1Online crowdfunding has become an increasingly popular source to raise funds for startups and early growth stage companies in developing economies around the world. Crowdfunding in the developing world is poised for an explosive growth period (136% year on year). The World Bank estimates that crowdfunding in the developing world could grow by up to $96 billion by 2025. While the market is still in a nascent stage, the demographics, infrastructure investments, and favorable trends in the adoption of technology mean that the market is on track to catch up quickly with the developed world. While some countries have readily embraced the model, there are many others that stand to benefit from facilitating crowdfunding for their economies (AlliedCrowds, 2015a).
2There are many potential opportunities in using crowdfunding to support and fund projects in the developing economies. Crowdfunding has been a highly effective medium for raising funds for emergency and disaster relief in developing countries. Crowdfunding, both financial and non-financial, has also played an important role in promoting the growth of renewable energy, agriculture and services sectors in developing nations.
3Amongst developing economies around the world, given its sheer size and large population, Asia presents huge potential for crowdfunding. While in some countries that potential is already being realized, in others there is still a long way to go. As a country that is starting to transition to a consumer economy, amongst the various Asian countries, India has been experiencing fast growth in both internet penetration and e-commerce and is likely to emerge as a crowdfunding powerhouse in the near future. According to AlliedCrowds data, India scored top of the list amongst the countries that raised the most money in 2015: India (USD 27.8 million), the Philippines (USD 26.9 million), Nepal (USD 25.5 million), Mexico (USD 24.8 million), and Kenya (USD19.9 million) (AlliedCrowds, 2016).
4India, an archetype for crowdfunding success in Asia, is amongst the nations presently in the process of considering crowdfunding regulation. Recognizing the need to establish a regulatory regime for crowdfunding, the securities and banking regulators in India have recently placed consultation papers in the public domain in order to seek views from the various stakeholders on the future course of action regarding the regulation of crowdfunding and P2P lending in India. Despite attempts to establish a regulatory framework since 2014, the regulators have failed to gauge the Indian crowdfunding trend and promulgate decisive regulations, leaving the legal regime shrouded in ambiguity.
5While the introduction of crowdfunding has been particularly successful in India, its development in satisfying the huge demand of finance for modest and poor projects, and for new high-tech and other startup ventures, raises certain pertinent questions—whether the proposed draft framework in India is capable of imbibing the key aspects and nuances of parallel model regulatory frameworks prevailing in certain developed economies, which have been recognized as being very supportive of crowdfunding? What experiences can be extracted from already enacted and mature regulations in order to promote a regulatory environment for crowdfunding in India, which is capable of striking an appropriate balance between the growth of entrepreneurship and investor protection? With the ever-increasing financial needs of venture capitalists against the backdrop of the liberalization of policies in India, what regulations will allow the crowdfunding platforms to address such needs?
6In order to provide insights into these questions, which we present as our research inquiry, we have undertaken a critical comparative analysis of the emerging regulatory framework relating to security-based crowdfunding and P2P Lending in India with the corresponding rules and regulations prevailing in the USA and UK. The analysis is based on certain key parameters which are integral to most crowdfunding and P2P Lending legislations across the world. A comparative analysis in tabular format, based on the points of distinction, has also been provided alongside for ease of reference. This is followed by certain key recommendations with respect to security-based crowdfunding and P2P lending regulations, which may be worthwhile considering in the Indian context.
7Crowdfunding and innovation have increasingly attracted attention as a predominant research avenue. Beyond being an innovative way of financing ventures out of conventional intermediation by collecting funds from a large pool of backers through peer-to-peer platforms (Assadi, 2016), researchers have increasingly studied crowdfunding as a way of enabling and raising awareness of innovations. Stanko and Henard (2017) indicate that the market performance of an innovation depends much more on the number of backers attracted to the campaign than the amount of funding raised.
8While all these studies have made a significant contribution to the practical and conceptual understanding of crowdfunding dynamism, there has been less study by scholars of the innovations legal environments need to efficiently support innovative crowdfunding for innovative ventures. Exploring the legal environments is even more important for equity-based crowdfunding, which is more complex than other forms of crowdfunding. Should it provide intermediation in the seed and early-stage market for young and innovative firms that play the critical role for job creation and economic growth (OECD, 2013; Haltiwanger et al., 2013), understanding the peculiarities of supportive legal framework seems to be decisive. We have also addressed this issue in this research paper.
Methodology
9The methodology of research primarily comprises online research. We have reviewed the draft consultation papers issued by the securities and central banking regulators in India, the relevant provisions of the Jumpstart Our Business Startups Act, 2012, prevailing in the US, and the body of rules developed by the Financial Conduct Authority in the UK in terms of the Financial Services and Markets Act, 2000. We have also reviewed academic papers and research reports published on crowdfunding, which are available online. For triangulation, we have sought feedback from a law practitioner and a law professor based in the US, who have both written extensively on the USA’s crowdfunding legislation. The feedback primarily included confirmation on the various distinguishing features of security-based funding between India and the USA, as discussed below, with special emphasis on the concept of Intrastate Crowdfunding. The experts also shared with us research papers and newspaper clippings on the latest developments in the crowdfunding space, which facilitated our understanding of the crowdfunding framework prevalent in the USA.
