What are the crowdfunding laws in India? Is it even legal? This article is written by Eklavya Malvai, 4th Year, B.A.LL.B (Hons.), Amity Law School, Noida and Debottam Chattopadhyay, 4th Year,B.A. LL.B(Hons.), School of Law, KIIT University, Bhubaneswar.

1. WHAT IS CROWDFUNDING-AN INTRODUCTION?

According to the SEBI Consultation Paper on Crowdfunding in India[1]

“Crowdfunding is solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause.”

Therefore crowdfunding is a method by which small amounts can be raised from multiple investors through various modes such as social networking sites for e.g. Facebook or Twitter and for a particular project which is generally a movie or a music album or even a business venture, etc.  In the Indian perspective several sectors and the Small and Medium Enterprises may in particular benefit strongly and significantly for particular micro-scale ventures by going to small investors by raising money through crowdfunding.

Types of crowdfunding include Donation Crowdfunding, Equity Crowdfunding, etc. and shall be discussed in depth in subsequent portions.

2. THE CONCEPT OF CROWDFUNDING: TYPES AND MODELS

When starting a business, one needs to weigh the various options and filter out the best alternatives that would suit his/her business and the type of activities one wants to carry out, the amount of capital one requires and the amount of liability one wants to incur. Starting up a business is a risky option with no sure shot returns which makes it averse to risk and low returns. Hence, one needs to adopt the next best alternative. Let us discuss the various types and models of crowdfunding as a concept;

There are primarily 4 types of crowdfunding models which have recently come into practice,

1. Donation Based Crowdfunding: As the name suggests, it is a form of crowdfunding where funds are raised via public campaigns and outreach programmes, eg, raising funds for a private scholarship by an individual. This option usually does not provide any kind of returns to the ‘investors’ and hence is done voluntarily without any formal documentation or collateral. This option might not be really viable in the long term due to its non-rewarding nature unless done for a public purpose which reaps benefit for the society as a whole.
2. Rewards Based Model: Type of crowdfunding that provides a certain attraction to its investors, tangible or intangible, varying from services provided to goods offered. This option also is considered as not very rewarding as it does not provide any equity options for the investors where they can reap a long term reward, though the kind of rewards proposed to the investors by targeting their intent of investment and fulfilment other than giving equity returns. Reward based crowdfunding is an option that needs to be explored further on and expanded further on what it can offer.
3. Equity Model: Funding where investors are made partakers of the equity and profit earned by the business. For any investor, return on investment is the basic criteria. Equity ownership brings confidence in terms of decision making, security of funds and accountability.
4. Lending Model: Parallel to the model of raising equity by debt, where money can be raised by taking loans from various investors by offering something in addition to the interest on the loan, eg, profit sharing during the period of investment, which can be set out in the terms of agreement. This model involves high risk, as start-ups may not be able to afford such loans at a high rate of interest, and repayment of the loan may result into bad debts in case of failure of business. But, on the otherhand, the lending model in any business is the first hand option.

Equity and reward based crowfunding are to areas which must be closely observed and studied, as both provide a certain sense of return to the investor. Combining equity plus reward based structures can immensely go a long way in attracting an investor, since in the current day scenario, one is always looking to get rewarded for what he has invested, where donation based structure starts to fade out.

3. CROWDFUNDING ACROSS THE GLOBE

Crowdfunding across the globe has recently taken the limelight with a lot of multi-million companies which have taken the recourse to crowdfunding for their various ventures. Companies like ‘GE’ have set forth a large crowdfunding model and have partnered with  “Local Motors” to develop “FirstBuild”, a website which connects engineers to manufacturers and have successfully raised $2.5 Million.

Crowdfunding as a model has been assessed to raise small amounts of money from a pool of large amount of investors wanting to invest their money in projects giving them high returns. The model has come under the B2C model, connecting businesses directly to consumers willing to invest their monies, without any intermediaries and complications.

The precursor to raising any investment via crowdfunding is an appropriate and attractive crowdfunding campaign, which requires public funding, usually done by close relatives, family and friends, which attract around 25-40% first hand investments. Social media in the recent times has played an important role in the recent times and has left an indelible impact on people’s lifestyle. It has been successful in connecting people across various time zones and access to knowledge and ideologies.

There are various business groups in the recent times that have come up, connecting the investor to the start-up owners requiring finance.  Crowdfunding also comes with a pertinent question of “liability”, since it’s a third party method of funding, largely unregulated, hence leaving this question open ended.

The UK legal sector has seen a steady increase in third-party funding over the last few years. A number of factors have contributed towards this increase including the following: the ‘Arkin cap’ established in the case of Arkin v Borchard Lines Ltd and others [2], which limited a third-party funder’s costs liability to the level of its contribution; support for third-party funding from the judiciary, particularly from Lord Justice Jackson; demand from lawyers and clients for alternative means of funding commercial cases; and lucrative returns available to third-party funders.[3]

With a large number of investors, determining liability becomes an imperative area of contention, since crowdfunding provides less or no scope of return to its investors, hence questioning the prospect of liability as mentioned in the case discussed above.

