FinTech Law in India: Crowdfunding and NeoBanking Companies

Crowdfunding Companies

General Mode of Operation: Crowdfunding is a mechanism through which funds are raised in order to finance projects, ventures, expenses, products. The funds are raised from a large number of individual investors and donators. Most of these companies charge a commission of around 5%-7.5% as platform success fee and subsequently, a 3% payment gateway fee on the total funds raised.

Source: Inc42

Types of crowdfunding:

• Donation: When funds are solicited from people for philanthropic, social and artistic purposes without any obligation for it to be returned back to them.

• Reward: When funds are solicited from investors with the latter getting a tangible award.

• Peer-to-Peer (P2P) Loan: When funds are collected in the nature of unsecured loans at nominal interest rates. Generally, the banks provide for such platforms over their service applications. – (Governed by RBI’s NBFC-P2P lending Direction 2017).

• Equity-based: When funds are raised by a business especially in the early stage of its existence by offering equity in exchange of the amount invested on the platform to a large number of investors.

As of now this form of crowdfunding is held to be illegal in India by SEBI (it is in a regulatory vacuum as Equity shares can only be raised in compliance with the Companies Act 2013 which itself does not recognise crowdfunding as one of the modes.

The legal framework

There has not been much development in the regulation of crowdfunding platforms in India. Recently, SEBI has started devising a distinct Security-based Crowdfunding (as discussed in the SEBI Consultation Paper on Crowdfunding 2014).

SEBI has adopted this definition of "Crowdfunding":

“Crowd sourced funding is a means of raising money for a creative project (for instance, music, film, book publication), a benevolent or public-interest cause (for instance, a community based social or co-operative initiative) or a business venture, through small financial contributions from persons who may number in the hundreds or thousands.

Those contributions are sought through an online crowd-funding platform, while the offer may also be promoted through social media.”[1]

The consultation paper also provides that only an ‘Accredited Investor’ can invest in crowdfunding based projects by businesses. Accredited investors include:

• Qualified Intuitional Buyers- like Banks and Insurance Companies

• Companies with an net worth of Rs.20 Crore or more

• High-Net-Worth Individuals (Rs. 2 Crore or more)

• Eligible Retail Investors (who have an annual income above Rs.10 Lakh)

The same paper provides for the Eligibility conditions for companies to crowdfund their activities:

1. The company is no more than 4 years old.

2. The company is unlisted.

3. The company is not a subsidiary of any large conglomerate or other private company.

4. The company will not engage in activities that lead to further lending of the funds.

5. The company does not have a turnover in excess ofRs.25 Crore

6. The company does not raise more than Rs.10 crore in a period of 12 months.

NeoBanking Companies

General mode of operation: These are basically fintech companies that provide banking and other financial services. They are 100% online and have little to no physical banking branches. Under the current legal framework, the RBI does not grant virtual banking licenses so, these companies have to partner up with traditional banks or small banks to provide banking services (such as extension of credit, small loans) and financial services (advisory, investment schemes etc.). For the latter, NeoBanks can also be set up under an NBFC to extend credit services.

The legal framework

Under clause 6 of RBI’s Master Circular – Mobile Banking transactions in India – Operative Guidelines for Banks [2014]

• [6.1] Banks which are licensed, supervised and having physical presence in India, are permitted to offer mobile banking services. Only banks who have implemented core banking solutions are permitted to provide mobile banking services.

• Under [6.2]: The services shall be restricted only to customers of banks and/or holders of debit/credit cards issued as per the extant Reserve Bank of India guidelines.

The clause specifically mentions “having physical presence” as a criteria for engaging in mobile (online) banking services. Since the NeoBanks do not comply with this aspect, they are bound to partner up with banks and NBFCs to operate.

In certain cases, NeoBanks act as outsourcing partners that verify customer data for credit requests or undertake preliminary work for opening and closing current accounts. In this scenario, the 2006 RBI guidelines on Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by banks shall be applicable.

Under [Annex-1 Para 2] of the guidelines: the RBI provides for activities which may NOT be outsourced:

“Banks which choose to outsource financial services should however not outsource core management functions including Internal Audit, Compliance function and decision-making functions like determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.”

Under [Para 3] of the same, material outsourcing agreements are discussed. The RBI provides for the basis used while determining if an outsourced aspect is material to the bank :

1. The level of importance to the bank of the activity being outsourced

2. The potential impact of the outsourcing on the bank on various parameters such as earnings, solvency, liquidity, funding capital and risk profile;

3. The likely impact on the bank’s reputation and brand value, and ability to achieve its business objectives, strategy and plans, should the service provider fail to perform the service;

4. The cost of the outsourcing as a proportion of total operating costs of the bank;

5. The aggregate exposure to that particular service provider, in cases where the bank out sources various functions to the same service provider.

