THE HAGUE UNIVERSITY OF APPLIED SCIENCESFACULTY OF INTERNATIONAL & EUROPEAN LAW

LL.B. THESIS

Equity Crowd-Funding and Investor

Protection: A Comparative Analysis

Student name: Vesela Valentinova Yaneva

Student number: 11034394

Submission date: 09.02.2015

LL.B. Thesis Mentor: Dr. Abiola Makinwa

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Table of Contents

Chapter 1: Introduction.........................................................................................................................3

1.1. Research question and structure..............................................................................................3

1.2. Methodology..........................................................................................................................4

Chapter 2: General overview of crowd-funding..................................................................................5

2.1. Definition of crowd-funding........................................................................................................5

2.2. Types of crowd-funding..............................................................................................................7

2.3. Differences between equity crowd-funding and traditional financing methods...........................8

2.4. Advantages of equity crowd-funding...........................................................................................9

2.5. Challenges in the equity crowd-funding market........................................................................10

2.6. Legal implications of crowd-investing: investor protection.......................................................11

Chapter 3: Crowd-funder protection in Europe...............................................................................13

3.1. European regulatory framework for crowd-funding investor protection....................................13

3.2. The protection of crowd-funding investors by European national regimes................................15

3.2.1. Legal framework in the United Kingdom: from unregulated to regulated..........................16

3.2.2. Legal framework in France: towards a balanced regulation..............................................17

3.2.3. The innovative Italian equity crowd-funding law................................................................19

3.3. Conclusive lines........................................................................................................................20

Chapter 4: Crowd-funder protection in the United States...............................................................22

4.1. The US securities regulatory past: keeping the crowd away......................................................22

4.2. The proposed crowd-funding exemption under the JOBS Act...................................................24

4.3. Potential impact on investor protection.....................................................................................27

Chapter 5: Comparative review..........................................................................................................29

5.1. Imposition of investment caps on crowd-funders......................................................................29

5.2. Requirements for equity crowd-funding intermediaries.............................................................29

5.3. Information for investors...........................................................................................................30

5.4. Availability of exit rights...........................................................................................................30

5.5. Dispute resolution rules.............................................................................................................31

5.6. Differences and similarities identified.......................................................................................31

Chapter 6: Conclusion and Recommendations..................................................................................33

Bibliography..........................................................................................................................................36

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Chapter 1: Introduction

The scarcity of traditional means of financing in the past years has contributed to the

increased ubiquity of crowd-funding as an alternative investment method. The media has been

reporting fascinating stories of creative projects which become reality thanks to people who

encountered them on the Internet, liked their ideas and decided to help them get launched with

small monetary contributions. In exchange they merely expect to see an artist perform his

skills or receive the product resulting from the collected capital. However, crowd-funding has

also made it possible for anyone with Internet access to support projects by purchasing shares

in them if he thinks it has the potential to become the next Google or Facebook. This type of

crowd-funding is known as equity crowd-funding and is the focus of this thesis due to the

legal difficulties it creates for legislators, drafting specific laws in the field.

1.1. Research question and structure

What does it mean to invest in a business which has not yet reached the market? It

means risk and risk again. A product or a process which has not been tested yet may not

survive more than a year, and not surprisingly, financial watchdogs such as the Financial

Conduct Authority in the United Kingdom describe crowd-investing as likely to cause

investors to lose all their money.1 A person from the general public does not have the

knowledge and experience to fully understand the risks of early-stage investment. The risks in

equity crowd-funding are big, placing the trust of investors in this emerging market at stake.

Due to the fact that equity crowd-funding is a novel financing model involving an open call

offering shares to the general public, the perceptions regarding its legality and most suitable

way of regulation vary among countries. In the last two years, the major crowd-funding

markets, Europe and the United States, introduced laws in the field aimed to reduce the risks

and serve the interests of both capital-seekers and investors. The goal of this thesis is to

investigate the recent developments in equity crowd-funding regulation, concerning

protection of investors. For that purpose it will analyze the positions in Europe and the United

States in order to compare the approaches they have developed to protect investors in a new

risky market and assess the need of further improvements to the way crowd-investing is

regulated.

In order to conduct a thorough and clear comparison between Europe and the United

States, the thesis will go through each system’s crowd-investing regulatory framework.

1 Judith Evans, ‘Equity crowd-funding thrives despite high risks’ (Financial Times, December 7th 2014) < http://www.ft.com/home/europe> accessed on 24 January 2015.

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Chapter 2 will begin by looking into the nature and features of crowd-funding in general,

emphasizing its potential to fill in the capital gap created by the hardships in obtaining

traditional financing and explain the major legal problem associated with equity crowd-

funding – investor protection. Chapter 3 will turn the attention to the regulatory approach

towards investor protection in Europe by looking into the implementation of the relevant EU

Directives in the domestic legal orders of three selected jurisdictions – the United Kingdom,

France and Italy, along with their specific national crowd-investing regulations. Chapter 4 of

the thesis will look at the proposed legal framework for equity crowd-funding in the United

States and its position on crowd-funder protection. Finally, Chapter 5 will present a

comparative review between the selected European jurisdictions and the USA in order to

assess their strong and weak sides and accordingly provide recommendations towards each

legal system for strengthening its measures and achieving better results.

