Crowdfunding is flourishing all around the world, exhibiting double or even triple digit growth rates in many markets, from the US to the UK to China.
Governments have seen this boom as both an opportunity and a challenge. From 2012 on, they started responding by issuing bespoke regulations, i.e. regulations tailored to crowdlending and crowdinvesting. In doing so, various countries demonstrated different approaches: more restrictive regulations in countries such as the US, Germany or France, versus more “light touch” ones in the UK and New Zealand. The contrast reflects a different weighting of the challenge versus opportunity sides of the crowdfunding equation.
Most Countries Have Opted for Bespoke Crowdfunding Regulations
As crowdfunding started to become a significant new source of business funding, governments realized the opportunity it presented for small and medium-sized enterprises (SMEs), economic growth, and hence employment, as well as how it could help small retail investors get better returns on their savings in times of low interest rates. The challenge, though, was to define a regulatory framework that would foster the sector’s growth while protecting retail investors and preventing fraud.
If there was any doubt that crowdfunding regulation was at all needed, those doubts were dispelled lately by two fraud incidents happening in unregulated crowdfunding markets. In October last year, ill-named P2P lending platform Trustbuddy was suspended after it was discovered that millions of dollars were unaccounted for. In February this year, Chinese P2P lending platform E’zu Bao was exposed as a Ponzi scheme that robbed 900,000 investors of $7.3 billion. In both cases, the lenders’ money was not held in segregated accounts, i.e. separate from the platform’s, as financial regulation would have made sure they were.
Of the 21 countries of the Americas, Asia, Europe and North Africa surveyed by the International Organization of Securities Commissions (IOSCO) in December 2015, eight, including Canada, France, Germany, Italy, Japan, Spain, the UK and the US have developed bespoke crowdfunding regulations while four, including Brazil, Korean, India and Mexico, are planning to do so. The remainders are relying on general securities and financial services law
The US pioneered bespoke crowdfunding regulation with the first enactments of the JOBS Act in 2012. It subsequently lost its regulatory lead by going through a long and fragmented process that only now, four years later, led to the finalization of Title III of the JOBS Act that regulates retail equity crowdfunding.
Like the US, most other countries tried to adopt a market-led approach to the regulation of crowdfunding, conducting industry discussions and waiting for the market to develop before intervening. For this reasons, most countries did not start regulating until late in 2014 (France, The UK), 2015 (Germany), and 2016 (Canada Ontario).
A Mix of Exemptions and Restrictions
The regulatory challenges posed by crowdfunding were quite similar across the different countries –one of the main issues being the inadequacy of existing laws and regulation to handle the public issuance of non-tradable securities to large numbers of retail investors.
Governments have responded by granting exemptions from general securities and other financial laws and by issuing restrictions to limit the scope of these exemptions. This applies, among others, to three main aspects of crowdfunding:
- Authorization: the existing licenses to market securities are long and expensive processes with high capital requirements that are not suited for the marketplace model of crowdfunding startups. Some bespoke regulations thus define special crowdfunding regimes with a lighter authorization process and lower capital requirements. This simplification is associated with restrictions, such as restrictions on the type of securities and the maximum amount of funding per project a crowdfunding platform could handle.
- Disclosure: the amount and the form of disclosure required from issuers of securities on regulated markets form costly and complex documents like prospectuses included in the SEC’s Form S-1 and European Prospectuses written by corporate lawyers. Bespoke crowdfunding regulations exempt issuers from such prospectuses and propose different levels of simplified disclosure that are proportionate to the size of the offer of securities and to the stage of development of the fundraising company.
- Retail investment limitations: Easing retail investors’ access to high-yield high-risk (and most often non-tradable) securities from unlisted companies could lead them to take on more risk than their financial situations warrants. To prevent this, most bespoke crowdfunding relations impose limitations on the amount investible by retail investors.
The table below shows examples of how the different rules that countries have implemented from what was at the onset a relatively similar agenda.
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* Per 12 months. This is the lowest level, for retail investors who have not provided financial information or have recorded lower income or wealth
Light Touch vs. More Restrictive Regulation
When comparing the various implementations of bespoke crowdfunding regulation, one can contrast a light touch and a more restrictive, sometimes even prescriptive, approach that not only issues exemptions from existing regimes but defines new ones.
