An Analysis of the Concept of Crowdfunding in India

Paper Details 

Paper Code: RP-VBCL-18-2024

Category: Research Paper

Date of Publication: April 20, 2024

Citation:  Ms. Rochani Rao, “An Analysis of the Concept of Crowdfunding in India", 1, AIJVBCL, 282, 282-294 (2024), <https://www.vbcllawreview.com/post/an-analysis-of-the-concept-of-crowdfunding-in-india>

Author Details: Ms. Rochani Rao, Asst. Professor of Law, RV Institute of Legal Studies, Bangalore, Karnataka, India.

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ABSTRACT

Crowdfunding is a financial strategy used by many new companies and independent ventures. It is an easy way of raising funds. It is a method where multiple individuals raise small investments over the internet for a project venture. By publishing a consultation paper in 2014, SEBI has suggested a framework for introducing equity crowdfunding in India by granting capital market access to small enterprises. SEBI has shown some interest in developing a market for crowdfunding in India. However, as we contend, SEBI's plans include significant restrictions and demanding requirements, which have the opposite impact of what they were intended to do-promote the expansion of crowdfunding in India. Furthermore, SEBI has not indicated if a certain regulatory framework will be implemented since its consultative attempt in 2014. Crowdfunding is a manner of raising funds for a venture or project through the Internet. It is a way of raising capital from a large number of individual investors. Social media and websites are the primary platforms for crowdfunding. This crowdfunding helps Startup companies.  The first company to engage in this business model of Crowdfunding was the U.S. website Artist Share. According to the definition given by SEBI in its consultation paper, crowdfunding means soliciting funds or small amounts from multiple investors through web-based platforms or social networking sites for a specific project, business venture, or social cause. In India, crowdfunding was done in the scheme of Dhirubhai Ambani in making Reliance Industries. Crowdfunding can take place in many ways also.    This concept is new to the Indian market but is growing rapidly after covid. In 2014, SEBI (Security Exchange Board of India) released a consultation paper regarding crowdfunding.  And SEBI has also given fee rules and regulations to govern this. Crowdfunding aims to help start-ups and small and medium enterprises to raise capital from multiple individuals over the internet. This has many advantages, but how far is it safe? And who will regulate it and what happens if it is not handled is a present question. But if this is not controlled properly, it will lead to many illegal practices and fraud. This paper discusses the importance, challenges, and procedures of crowdfunding, guidelines given by SEBI, and regulations imposed on them. It also analyzes whether those guidelines are properly implemented or not.

Keywords: SEBI, Crowdfunding, startups, consultation paper, regulation, capital.

INTRODUCTION

When it comes to raising funds, start-up businesses have limited options since they infrequently have access to venture capital, angel investment, or other more traditional types of financing. This is especially true for start-up businesses in highly competitive sectors that have a high chance of failure. The 2008 global financial crisis added to this financing shortfall.[1] Around this period, crowdfunding emerged as a desirable alternative method of raising financing for startups by using technology (particularly the Internet) to acquire funding from the "crowd."[2] Since then, while crowdfunding has experienced exponential growth, it has also run into regulatory hurdles in the nature of securities regulations which may prevent it from reaching its full potential. Crowdfunding is the process by which a business or entrepreneur generates capital through a large number of small contributions from people using the Internet for mass communication. In most cases, a website that facilitates crowdfunding is used to raise money.[3]

TYPES OF CROWDFUNDING

Although there are many different forms of crowdfunding, they can be categorized into two main groups. In one, people could contribute money to a company's idea either without expecting a financial gain, which is like donation crowdfunding, or in exchange for a set number of good or service whose development they are sponsoring, which is like reward crowdfunding.[4] On the other, a business or entrepreneur might get capital in the form of a loan without interest which is like peer-to-peer lending, or in exchange for an ownership position in the enterprise, which is equity crowdfunding. Greater regulation is imposed on the second type of crowdfunding.[5] This is because the donors have financial interests in the venture that they have supported. Peer-to-peer lending is closest to banking in terms of regulation, while equity crowdfunding entails investing in a firm and is, therefore, subject to securities regulation. At the same time, different forms of crowdfunding could raise distinct legal concerns. Start-ups are benefited from equity crowdfunding. That is because it allows them to reach a large audience of potential investors, and given the power of the Internet, those investors can be located anywhere in the globe. It aids them in getting over the restrictions of earlier types of finance. Additionally, it helps investors because it democratizes the investment process by opening up chances to all investors.[6]

