Equity Based Crowdfunding Platforms

A recent trend for fund raising in the Indian start-up ecosystem is the emergence of technology platforms that connect businesses with retail / public investors to facilitate investments, particularly early-stage equity funding, popularly known as ‘equity based crowdfunding’ (“EBC”). Businesses seeking to raise capital through this mode typically advertise online through a technology platform to the users of such platform for making investments in the business. EBC provides start-ups an early-stage alternative to traditional venture capital or private equity funding, while at the same time providing retail investors a new class of investment opportunity. In this manner, the crowdfunding platforms claim to ‘democratize’ equity investments in private companies which thus far would not have been available to individual investors. This mode of fund-raising though, has recently caught the regulator’s eye, and is being subject to scrutiny for violation of the provisions of the Companies Act, 2013 (“Companies Act”).

Private Placement Rules under Companies Act

The Companies Act regulates private issuances by companies more leniently than public offers. To protect the interests of the subscribers, public offers are subject to more rigorous compliance requirements, disclosure standards and are also subject to the regulations prescribed by the Securities and Exchange Board of India (“SEBI”).

Accordingly, the Companies Act requires certain conditions to be satisfied for an issuance to qualify as a ‘private placement’, including:^[1] (collectively, the “Private Placement Rules”)

• ‘private placement’ means “any offer or invitation to subscribe or issue of securities to a select group of persons by a company (other than by way of public offer) through private placement offer-cum-application”, which satisfies the conditions specified in section 42 of the Companies Act;
• private placement shall be made only to a select group of persons who have been identified by the board of directors of the company, and such offer or invitation shall not be made to persons more than 200^[2] in the aggregate in a financial year^[3] (the “Private Placement Threshold”); and
• no company making a private placement shall release any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue (“No Publication Rule”).

If a company makes an offer or accepts monies in contravention of section 42 of the Companies Act, such company, its promoters and directors shall be liable for a penalty which may extend up to the amount raised through the private placement or INR 2,00,00,000, whichever is lower, and the company shall also be liable to refund all monies with interest to the subscribers within a period of 30 days of the order imposing the penalty.^[4] Further, a private placement in breach of the Private Placement Threshold shall be deemed to be a public offer.^[5]

Regulatory Glare

Within the year 2023 itself, at least three private companies have been penalized by the Adjudicating Officer (Registrar of Companies) (“AO” / “ROC”) for using a crowdfunding platform to undertake private placement of their securities in violation of the Private Placement Rules.^[6]

In the cases of Anbronica Technologies Private Limited and Septanove Technologies Private Limited, online pitches were organized for these private companies on an online platform with more than 1,50,000 members, where the companies interacted with members to collect investment interest. Thereafter, the members of the platform communicated their intention to invest, and Anbronica and Septanove identified 28 and 196 members respectively, to whom private placement offers would be made for subscription to compulsorily convertible debentures (“CCDs”) for aggregate amounts of INR 12,50,000 and INR 32,51,000 respectively. The companies then completed the issuance and allotment of CCDs to such identified persons. The platform charged on-boarding fees to the issuer companies, and also provided certain other services such as facilitating set up of escrow account, access to third party vendors for KYC verification etc. and charged service fees for such services. The AO observed in both cases that:

• the Private Placement Threshold shall apply not just with respect to the number of persons who ultimately subscribe to securities, but also cannot be exceeded at the time of making an offer or invitation to offer of the securities of the company; and
• the platform was used by the issuers as a media/marketing/distribution channel/agent to inform the public at large about the issue of securities. The platform has charged fees to the companies for various services, and the role of the platform cannot be relegated to mere “generation of interest in the company”, and instead it is an active facilitator for allowing the companies to raise investments through its portal and it is providing end-to-end services, either by itself of through its agents/partners.

The AO held that the companies had violated the No Publication Rule and imposed reduced penalties of INR 2,00,000 on each company and INR 1,00,000 on each of its respective promoters and directors, as each company qualified as ‘small company’.^[7] Curiously, while the penal provision under the Companies Act^[8] requires imposition of penalties as well as refund of subscription amounts (with interest) to all subscribers, the aforesaid orders do not direct the refund of the subscription amounts to the subscribers and do not comment on the validity of the issuance and allotment of CCDs.

Recently, in September 2023, a similar digital campaign by Solargridx Ventures Private Limited was also held to be violative of the Private Placement Rules. Solargridx had raised funds aggregating to INR 61,86,000 from more than 550 persons by way of issuance of ‘community stock options’ (“Community Options”) under a ‘Community Stock Option Plan’ (“CSOP”), which was a plan adopted by Solargridx to grant eligible ‘community members’ identified and approved by its board, the right to receive payouts ‘based on future valuation of the company’ upon occurrence of certain events,^[9] among other incentives such as ‘curated deals’, ‘access to exclusive events’, ‘catchup with founders’ and ‘participation in surveys’. Solargridx had contended before the AO that: (a) the Community Options were not derivatives and were not ‘securities’ for the purpose of section 42 of the Companies Act and their issuance does not need to comply with the Private Placement Rules, and (b) the amounts raised under the CSOP were recognised by it as ‘other income’ and it had paid GST on such income.