10In this paper, the USA and UK regulations have been selected as benchmarks for security-based crowdfunding and P2P lending respectively, primarily due to each country being a pioneer in terms of the origination of the relevant subjects. Also, in the USA, lending-based crowdfunding includes P2P lending to consumers and peer-to-business lending, both of which are essentially subsumed within the overall regulatory framework for security-based crowdfunding and therefore the comparative analysis for P2P lending vis-a-vis the USA has not been undertaken separately. At the same time, donation and reward-based crowdfunding have not been considered for the present analysis since such forms of crowdfunding are primarily free from most regulations, especially securities and banking regulations.
11In this paper, we have selected certain key parameters for undertaking the comparative analysis on Crowdfunding and P2P lending which are integral to most countries which have either adopted the crowdfunding regulations or are going through the consultative process of developing new crowdfunding regulations. The rationale for selection of these parameters is that a comparative analysis based on such parameters would help in ascertaining whether the regulation is capable of creating a fine balance between the twin objectives of capital formation and investor protection and the specific measures that can be suggested for attainment of the stated objectives. Moreover, studies have also been conducted by researchers (Gilinisky, 2016; Yin, 2016; Quinn, 2014) who have adopted and applied a similar methodology in comparing the regulatory frameworks in different countries on similar parameters as suggested in the instant research study, which have yielded reliable results. Therefore, the methodology adopted for the preparation of the research paper is suitable for comparing the regulatory environments in India, the USA and UK.
Crowdfunding & P2P Lending: a Comparative Analysis
Security-Based Crowdfunding: India vs. USA
Regulatory Framework
12In the United States, Crowdfunding is regulated by the Securities Exchange Commission (‘SEC’) in terms of Title III of the Jumpstart Our Business Startups Act, 2012 (‘JOBS Act’) [2] which was enacted on April 5 2012 (‘Title III’) under the Securities Act, 1933 and Securities Exchange Act 1934. Subsequently, the SEC has also adopted a new Regulation on Crowdfunding to implement the requirements of Title III, which is effective from May 16 2016 [3] (together referred to as ‘US Crowdfunding Regulations’).
13The JOBS Act establishes a regulatory structure for startups and small businesses to raise capital by way of securities offerings (both debt and equity) using the Internet through crowdfunding. Title III prescribes rules governing the offer and sale of certain securities under a crowdfunding issue which, if fulfilled, would result in an exemption from registration of such securities with the SEC.
14Recognizing the need to establish a regulatory regime for crowdfunding in India, the securities regulator in India i.e. the Securities and Exchange Board of India (‘SEBI’), had come up with a consultation paper in June 2014 (‘SEBI Consultation Paper’) [4], proposing a regulatory framework (‘Draft Indian Framework’) to usher in crowdfunding. Through its consultation paper, SEBI had invited comments and suggestions from industry and market participants regarding the various possible structures for crowdfunding within the existing legal framework in India and other associated issues.
15In its consultation paper, SEBI recognizes crowdfunding as the “solicitation of funds (small amounts) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause”. Further, Security-Based Crowdfunding is understood as a form of Financial Return Crowdfunding and includes Equity, Debt and Fund-based Crowdfunding.
Requirements for Investors
i – Eligible Investors
16Under the US Crowdfunding Regulations, any person can invest in crowdfunding offerings irrespective of whether such a person is accredited or not. The USA Crowdfunding Regulations allow even small investors to participate in crowdfunding, while providing for appropriate safeguards for their protection. Thus, while there is no restriction on who can invest under a crowdfunding offering in USA, however, because of the risks involved, an investor is limited on the amount he can invest during any 12-month period in such offerings. The limitation on the amount that an investor can invest depends on his net worth and annual income.
17Unlike in the USA, where there is no restriction on who can invest under a crowdfunding offering, the Draft Indian Framework permits only specified accredited investors to participate in a crowdfunding issue. Accredited investors include the following categories: a) Qualified Institutional Buyers (‘QIBs’) [5]; b) Companies incorporated under the Indian Companies Act with a minimum net worth of Rs. 200 million (i.e. Euro 2.8 million approx.); c) High Net Worth Individuals (‘HNIs’) with a minimum net worth of Rs. 20 million (i.e. Euro 0.28 million approx.); d) Eligible Retail Investors (‘ERIs’) i.e. investors who receive investment advice or avail themselves of the services of a portfolio manager and (i) who have a minimum annual gross income of Rs. 1 million (i.e. Euro 0.014 million approx.); or (ii) who have filed Income Tax returns for at least last three financial years; or (iii) who certify that they will not invest more than Rs. 60,000 (i.e. Euro 850 approx.) in an issue through a crowdfunding platform; or (iv) who certify that they will not invest more than 10% of their net worth through crowdfunding.
ii – Maximum Number of Investors
18The US Crowdfunding Regulations do not contemplate any limit on the number of investors who can participate in offers made through a crowdfunding platform.
