Share-hawkers of digital era: Legality of platforms offering unlisted shares
– SEBI cautions investors from transacting in securities of unlisted public companies on electronic platforms
– Burhanuddin Kholiya (corplaw@vinodkothari.com)
From rental rooms to cabs to domestic furniture, almost everything is made available using technological aggregators. But the moment one tries to sell securities on public platforms, the chances of potential investors being duped by dream merchants increase – something which regulators have very carefully barred over the years. Hence, unless it is a recognised stock exchange, making securities available on public platforms constitutes “offer for sale”. Sometimes, people look at the number of investors as less than 200 and tend to argue that is not a deemed public offer, but it is important to understand that if the offer has gone to people in general, the actual number of investors who bite the bait does not matter.
Many platforms encourage investments in unlisted or pre-IPO stocks. At times bunching either securities or investors. SEBI, in its press release dated December 9, 2024, warned investors against transacting on such platforms, emphasizing the risks involved and clarifying that these platforms operate outside SEBI’s regulatory framework.
Regulatory framework for platforms:
On the intermediaries front, stock brokers are permitted to deal only on recognised stock exchanges and are prohibited from facilitating trading outside these exchanges. In 2022, SEBI extended its regulatory framework to Online Bond Platform Providers (‘OBPP’) by mandating them to register as stock brokers in the debt segment and restricted their offerings to listed debt securities or debt proposed to be listed through a public offering. Only recognized stock exchanges are authorised to provide a platform for fund raising and trading in securities of “to be listed” and “listed” companies.
Apart from above, today, numerous platforms have emerged offering unlisted securities to the public at large. However, being unregulated, it poses significant risks to investors. While SEBI’s mandate may not extend to unlisted securities, it continues to caution investors about platforms dealing with such securities. Recognizing the potential risks and lack of oversight, SEBI and the Registrar of Companies (ROC) have issued several orders against platforms offering unlisted securities to the public. These actions aim to protect investors from being misled and address violations of private placement & public issue related provisions under the Companies Act, 2013.
Modus Operandi of unlisted share brokers
Unlisted securities are primarily traded by way of a transfer. Traditionally, the transfer of securities is a private arrangement between two identified parties, namely the transferor and the transferee, who explicitly agree on the sale and purchase of a fixed number of securities.
The key distinction between transfer of securities and public offer of securities lies in the pre-identification of parties, exclusive offer and defined terms.
Therefore, when securities are offered for sale to unidentified persons without limiting the number of purchasers, this could effectively constitute an indirect public offer (which also includes an offer for sale).
As pointed out above, many unregistered platforms offering unlisted securities have emerged. These platforms often target unidentified persons and provide no limit on the number of purchasers, effectively transforming such offers into indirect public offers in the form of “offer for sale”.
Listing securities for sale on a publicly accessible platform may, intentionally or unintentionally, transform a private arrangement into an offer resembling a public offer. Unlike private transfers, public offers are subject to stringent regulatory requirements, such as issuing prospectus, detailed disclosures, and continuous regulatory oversight. Failing to adhere to these requirements could undermine investor protection and market integrity.
Structuring of Transactions as “Secondary Sale”
The practice of structuring transactions as secondary sales is an innovative strategy employed by fintech platforms to broaden market access while navigating regulatory challenges. However, this approach raises significant concerns about compliance, investor protection, and market integrity. Striking a balance between innovation and regulatory compliance is essential to establish a transparent, fair, and robust investment ecosystem.
In this model, a fintech platform, operating through its legal entity, subscribes to securities offered via private placement by a company. Often, these platforms are the sole or principal investors in such placements. Once the securities are acquired, the platform lists them on its portal as available for investment by way of transfers from itself to individual investors, presenting them as secondary market transactions ostensibly outside the scope of public offer regulations. The interface almost resembles a broking app, where one can click and ‘buy 1 share’ instantly.
In some cases, the platform and the warehousing entity are separate. Additionally, some platforms claim that the transferors comprise of promoters, employees, KMPs of those enlisted public companies.
Motivations behind structuring as Secondary Sale are twofold:
1. Avoiding Public Offer Regulations:
Public offers of securities are subject to extensive regulatory oversight, including stringent disclosure requirements and mandatory listing. By structuring transactions as secondary sale, platforms consider to bypass these regulations.
2. Enabling Retail Investor Access:
Structuring investments as secondary sale allows platforms to make securities available to retail investors who might otherwise be ineligible to participate in private placements.