The 2013 Companies Act significantly tightened the regulations in India governing corporate fundraising. Fundraising offers will be considered public offers and they also subject firms to a wide range of disclosures and compliances unless they are made to a very small group of participants.  A number of incidents involving corporate groups seeking millions of dollars in investments from thousands of investors under the false pretense of private placements without adhering to the requisite legal standards led to the creation of such a rigorous regime. By publishing a consultation paper in 2014, SEBI has suggested a framework for introducing equity crowdfunding in India by granting capital market access to small enterprises; SEBI has shown some interest in developing a market for crowdfunding in India. However, as we contend, SEBI's plans include major restrictions and onerous requirements, as a result of which they have the opposite impact of what they were intended to do—promote the expansion of crowdfunding in India. Furthermore, SEBI has not indicated if a certain regulatory framework will actually be implemented since its consultative attempt in 2014.

It is essential to consider the benefits and risks of crowdfunding while regulating it in order to strike the right balance. Such crowdsourcing has evolved as a practical alternative to current forms of start-up financing. It is advantageous to start-ups as well as to potential investors who may like to participate in the financial success of such enterprises. Equity crowdfunding, on the other hand, comes with a lot of dangers, especially for investors.

ADVANTAGES OF EQUITY CROWDFUNDING

Equity crowdfunding benefits both business owners and crowd investors greatly because it offers a practical alternative method of starting businesses.

●       Startups and their founders can access investors outside of their personal networks and relationships by using crowdfunding to raise capital. They can get funding from a wider range of investors from different geographical locations by using the Internet.[7] Due to the decreased cost of such finance, crowdfunding provides startups with an accessible and alluring means of acquiring money.[8]

●       By asking potential customers to invest in the financial future of such ideas, crowdfunding also enables start-ups to test their ideas on the market. The "wisdom of the crowd" would give a solid indication of how well the start-up's product or service was received. All of these are anticipated to create an environment that is favorable to entrepreneurship and, ultimately, economic growth.

●       Crowdfunding has advantages for the general public in addition to startups. Until recently, start-up investments were exclusively available to wealthy and experienced investors. Crowdfunding enables a larger community of investors to participate in start-ups' success by increasing access to investments beyond such investors, known as "accredited investors" in securities legislation.

RISKS OF EQUITY CROWDFUNDING

●       Risk of making an early-stage firm investment. There is a danger of failure inherent in start-up businesses. According to failure statistics, almost 50% of newly established companies fail within the first five years—for example, the fair trade soap manufacturer Bubble and Balm. Through the equity crowd-funding website Crowdcube, which is situated in the United Kingdom, raised GBP 75,000 in 2011. It gave 15% of the company's equity in exchange. The company abruptly shut down in July 2013, leaving contributors stranded. The contributors ultimately lost everything they had invested.[9]

●       The second danger is related to the investment's illiquidity. Securities raised through crowdfunding are not traded on stock exchanges or crowdfunding websites. As a result, investors are unable to regain their investments by selling their assets on the market. Investors are likely to be trapped with their money without seeing a return because investments in start-ups are unlikely to produce dividends for a very long time.

