This article has been written by Mr. Tejas Chandna, a Third year student of Symbiosis Law School, Pune

Introduction 

The concept of real estate crowdfunding is gaining momentum in India, spurred by the success of Western ventures in the field. Peer-to-peer crowdfunding is legal in India and regulated by the Reserve Bank of India, enabling widespread participation through digital platforms. Fintech companies have emerged, offering sophisticated crowdfunding platforms facilitating developer funding for large real estate projects. These platforms prioritize user-friendly interfaces, transparent transactions, and precise return tracking.

SEBI’s interest in regulating India’s real estate crowdfunding market, including equity-based returns, is evident through the release of a consultation paper in 2014 assessing risks, benefits, and regulatory frameworks. The future of India’s real estate crowdfunding appears poised for greater structure and regulation, akin to established financial securities. SEBI has explored two main options under this model:

1. Equity-based Crowdfunding (EbC): Eligible entities can raise up to INR 100 million by issuing equity shares to Accredited Investors, with certain conditions such as limiting individual investor stakes to 25% and requiring promoters to retain a minimum 5% equity stake for at least 3 years.

1. Debt-based Crowdfunding (DbC): Eligible entities can raise up to INR 100 million by issuing debentures or debt securities to Accredited Investors in compliance with the Companies Act, 2013.

This article argues why non allowance of Equity Based Crowdfunding for real estate is not proportional against already regulated Alternative Investment Funds (AIFs) by SEBI, where SEBI itself in the consultation paper justifies the importance of Equity based crowdfunding. Secondly, being the only option of crowdfunding, it is argued that that private placement through Alternative Investment Funds (AIFs) may not be best to be the only mechanism. By inference, it is subsequently contended how public and private placement through Equity crowdfunding suffer and effect on SMEs and startups is thereafter analysed. 

Conundrum of Acceptance of Importance against non-allowance of Equity Crowdfunding in India 

Purchasing an investment property has become common due to record law mortgage prices, however hefty upfront payments from banks and multiple invoices involved in transactions have increased credit risk. Crowdfunding makes it easier, by its nature of combining all funds from investors, and using Fintech technology to make continuous dividends or set up a one time payment mechanism. However, there happens to be no legal mechanism in India for real estate crowdfunding. 

In a proposed consultation paper on Crowdfunding in 2014, it was proposed to allow additional channels for startups and SMEs, after BASEL Norms III had made accessibility difficult after the 2008 Financial Crisis. These channels through EbC or DbC routes as mentioned in paragraph 9.4, restricts among others, a company which is not engaged in real estate. However, Alternative Registered Investment Funds (AIFs) have been regulated by SEBI, which include real estate funds, private equity funds (PE funds), funds for distressed assets under Category II of AIFs under Regulation 3(2) of SEBI (Alternative Investment Funds) Regulations, 2012.

Now, the nature of real estate investments modules it towards Equity based crowdfunding, where solicitation is done at earlier stages. It can be assumed that the paper accepts the importance of Equity crowdfunding as firstly, Crowdfunding offers a much-needed alternative financing option for startups and small to medium-sized enterprises (SMEs), facilitating increased credit flow to these entities and others. Secondly, funding at reduced capital costs can be accessed without enduring stringent procedure. Thirdly, investors are offered a new product for portfolio diversification. However, to a contrary turn, the paper mentions five types of risks, which justifies its denial of legalization of Equity based crowdfunding in India. 

Why private placement through Alternative Investment Funds (AIFs) may not be best to be the only mechanism?

Critically, a real estate or retail investor is only left with the option of equity crowdfunding through private placement and not through public issuance. Looking at the risks of retail risks, systematic risks, risk of fraud, risk of default, role of internet and information asymmetry, non-allowance may not be proportional as justification as Alternative Investment Funds (AIFs) are already regulated through SEBI, with similar risks involved. 

However, the conundrum lies for listed companies to get equity crowdfunding against Section 55A(b) of the Companies Act, 1956,  Section 73 read with Section 60B and allied provisions of the Companies Act, Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 [for short ‘DIP Guidelines’] and various regulations of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 [for short ‘ICDR 2009’], which mandate a listing of securities on stock exchange and transfer of securities to the public by listed companies intending to get their securities listed on any recognized stock exchange in India.

For companies in general, Section 42 of Companies Act, 2013 restricts private placement to a maximum of 200 investors. Now theorizing non-allowance of Equity Crowdfunding through public or regulation through private investment with more than 200 investors, on the basis of mere risks, falters against three contentions:-

Firstly, SMEs, small companies and startups are indirectly unwelcomed as the rationale behind permitting Private Placements as a means of raising capital was to enable startups to fulfill their financial needs by offering securities to a limited group of individuals, institutional investors, or high-net-worth individuals, instead of navigating the intricate, time-consuming, and costly IPO process, which entails significant compliance requirements.

Secondly, unlike IPOs, where regulations and compliance standards are well-established by SEBI or the Companies Act, the framework for Private Placements is less defined. 

