Crowd funding, also popularly known as crowd financing or equity crowd funding, could broadly be described as the raising or pooling of monies by a group of people, driven by common goals/objectives and trust to support an effort initiated by like-minded people or organisations.
The medium of collaboration and raising of monies is usually the internet and given the prevalence of social networking, which is enmeshed in our day-to-day lives, it is not a far-fetched idea that this hyper-interconnectivity shall drive our lives and economy to a large extent in the years to come. In the past, crowd funding has been used for disaster relief, movies, funding startup companies, music by upcoming artists, etc. In return, the investors may get CDs, customised memorabilia, special tickets to shows, special fan sneak peeks, etc. Crowd funding has often been used by small startup companies to raise capital, for which a certain amount of equity may be issued to the investors. The money is usually raised through social networking or specialised crowd funding websites like start.ac, kickstarter.com, indiegogo.com amongst others. To give an indication of its success in the U.S., I would like to lay forth a few facts and figures.
Till date, kickstarter has launched more than 63,000 projects, out of which more than 24,000 have been successfully funded, giving the website a success rate of 44 per cent. All these projects have collectively received more than $280 million. Some of the most successful projects under kickstarter platform have been Pebble (an e-Paper watch for iPhone and Android phones), which amassed more than $1 million and Double Fine Adventure (a video game developed by Double Fine, company involved in the production, promotion, and distribution of the video games), where a staggering $ 3,336,371 was raised. Another website indiegogo, which was founded in early 2008, has launched 100,000 projects from more than 196 countries and has raised around $16.5 million in total.
Though crowd funding has not kicked off in a real sense in India, websites like wishberry.in, which is broadly designed after kickstarter and provides a platform for projects to get access to contributions, has already made inroads into the heavily networked Indian population, mostly urban, eager to be a part of a cause they believe in or be part of a core fan group by paying a small amount.
Furthermore, due to a common belief in the business, enterprise or idea, the participation of the crowd funding ‘investors’ in a start-up company is much more collegial and passionate than what may be the case with a VC or an angel investor, which in most cases is driven by IRR goals and a definite exit horizon. In this article, I shall focus on the possible regulatory issues that may affect crowd funding in India, wherein shares or securities are issued to investors by the fund raising company and the current regulatory position in the US.
The Indian regulatory framework
As we’ve see, although there is a lot of buzz around crowd funding as an alternate investment opportunity for startup companies, in the Indian market, a few regulatory hurdles could be major impediments to its success. The first and the most significant issue arise from Section 67 of the Indian Companies Act, 1956. Section 67 requires that in case an offer or invitation is made to 50 or more persons for the issuance of securities, such an offer could fall within the purview of a ‘public offer’, requiring a prospectus and associated compliances, including listing of such securities on a recognised stock exchange, which could be quite meaningless for a startup. The company can stay out of the purview of this section by making distinct offerings, each of which offering is made to less than 50 persons. However, a company may not be out of the woods by merely making the offer to less than 50 persons. It may be noted that under Section 67, if the offer or invitation to subscribe for shares can be accepted only by persons to whom it is made, then it shall not be regarded as an offer to the public. However, typically in case of crowd funding, the offer or invitation is made through the internet to unknown and not specified persons, and hence, there would typically be no ability to control the number of offerees.
In this regard, we also need to look at the Securities Appellate Tribunal’s (SAT) order dated October 18, 2011, with respect to the issue of securities by two Sahara Group companies, both of which were unlisted, to more than 30 million persons. The Indian securities regulator, the Securities and Exchange Board of India (SEBI), in its order dated June 23, 2011, had found that the companies had raised sizable amounts of money from the public without adhering to norms governing public issues in India in relation to disclosure and investor protection. One of the main findings of the SAT in its order was that a private placement is made to a handful of known persons whose number is less than 50 and therefore an issue to more than such a number is a public issue. The SAT observed that in the current case the companies had made a ‘public issue’ by approaching more than thirty million investors, but by avoiding the requirements of the law. SAT expressly stated in this regard- “the fact that information memorandum was circulated to more than thirty million persons through ten lakh agents and more than 2,900 branch offices is nothing but advertisement to the public”. Another important issue deliberated upon by the SAT was whether the SEBI has jurisdiction to regulate unlisted companies.
SAT held that SEBI has jurisdiction over unlisted companies too as long as the same can be said to be ‘persons associated with securities market’. Therefore, so long as the unlisted company is making a ‘public offer’, as discussed above, SEBI shall have jurisdiction to regulate it. The SAT also went on to state that when it comes to regulating the securities market and protecting the interests of investors in securities, the SEBI Act, 1992 , is a standalone enactment and SEBI’s powers under it are not fettered by any other law including the Companies Act.