●       The third danger is a total fraud, which is brought on by an informational imbalance, a lack of transparency, and the relative inexperience of crowdfunding investors. Startups and their founders will have access to important information about the state of their company that investors do not. Additionally, when investing in a project that is crowdfunded, investors typically only rely on the fundraisers' claims and do not conduct their own research on the company they are backing. Asymmetry in information, a lack of transparency, and the relative inexperience of crowdfunding investors all contribute to the final threat, which is total fraud. In contrast to investors, startups and their founders will have access to crucial information on the state of their businesses. Additionally, when funding a project using a crowdsourcing platform, investors frequently rely on the claims made by the fundraisers and do not research the company they are supporting.[10]

THE LEGAL FRAMEWORK OF CROWDFUNDING

In most countries, crowdfunding would be considered a public offering of securities because it includes gathering money from a range of investors. As a result, complete compliance with the prospectus and other regulations would be necessary. As a result, start-ups would find it prohibitively expensive and unable to use that strategy for generating money.

It would be necessary to set out a distinct regime under securities legislation to permit crowdsourcing in order to allow a larger pool of investors, including non-accredited investors, to invest in these start-ups. Consideration must be given to the dual goals, which are of conflicting nature, that is, to encourage economically advantageous start-up activity while maintaining investor protection when developing the proper regulatory framework for crowdfunding. In a "win-win" scenario, the advantages of crowdfunding would be realized while the risks were reduced.

CATEGORIES OF LEGAL REGIMES THROUGHOUT THE WORLD 

Three major categories can be used to group the manner in which equity crowdfunding is regulated in different countries throughout the world.  In the first category, the regulatory framework reaffirms the current regulation on corporate fundraising while outright banning equity crowdfunding. The second concerns nations that have started to accept this unique mode of capital raising and consider it as a public offering of securities, though with proper exclusions. Using the third method, several nations have enacted policies that are specifically designed to promote this type of funding without, at least technically, undermining investor protection.[11]

●       Prohibition of Crowdfunding:

Hong Kong is an excellent illustration of a jurisdiction that supports its current legislation banning fundraising through techniques like equity crowdfunding. The Securities and Futures Ordinance, 2002 ("SFO") establishes rules for the industry and market for securities and futures and regulates financial product-related activities and investor protection in Hong Kong. The SFC has clarified its intentions by issuing a notice that alerts participants in crowdfunding-type activities to the potential risks involved. These risks include default, illiquidity of the investment, platform failure and insolvency, fraud, and those connected to platforms operating outside of Hong Kong, information asymmetry and lack of transparency, cyber security concerns, and potentially illegal activities.

●       Creating Exemptions:

Some countries have taken a more flexible approach toward equity crowdsourcing and have established particular exemptions to the laws governing public securities offerings. Many nations are taking inspiration from the Jumpstart Our Business Startups Act of 2002 ("JOBS Act") in the United States ("US"). This is the favored approach for regulating equity crowdfunding. This exemption makes it possible for new companies and small businesses actually to reach their target market. The CROWDFUND Act was implemented by the SEC in the form of Regulation Crowdfunding, enacted in 2015 and enacted in May 2016.[12] Australia is another nation that uses the exemption strategy to include various types of crowdfunding. While most capital raising methods require comprehensive disclosures in the form of prospectuses, there are two exceptions to the rule: (i) offers made to experienced investors and (ii) small-scale offerings.

●       Comprehensive Legislation:

A limited number of nations have developed legislation that is specifically designed to promote equity crowdfunding while emphasizing investor protection. Italy was one of the first countries to adopt a specific regulation on equity crowdfunding. Crowdfunding is expressly permitted by law to encourage the growth of "innovative start-up companies." The law particularly mentions innovative start-ups, which is intended for enterprises with a solid connection to innovation and technology rather than simply any new business. The Commissione Nazionale per le Società e la Borsa ("CONSOB"), Italy's securities regulator, further formalized this in a series of regulations that allow "the collection of risk capital on the part of innovative start-ups via online portals”[13]. The portal has been given a large portion of the responsibility for shareholder protection. Outlets must register with the CONSOB and continuously adhere to standards of professionalism and integrity. The Financial Markets Conduct Act of 2013 also controls how financial products are developed, advertised, and marketed in New Zealand and the ongoing obligations of those who provide, deal with and trade in them. It expressly permits intermediate service providers, such as portals, to get Act licensing. This licensing system aims to make it easier for crowdfunding services to operate legally in New Zealand. Offers made by authorized intermediaries are exempt from the disclosure requirement. Additionally, the Financial Markets Conduct Regulations, 2014 define crowdfunding services and specify requirements for portals applying for a license to offer these services.

