Thursday, July 31, 2014

Guest Post: Comments on SEBI’s Crowdfunding Paper

[The following post is contributed by Debanshu Mukherjee, a Senior Resident Fellow at Vidhi Centre for Legal Policy, New Delhi]

Last month, SEBI had issued a Consultation Paper on regulating Crowdfunding in India. Vidhi Centre for Legal Policy, a New Delhi based independent and not-for-profit think-tank prepared a detailed response to the Paper and submitted it to SEBI earlier this month.

Crowdfunding, if regulated appropriately can provide an excellent funding alternative for early-stage ventures and cash-strapped small businesses. However, given its vulnerability to ‘regulatory arbitrage’ and fraud, the regulatory framework needs to strike the right balance between protection of investors and promotion of entrepreneurship.

Here’s a summary of some of the key arguments advanced in the Vidhi response:

- Eligible Investors: The consultation paper proposes to allow only a limited class of investors (‘Accredited Investors’) to participate in crowdfunding. Crowdfunding, by definition, is typically aimed at raising funds through relatively small contributions from a large number of people (the ‘crowd’), and not from a small group of sophisticated investors. Since most ‘Accredited Investors’, particularly the Qualified Institutional Buyers (QIBs), are unlikely to invest in early stage ventures (given their exhaustive screening and diligence related requirements), many of those investors may not be interested in crowdfunding at all. The proposed definition of eligible investors should be modified to allow greater participation from retail investors.

- Number of Investors: Limiting the number of potential investors to 200 could severely limit a venture’s fundraising attempts. Given that most QIBs are unlikely to invest through the crowdfunding route, the other categories of investors need to be sufficiently large in number to raise any substantial amount. While allowing a large number of investors to participate in crowdfunding may increase the transaction costs and cause administrative difficulties for the issuer company, such issues can be dealt with by restricting the rights given to shareholders through issuance of shares with differential voting rights and providing for a trustee/nominee to represent the shareholders’ interests. Appropriate amendments to the Companies Act, 2013 and the relevant rules thereunder will be required to facilitate this.

- Disclosure Requirements: A typical venture resorting to crowdfunding is likely to be at a very early stage of its operations and may not have the resources to produce (on its own or by hiring external advisors) the necessary information required for enabling the investors to make an informed decision. Moreover, in the absence of proper legal advice at the time of making disclosures, the issuer company may be at the risk of disclosing intellectual property which could otherwise be legally protected under the laws of patent, etc. It is here that the role of the crowdfunding portal becomes crucial. The crowdfunding portal could hire specialists to enable the issuer to make the necessary disclosures without undermining its legal interests (especially   in relation to product-details and business methods). The portal could then factor the cost of generating this information in its fee (to be recovered after the funding is complete).

- Rating: Though not specifically addressed in the SEBI paper, the crowdfunding regulations may require issuers to obtain a ‘compulsory rating’ from a registered financial analyst about the financial viability of the venture. The regulations may prescribe the methodology for the rating service and require the service providers to be registered with SEBI. In the absence of other traditional intermediaries (investment banks, underwriters, etc.) it is important that independent analysts or business specialists lend their reputation to the issuer company to signal the investors about the viability of the venture. Alternatively, the start-up community could be urged to organise itself voluntarily and develop a self-regulatory system for rating issuers on crowdfunding platforms. Given that many ventures may not have the financial resources to obtain such rating, the cost should be initially borne by the portal (and factored in its fee).

- Funding Portals:  Whilst SEBI understandably proposes extensive regulation of platforms that facilitate crowdfunding, some requirements might be potential deterrents for competitiveness and efficiency in crowdfunding. For instance- limiting the category of entities that can establish funding portals to stock exchanges, depositories, technology business incubators (TBIs) and association of private equity/angel investors is counter-productive. Given that internet and technology companies have defined the crowdfunding experience so far and increased regulations would only require enhanced innovation, capabilities and systems to manage risk control and data protection, the aforesaid entities should qualify as eligible entities for establishing funding portals. Further, networks of entities with past experience and expertise in identifying, funding and incubating potentially successful social ventures/SMEs, should also be permitted. Finally, in order to promote diversification, enhanced capital flows and greater resilience in crowdfunding, SEBI should examine additional measures, including, inter alia, promoting investor education, ensuring inter-operability of funding portals, centralizing the verification of accredited investors and addressing moral hazard concerns.  

- Secondary Sales: In conventional capital markets, it is the existence of a robust secondary market (a stock exchange) that encourages investors to invest in the primary market, i.e., the initial offer. In the absence of an ‘informationally efficient’ secondary market (where the prices of the securities reflect their fair value), investors may not be able to exit at a desired time.  Retail investors are particularly prone to facing personal exigencies, which may require them to liquidate their holdings at any time and exit the venture. Any uncertainty about exit options may discourage investors from making the initial investment in the first place. While a full-fledged secondary market for securities issued through crowdfunding may not be permissible given the regulatory framework for stock exchanges, the discussion forums/ social networks on the funding portal may be used as a platform to facilitate information exchanges between potential buyers and sellers. Any transfer of shares facilitated through such forums may be subjected to separate pricing and anti-manipulation guidelines to ensure that the prices are not manipulated.

As long as the regulatory regime provides for sufficient safeguards to prevent frauds, raising equity capital through crowd-funding may go a long way in unlocking the true potential of early-stage ventures. Having said that, crowdfunding transactions are susceptible to frauds and regulatory arbitrage. Regulatory arbitrage occurs when the regulated entities take advantage of the variations between two or more regulatory regimes by subjecting themselves to a system that involves lesser costs or compliances. Allowing companies to raise funds through crowdfunding may create such arbitrage opportunities for transactions which could otherwise be subjected to SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, SEBI (Collective Investment Scheme) Regulations, 1999, the AIF Regulations or the Foreign Contribution (Regulation) Act, 2011. In view of the above, issuance of securities through crowdfunding may be introduced in a phased manner to gauge its suitability for the Indian markets. Companies in sectors with dynamic entrepreneurial activity could be allowed to raise money through crowdfunding on a pilot basis (for instance, in the technology sector), before introducing this on a wider scale.

Vidhi’s detailed response to the SEBI paper can be downloaded from its website:  (the report is prepared by a Vidhi team comprising Debanshu Mukherjee, Shubhangi Bhadada, Aditi Singh and Ketan Paul).

- Debanshu Mukherjee

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