In an ideal world, equities “crowdfunding” via the Internet would provide a cost-effective new way for companies to find financing, for investors to fund startups and for the “crowd” to replace investment bankers as arbiters of good ideas. However, this utopian vision is no match for the reality of fragmented, politicized securities regulation.
Nevertheless, it appears that the phenomenon of equities crowdfunding is coming to the Canadian securities market. In early October, Saskatchewan’s Financial and Consumer Affairs Authority (FCAA) was the first regulator to propose a new exemption to facilitate crowdfunding for equities investments. The comment period for this proposal was out for just 30 days, and a final rule may not be far behind.
At the same time, the Ontario Securities Commission (OSC) is continuing to work on its own exemption. In late August, the OSC announced that it has decided to focus on a couple of options, including a crowdfunding exemption, after considering a host of possible new exemptions.
Although Ontario and Saskatchewan are the only provinces explicitly pursuing an exemption to permit crowdfunding, the rest of the Canadian Securities Administrators (CSA) are not ignoring the issue. According to a report from the European Crowdfunding Network (ECN), most other Canadian regulators believe that their existing offering memorandum (OM) exemptions should be used for crowdfunding.
Of course, Ontario doesn’t currently have an OM exemption, although it’s considering creating one along with a specific framework for crowdfunding. The ECN report suggests that unlike much of the CSA, the OSC believes that a less restrictive approach than the prevailing OM regime is required to facilitate crowdfunding. So, as is often the case within the provincial regulatory system, philosophical differences among the regulators are likely to lead to differing rules among the provinces.
This lack of regulatory uniformity in the exempt market has long been a complaint. Although efforts at harmonizing these exemptions have improved matters significantly, differences remain. And the trouble with this lack of unanimity is particularly evident in the case of crowdfunding, which grew out of the largely borderless Internet and is premised on the concept that a broad, diverse base of prospective investors can revolutionize the troubled world of startup financing.
In that context, a fragmented regulatory approach represents a needless hurdle for a novel form of financing that requires wide participation if it’s to have any hope of success. And the viability of equities crowdfunding remains an open question. (See sidebar.)
Whether you buy into the hype surrounding crowdfunding or not, the prospect of differing rules among the provinces certainly limits this financing method’s potential. The Canadian Advocacy Council for Canadian CFA Institute Societies’ (CAC) submission on the FCAA’s proposals calls upon regulators to harmonize their exemptions, noting that this would make matters easier on issuers and investors alike. In terms of crowdfunding, in particular, the CAC submission says: “Rather than instituting a crowdfunding exemption on a jurisdiction by jurisdiction basis,” regulators should agree on a common approach.
“As the exemption is intended to be available to raise only a small amount of capital,” the CAC’s comment continues, “it would not seem economically feasible for issuers to raise capital based on this exemption if the terms were different in various Canadian jurisdictions.”
For now, though, there is no uniform CSA approach. And the traditional securities industry remains skeptical of the idea altogether. Although the FCAA has yet to publish the comments it received on its proposal, certain commenters have released them on their own – providing some insight into the reception for the FCAA’s plan.
The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada), for example, has published its submission to the regulators in Saskatchewan. That comment calls into question both the underlying rationale for allowing crowdfunding and some of the specifics of the FCAA’s proposal: “Existing equities crowdfunding proposals result in too large a degree of informational asymmetry and too great a risk of fraud and potential for investor harm. These proposals will not result in efficient markets nor will they have the desired economic benefits that proponents argue equity crowdfunding will achieve.”
The FAIR Canada submission suggests that regulators haven’t yet figured out how to provide adequate investor protection within a crowdfunding model. Regarding the FCAA proposal in particular, FAIR Canada is strongly opposed to the plan to allow unregulated portals to facilitate equities crowdfunding transactions.
“Registration and regulation of crowdfunding portals is essential to investor protection,” that comment notes, adding that this is necessary to ensure oversight and compliance. “We believe that permitting equity crowdfunding transactions through unregulated portals would be a complete abandonment of the FCAA’s consumer protection mission, and will cause irreparable damage to investor and issuer confidence in Saskatchewan’s financial markets.”
