Wednesday, March 4, 2015

Regulating Equity Crowdfunding in India

[The following guest post is contributed by Arjya Majumdar, who is an Assistant Professor at the Jindal Global Law School. He can be contacted at]

In the aftermath of the 2008 financial crisis, small businesses found it increasingly difficult to raise funds. As a response, crowdfunding has emerged as a viable alternative for sourcing capital to support innovative, entrepreneurial ideas and ventures. With the swift growth of the crowdfunding industry, risks associated with it have also come into sharp focus. According to a World Bank commissioned report in 2013, Kickstarter, the market leader in pledge or donation-based crowdfunding, has channeled over USD 815 million from 4.9 million backers to nearly 50,000 projects throughout the world, between 2009 and 2013. By March 2014, Kickstarter had surpassed USD 1 billion.

In India, the Securities and Exchange Board of India (SEBI) released a consultation paper in 2014 which, inter alia, proposes a framework for ushering in crowdfunding by providing start-ups and small-and-medium enterprises (SMEs) access to the capital markets and to provide an additional channel of early-stage funding. A brief background and the purport of the consultation paper may be found here.

A number of issues arise concerning crowdfunding in India - the first of which is the requirement of regulating crowdfunding, particularly when pre-existing securities laws may be interpreted to include crowdfunding activities. The nature of crowdfunding is inherently different from venture capital and public funding. This sets up the foundation for which a separate exemption may be carved out of existing securities laws. There are several primary risks arising out of equity crowdfunding which must be addressed by any securities regulator seeking to regulate this mechanism.

The first risk involves the possibility of a large number of likely non-sophisticated investors in an early-stage company, which has a high chance of failure making it an added complication. Because of the low cost of capital and the relative ease with which entrepreneurs may access and engage with crowdfunding portals, crowdfunding has been used by many startup companies to raise smaller amounts of money for their initial stage. Startup companies have an inherent risk of failure. Failure statistics universally show that over 50% of newly founded firms will fail during their first five years.

Crowdfunding portals and their operations create concerns as well – primarily due to the lack of a secondary market. Typically in a company which has issued securities to the public, such securities are freely tradable on stock markets. The Companies Act, 2013 also limits restrictions on transferability of public, listed company shares. Conversely, crowdfunded securities cannot be traded on crowdfunding portals as on date - leading to illiquidity. As a result, contributors cannot sell their securities to recoup their investments. This risk is exacerbated in cases of default or fraud, where an immediate exit option from the company does not exist.

At the same time, equity crowdfunding offers a number of advantages, the largest of which – curiously enough - is the lack of regulation. Companies that raise funds from fifty or more investors are required to undertake a public offer, regulated under the Companies Act, 2013 as well as the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. Using the Internet, an entrepreneur can sell an idea that is viable and can be monetized to literally millions of potential investors. No intermediary such as a merchant bank or an underwriter is needed. Other advantages include the spreading of risk and the boost to the economy through encouragement in the growth of SMEs.

In India, companies are prohibited from offering to issue shares to more than 200 potential investors in a financial year or from allotting shares to 50 or more shareholders, without undertaking a public offer. A public offering of shares or convertible debt securities involves the appointment of one or more merchant bankers, a registrar to the issue, filing of a draft offer document with SEBI, eligibility requirements such as previous track record, minimum promoter’s contribution, lock-in requirements, requirement to have a monitoring agency, etc., apart from detailed disclosure requirements.

Legislation exempting crowdfunding activities from traditional securities laws have been passed in a number of other jurisdictions, beginning with the United States. Other countries, including Italy, New Zealand, the United Kingdom and Australia have followed suit. Three regulatory regimes can be identified in equity crowdfunding. In the first case, regulation prohibits equity crowdfunding in its entirety while reiterating the existing law on fundraising by companies. In the second case, countries have begun to consider crowd funding as a new way of raising capital and that it falls under the regulation of public offers of securities. In the third case, several countries have adopted tailored regulations which seek to encourage this financing without apparently compromising investor protection

Similar to the Jumpstart Our Business Startups (JOBS) Act in the US and other legislations around the world, SEBI’s consultation paper also seeks to create exemptions for crowdfunding activities. This raises the second issue involving a comparison of SEBI’s proposed regulations, particularly in terms of eligibility criteria for fundraisers and contributors, mechanisms, levels of disclosure and independent accreditation, etc., with that of other jurisdictions.

Policymakers continually face the challenge of effectively balancing the benefits of encouraging small business formation against the investor protection goals of the securities laws. This challenge becomes even more pronounced in the case of crowdfunded companies which typically are small and medium enterprises. In terms of the existing law on raising capital, a proposition may be made that the present-day law in India makes it impossible for crowdfunding activities to occur. Any exemptions offered to crowdfunding activities must still address certain basic issues concerning information asymmetry, agency costs and investor protection at the very least. A review of SEBI’s consultation paper would ascertain whether the principles followed by SEBI in regulating this sector would culminate in the development of crowdfunding activity, or stifle it.

