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Individual Investors’ Access to Crowdinvesting: Two Regulatory Models

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The Economics of Crowdfunding

Abstract

Crowdinvesting—raising many small contributions of capital from individual funders via specialized online platforms—is a burgeoning phenomenon. This chapter first highlights the perils to which individual investors are exposed when they access these platforms. Next, it describes the legal regime in two sample jurisdictions, the US with its tradition of high-fixed-cost, disclosure-intensive securities laws that had to be tweaked to make equity crowdfunding viable, and the UK, which has early on provided for a nimble set of rules for the same. Finally, the chapter offers some thoughts on the merits of introducing a lighter regime for equity crowdfunding.

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Notes

  1. 1.

    The figure for the UK’s most popular platform is GBP 440,242 (USD 559,855). See https://www.crowdcube.com/infographic (accessed on December 5, 2016).

  2. 2.

    Angels’ investing styles vary significantly: while the overall picture is one of less formal arrangements than in the case of VCs, still some angels adopt the same protective measures that are common in VC investment contracts. See Ibrahim (2008, 1420–1425).

  3. 3.

    The available empirical evidence on the incidence of fraud in reward crowdfunding platforms shows that it is a contained phenomenon. Cumming et al. (2016) find that actual or suspected fraud occurred in 0.01%of initiated projects per year. One may well question, though, whether that is a good predictor of the incidence of fraud on crowdinvesting platforms.

  4. 4.

    See SEC, Crowdfunding, 78 Fed. Reg. 66,428, 66,458 n. 309 (to be codified in scattered parts of 17 C.F.R.); Financial Conduct Authority (2013).

  5. 5.

    Article 1(2)(h) Prospectus Directive [2003] O.J. L 345/64 (as amended) (the “Prospectus Directive”).

  6. 6.

    Financial Services and Markets Act 2000 (“FSMA”), Section 85(5)(a), Schedule 11A, para 9.

  7. 7.

    Annex I, Section C, of MiFID 2 defines financial instruments to include transferable securities. Transferable securities are defined in Art. 4(1)(44) to include securities negotiable on the capital market, such as shares in companies.

  8. 8.

    Markets in Financial Instruments Directive [2004] O.J. L 145/1 (“MiFID”).

  9. 9.

    MiFID allowed member states to carve out an exemption for crowdinvesting platforms under Article 3, and at least two member states have apparently done so. Id., p. 19, para 57. Such an exemption is premised on the platform not holding client funds or securities, not providing any investment service except the reception and transmission of orders, and transmit such orders only to other authorized firms. Art. 3 MiFID. While this exemption remains in MiFID 2, a new Art. 3(2) therein requires member states to apply to them rules and regulations equivalent to MiFID 2 in many respects, including conditions for authorization and supervision and conduct of business obligations.

  10. 10.

    Art. 25, The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, SI 2001/554 (available at http://www.legislation.gov.uk/uksi/2001/544/article/25/made).

  11. 11.

    FSMA 2000 s. 21.

  12. 12.

    FCA’s Conduct of Business Sourcebook (“COBS”) 4.2.1R., implementing Art. 19(2) MiFID (now Art. 24(3) MiFID II).

  13. 13.

    COBS 4.7.7R. Clients could also be advised under COBS 4.7.8R, so that the suitability of the crowdfunding is assessed by the firm or another authorized firm, although that would likely be uncommon in the case of crowdfunding.

  14. 14.

    The tests are not onerous. Typical questions might be of the following form: “Most early-stage and many growth-focussed businesses: (a) succeed; (b) break even; (c) fail.” (Taken from sign-up questionnaire at Seedrs, a UK platform: see https://www.seedrs.com/signup/investor-profile/quiz).

  15. 15.

    Jumpstart Our Business Startups Act, Pub L. No. 112–106, 126 Stat. 306 (2012) (the “JOBS Act”).

  16. 16.

    Proposed Rule: Crowdfunding, 78 Fed. Reg. 66,428, November 5, 2013.

  17. 17.

    15 U.S.C. 77a et seq. (the “Securities Act”).

  18. 18.

    Under 17 CFR § 227.100(2), the maximum investment for an investor in a single issuer is determined as follows. If the investor has both annual income and net worth of less than USD 100,000, a limit of USD 2,000 or 5% of annual income or net worth, whichever is greater, applies. If either the investor’s annual income or net worth exceeds USD 100,000, a limit of 10% of annual income or net worth, whichever is greater, but not to exceed USD 100,000, applies. (The JOBS Act actually stipulated these limits, but did so in a logically inconsistent way, which required the SEC to clarify its position in its final Regulation Crowdfunding).

  19. 19.

    17 CFR § 227.100, 17 CFR § 227.203.

  20. 20.

    Section 4A(b)(1)(B) of the Securities Act, 17 CFR § 227.201(b), 17 CFR § 227.201(m)(2).