Other high-profile financial services organizations, such as the Investment Industry Association of Canada (IIAC) and the Exempt Market Dealers Association of Canada, indicate that they didn’t submit comments on the FCAA’s proposals. Instead, they note that they already have expressed their concerns about the basic concept of equities crowdfunding and that their views are well known by regulators.
For example, the IIAC previously characterized crowdfunding as “fraught with excessive investor risk.” Moreover, the IIAC has argued, there needs to be a level playing field between crowdfunded investments and traditional offerings in terms of basic investor protection measures such as suitability, “know your client” and “know your product” requirements.
The IIAC says that if regulators want to facilitate startup financing, they should be relaxing the regulatory burden on the existing securities industry. The IIAC also calls on federal policy-makers to support greater investment in small businesses through targeted tax incentives.
Concerns about the details of the FCAA’s proposal are not limited to crowdfunding skeptics. The Toronto-based National Crowdfunding Association of Canada (NCFA), which is obviously supportive of the crowdfunding concept, has its own concerns with the FCAA proposal, suggesting in its submission to the FCAA that the investment limits should be higher, for both companies looking to raise capital and investors. The FCAA proposal would allow companies to make two $150,000 offerings per year and would limit investors to risking $1,500 per offering.
The NCFA also is concerned that investor protection be adequate in order for the system to work. For example, the NCFA submission stresses that crowdfunding portals must not be linked directly to issuers seeking to raise money on them: “If we don’t have at least some semblance of due diligence from the portal, as an industry we risk being perceived as just flogging snake oil.”
SEC introduces extensive crowdfunding rules
In late October, the U.S. Securities and Exchange Commission (SEC) finally published its set of proposed rules for crowdfunding.
The SEC’s proposal, which is out for a 90-day comment period, sketches out a framework for crowdfunding that largely follows legislation passed in the summer of 2012 as part of a bill designed to help kick-start economic growth. That legislation called upon the SEC to come up with crowdfunding rules by the end of last year, but it took the SEC much longer than envisioned.
The extensive initiative sets out the basic challenge facing regulators, which involves finding a way to facilitate grassroots online financing while also ensuring adequate investor protection. Thus, the SEC proposals limit issuers to raising $1 million a year; restricts how much investors can risk, depending on their income and net worth; imposes assorted requirements on the portals that bring together aspiring issuers and prospective investors; and sets disclosure requirements for issuers.
The SEC also has provided an economic analysis of the possible impact of the introduction of equities crowdfunding as part of its proposal. That report indicates that the SEC anticipates that the likely audience for such offerings will be small, retail investors who don’t qualify as accredited investors or have access to early-stage ventures.
The report also warns that the appeal of crowdfunding may be limited by investor perception of the return potential, the prevalence of fraud, lack of liquidity for these securities and the absence of established exit strategies for investors. The report adds that the SEC doesn’t anticipate that many businesses that raise financing through crowdfunding will end up having an initial public offering on a major stock exchange.
In addition, even in cases in which investors do manage to invest in a winner, the SEC report warns that these investors may face expropriation risks that could limit their returns. For instance, they could find their early holdings diluted or otherwise devalued by the issuer as it grows – and such investors aren’t likely to have the sophistication or resources to defend their interests amid these sorts of tactics.
The SEC’s analysis also suggests that brokers who deal in the exempt market in the U.S. could be affected by the introduction of crowdfunding rules, particularly if firms that would have raised funds through a traditional private offering opt for crowdfunding instead. But this impact could be offset if crowdfunding reveals potential new clients for these dealers.
For issuers seeking to raise money through crowdfunding, the SEC estimates the costs of raising less than $100,000 under its proposed rules will be $13,000-$18,000. For offerings of more than $500,000, the SEC projects issuer costs of $77,000-$144,000.
For firms seeking to act as portals, building a platform from scratch and obtaining registration would cost about $417,000 in the first year, with ongoing compliance and operational costs of about $90,000 a year. And for brokers that already are registered and seek to add a crowdfunding service to their business, the SEC estimates the initial cost would be about $295,000 plus annual costs of $70,000.
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