[The following guest post is contributed by Nikunj Agarwal, who is a 3rd year student pursuing the B. A. LL.B. (Hons.) course at RML National Law University, Lucknow. He can be contacted at firstname.lastname@example.org.
In this post, the author considers the regulation of a specific type of intermediary involved in crowdfunding, viz. the funding portals. This follows a previous guest post on a related topic that deals with the overall regulation of equity crowdfunding in India]
Intermediaries are essential to a capital market system. In crowdfunding transactions, the project, also called “campaign”, is listed on a “funding portal” which acts as an intermediary to the fundraising process. The portal provides a platform for the investment or donation of money. But, most importantly, given the concept of crowdfunding, which involves smaller sums of money pooled from a large number of people, a funding portal provides access to the potential investment, lending, or donation.
A simple web search would reveal the emerging crowdfunding-portals in India. Thus, the need for regulation of crowdfunding portals, the web-based crowdfunding intermediaries, is necessary. In the absence of regulation, money is being pooled from people without any statutory protection to these investors or altruists, and without any accountability of the fund raisers and campaign advertisers.
The aim of this post is to point out the concern areas which the regulation must address. The relevant issues demand immediate attention of the capital markets regulator
Basis for Regulating Intermediaries
The crowdfunding regulations, even if premised on long established theories, assumptions and legal principles, must still be innovative. This is essential given the Internet based ecosystem of crowdfunding. Such feature may facilitate schemes like short-term licensing by the capital markets regulator to use a crowdfunding portal and simultaneous record of such a license with the capital market regulator. Such record could then be made publicly accessible by listing it on the SEBI website or any other authorized portal. Such innovation, as stated earlier, is particularly effective given the Internet based structure of crowdfunding.
The Essence of Regulation
An effective ‘set of obligations’ upon such intermediaries to perform due diligence, background check, fundamental disclosure requirements and similar matters is the need of the hour, which demands public regulation. These obligations would ensure that ‘blind listing’ is discouraged and more responsible project-listing takes place. But, any set of obligations imposed upon these intermediaries would have to correspond to the fact that start ups raising seed capital may or may not have a successful, or any, business track record given the early stage of commercial evolution. Thus, the disclosure obligations would have to be reasonable and substantially lesser as compared to the disclosure requirements for the purposes of public issue of equity or debt instruments.
A scheme of registration of crowdfunding portals with the capital market regulator may be implemented so that an investor can verify the funding portal’s details on the website of the regulator before entering into a crowdfunding transaction. This may involve assigning a unique identification number to the intermediary.
Another obligation could be to introduce a standard of ‘analysis and satisfaction’. Under this standard, the intermediary could be required to undertake due diligence of the fund raiser and issue a statement to the effect that the funding portal has conducted such an assessment. Additional obligation for any ‘misrepresentation ’or ‘fraud’ attributable to wrongful assessment by the intermediary could also be imposed. Certainly, the burden of this assessment must be meaningful and more than the paper formality of asking the fund raiser a set of predetermined questions.
These would ensure that the crowdfunding participant, who may not be capable or willing to conduct an elaborate analysis of the fund raiser, does not suffer due to lack of any form of scrutiny at any stage. Moreover, since the intermediary-portals possess the economic incentive of listing a project on their platform, the cost burdens of such obligation must be borne by the intermediaries. This does not dilute the liability of the fund raiser to make the disclosure, which obligation may be created additionally.
Relationships and Obligations
It would also be interesting to explore what kind of relationship exists between the intermediary and the investor if the intermediary undertakes obligations as to the averments made upon the portal in relation to the project and the investor operates upon those representations. Would the relationship change based upon the nature of the contribution to the fund e.g.: donation, lending or investment?
Crowdfunding regulations must, therefore, establish statutory relationship between the portal and the fundraiser; and between the portal and the investor, lender or the donor. Whether the funding portal would be considered an agent of the fundraiser while making representations in reference to the fund raising campaign and whether such portal would owe any fiduciary obligations to the user of such portal are important concern areas.
