The first domino to fall? The impact of equity crowdfunding in India following a regulator’s stern order
Introduction
In what is sure to be a case that rattles the start-up crowdfunding world, the RoC — Delhi, Haryana recently found a Delhi-based company liable for breaching the private placement regulations. The company’s use of an equity crowdfunding site to secure funding was at the centre of the infringement. The decision raises several important points that serve as both cautionary tales and reference points for crowdfunding websites and the companies that use them to generate capital.
To set the context, the company is minimally capitalised, with an approx. revenue of INR 31 lakh and a loss of about 75 lakhs. To raise funds, it engaged Tyke, a portal that offers a tech-based community that allows users to attend pitch meetings for companies seeking financing. It seems Tyke also facilitated various aspects of the fundraise that included conducting a KYC of prospective investors, establishing an escrow account on behalf of the company, and assisting the company in completing the private placement process as required under the Companies Act 2013
What is a private placement process?
Every company wishing to raise capital by issuing securities (a broad term that encompasses equity shares and equity-linked instruments such as compulsorily convertible debentures) is required to complete specific measures before allotting securities and raising capital. These include seeking necessary corporate approvals from the board and shareholders, issuing appropriate letters and documents to the proposed investors, and filing the relevant forms with the RoC. Most importantly, after the Sahara debacle that allowed a corporate group to subvert capital market requirements, a ‘private placement’ under the new 2013 statute, could only be offered to a limited number of persons per round and per financial year. For the aggregate total, that number is 200.
With that out, let us continue with the order.
The terms of use for Tyke were clear; they stated that Tyke’s purpose was only to act as a service provider to its members and companies on the platform. While it may have suggested to the company that it would help with the private placement process, Tyke’s terms of use clearly specified that it is the company’s responsibility to ensure compliance with the private placement rules. Most importantly, the terms of use also represented that no information on its platform “…is intended to constitute… an offer or solicitation of offer…” and “…Our platform has an internal mechanism to restrict the number of Investors that view the detailed profile to 200 by default thereby making it compliant with the applicable laws.” These sentences will be important as we move on.
Interestingly, the order notes that the Company issued compulsorily convertible debentures through Tyke. Tyke advertises investments through various instruments that include CCDs, compulsorily convertible preference shares, non-convertible debentures, and an innovative instrument called a CSOP which appears to be akin to a stock option plan where the ‘investors’ receive stock appreciation rights instead of straight-up equity or debt instruments. Thus, it is important to clarify that the order pertained to the issuance of CCDs by the company. While it is clear that a company must adhere to the private placement regulations in order to issue CCDs or CCPS, the clarity is diminished when one considers a CSOP. It will be interesting to understand how (if at all) the RoC considers the participation of investors in a CSOP as one that requires compliance with the private placement norms.
So, what did the company say?
The company responded with a clear chronology of the steps it took to provide certain Tyke platform users with the private placement offer documents after receiving the required board and shareholder permission. It also clarified that Tyke’s role included facilitating the “verification of information…and, to facilitate the collection of the subscription amount in the designated escrow account of the company.”
However, the RoC was not satisfied. Particularly, the order noted that Tyke’s website specified that the “CCDs [were] oversubscribed” and that the company had not given a satisfactory response to the allegation that engaging the services of Tyke, amounted to a violation of Section 42(7) of the Companies Act.
Section 42 (7) is an important provision under the private placement rules that prohibits an entity from advertising or marketing its fundraise. Below is the exact language:
(7) No company issuing securities under this section shall release any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue.
The RoC also noted a crucial issue — the money from the subscribers was received in the virtual escrow account of the company between 15 July 2021 and 28 July 2021. However, the shareholder approval for the private placement offer came only on 2 August 2021, after all the funds had already been received.
What’s wrong, you ask?
A company can only accept funds from those to whom the offer is made. An offer can only be made if the company (through its shareholders) approves the offer. In this case, it’s a situation of the cart following the horse, ie, the company received the funds even before it approved the list of persons to whom it could have offered the securities!
Back to the order.
The RoC sought more details and offered the representatives of the company and of Tyke an opportunity to represent themselves. Tyke’s representative specified that Tyke’s role in the process was to allow the company to “display the pitching information on…Tyke’s website and organise Ask Me Anything sessions to showcase the company’s business.” Tyke also admitted that at these events, “the number of community members…can exceed 200. In case the community members who have shown interest to invest exceed 200… this is terms as ‘over-subscription.’” The representative also clarified that the company commences the private placement offer and Tyke’s platform is utilised to circulate the offer letter that is required to be circulated under the private placement rules, along with the investment agreements. After completing the requirements, the escrow account agent becomes authorised to remit the investment amounts to the company’s bank account.
