Crowdfunding platforms – risks and concerns in the Indian context

Timothy Lopes, Manager

Introduction

Crowdfunding as a concept has been in the limelight for quite some time now. Globally there are several crowdfunding platforms that exist. These crowdfunding platforms essentially allow almost anybody to raise funds for any cause, ideas or business ventures. Interestingly, the first online crowdfunding platform was launched back in 2001^[1].

However, with the advent of online crowdfunding platforms also comes the inherent risks associated with it. Through this article, the author aims to highlight the inherent risks associated with crowdfunding along with the legal permissibility and restraints in India.

Crowdfunding and its types – Global scenario

The concept of crowdfunding is rather wide and even includes raising funds for social causes/ donations. The 2nd Global Alternative Finance Market Benchmarking Report, 2021^[2] (‘Alternative Finance Report’) highlights the various types of ‘Alternative Finance’ of which, crowdfunding (along with its various types) account for the bulk of Alternative Finance volumes^[3]. Data from the Alternative Finance Report shows that in 2020, Alternative Finance facilitated $114 billion in transaction volume globally. This volume, however, represents a 62% decline compared to 2017, mainly due to a sharp decline in crowdfunding activities in China.

The International Organisation of Securities Commission (IOSCO) in a staff working paper titled ‘Crowd-funding: An Infant Industry Growing Fast’ (2014)^[4] drew up a classification of different types of crowdfunding.

More recently however, the Alternative Finance Report highlights the various types of crowdfunding shown in the table below –

Category	Business Model	Stakeholders
Equity-based	Equity-based Crowdfunding	Individuals or institutional funders purchase equity issued by a company.
	Real Estate Crowdfunding	Individuals or institutional funders provide equity or subordinated debt financing for real estate.
	Revenue/ Profit sharing	Individuals or institutions purchase securities from a company, such as shares or bonds, and share in the profits or royalties of the business.
Non-investment based	Reward-based Crowdfunding	Backers provide funding to individuals, projects or companies in exchange for non-monetary rewards or products.
	Donation-based Crowdfunding	Donors provide funding to individuals, projects or companies based on philanthropic or civic motivations with no expectation of monetary or material.
	Crowd-led Microfinance	Interests and/or other profits are re-invested (forgoing the interest by donating) or provides microcredit at lower rates.
Other		The research team recorded volumes raised through other alternative finance models, including Community Shares, Pension-led Funding, and other models that fall outside the existing taxonomy.

Source: 2nd Global Alternative Finance Market Benchmarking Report, 2021

Apart from the above the Alternative Finance Report also highlights the meaning of peer-to-peer or marketplace lending which include “non-deposit taking platforms that facilitate online credit to individuals, businesses or other borrower entities from individual lenders or institutional investors”.

Another type of crowdfunding that exists is called ‘crowdfunding for fractional assets/ property’. This will be discussed in more detail later.

Inherent risks and concerns in crowdfunding

When we talk about crowdfunding (mainly equity-based), which is in essence, pooling of money/ raising capital by early stage ventures from the public at large while promising an enticing return, there exists an inherent risk of small investors losing money.

There have been massive financial scams in the past where small investors have fallen prey to the risks of crowdfunding. Where bigger investors like qualified institutional buyers (QIBs), high net-worth individuals (HNIs), angel investors are involved in crowdfunding, there does not seem to be an issue, since these investors have a higher risk tolerance and are able to fully comprehend the risks involved from investing in whatever scheme of capital raising, because they have the expertise to make such a financial call or they have the means to bear losses, if any.

However, where retail investors or smaller investors’ money is involved, there is an inherent risk. These investors may not fully understand the risks associated with crowdfunding investments and may be lured into making an investment just by the enticing returns promised to them. A report^[5] highlighted this concern and states that “Small investors in equity crowdfunding are less equipped to perform due diligence relative to professional investors and investment bankers. They cannot rely on the role of financial analysts and have limited incentives to actively engage in due diligence, due to the fixed costs incurred relative to the small size of their investment. Additionally, the valuation of the type of firms that they are asked to finance is likely to be difficult.”

