NAVIGATING THE GRAY: UNVEILING THE DANGERS OF INVESTING IN STARTUP EQUITY THROUGH ONLINE PLATFORMS
In today’s dynamic investment landscape, private equity funding has surged to the forefront as entrepreneurs and investors seek innovative avenues for capital growth. With the digital era in full swing, online platforms have emerged as powerful tools, promising streamlined access to lucrative investment opportunities. Yet, amidst the allure of these virtual marketplaces lies a shadow of uncertainty. While the appeal of advertised private equity funding is undeniable, questions loom large over its legality under prevailing regulations. As the tide of capital flows online, navigating the murky waters of compliance has become paramount for both investors and enterprises alike.
The Companies Act of 2013 (“Act”) serves as the cornerstone of legal regulations governing the establishment, governance, and operation of companies and investments in companies across India. Among its extensive provisions, Section 42 stands out for its focus on regulating the private placement of securities (the legal term for the most common method of funding). Recent developments have shed light on the significant repercussions of both direct and indirect violations of Section 42 of the Act. This article dives into recent cases of companies that have been ordered to pay a penalty under Section 42 of the Act, focusing on the critical aspects, and implications of violating Section 42 of the Companies Act of 2013, and the role of online platforms such as “Planify” and “Tyke”. Recently, private companies’ actions, particularly the sale of shares and running fundraising campaigns through an online platform, have drawn regulatory scrutiny.
UNDERSTANDING SECTION 42
As per sub-section (2) of Section 42, “a private placement shall be made only to a select group of persons who have been identified by the Board (herein referred to as “identified persons”), whose number shall not exceed fifty or such higher number as may be prescribed (Note: 200 as per Rule 14(2) of the Companies (Prospects and Allotment of Securities) Rule,2014 (“the Rule, 2014)) [excluding the qualified institutional buyers and employees of the company being offered securities under a scheme of employees stock option in terms of provisions of clause (b) of sub-section (1) of section 62], in a financial year subject to such conditions as may be prescribed”.
As per sub-section (3) of Section 42, “a company making private placement shall issue private placement offer and application in such form and manner as may be prescribed to identified persons, whose names and addresses are recorded by the company in such manner as may be prescribed: Provided that the private placement offer and application shall not carry any right of renunciation.”
As per sub-section (6) of Section 42 of this Act, “A company making an offer or invitation under this section shall allot its securities within sixty days from the date of receipt of the application money for such securities and if the company is not able to allot the securities within that period, it shall repay the application money to the subscribers within fifteen days from the expiry of sixty days and if the company fails to repay the application money within the aforesaid period, it shall be liable to repay that money with interest at the rate of twelve per cent. per annum from the expiry of the sixtieth day: Provided that monies received on application under this section shall be kept in a separate bank account in a scheduled bank and shall not be utilised for any purpose other than—(a) for adjustment against allotment of securities; or (b) for the repayment of monies where the company is unable to allot securities”.
As per sub-section (7) of Section 42 of the Act, “No company issuing securities under this section shall release any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue”.
As per sub-section (10) of Section 42 of the Act “Subject to sub-section 11 of Section 42, if a company makes an offer or accepts monies in contravention of this section, the company, its promoters and directors shall be liable for a penalty which may extend to the amount raised through the private placement or two crore rupees, whichever is lower, and the company shall also refund all monies with interest as specified in sub-section (6) to subscribers within a period of thirty days of the order imposing the penalty”.
CASE STUDIES
1. Solargridx Ventures Private Limited
Solargridx Ventures Private Limited (“SVPL”), a growing renewable energy company, faced regulatory scrutiny for its securities placement practices. In an effort to broaden its investor base, the company launched a private placement campaign, issuing Community Stock Option Plans (CSOPs). SVPL took the position that the CSOPs were merely subscription/membership fees paid by subscribers for rewards and were not anywhere close to a Stock Appreciation Rights (SAR). However, it was observed that CSOP Agreement clearly enabled CSOP holder to unlock value based on future valuation of the company. Further, the payment provided to CSOP holder will be on the fair market value of the equity shares and even at the time of issuance of CSOP the value was tied to the pre-money valuation of the equity shares. Therefore, it was noted that CSOP is clearly a “derivative” and in turn a “security” under the provisions of the Securities Contracts (Regulation) Act, 1956. As a result of which, issue of CSOPs trigger Section 42 of the Act.
It is noted that the said CSOPs were issued to a staggering total of 565 subscribers during the fiscal year 2021–2022 exceeding the statutory limit set by Section 42(2) of the Act read with the Rule 14 of the Rule, 2014, which requires a maximum of 200 allottees per fiscal year.
It was also observed that SVPL failed to adhere to the strict timeline prescribed by Section 42(6) of the Act. Despite receiving application money, the company neither allotted securities within the mandated 60-day period nor initiated refunds within 15 days thereafter. This lapse not only reflected poorly on the company’s governance but also attracted penalties and interest for non-compliance.
SVPL breaches were made worse when it used the Tyke platform to publicize its CSOP offering. By doing so, the company violated Section 42(7), which expressly prohibits companies from disseminating information about private placements through public advertisements or media channels. SVPL actions drew the ire of regulatory authorities, resulting in adjudication proceedings and penalties imposed on the company and its directors.
Penalties
As per the order for adjudicating in the matter of SVPL dated 22nd of September 2023, penalties for violations of multiple provisions of Section 42 the Act were imposed and consequently the company faced the maximum penalty of Rs. 2 lakhs, while three of its officers were each fined Rs. 1 lakh for each violation of Section 42(2) and 42(7) of the Act.