1.2. Methodology

The research paper is going to trace the developments in equity crowd-funding and

investor protection by using the comparative analysis method – looking into two different

positions on regulating investor protection in equity crowd-funding, the European and the US

one, and compare them to highlight their differences and similarities.

The mentioned systems have been selected as the focus of this paper because they are

interesting to be separately analyzed and challenging to compare. The situation in Europe is a

suitable choice because it is the second biggest crowd-funding market and the regulation of

the latter involves two levels – the supranational and the national one. The levels’ co-

existence and its impact on investor protection are of significant importance. The situation in

the USA, the biggest crowd-funding market, is strongly debated due to the fact that the legal

framework on equity crowd-funding itself has not been “tested” yet. It is therefore

challenging to examine the proposed rules and outline the direction they intend to give to the

US equity crowd-funding market.

The selected European countries and the United States will be compared on the basis

of specific criteria developed after having discussed the regulatory positions towards investor

protection.

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Chapter 2: General overview of crowd-funding

This chapter is going to provide a general overview of crowd-funding as an alternative

investment method. In particular, it will discuss the nature of the process, its roots, types of

crowd-funding which currently exist and the type which is the focus of this paper. Thereafter,

the chapter will look at the factors that have led to the existence of equity crowd-funding

making it an attractive option for small businesses. Finally, the advantages and disadvantages

of equity crowd-funding for national economies will be discussed as well as investor

protection as the biggest legal issue associated with this model of crowd-funding.

2.1. Definition of crowd-funding

Approximately 100 million new business start-ups are launched globally every year

according to a study by Moya K. Mason.2 This is the number of various novel ideas waiting to

get to the market and end users. Before going there, however, entrepreneurs need to find an

appropriate ‘bridge’ to substantiate their business plans and allow their actual development –

resources such as equipment, raw materials, pivotal studies, trials, campaigns, personnel, etc.

According to Leah Grant the most traditional way in which an entrepreneur can get a

promising business idea financed is by applying for a small business bank loan. The same

article lists three other traditional methods for financing small businesses3. Venture capitalists

or firms willing to invest their money into ventures and seize the returns on those are another

possibility.4 The last two ‘seats’ are reserved for angel investors or wealthy individuals

looking for business projects with high potential to bring returns and private or public grants

available for particular types of businesses on a strict basis.5

Various factors have however made it quite difficult for small businesses to seize these

traditional financing methods such as the global economic crisis, the risky nature of start-ups,

the uncertainty regarding when can first profits be expected, etc.6 Deprived of traditional

funding means, small businesses have in recent years started seeking alternatives that would

enable them to launch their business ideas.

2 Moya K. Mason,‘Worldwide Business Start-ups’(2014), <http://www.moyak.com/papers/business-startups-entrepreneurs.html> accessed on 25 November 2014.3 Leah Grant, ‘Four Traditional Funding Methods for Small Businesses’ (NASDAQ, 12 October 2010) http://www.nasdaq.com/article/four-traditional-funding-methods-for-small-businesses-cm40099, accessed on 25

November 2014.4 Ibid.5 Ibid. 6Gmeleen Faye B. Tomboc, ‘The lemons problem in crowd-funding’ (2013) 30 J. Info. Tech. & Privacy L. 253, 2.

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One particular type of alternative financing for start-ups and small businesses is

crowd-funding. It is associated with the process of raising money from the crowd, the general

public, normally through the means of the Internet.7 Andrew Schwartz provides a definition of

crowd-funding by comparing it to crowd-sourcing outlining their similarities and differences.8

In his view, crowd-funding similarly to crowd-sourcing is an online activity in which a

company or an organization proposes in an open call to a large group of people the

undertaking of a particular task on a voluntary basis9. He highlights this similarity by various

examples of crowd-sourced projects such as Wikipedia10, and Yelp!.11 However, the main

difference Schwartz identifies between crowd-sourcing and crowd-funding is that in the latter

the crowd invests capital instead of labour and, depending on its type crowd-funding may give

the participants something in return.12

The way in which crowd-funding works in real life and the actual operation of the

market can be most clearly exemplified by looking at case studies of successful crowd-

funding campaigns from different countries.

