulations do not stifle financial inclusion and fair competition.