Crowdfunding has grown steadily over the last few years as an alternative form of finance for start-ups and small- to medium-sized enterprises (SMEs). If a proposed new “passport” licence for crowdfunding service providers becomes a reality, investors and SMEs alike may finally have the tools they need for European crowdfunding to take flight.
As part of its FinTech Action Plan, the European Commission will introduce new legislation on crowdfunding to encourage crowdfunding's expanding role in funding start-ups and SMEs in Europe. The Commission’s proposal (the Proposal) aims to establish a new “passport” licence that would allow crowdfunding platforms to operate in all EU Member States without having to comply with the patchwork of national rules that currently exist. The Proposal arises following extensive research, including the Commission’s reports on crowdfunding published in March and December 2017 and the responses to the public consultation on FinTech in June 2017.
Crowdfunding is an open call to the public to raise funds for a project; crowdfunding service providers are websites that enable fundraisers to interact with potential investors and donors. The Commission’s reports have found that crowdfunding remains relatively small and largely a local phenomenon but is developing rapidly. The main examples of financial return crowdfunding are equity investments (investment-based crowdfunding) and peer-to-peer lending (lending-based crowdfunding). Broadening access to finance for SMEs is at the heart of the Commission’s Action Plan on Capital Markets Union (CMU) – the Commission sees the success of start-ups and SMEs as crucial to the future of jobs and economic growth in Europe.
The Commission, in its report, identified a number of market and regulatory barriers impeding further growth in this area. Currently, there is no EU-wide framework that specifically caters for lending-based crowdfunding, and national authorisation requirements differ by Member State. Domestic rules may include capital requirements, professional qualification requirements and codes of conduct. Approaches to regulating lending activity also vary depending on the type of fundraiser and/or lenders involved. For example, distinctions may exist between retail and institutional investors. Client account rules may also apply where a crowdfunding platform directly handles money between fundraisers and investors.
In a separate report, the European Securities and Markets Authority (ESMA) expressed concerns that crowdfunding in Europe developed outside the existing legal requirements, which has had negative effects for both investors and crowdfunding platforms. According to ESMA, crowdfunding is regulated inconsistently by Member States. This impedes scalability and, in jurisdictions that lack any regulation at all, stability. Legal obstacles mentioned in ESMA’s report include vague legal definitions, a lack of or poor transparency rules and regulatory ceilings on the size of possible investments. This was reiterated in ESMA’s response to the Commission consultation on FinTech in June 2017.
To overcome these barriers, the Proposal would introduce an optional, harmonised regulatory regime, allowing crowdfunding service providers to obtain a “passport” licence from ESMA, permitting them to operate in all Member States. Such passporting would make it easier for crowdfunding service providers to operate across the EU, increase the accessible pool of investors, and improve an SMEs chances of successfully attracting investment.
A crowdfunding passport would help service providers overcome regulatory barriers to operating cross-border by giving them a choice between complying with either individual Member States’ legislation or the new regime. The Proposal would provide tailored rules for both investment-based and lending-based models, and clearly define the requirements that crowdfunding service providers would need to fulfil to secure authorisation.
It is important to note that the Proposal will apply only to investment-based crowdfunding and lending-based crowdfunding, and not to reward or donation based crowdfunding since these do not constitute financial services. Crowdfunding campaigns of a total consideration of more than €1 million over a period of 12 months will not be eligible; these would fall under the Recast Markets in Financial Instruments Directive 2014/65/EU and the Prospectus Regulation (EU) 2017/1129.
The Proposal provides for additional investor protections to enhance the stability of the crowdfunding market. These include disclaimers on crowdfunding platforms, and mandatory knowledge and risk appetite tests for investors. The Proposal would also require the individual or company behind each crowdfunding campaign (the Project Owner) to prepare a “Key Investment Information Sheet” (KIIS) for each campaign that would include information on the Project Owner, the crowdfunding process, information relating to the securities, and investor rights. The goal of these KIISs is to ensure the transparency of individual campaigns and provide investors with accurate information. Furthermore, the Proposal includes a duty for crowdfunding platforms to avoid conflicts of interest between it and its clients (e.g. the investors) by, for example, prohibiting the platform from financial participation in any of the crowdfunding offers on their own platforms.
The Commission is also aware that crowdfunding platforms are a potential target for money laundering. The Proposal thus requires that:
- platform managers have no criminal record under anti-money laundering legislations
- all transactions must take place via payment service providers under the Payment Service Directive (EU) 2015/2366, and
- National Competent Authorities (NCAs) are obliged to notify ESMA of any issue that they deem relevant under the fourth Anti-Money Laundering Directive (EU) 2015/849.
ESMA would reserve the right to withdraw a crowdfunding license should it become aware of any money laundering activity.
KIIS of death?
The success of the Proposal will be determined by crowdfunding service providers. They will decide whether the opportunities presented by the licence outweigh the regulatory burdens accompanying it. Access to the entire EU market would be a strong incentive, giving crowdfunding service providers more access to projects and investors, which is likely to increase their revenue and profitability. However, the price of that access is compliance with the above regulation and in particular with the proposed KIIS. A KIIS is a standalone document and must consist of a maximum of six sides of A4-sized paper and be updated at all times during the crowdfunding period. To reduce the regulatory burden, the KIIS need not be approved by an NCA or be translated to every relevant Member State’s official language.