19The Draft Indian Framework, on the other hand, based on the existing provisions of the Indian Companies Act relating to the private placement of securities [6], suggests that equity-based crowdfunding and debt-based crowdfunding shall allow private placement offers through internet-based crowdfunding platforms up to a maximum of 200 persons. However, any offer or invitation made to QIBs shall not be considered while calculating the maximum limit of 200 persons.
iii – Investment Limits
20The US Crowdfunding Regulations neither prescribe any restriction on the number of investors who can participate in offers made through a crowdfunding platform, nor any limits for minimum investment under a crowdfunding issue. However, the US Crowdfunding Regulations do prescribe that the individual investors are limited in the maximum amounts they can invest in all Regulation Crowdfunding offerings over the course of a 12-month period as follows: a) If either of an investor’s annual income or net worth is less than USD 100,000/- (i.e. Euro 94,000/- approx.), then the investor’s investment is limited to the greater of: (i) USD 2,000/- (i.e. Euro 1,800/- approx.) or (ii) 5% of the lesser of the investor’s annual income or net worth; b) If both annual income and net worth are equal to or more than USD 100,000/- (i.e. Euro 94,000/- approx.), then the investor’s investment is limited to 10% of the lesser of their annual income or net worth; c) Further, during the 12-month period, the aggregate amount of securities sold to an investor through all Regulation Crowdfunding offerings should not exceed USD 100,000/- (i.e. Euro 94,000/- approx.), regardless of the investor’s annual income or net worth.
21While the US Crowdfunding Regulations prescribe only the maximum limits for investment by an investor in a crowdfunding issue, the Draft Indian Framework prescribes both minimum and maximum limits for such issue.
22The minimum investment limits proposed by SEBI are as follows: a) A QIB is required to individually purchase at least 5 times the minimum offer value per person [7] and, collectively, all QIBs are required to hold a minimum of 5% of the securities issued b) A company is required to purchase at least 4 times the minimum offer value per person c) An HNI is required to purchase at least 3 times the minimum offer value per person d) An ERI is required to purchase at least the minimum offer value per person.
23Further, certain individual and cumulative limits have also been proposed for maximum investment. It is proposed that the maximum investment by an ERI in a crowdfunding issue shall not exceed Rs. 60,000/-(i.e. Euro 850/-approx.) and the total of all investments for an ERI in a year through crowdfunding platforms shall not exceed 10% of the ERI’s net worth.
24Also, in the case of equity-based crowdfunding, no single investor shall hold more than a 25% stake in a company and the promoters shall be required to maintain a minimum 5% equity stake in the company for a period of at least three years.
Requirements for Issuer Entity
25Under the US Crowdfunding Regulations, certain companies are not eligible to use the Regulation Crowdfunding exemption. These include a) Non-US companies b) Exchange Act reporting companies c) Certain investment companies and companies subject to disqualification under Regulation Crowdfunding d) Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement e) Companies that have no specific business plan or that have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies (SEC 2016, A Small Entity Compliance Guide for Issuers).
26On similar lines, it has been proposed by SEBI under the Draft Indian Framework that an early stage startup or a Small and Medium Enterprise that is an unlisted public company incorporated in India can access funds over a crowdfunding platform, provided it is: a) a company intending to raise capital not exceeding Rs. 100 million (i.e. Euro 1.4 million approx.) in a period of 12 months, b) a company that is promoted, sponsored or related to an industrial group that has a turnover in excess of Rs. 250 million (i.e. Euro 3.5 million approx.), or has an established business, c) a company that is not listed on any exchange d) a company that is not more than 48 months old, e) a company that proposes to engage in non-financing ventures, i.e. funds raised through the crowdfunding platform will not be further used for providing loans or investments in other entities f) a company that is not engaged in real estate activity and activities that are not permitted under the Industrial Policy of Government of India.
27There are some common regulatory features between the Draft Indian Framework and the US Crowdfunding Regulations in terms of investor protection. Detailed provisions have been prescribed which place an obligation on the issuers in terms of disclosure requirements, inter alia including the following: a) a description of the company’s financial condition, b) the name of each person who is a beneficial owner of 20% or more of the company’s outstanding voting equity securities c) Description of the valuation of securities offered d) Ownership details and capital structure e) Principal risks to the issuers business etc.
28The Draft Indian Framework differs from the US Crowdfunding Regulations as far as the permissibility of a crowdfunding offering by a private company is concerned. While a private company (with the exception of non-eligible companies) is contemplated as an eligible issuer under the US crowdfunding regulations, the Draft Indian Framework proposes to allow only an unlisted public company to make a crowdfunding offering, provided it fulfils the prescribed conditions.
Requirements for Crowdfunding Intermediary / Platform
29In terms of the US Crowdfunding Regulations, in order to rely on the exemption, a crowdfunding issuer is required to conduct its offering exclusively through an online platform operated by an intermediary that is registered either as a broker-dealer or as a funding portal and is a member of a national securities association i.e. the Financial Regulatory Authority (‘FINRA’) (SEC 2016, A Small Entity Compliance Guide for Intermediaries).
30A funding portal is a crowdfunding intermediary that, in accordance with Section 304(b) of the JOBS Act and Section 3(a) (80) of the Securities Exchange Act, 1934, can engage in only limited activities. In particular, amongst other things, the funding portal cannot: a) Offer investment advice or recommendation; b) Solicit purchases, sales or offers to buy the securities offered or displayed on its platform; c) Compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its platform; or d) Hold, manage, possess, or otherwise handle investor funds or securities.
