A legal perspective on Sebi’s crackdown on Growpital

Sebi asserts that the illegal mobilization of funds for a CIS constitutes a fraudulent practice under the Sebi PFUTP Regulations.
Sebi asserts that the illegal mobilization of funds for a CIS constitutes a fraudulent practice under the Sebi PFUTP Regulations.

Summary

  • The Sebi order directed a freeze on their bank and demat accounts, effectively restraining further activities and safeguarding assets.

In a significant turn of events, the Securities and Exchange Board of India (Sebi) recently issued an ad interim ex parte order against the platform ‘Growpital’ and its designated partners (DPs). The order directed a freeze on their bank and demat accounts, effectively restraining further activities and safeguarding assets, particularly the alleged 184 crore mobilized from the public. ‘Growpital’s’ unconventional strategy, treating investors as partners in limited liability partnerships (LLPs) and framing their investments as capital contributions, has triggered a legal debate on the platform’s operational legitimacy. With one LLP having nearly 4500 partners, a question has emerged regarding the absence of an upper limit on partner induction under the LLP Act, 2008. Following a preliminary examination of ‘Growpital’s’ structure and operations, Sebi concluded that the platform and its DPs had orchestrated an unregistered collective investment scheme (CIS), thus committing securities fraud.

Venturing into the regulatory landscape, the Sebi order invokes Section 11AA of the Sebi Act, 1992. This section, rooted in the S.A. Dave Committee Report, was introduced in 1999 to address the proliferation of investment schemes, particularly those related to plantations and emu framing. Section 11AA outlines 4 conditions for a scheme or arrangement to be classified as a CIS, thereby requiring Sebi registration. These conditions include the pooling and utilization of investors’ money for the stated scheme, an economic motive behind the scheme, management of investment on behalf of investors, and the scheme’s management and operation being the effort of an entity other than the investors. Certain institutions, such as co-operative societies, NBFC deposits, and mutual funds, are explicitly excluded. Additionally, the government holds the residual power to include any scheme in the excluded category.

In the aftermath of the Saradha and PACL scams, the section underwent an amendment in 2014, stipulating that schemes with a corpus of 100 crore or more would be deemed as a CIS. The rationale behind this threshold, remains unclear, sparking litigations challenging Sebi’s diverse orders. This has led to questions regarding whether pooling funds of 100 crore or more means that the four conditions do not need to apply [mere size is sufficient for the vehicle to be classified as a CIS without further tests].

Drawing insights from a landmark US Supreme Court judgment in SEC v. WJ Howey (1946) and discerning patterns in Sebi’s orders, one can infer that pooling of 100 crore does not necessarily trigger the 4 conditions for an arrangement or scheme to be classified as a CIS. In other words, it is not alone a sufficient condition. Also, pooling money below 100 crore does not necessarily exempt the entity from being classified as a CIS. The classification depends on meeting or not meeting specific 4 conditions as outlined by Sebi.

Despite Sebi’s widespread authority and numerous orders against such activities, concerns persist about the efficacy of recovering funds or refunding investors. This has reignited discussions on a 2017 proposal to establish an independent agency to regulate CIS, with Sebi arguing that state-level authorities would be better equipped for monitoring. In the case of ‘Growpital,’ the Sebi order deems the platform’s arrangement an unregistered CIS, forwarding the order to the government of Rajasthan and Registrar Of Companies (ROC) - Jaipur, in alignment with the platform’s registration location. This echoes Sebi’s 2017 call for an independent agency in collaboration with state-level bodies.

The order meticulously dissects ‘Growpital’s’ solicitation process, LLP agreements, and profit-sharing terms, ultimately determining that it fulfills the conditions for pooling contributions and assured returns, despite Sebi’s explicit prohibition of the latter. It also emphasizes the extensive rights of the DPs, meeting the conditions for the platform to be classified as an unregistered CIS.

Sebi asserts that the illegal mobilization of funds for a CIS constitutes a fraudulent practice under the Sebi PFUTP Regulations. This allows Sebi to impose a higher penalty, invoking Section 15HA, which permits penalties of up to 25 crore or three times the profit, whichever is higher.

The ‘Growpital’ case isn’t the first instance of Sebi penalizing LLPs for pooling funds without proper registration. In 2015, a similar interim order was issued (and the final in 2020) in HBJ Capital case. Curiously, one case was categorized as an unregistered AIF while another as an unregistered CIS, adding an intriguing layer to Sebi’s regulatory history.

In conclusion, while Sebi’s order against ‘Growpital’ underscores regulatory vigilance, it prompts a critical examination of the need for a more nuanced approach. ‘Growpital’s’ LLP structure, despite promising guaranteed profits, may potentially shield investors from losses due to the limited liability protection inherent in the LLP structure. This means investors may not be personally responsible for the losses beyond their invested capital in the LLP.

It raises questions about whether Sebi should explore avenues to regularize such platforms instead of imposing outright prohibitions. For instance, Sebi’s order against PACL, seeking a refund of 50,000 crore, pending enforcement even after a decade, highlights the overarching issue of numerous schemes being prohibited without effective fund recovery or regularization. This necessitates a thorough evaluation of Sebi’s regulatory strategies over the past 25 years, pondering whether it’s the compliance burden or the regulatory structure that dissuades entities from registering with Sebi. As Winston Churchill aptly said, “When you make 10,000 regulations, you destroy all respect for the law." Sebi’s ongoing challenges with unregistered CIS cases call for a reassessment of regulatory framework to strike a balance between compliance and facilitating legitimate financial platforms.

Sumit Agrawal is managing partner, Regstreet Law Advisors, and a former Sebi officer. The views expressed in this artcile are personal.

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