Making securities available to large number of unverified investors
As discussed earlier, an offer that can be accepted by anyone effectively qualifies as a public offer, regardless of how it is officially labeled. In contrast, private placements are designed for a limited, pre-identified group of investors and are subject to stricter regulatory controls to maintain their exclusivity.
Fintech platforms, however, challenge this distinction by leveraging technology to make securities accessible to a broad audience of unverified users, thereby creating a regulatory gray area. By listing securities on their portals—accessible to anyone who registers—these platforms effectively transform private placements into publicly available investment opportunities.
Moreover, these platforms often lack stringent verification processes to ensure that users meet the criteria for accredited or eligible investors. Instead, they use digital advertising, user-friendly applications, and social media campaigns to promote investment opportunities, indirectly engaging in general solicitation. This practice, while sometimes technically compliant, directly conflicts with the principles governing private placements, which prohibit public solicitation.
These practices raise significant concerns regarding investor protection and compliance with the existing regulatory framework. By making securities easily accessible to a wide, largely unverified audience, fintech platforms blur the line between private and public offerings. This not only undermines the purpose of private placement regulations but also exposes retail investors to potential risks without the safeguards typically associated with public offers.
While fintech platforms argue that their practices promote financial inclusion and innovation, they also highlight the urgent need for regulatory clarity. Striking a balance between fostering innovation and ensuring compliance is critical to maintain market integrity and protect investors.
Pricing Mechanism: Misalignment with Market Practices
Fintech platforms often claim that the pricing of unlisted shares is driven by demand and supply, similar to listed securities. However, this approach diverges significantly from standard practices for valuing privately placed securities, which typically rely on Fair Market Value (FMV) mechanisms.
Unlisted securities, being inherently illiquid and less transparent, are usually valued based on financial fundamentals, such as earnings, book value, or discounted cash flows, rather than speculative demand and supply dynamics. The reliance on a demand-supply pricing mechanism for illiquid securities can result in significant price distortions. Prices may be artificially inflated or deflated, often without any material change in the underlying company’s fundamentals.
This speculative approach to pricing can mislead investors into believing that the listed price represents a fair valuation of the security. In reality, such pricing mechanisms expose investors to risks of overvaluation or mispricing, especially in the absence of robust valuation methodologies.
Furthermore, the process for investors seeking to liquidate their unlisted shares on these platforms is often vague and lacks the transparency necessary for informed decision-making. Without clear guidelines on how prices are determined or how liquidity is managed, investors may face challenges in accurately assessing the risks and returns associated with their investments.
Violation of private placement & public issue norms
The aforementioned two modes of issuance differs from each other on various parameters:
Parameters | Private Placement | Public Offer |
Meaning | Offer or invitation to a select group of persons to subscribe to securities, excluding the general public. | Includes IPO or FPO of securities to the public or an offer for sale of securities by an existing shareholder through issue of prospectus. |
Who can invest? | Restricted to pre-identified investors addressed in the private placement offer-cum-application letter. | Open to the public at large. |
Maximum number of investors | 200 persons in a financial year, excluding QIBs and employees offered securities pursuant to ESOP scheme under Section 62 (1) (b) of CA, 2013. | No maximum limit on number of investors. |
Offer Communication | Communicated directly to the identified investor; cannot be advertised to the general public. | Communicated via advertisements, circulars, or a prospectus to the public. |
Process | Conducted via a private placement offer-cum-application, adhering to specific conditions outlined in Section 42 of Act. | Requires a prospectus with mandatory disclosures and regulatory oversight, governed by SEBI (ICDR) Regulations, 2018 |
In terms of Section 25(2) of CA, 2013 a private placement will be considered as securities being offered for sale to the public if it is shown that an offer of the securities or any of them was made within 6 months after the allotment or agreement to allot; or on the date when offer was made, the consideration was not received by the company in respect of the securities. Therefore, subscribing to private placement merely with the intent to warehouse temporarily and downsell to the public will attract the public issue norms. Penal provisions for flouting private placement norms, not following public issue norms are quite stringent.
Conclusion
While securities of public companies are freely transferable, it cannot be traded on unregulated platforms. The fintech platform’s current modus operandi raises concerns about pricing practices, process transparency, and regulatory compliance. SEBI’s advisory underscores the need for vigilance, as these platforms often lack regulatory oversight, investor safeguards, and transparency. Unlike public issues, which ensure grievance redressal mechanisms like SCORES and SMART ODR transactions on these platforms leave investors without formal recourse. The numerous platforms offering unlisted equity shares need to revisit in view of SEBI’s caution letter.