Aatmin Shah and Bhargavi Zaveri
At the beginning of March, several crowdfunding platforms reportedly registered themselves with SEBI as 'alternative investment funds', which are pooling vehicles for making downstream investments. Regulating crowdfunding platforms as alternative investment funds is inappropriate.
Unlike alternative investment funds that adopt an active fund management role, crowdfunding platforms do not take any risk on their balance sheets, do not make investment decisions on behalf of investors and merely match the investor to the issuer. Due to the balance sheet risk that they expose themselves to, alternative investment funds are subject to several restrictions on the kinds of investors they may accept, the size of their investment and their portfolio allocation. A regulatory strategy for governing such alternative means of raising capital must harness the potential that such platforms offer to small firms for accessing investors that they otherwise would not have access to while being sensitive to the actual risks involved.
At the outset, the potential of such platforms to allow access to finance for small firms cannot be understated. These firms typically have limited or no credit history, assets and social capital, thereby excluding them from formal bank lending and public markets. Data on the size of the crowdfunding market and the kinds of firms that have used crowdfunding platforms in India to raise capital is hard to come by. However, a 2017 study surveying crowdfunding platforms in the United States found that firms accessing capital through such platforms are small with an average workforce size of five employees. Primarily, young firms which are slightly more than two years old used such platforms to seek capital. Sixty percent of the issuers were in their pre-revenue phase and 23 percent of the issuers had no assets. This firm profile represents a classic enterprise that a bank will not serve and will not be allowed in the public markets in India. The average issuance size is also small-ticket for a single institutional investor.
While such platforms have the potential to service small businesses seeking capital, they pose certain risks that cannot be addressed by pure contract enforcement mechanisms. Additionally, a simple regulatory framework, governing the activity of matching firms to investors, will provide certainty in an area that has been erratically governed so far. In 2016, more than two years after having issued a consultation paper inviting public feedback on a proposed regulatory framework for crowdfunding platforms, SEBI reportedly decided to not pursue the consultation paper, and reportedly issued a warning to investors that such platforms were "neither authorised nor recognised under any law governing the securities market". In 2017, SEBI again directed such platforms to add a disclaimer that they were neither stock exchanges nor authorized by the capital markets regulator to solicit investments. A key takeaway from the story of the peer-to-peer (P2P) industry, on the other hand, shows remarkable growth or at the least good reporting on the size of the P2P market once RBI issued a regulatory framework governing P2P platforms.
There are three key risks posed by such platforms that regulation must address. First is to address the information asymmetry between the investors and the issuers. Information about the issuer and the transparency about the rates of default and return is imperative for investors. At the same time, given the small size of issuers, the disclosure norm must balance the amount and frequency of disclosures on the one hand and the issuer's size on the other.
Second, since the issuers are entities that are otherwise excluded from formal sources, there is a natural adverse selection problem for lenders on such platforms. Part of this is accounted for in the risk premium charged by the investors. Mechanisms to resolve the issue of information asymmetry also address this concern. Platforms are also known to offer due-diligence services to lenders. Some platforms seek to address this problem by investing in the issuance themselves thus bringing in their own skin in the game.
Given the problems of adverse selection, a critical question is whether retail investors must be allowed to invest through such platforms and whether the offer-size and the number of investors should be restricted. Under the current legal regime, an offer to more than 200 persons is regulated as a public offer. The regulation must do away with this approach of hard-coding the number of investors in the law. This is because first, capping the absolute number of investors offers no real protection to a retail investor from the perceived risks that she takes on by investing through such a platform. For example, even where an offer is made to less than 200 investors, each such investor may be a retail investor, in which case the numeric threshold fails its regulatory purpose. Second, there is no science to the absolute numeric threshold of 200. A hard-coded numeric threshold, which restricts an offer to the world at large, constrains the number of investors who could have invested through the platform and the manner in which the offer can be made, without protecting the investors who it intends to protect in the first place.
Instead, a nuanced approach of identifying whether the investment is suitable for the investor and the extent of exposure that a retail investor may take on the platform must be built into the regulatory framework. For instance, Regulation Crowdfunding, which regulates crowdfunding platforms in the United States mandates a suitability assessment to be done by the intermediary for any investor who seeks to invest through such a platform and links the extent of exposure that retail investors may take through such platforms to their networth. In the UK, where a large part of the regulatory framework is left to self-regulation, suitability assessment is built-in through self-regulation. Moreover, sophisticated investors and investors advised by a professional intermediary, have no limit. Otherwise, an investor’s exposure to an issuance on the platform is restricted to 10 percent of her assets.
Finally, since crowdfunding platforms do not undertake maturity transformation risk, capital and net-worth related requirements must be nominal. However, it is possible that the failure of the platform will cause disruption for issuers raising capital and investors investing through the platform, especially where the platform’s business model requires the capital to be routed through the platform (such as through an escrow or custodianship arrangement). In such cases, it is critical that the legal resolution framework recognises that the funds that continue to be in the custody of the platform are bankruptcy-remote and appropriate mechanisms are built for an immediate refund of such funds to the investors.
Technology has reduced the barriers that firms face in reaching out to a community of investors for raising capital. A regulatory strategy that allows firms to harness the benefit of technology, must be risk-based. Straight-jacketing new business models, such as crowdfunding into known regulatory frameworks, such as alternative investment funds, is costly. (Aatmin Shah and Bhargavi Zaveri are, respectively, Research Associate (Legal) and Senior Researcher at the Finance Research Group, Indira Gandhi Institute of Development Research, Mumbai)