In addition to the penalties, a direction has been issued to rectify the default concerning the violation of Section 42(6) of the Act. Pursuant to Section 42(6), the company was obligated to make allotments within sixty days or refund the money within 15 days from the expiry of the sixty-day period. Since the company failed to meet these requirements, it is liable to pay money with interest at a rate of twelve percent per annum from the expiry of the sixty-day period until the date of the Show Cause Notice. The company is required to provide refunds to all 565 subscribers along with interest within 45 days and submit a compliance report within 60 days.
2. Septanove Technologies Private Limited
In another case involving Septanove Technologies Private Limited, the company used Tyke platform to launch a fundraising campaign for issuing Compulsory Convertible Debentures (CCDs). This action was found to contravene Section 42(7) as Tyke platform served as a distribution channel for disseminating information about the securities offering to the general public. The campaign experienced oversubscription, leading to penalties imposed on the company and its directors were fined Rs. 2 lakhs, while the two directors were fined Rs. 1 lakh each under section 42(10) read with section 446B for violation of section 42 (7) of the of the Act (Decided on 1st March 2023).
3. Anbronica Technologies Private Limited
Similarly, Anbronica Technologies Private Limited engaged the Tyke platform to issue Compulsorily Convertible Debentures (CCDs), with Tyke facilitating the fundraising process. Despite Tyke’s initial intention to facilitate private placement, its public-facing nature inadvertently allowed a broader audience to engage with Anbronica’s fundraising campaign. This raised concerns about informing the public at large about the CCD offering, further exacerbating the violation of Section 42. The violation of Section 42(7) prompted regulatory authorities to issue a Show Cause Notice. Anbronica and its promoters/directors were held accountable for penalties to the tune of Rs. 2 lakhs and Rs. 1 lakh respectively under section 42(10) read with section 446B for violation of section 42 (7) of the of the Act (Decided on 1st March 2023).
4. Planify Capital Limited
Planify Capital Limited (“PCL”), a fundraising platform for startups that sells shares of unlisted companies to investors via its website (www.planify.in), became entangled in a web of regulatory violations under Section 42 of the Act. It was found that the said platform event engaged in fundraising campaigns for its own operations and group entities.
The allegations against PCL included multiple violations of Section 42. Firstly, the company was accused of exceeding the limit of private placement offers set by Section 42(2) of the Act. Secondly, PCL was found guilty of violating Section 42(7) by issuing public advertisements or using media channels to notify the public about securities issuance. In addition, the company violated Section 42(8) by failing to file a return of allotment within the timeframe specified.
During the adjudication proceedings, it was revealed that PCL in fact sold shares to Planify Enterprises Private Limited, who then distributed them to 76 individuals via. the online platform. Despite claims that these were secondary market transactions, evidence suggested otherwise, indicating a direct violation of Section 42 provisions. Furthermore, in the context of secondary market transactions, it became clear that PCL’s private placement of shares to Planify Enterprises Private Limited was solely designed and authorized to find buyers for its securities via the online Planify platform. The order noted that the real intention was to issue the shares to the public at large, and thus the first transaction of selling shares to Planify Enterprises Private Limited was done to find potential investors for PCL through the Platform. It emerged from a private placement, creating a distribution channel—an unlawful act under Section 42(7) —for selling securities to the public at large on the online platform, thus violating the law.
Additionally, the valuation report used for this deal was also brought under scrutiny for which PCL tried to push the blame to the registered IBBI valuer but the authority observed that PCL was incorporated in 2021 but the valuation report contains financials from 2019. The valuation report shows the date of incorporation and CIN of Planify Enterprises Private Limited. Based on the findings, the order noted that the valuer had actually been valuing a different company of the group and giving the impression that PCL is being valued. People at large were also misled by this valuation report.
Penalties
As per the order for adjudicating in the matter of PCL dated 3rd of April 2024, maximum penalties totaling Rs. 2 Crore were levied on PCL for violation of Section 42(7) of the Act. Further, the directors including non-executive directors and independent directors were also imposed with penalties ranging from Rs. 1 Crore to Rs. 2 Crore, as they knew about the business model of the company and they also passed the board resolution authorizing Planify Enterprises Private Limited to utilize the online platform for selling the shares of PCL.
CONCLUSION
In conclusion, the case studies herein illustrate the varied challenges of complying with securities regulations under Section 42 of the Companies Act of 2013. These cases draw attention to the serious consequences of violating such regulations, with penalties levied against both companies and their officers. The misuse of online platforms facilitating equity funding via private placement of securities shows the value of stringent compliance measures and regulatory oversight. The penalties imposed serve as a deterrent to future violations and emphasize the importance of upholding legal standards in the financial sector. As businesses navigate the complex landscape of private placements and fundraising campaigns, strict adherence to regulatory frameworks is critical to maintaining investor trust and protecting the public interest.
In the ever-evolving landscape of finance, the allure of online platforms for private equity funding is undeniable, promising efficiency and accessibility. However, as we’ve explored, the legal landscape surrounding these platforms is rife with complexities and uncertainties. For companies considering this route, the cautionary tales and legal precedents outlined in this article serve as invaluable guideposts, urging prudent decision-making and thorough due diligence. Similarly, for investors eager to partake in the excitement of funding startups through online channels, a keen awareness of the potential legal pitfalls is paramount. In the end, while these platforms offer tantalizing prospects, navigating their legal intricacies demands vigilance and foresight from all parties involved.
Disclaimer: The information provided in this article is for general informational purposes only and should not be construed as legal advice. The content is not intended to create, and receipt of it does not constitute an attorney-client relationship. Readers should not act upon this information without seeking professional counsel.
