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In a significant turn of events, the Securities and Exchange Board of India (Sebi) recentlyissued an ad interim ex parte order against the platform β€˜Growpital’ and its designatedpartners (DPs). The order directed a freeze on their bank and demat accounts, effectivelyrestraining further activities and safeguarding assets, particularly the alleged β‚Ή184 croremobilized from the public. β€˜Growpital’s’ unconventional strategy, treating investors aspartners in limited liability partnerships (LLPs) and framing their investments as capitalcontributions, has triggered a legal debate on the platform’s operational legitimacy. Withone LLP having nearly 4500 partners, a question has emerged regarding the absence ofan upper limit on partner induction under the LLP Act, 2008. Following a preliminaryexamination of β€˜Growpital’s’ structure and operations, Sebi concluded that the platformand its DPs had orchestrated an unregistered collective investment scheme (CIS), thuscommitting securities fraud.

Venturing into the regulatory landscape, the Sebi order invokes Section 11AA of the SebiAct, 1992. This section, rooted in the S.A. Dave Committee Report, was introduced in1999 to address the proliferation of investment schemes, particularly those related toplantations and emu framing. Section 11AA outlines 4 conditions for a scheme orarrangement to be classified as a CIS, thereby requiring Sebi registration. Theseconditions include the pooling and utilization of investors’ money for the stated scheme, aneconomic 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 theinvestors. Certain institutions, such as co-operative societies, NBFC deposits, and mutualfunds, are explicitly excluded. Additionally, the government holds the residual power toinclude any scheme in the excluded category.

In the aftermath of the Saradha and PACL scams, the section underwent an amendmentin 2014, stipulating that schemes with a corpus of β‚Ή100 crore or more would be deemedas a CIS. The rationale behind this threshold, remains unclear, sparking litigationschallenging Sebi’s diverse orders. This has led to questions regarding whether poolingfunds of β‚Ή100 crore or more means that the four conditions do not need to apply [meresize 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 β‚Ή100 croredoes not necessarily trigger the 4 conditions for an arrangement or scheme to beclassified as a CIS. In other words, it is not alone a sufficient condition. Also, poolingmoney below β‚Ή100 crore does not necessarily exempt the entity from being classified as aCIS. The classification depends on meeting or not meeting specific 4 conditions asoutlined 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 hasreignited discussions on a 2017 proposal to establish an independent agency to regulateCIS, with Sebi arguing that state-level authorities would be better equipped for monitoring.In the case of β€˜Growpital,’ the Sebi order deems the platform’s arrangement anunregistered CIS, forwarding the order to the government of Rajasthan and Registrar OfCompanies (ROC) – Jaipur, in alignment with the platform’s registration location. Thisechoes Sebi’s 2017 call for an independent agency in collaboration with state-levelbodies.

The order meticulously dissects β€˜Growpital’s’ solicitation process, LLP agreements, andprofit-sharing terms, ultimately determining that it fulfills the conditions for poolingcontributions and assured returns, despite Sebi’s explicit prohibition of the latter. It alsoemphasizes the extensive rights of the DPs, meeting the conditions for the platform to beclassified as an unregistered CIS.

Sebi asserts that the illegal mobilization of funds for a CIS constitutes a fraudulentpractice under the Sebi PFUTP Regulations. This allows Sebi to impose a higher penalty,invoking Section 15HA, which permits penalties of up to β‚Ή25 crore or three times the profit,whichever is higher.

The β€˜Growpital’ case isn’t the first instance of Sebi penalizing LLPs for pooling fundswithout proper registration. In 2015, a similar interim order was issued (and the final in2020) in HBJ Capital case. Curiously, one case was categorized as an unregistered AIFwhile another as an unregistered CIS, adding an intriguing layer to Sebi’s regulatoryhistory.

In conclusion, while Sebi’s order against β€˜Growpital’ underscores regulatory vigilance, itprompts a critical examination of the need for a more nuanced approach. β€˜Growpital’s’ LLPstructure, despite promising guaranteed profits, may potentially shield investors fromlosses due to the limited liability protection inherent in the LLP structure. This meansinvestors may not be personally responsible for the losses beyond their invested capital inthe LLP.

It raises questions about whether Sebi should explore avenues to regularize suchplatforms instead of imposing outright prohibitions. For instance, Sebi’s order againstPACL, seeking a refund of β‚Ή50,000 crore, pending enforcement even after a decade,highlights the overarching issue of numerous schemes being prohibited without effectivefund recovery or regularization. This necessitates a thorough evaluation of Sebi’sregulatory strategies over the past 25 years, pondering whether it’s the complianceburden or the regulatory structure that dissuades entities from registering with Sebi. AsWinston Churchill aptly said, β€œWhen you make 10,000 regulations, you destroy all respectfor the law.” Sebi’s ongoing challenges with unregistered CIS cases call for areassessment of regulatory framework to strike a balance between compliance andfacilitating legitimate financial platforms.

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