Crowdfunding – a brave new world for securities disclosure

1 March 2013

Crowdfunding – a brave new world for securities disclosure

Introduction

A number of recent conversations, including one that was started by an article in the local rag, have lead me to talk to a couple of people about ‘Crowdfunding’ as a means of raising seed capital for ventures in the business sector and by not-for-profits.

One such conversation started with someone saying that they didn’t like Kickstarter projects. This was in the context of a couple of new gizmos and the belief that good old fashioned pre-orders were the way to get a new (consumer) product to market. As I had only learned about Kickstarter a few weeks prior to the conversation taking place and had not reached the conclusion that crowd funding has got out of hand (indeed I have been guilty of sending some of the links to others I thought would be interested), I thought I would investigate this trend further. And then came official recognition in the form of work done by officials for the Financial Markets Conduct Bill and, more recently, the proposals for the Financial Markets Conduct regulations that are required to make the FMC Bill “work”.

At its simplest, crowdfunding is a description of the process of pooling a large number of small contributions to fund a business or project (often the projects are in the arts and culture space or provide other ‘community good’ type benefits), generally over the internet.

Most crowdfunding overseas and in New Zealand currently provides either no promise of any benefit (financial or otherwise) or the prospect of an in-kind benefit to those who contribute to projects. As a result, this activity is not regulated by existing securities law. For example, a musician obtains funding to record an album and those who contribute are promised a signed copy of the completed album or a voucher to attend a live performance.

A more recent movement has been the development of platforms for investment-oriented crowdfunding. Websites such as CrowdCube in the UK facilitate investment in businesses that pay contributors with financial returns rather than in-kind benefits.

It is apparent that crowdfunding is starting to play an important role in small-scale capital raisings, typically by a start-up to raise venture capital for a new product .

Crowdfunding under the Securities Act

As noted above, my understanding of crowdfunding is that the crowd are generally not promised any financial return. Instead, they may get an indirect benefit of seeing their community enjoy (say) the performance of a play written by a local playwright or some in-kind benefit. In the case of many of the Kickstarter projects that have hit my inbox, it is the prospect of being able to buy some innovative new widget.

However, the range of uses to which the model is being applied is expanding rapidly and platforms such as CrowdCube have been developed to facilitate the use of the crowdfunding model by start-ups as a means of raising venture capital. In many of those cases, the contributors are (arguably) being offered:

“…an interest or right to participate in [the] capital, assets, earnings, royalties, or other property of [another] person…”

(i.e. a “security” for the purposes of the Securities Act 1978).

As a result, some care will need to be taken with the wording of the relevant offer – as the offer of a security and/or some of the email teasers could be an offer of securities to the public (in New Zealand) for the purposes of the Securities Act (and those teasers may well be an “advertisement” for the purposes of the Securities Act).

Enter the Financial Markets Conduct Bill

Last year, it became apparent that officials in the MED (now the Ministry of Business, Innovation & Employment) were thinking along similar lines. Those officials’ reports found their way into the Select Committee report on the Financial Markets Conduct Bill (“FMC Bill”) with a recommendation that capital-raising by means of a crowdfunding platform should be facilitated in this country by means of a licensed intermediary.

The MBIE discussion paper on the proposed Financial Market Conduct regulations notes that the US has recently introduced a crowdfunding exemption from its Securities Act, as part of the Jumpstart Our Business Startups Act (“JOBS Act ”). This exemption would allow capital raising through registered internet ‘funding portals’ or through registered brokerdealers.
The exemption is subject to a number of conditions relating to, for example, limits on the maximum amount an issuer can raise, and the amount that each investor can contribute.

The MBIE discussion paper continues by noting that it is proposed to provide an exception for crowdfunding through specifying a ‘crowdfunding platform’ as a second category of prescribed intermediary services. This will enable providers of crowdfunding platforms to obtain a licence. Offers made through a crowdfunding provider will then be able to make use of an exclusion from the new disclosure regime under the FMC Bill (when it becomes law). It is also suggested that, as in the US, an exception for issuers using crowdfunding platforms would require consideration of both:

• the eligibility criteria and conditions that should be applied to the platform; and
• the conditions that should be imposed on issuers making use of the platform.