The first example comes from the Netherlands where in 2012 the Dutch solar energy

developer Off-Grid Solutions raised $100,000 for its WakaWaka Solar Light technology

through Symbid, an equity-based crowd-funding platform.13 320 investors financed the project

and became equity investors expecting while the crowd-funding campaign allowed the

company to develop, manufacture and market high-tech low-cost solar lamps and chargers

globally.14

Another interesting crowd-funding campaign is that of the Pebble watch listed on the

US crowd-funding platform Kickstarter. The idea behind the project was to create an

inexpensive e-paper watch which could be customized with applications and provide email

and calendar notifications.15 Pebble exposed the idea to the public via Kickstarter’s website

7 P. Belleflamme, T. Lambert, & A. Schwienbacher, ‘Crowd-funding: Tapping the Right Crowd’ (2014) J. of Bus. Vent. 29(5), 585-609.8 Andrew Schwartz, ‘Crowd-funding Securities’ (2013) 88:3 Notre Dame Law Review 1457, 1459.9 E. Estelles-Arolas & F. Gonzales-Ladron-de-Guevara, ´ Towards an Integrated Crowd-sourcing Definition’(2012) 38 J. Info. Sci. 189, 197; A. Ley & S. Weaven, ‘Exploring Agency Dynamics of Crowdfunding in Start-up Capital Financing’ (2011) 17 Acad. Entrepreneurship J., 85, 86.10 Wikipedia, WIKIPEDIA, http://en.wikipedia.org/wiki/Wikipedia, accessed on 25 November 2014.11 What is Yelp?, YELP, http://www.yelp.com/faq#what_is_yelp, accessed on 25 November 2014. 12 C. Steven Bradford, ‘Crowd-funding and the Federal Securities Laws’ (2012) Colum. Bus. L. Rev. 1, 16–17.13 O. Gajda & J. Walton, Review of Crowd-funding for Development Initiatives (IMC Worldwide for Evidence on Demand Paper, July 2013), 15.14 Ibid.15 George Deeb, ‘Lessons in Entrepreneurship: Pebble’s $10 MM Raise via Kickstarter’ (Red Rocket Blog, 16 July 2012) http://redrocketvc.blogspot.nl/2012/07/lessons-in-entrepreneurship-pebbles.html accessed on 25

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and set a target to raise $100,000 for research and development. Donating to the campaign

promised as a reward the receipt of the watch once done. By the end of the campaign Pebble

had collected $10 million, 100 times its initial goal.16

The roots of the broader concept of crowd-funding stem from the microfinance

movement pioneered by Nobel Prize winner Muhammad Yunus aimed at fighting poverty by

providing access to financing to individuals who otherwise cannot afford the costs of bank-

based financing.17 Dr. Yunus from Bangladesh was strongly inspired by a woman he met, who

was trying to make a living from weaving bamboo stools but was unable to afford buying the

materials she needed, given that commercial banks were rejecting a person with no assets.18

Dr. Yunus was determined to make stories like this remain in the past. He established

Grameen bank in his native Bangladesh to lend small amounts of cash to local people for

developing small businesses by for example buying a sewing machine to make clothing or a

cow to sell milk.19 Dr. Yunus claimed that the poor people were equally creditworthy as the

rich if lending was based on trust, not on financial guaranties. His undertaking inspired other

banks throughout the world to follow his example and open up towards small entrepreneurs.20

According to Anand Giridharadas and Keith Bradsher from the New York Times the selection

of Dr. Yunus for the Nobel Prize reflects two developing ideas namely that tackling poverty is

essential to achieving peace and that private enterprise is essential to tackling poverty.21

2.2. Types of crowd-funding

Depending on what the backers of a particular business idea receive in return for their

money, different types of crowd-funding can be identified.

Crowd-funding in which the crowd does not receive anything in return for its money is

called donation-based and the motivating factor is the cause for which the crowd is donating

such as helping to develop a social rights campaign or supporting a politician’s campaign.22

November 2014.16 Ibid. 17 Ross S. Weinstein, ‘Crowd-funding in the U.S. and abroad: what to expect when you’re expecting’ (2013) 46 Cornell Int’l L.J. 427, 3.18 A. Giriharadas & K. Bradsher, ‘Microloan Pioneer and His Bank Win Nobel Peace Prize’ (New York Times, Oct. 13, 2006), <http:// www.nytimes.com/2006/10/13/business/14nobelcnd.html?_r=0> accessed on 25 November 2014.19 Ibid. 20 Ibid. 21 Ibid. 22 Supra note 12, at 15-16.

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Another crowd-funding model is the reward-based one in which backers receive

rewards in exchange for their money. This model has gained popularity in the art world where

the crowd may support art projects and in return receive free tickets for concerts or get the

chance to meet artists23. A similar type of crowd-funding is the pre-purchase arrangement in

which funding participants receive the fruits of the project they have backed up such as for

instance the original copy of a book they have financed.24

The type of crowd-funding where crowd-funders make loans, with or without interest,

and expect to receive their contributions back in the future is called peer-to-peer lending.25

The most challenging variation of crowd-funding is the equity-based type, involving

businesses that, using the Internet connect to diverse and usually large in number groups of

people, interested in owning stock in their company.26 Equity crowd-funding is the focus of

the present paper because unlike other crowd-funding types it involves the establishment of an

investment relationship over the Internet between early-stage ventures and members of the

general public who may have never before had a similar experience and may therefore not be

aware of the associated risks. It creates an exception to the tradition of offering unlisted

securities only to accredited investors, investors who are financially sophisticated and have a

reduced need for regulatory protection27 due to their financial knowledge or ability to bear the

risk of loss.28

2.3. Differences between equity crowd-funding and traditional financing methods

While traditional early-stage funders, angel investors and venture capitalists, have a

background in finance and entrepreneurship, crowd-funders, members of the general public

who finance business projects online, have differing backgrounds and often no experience in

investments.29 Furthermore, crowd-funding investments take place online and most investors

are quite distant from the ventures they invest in, whereas angel investors and venture

capitalists invest locally and nationally in order to be able to keep in touch with the companies