Thirdly, Section 42(2) of the Companies Act, 2013 mandates Private Placement identified persons, stipulating that only identified persons willing to subscribe to the Private Placement issue may apply.This furthers restricts such companies in advertising in public forums or utilizing any form of media or marketing for Private Placement purposes.

Public or Private: Both suffer the restrictions for startups and SMEs

Subsequently, leaving out the fact of listed company from Sahara India Real Estate Corporation Limited & Ors. vs Securities and Exchange Board of India & Anr., for the sake of arguendo, it would be have been illegal and unlawful even for an unlisted company in real estate equity crowdfunding to raise INR 17,400 crores from over 2 million investors in limits under category II Alternative Investment Funds may not borrow funds directly or indirectly and shall not engage in leverage except for meeting temporary funding requirements for not more than thirty days, not more than four occasions in a year and not more than ten percent of the 19[investable funds] under Regulation 17 of  SEBI (Alternative Investment Funds) Regulations, 2012.

Therefore, the investment criteria for Category II Alternative Investment Funds does not indirectly make it the best possible way for SMEs and startups, after India being recognised as the 3rd largest ecosystem for startups globally with over 1,12,718 DPIIT-recognized startups across 763 districts of the country in 2023. The restriction on investing solely in units of Category I or Category II Alternative Investment Funds, while excluding investments in Fund of Funds, suggests a cautious approach. 

This limitation may aim to mitigate risks associated with diversified portfolios and focus on direct investments in underlying assets. The prohibition on borrowing funds and engaging in leverage, except for short-term funding needs within specified limits, reflects a conservative risk management strategy.By limiting leverage and borrowing, these funds aim to reduce potential financial risks and maintain liquidity. 

Drawbacks of Alternative Investment Funds

These come at drawbacks of non allowance of debt crowdfunding for these SMEs and startups based in real estate.

Firstly, Category II Alternative Investment Funds are primarily directed towards investing in unlisted investee companies or units of other specified Alternative Investment Funds, as indicated in the placement memorandum. 

Secondly, Funds categorized as Category II may also invest in units of Category I or Category II Alternative Investment Funds, with the condition that they exclusively invest in such units and refrain from investing in units of other Fund of Funds.

Thirdly, Category II Alternative Investment Funds are prohibited from directly or indirectly borrowing funds and engaging in leverage, except for addressing temporary funding needs for a maximum of thirty days, not exceeding four occasions annually, and not surpassing ten percent of investable funds.

Fourthly, despite the restriction in clause (c), Category II Alternative Investment Funds may partake in hedging activities, subject to guidelines stipulated by the Board periodically.

Fifthly, Category II Alternative Investment Funds are permitted to enter agreements with merchant bankers to subscribe to the unsubscribed portion of issues or to facilitate the receipt or delivery of securities in the process of market making, in accordance with Chapter XB of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009.

Sixthly, Category II Alternative Investment Funds are exempt from regulations 3 and 3A of the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, regarding investments in companies listed on the SME Exchange or SME segment of an exchange, subject to certain conditions:

(i) The fund must promptly disclose any acquisitions or transactions in securities resulting from such due diligence to the relevant stock exchanges within two working days.

(ii) Investments made in such companies shall be locked in for a duration of one year from the date of investment.

Conclusion 

Hence, it can be recommended that allowing Category II Alternative Investment Funds to engage in hedging, subject to regulatory guidelines, provides them with a tool to manage risks effectively. Hedging strategies may help mitigate downside risks associated with their investment portfolios, thereby enhancing overall risk-adjusted returns.

The provision allowing agreements with merchant bankers for subscribing to unsubscribed portions of issues or facilitating securities transactions in market making activities indicates a proactive approach towards market participation. This provision may enhance liquidity and provide opportunities for strategic investments in the primary market.

The exemption from certain insider trading regulations for investments in companies listed on SME Exchanges, subject to disclosure and lock-in requirements, acknowledges the unique characteristics of these investments. This exemption may facilitate efficient investment processes while ensuring transparency and accountability.

References

1. This article was originally written by SEBI published on SEBI website. The link for the same is herein: https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf
2. This article was originally written by published on Invest India website. The link for the same is herein: https://www.sebi.gov.in/sebi_data/meetingfiles/nov-2023/1701238466470_1.pdf
3. This article was originally written by SEBI published on ‘SEBI (Real Estate Investment Trusts) Regulations, 2014 (“REIT Regulations”) for creation of new regulatory framework’. The link for the same is herein: https://www.sebi.gov.in/sebi_data/meetingfiles/jan-2023/1673531606137_1.pdf
4. Sahara India Real Estate Corporation Limited v. Securities and Exchange Board of India, 2012 SCC OnLine SAT 227
5. This article was originally written by SEBI published on ‘SECURITIES AND EXCHANGE BOARD OF INDIA (ALTERNATIVE INVESTMENT FUNDS) REGULATIONS, 2012’ The link for the same is herein: file:///C:/Users/tejas/Downloads/1492524621072.pdf
6. This article was originally written by SEBI published on SEBI website. The link for the same is herein: https://www.sebi.gov.in/sebi_data/attachdocs/1471519155273.pdf