- The light touch approach is represented by the UK and New Zealand. In these countries equity crowdfunding platforms are not restricted to a new crowdfunding status as financial services. They can choose among existing licenses in function of their business model, for example a broker dealer license or an unlicensed marketplace. UK platforms are not restricted either in the type of securities they can market. Last but not least, the ceilings set to the size of issuance and the amounts that retail investors can invest are much higher in the UK than in other countries. The €5 million issuance limit applied in the UK is the current European limit for Prospectus exemption. It is planned to rise to €20 million as the Prospectus Directive evolves (if Britain remains in the EU, that is).
- The more restrictive approach is exemplified by France, Germany and Italy. In these countries, bespoke crowdfunding regulations restrict the types of securities that platforms can market. In addition, German and French equity platforms are given an advisory status that potentially exposes them to liabilities, while Italian crowdfunding platforms are required to partner with banks and custodians licensed to operate on traditional regulated markets. The US regulation of equity crowdfunding targeting retail investors (Title III) can be categorized in this restrictive camp in that, among others, it sets the lowest ceilings for this category of investors: $1 million issuance and $2,000 or 5% of the lesser of annual income and net worth for retail investors with annual income or net worth of less than $100,000.
Regulation is (but) One Driver of Crowdfunding Adoption
Crowdfunding platforms clearly prefer the light touch approach. Surveys by the University of Cambridge and its research partners show that 51% of US lending platforms and 43% of US equity platforms consider their current regulation as “adequate and appropriate” whereas 91% of UK peer-to-peer lending platforms and 89% of equity platforms do so with regards to the UK regulation.
However, evaluating the impact of regulation is not that straightforward. The UK’s and New Zealand’s crowdfunding markets are flourishing. They rank among the top five markets globally with crowdfunding volume per inhabitant of respectively $71 and $59. But the two global leading markets are the more strictly regulated US market, No. 1 with $113 per inhabitant, and the up-to-now unregulated market of China with $74 per head.
Regulation is but one of the factors that drive the adoption of crowdfunding. Other factors include, of course, the overall health of the economy and the resulting willingness of individuals and businesses to invest. The exceptionally attractive tax breaks (EIS, SEIS) offered to UK investors in crowdfunding are a major cause of the success of crowdinvesting in that country. Another factor is the level of self-regulation, guidance and disclosure (above and beyond legal requirements) demonstrated by associations such as the UK peer-to-peer finance association.
An Ongoing Challenge
As crowdfunding continues to evolve rapidly, regulations, and in particular the more prescriptive forms of regulations, will constantly need to adapt. Here are two examples of issues that are already surfacing.
- Regulations overlap. For instance, the European MiFID regulation of Investments Services providers overlaps with local crowdfunding regulations. Within Europe, interpretations vary about whether both are needed to carry out crowdfunding activities in all Member States through a passport.
- Local regulations could make markets insular. It is symptomatic that the UK with its light touch approach is currently driving the strongest international expansion and the largest proportion of cross border transactions. To prevent isolation, Australia, New Zealand, South Korea and Japan have recently committed to creating an “Asia Region Funds Passport”.
In short, regulators will have to continue to balance adding regulatory burden against closing loopholes and creating more clarity.
Thomson Reuters Practical Law is collaborating with Crowdfund Insider on a series of articles about the recent regulatory changes in the crowdfunding industry. The themes include JOBS Act Title III overview, global regulatory framework, and future regulatory improvements for existing crowdfunding regimes. The views expressed by the authors of these articles do not necessarily represent the views of Thomson Reuters nor any of its affiliates.
Therese Torris is an entrepreneur and consultant in eFinance and eCommerce based in Paris. She has covered crowdfunding and P2P lending since the early days when Zopa was created in the United Kingdom. She was a director of research and consulting at Gartner Group Europe, Senior VP at Forrester Research and Content VP at Twenga. She publishes a French personal finance blog, Le Blog Finance Pratique.
- Crowdfunding Survey Report 2015 by the IOSC, 2015
- Pushing Boundaries The 2015 UK Alternative Finance Industry Report by Cambridge University and partners, 2016
- Harnessing Potential The Asia-Pacific Alternative Finance Benchmarking Report by Cambridge University and partners, 2016.
- Breaking New Ground The Americas Alternative Finance Benchmarking Report by Cambridge University and partners, 2016
- Crowdfunding in the EU Capital Markets Union , European Commission, 2016
- The Current State of Crowdfunding in Europe, CrowdfundingHub, 2016