At the same time, SEBI’s consultation paper does not take into account two key aspects of crowdfunding. The first is that of peer to peer lending – when the proceeds of crowdfunds are issued to an individual and not a company. The second is that of cross-border crowdfunded companies. Given that crowdfunding is typically facilitated by web-based portals and promoted through social media and other internet-enabled networks, it is likely that crowdfunding activities will transcend national boundaries. Perhaps suitable checks and balances could be designed into Indian crowdfunding regulations.

- Arjya Majumdar

Tuesday, March 3, 2015

DIPP Operationalizes Insurance FDI Reforms

The Government had earlier begun the process of enhancing foreign direct investment (FDI) in the insurance sector by increasing the investment cap from 26% to 49%. Given the political stalemate in the Parliament’s legislative process, the Government had initiated the reforms in December 2014 through the promulgation of the Insurance Laws (Amendment) Ordinance, 2014. Subsequently, the Finance Ministry also issued the Insurance Companies (Foreign Investment) Rules, 2015 in order to incorporate the amendments above (see press release).

In the same vein, yesterday the Department of Industrial Policy and Promotion (DIPP) issued the Press Note No. 3 (2015 Series) that operationalizes the revised FDI norms in the insurance sector. Pursuant to these reforms, foreign investment is allowed in this sector up to 49%, which is an aggregate limit for all forms of foreign investment (whether through the direct or portfolio routes). Automatic approval is available for foreign investment up to 26%, beyond which it is necessary to obtain the approval of the Government. Given that foreign investors are allowed to hold only a minority stake, there is considerable emphasis on “control” requirements, whereby “ownership and control [must remain] at all times in the hands of resident Indian entities”. This is similar to the position that ensues in the civil aviation sector (for air transport services) where a cap of 49% exists for foreign investment.

The increased foreign investment cap in the insurance sector has been long pending. It is likely that these changes will see further investment into this sector, and this may also trigger a round of consolidation in the industry through mergers and acquisitions. However, given that the current reforms are premised on an Ordinance, it will be interesting to see if companies will act upon this regime or await legislation from Parliament. In any event, the introduction of the Bill in Parliament is imminent.

Definition of ‘Remuneration’ Under the Companies Act, 2013

[The following post is contributed by Nivedita Shankar, who is a Senior Associate at Vinod Kothari & Company. She can be contacted at]

As the financial year 2014-2015 approaches its end, companies are gearing up to meet the “many” requirements pertaining to preparation of board’s report in line with the new Companies Act, 2013 (‘Act, 2013’). Amongst the other requirements of section 134, managerial remuneration is one area that requires a lot of attention. In this regard, it would be necessary to rexamine the basics of managerial remuneration – the definition of ‘remuneration’ to unveil some surprising aspects of the Act, 2013. The previous Companies Act, 1956 (‘Act, 1956’) was however without any such difficulties since it did not define ‘remuneration’ at all except for the purpose of Schedule XIII.

Definition of ‘remuneration’ under Act, 2013

Section 2(78) of the Act, 2013 defines ‘remuneration’ as follows:

“means any money or its equivalent given or passed to any person for services rendered by him and includes perquisites as defined under the Income-tax Act, 1961”

It is clear from the definition above that any money or money’s equivalent paid to a person will be remuneration under Act, 2013. Additionally, any perquisite paid to a person as defined under the Income Tax Act, 1961 (‘IT Act, 1961’) will also be taken to be a part of remuneration.

‘Perquisites’ under IT Act, 1961

Further, according to section 17(2) of the IT Act, 1961, ‘perquisite’ includes the following:
(i) the value of rent-free accommodation provided to the assessee by his employer;
(ii) the value of any concession in the matter of rent respecting any accommodation provided to the assessee by his employer
(iii) the value of any benefit or amenity granted or provided free of cost or at concessional rate in any of the following cases—
(a) by a company to an employee who is a director thereof;
(b) by a company to an employee being a person who has a substantial interest in the company;
(c) by any employer (including a company) to an employee to whom the provisions of paragraphs (a) and (b) of this sub-clause do not apply and whose income under the head “Salaries” (whether due from, or paid or allowed by, one or more employers), exclusive of the value of all benefits or amenities not provided for by way of monetary payment, exceeds fifty thousand rupees
(iv) any sum paid by the employer in respect of any obligation which, but for such payment, would have been payable by the assessee;
(v) any sum payable by the employer, whether directly or through a fund, other than a recognised provident fund or an approved superannuation fund 87[or a Deposit-linked Insurance Fund established under section 3G of the Coal Mines Provident Fund and Miscellaneous Provisions Act, 1948 (46 of 1948), or, as the case may be, section 6C of the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 (19 of 1952)], to effect an assurance on the life of the assessee or to effect a contract for an annuity
(vi) the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.
(vii) the amount of any contribution to an approved superannuation fund by the employer in respect of the assessee, to the extent it exceeds one lakh rupees; and
(viii) the value of any other fringe benefit or amenity as may be prescribed.
Provided that nothing in this clause shall apply to,
(v) any sum paid by the employer in respect of any expenditure actually incurred by the employee on his medical treatment or treatment of any member of his family [other than the treatment referred to in clauses (i) and (ii)]; so, however, that such sum does not exceed 2[fifteen] thousand rupees in the previous year