In order to make this more regulate, the US security and Exchange Commission (SEC) have laid down some guidelines for regulating crowdfinding detailed out in their “A+”  factsheet which are as follows:[4]

1. Tier 1, which would consist of securities offerings of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer.
2. Tier 2, which would consist of securities offerings of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer.

4. CROWDFUNDING FOR MEDIUM AND SMALL ENTERPRISES (MSME)

Crowdfunding as we all know, is suitable for small enterprises, paving their way into the market and looking to raise investments.  The MSME sector consists of medium, small and micro enterprises which usually raise funds by tapping the share market and raise their funds from the public sector.

Recently, the European Commission came out with a communication exploring potential risks of this relatively new and growing form of finance.

Access to finance is one of the most pressing problems for SMEs who report a deterioration in public financial support (-13%), access to loans (‑11%), trade credit (-4%) and the willingness of investors to invest in equity (-1%). Many projects’ demand for financing is not met by any existing sources of finance, which is referred to generally as the financing gap. Some segments of the economy, such as social enterprises or the cultural and creative sector, do not find many responses tailored to their needs, due to their specific characteristics including social objectives or the dependence on intangible assets and the high uncertainty of market demand.  Crowdfunding matches small – or even bigger – contributors and investors directly with the projects in need of funds, mainly in the early stages.[5]

Crowdfunding not only has a singular aspect of funding, but also attracting and encouraging inventions, market analysis of what the consumer requires and acquiring of essential market knowledge and skill sets required to start a business. It brings about community funding which is necessary for job development and community building as well, which is rather a substantive way of encouraging the process of learning.

This alternative route of raising finance has come about as a ‘funding escalator’, giving a jump start to business persons to raise finance.

5. CROWDFUNDING: ISSUES AND PROSPECTS

   Issues

Certain types of crowdfunding such as Pure Donation Based Crowdfunding and Peer-to-Peer lending do not fall within the regulatory purview of SEBI, as they do not generally involve issuance of securities for financial return, and may require authorization from other regulators. For example, Peer-to-Peer lending may fall under the purview of Reserve Bank of India. The Reserve Bank of India is yet to bring about any circulars to give clarity to such P2P lending though it has acknowledged the important role it can play in the context of changing financial markets in the Financial Stability Report dated June 26, 2014.[6] Therefore, while equity and security related crowdfunding will be governed by SEBI, lending based crowdfunding will be governed by RBI. For Pure Donation Based Crowdfunding statutes like Foreign Contribution Regulation Act, 2010 may also come into play.  The major issue will be if a crowdfunding by more than fifty people in the form of equity crowdfunding will amount to public offer under Companies Act, 2013 and SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 or not? If the answer by regulators is in the affirmative it will needlessly make the process complicated and cumbersome for start-ups.  The process more than anything else will make crowdfunding an expensive and complicated affair due to the requirement of appointing merchant bankers, underwriters and registrars to the issue. The issue will deter and impede economic growth as most entrepreneurs’ will want to avoid these legal complications for early stage start-ups. The other issue would be that there cannot be any contradictions between these several legislations when they do get notified. A consolidated law to govern crowdfunding will be the manna from heaven to ameliorate the process of funding for start-ups by decreasing legal fees. Another issue will be if internet service providers who facilitate the crowdfunding would be intermediaries regulated by SEBI or not?  This will be something that some internet companies will be closely looking at.

PROSPECTS

 Crowdfunding will be a much needed elixir for star-ups if the regulators manage to keep things uncomplicated. A lot of Section 8 companies (not-for-profit), charitable trusts and NGOs/NPOs can benefit immensely out of crowdfunding if it is extended to them by law. Furthermore, a huge beneficiary will be art and culture related ventures such as movies, music albums, documentaries and theatre production.  While such entities will only be required to comply with say provisions similar to Section 42 of Companies Act (private placement), 2013 yet they will be able raise money from hundreds of persons like a public issue.  Further, to safeguard the interest of investors only such investors will be allowed to invest who can are able to bear the risk involved and by entities which have a clean track record.

6. CONCLUSION

The biggest challenge for regulators will be forming a comprehensive legal framework for all types of crowdfunding, so that there is no contradiction or ambivalence among several Regulators. It is also a great need for the hour to have expedited legislation on this matter to give clarity to those who are already crowdfunding their ventures. Further, there is a need to assess if at all crowdfunding requires the sudden attention that it is receiving given the impact of other sources of raising funds like the SME Platforms in Stock Exchanges, Private Placements, Angel Funding and  Alternative Investment Funds or will it become a proverbial “storm in the teacup”.  Consequently, the SEBI and RBI should assess the needs of the stakeholders and bring out some clarity to what the future holds for Crowdfunding in India.

[1]SEBI (2014), “Consultation Paper on Crowdfunding in India”, June17, 2014. (http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf)

[2] [2005] EWCA Civ 655

[3] http://www.lawgazette.co.uk/law/practice-points/litigation-crowdfunding/5048431.fullarticle

[4] http://www.sec.gov/news/pressrelease/2015-49.html

[5] http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52014DC0172

[6]RBI (2014) ,”Financial Stability Report”,June 26,2014

(https://rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=792)