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Kushal Tekriwal & Shrey Aggarwal*
I. INTRODUCTION
India has experienced a transition in start-up investing over the years. However, unlike traditional methods of investing, i.e. through alternative investment funds, in more recent times, various online fundraising platforms such as LetsVenture, AngelList, Infubiz and Tyke Invest have emerged. These platforms allow public investors to invest in a private limited company. The minimum investment amount on such platforms could be as low as INR 5,000. While the introduction of above-mentioned platforms may provide useful opportunity to participate by retail investors, investment in private limited companies by the general public is prohibited under Section 2(68) of the Companies Act, 2013 (‘Act’) of India. Section 2(68) of the Act defines the minimum eligibility conditions for categorizing an entity as a private company i.e. a company with (a) minimum paid-up share capital as prescribed; (b) restriction on the transfer of its shares; (c) limiting the number of members to two hundred; and (d) prohibiting any invitation for subscription of any of its securities to the general public.
One of the fundamental distinctions between a public and private company lies in the manner of raising capital for the company, wherein a public company can invite the general public to invest in it, private companies cannot. Amidst all this, platforms as mentioned above, have allowed retail investors to bypass such legal requirement, raising key issues on the regulation front to provide coverage for such usage of the loophole. The aim of this article is to highlight the grey area of law under which various platforms and start-up companies are raising money from general public using such tools which have yet not received any regulatory nod. By blurring the fundamental distinction between a public and a private company, such practice of raising money, is also an attempt to bypass the claws of the watchdog of the Indian securities market, i.e. Securities Exchange and Control Board of India (“SEBI”). By providing a background into how such practice of raising funds is potentially contrary to the current position of law, this article discusses the stance taken by regulatory authorities in similar circumstances and highlights the risks that retail investors run by adopting such means of investing.
II. RECENT MCA ORDER AND IRREGULARITIES OBSERVED
The recent orders by Registrar of Companies (‘RoC’) in the matter of Anbronica Technologies Pvt. Ltd. and Septanove Technologies Pvt. Ltd. has put light on issuance of compulsorily convertible debentures (‘CCD’) as part of private placement process through one of the fundraising platforms, Tyke Invest. Since the company’s pitching information was accessible and visible to general public (approximately 1.5 lakhs) leading the issue to be over-subscribed (as confirmed by platform), it fundamentally breached the two hundred limit threshold as prescribed under Section 42 of the Act read along with Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014 for any private placement offer. Every company proposing to make a private placement under law is required to make such offer only to select group of individuals i.e. maximum two hundred persons, categorising it as the threshold for deemed public offer. If breached, then issuance of securities requires issuance of prospectus for a public offer, as applicable only for a public company. It is pertinent to note that the threshold adherence should be at the time of making an offer/invitation to offer and not with respect to those who ultimately subscribe to the securities rendering it as ‘active facilitator’ than in mere ‘generation of interest in the company’.
Among the various instruments listed such as CCD, Compulsorily Convertible Preference Shares (‘CCPS’), Non-Convertible Debenture (‘NCD’) on these platforms, an alternative named as Community Stock Option Pool (‘CSOP’) has been introduced through which Tyke Invest essentially offers a contractual agreement between the company and subscriber entitling the latter to community benefits in the nature of Stock Appreciation Rights (‘SAR’). Subscription to CSOPs does not appear in the capital structure of the company. Rather the funds raised through the issue of CSOPs are treated and shown as revenue in P/L account, implying no shareholder rights relating to dividend, voting rights, etc. Furthermore, issuance of SARs by private companies is a regulatory loophole and currently falls under a grey area of law as the Act is silent on it and the SEBI (Share Based Employment Benefits and Sweat Equity) Regulations, 2021 are only applicable to listed entities. Therefore, the issuance of such securities and manner of making investments serve a dual purpose for the founders/promotes wherein they get to retain their equity of the companies without any fear of dilution and at the same time retail investors get to be a part of the growing start-up culture that can yield significant returns on their investment.
However, this is not without obvious risks. A reemphasis on the definition of the term ‘security’ under Section 2(h) of the Securities Contract (Regulation) Act, 1956 (‘SCRA’) is essential as it covers a wide ambit of instruments under its applicability. Since CCDs and other instruments like CCPS and NCD which are prominent on these platforms are already included under ‘security’, it becomes interesting to observe the applicability of CSOPs in this context. The applicability of an instrument coming under the broad ambit of the term ‘security’ permits the regulatory authorities to interpret, intervene and accordingly extend their jurisdiction over a company, on which it can act/regulate upon in order to prevent any suspected irregularities. In other words, if CSOP is covered under the ambit of ‘security’ then its issuance is barred under Section 2(68) read with Section 42 of the Act along with Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014. As CSOPs provide for a speculative contract deriving its value from the performance and growth of the company in future, essentially containing all features of a ‘security’ via a ‘derivative’, it is riveting to see whether SEBI’s stance on the interpretation of law remains similar to extend its jurisdiction in light of the Sahara India Real Estate Corporation Ltd. v. SEBI (‘Sahara India’) judgement where Optionally Fully Convertible Debentures (‘OFCDs’) were considered as a ‘security’ by expanding its scope of applicability and the only relevant aspect to note is with respect to maintaining the two hundred threshold limit set by the Act irrespective of entity’s nature being public listed or unlisted, terming it as a ‘deemed public issue’. Even an argument on behalf of such online fundraisers on crowdfunding is not sustainable as SEBI has completely prohibited equity crowdfunding in India.