31Therefore, in case a crowdfunding platform proposes to engage in any of the abovementioned activities, it must register as a broker-dealer rather than as a funding portal.
32Under the Draft Indian Framework, it has been proposed by SEBI that the entities which fall under any of the following classes shall be allowed to set up a crowdfunding platform: a) Class I Entities i.e. Recognized Stock Exchanges with nationwide terminal presence and SEBI registered Depositories b) Class II Entities i.e. Technology Business Incubators promoted by Central or State Government and which, inter alia, have at least 5 years of experience and a minimum net worth of Rs. 100 million (i.e. Euro 1.4 million approx.).
33In order to enable fund-based crowdfunding, in addition to Class I entities, a dedicated set of Class III Entities have also been prescribed i.e. Associations and Networks of Private Equity or Angel Investors which, inter alia, is a non-profit company having a minimum three-year track record, a minimum paid up share capital of Rs. 200 Million (i.e. Euro 2.8 million approx.), and a minimum member strength of 100 active members from the relevant industry.
34Under both the US Crowdfunding Regulations, as well as the Draft Indian Framework, detailed provisions have been laid down which place an obligation on the crowdfunding platform to perform a due diligence process on both the investors and the issuing entities, which, inter alia, include the following measures: a) conducting background and regulatory checks on the issuers, whole time directors, promoters, shareholders holding more than 20% of equity shares in the issuing entity, b) due diligence of the business of the issuing start up, c) obtaining positive affirmations/acknowledgement from each investor that the investor understands that he is risking the loss of the entire investment and, d) ensuring that the investors invest within the prescribed limits etc.
35In addition to the above, the Draft Indian Framework also provides for the establishment of a Screening Committee which, apart from conducting basic due diligence on the issuer companies, also ensures a filtering mechanism to differentiate between the quality of its ideas and business plans.
36An important point of distinction between the US Crowdfunding Regulations and the Draft Indian Framework is that, under the Draft Indian Framework, the crowdfunding platforms are restricted from undertaking certain activities, inter alia including the provision of investment advice and solicitation and management of funds/securities. However, under US laws, such activities are permissible for crowdfunding platforms provided that they are registered as broker-dealers with the SEC.
Restriction on Transferability of Securities
37The US Crowdfunding Regulations provide that securities acquired on a crowdfunding platform shall be subject to a lock-in period and accordingly shall not be transferable by the purchaser for a minimum period of one year after the date of purchase. However, the said lock-in restriction shall not be applicable where the shares are transferred to either of the following categories of persons: (i) to the issuer of the securities; (ii) to specified categories of accredited investors; (iii) as part of an offering registered with the SEC; or (iv) to a family member of the purchaser, or in connection with certain events, including death or divorce of the purchaser, or other similar circumstances, at the discretion of the SEC.
38Similarly, under the Draft Indian Framework, it has been proposed that the securities acquired on a crowdfunding platform are not transferable unless (i) they are either purchased back by the issuer under a buyback scheme in accordance with the Companies Act 2013 or (ii) by another accredited investor registered with the platform or (iii) by a family member or relative or friend of the accredited investor. Additionally, it has also been proposed that exit would be available to the investor only in the event of the sale of the company, management buyout, flotation of IPO, or listing of the company on a recognized stock exchange in the SME segment or main board. Also, the promoters shall be required to maintain a minimum of a 5% equity stake in the Company for at least three years from the date of issue.
39It is understood from the above that, unlike in the case of the Draft Indian Framework, where exit is offered to the investor only upon the occurrence of certain defined events, the US Crowdfunding Regulations facilitate an exit for the investor at any time after the expiry of the lock-in period of one year, and such an exit is not contingent on the occurrence of any event. Further, unlike the Draft Indian Framework, the US Crowdfunding Regulations do not require maintenance of a minimum equity stake by the promoters for a specified period from the date of issue.
Applicability of State Laws
40Under Section 305(b) of the JOBS Act, in case of a crowdfunding issue which satisfies the prescribed conditions of Title III, the federal law pre-empts the operation of state law and accordingly, while such an issue is exempt from state registration, documentation and offering requirements, the state authorities can continue to have enforcement authority.
41Separately, Section 3(a) (11) of the Securities Act, 1933, as amended, exempts from registration and many other rules under the Securities Act, 1933 “any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory”. This section of the Securities Act, 1933, together with Rule 147—a safe harbor rule simplifying compliance with Section 3(a) (11), facilitated what has become known as “Intrastate Crowdfunding”. Offerings of securities meeting the Section 3(a) (11) exemption are not required to be registered under the Securities Act, 1933, but are required to be registered or otherwise be exempt from registration under the law of the particular state in which the offering is made. A number of states have adopted registration exemptions for crowdfunded securities offerings, enabling Intrastate Crowdfunding.
