The wisdom (or lack of wisdom) of the crowd

By Mathew Chacko and Praveen Raju, Spice Route Legal
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India’s underserved debt and equity investment markets have seen a proliferation of specialized lenders creating avenues for capital that used to be stashed under beds to be put to better (hopefully) and riskier (definitely) uses. Given that these lenders are solving a problem that has vexed the Indian economy, one would imagine that the regulator would be dancing around a fire, singing ai se eu te pego (roughly, oh if I get you).

Mathew Chacko Partner Spice Route Legal
Mathew Chacko
Partner
Spice Route Legal

And reality? The Securities and Exchange Board of India (SEBI), in a press release in August 2016, declared that “electronic platforms” that are “facilitating fund raising on digital platforms” are illegal, on the ground that facilitating investments in the form of “private placements” contravenes provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA), and the Companies Act, 2013 (CA).

Devoid of nuance, SEBI’s absolutist proclamation requires closer examination – what do these acts say? And do all “electronic platforms” fall afoul of the law?

Crowdfunding is the process of raising money for a project or a venture from a large number of people, typically (although not exclusively), by using electronic platforms. For simplicity, we can divide crowdfunding platforms into: (a) those that enable ventures and projects to raise money without receiving anything in return; (b) those that enable ventures and projects to raise money, and thereafter receive the principal with no interest or reward; (c) those that enable ventures and projects to raise money, and offer a debt instrument in return; and (d) those that enable ventures and projects to raise money, and offer an equity instrument in return.

So are all these electronic platforms illegal?

SEBI’s fiat declares that electronic platforms that facilitate investments in the form of private placements contravene the SCRA and the CA. Therefore, platforms that enable ventures and projects to raise money without receiving anything in return clearly have not been caught by SEBI’s broad brush. Complicated arguments apart – they do not violate either the SCRA or the CA.

Platforms that enable ventures and projects to raise money and thereafter receive the principal with no interest or reward do not appear to have caught the attention of the regulator. Regardless, the CA restricts the power of a company to accept a loan, and restricts the right of a company to extend a loan. However, a company may well structure around these restrictions – and multiple structures that do not currently flout any law exist.

Generally, there is no restriction on an individual or company resident in India from purchasing shares of another company. However, there are restrictions on companies offering shares for sale to more than a prescribed maximum number of potential purchasers (currently 50). Therefore, companies that use platforms that provide access to fewer than 50 investors do not fall afoul of the law – others may!

Praveen Raju Partner Spice Route Legal
Praveen Raju
Partner
Spice Route Legal

Therefore, the actions of investors or investees (or both) that use a crowdfunding platform may violate Indian law in some circumstances. There is no recognized general principle of contributory infringement under Indian corporate law – and so the platform remains an unregulated entity that is not responsible for the legality, or otherwise, of the actions of its users (unless it is an illegal stock exchange). Further, structures and solutions currently exist that allow crowdfunding platforms to remain within the law – a possibility that SEBI does not seem to have considered.

As for the SCRA, it deals only with marketable securities – and so may not apply to platforms that enable ventures and projects to raise money without receiving anything in return, or platforms that enable the raising of debt that may not be assigned. A platform that deals with marketable securities (which may include the shares of a private company) may find itself running an illegal “stock exchange”. But a website that merely allows purchase of shares is hardly a stock exchange.

And what of policy? Innovative solutions to age-old problems tend to disrupt the status quo. Fintech poses particular challenges on account of how strict financial regulations tend to be. We understand that the regulator has assured many existing actors that its actions did not target “genuine” crowdfunding websites – but were rather targeted at companies trying to create an illegal stock exchange. However, a more institutional approach would be welcome.

Rather than blanket declarations of illegality, SEBI would do well to adopt a nuanced approach to crowdfunding, and to implement a regulatory sandbox, where innovations can be tested without incurring the usual regulatory consequences. Still, at this stage, investors in crowdfunding platforms that operate in India should look closely at the law, and at SEBI and its proclamations.

Mathew Chacko and Praveen Raju are partners at Spice Route Legal.

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