The provisions relating to ‘perquisites’ in IT Act, 1961, evidently provide that the entire quantum/component of perquisites paid is not taxable for example superannuation fund, medical reimbursements, etc.


Perquisites and Managerial Remuneration under the Act, 2013

In pretext of the above definitions, the following can be deduced pertaining to the definition of ‘remuneration’ under Act, 2013:

(i) perquisites paid by a company as per IT Act, 1961 forms a part of the remuneration;

(ii) the entire quantum of the perquisites, irrespective of the taxable value will be a part of ‘remuneration’. On an apparent reading of section 2(78) of Act, 2013, it may seem that only the taxable value of the perquisites paid will be taken to be a part of remuneration. However, a closer examination of the definition of ‘remuneration’ will show that the section only states that perquisites paid as defined under IT Act, 1961 will be included. It does not make any reference to the quantum or valuation or taxable component of the perquisites. Thus the entire amount of perquisites paid or agreed to be paid will form part of remuneration. The taxable value as prescribed under IT Act, 1961 will have no bearing on the calculation of ‘remuneration’ under Act, 2013.

This reasoning is further strengthened by the definition of ‘remuneration’ under Section IV of Part II of Schedule V of Act, 2013 which reads as follows:

A managerial person shall be eligible for the following perquisites which shall not be included in the computation of the ceiling on remuneration specified in Section II and Section III:—

(a) contribution to provident fund, superannuation fund or annuity fund to the extent these either singly or put together are not taxable under the Income-tax Act, 1961 (43 of 1961);
(b) gratuity payable at a rate not exceeding half a month’s salary for each completed year of service; and
(c) encashment of leave at the end of the tenure.

Looking at clause (a) above, it is clear that any contribution made to provident fund, superannuation fund or annuity fund in excess of taxable limits under IT Act, 1961 shall not be included for the purpose of calculation of managerial remuneration in the event of inadequate profits or nil profits. The law herein clearly prescribes what value of perquisites shall not be considered as part of remuneration in cases of inadequate profits. Further, had the intent of law been to include only taxable amount of perquisites in the definition of ‘remuneration’ under section 2(78), then this clause would have been rendered meaningless. Thus, one can safely presume that where the intent was to specifically cover taxable value of perquisites law has been drafted clearly.

Therefore, to conclude, for the purpose of calculation of remuneration:

i. in the event of adequacy of profits – the entire value of perquisites as per IT Act, 1961 will have to be considered.
ii. in the event of inadequacy of profits of nil profits - only the taxable amount of perquisites should be considered. This is relevant only in case of managerial person.

Preparation of Board’ Report under Act, 2013

The definition of ‘remuneration’ is of particular importance when it comes to preparation of Board’s Report since Rule 5 of Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014 requires a listed company to make a number of disclosures pertaining to remuneration of not just directors, but also of key managerial persons and other employees. The definition of ‘remuneration’ under section 2(78) does not distinguish between a director, key managerial person or any other employee. Thus, while preparation of board’s report, the discussion above will be relevant for the purpose of calculation of remuneration of every director, key managerial person and other employee of the company.

- Nivedita Shankar

Monday, March 2, 2015

Budget 2015: Foreign Investment

Given the economic orientation of the new government, one would expect that the Budget would make wholesale relaxations to the foreign investment policy and open up or further liberalise various sectors. But, anyone adopting that tack is bound to be disappointed as the Budget makes minimal changes regarding foreign investment.

First, the vehicle of alternative investment funds receives a boost as it now eligible to receive foreign investment. Hence, entities in India that are pooling vehicles for investments such as private equity, hedge fund or real estate funds may now attract foreign investment. This sector would therefore be able to attract further capital. However, some doubts remain on the effectiveness of such an approach given some outstanding issues (including taxation) in relation to alternative investment funds.