Indian case studies – where crowdfunding became crowdfrauding

The Sahara bond scam –

Take for example the Sahara bond scam, where over Rs. 20,000 crores was raised from 22.1 million investors, claiming that this was ‘private placement’, putting at risk millions of small investors, who may not have had the know-how or expertise when it comes to investing in such crowdfunding schemes^[6].

The Sahara case took place in 2012, after which the private placement norms were tightened and made more stringent^[7] to avoid such a case from recurring again. The Securities and Exchange Board of India (SEBI) had issued a consultation paper on crowdfunding in India^[8] which recognised the tightening of private placement norms by stating that “Taking into account the recent misuse of private placement route by some companies which issued huge number of debt securities to public under the garb of private placements, Companies Act, 2013 and Rules made thereunder, have put some restrictions on private placements, which was previously lightly regulated.”

The case of collective investment schemes and chit funds –

Likewise, the case of plantation schemes, where massive returns were offered on small investments to lure and trap investors in a Collective Investment Scheme (CIS)^[9], pursuant to which the government realised the need for regulation of such schemes and introduced the SEBI (Collective Investment Scheme) Regulations, 1999^[10]. Further, the so-called ‘chit fund’ scams brought into picture the Banning of Unregulated Deposit Schemes Act, 2019^[11].

So it would seem that regulation has always followed in order to curb crowdfunding scams that lure retail investors under the pretext of making fast money. The intent is logical and emphasises that where small investors’ money is involved, crowdfunding must be strictly regulated so as to avoid another massive scam.

Recently, the Registrar of Companies (ROC) in India, issued orders^[12] against companies who were raising money by way of private placement from the public at large through crowdfunding platforms. This makes it interesting to understand what type of crowdfunding comes under scrutiny from regulators.

Crowdfunding – the scenario in India

Earlier we discussed the different types of crowdfunding that are prevalent. Let us dive deeper and understand the concerns, if any, with these different types of crowdfunding.

Social Lending or Donation-based crowdfunding –

This type of crowdfunding is a non-investment based crowd-funding. The idea of donation based crowdfunding is to make a donation without the expectation of any return. There are no financial returns involved and hence, even individual participants have the freedom to make a donation for a cause they want to support.

While this type of crowd-funding does not necessarily seem carry paramount risks, in the Indian context, SEBI has recently issued a ‘Framework on Social Stock Exchange’^[13] where donation-based crowdfunding can happen, within a regulatory framework governed by SEBI^[14]. Accordingly, social enterprises are encouraged to come under the ambit of the social stock exchange framework for donation based crowdfunding.

Peer-to-peer lending/ marketplace lending –

This type of crowdfunding essentially connects lenders with borrowers on an online platform, for loans/ financial assistance of an unsecured nature^[15]. There are concerns with this type of crowdfunding and hence, there exists a regulatory framework for peer-to-peer lending in India. A consultation paper on peer to peer lending was issued by the Reserve Bank of India (‘RBI’) in April 2016^[16] which laid out the arguments for regulating peer-to-peer lending activities stating that “If the sector is left unregulated altogether, there is the risk of unhealthy practices being adopted by one or more players, which may have deleterious consequences”.

In this regard, the RBI has issued the Master Directions – Non-Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017^[17] that lays down the regulatory framework within which peer-to-peer lending may be done.

Securities-based/ equity-based crowdfunding –

When it comes to crowdfunding for the purpose of capital raising and where the issue of securities of any kind are involved, there is certainly an issue with this type of crowdfunding. The Sahara case highlighted earlier is one of the reasons why there are strict norms in place for this type of crowdfunding.

The issue that arises is that most of the crowdfunding platforms, whether fintech or otherwise, raise capital for the companies onboarded on such platforms by way of private placement under the Companies Act, 2013. The private placement norms under the Companies Act, 2013 are covered under section 42 read with the Companies (Prospectus and Allotment of Securities) Rules, 2014.