23 Supra note 12, at 3. 24 Steven Johnson, Future Perfect: The Case for Progress in a Networked Age (Riverhead Trade, 2013), 15-16.25 John S. (Jack) Wroldsen, ‘The social network and the Crowd-fund Act: Zuckerberg, Saverin, and venture capitalists’ dilution of the crowd’ (2013) 15 Vand. J. Ent. & Tech. L. 583, 5.26 Joan MacLeod Heminway & Shelden Ryan Hoffman, ‘Proceed at Your Peril: Crowdfunding and the Securities Act of 1933’ (2011) 78 Tenn. L. Rev. 879, 892-907.27 Laura Michael Hughes, ‘Crowd-funding: Putting a Cap on the Risks for Unsophisticated Investors’, (2014) 8 CHARLR 483, 486.28 Benjamin P. Siegel, ‘Title III of the JOBS Act: Using Unsophisticated Wealth to Crowdfund SmallBusiness Capital or Fraudsters' Bank Accounts?’, (2013) 41 Hofstra L. Rev. 777, 794.29 K. E. Wilson, Financing High-Growth Firms: The Role of Angel Investors (OECD Publishing Paper, December 2011).

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they fund.30 Another aspect in which these three types of early-stage financing differ is the

due diligence of the venture selected for financing – crowd-funders frequently omit this step,

while angel investors and venture capitalists carry out due diligence at all times.31 The way in

which the investment deals take place also differs as crowd-funding deals flow through an

intermediary, an online platform, while angel investments and venture capital investments can

take place directly between the investors and the ventures.32 Finally, crowd-funders differ in

their role following an investment as they remain passive while angel investors and venture

capitalists get involved in the control of the funded venture.33

2.4. Advantages of equity crowd-funding

Crowd-funding gives a chance to small entrepreneurs who have not yet commenced

their businesses but cannot afford relying on personal funds to launch and face refusal by the

traditional sources of capital.34

Bank loans are not a good option due to the hardship for start-ups to fulfil their

requirements coupled with their overall reluctance to give loans in the context of global

financial instability.35 Venture capital funds are also not a reliable financing source for start-

ups as they normally invest huge amounts in only a few selected projects and their pickiness

has increased even further due to the economic crisis.36 Angel investors, wealthy individuals

with entrepreneurial experience are another unsuitable choice because their number is not as

big as the number of companies in need of funding and they prefer pooling their funds in large

projects rather than in start-ups.37 Raising capital via initial public offering (IPO) is also

improper in the case of start-up companies due to the numerous costs associated with

registrations and compliance.38

Another advantage of equity crowd-funding is the economic benefits it has the

potential to bring to national economies. Jason Best, Sherwood Neiss and David Jones,

30 A. K. Agrawal, C. Catalini & A. Goldfarb, Some simple economics of crowd-funding (National Bureau of Economic Research Working Paper 19133, 2013).31 Supra note 27. 32 Supra note 27.33 Supra note 27.34 Supra note 6.35 Jill E. Fisch, ‘Can Internet Offerings Bridge the Small Business Capital Barrier?’(1998) 2 J. Small & Emerging Bus. L. 57, 60-61; Peter C. Sumners, ‘Crowdfunding America's Small Businesses after the JOBS Act of 2012’, (2012) 32 Rev. Banking & Fin. L. 38, 38.36 D. Tapascott & A. D. Williams, Macrowikinomics – Rebooting Business and the World (Penguin Portfolio, 2010), 51; D. Mashburn, ‘The Anti-Crowd Pleaser: Fixing the Crowdfund Act's Hidden Risks and Inadequate Remedies’, (2013) 63 Emory J. L. 127, 136-140. 37 Supra note 12, at 103.38 Supra note 35, at 61.

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crowd-funding capital advisors, suggest that crowd-funding can boost jobs creation because

start-ups create the most employment opportunities within an economy.39 Moreover it can

help in increasing national Gross Domestic Products by providing an open forum for testing

risky ventures and therefore decrease their failure rate and allow the easy monitoring of

transactions reducing governmental costs for screening agencies.40

Finally, equity crowd-funding is advantageous due to its reduced transaction costs.41

The existence and operation of the Internet has made it possible for entrepreneurs to connect

in real time to millions of potential investors at no transaction cost, leaving in the past the

costs associated with lending money from banks.

2.5. Challenges in the equity crowd-funding market

Among the main downsides of equity crowd-funding is the volatile nature of early-

stage ventures as they aim to launch new products or services which have not yet been proven

on the market and therefore their success is a big unknown.42 However, this aspect of

securities crowd-funding cannot be amended via regulation as it is an inherent characteristic

of the process, what can be changed is its facilitation.

