Crowdsourcing funds faces stiff penal actions

Nuanced structuring, conduit investor or platform advertising punished with crores of penalties

(last updated November 21, 2024)

– Pammy Jaiswal, Partner | pammy@vinodkothari.com

Background

Use of digital platforms for tapping the early stage or ongoing funding is being seen more often than before, and quite obviously so, in a networked world where crowdsourcing and crowd placing of almost everything is the norm^[1]. Several well-known platforms have been showcasing the immense potential to raise funds for startups from either private equity investors, reaching very often to retail investors too. Popular TV shows spotlighting investments in start-ups have turned fundraising entrepreneurs into celebrities, further fueling this trend. In such an environment, it is notable to find that crowdsourcing funds by a startups is said to breach the law and is attracting huge penalties.

It is essential to consider several provisions of the Companies Act, 2013 (‘CA 2013’ or ‘Act’) dealing with public issuances and private placement, along with recent orders by the RoC and SEBI. These authorities, through detailed reasoning, have imposed significant penalties for violation, highlighting that offering privately placed securities to the public—especially through online platforms—is being done in striking contravention to Act, SEBI Act as well the SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 (‘NCS Regulations’).

This article delves into the regulatory framework for private placements, instances of non-compliance, and the legal challenges highlighted by the RoC Delhi’s order as well as a recent ex-parte interim order passed by SEBI. It also explores how start-ups with innovative ideas but limited financial history can navigate these rules to raise funds without affecting enterprise and innovation.

Explicit stipulations and restrictions under private placement norms

The provisions of the Act dealing with raising of funds privately is primarily section 42 read with the rules made thereunder along with other related provisions like sections 62 (1) (c), 23, 25 as well as 71 (in case of issuance of debentures) of the Act.

Following the uncontrolled and misguided actions in the issuance of securities on a private placement basis and the decision rendered by the Hon’ble Supreme Court in the case of Sahara India Real Estate Corporation Ltd. v. SEBI & Ors. [(2012) 10 SCC 603], the scope of private placement was substantially modified under the new Act regime when compared to the erstwhile Act. Section 42 of the CA 2013,  corresponding to section 67 of the Companies Act, 1956 further underwent several changes pursuant to various amendment brought in by the Companies (Amendment) Act, 2017^[2].

Stipulations / conditions	Absolute restrictions
Offer or invitation to a select group of persons not exceeding 200	Use of any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue.
Circulation of PAS-4 only after filing of form MGT-14	A subsequent offer of private placement cannot be made unless the allotment under the previous offer has been completed or has been abandoned or canceled, as the case may be.
Application to made along with subscription money paid either by cheque or demand draft or other banking channel and not by cash	Restriction on utilization of funds raised till allotment is filed with the RoC
Funds received on application under this section shall be kept in a separate bank account in a scheduled bank

Having said that, it is important to note that in case of diversion with the private placement norms, the same is likely to take the character of a public issuance which again is regulated by SEBI. Section 42(2) of the Act also states that where the offer to subscribe to the securities exceeds 200 in any financial year, the said issuance is deemed to be a public offer and will therefore attract all the applicable requirements under the concerned SEBI regulations. In fact, to be precise, the public issuance of debt securities is governed by the NCS Regulations where as specified securities are covered under the SEBI ICDR Regulations. There are several requirements under the SEBI regulations which become applicable in case of public issuance of securities so as to safeguard the interest of investors at large.

Platforms for listed debt

SEBI has established a regulatory framework for Online Bond Platform Providers (‘OBPPs’) to facilitate the offering of listed debt securities in a controlled and compliant environment. SEBI recorded a detailed discussion on why the restrictions on either selling of listed bonds on an OBP as well as selling without any lock-in restrictions cannot be said to have any concern or impact on the interest of the investors. To summarize, the rationale was given on the following lines:

SEBI already has regulations on issue and listing of privately placed debt securities which inter-alia provides for furnishing of private placement memorandum (which itself is very elaborate), memorandum of association, articles of association, requisite resolutions from the board or committees authorizing such listing of securities on Stock Exchanges.

Once listed, the issuer has to follow all the requirements including detailed disclosures at various intervals. Hence, once the securities are listed, there is not likely to be any circumvention of key public issue requirements. Lock-in requirements, if introduced, may rob the investors from liquidity and the opportunity to exit their investments, if so desired.