The main features of the private placement norms to note here are that the offer or invitation to subscribe to securities under private placement cannot exceed 200 persons in aggregate in a financial year. Also, there can be no public advertisements or use of any media, marketing or distribution channels or agents to inform the public at large about such an issue. Further, the offer can be made only to persons who are specifically identified by the company prior to making such an offer to subscribe.

If a start-up intends to raise capital on crowdfunding platforms by way of private placement, this would not be possible at all for the following reasons –

The investors have to be pre-identified (which is not the case when it comes to a crowdfunding platform;
A private placement of securities cannot be publicly advertised to the public at large to subscribe to the issue, which is essentially what is done on crowdfunding platforms in India;
Further, the private placement can be done only to 200 persons in aggregate in a financial year.

The private placement norms have always made this clear and thus, the recent rulings by the ROC is nothing new.

The SEBI consultation paper on crowdfunding referred to above also recognised the private placement concerns in security-based crowdfunding and made a proposal that crowd-funding be allowed only to ‘accredited investors’ (which would’ve include QIBs and HNIs)

Crowdfunding for fractional assets –

This type of crowdfunding essentially involves a platform where individuals can get together to buy a property and participate in the rentals and capital gains it can generate. The investors would be ‘fractional owners’ or ‘shared owners’ of the property.

The coming together of persons for the purpose of collective business pursuits or collective ownership of properties is common and would not attract any regulatory concerns so-far as crowdfunding is concerned. However, if the collective ownership of property where the investors have no exclusive control over the property, concerns arise that it could be in the nature of a financial investment that ought to be regulated as a ‘Collective Investment Scheme’^[18].

Conclusion

With crowdfunding comes concerns and potential scams that small investors or rather the public at large are exposed to, which could lead to substantial amounts of losses and the subsequent loss of confidence in the financial system of a country.

While crowdfunding and its various types certainly carry benefits, operating within a prescribed and carefully laid out regulatory framework is the way to go, so as to avoid the inherent risks associated with crowdfunding.

^[1] Source: A literature review and integrated framework for the determinants of crowdfunding success (2022) – https://link.springer.com/article/10.1186/s40854-022-00345-6

^[2] https://www.jbs.cam.ac.uk/wp-content/uploads/2021/06/ccaf-2021-06-report-2nd-global-alternative-finance-benchmarking-study-report.pdf

^[3] This was also noted by the crowdfunding report published in September 2021, by the Investment Climate Reform Facility – https://www.icr-facility.eu/fileadmin/files/downloads/icreports/icreport_crowdfunding_english.pdf

^[4] https://www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf

^[5] Inclusive digital finance: the industry of equity crowdfunding (Vincenzo Butticè & Silvio Vismara), 2022 – https://link.springer.com/article/10.1007/s10961-021-09875-0

^[6] More on the Sahara case here – https://www.moneylife.in/article/supreme-courts-sahara-ruling-salute-to-the-judges-but-a-huge-question-mark-before-financial-regulators/28218.html

^[7] The Companies (Prospectus and Allotment of Securities) Rules came out in 2014

^[8] https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf

^[9] More on the plantation schemes scam – https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

^[10] https://www.sebi.gov.in/legal/regulations/may-2022/securities-and-exchange-board-of-india-collective-investment-scheme-regulations-1999-last-amended-on-may-10-2022-_58896.html

^[11] https://egazette.nic.in/WriteReadData/2019/209476.pdf

^[12] See – https://www.mca.gov.in/bin/dms/getdocument?mds=I4whIqT0vI2s3pZZHS8PiQ%253D%253D&type=open and https://www.mca.gov.in/bin/dms/getdocument?mds=lMLiMBtr8is12CmacNEbag%253D%253D&type=open

^[13] https://www.sebi.gov.in/legal/circulars/sep-2022/framework-on-social-stock-exchange_63053.html

^[14] Our article on social stock exchange can be viewed here – https://vinodkothari.com/2022/08/social-stock-exchanges-philanthropy-on-the-bourses/

^[15] Read our report on P2P lending in India for more details – https://vinodkothari.com/2023/02/p2p-lending-in-india-report/

^[16] https://rbidocs.rbi.org.in/rdocs/content/pdfs/CPERR280416.pdf

^[17] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11137