42The SEC recently amended its safe harbor compliance rules in order to better facilitate Intrastate Crowdfunding. The revised intrastate offering regime retains the pre-existing Rule 147 safe harbor under Section 3(a) (11) of the Securities Act, while simultaneously expanding the availability of the intrastate offering exemption from Section 5 of Securities Act registration by adopting the new Rule 147A. As a result of the amendments, certain issuers will now be able to rely on the federal offering registration exemption, even if offers are made outside of the relevant state, as long as sales are only made in that state (SEC 2015, RIN 3235-AL80; SEC 2016 Press Release 2016-226; Locavesting 2016).
43Under the Draft Indian Framework, no parallel provisions in relation to intrastate crowdfunding like those in the USA have been contemplated.
44A comparative analysis in tabular format, based on the above points of distinction for crowdfunding, has been given above in Table 1 for ease of reference.
Comparative Analysis—Security Based Crowdfunding
| S.No. | Parameter | United States | India |
|---|---|---|---|
| 1. | Eligible Investors | No restriction on who can invest under a Crowdfunding issue. | Only accredited investors permitted to participate under a crowdfunding issue
|
| 2. | Maximum Number of Investors | No limit prescribed on number of Investors | Number of investors restricted to 200 persons (excluding QIBs) |
| 3. | Minimum Investment Limit | No limits prescribed for minimum investment under a crowdfunding issue |
|
| 4. | Maximum Investment Limit | Investment by individual investor in all crowdfunding offerings in a 12-month period not to exceed:
| Investment by ERIs:
|
| 5. | Requirements for Issuer Entity |
|
|
| 6. | Requirements for crowdfunding/ intermediary platform |
| Such activities prohibited for crowdfunding platforms |
| 7. | Restriction on transferability of securities |
|
|
| 8. | Applicability of State Laws |
| Not contemplated |
Comparative Analysis—Security Based Crowdfunding
Peer-to-Peer Lending: India vs. UK
Regulatory Framework
45P2P lending is regulated under the Financial Services and Market Act, 2000 (‘FSM Act’) with the Financial Conduct Authority (‘FCA’) being the regulator, implementing new regulatory measures on crowdfunding. Previously, P2P lending in UK used to be regulated as consumer credit by the Office of Fair Trading, however, it was transferred to the FCA for regulation with effect from 1 April 2014. The FCA has thus introduced a newly regulated activity called “operating an electronic platform in relation to lending” into the FSM Act in 2014 for the regulation of P2P lending businesses (Chu, 2016).
46The FCA has gone to great lengths following a public comment process to develop and implement a body of rules specific to the P2P lending industry, which address the specific risks and operational features characteristic to the industry (Quinn, 2014).
47P2P lending is recognized by the FCA as “loan based crowdfunding where people lend money to individuals or businesses in the hope of a financial return in the form of interest payments and a repayment of capital over time” (FCA 2014, PS14/04).
48While P2P Lending is currently unregulated in India, RBI is of the view that P2P Lending Platforms need to be regulated, even though they have not yet really taken serious magnitude (Gandhi, 2016). Accordingly, the Reserve Bank of India (‘RBI’) published a discussion paper on P2P Lending on April 28 2016 (‘RBI Discussion Paper’) [8] vide which the RBI had sought submission of comments to its discussion paper until May 31 2016.
49In its discussion paper, the RBI has examined international regulatory practices on crowdfunding and the P2P lending available in the public domain to obtain an understanding of the regulatory approaches adopted in this regard by different jurisdictions such as China, Korea, Australia, France, Germany, Italy, the United States of America and Japan.
50It is proposed to bring the P2P Lending Platforms under the purview of RBI’s regulation by defining P2P platforms as a separate category of Non-Banking Finance Companies (‘NBFCs’) which are required to be registered with the RBI under the relevant provisions of the Reserve Bank of India Act, 1934.
51P2P lending is recognized by RBI “as a form of crowdfunding used to raise loans which are paid back with interest. It can be defined as the use of an online platform that matches lenders with borrowers in order to provide unsecured loans”.
52Further, considering the present stage of development, it is proposed that the lending platform shall be registered only as an intermediary i.e. the borrowing and the lending activity shall not be reflected on its Balance Sheet. The funds must necessarily move directly from the lender’s bank account to the borrower’s bank account to obviate the threat of money laundering.
53It has also been proposed that P2P Platforms must mandatorily adopt a company or cooperative society format and shall not be operated under any other alternative format such as individuals, proprietorship, partnership or limited liability partnerships.
Business Trends / Developments
54P2P lending business has taken off in a huge way and has grown rapidly, especially in the recent past in the UK. The modern formula for P2P lending originated in the UK when, in as early as 2005, Zopa opened its doors. Since then over £725 Million (i.e. Euro 850 million approx.) has been lent to over 80,000 people, earning their lenders £45 Million (i.e. Euro 53 million approx.) in interest payments (Osullivan, 2015). There are eight established P2P Lending Platforms in the UK, all members of the UK Peer-to-Peer Finance Association, which states on its website that it represents over 90% of the UK peer-to-peer and invoice trading market. This comprises Funding Circle, Landbay, Lending works, LendInvest, MarketInvoice, RateSetter, ThinCats and Zopa [9].
55In India, on the other hand, P2P Lending is still a nascent business model that has begun to gain momentum only over the past couple of years. Faircent was the first company to commence P2P Lending operations in India in April 2014. Currently, there are around thirty P2P Lending Platforms in India, including Faircent, i2i Lending, Lenden Club, Lendbox etc. (Bhakta, 2016).