Amongst such existing regulatory gap, it then becomes pertinent to address the applicability of jurisdiction of regulatory authorities over these fundraising platforms. Whilst SEBI has come up with its precautionary guidelines to categorize them as ‘online bond platform providers’ being unauthorised and unrecognized under any law which governs securities market facilitating fundraising similar to stock exchanges, its applicability extends only towards debt instruments such as CCDs. The RoC order was also in light of CCD issuance analysing applicable provisions of the Act (i.e. Section 2(68) & Section 42(7)). Section 42(7) of the Act specifically prohibits private limited companies for any invitation via public advertisements or marketing/media/distribution channels to the general public at large to subscribe its securities. As a result, only companies which issued CCDs were penalised by RoC for fundraising, making possible for the platforms as well as those companies issuing other securities to escape regulators scrutiny.
III. IMPACT ON RETAIL INVESTORS
The commercialization of the startup ecosystem through increased marketing of funding campaigns coupled with the growth of innovative businesses in India, has now evoked a demand for investment by retail investors who look with an intent to obtain substantial returns in such ‘promising startups’. Startups, unlike a listed company, have their own risks attached with them which are distant to the knowledge and awareness of the general public. These risks, to name a few, largely revolve around high quantitative value of funds, high failure rate leading to early closure, financial losses, and regulatory and market risks, implying a very high risk-to-reward ratio for the investors which can be taken on only by high-net-worth individuals, qualified institutional buyers or private equity funds. Pursuant to Regulation 26 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, a public company mandatorily needs to issue a red herring prospectus before inviting funds from the public which highlights any irregularities with the operations of the company including its financials, ongoing litigations or any other risks associated with investment in it.
Such disclosures are further vetted by SEBI before making them publicly available. However, there is no such obligation on private companies. In line with the principle of caveat emptor, an investor needs to carry out its own due diligence on private companies. Such due diligence reports are not publicly available and even if carried out by such retail investor, involves high costs and with no such disclosure obligations as observed for a public company, this exercise would not be feasible for the retail investors due to the lack of internal workings and operations of such private companies. Hence a retail investor is unaware of any potential risks associated with its investment. Online platforms essentially allow private companies to raise funds from investors without imposing an obligation on them to disclose essential information as in the case of public companies.
IV. WAY FORWARD
Other jurisdictions such as the United States of America and United Kingdom have adopted various different crowdfunding norms in a regulated manner to address the subject matter at hand. For instance, in United States, the Jumpstart our Business Startups (“JOBS”) Act have been implemented enabling equity crowdfunding which over the years, have broadened the scope of the Act to allow start-ups to solicit funding up to USD 1 million in a financial year from the general public, with lower reporting and disclosure requirements. Subject to the eligibility criteria, companies are enabled to advertise its securities to the general public without obtaining registration from the Securities and Exchange Commission.
In United Kingdom, the Financial Conduct Authority (“FCA”) regulates loan based and investment based crowdfunding. Start-ups are covered under investment based crowdfunding wherein platforms allow retail investors to invest in unlisted shares or debt securities offered by a company. However, in the interest of protecting the investors, FCA imposed certain restrictions stating that only high net worth individuals; people who take regulated advice or those whose investment in such securities does not exceed 10% of their net assets can avail the services of an equity crowdfunding platform.
However, in India, the SEBI has clearly disallowed any form of equity crowdfunding as mentioned above, which given the current and evolving market situations would need to be revisited and accordingly be revised.
V. CONCLUSION
There have been further developments with some companies offering CSOPs on their own platform to the general public via a tweak in the model to evade the scope of section 42 and obtain protection under section 58(2), wherein the primary issuance is being done to a single group entity pursuant to which secondary transfers are being transacted to the general public at large (aka ‘down-selling of securities’). Section 58(2) provides for free transferability of securities in a public company and also provides for enforceability of a contract with respect to transfer of securities. The RoC have categorically denied companies of usage of such legal provisions to evade the private placement restrictions and have ruled the applicability of section 58(2) to be subject to section 42(7) of the Act. Any such transaction which emanates out of a private placement creating a distribution channel for selling securities to general public shall be violative of the provisions of the Act.
Therefore, amidst this grey area of law and in lieu of the regulator’s object towards unsuspecting general public, retail investors’ vested interests need to be catered and addressed as in current times, there exists major red flags towards these ‘active facilitators’. Similar to a situation of cryptocurrencies in the recent past which were earlier gaining high involvement from general public and were unregulated as well, the Government of India through the income tax authority, accordingly swooped in with its set of regulations, keeping it broad to include them under its ambit; challenges still persist in this present situation as well. Since the active engagement of subscribers being attached to platforms are over one 150,000 as observed in para 9 of the MCA order, there exists a large group of vested interests by the general public towards them, requiring an involvement from the regulators such as the RoC, SEBI, and any other appropriate authority to accordingly opt again and include such platforms under its grasp to regulate over this space as well. Though the RoC in its orders did not initiate a reversal of the issuance of shares by the company or asked for a cancellation of the entire private placement process, restricting it just to impose penalties, it would be an interesting take to observe the consequences of its actions in the aftermath both by companies as well as the regulators. This essentially also raises questions over accountability, on who will initiate refunds and if it is the fundraising platforms itself, then whether it would entail a reversal of their platform fees as well which is charged at the hands of the investors.
(Views expressed in this article are those only of the authors and does not represent of any firm or third-party institution. The article may not be construed as a legal advice)
*Kushal Tekriwal is an Associate at Cyril Amarchand Mangaldas and Shrey Aggarwal is an Associate at Luthra and Luthra.
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