  21. 21.

    Section 4A(b)(1)(C) of the Securities Act, 17 CFR § 227.201(d).

  22. 22.

    Section 4A(b)(1)(E) of the Securities Act, 17 CFR § 227.201(i).

  23. 23.

    Section 4A(b)(1)(G) of the Securities Act, 17 CFR § 227.201(m)(4).

  24. 24.

    Section 4A(b)(1)(F) of the Securities Act, 17 CFR § 227.201(g).

  25. 25.

    Section 4A(b)(1)(H) of the Securities Act, 17 CFR § 227.201(m).

  26. 26.

    Section 4A(b)(1)(D) of the Securities Act, 17 CFR § 227.201(t).

  27. 27.

    Ibid.

  28. 28.

    Section 4A(b)(1)(D) of the Securities Act, 17 CFR § 227.201(s).

  29. 29.

    Section 4A(b)(4) of the Securities Act, 17 CFR § 227.202.

  30. 30.

    The SEC was given discretion under Section 4A(b)(1)(I) of the Securities Act to require additional disclosure for the protection of investors and in the public interest.

  31. 31.

    17 CFR § 227.201(o)(1).

  32. 32.

    17 CFR § 227.201(p).

  33. 33.

    17 CFR § 227.201(m)(5).

  34. 34.

    Section 4(a)(3) of the Securities Act, 17 CFR § 227.501.

  35. 35.

    Section 4A(a)(11) of the Securities Act, 17 CFR § 227.300.

  36. 36.

    Section 4A(a)(5) of the Securities Act, 17 CFR § 227.301. The intermediary is entitled to rely on representations from the issuer, absent knowledge, or indications to the contrary.

  37. 37.

    Section 4A(c) of the Securities Act.

  38. 38.

    Proposed Rule: Crowdfunding (n. 16), 66,499.

  39. 39.

    Crowdfunding, Final Rule, 80 Federal Register 71,387, 71,478.

  40. 40.

    Crowdfunding, Final Rule, 80 Fed. Reg. 71,387, 71,500. Estimates by SeedInvest, a crowdfunding platform, are even higher: if one raises one million dollars via Title III crowdfunding, the cost of the offering will be USD 250,000. See https://www.seedinvest.com/blog/jobs-act/crowdsourcing-title-iii-crowdfunding-cost-model.

  41. 41.

    For example, in the case of an issuer raising USD 100,000 under Regulation Crowdfunding with fees in the region of USD 17,500, the equity actually contributed to the issuer’s operations would be USD 82,500 and it would need to increase in value by USD 17,500/USD 82,500, or 21.2%, before the value of issuer’s equity would reach the valuation of USD 100,000 where equity investors would break even.

  42. 42.

    Section 201(a) Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012) (codified in 15 U.S.C. §77d). “Accredited investor” is defined in Rule 501 under the Securities Act, 17 CFR §230.501, to include among others any corporation with assets over USD 5million and any individual with either a net worth exceeding USD 1 million or an income above USD 200,000 in the two most recent years and a reasonable expectation of reaching the same income in the current year.

  43. 43.

    Within the EU (and therefore, currently, in the UK) an investment vehicle acting as the crowdinvestors’ nominee would seem not to qualify as an Alternative Investment Fund as defined in the Alternative Investment Fund Management Directive. According to this Directive, Alternative Investment Funds are defined as “collective investment undertakings, including investment compartments thereof, which: (1) raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors; and (2) do not require authorisation pursuant to Article 5 of Directive 2009/65/EC (the UCITS Directive) (Article 4(1)(a))”. While ESMA’s guidelines clarify that it is enough to raise capital from more than one investor for capital raising to be from a “number of” them, they also define the term “defined investment policy” in a way that appears to be inconsistent with the mere purchase and holding of securities issued by an individual company in order to exercise the related rights on behalf of investors. See ESMA (2013, 7). Consistent with this interpretation, examples exist of European crowdfunding platforms that use investment vehicles that are not registered as AIFs (see Armour and Enriques 2017).

  44. 44.

    15 U.S. Code § 80a–3(c)(1).

  45. 45.

    See above, n 14.

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Authors and Affiliations

  1. Faculty of Law, University of Oxford, Oxford, UK

    John Armour & Luca Enriques

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  1. John Armour
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  2. Luca Enriques
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Editors and Affiliations

  1. Schulich School of Business, York University, Toronto, Canada

    Douglas Cumming

  2. Faculty of Business Studies and Economics, University of Bremen, Bremen, Germany

    Lars Hornuf

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Armour, J., Enriques, L. (2018). Individual Investors’ Access to Crowdinvesting: Two Regulatory Models. In: Cumming, D., Hornuf, L. (eds) The Economics of Crowdfunding. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-66119-3_11

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  • DOI: https://doi.org/10.1007/978-3-319-66119-3_11

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