Prudential Norms
56The FCA requires the platforms to maintain a certain amount of minimum capital to ensure that they can withstand financial shocks. It is to be estimated as higher than the fixed minimum amount that firms will be required to hold i.e. £50 000; or a percentage of a volume-based financial resources requirement calibration, which is the sum of (a) 0.2% of the first £50 million of total value of loaned funds outstanding; and (b) 0.15% of the next £200 million of total value of loaned funds outstanding; and (c) 0.1% of the next £250 million of total value of loaned funds outstanding; and (d) 0.05% of any remaining balance of the total value of loaned funds outstanding above £500 million (FCA 2013, CP 13/13; FCA 2014, PS 14/4).
57On similar lines, the RBI consultation paper also specifies the need for the P2P platform to satisfy certain prudential requirements, which include a minimum capital of INR 20 million (i.e. Euro 0.28 million approx.). Prudential limits on a maximum contribution by a lender to a borrower/segment of activity may also be specified.
58The draft framework in India, unlike the UK regulatory framework, also contemplates a prescribed leverage ratio as part of the prudential requirements so that the platforms do not expand with indiscriminate leverage.
Client Money Rules
59The UK framework envisages that P2Ps should comply with detailed Client Money Rules [10] in terms of monies received from lenders and in terms of acting as a channel for borrower repayments. Platforms must abide by certain rules regarding client funds, to the extent that they collect them including not co-mingling the funds and performing a reconciliation (Quinn, 2014). Further, the platforms are required to deposit client money with an appropriate third-party institution and undertake relevant due diligence in relation to such a third party.
60On the other hand, the draft framework in India does not contain any provision for the platform to hold client money through nodal or escrow accounts and requires that the money should mandatorily pass directly from the lender’s account to the borrower’s account without being reflected on the balance sheet of the crowdfunding platform (Bhakta, 2016; Rao, 2016).
Business Continuity Plan
61The UK regulatory framework requires platforms to ensure that they have a robust back-up plan in place to service loans in the event they go out of business or otherwise cease to operate (Quinn, 2014).
62Similarly, the RBI Discussion Paper requires the platforms to put in place an adequate risk management system for its smooth operations. In case of the failure of the platform to continue its operations, it should have a ‘living will’ or alternative arrangement in the form of an agreement for continuation of its operations.
Protection for Small Lenders
63In the UK, each P2P Lending Platform is required to provide investors with the latest and up-to-date educational materials based on which the investors must consider the appropriateness of an investment through the platform. Further, the UK regulations also prescribe that prior to accepting any investor commitment, the platform is required to obtain from the investor representations that the investor has reviewed the intermediary’s educational materials and a completed questionnaire demonstrating the investor’s understanding of the restrictions on investment cancellations, potential challenges for resales, and the inherent investment risks. Also, the loan size for each investor is restricted up to £25,000/-, thereby mitigating the risk attached to the investment up to its maximum size (Leveque, 2016).
64Under the draft guidelines in India, unlike in the UK, no separate provisions have been considered to address risks where unsophisticated individual investors/lenders may get involved and where they do not have sufficient information to make informed decisions about whether or not to participate on the P2P platform.
Dispute Resolution
65In terms of the UK regulations, investors will have the right to complain first to the platform and then to the Financial Ombudsman Service and disputes are subject to a standards-based process (FCA 2014, PS 14/4).
66Similarly, under the draft guidelines in India, the operators would also be mandated to have a proper grievance redressal system to deal with complaints both from borrowers and lenders.
Provision of Cancellation Rights
67Platforms must allow investors to cancel their investments under certain conditions and within certain timeframes. This basically makes UK law conform to current EU regulations (Quinn, 2014). However, no such parallel provisions have been contemplated under the Draft Indian Framework.
Ongoing Reporting
68In terms of the UK regulatory framework, platforms are required to have regular reporting requirements such as disclosing their prudential and financial position, notification of a change in the total value of outstanding loans of 25% or more, client money positions, investor complaints and information on loans arranged over the previous quarter, among other items (Quinn, 2014). Additionally, the rules require platforms to provide relevant and accurate information to their customers under a high-level approach aimed at providing useful information, and not overburdening consumers with too much detail.
69Similarly, in terms of the RBI Discussion Paper, the platforms are required to submit regular reports on their financial position, loans arranged in each quarter, complaints etc. to RBI. Minimum disclosures to borrowers and lenders are also proposed to be mandated through a fair practices code.
70A comparative analysis in tabular format based on the above points of distinction for P2P Lending has been given above in Table 2 for ease of reference.
Comparative Analysis—P2P Lending
| S.No. | Parameter | UK | India |
|---|---|---|---|
| 1. | Client Money Rules | Platforms required to abide by certain Client Money Rules regarding client funds, including deposit of client money with a third party. | Client monies required to pass directly from the lender’s account to the borrower’s account: No role for platform in the collection of monies |
| 2. | Prudential Norms | The higher of £50,000/- or a percentage of a volume-based financial resources requirement calibration | Minimum capital of INR 20 million (i.e. Euro 0.28 million approx.). |
| 3. | Leverage ratio | Not applicable | Proposed to be specified |
| 4. | Protection of small investors | Specific guidelines prescribed | No specific guidelines proposed |
| 5. | Provision of Cancellation Rights | Cancellation of investments by investors permitted under certain conditions | No such provision contemplated |
Comparative Analysis—P2P Lending
Key Recommendations
71Based on the above comparative study, the following recommendations would be worth noting with respect to security-based crowdfunding and P2P lending.