As seen in Italy and New Zealand, comprehensive regulation has the advantage of attempting to address the unique characteristics of crowdfunding, such as the fact that securities representing small amounts are offered and issued to a large group of investors, which necessitates advertising using the Internet and new-age media with few restrictions. They more accurately capture the spirit of crowdsourcing in that regard.

CROWDFUNDING REGULATION IN INDIA

Right now, equity crowdfunding is possible due to the regulatory environment. More specifically, the path of regulatory reforms has moved it in a direction that is incompatible with the requirements of a friendly regulatory system for crowdfunding, leading to stricter oversight and limits on the sales of shares by enterprises. The objectives of investor safety are prioritized over the promotion of the crowdfunding industry in the formulation of the present Indian rules. The laws of the Companies Act as well as the SEBI Act of 1992's regulations, apply to a company's offer of securities in India. Under the previous Companies Act of 1956, a firm could only offer securities to the public through a prospectus, with the securities having to be listed on a recognized stock market to give investors liquidity.

This compelled companies to go through a lengthy, expensive, and time-consuming process of going public, which was especially necessary for small businesses. Since they were targeted offers made to particular individuals and the number of offerees did not exceed 49, private placements of securities were exempt from these onerous regulations (Companies Act, 1956: section 67). This effectively turned any offer made to 50 or more people into a public offering. As a result, crowdfunding in its typical form was not allowed under that system. India saw multiple scandals involving unlawful securities offerings by some corporations when the Corporations Act was being revised. These scandals had a more significant impact and fundamentally altered the direction of securities regulation reform.[14]

CROWDFUNDING SCANDAL

●       The Sahara Case:

In the Sahara case, for the first time court held that the act of the Sahara company has resulted in crowdfunding. Sahara India Real Estate Corporation Ltd. & Ors. v. Securities Exchange Board of India & Anr[15], in this case, Sahara India Real Estate Corporation Limited (SIRECL) and Sahara Housing Investment Corporation Limited (SHICL), two unlisted firms in the Sahara Group of firms, intended to raise money by issuing optional fully convertible debentures on a private placement basis. The Sahara firms' Red Herring prospectus stated that they had no plans to offer these securities on any reputable stock exchange. The Sahara companies believed that the prospectus would only need to be filed before the Registrar of Companies and not the Securities and Exchange Board of India because the OFCDs were not intended to be listed.

A million agents and 3,000 branch offices distributed the information memorandum, which served as a preface to the prospectus, inviting more than thirty million people to subscribe to the OFCD. The Securities and Exchange Board of India believed that this qualified as a public offering and, as it processed the request for draught RHP (DRHP) submitted by Sahara Prime City Limited, a different Sahara group company, for its initial public offering, took note of the distribution of the information memorandum. Sahara Prime City Limited aimed to collect up to INR 30 billion through the IPO at the time to finance its numerous housing projects nationwide. It was obligated to include information on its group firms' financing in its red herring prospectus. Following the publication and notification of the red herring prospectus, SEBI has got public requests and objections. Many complaints were received regarding the information disclosed on Sahara Prime City Limited's group firms, including SIRECL[16] and SHICL[17]. These accusations claimed that Sahara Prime City Limited was unaware that SIRECL and SHICL had been selling convertible bonds to the public across the nation for several months. Even though SEBI repeatedly asked the Sahara firms for clarifications on the matter of the OFCDs, the Sahara companies refused to provide the information requested by SEBI. Finally, SEBI opened an inquiry and issued a final ruling on June 23, 2011. SEBI came to the conclusion that neither SIRECL nor SHICL had given OFCDs through a "private placement" and that the issue of the OFCDs actually amounted to a public issue, which would fall under SEBI's purview. The Sahara firms first filed an appeal with the Securities Appellate Tribunal, and after that appeal was rejected, they filed a petition with the Supreme Court of India.