On the issue of liability, the KIIS is drawn up by the Project Owner, but crowdfunding service providers must ensure that the KIIS is complete and must cancel any existing offer where there is a material omission or mistake. Therein lies the ambiguity at the center of this calculation: who is liable for any material omission or mistake in the KIIS? Is it the Project Owner, the crowdfunding service provider, or both? The Proposal states that “crowdfunding service providers shall have in place and apply adequate procedures to verify the completeness and the clarity of information contained in the key investment information sheet.” However, it leaves open the definition of “adequate procedures” and more importantly, leaves open the question of liability. Is the crowdfunding service provider liable for ensuring that they have adequate procedures in place or are they also liable for any material omission or mistake in the KIIS?
If crowdfunding service providers become liable for any material omission in the KIIS, they would significantly increase their exposure to litigation and as a consequence would have to invest in extensive compliance procedures for each new project. They may pass on the cost of this compliance to either investors or Project Owners, increasing the cost of crowdfunding to the point where it may become economically unjustifiable. If this is the case, crowdfunding service providers may simply forgo this EU “passport” licence and focus on their domestic market instead.
While requiring a single, short consumer friendly document is a good idea in theory, it may be difficult to put into practice. It is extremely difficult to summarize a complex topic into a short, easily digestible document without oversimplifying or being misrepresentative. We have historical precedent for this: “Key Information Documents” (KIDs) required under the Packaged Retail Insurance-based Investment Products Regulation (EU) No 1286/2014. KIDs are three page “consumer friendly” documents used to describe an investment where the amount payable is subject to fluctuations because of exposure to reference values or performance of one or more underlying asset, such as derivatives and securitizations. It is so difficult to distill these complex transactions into such a short document without being misrepresentative that many market participants have the decided to forego selling structured products to retail investors to avoid having to draft a KID. KIISs could have the same effect on the crowdfunding licence if it becomes too difficult to draft a KIIS. It may go the way of the KID and simply be avoided.
Current national legislation
CMU is a constantly evolving project and while the Proposal is under consideration by the European Parliament and Council, it is important to consider the effects of existing national legislation and the actions of individual Member States on the crowdfunding market. A number of Member States (Austria, Belgium, Spain, France, the United Kingdom, Italy, Germany, Portugal, Finland, and Lithuania) have introduced domestic regimes on crowdfunding, and other Member States are planning to do so. These national-level rules are broadly consistent in their objectives. They cater for local market needs and domestic regulatory structures, and reflect the fact that crowdfunding is still a largely local phenomenon. However, business models that involve peer-to-peer or business-to-consumer interaction will also need to consider the application of EU consumer protection directives, namely, the Unfair Commercial Practices Directive (2005/29/EC) and the Unfair Contract Terms Directive (93/13/EEC). Crowdfunding will likely involve large amounts of personal data processing, which will engage data protection laws.
In December 2016, the Financial Conduct Authority (FCA) published a feedback statement in relation to its review of the UK crowdfunding rules. The majority of issues raised were in relation to the lending-based crowdfunding market, including concerns over the level of available disclosure of risk and loan performance, the potential for arbitrage with investment management and banking activities and, in relation to investment-based crowdfunding, varying due diligence standards. The FCA remains particularly focused on investor protection, highlighting the potential for conflicts of interest for crowdfunding platforms servicing both retail and institutional investors.
In February 2017, the FCA published a “Dear CEO” letter to loan-based platforms highlighting that certain practices they facilitate may be classed as “accepting deposits” for the purpose of Article 5 of the FSMA (Regulated Activities Order) 2001. Where a platform enables unregulated entities to accept deposits, the FCA have advised that it will be in breach of its own regulatory requirements, prompting proactive self-regulation by loan-based platforms and increased scrutiny into who is using their services and how. Beyond this interim measure, the FCA proposes to introduce new rules in the UK at some point in the near future. It is expected that any new regime will further the current approach taken by the FCA, in that avoidance of full banking regulations will not be permitted in instances where the FCA perceives banking activities to be taking place.
The future of crowdfunding and Brexit
The Proposal will introduce EU-wide legislation on crowdfunding in an attempt to balance investor protection with Project Owner’s interests. While we are cautiously optimistic about the benefits of this legislation, there are still many details to be provided and these will determine in large part whether the Proposal is a success.
The Proposal is currently under consideration by the European Council and Parliament and is unlikely to come into effect before Brexit occurs. The UK remains the largest crowdfunding market in Europe by far, at €5.6 billion. In the absence of a political agreement, the benefits of the Proposal may be muted if EU-based Project Owners and service providers are effectively shut out of the UK market.
As the CMU project develops, the Commission will continue to monitor the sector and maintain a regular dialogue, through twice yearly meetings with the European Supervisory Authorities, Member States and crowdfunding sector participants. The Commission has also created a European Crowdfunding Stakeholder Forum to raise awareness, promote best practice and assist the Commission in monitoring the crowdfunding landscape. We continue to work closely with the crowdfunding sector and regulators, and will update our CMU technical resource as this initiative develops.