Crowdfunding: Policing the border between ideas and capital

The facilitation and regulation of crowdfunding, one of the fastest growing ways of financing start-up businesses, is under consideration by the European Commission. David Blair, Head of Financial Regulation at Osborne Clarke, considers this move, which indicates the Commission will take a pragmatic approach to make Europe a hub for entrepreneurial activity.

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The European Commission is keen to assess the potential benefits and risks of crowdfunding, an alternative form of financing, with a view to promoting it across the EU and increasing entrepreneurship. It is asking, via consultation, for the views of anyone with an opinion on crowdfunding or who might contribute to the growth of crowdfunding platforms, in order to help it design a policy framework to untap the potential of this new form of funding.

What concerns have the Commission raised around the crowdfunding model?

The Commission’s main concern is to ensure the protection of investors. Internet promotions that offer no potential for dialogue are limited in their ability to provide a full and accurate description of an investment opportunity in a way that is capable of being understood by a retail audience. On the other hand, it is easy for interactive dialogue to stray into the territory of investment advice, which is not a service crowdfunding enthusiasts would typically want to pay for.

The Commission has also considered the perspective of the investment recipient. It is difficult for cash-strapped start-ups to strike a balance between providing comprehensive public investor disclosure without giving away their intellectual property.

The Commission notes that existing European regulation in the fields of e-commerce, intellectual property and anti-money laundering (not to mention distance marketing) already address many of the key identified risks.

What are the risks for individuals who engage in crowdfunding?

Crowdfunding presents the same risks that are inherent in trusting a third party to have day-to-day control of one’s money. These risks include the ‘unacceptable’ risks of misrepresentation, fraud or incompetence on the part of the investee or the crowdfunding platform. In addition, there are the ‘accepted’ risks such as uncertainty of return and illiquidity and variable factors such as changing tax treatments.

The risk faced by investors will be largely determined by reference to the underlying investment. It is not appropriate to equate the investment risk associated with lending to an established asset-backed business with investing in the development of a computer game merely because both investments have been proposed through a crowdfunding platform.

Crowdfunding does however pose some new types of risk as a sector. It enables retail investors to gain access to investments that were traditionally the domain of professional investors. Unlike investment professionals, crowd investors, taken individually, do not have the status to negotiate with or scrutinise the investee. Nor do they have the experience to anticipate the barriers to realising a successful exit. This is not to say the retail public cannot be educated, or that platforms cannot be the guardians of their interests. Platforms that manage these risks well on behalf of their investors and investees will develop reputations, as will those who fail to do so. Investors and entrepreneurs alike can benefit from the removal of a layer of toll collectors at the border between capital and ideas.

Are there any concerns that crowdfunding is being used to avoid business regulation/tax, etc?

As with the sale of any product, there is potential for people seeking funding to omit important details. The question is the extent to which trusting in a third-party regulator to impose pro-active policing will prevent investor disappointment. Legislators need to be mindful of balancing the protections of regulation with the cost of policing—a price that is ultimately borne by the investor.

In the UK, platforms promoting equity investments have been very inventive in structuring their businesses to fall within exemptions from regulation that were not created with crowdfunding in mind. A similar phenomenon has taken place in several jurisdictions in Europe. European financial services laws that could have been interpreted as being incompatible with crowdfunding have not been applied in that manner. While the use of these exemptions has often subverted original legislative intent, the forbearance of regulatory authorities has had the positive effect of demonstrating an investor appetite to make a cash injection into the economic system.

The European Commission’s Consultation considers that existing European legislation provides consumer protections, which indicates a desire to re-position the curtain demarcating the retail and professional investment worlds. Hopefully this will push member states to develop the light touch regulatory regime that will encourage more firms to accept the implications of operating within a regulated environment, rather than seeking exemptions from regulation as a pre-requisite to doing business at all.

Are other jurisdictions considering regulating crowdfunding?

Italy was the first country in Europe to enact specific legislation. The Italian Financial Authority (CONSOB) issued a regulation in July 2013 creating a registration and conduct regime for platforms facilitating equity investment in ‘innovative start-ups’. The requirement that the investment be in shares or quotas in an innovative start-up is a clear limitation, but there are indications the restrictions may be widened after an initial trial period.

Other than in the UK (where debt-based crowdfunding will be regulated from April 2014 and guidance provided on the application of existing securities legislation to equity crowdfunding), there are no major public legislative initiatives in European member states to create a regulatory regime specific to crowd investing. However, existing securities, lending and payments regulation does mean that many platforms are already regulated as financial institutions.

Outside of Europe, the US was quick to enact the Jumpstart Our Business Start-ups Act in April 2012, but fell behind in actually bringing it into effect. The US model is based on limiting the participation of an investor by reference to their net worth or income.

Are there concerns regulation might undermine the integrity of the model?

Existing regulation has created an environment where wealthy and experienced investors are afforded full retail investor protections. It is very costly for small financial services businesses to deal with retail clients. This restriction in the flows of capital has been brought into sharp focus during the credit crunch. The low interest rate environment has highlighted the lack of investment opportunities available to the public.

The prevailing direction in financial services is to keep building investor protection. The recent Alternative Investment Fund Managers Directive 2011/61/EU is primarily an investor protection initiative despite the fact that it largely applies to funds that are only available to the shriveled class of professional investors. If this investor-protection philosophy were to be applied consistently to crowdfunding it would simply outlaw industry participants who do not move in a crowd of institutional investors. The Commission does not appear to be seeking to expand investor protection principles in a disproportionate manner in its consultation.

What should lawyers advise individuals/businesses who are considering using the crowdfunding model?

An advantage of crowdfunding is that investors and entrepreneurs can engage at a fairly low cost to both parties. There is generally no need or justification for engaging lawyers or other service providers in order to conclude individual transactions. As the profile of crowdfunding rises and the scale of investment increases, the involvement of lawyers, particularly on behalf of project owners seeking finance, is likely to become more appropriate.

David Blair is Head of Financial Regulation at international law firm Osborne Clarke and a member of the UK Crowdfunding Association.  His practice is dedicated to providing practical advice on the impact of financial services regulation on business. He has more than a decade’s experience specialising exclusively in advising financial services businesses. His experience centres on fund and asset management, crowdfunding private wealth management, investment banking, broking and dealing and extends to insurance, mortgage and retail banking business.

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