Licences for crowdfunding platforms will be subject to the standard eligibility criteria and ongoing conditions (applicant is a fit and proper person to hold the licence, etc).

The MBIE discussion paper notes that any exclusion for crowdfunding must be consistent with the purposes of the FMC Bill. While the prescribed intermediary exclusion removes the regulatory obligations, the discussion paper suggests that where crowdfunding platforms are internet based, they create new ways to achieve the FMC Bill’s disclosure objectives. Instead of individual investors making investment decisions based on an issuer prepared disclosure document, crowdfunding allows open, transparent, two-way communication between the issuer and investors. Instead of due diligence processes and adviser recommendations it draws on the ‘wisdom of the crowd’ to ascertain the quality of investment opportunities and uncover risks.

MBIE notes that there are a range of options for providing information to investors about issuers making use of the platform. Rather than reaching a landing on the approach, the discussion paper asks:

• What approach should be taken to the provision of information through crowdfunding platforms?
• What information about an issuer should the issuer and the crowdfunding platform be required to provide to investors?

As a signal of the likely regulatory approach (which seems to me to be mercifully enlightened) the MBIE discussion paper notes that the extent of the crowdfunding platform’s role is likely to be inversely proportional to the amount and detail of information that needs to be disclosed by issuers to investors. From this, it follows that the greater the role of crowdfunding platform in screening and assessing issuers and presenting information to investors, the less this role needs to be performed by issuers and the more useful and digestible the information is likely to be to individual investors.

Clearly, crowdfunding also needs to fit with the other significant new initiative for small-scale fundraising (by SMEs) – in the form of the Australian-style ‘20 x 12’ exemption. (Enabling businesses to raise up to $2m from not more than 20 investors in any 12 month period). The MBIE discussion paper asks whether submitters consider a limit of $2m per issuer / $10,000 per investor in any 12 month period is appropriate.

Across the Tasman

To date, the MBIE approach appears to me to be more forward-thinking than that of ASIC in Australia. Thus far, ASIC seems to be suggesting that some crowdfunding activities in Australia may be subject to disclosure obligations under the Corporations Act 2001 (Australia).

As a result, ASIC has indicated there are no current legislative proposals to create specific exemptions for crowdfunding from the Australian securities disclosure regime (or to license crowdfunding platforms).

On the face of it, this puts New Zealand in the unique position of being ahead of Australia on a capital markets matter. A generation of compulsory superannuation across the Tasman and the much deeper capital markets that have been created as a result, has usually seen us playing catch-up. I cannot see this lasting – it is likely to be mid-2014 before the FMC Bill comes into force. In the meantime, knowing that the SME sector is just as important in Australia as it is in New Zealand (contributing roughly 40% of GDP in both countries) I expect that ASIC will make good use of its greater rule-making powers to facilitate crowdfunding before the new regime is “live” in New Zealand.

Final thoughts

Thus far, the signals from the reporting back on the FMC Bill and the MBIE discussion paper are very promising. The MBIE officials are giving every indication that they are prepared to embrace another one of the benefits of the internet to provide a regulatory framework that is ‘right-sized’ for the New Zealand economy. As a result, initiatives in the US and the UK may shape a suitable series of carve-outs that provide some basic investor protections whilst allowing sufficient freedom to ensure that crowdfunding is cost-efficient (relying on market behaviours to be moderated by the wisdom of the crowd) – with some backstopping in the form of regulatory penalties for issuers and the risk of loss of licence for platform providers.

In the interim, great care will continue to need to be exercised with crowdfunding initiatives – to ensure that they do not fall foul of the existing securities disclosure regime under the Securities Act.