Security-Based Crowdfunding
72Firstly, while framing the final legislation for the regulation of crowdfunding in the Indian context, it needs to be borne in mind that the most likely investors in crowdfunding issuances are small, unsophisticated individual investors who may be interested in investing small amounts in a new idea or business without exposing themselves to undue risks. The higher entry barriers for retail investors, being knowledgeable in investments, or at least having access to investment advice, along with being able to absorb losses on crowdfunded issues, only exacerbate the removal of the crowd from crowdfunding. The high threshold for qualifying as an eligible retail investor is opposed to the crowdfunding model’s basics, which aim to pool small amounts from “the crowd” i.e. non-sophisticated individuals who otherwise refrain from investing in the securities market. Therefore, there may be a need to enlarge the scope of accredited investors in order to facilitate participation by small investors, subject to the provision of certain additional protections. Such protections may include limits on the maximum amounts that can be invested in proportion to the investors’ net income, net worth etc. (Mukherjee et al., 2014; Majumdar, 2015; Tripathy, 2016).
73Secondly, considering that the underlying premise of ‘crowdfunding’ is to raise funds through relatively small contributions from a large number of people, i.e. “the crowd”, and not from a small group of sophisticated investors, restricting the number of investors to 200 persons could severely hamper this premise, which renders crowdfunding unique. Further, limiting the number of investors to 200 could also affect the potential of a venture to raise the desired amount of funding, especially considering that most QIBs are averse to investing through the crowdfunding route and look at restricting their investment to slightly less risky companies that have a proven track record, and which provide clearer exit opportunities. While crowdfunding in its truest sense is meant to engage with investors who would otherwise be unable to participate in regular capital markets, the high thresholds for accreditation or even for eligibility as a retail investor means that participation in crowdfunding would remain isolated from large sections of potential retail investors. Accordingly, while framing the final legislation for regulation of crowdfunding in the Indian context, SEBI may either consider an increase in the abovementioned limit of 200 persons or the removal of the limit altogether in order for “the crowd” to participate in the funding issue, thereby resulting in the emulation of the US regulatory model on crowdfunding (Mukherjee et al., 2014; Majumdar, 2015).
74Thirdly, even with the inclusion of qualified retail investors, it would be impossible for a startup to be truly crowdfunded. The SEBI consultation paper suggests minimum investment limits for Qualified Institutional Buyers as 5% of each company that they invest in, through the crowdfunding mechanism. Considering that QIBs are unlikely to invest in early stage ventures and startups with no track record of operations, it may not be feasible to require QIBs to hold a minimum amount of investment, both individually and cumulatively, since this may impose an unrealistic burden on the issuer companies and defeat their fundraising attempts. Such a requirement may also lead to a situation where the company succeeds in raising the requisite amount from HNIs and retail investors but cannot close the transaction due to a shortfall in QIB investment (Mukherjee et al., 2014; Majumdar, 2015).
75Fourthly, the rationale of limiting the crowdfunding platform only for unlisted public companies to the complete exclusion of private companies is unclear, specifically when most of the startups and small and medium enterprises are incorporated as private companies. On similar lines as in the USA, in addition to an unlisted public company, SEBI may also consider including a private company within the category of an eligible issuer company, provided such a company fulfils the prescribed conditions (Mukherjee et al., 2014; Tripathy, 2016; Bhargava et al., 2017).
76Fifthly, drawing a parallel from the US Crowdfunding Regulations, where no minimum investment has been prescribed for investors under a crowdfunding issue, while drafting the final regulations, SEBI may consider dispensing with any such requirement for minimum investment (Mukherjee et al., 2014).
77Finally, under the Draft Consultation Paper, there is no secondary market provided for the investors. Securities cannot be transferred to anyone else except to the issuer (provided that the transfer has been made in accordance with the sections of Companies Act 2013 and the rules made thereunder which are in relation to the buyback of securities by unlisted public companies), another accredited investor who has been registered, and a family member or a relative or a friend of the accredited investor, or any such person who is an equivalent to these. Further, the transfer is contingent only upon the occurrence of certain events such as the sale of the company, a management buyout, flotation of an IPO, or listing of the company on a recognised stock exchange in the SME segment or main board. Now, since there is no secondary market provided, the investors do not have any exit option available to them. This exit option is necessary because at times the company may not be able to give expected returns or may have some internal mismanagement, and in that case investors always prefer to have a safe option of exiting the whole chaotic situation. The unavailability of this option could create a deterrent for investors to engage in such crowdfunding activities, they would rather prefer to go along with another option in which they can safely back out if the venture does not work out according to their needs (Bhargava et al., 2017). It is therefore suggested that, as in the case of the USA, where flexibility for the investors is allowed, the exit should not be dependent on the occurrence of the above-stated events and should be permissible on a secondary market, subject to a reasonable lock-in period.