Debt investors may involve mutual funds or other institutional investors. Restrictions on liquidity can have ramifications which could have large scale implications. Accordingly, lock-in requirement for listed debts is not proceeded with.

Detailed discussion can be referred to in our write-up “Regulatory Framework for Online Bond Platform”.

Recent Cases where private placement norms were found to be flouted

There have been several cases where the provisions of private placement were found to be violated either explicitly or by the use of certain devices like stopover investor; agreements’, use of open-ended electronic media or other nuanced structures. However, use of devices cannot beat the law and whether it is raising of equity or debt, does not make any difference.

RoC’s adjudication orders:

The major issues for which the MCA has penalized the companies as well as their officers are as follows:

1. Use of media, advertisement and distribution channels to inform the public at large about private placement

In the matters of some private companies[3], tyke platform was used to inform the public at large about private placement of CCDs. The argument of the company that the allotment is made to persons less than 200 does not hold any merit as the first restriction by itself has been flawed by these companies.

2. Structuring of the instrument in a manner that makes it fall outside the meaning of securities as well as other violations (usage of media/ advertisement, non-filing of PAS-3, etc)

In one of the cases[4], the company came out with Community Stock Option Plan (CSOP) and offered and issued community stock options on digital platform wherein the investors may be rewarded based on the future valuation of the company. These options also gave a chance to receive Share Appreciation Rights (SARs) as communicated by the issuer entity to the investor. The issuer referred to the case ruling of Hon’ble Supreme Court in SEBI v. Rakhi Trading Pvt. Ltd.[ 2018 (13) SCC 753] and of the Hon’ble Bombay High Court in Percept Finserve Pvt Limited v. Edelweiss Financial Services Limited [2023 (2) TMI (Bom HC) ] to state that CSOP is not deriving its value from any underlying variable like shares. 

However, based on the evidence, the regulator clearly concluded that since the valuation of these options are linked with the valuation of the equity shares, these are nothing but derivatives and hence, securities. Following these, the company was found to be in violation various provisions of section 42 which included

• sub-section (2)  – offer to a selected group of persons;
• sub-section (6) -allotment of securities within a period of 60 days of receiving the subscription amount;
• sub-section (7) –  usage of media, advertisement and distribution channels; and
• sub-section (8) – filing of form PAS-3 for allotment of securities within a period of 15 days of allotment

3. Offer to subscribe to one allottee which in turn uses the digital platform for down-selling the securities so acquired

In one of the cases[5], the said company offered and issued equity to one of its group entity which in turn used the platform of the same issuer entity to down-sell the shares so acquired.

The regulator came down heavily by calling the transaction as a ‘nuanced structuring’ by clearly indicating the following:

• offer was made to large section of people and not limited to 200 – issuing securities in open forum is considered as a non-compliance
• Use of the platform for raising securities, putting pitch information, raising money from general public through platform amounts to issuance of public advertisements or utilization of media, marketing or distribution channels or agents to inform the public at large about such an issue.
• there was a clear nexus between the first issuance and the down-selling it is nothing but offer to those to whom the securities have been sold and therefore filing of the details in PAS-3 will also be required within the time frame given in section 42(8)
• apart from the alleged non-compliances there was irregularities like valuation date was as on date when the company was not even in existence
• website of the issuer shows that 1 crore was raised from 76 investors and on the other hand the company alleges that it has issued it to only one investor
• crucial financial information was used to pitch like financial ratios, etc and there were misleading advertisements in news media and other portals.
• Pitch information contained
  • access to several companies
  • returns are over and above the expectations
  • easy investment mode
  • research based reports available for investing decisions
• the intention was always to offer the securities at large to the public at large and the stopover entity was used only as a smokescreen.
• in case of secondary transfer section 58(2) provides for free transferability for shares of a public limited companies however the same has to be read with due subject to the provisions of section 42(7).
• the quantum of penalty is dependent upon the factors given under rule 3(12) of the companies (Adjudication of Penalties) Rules and appeal lies to the Regional Director.