The AO, however, held that the Community Options were derivatives and hence ‘securities’ within the meaning of the Companies Act, that their issuance would trigger the private placement provisions under the Companies Act, and that Solargridx had violated the Private Placement Threshold and the No Publication Rule. The company and its promoters and directors were ordered to pay penalties for violation of the Private Placement Rules. The AO also observed that under section 42(6) of the Companies Act, the ‘allotment’ of the Community Options should have been made within 60 days of receipt of subscription money by the company, and ordered the Company to refund the subscription money to all subscribers with interest on the ground that it had not made any allotment of the securities.

The above orders also observed that the provisions of Section 42 of the Companies Act do not allow the AO to impose any penalty on the platform in question “which has clearly facilitated the subject company in the act of commission of default of sub-section (7) of Section 42”.

‘Warehousing’ – A Quick Fix?

Another business model which is prevalent is where a related party of the platform  participates in the fund-raising process by subscribing to securities in a private placement, and then holding or ‘warehousing’ them for onward sale to retail investors. Notably, while the restrictions under section 42 of the Companies Act apply only on offer of securities for subscription simpliciter, under the erstwhile Companies Act, 1956, any offer which is “calculated to result, directly or indirectly, in the shares or debentures becoming available for subscription or purchase by persons other than those receiving the offer or invitation”^[10] is deemed to be a public offer, and we are yet to come across such a business model being tested before judicial fora under the new Companies Act.

Concluding Remarks

Interestingly, the concept of EBC and its legal framework in India was discussed in great length by SEBI in its ‘Consultation Paper on Crowdfunding in India’ (“Crowdfunding Paper”) published June 2014. SEBI had identified certain risks of EBC including: (a) retail investors may be uninformed and unsophisticated and having low risk tolerance, (b) absence of secondary markets for the securities may make them illiquid, (c) risks of default or frauds, (d) information asymmetry, and (e) lack of disclosure and reporting obligations.

SEBI further observed that EBC is permitted as an exemption to the law on public offers in some jurisdictions in case of offers made to ‘accredited/informed/wealthiest’, and in other jurisdictions by capping the amount that can be raised or the amount that can be invested by each investor. The Crowdfunding Paper proposed a broad framework under which crowdfunding could operate in India including eligibility criteria for investors, issuers, and platforms, compliance requirement for platforms, disclosure norms and imposing certain investment limits and conditions. While such a framework is yet to be put in place, SEBI had expressed caution in 2016^[11], that “certain electronic platforms are facilitating fund raising […] in the form of private placement […] amounting to a contravention of the provisions of Securities Contract (Regulation) Act, 1956 (SCRA) and the Companies Act, 2013.”

The proposals in the Crowdfunding Paper are worth revisiting, given the significant increase in not only the number of businesses that are actively scouting for fresh sources of capital but also the number of public investors who are continuously exploring new investment avenues. However, past experiences such as the Sahara case which serve as a manifestation of the risks posed to the members of the public should be taken into consideration in any regulatory framework for crowdfunding.

In the meantime, given the approach adopted by the ROC, companies using online platforms for fundraising should ensure that the Private Placement Rules are not being breached in the process followed for such fundraising.

Footnotes:

[1] Section 42 of the Companies Act read with Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014 (“PAS Rules”).

[2] As per the PAS Rules, an offer or invitation made to qualified institutional buyers, or to employees of the company under a scheme of employees stock option is not to be considered while calculating the limit of 200 persons.

[3] As per the PAS Rules, this restriction would be reckoned individually for each kind of security that is equity share, preference share or debenture.

[4] Section 42(10) of the Companies Act.

[5] Explanation III to section 42(3) of CA13, section 42(11) of the Companies Act 2013.

[6] See the orders of the ROC, NCT of Delhi & Haryana dated (a) March 1, 2023 in the matter of Anbronica Technologies Private Limited, (b) March 1, 2023 in the matter of Septanove Technologies Private Limited, and (iii) September 22, 2023 in the matter of Solargridx Ventures Private Limited. In respect of Anbronica, we understand from a news report that an appeal has been filed by Anbronica against the order of the ROC, however, we are yet to come across any order in any such appeal.

[7] Section 446B of the Companies Act.

[8] Section 42(10) of the Companies Act.

[9] The Community Options have also been described as ‘stock appreciation rights’ by the platform as per screenshots from the platform’s website published in the Solargridx order.

[10] Section 67(3)(a), Companies Act, 1956.

[11] SEBI Press Release PR No. 137/2016, August 30, 2016 (https://www.sebi.gov.in/sebi_data/docfiles/34568_t.html)