P2P Lending
78The prescribed leverage ratio for the platforms may not be suitable because the credit does not come from the platform. Instead, it is suggested that what the regulator can ask the P2P lenders is to create a credit insurance fund of some kind to offer relief in the case of default (Vishwanathan, Nair, 2016).
79Further, it would be important for the draft Indian legislation to consider the maintenance of an escrow/nodal account which will allow pooling of the funds until the funds are ready for disbursal to the borrower. In the absence of such a mechanism, the movement of funds between borrowers and lenders will be extremely slow and it will be difficult for the platform to monitor the flow of loan monies from the lender to the borrower (Vishwanathan, Nair, 2016).
80Finally, while issuing the final guidelines on P2P lending, RBI may consider emulating the disclosure norms for platforms suggested by the UK P2P Finance Association, including disclosures on cumulative lending, outstanding loan book, net lending, number of lenders and borrowers etc. (George, 2016).
Conclusion
81The above comparative study points out both differences and similarities in the proposed legislation in India to already enacted regulations in USA and UK. The similarities may be related to the nature of the subject matter. The regulatory authorities in the USA and the UK have made appropriate laws to accommodate a new industry and to regulate related businesses effectively, and at the same time have left enough space for industry innovation (Yin, 2016). Similarly, we note that the draft legislation proposed in India is innovative in many ways as the securities and banking regulators have attempted to adapt the various rules and regulations to the available Indian institutional infrastructure. However, in doing so, at times, the legislator forgets that at the early stages of an industry, regulation should be enabling and not limiting.
82The findings as discussed in this research paper may be useful not only in the Indian context, but also for other emerging countries which are in the process of evolving crowdfunding regulations. Vietnam is exploring ways to regulate the funding model. Thailand is looking to authorize its first equity crowdfunding platform by the end of the year, while Malaysia’s Securities Commission recently allowed six platforms to begin operating just this summer. If these platforms can show quick successes, more countries in the region will consider implementing their own regulations (AlliedCrowds, 2015b).
83In order to further understanding in this area, future researchers may consider examining the corresponding legislation in China, which has seen the growth of alternative finance, including crowdfunding, at levels far greater than those found in the USA.
84Enabling legislation is of course only one part of the crowdfunding industry building process. However, legislation is only one facilitator among others. The roles of customs and soft institutions such as charitable giving and trust also need to be examined (Ashta, Assadi, 2010). With the benefit of hindsight, once large-scale data is available, future researchers could examine all the different institutional rules and norms and their role in impacting the probabilities of adopting crowdfunding.
85This research has been based on comparing the content amongst legislations and not the regulatory process. According to the World Bank Global Indicators of Regulatory Governance, the USA [11] and the UK [12] are both model legislators scoring 6 points on a 6-point scale, while India [13] scores 3.4 on the same scale. Therefore, a comparison of the regulatory procedure with ideal-types would be a good area for future research. Individual researchers could look at transparency, public consultation, impact assessment, access to laws, as well as the process of challenging regulations.
Notes
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[1]
Acknowledgements: I would like to thank Umang Gupta for research assistance, Arvind Ashta and Djamchid Assadi for their continuous encouragement and guidance all along during the tenure of this project, Dipankar Vig for his support and Joan MacLeod Heminway and Jack Wroldsen for their valuable inputs on the USA crowdfunding regulations.
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[2]
Jumpstart Our Business Startups (Jobs) Act, Title III, H. R. 3606, available at: https://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf
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[3]
Final rule on crowdfunding, RIN 3235-AL37 available at: https://www.sec.gov/rules/final/2015/33-9974.pdf
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[4]
Securities and Exchange Board of India (2014), Consultation Paper on Crowdfunding in India, Press Release: PR No. 62/2014, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf
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[5]
A QIB is defined under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 to include a mutual fund, venture capital fund, Alternative Investment Fund, Foreign Venture Capital Investor registered with SEBI, a scheduled commercial bank, registered insurance company, multilateral and bilateral development financial institution etc.
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[6]
Chapter III—The Companies (Prospectus and Allotment of Securities) Rules, 2014 of Companies Act, 2013.
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[7]
The minimum offer value per person must be at least Rs. 20 000/- (Euro 280/- approx.) of the face value of the securities.
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[8]
Reserve Bank of India (2016), Consultation Paper on Peer to Peer Lending, available at: https://rbidocs.rbi.org.in/rdocs/content/pdfs/CPERR280416.pdf
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[9]
P2PFA, available at http://p2pfa.info/
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[10]
FCA Client Money Rules, Client Asset Sourcebook available at: https://www.handbook.fca.org.uk/handbook/CASS/7/?view=chapter
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[11]
World Bank Global Indicators of Regulatory Governance, available at: http://rulemaking.worldbank.org/data/explorecountries/united-states
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[12]
World Bank Global Indicators of Regulatory Governance, available at: http://rulemaking.worldbank.org/data/explorecountries/united-kingdom#cer_consultation
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[13]
World Bank Global Indicators of Regulatory Governance, available at: http://rulemaking.worldbank.org/data/explorecountries/india
