Crowdfunding can be further classified as follows:

• Donation based crowdfunding, where funds are collected for social, artistic or philanthropic purposes without any tangible returns;
• Reward based crowdfunding, where funds are collected and some existing or future rewards are promised as consideration;
• Peer-to-peer lending (“P2P Lending”), where an online platform matches lenders with borrowers for providing unsecured loans at an interest;
• Securities based crowdfunding, where in consideration of the funds solicited from the investors, equity shares / debentures of the company are issued; and
• Fund based crowdfunding, where funds are raised for pooling under an alternative investment fund through a crowd funding platform.

While the donation-based crowdfunding should be mostly unregulated, P2P Lending would be regulated by the Reserve Bank of India (“RBI”) and securities based and fund-based crowdfunding would fall within the purview of the SEBI.

P2P Lending is facilitated by an online credit intermediary, where the intermediary matches lenders with borrowers. The interest rate can be as mutually agreed between the lenders and the borrowers or could be set by the intermediary. The lenders and borrowers pay a fee to the intermediary for the services provided. The platform may also provide additional services like collection of loan repayment and assessment of creditworthiness of the borrowers. Online intermediaries, unlike the banks, make a profit from the fees provided by the participants and not from the spread between the lending and the borrowing rates.

The RBI issued a consultation paper dated April 28, 2016 on P2P Lending, wherein it proposed to provide a regulatory framework for P2P Lending in India. While examining the need for regulating P2P Lending in India,

RBI justified the need for a regulatory framework on P2P Lending by inter alia quoting Section 45S of the Reserve Bank of India Act, 1934 (“RBI Act”) which prohibits an individual from accepting deposits, if his business wholly or partly falls within the ambit of Section 45I(c) (activities of a financial institution) of the RBI Act. Section 45I(bb) defines deposits to include any receipt of money by way of deposit or loan or in any other form. The RBI seems to indicate that the borrowers and lenders engaged in P2P Lending could fall within the prohibition as set out in Section 45S of the RBI Act.

This indicative opinion, though noncommittal, highlights the need for examining the legality of the P2P Lending in India and espouses the need for the participants in P2P Lending in India to create appropriate reserves, in the unlikely event the RBI takes a view that P2P Lending, as currently carried out, is in violation of Section 45S of the RBI Act. This becomes even more pressing, as under Section 58B(5A) of the RBI Act, borrowing in violation of Section 45S can make the borrowers liable to a penalty up to twice the amount received and an imprisonment up to two years. However, as per the consultation paper, RBI has indicated its intention to legitimise and regulate P2P Lending in India rather than to prohibit and prosecute it. It proposes to do so by notifying the P2P Lending platforms as non-banking financial companies. Further, under the indicative regulatory framework, it proposes to pass the compliance burden on the intermediary, where the intermediary would be required to ensure that Section 45S of the RBI Act is not violated by its activities. [It is worth noting that currently, it can be argued that the intermediaries cannot be held in violation of Section 45S, as the prohibition is on the person accepting the deposits and not the intermediary per se.] Further, the RBI has indicated that the intermediary would be responsible for ensuring that the transactions taking place through its platform are in compliance with the Foreign Exchange Management Act, 1999.

Certain additional requirements, such as maintaining a minimum capital of Rs 2 crore; compliance with the fit and proper criterion; requirement of opening a brick-and-mortar place of business in India; stationing the operational and management team in India; institution of a grievance redressal mechanism; quarterly reporting requirement; adoption of a mandatory corporate structure etc. may be mandated by the RBI for the intermediaries.

Growth in P2P Lending is primarily premised on the fact that the P2P Lending intermediaries provide an efficient and accessible alternative to financial institutions. Conceding that RBI should have a regulatory framework which should regulate this sector, insofar it is required to lend credibility to this sector and to prevent instances of fraud and malpractice by its participants, care should be taken to ensure this sector is not over-regulated to the extent that it loses its competitive edge over conventional financial institutions or becomes unviable as a source of credit. Further, excessively shifting the regulatory and compliance risk on the intermediary could have an adverse effect of increasing the operating fee and stifling the growth in a sector, which otherwise could perhaps be an alternative model for galvanising public savings directly and efficiently.

SEBI’s consultation paper on crowdfunding in India outlined a regulatory framework which could be implemented in India.

Issuance of securities by companies in India would inter alia be regulated under the Companies Act, 2013, the Securities and Exchange Board of India Act, 1992, Securities (Contract) Regulation Act, 1956, and Depositories Act, 1996. Further, even where the securities are issued by the issuer company on a private placement basis on an online platform, care would have to be taken by such investee company and the online platform to ensure that any such private placement is strictly in compliance with the law. In India, the private placement process is heavily regulated and contains severe restriction on the issuing companies and the subscribers. For instance, in case of private placement by companies, offer can be made by companies only through an offer letter in a prescribed format, which has to be specifically addressed to the proposed subscriber, be serially numbered and records of such offerees has to be maintained by the Company; the offer cannot be made by a company to more than two hundred persons in a financial person; the offer size cannot be less than ` 20,000 per investor etc.

Further, pursuant to a press release dated August 30, 2016, SEBI cautioned the investors stating that online platforms engaged in facilitating investments are neither authorized nor recognized under the prevalent securities law in the country. It further stated that facilitation of investments through private placement by such platforms is in violation of the Companies Act, 2013 and the Securities Contract (Regulation) Act, 1956.

This notice highlights the regulatory risk being faced by equity crowdfunding in India. Further, since the current legal climate for equity crowdfunding is not calibrated to fully operationalize equity crowdfunding. The Companies Act and the securities law in India may have to be amended to fully accommodate the concept of equity crowdfunding.

Given the gigantic population, burgeoning middle class, and a bevy of aspirational entrepreneurs who do not have access to conventional funds, the potential for crowdfunding in the country is tremendous and will also promote aspiration of such entrepreneurs. The legislature and the regulators have to balance the need for facilitating access to funds into start-ups and small and medium enterprises, while also protecting the interests of the lenders/investors. Therefore, any regulatory framework would have to be carefully balance through this prism.

Given the current government’s thrust in the area of promoting start-ups, the SEBI and the government could perhaps consider relaxing the current regulatory framework for equity based crowdfunding which is effectively prohibitive in nature and instead replacing it with a framework which is more conducive towards its growth; which could be quasi equity with conversions at future valuation and also provide for ease of any return of capital. This would increase the funds available to start-ups and small and medium enterprises and also permit the general public to participate in the start-up boom, which, so far is only limited to high net-worth individuals who have access to private equity/ venture capital funds.