Conundrum under Equity Crowdfunding

Introduction

Startups and small companies in India are always on the lookout for viable sources of capital. At the same time, small investors are interested in diversifying their portfolios and betting on promising new ventures. This, coupled with the increased popularity of the startup ecosystem due to TV shows such as Shark Tank, has led to the mushrooming of many platforms offering companies the opportunity to connect with investors to crowdsource their funding goals. However, equity crowdfunding in India operates within a realm of regulatory grey area as there are no specific statutes, rules, or regulations governing it.

The lack of regulatory clarity had created an opportunity to some of the equity crowdfunding platforms to devise innovative instruments that are not a security per se, but carry a monetary value similar to the equity of the issuing company. These platforms allow startups to raise funds from small retail investors via a “community subscription offer plan” (CSOP). CSOP is an investment plan for retail investors to invest in exchange-traded funds and is a kind of instrument to acquire shares/rights.

Crowdfunding and issuance of CSOPs have recently come under the scanner of the regulatory authorities under the Companies Act, 2013 (CA, 2013). Recently, in March 2023, the Registrar of Companies (ROC), NCT of Delhi and Haryana passed its order, penalising two companies for issuing compulsorily convertible debentures (CCDs) through Tyke Invest (March order).¹ Again in September, the same ROC has penalised another company for issuing CSOPs through Tyke Invest (September order).² From the said orders, it is being made understood that issuing CSOPs by said companies is in violation of provisions pertaining to private placement under Section 42 of the CA, 2013.

Analysis of the ROC orders

ROC penalised Anbronica Technologies Pvt. Ltd. and Septanove Technologies Private Ltd. for issuing CCDs in violation of Section 42 of the CA, 2013. These companies have issued CCDs to 28 and 196 subscribers for an amount of INR 12,50,000 and INR 32,51,000 respectively.

The ROC issued a show-cause notice to the companies stating that such an issue was in violation of Section 42 of the Companies Act and thus amounted to a public offering. The companies and Tyke contested that the issuance was not a public offering as the offer was made available only to the Tyke community. ROC had rejected the contentions of the companies and held that said issue of CCDs is in violation of Section 42(7) of the CA, 2013, which prohibits any company issuing securities through private placement from releasing any public advertisement, utilising any media, marketing, or distribution channels, or agents to inform the public at large about such issuance. Once a company is onboarded by Tyke for crowdfunding, the company runs a campaign to attract investors, which includes live sessions on social media platforms for pitching the startup and ask-me-anything (AMA) sessions by the founders.

So far as the contention of the companies with respect to the allotment of CCDS only to 28 and 196 subscribers, which is well within the statutory limit of 200 subscribers as prescribed under Section 42 of the CA, 2013, is concerned, the ROC had held that these promotional events are accessible to anyone over social media and thus amounted to a public advertisement/invitation. Further, it also observed that the restriction of 200 subscribers is not only limited to the stage of allotment of securities but is also applicable at the offering stage. Accordingly, the two companies were penalised by the ROC.

An immediate aftermath of the ROC order was that these platforms stopped debt-based crowdfunding campaigns. However, the platforms continued with their equity-linked campaigns, wherein CSOPs were issued in lieu of the subscription amount. The platforms and companies continued the campaigns with an assumption that CSOPs do not classify as a security and hence, their issuance does not fall within the ambit of Section 42.

However, the September order³ of the ROC clarified that CSOPs are securities. In this case, SustVest (formerly known as Solargridx Ventures Pvt. Ltd.) had issued CSOPs to 565 subscribers. The statutory auditor of SustVest had raised a question as to the treatment of the funds received from the CSOPs as “other income”. Consequently, ROC issued a show-cause notice to the company, averring that the issue of CSOPs was done in violation of Section 42.

The main argument taken by the company was that CSOPs are not a security and hence, it does not come within the ambit of Section 42 of the CA, 2013. However, the ROC rejected the said contention and held that CSOPs qualify as a “security” under Section 2(81) of the CA, 2013 read with Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA).

Legal status of CSOPs

A. Anatomy of CSOPs

Tyke allows retail investors to invest in startups with a coupon size, as small as INR 5000. In return for the investment, the company issues CSOPs. CSOP is an innovative instrument that is not equity but grants a right to the holder through stock appreciation (SAR). According to the FAQs provided on Tyke’s website, “SAR entitles the grantee to receive value equivalent to the appreciation in value linked to factors such as revenue of the company.” Tyke presents SAR as privilege connected to the appreciation of a company’s stock value or share price. Essentially, the value of SAR is linked to the value of a certain number of shares. Accordingly, at the time of exit, the company would redeem the SARs in accordance with the increased value of the shares/stocks of the company. Thus, CSOPs are to be considered an instrument that derives their value from the underlying securities i.e. the shares of the issuing company.