4. Execution of agreement with the first allottee which owns the digital platform to act as an exclusive partner to find potential investors

In one of the cases[6],  the issuer entity under a specific brand name contended that it has offered and issued shares to only one entity (platform entity). However, it was found and concluded that the said allottee was used as a stopover to actually offer securities to the public at large through the platform. It was also found that agreement entered into between issuer and the platform entity to state that the platform entity may approach the potential investors with whom the platform entity already has established a substantive and pre-existing relationship. With this, the issuer entity ended up in having 1806 investors. While the issuer contended that the change in number is primarily due to transfer of shares, however, the clauses on having a referred buyer and outreaching on a public platform made it a case violating the provisions of section 42. In fact, it was evident that the platform entity had no intention of keeping the shares so acquired from the issuer since the categorisation of the investment was inventories rather than non-current investment

Under all the aforesaid cases, the regulator found evidences to conclude by primarily looking at the following:

• Financial Statements filed to look for the basic details about the company;
• Website of the issuer entity as well as the platform entity to see what all information has been showcased including any specific video presentation made for pitching;
• Annual return of the issuer entity to understand about the business of the issuer entity; and
• Other information like emails or letters sent to the subscribers

SEBI’s order in the matter of Unregistered Online Platforms

Recently SEBI issued interim ex-parte order to addresses the concern with respect to the unregistered online platforms (UOPs) offering unlisted Non-Convertible Debentures (NCDs) to the public, which violates the Act, SEBI Act, 1992, and related SEBI regulations.

Certain online platforms have come under scrutiny for violating these regulations and have been identified for examination due to their alleged practice of offering unlisted NCDs to retail investors without obtaining the necessary registration under NCS Regulations.

These platforms were reportedly selling unlisted NCDs to the public, even though they had initially subscribed to these securities through private placement—a process subject to less stringent regulatory requirements compared to public issues. SEBI categorically pointed out that by doing so, they bypassed the stricter compliance framework mandated for public issuances, raising significant regulatory concerns about investor protection and market integrity.

The key findings of SEBI examination under said order are as follows:

1. Lack of Safeguards and Public Accessibility

As per SEBI, the current structure of these platforms appears deficient in mechanisms to ensure compliance with the regulatory cap of offering unlisted NCDs to no more than 200 investors. These platforms allowed unrestricted public access, enabling any registered user to subscribe to the NCDs, thereby breaching private placement norms and exhibiting characteristics of a public offer.

2. Down-selling of privately placed unlisted NCDs

SEBI noted that unlisted NCDs were initially offered by private limited companies on a private placement basis, as outlined in the offer letter (PAS-4). Citing Section 25(2) of the Companies Act, 2013, SEBI emphasized that the subsequent down-selling of these privately placed unlisted NCDs to the public by online platforms exhibited the traits of a public issue, thereby necessitating adherence to stricter regulatory norms.

3. Misleading Disclosures and Potential Mis-Selling

It was also mentioned that these UOPs claimed that the transactions on their platforms and the products offered complied with the provisions of the Companies Act and SEBI Regulations. These disclosures appear to be misleading, raising concerns about the mis-selling of securities to investors. The activities carried out on these platforms prima facie fall under the scope of Regulation 4(2)(s) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practice Related to Securities Market) Regulation 2003, which prohibits fraudulent or deceptive practices in securities transactions.

4. Use of media, advertisement and distribution channels

Section 42(7) of the Companies Act, 2013, explicitly prohibits issuers from using distribution platforms to facilitate private placements. SEBI observed that the identified platforms facilitated the sale of privately placed securities to the public, effectively constituting a public issue without complying with the applicable regulatory norms. Based on its prima facie findings, SEBI has directed further investigation into the matter.

Above findings led SEBI to issue interim ex-parte directions to cease the public offering of securities on these platforms and preserve all related records for further investigation. The order aims to protect investor interests and maintain the integrity of the securities market by preventing unauthorized public offerings of unlisted NCDs.

Critical analysis

As discussed above, it is clear that private placement of securities excludes the engagement of any sort of media, whether in print, electronic or oral so as to advertise the fund raise. Further, the same involves making a private offer or invitation to a select group of persons by circulating an offer letter which contains the details about the proposed issuance as opposed to a public announcement through offer document in case of public issue. It is imperative to note that the stipulations and restrictions under section 42 are clearly laid down so that the issuers can ensure compliance with the same.

However, given the cases adjudicated by the regulator, it was observed by the RoC and SEBI that companies are trying to create gullies to avoid or overcome the conditions as well as the restrictions under the private placement norms.