Whether the OFCDs issued by SIRECL and SHICL were by means of a "private placement" as claimed by the Sahara Companies on appeal or by way of an invitation "to the public" as counterclaimed by the SEBI was one of the questions that, among other things, came before the Supreme Court of India. And the court held it as a public offering, not a private placement.

CONSULTATION PAPER BY SEBI REGARDING CROWDFUNDING

In terms of broad policy, SEBI's Consultation Paper emphasizes the need to "strike a balance between retail investor protection and capital market access" for small businesses and start-ups. It also warns that the crowdfunding market will be severely restricted if regulatory provisions geared toward investor protection are too strict. In order to warn from their experience, SEBI also takes into account the regulatory framework in several other countries while developing suggestions for crowdfunding in India. Here are some of SEBI's most important recommendations and evaluate how well they achieve the right balance.[18]

●       Eligibility criteria for issuers:

As a result, SEBI has established a set of requirements that companies must meet to use the crowdfunding option. These requirements include that the issuer be listed and have a tenure of at most 48 months, that it not be a member of a bigger industrial group, and that the total size of the offering not be greater than INR 100 million. Other requirements for disqualification are listed, such as the issuers' or their controllers' compliance with corporate and securities laws. These terms are reasonable and aid in striking the necessary balance between encouraging crowdfunding and safeguarding investors.

●       Nature of the investors:

SEBI has taken quite a strict approach when it comes to the qualifications of the investors. According to its suggestions, only "accredited investors"—QIBs, high-net-worth businesses with a minimum net value of INR 200 million, and high-net-worth individuals with a minimum net worth of INR 20 million—are permitted to participate in crowdfunding. In essence, these are wealthy investors who are willing to accept the risks associated with crowdsourcing.

●       Limitations on investment and offer:

Additionally, SEBI's designs establish personal investment limitations for crowdsourcing. SEBI has established minimum funding limitations.

●       Procedures and Disclosures:

A company must apply to a crowdfunding platform in order to be screened and put through due diligence if it fits the requirements for eligibility for crowdfunding. Once approved, the company's information and the amount of money needed may be placed on the crowdfunding website. Accredited investors then use the platform to research and assess the business and its financial needs. If there is sufficient interest in the company, it may then send a private placement offer letter to the potential investors.

Regarding information disclosures, companies are required by section 42 of the Companies Act of 2013 to disseminate information similar to that of a private placement offer letter. These disclosures include an explanation of the current or new venture for which the funds are being raised, the target offering amount and intended use of the funds, a description of the valuation of the securities offered, a history of prior funding, if any, essential financial information about the company, ownership and governance structures, and the key business risks for the issuer.

Analysis of SEBI's proposals shows that they are unlikely to encourage the development of a crowdfunding sector. Small enterprises and start-ups find it difficult and expensive to use crowdfunding due to the stringent criteria enforced.

CONCLUSION

In recent years, equity crowdfunding has gained popularity. Given India's enormous population, the country's crowdfunding potential is limitless.[19]. Any regulatory action has the potential to either strengthen or undermine crowdfunding. In the end, authorities must balance investor protection on the one hand with the growth of startups and small enterprises on the other. Equity crowdfunding has been effectively eliminated since the Indian Parliament and its securities regulator, SEBI, have erred on the side of caution and are heavily in favor of investor protection. This is not surprising given the significant scandals that preceded the most recent round of regulatory reforms.