One of the biggest challenges associated with crowd-investing is the so called ‘lemons

problem’.43 Online investors face a higher degree of uncertainty than offline ones due to the

information asymmetry in equity crowd-funding.44 Extensive and detailed information on

listed business projects remains hidden from investors as presented business plans on the

platforms’ websites are mere projections45 and exposing too detailed business plans creates

the risk that the ideas may easily be stolen by any visitor of the website.46 Investors cannot tell

which start-ups are high-potential ones and which are unworthy and will therefore reduce the

average amount they will invest.47 Receiving lower funding than expected, entrepreneurs with

good ideas may exit the market, which will reduce even further the amount funders will be

39 Jason Best, Sherwood Neiss & Davis Jones, “How crowd-fund investing helps solve three pressing socioeconomic challenges (Crowdfund Capital Advisors Paper, 2012).40 Ibid. 41 Supra note 6, at 3.42 Karina Sigar, ‘Fret No More: Inapplicability of Crowd-funding Concerns in the Internet Age and the JOBS Acts Safeguards’ (2012) 64 Admin. L. Rev. 473, 481-482.43 Supra note 6, at 6.44 Toshio Yamagishi et al., ‘Solving the Lemons Problem with Reputation’ in Karen S. Cook et al. (eds.), Etrust: Forming Relationships in the Online World (Russel Sage Foundation, 2009).45 Ibid., 73.46 Supra note 6, at 7. 47 Stephen J. Choi, ‘Gatekeepers and the Internet: Rethinking the Regulation of Small Business Capital Formation’ (1998) 2 J. Small & Emerging Bus. L. 27, 38.

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willing to invest.48 In the end, the market will only be inhabited by low quality ideas, also

referred to as ‘lemons’.49

Closely related to the ’lemons problem’ is the wisdom of the crowd factor in crowd-

funding. Internet crowds comprise of individuals connected to issuers of securities over the

Internet,50 sharing similar interests and therefore likely to select which projects to finance

based on their popularity among the crowd and relying that the other backers have made their

choices wisely.51 However, sometimes crowds are not wise and it may turn out that the initial

funders were not skilled or informed enough to assess the potential value of a project. 52 The

described behaviour is referred to as herding behaviour caused by information cascades,

decision making in which decisions are based on inferences made from the choices of

previous decision-makers.53

Finally, the lack of repeated interactions with crowd-funding platforms for

entrepreneurs may reduce the potential of reputation as a tool to motivate entrepreneurs to

behave in accordance with investors’ interests.54 As a crowd-funding campaign may be a one-

time event for an entrepreneur, he/she may not see a big advantage in behaving properly and

is therefore more likely to commit fraud.

2.6. Legal implications of crowd-investing: investor protection

It is reasonable to question the legality of raising capital for unlisted companies from

the general public without issuing a prospectus, a document describing financial securities to

their buyers and disclosing the risks.55 Equity crowd-funding functions without prospectuses56

and governments realize the rationale behind that – start-ups cannot afford the expensive

48 Supra note 27.49 Supra note 6.50 Joan MacLeod Heminway, ‘Investor and Market Protection in the Crowd-funding Era: Disclosing to and for the “Crowd’ (2014) 38 Vt. L. Rev. 82, 3.51 Supra note 12.52 E. L. Mollick, ‘The Dynamics of Crowd-funding: an Explanatory Study’ (2013b) J. of Bus. Vent. 29, no 1:1-16.53 Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (Three Rivers Press, 1980).54 Supra note 12. 55 Antti Hemmilä, ‘Legal Challenges Related To Crowdfunding: Volume 2’, 26 November 2012 < http://www.arcticstartup.com/2012/11/26/legal-challenges-related-to-crowdfunding-volume-2> accessed on 02 December 2014.56 Directive 2010/73/EU of the European Parliament and of the Council of 24 November 2010 amending Directives 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading and 2004/109/EC on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (‘Prospectus Directive’), Article 1(2)(h).

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issuing process and the amounts they aim to raise are normally not as high as the ones public

companies set as a goal.57

This being said the question remains of how investors in equity crowd-funding are

protected and made aware of risks if no prospectuses are issued by the companies they fund.

The issue is brought to a higher level keeping in mind that a crowd-funding investor involves

anyone from the general public, with or without knowledge and experience in investments. It

is true that sometimes the amount provided by an individual investor is not significant

(sometimes as less as $20) and losing it may not seem like causing significant harm.

However, the equity crowd-funding industry should not turn into gambling where people lose

money on day-to-day basis because of mere curiosity to “try out the experience”. Equity

crowd-funding aims at more than that – presenting small businesses with the capital they need

but also with knowledgeable investors who can advise entrepreneurs and participate in

growing the business they own equity in.