Secondary transfers

In some of the cases discussed above, it was contended by the subject companies that their offer was only to one or permissible number of allottees as provided under the law, and the other investors coming into existence is by virtue of transfer of securities and not subscription to the security being offered. The cases also refer to section 58(2) which allows for free transferability of securities in case of a public company. However, the RoC was clear enough to state that the compliance with the same has to be seen subject to the protection of the norms of private placement and not in isolation.

Deemed public issuance – Section 25(2)

An extremely underrated provision which automatically makes an issuance akin to a deemed public issue is the provision under section 25 (2) of the Act. The said provisions starts with the deeming provision clause to be proved otherwise, if the specified events take place. One of these events is to offer the securities or any of them for sale to the public within six months after the allotment or agreement to allot. Having said that this restriction is not to be applied for listed debt being sold on Online Bond Platforms, as discussed below.

Way Forward

After going through the provisions of section 42 and the non-compliances pointed out by the RoC and SEBI in all above cases, it becomes clear that as long as the issuer company complies with the stipulations and restrictions of the said provisions, the regulators will not side gaze the concerned entities.

Having said that, we also need to understand that for entities with no track record of capital raising but promising business ideas, absolute closure of access to potential investors will create an environment to kill the budding enterprises. This cannot surely be the intent of private placement norms where the idea is to curb disguised public issuances under the banner of private placement to dodge the compliances requirements. In doing so, there is a lack of information about the issuer which may lead to misguided investment decisions for those wanting to invest, especially the  naive investors. The public issuances are anyway either on the main board or the SME board of the exchange, therefore, one may look at a proposed framework which does not close the door for fund raising from a closed group of investors and at the same time is within the periphery of section 42 of the Act.

A possible way forward has been discussed below which may be considered, however, with caution to allow private placements without contravention of the provisions.

Major Restriction which is violated

Probable solution

absolute restriction to use or engage any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue. This means that the following cannot be done in case of private placement: informing the public at large throughusing public advertisementutilizing media, marketing or distribution channelengaging agents

If there is a closed group of potential investors with certain specified eligibility criteria.   Any new person who happens to meet the criteria can join the group for looking out for promising startups or investment avenues   A platform may be floated where this group of investors may be registered with. Such platforms may be that of the govt like parallel to the OBPPs for listed debt or private platforms which have been registered with authorities (where required by law).   Similarly the start up which is looking to raise funds provides all the necessary information to the said platform.   The said platform may consider sharing of the investment opportunity with only limited number of those participants who or which meet the eligibility criteria for such investment and in doing so takes care of the provisions of section 42, especially with respect to the following:   does not advertise the issuance to all on its platform but either engages on one to one discussion or arranges discussion between the issuer and the investorin no event can the offer (post discussion) is made individually by the platform to such proposed investors which exceeds 200 for each issuance and with the express authority of the issuer entity.there is a specific and mandatory requirement for both potential investors as well as startups to be allowed to register only if both the parties feed all required details like for investor, some indicative information like minimum net worth, minimum past investment criteria,risk appetite, etcfor the issuer, some indicative information like business plan, projections, existing market share, etc.express restriction to down sell such securities within the next 6 months in conformity with section 25(2) of the Act.

Concluding remarks

In the year 2016, SEBI started observing such practices and issued a cautionary notice to the investors to access unregistered electronic platforms for making investment. The regulators looking after the compliance requirements and interest of the stakeholders have already started to show signs of disagreement with the model on various fronts. In today’s environment, having access to funds is fundamental to any organization. In fact globally, the crowdfunding norms have already been made a part of the regulatory framework, for example the US already have their Regulation Crowdfunding Rules and there are Crowdfunding Rules issued by the Financial Conduct Authority in the UK. Therefore, to curb such cases in India, it is important to consider if some sort of specific review is needed in the policy framework itself so as to make it fit into the present day funding and investment matrix.

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^[1] Read the research based article on the concept of digital crowdfunding here: https://www.researchgate.net/publication/357293880_Digital_disbursements_over_crowdfunding_platform_for_start-ups_in_India_with_blockchain_technology_a_conceptual_framework

^[2] Read our write up on “Revised, stringent private placement framework becomes effective: a step-by-step guide to compliance”

[3] See the detailed orders here: 1^st company and 2^nd company

[4] See the detailed order here

[5] See the detailed order here

[6] See the detailed order here

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