Another obligation which might be imposed upon the intermediaries is ‘obligation of honest representation’. The obligation may appear normative and a good conduct recommendation but given the nature of claims made by the crowdfunding portals, it is relevant that the regulation discourages untrue statements even if they were elaborate bluffs. Given that there might be absence of credible benchmark to reflect the credibility of the intermediary platform, such a ‘fair-play obligation’ may serve to bridge the gap.
Classification of Intermediaries
The intermediaries operating in crowdfunding may be classified based upon the functions they perform. Some funding portals may act only as listing avenues which inform the potential investor of the investment opportunities. Others might serve the rating or certification function which might undertake to ‘recommend’ some projects over the others. Such recommendation is to be differentiated from mere ‘priority listing for consideration’ which then must not include a statement of credibility or recommendation for the project.
Therefore, since the intermediaries can serve different roles, the regulations must not burden a portal with the performance of such functions which it would have not taken as a business activity sans the regulation. Thus, a regulation demanding due diligence and credibility grading by the portal where such portal is intended only to be a listing portal can be indirectly establishing a rigid standard business structure for the intermediaries.
Independence; Conflicts of Interest
Independence of the funding portal from the listed project is a crucial consideration. This would prevent a funding portal from listing its own campaign thereby leading to a conflict of interest. It is also relevant to determine whether the start ups should be allowed to raise money online directly, through their own web portals. This direct business lending or investment would skip the fund portal intermediary. Therefore, the definition of “funding portal” would have to accommodate such portals, failing which the business can skip the regulatory burden of disclosure etc if they are allowed to raise fund of their own. Alternatively, use of fund portals could be made mandatory for web based crowdfunding. Also, restricting regulation to crowdfunding process to Internet based funding and leaving a regulatory gap for offline fund transfer as crowdfunding can defeat the purpose of the regulation.
Therefore, either the regulations must mandate the crowdfunding process to be undertaken through an independent online funding portal or otherwise regulate the offline fund campaign. The former method might bring symmetry in the crowdfunding process whereas the latter would increase the regulatory burden and monitoring cost. Additionally, there must not be a substantial difference in offline and online fund raising process otherwise it may lead to per se defeat of one of the systems. Thus a practical parity would be required.
Foreign Projects; Jurisdictional Matters
Whether foreign projects must be allowed to list their campaign on an Indian fund portal i.e. whether foreign projects should be allowed to run a crowdfunding campaign for Indian investors is another area of regulation. Indeed, in the absence of any restriction, the investor, or one who is willing to make a donation, might access any website and donate money to a foreign campaign. Thus, eligibility norms to use the intermediary (funding portal) for campaigning are also essential.
The regulations must also deal with the issue of jurisdiction of the capital markets regulator over the crowdfunding portals even if the platform only undertakes donation crowdfunding and does not list or recommend equity or lending crowdfunding.
In United States, Section 304 of the Jumpstart Our Business Startups Act of 2012 (JOBS Act) gives powers to the Securities Exchange Commission (SEC) to exempt, either conditionally or unconditionally, the ‘registered’ funding portals to register as brokers or dealer. Section 3(a)(80) of the Securities Exchange Act of 1934 defines “funding portal”. This legislation was amended by the JOBS Act. The provision incorporates a prohibition of ‘holding, managing or possessing investor funds’ as one of the preconditions to be a qualified funding portal within the definition of the act. The provision also prohibits the funding portals from engaging in any activity which the commission deems inappropriate. It is pertinent to note that in the US detailed regulation with reference to funding portals is due. It is expected that the regulations would be made available in October 2015.
Thus, irrespective of what is the final shape of the Indian crowdfunding regulations, the above mentioned concern areas should find a substantive mention in an effective regulation for crowdfunding intermediaries: the funding portals.
- Nikunj Agarwal