How should the general public member be protected in the context of equity crowd-

funding? This question is of major concern for legislators worldwide who currently consider

introducing equity crowd-funding legislation for the first time. Different jurisdictions however

may not perceive the legislative solution to the issue in the same way due to a variety of

factors. These include the degree to which equity crowd-funding has entered into the national

capital market, the availability of traditional financing methods, the presence of supranational

rules, history and traditions in the national legal order.

The following chapters will discuss the differing regulatory opinions on investor

protection in equity crowd-funding in Europe and the United States as they are the two major

crowd-funding markets on a global scale, they do not share the same regulatory history or

legal tradition, the methods of financing differ in each of the two and supranational rules exist

in one but are absent in the other.

Chapter 3: Crowd-funder protection in Europe

The first regulatory approach towards crowd-investing to be discussed is the European

one. Europe represents the second biggest crowd-funding market in the world, after the

United States. In Europe venture capital financing and business angels are not common and

banks are the more popular choice for early-stage financing. However, obtaining start-up

57 Supra note 6, at 3.

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loans from banks has become close to impossible after the crisis in 2008. Crowd-funding

provides half a million European projects per year with capital they may otherwise have no

means to obtain given for instance the decrease in investments made by venture capital

funds.58 Discussing the regulatory approach towards crowd-investing in Europe is challenging

– adopted national legislations have crucial importance but remain limited within the scope

provided for by EU.

This chapter will first discuss the supranational EU laws affecting investor protection

in equity crowd-funding and a selection of European national equity crowd-funding

legislations. The paper does not aim to cover all European jurisdictions but to exemplify the

diversity of national laws in the clearest way possible. Therefore, the most differing regimes

on equity crowd-funding will be taken into consideration: the United Kingdom which has

swayed from an ‘open’ no-regulation attitude to a recently welcomed regulation in the crowd-

funding field, France which previously had an overly stringent regulatory regime but recently

introduced balanced laws, and Italy giving an innovative regulatory example to other

countries both in Europe and globally.

3.1. European regulatory framework for crowd-funding investor protection

The European Union shares with the Member states the competence to regulate in the

field of the internal market, involving the regulation of financial activities for both traditional

and alternative sources.59

Since the focus of this paper is placed upon the issue of investor protection in the

context of equity crowd-funding only the EU rules having the potential to affect this matter

will be discussed.

For the time being, no specific European legislation has been passed to regulate equity

crowd-funding and until this happens the market needs to comply with the existing EU

Directives created for financial activities in general and implemented on national level.

The most important EU legislation that concerns equity crowd-funding is the

Prospectus Directive.60 Its general aim is to protect investors and provide for market

58 Ernst & Young, ‘Turning the corner: global venture capital insights and trends 2013’, http://share.endeavor.org/pdf/Turning%20the%20corner_VC%20insights%202013.pdf accessed on 17 December 2014, 13.59 Treaty on the Functioning of the European Union, Article 4(2)(a).60 Directive 2010/73/EU of the European Parliament and of the Council of 24 November 2010 amending Directives 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading and 2004/109/EC on the harmonisation of transparency requirements in relation to information about

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efficiency by imposing a requirement on companies intending to offer equity to the public to

publish a prospectus informing investors about the risks of purchasing shares and allowing

them to make reasoned decisions.61 The Directive exempts from this general requirement

public offerings worth less than €5 million62 where most crowd-funding campaigns are likely

to fall.63 Irrespective of this exemption, the Directive further provides for other situations

which would not require the issuing of a prospectus.64 Crowd-funding campaigns aimed at

raising more than €100.000 may wish to rely on the general €5 million exemption, but it will

only exempt them from the European prospectus requirement. These campaigns will not be

exempted from the national regimes on public offerings which have the discretion under the

Directive to vary from full prospectus exemption to full prospectus requirement.65

De Buysere considers that equity crowd-funding platforms could theoretically fall

within the definition of Alternative Investment Fund Manager under the Alternative

Investment Fund Manager Directive (‘AIFMD’) being a legal person whose regular business

is the managing of one or more Alternative Investment Funds.66 However, equity platforms

are not likely to go beyond the €100 million size threshold required for the Directive to

apply.67 The AIFMD requires EU member states to implement minimum regimes consisting

of at least a registration and an information requirement68 in achieving the general goal of the

Directive to provide for a coherent approach towards investor protection within the Union.69

Finally, the Market in Financial Instruments Directive (‘MiFID’) aims to reinforce the

transparency of financial markets and improve investor protection by requiring investment

firms to establish systems and controls for ensuring a robust governance framework.70 While

the definition of an investment firm is wide enough to cover crowd-funding platforms, the

factor having a decisive role in determining if they need authorization under the Directive is

issuers whose securities are admitted to trading on a regulated market (‘Prospectus Directive’).61 Ibid. 62 Ibid., Article 1(2)(h).63 K. De Buysere, O. Gajda, & D. Maron, ‘A Framework for European Crowdfunding’ (Stockholm, Sweden, EURADA, INSME & European Crowd-funding Network, October 2012), 28.64 Supra note 60, Article 3(2) : including the offer of securities to accredited investors only or to fewer than 150 unaccredited investors.65 Supra note 63.66 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, Article 6; Article 4(1)(a): “Collective investment undertaking which raises 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.”67 Ibid., Article 3(2)(a).68 Ibid., Article 3(3).69 Ibid., Consideration (2).70 European Securities and Markets Authority, Consultation Paper MiFID (ESMA/2011/446), December 2011, 6.

