When three is a company

As SEBI tries to regulate equity crowdfunding(Use of a large diffuse group of people to raise funds, esp. charitable funds raised by use of the internet), the Internet promises to play disrupter.
Roughly a year ago, the Securities and Exchange Board of India (SEBI) issued a consultation paper setting out its proposal to regulate equity-based crowdfunding in India. Comments were solicited from the public. Earlier this week, SEBI announced that it was working on the norms and that a decision may be taken soon.

A quick review of the SEBI paper gives us pointers to what the possible regulations could be. Under the proposed terms, three entities, namely, the crowdfunding platform, the investor, and the issuing company, would be regulated. The issuing company is restricted in terms of its size, the amount of funds to be raised and its age. The investor is restricted in terms of its accreditation, minimum net worth and, in case of eligible retail investors, the maximum investment that may be made overall or in a single crowdfunding event. Crowdfunding platforms are also restricted in terms of who may set them up and the checks and balances to be put in place.

While certain concepts such as accredited investors and maximum caps on investment in a single crowdfunded venture have been transplanted from the Jumpstart Our Business Startups (JOBS) Act in the U.S., others are homegrown. Largely, SEBI’s proposed regulations do not give an exemption to small companies to access public funds, as in the case of the JOBS Act. Perhaps a major reason for the lack of exemption stems from the fact that Indian corporate finance markets are simply not as developed or sophisticated as the ones in the U.S. and other developed economies.

The proposed regulations require that equity crowdfunded companies follow the requirements in Section 42 of the Companies Act, 2013. This means that companies may offer their securities to a maximum of 200 persons and may have up to 50 shareholders, without being required to undertake a public issue. Thus, the act of crowdfunding, under the SEBI, cannot include an offer for shares and can be used only to garner(collect,जमा करना) interest in the company seeking funds.

Cross-border crowdfunding
However, SEBI’s paper does not take into account one critical aspect — that of cross-border crowdfunding. A number of countries have passed regulations, falling largely into two categories. The first is the U.S. model, which creates an exemption as described previously. Other countries that fall into this category include Australia, Italy, Japan, New Zealand and Singapore. The second category includes countries that do not offer an exemption, such as India, Hong Kong and Malaysia.

Of particular interest is the crowdfunding law in New Zealand. It specifically allows intermediary service providers, such as crowdfunding portals, to be licensed. This licensing regime(rule,शाशन) is intended to facilitate suitably regulated ‘peer-to-peer lending’ and ‘crowdfunding’ services to operate. With regard to the fund-seeking company, the upper limit for raising funds is capped at NZ$2 million, but there are no upper limits on investment, nor is there a distinction between sophisticated and retail investors, making New Zealand one of the most crowdfunding-friendly jurisdictions.

There are two ways we may consider the case for cross-border crowdfunding in the Indian context. First, a company seeking funds from non-resident investors. Second, a company set up outside India seeking funds from investors around the world, including India. In the first case, the provisions of Section 42 of the Companies Act, 2013 would continue to apply.

Therefore, the question arises whether it would be possible to have a foreign company raise funds in India and for foreign investors to participate in crowdfunding activities in India, subject to extant inward and outward bound investment regulations and policies. But given the nature of both crowdfunding and the global reach of the Internet, it is possible that Indian investors may be involved in crowdfunding activities in other jurisdictions.

Overseas companies

The ability of Indian residents to invest in overseas companies, coupled with crowdfunding-friendly laws in other countries, come together to create an interesting scenario. Assume that a company incorporated in India is unable to raise funds from the crowd. It simply sets up a parent in a crowdfunding-friendly jurisdiction, which then seeks crowdfunding from investors around the world. An Indian retail investor, who was hitherto(till now,अब तक) unable to participate in the equity of the Indian company, is now able to do so, subject to the Overseas Direct Investment regulations. The funds raised by the parent company are then invested in the Indian subsidiary. This possible scenario brings to light the global nature of Internet-based corporate fundraising. The cross-border aspect of the platforms and, more particularly, the uncertainty surrounding contract law application in different jurisdictions has yet to be dealt with effectively. This has been acknowledged by the International Organization of Securities Commissions.

Thus, we see that in jurisdictions where crowdfunding activities are not regulated, or have minimal regulations, it would be easier to raise funds and then invest in an Indian company. The opportunities arising from the resultant regulatory arbitrage could then be used by fund-seeking companies in India. This regulatory arbitrage has been used in other modes of financing as well. It is not unusual to see companies offer a minimal IPO in India only to undertake a substantially higher fundraising exercise through a GDR issue in a listing-friendly jurisdiction, such as Luxembourg.

How does a securities regulator deal with this then? One option would be to completely ban overseas investment by individuals unless they conform to the crowdfunding regulations. A more elegant — albeit(even though,यद्यपि) difficult — solution, in my opinion, requires securities regulators across the world to work together to remove possible avenues of regulatory arbitrage.

Having said that, however, we may expect that some jurisdictions will see in this as an opportunity to begin a ‘race to the bottom’ in terms of crowdfunding regulations. Coupled with low capital gains taxes, a jurisdiction with a relatively low level of crowdfunding regulation would certainly attract fund-seeking companies.

While the Internet has acted as an enabling development in almost all industries without fail, it has its disruptive effects from time to time as well. The traditional boundaries of corporate finance are breaking down. It is time to shed older notions of corporate finance within the frameworks of political confines(limit,सीमा) and instead address the issue of the world being better connected, even within the realm(area,क्षेत्र) of corporate finance.