The terms of an outsourcing agreement is provided under [Para 5.5.1] of the same annexure.

The extension of banking services is covered under the 2010 RBI guidelines on Financial Inclusion by Extension of Banking Services – Use of Business Correspondents (BCs):

Under [Clause 2], eligible individuals and entities are provided :

“

i. Individuals like retired bank employees, retired teachers, retired government employees and ex-servicemen, individual owners of kirana / medical /Fair Price shops, individual Public Call Office (PCO) operators, agents of Small Savings schemes of Government of India/Insurance Companies, individuals who own Petrol Pumps, authorized functionaries of well-run Self Help Groups (SHGs) which are linked to banks, any other individual including those operating Common Service Centres (CSCs);

ii. NGOs/ MFIs set up under Societies/ Trust Acts and Section 25 Companies

iii. Cooperative Societies registered under Mutually Aided Cooperative Societies Acts/ Cooperative Societies Acts of States/Multi State Cooperative Societies Act;

iv. Post Offices; and

v. Companies registered under the Indian Companies Act, 1956 (also 2013) with large and widespread retail outlets, excluding Non-Banking Financial Companies (NBFCs).”

[Clause 4] provides for the scope of activities that can be undertaken by a Business Correspondent [BC] :

“The scope of activities may include:

(i) Identification of borrowers;

(ii) Collection and preliminary processing of loan applications including verification of primary information/data;

(iii) Creating awareness about savings and other products and education and advice on managing money and debt counselling;

(iv) Processing and submission of applications to banks;

(v) Promoting, nurturing and monitoring of Self Help Groups/ Joint Liability Groups/Credit Groups/others;

(vi) Post-sanction monitoring;

(vii) Follow-up for recovery,

(viii) Disbursal of small value credit,

(ix) Recovery of principal / collection of interest

(x) Collection of small value deposits

(xi) Sale of micro insurance/ mutual fund products/ pension products/ other third party products and

(xii) Receipt and delivery of small value remittances/ other payment instruments.”

It is evident from this clause that the NeoBanks are plying their trade by providing these services to the banks and also extending financial and banking services directly to the doorstep (personal devices) of the customers. Under [Clause 9], banks are required to furnish commissions to their Business Correspondents for their activity.

Under [Clause 10], the banks are required to furnish the details of their arrangement/engagement with the BC :

“The arrangements with the BC shall specify:

i) Suitable limits on cash holding by intermediaries as also limits on individual customer payments and receipts;

ii) Cash collected from the customer should be acknowledged by issuing a receipt on behalf of the bank;

iii) That all off-line transactions are accounted for and reflected in the books of the bank by the end of the day; and

iv) All agreements/ contracts with the customer shall clearly specify that the bank is responsible to the customer for acts of omission and commission of the BC.”

In addition, NeoBanks have to comply with the (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011- “SPDI Rules” regarding collection of personal information (which includes bank and payment instrument details)

They also have to abide by the provisions of Section 43A of IT Act 2000 (post- amendment of 2008) in matters related to data privacy and storage of information utilities for the same. They also have to follow the direction given for Digital Signatures under the same Act u/s 41.

What NeoBanks can do :

• Since they are not under the direct supervision of RBI, Neo Banks usually function as banking correspondents (helping in user acquisition and transactions).

• NeoBanks can act as technology partners providing an onboarding platform and by using a multitude of algorithms and systems to provide better customer assessments. These platforms make account opening and KYC mechanisms much simpler and efficient.

• Grant small term loans

• Automate operational payments and monitor business transaction (reporting them to their partnered banks)

What NeoBanks cannot do :

• Manage or have any involvement in managing an investment portfolio.

• Determine their own KYC or other regulatory norms regarding opening of deposit accounts.

• Extend overdraft services.

• Offer lending products on their own books (they can via the banking partner)

• Collect large value deposits or render recurring deposit accounts.

Two major challenges that NeoBanks face in India (currently) :

Lack of tech savvy people

In 2020, India was reported to have about 54% of its population using a smartphone. Over 25,000 villages are yet to have internet connectivity. Since neo-banks are highly digital focused, they may not be able to cater to the banking needs of non-tech savvy consumers or people from the remote or rural parts of the country, who believe in face-to-face interaction with their financial custodians.

Lack of trust

One of the main aspects of NeoBanks is that they do not have physical branches that customers can reach out to. So, customers cannot rely upon them in case of any pressing issues/challenges. Secondly, neo-banks are yet to be officially recognized by the Reserve Bank of India (RBI).

That's it for Part 3, keep on the lookout for Part 4 which shall discuss Lending Companies and WealthTech (InvesTech) Companies :)

Thank you for reading!

[1] Corporations and Markets Advisory Committee, Australia, 2013. Crowd Sourced Equity Funding- Discussion Paper, Corporations and Markets Advisory Committee, p.5,