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whether they perform any of the activities listed in Annex I Section A.71 This determination is

left to Member states’ interpretation meaning that a platform’s activities may fall under the

MiFID in one Member state but be considered as falling outside its scope in another.72

The EU directives affecting the equity crowd-funding market bind Member states only

with regards to their goal and allow national authorities to select the methods of

implementation. They give a great scale of discretion to national legislators in determining the

rules for offers below the Prospectus Directive’s €5 million threshold, the choice on whether a

crowd-funding platform falls in the definition of Alternative Investment Fund Manager and

whether a platform’s activities would fall within the scope of the MiFID. The diversified

national implementation creates a landscape with a high level of legal uncertainty concerning

investor protection.

3.2. The protection of crowd-funding investors by European national regimes

It is important that a distinction is made between legislative frameworks created on

European level and the implementation of the same on national Member state level.73 The

differing implementation of European Directives results in a fragmented regulatory landscape

for equity crowd-funding and investor protection in Europe.74

3.2.1. Legal framework in the United Kingdom: from unregulated to regulated

The UK has implemented the Prospectus Directive in the UK Financial Services and

Markets Act 200075 fully exempting offers worth less than €5 million for a period of 12

months.76 The AIFM Directive has also been transposed into UK national law but a limited

compliance regime has been introduced for managers with total assets under management of

less than €100 million (where most crowd-funding platforms are likely to be).77 These are

required to either register with the FCA as a small registered AIFM and provide annual

reports on the level of their funds under management or become authorized as a small

71Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, Annex I, Section A.72 Supra note 63, at 31.73 Aschenbeck-Florange et al., ‘Regulation of Crowdfunding in Germany, the UK, Spain and Italy and the Impact of the European Single Market’ (European Crowdfunding Network in association with Osborne Clarke, June 2013), 5.74 K. De Buysere, ‘The ‘new’ venture capital cycle: Obstacles in using the Internet for equity raise campaigns’,January 2012, 28. On file with author.75 Financial Services and Markets Act 2000, Section 85. 76 Ibid, Section 86.77 Tax & Legal Work Group of the European Crowd-funding Network, “Review of Crowd-funding Regulation. Interpretations of existing regulation concerning crowd-funding in Europe, North America and Israel” (European Crowd-funding network AISBL, 2013), 186.

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authorized AIFM and comply with a limited conduct of business and capital requirement

regime.78

Until recently the United Kingdom has been the most notable example in Europe of an

open regulatory approach towards equity crowd-funding as it had no specific regulation in the

field. UK regulators were observing the market’s development willing to learn the specific

needs of all stakeholders before passing laws.79 The field was dominated by a high degree of

uncertainty where some equity platforms were authorized by the Financial Conduct Authority

(FCA) under the Financial Services and Markets Act 200080 while others were making use of

the variety of exemptions available to avoid regulation.81

In March 2014 the FCA produced a policy statement82 outlining the new crowd-

funding rules that came into force on 1st April, 2014. The major driving force behind them

was the belief that crowd-investing should only be promoted to those who understand or have

the financial capacity to deal with all the risks associated with this type of alternative

investment.83

The new regime places an important limitation on the type of investors to whom

equity platforms are allowed to send offers of unlisted securities - professional clients, retail

clients confirming they will receive regulated investment advice from an authorized person,

venture capital firms, certified sophisticated investors, certified high net worth investors, and

clients certifying they will not invest more than 10% of their net investible financial assets in

unlisted securities during one year.84 The new laws also provide that if an equity platform

does not provide investment advice it must check that clients have the knowledge and

experience necessary to assess the risks associated with investing in unlisted securities by

sending them an appropriateness test in line with the rules in Chapter 10 of the Conduct of

Business Sourcebook.85 Not in the last place, the new legislation introduces dispute settlement

rules for loan-based crowd-funding but does not envisage similar that fit into the context of

the equity-based model.86

78 Ibid. 79 Supra note 73, at 6. 80 Financial Services and Markets Act 2000.81 Financial Promotions Order (‘FPO’).82 The Crowdfunding and the Promotion of Non-Readily Realisable Securities Instrument 2014, March 2014.83 King & Wood Mallesons, ‘UK new crowd-funding rules’, 27 March 2014, http://www.sjberwin.com/insights/2014/03/27/uks-new-crowdfunding-rules accessed on 17 December 2014.84 Supra note 82, Section 4.7.7 R (1), (2).85 Supra note 82, Section 4.7.7 R (3). 86 Ibid.

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The UK has taken a cautious approach towards equity crowd-funding but the mere fact

that regulation has been put in place carries a positive sign. The new legislation has brought

legal certainty in the market and the importance of protecting crowd-funders to the spotlight.