Going by this order of the SAT, which has been appealed to before the Supreme Court and is currently sub judice, raising of funds by companies (even if they are unlisted) through the internet using crowd funding, where the number of investors to whom securities are being issued is 50 or more who are not specified, may be termed as a public offer and hence attract stringent and onerous compliance requirements including listing of such securities on a recognised stock exchange in India.
Another issue that we need to keep in mind while analysing the regulatory framework for crowd funding is whether the internet websites that offer/deals in these securities shall require registration as an intermediary who may be associated with securities market under the SEBI Act, and hence subject to the SEBI (Intermediaries) Regulations, 2008, and other securities regulations. More specifically, Section 12(1) and (2) of the SEBI Act states that no intermediary who may be associated with securities market shall buy, sell or deal in securities, except in accordance with the conditions of the certificate of registration obtained from the SEBI as per the SEBI Act and the Regulations. “Securities”, as defined under the Securities Contracts (Regulation) Act, 1956 (“SCRA”), includes shares of any incorporated company and includes rights or interest in securities as well. Going by this definition, if securities are being issued by a company, which is raising funds through the crowd funding website, in all probability, the website may be considered as an intermediary dealing in securities, which is bringing the fund raising company and the investors together and hence may require a certificate of registration from the SEBI. In addition, such intermediary shall be bound by the norms listed in the Regulations including making regular disclosures, maintenance of books, accounts and records, ensuring redressal of investor grievances, appointment of a compliance office, abiding by a code of conduct specified in the Regulations and being subject to scrutiny and inspection by the SEBI. From a reading of these related legislations and sub-ordinate legislations, it seems like the website offering services to bring the crowd and the investee company together resulting in issuance of securities may be considered an intermediary and be subject to registration requirements and other ongoing compliances, which may or may not be palatable to most such service providers.
The US regulatory framework
While discussing the regulatory framework that governs crowd funding in India, I believe it is pertinent to briefly discuss the recent regulatory changes introduced in the US as well. On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), which is a law designed to encourage funding of small businesses without the need to adhere to various existing securities regulations issued by the US securities regulator, the Securities and Exchange Commission (SEC). What is interesting to note is that the JOBS Act specifically deals with crowd funding as well and provides an exemption from the requirement to register public offerings with the SEC for some small offerings, subject to certain conditions. The JOBS Act has amended the Securities Act of 1933 by adding an exemption to Section 4, whereby transactions involving the offer or sale of securities by an issuer would be exempt from the requirement of filing a registration statement provided certain conditions relating to the aggregate amount sold by the issuer during the previous 12-month period and the aggregate amount sold to any investor during the previous 12-month period are met. It has also been clarified that an intermediary shall not be required to register as a broker under SEC Act of 1934 with respect to transactions relating to crowd funding, giving a much needed breather to such websites.
It should also be noted that the SEC has not given a carte blanche to the crowd funding websites to raise funds from investors without any duty of care or reporting requirements to the SEC. It has added a few requirements under Section 4A of the Securities Act, which needs to be complied with by the intermediaries in order to qualify for the crowd funding exemption like warning investors of the speculative nature of the investment, carrying out background checks of the issuer’s principals, taking reasonable measures to reduce the risk of fraud, maintaining proper books and records, refraining from offering investment advice, providing the SEC with notice of the offering including the stated purpose and intended use of the proceeds of the offering and the target size, and providing the SEC with continuous investor-level access to the intermediary’s website. It has also been clarified that in the absence of an intermediary, the issuer would still have to comply with these requirements, hence placing the onus of complying with these requirements on the company even if no intermediary is involved in the crowd funding exercise.
This development in the US has come as a shot in the arm for the crowd funding industry and we are bound to see exponential growth in funding of start-ups, which would not have otherwise been able to raise funds or may have been reluctant to do so due to regulatory requirements or fear of the loss of their freedom in the way they may be running their companies.
Though the potential for crowd funding to change the investment landscape in India and provide a cheap and effective form of investment for small start-up companies is very high, unless the regulatory framework in India is effectively addressed, as has been done in the U.S., the proverbial Damocles Sword of registration, restrictions and on-going onerous compliance requirements shall keep hanging on the websites propagating crowd funding and the companies wishing to raise funds through this channel. The need of the hour is for the Indian government and regulators to carve out specific exemptions for crowd funding in applicable Indian legislations, of course with effective checks and balances, to ensure that regulations enable wealth generation, rather than act as an impediment to it.
(Prashant Kataria is the Principal, Lexygen, a Bangaore based law firm focused on private equity/venture capital, M&A and general corporate transactions.)