Another crucial point was made by the Tyke representative, who said that the company pays service fees to Tyke that are determined as a percentage of the money raised from investors. This fee is deducted from the amount transferred to the company.
The company was also provided with an opportunity to provide submissions to the RoC and it clarified that Tyke was merely used as a platform that provided value-added services and that availing of such services did not contravene Section 42(7).
Ok, so we heard Tyke and we heard the company. What did the RoC finally decide?
The RoC’s ruling really rested on how Clause 42(7) was interpreted. It noted that the AMA organised by Tyke to generate interest constituted an invitation to subscribe as the pitch-related information became available to Tyke’s entire membership of 1.5 lakh members. Another issue raised by the RoC was Tyke’s representative admitting that more than 200 members might potentially view pitch-related information, which the RoC considered violated Tyke’s own Terms of Service. Ultimately, the RoC noted that the company used Tyke as “a media/marketing/distribution channel/agent to inform the public at large about the issue of securities…[and that Tyke] is an active facilitator for allowing the companies to raise investments through its portal and it is providing end-to-end services, either by itself or through its agents/partners.”
Thus, utilising Tyke effectively meant that the Company had used Tyke as a means to market their offer of securities and since it was done to more than 200 people, the RoC considered this a violation of Section 42(7) and imposed penalties on both the company and its directors. Notably, the RoC noted that it could not penalise Tyke despite noting that Tyke facilitated the commission of the breach by the company.
My two cents.
Personally, I feel there are more aspects that need careful observation. If one were to understand the intent of Section 42(7), it’s clear that the spirit of the law is to ensure that offers are made only to a limited number of people. Tyke effectively allowed all its members to participate in the AMA. However, can that be considered an invitation to subscribe? Think of Shark Tank. The viewership (if the latest data is to be believed) far exceeds that of Tyke. The platform is also one where people pitch their companies and seek investments. However, the format of the show is such that investment opportunity is (presumably) available only to the five judges (although this is also rebuttable, especially in cases where the company’s funding round is still open). Similarly, can one argue that the AMA was a presentation by the company and that actual offers could only be made by interested people who would be limited to below 200 by Tyke?
These are as much conceptual questions as they are factual but I am trying to suggest that there are possible arguments that could be taken here. Another technical argument could be that at the time of the AMA, is the company “issuing” securities? A technical reading of Section 42(7) could suggest that it applies to companies utilising media or marketing to inform the public at large about such an issue. A shrewd lawyer may use this to prepare another line of defence.
One issue that wasn’t highlighted (or may not have been an issue but isn’t clearly described in the order) relates to Tyke’s deduction of commission from investor proceeds before remitting the funds to the company. As I understand, the private placement offer identifies the price at which the securities are offered, and an investor is required to remit the exact amount (or a bit higher) to ensure that it is allotted the correct number of securities. Thus, as an investor, once I remit funds to even an escrow account, the exact amount should then be reflected against my name in lieu of the securities, and not an amount that is reduced by 1–4%. I can understand if the service charges are collected separately, but any reduction in funds that arrives in the company’s bank account may be open to additional regulatory scrutiny or auditor issues (these concerns, I acknowledge, may also be inflated).
This all sounds scary for a company. So, what should they do?
First and foremost, ensure that your company-law-related compliances are airtight. One concern with this company was that funds were deposited into its account before corporate authorisations were obtained. It is imperative you hire professionals who can guide you even through the most nuanced aspects of the private placement process.
Second, and most importantly, be extremely cautious and mindful of raising funds through platforms. As was evident, the axe fell on the company and not the platform. Ultimately, as the issuing entity, you are responsible for ensuring compliance. Even aspects such as AMAs can evidently lead to disastrous consequences.
Now, what should a platform do?
This is where things get tricky. Platforms follow multiple different types of business models. Each comes with its own set of risks and challenges given there is no legal certainty around equity crowdfunding. In light of the RoC’s order, it would be prudent for platforms to conduct a third-party audit of their business models and fine-tune any issues to ensure that its members maintain their faith in using the platform for their fundraising activities.
I am sure that there will be more such orders in the future which is why it becomes important to course-correct and use the RoC’s order as a warning sign.