B. Legal framework defining “securities”

The definition of “securities” under Section 2(h) of the SCRA includes “derivatives”. According to Section 2(ac) of the SCRA “derivative” includes a contract that derives its value from the prices, or index of prices, of underlying securities.

The courts in India have discussed the constitutive elements of “underlying securities” in relation to “derivative” as defined under SCRA.

The Madras High Court, in Rajshree Sugars & Chemicals Ltd. v. AXIS Bank Ltd.⁴ , held that the underlying assets for a derivative, inter alia, can be “financial assets such as shares, bonds, and foreign currencies”. This observation has also been upheld by the Bombay High Court in CIT v. Bharat R. Ruia⁵,. In Rajshree Sugars’ case⁶, the Madras High Court even observed that options such as call option and put option are also derivative as the value of these options is derived from the value of shares that can be bought or sold through the exercise of these options.

Basis the ruling of Madras High Court, it can be interpreted that any contract deriving its value from the value of underlying shares will be considered to be a derivative.

On examination of the CSOP agreement as available on Tyke’s website, it can be understood that the amount received by a subscriber upon exit is dependent upon the value of the company’s equity shares. CSOP agreement provides the method of calculating the value of SAR, which states that the payout received by a subscriber upon exit is dependent upon the pre-money valuation of the company i.e. the value of the equity shares.

On a conjoint reading of the agreement with the judgment of the Madras High Court, it can be understood that CSOP is a derivative. ROC in September order⁷ had observed that:

…it is apparent that CSOP’s value is linked to the equity securities of the subject company at the inception stage, capital restructuring stage and the payout stage. Besides this, CSOPs have other trappings of securities like transferability, maintenance of a register. Thus, CSOP is a “derivative”….

Consequently, the issuance of instruments such as CSOPs is regulated under Section 42 of the CA, 2013.

However, the order of ROC may have an impact on the availability of capital for startups and investment opportunities for retail investors.

Position in other jurisdictions

Various other jurisdictions have recognised the need to make such capital available to smaller startups and have attempted to regulate such crowdfunding in a manner different from the traditional issuance of securities. One of the prime examples of such non-traditional regulation is the Jumpstart Our Business Startups Act, 2012 (JOBS Act) of the USA.

JOBS Act essentially creates an exemption to the existing law to allow the issue of securities through crowdfunding. The Act caps the maximum amount that can be raised by a company and invested by a retailer. It allows for limited advertisement of issuance to enable issuers to gain traction. Intermediary platforms such as Tyke are required to mandatorily register themselves and are accordingly regulated by the Securities and Exchange Commission. Since the JOBS Act aims to enable smaller companies to raise funds, the compliance requirements for issuers are also fairly simple. A legislation emulating the features of JOBS Act may be necessary in India.

Conclusion and suggestion

The recent developments in the realm of equity crowdfunding in India, as highlighted through the orders of the ROC, underscore the need for regulatory clarity in this space. The orders of ROC have not only raised questions about the legal status of instruments such as CSOPs but also brought to light the challenges faced by startups and crowdfunding platforms in navigating the existing regulatory framework due to the unpredictability.

In light of these challenges, it becomes imperative for Indian regulators to consider alternative regulatory frameworks that accommodate the unique dynamics of equity crowdfunding. The Securities and Exchange Board of India (SEBI) recognised the need for a specialised regulation of equity crowdfunding in 2014 and released a consultation paper titled “Consultation Paper on Crowdfunding in India.”⁸ However, SEBI did not follow up on the consultation paper, and no further development took place for almost a decade after the consultation paper was released. During this tenure, the startup ecosystem in India has evolved manifold and has become much more complex. Thereby, the need for capital for smaller startups is more than ever. The JOBS Act’s exemption framework and simplified compliance requirements for issuers and crowdfunding platforms strike a balance between investor protection and fostering capital access for smaller businesses.

As evidenced, the retail investors have very little bargaining power, limited information, and limited avenues for investment. Therefore, regulatory framework needs to balance the considerations of making capital available to smaller startups and the protection of retail investors.