Second, and more significantly, the Budget seeks to abolish the differential caps on foreign investment under the two categories of foreign direct investment (FDI) and foreign portfolio investment (FPI). Currently, in several sectors there are different caps for FDI and FII. For example, in the banking sector, while there is an overall foreign investment cap of 74%, FPI is capped at 49%. The rest of the foreign investment must necessarily come in through FDI. Once composite caps are introduced, the total investment through either route (or both collectively) could be 74%. Hence, FPI would obtain more headroom and enhance their stake (which is likely to be the case in certain private sector banks as reported here and here).

Finally, the section on foreign investment refers to a “Look East Policy” with a view to encouraging Indian companies to make outbound investments in manufacturing facilities in countries such as Cambodia, Myanmar, Laos and Vietnam.

Overall, the Budget is quite thin on reforms pertaining to foreign investment. They are relatively minor in nature. The Finance Minister appears to have adopted a cautious approach, and has avoided the issue of opening up further sectors or enhancing the caps in existing sectors open to foreign investment. Given the broad focus of the Budget in terms of advancing industrial activity in India, this is somewhat surprising.

Sunday, March 1, 2015

Budget 2015: Financial Markets

The Budget makes some proposals to boost the financial markets in India, both in the debt and equity segments, but arguably the reforms are only incremental and many not necessary result in drastic expansion of the markets.

Corporate Bonds

The first proposal is to give a fillip to the bond markets. As a co-author and I have observed in an earlier paper, the equity markets in India have developed much faster and wider than the bond markets, which are lagging far behind. While the equity markets have received substantial support from the Securities and Exchange Board of India (SEBI) as the market regulator, its reforms pertaining to the bond markets have been far from being as successful. This is despite the need for deep bond markets to service the funding needs of specific sectors such as infrastructure. The previous incremental efforts to boost that market did not elicit the anticipated results. Hence, the Budget makes a proposal that the Government will set up a Public Debt Management Agency (PDMA) to bring India’s external borrowing and domestic debt under one roof. More details are awaited on the functioning of this Agency and as to what impact that might likely have on India’s bond markets.

In the aforesaid paper, we argued that mere incremental reforms in the bond markets are insufficient, and wholesale changes are necessary to the legal system, especially when it comes to contract enforcement and an efficient bankruptcy regime, which are necessary to invigorate bond markets. These concerns have been addressed, at least tangentially, given that the Budget considers contract enforcement (dispute resolution) and bankruptcy, as discussed in the post relating to the ease of doing business.

Commodities and Securities Markets

The second set of proposals deals with the regulation of certain aspects of the financial markets and more specifically on investor protection measures. The Budget seeks to merge the Forward Markets Commission (FMC) with SEBI so as to strengthen the regulation of the commodity forward markets and reduce wild speculation. This will result in regulatory consolidation of the forward markets and derivatives trading in both the commodities as well as securities markets. This move is perhaps attributable to the issues faced in the commodities markets due to recent episodes.

Capital Controls

A related proposal pertains to the allocation of regulatory domain over capital controls. Hitherto, the RBI has been exercising primary power over capital controls by virtue of section 6 of the Foreign Exchange Management Act, 1999 (FEMA). Now, the Budget proposes to amend that provision to reallocate the powers between the RBI and the Central Government. Under the new dispensation, RBI will have primary regulatory control over capital account transactions in respect of debt instruments. In case of all other capital account transactions (including equity), the regulatory domain will shift to the Central Government, which will exercise its powers in consultation with the RBI.

This would affect the existing role of the RBI in matters relating to foreign investment on the equity side. Currently, the Government of India lays down the overall policy on foreign investment, while the RBI regulates the foreign exchange flows in connection with such investments. Now that the entire domain over foreign investment and foreign exchange are to be located in the Central Government, the RBI would cease to exercise control over foreign investments in equity. While this will affect the exercise of powers of RBI as an independent regulator, at a practical level it might end up streamlining the foreign investment process. As observed in an analysis on this change, currently there are often mismatches in the regulatory supervision because often the Central Government announces changes in foreign investment policies, but they are not followed up by the RBI through a change in its regulations until much later, which leads to incongruities in the interim. Going forward, these issues are likely to be settled as the Central Government will be the single regulator for capital account transactions (except for debt instrument).

As for debt instruments, the RBI would continue to exercise domain over those. The types of instruments that would constitute debt will be determined by the Central Government consultation with the RBI, but one may surmise that it would include instruments such as corporate bonds and other forms of external commercial borrowings (ECBs).

Other Matters

The Budget proposes the establishment of a Financial Redressal Agency that will address the grievances of consumers of all financial services providers.  More details are awaited.

Finally, the Indian Financial Code is likely to be introduced in the Parliament soon, which is pursuant to the recommendations of the Justice Srikrishna Committee.

Overall, the Budget proposals relating to the financial markets are incremental in nature, which would help to boost the markets. However, there appear to be no radical reforms as such.