The proposed SEBI regulations lack two crucial elements. Peer-to-peer lending is the first. Peer-to-peer lending involves a borrower looking for money on a debt basis, a group of creditors who agree to lend the borrower money, and a middleman who decides to put the loan arrangement together for a fee and under predetermined terms and conditions. The crowdfunding platform is the typical mediator in this scenario. Although debt-based crowdfunding is mentioned in the SEBI consultation paper, the same procedures as for equity crowdfunding would be used, with exceptions. Cross-border crowdfunding is the second element the proposed SEBI regulations do not address. Subject to current inward and outward-bound investment restrictions and policies, it would be possible for a foreign company to raise money in India and for foreign investors to participate in crowdfunding operations there. However, given the nature of crowdsourcing and the internet's global accessibility, investors from India may participate in crowdfunding initiatives in other countries. The intriguing topic of whether SEBI's role in defending such investors goes beyond Indian boundaries is raised.

[1] Andrew A. Schwartz, Inclusive Crowdfunding, (2016) UTAH L. REV. 661.

[2]Mark Methenitis, Evan Fitzmaurice, Ryan Barrett & Patrick Holleman, Crowdfunding, 16 SMU Sci. & TECH. L.  (2013) REV. 59.

[3]Majumdar, Arjya and Varottil, Umakanth, Regulating Equity Crowdfunding in India: Walking a Tightrope . In P.M. Vasudev and Susan Watson (eds), Global Capital Markets – A Survey of Legal and Regulatory Trends (Edward Elgar 2016), Available at SSRN: https://ssrn.com/abstract=2804427 .accessed on July 4, 201.

[4] Lloyd Hitoshi Mayer, Regulating Charitable Crowdfunding, (2022) 97 IND. L.J. 1375 .

[5]Sharath Chandupatla & Manal Shah, Peer-to-Peer Lending and Equity-Based Crowd Funding - Status Quo and the Leap Forward, (2019) 9 NIRMA U. L.J. 97

[6]Jennifer Y. Poon, Walter Stuber, Daniel Rodriguez Bravo, Juha Koponen, Mark Falcon, Ravi Kini, Ken Kiyohara, Daniel Winterfeldt & Walter Van Dorn, International Securities, and Capital Markets, 51 ABA/SIL YIR (n.s.) 281.

[7]Tayyaba Barqi, Crowdfunding and Intellectual Property Rights, 1 LAW Essentials J. (2021) 32 .

[8]David Groshoff, Equity Crowdfunding as Economic Development, 38 CAMPBELL (2016) L. REV. 317 .

[9] Danny Quah, Insolvency of Crowdfunding, 14 Insolvency & Restructuring  (2020) INT'l 60.

[10]Cody R. Friesz, Crowdfunding & Investor Education: Empowering Investors to Mitigate Risk & Prevent Fraud, 48 Suffolk U. L.  (2015) REV. 131.

[11]Christian Hofmann, An Easy Start for Start-ups: Crowdfunding Regulation in Singapore, 15 (2018) BERKELEY Bus. L.J. 219

[12]Edan Burkett, A Crowdfunding Exemption - Online Investment Crowdfunding and U.S. Securities Regulation, 13 Transactions: (2011) TENN. J. Bus. L. 63 .

[13]CONSOB Regulation 2013.

[14] Stuti Shah, Equity Crowdfunding in India: Towards a Regulatory Framework, 4 RGNUL FIN. & MERCANTILE  (2017) L. REV. 168.

[15]Sahara India Real Estate Corporation Ltd. & Ors. v. Securities Exchange Board of India & Anr(2013) 1 SCC 1

[16] Ibid

[17]Ibid

[18]Jasmine Khan & Ummey Kulsum Khan, Crowdfunding in India and Its Regulation: A Critical Analysis of SEBI's Consultation Paper on Crowdfunding, 3 (2020) INT'l J.L. MGMT. & HUMAN. 2100 .

[19]Dana Brakman Reiser & Steven A. Dean, SE(c)(3): A Catalyst for Social Enterprise Crowdfunding, 90 (2015) IND. L.J. 1091 .