However, the solutions of the FCA for protecting investors do not seem to be the most

suitable and effective ones. Is really high net income the most appropriate filter in assessing

an investor’s experience and readiness to cope with the risks associated with crowd-investing?

An individual can have a high salary and still lack sufficient knowledge of investments. UK

legislators deserve admiration for regulating equity crowd-funding but need to reconsider the

selected methods.

3.2.2. Legal framework in France: towards a balanced regulation

France has implemented the Prospectus Directive requiring public offerings to prepare

prospectuses and get approval by the securities regulator, the Autorité des Marchés Financiers

(AMF).87 The exemptions available to this rule closely follow the Prospectus Directive and

even adopt a stricter approach.88

The AIFMD on its side although implemented in France89 is not likely to affect crowd-

funding activities in the country. This stems from the fact that under French law equity-based

platforms do not meet the definition of collective investment undertakings as they raise capital

from investors with commercial purpose, do not maintain the collected amounts in the form of

collective investments and allow the establishment of investors-funders relationships.90

Unlike the United Kingdom, France had until late 2014 quite rules, making the

operating of the whole crowd-investing market burdensome.91 On 1st October 2014 specific

equity crowd-funding law entered into force in France ‘liberalizing’ the regulatory

landscape.92 The most interesting aspect of the legislation is that it provides for a separate

87 Supra note 77, at 78.88 Code monétaire et financier (CMF), Article L.411-2; AMF Règlement Général, Article 211-2. The exceptions available include private placements addressed to qualified investors and fewer than 150 other investors, for up to 20% of the issuer’s pre-offer capital or high value placements (at least €100.000 per investor or €100.000 per security) and for offerings of less than €100.000 in total or larger offerings representing up to 50% of the issuer’s pre-offer capital and not exceeding €2.5 million if traded on a multilateral trading facility or €5 million if not so traded.89 Code monétaire et financier, Articles L.214-24.90 Supra note 77, at 81.91 Ludwine Dekker, ‘Figuring Out Crowd-funding: Should We Support Open or Closed Markets?’, 14 April 2014 http://www.crowdfundinsider.com/2014/04/35872-figuring-crowdfunding-support-open-closed-markets/ accessed on 19 December 2014.92 Ordonnance no. 2014-559 du 30 mai 2014 relative au financement participatif (Presidential Order no. 2014-559); J. D. Alois, ‘French Crowd-funding Laws Now in Force’, 2 October 2014 http://www.crowdfundinsider.com/2014/10/51484-french-crowdfunding-laws-now-force/ accessed on 20 December 2014.

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legal status of equity crowd-funding platforms – ‘conseiller en investissements participatifs’

(CIP)93 and abolishes the previous minimum capital requirement for platforms.94 The CIPs are

required to register with ORIAS (the Single Register of Insurance Intermediaries),95 adhere to

a code of conduct and establish adequate management procedures.96 Portal managers need to

have a background in banking or finance and must not be bad actors.97 The website of an

equity platform is required to provide investors with minimum information about the authors

of listed projects and the risks associated with investing in unlisted securities, and get their

confirmation that they realize the risk of losing the money they have invested.98 Another

important change is that the crowd-funding limit for equity raised through the website of a

CIP has been increased from €100.000 to €1 million per issuer in any 12-month period with

the requirement of issuing a light 4-5 pages prospectus document.99

The new French crowd-investing law places on the shoulders of equity-based

platforms the responsibility to ensure they are capable of operating in that market and

accordingly ensure that investors will be appropriately informed about its risks. Along with

that French legislators try to balance the interests of investors with those of entrepreneurs by

increasing the maximum amount allowed to be raised within a year to €1 million.

3.2.3. The innovative Italian equity crowd-funding law

Italy is the first country in the world that enacted specific equity crowd-funding laws100

and one cannot omit noticing that the spirit behind these is protecting investor interests in a

new, risky market such as equity crowd-funding.

On 17 December 2012 Decreto Crescita Bis 2.0 came in force legalizing equity crowd-

funding only for ‘innovative start-up companies’101 and delegating the final implementation of

the law to the CONSOB, the Italian Securities and Exchange Commission. The law

transposed the Prospectus Directive into Italian law102 and the MiFID by requiring each

93 Décret no. 2014-1053 du 16 septembre 2014 relatif au financement participatif (Ministerial Decree no. 2014-1053).94 Ibid.95 Ibid.96 Ibid.97 Ibid. 98 Ibid. 99 Ibid. 100 The Soho Loft, ‘Italy announced for Equity Crowdfunding today’, 12 July 2013, http://thesoholoft.com/2013/07/12/italy-law-announced-for-equity-crowdfunding-today/ accessed on20 December 2014.101 Italian Growth Decree bis 2.0, Article 25(2).102 Supra note 77, at 117.

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securities offering to be finalized by a CONSOB-registered broker-dealer who is required to

manage an investor’s money and check his readiness to assess the investment risks by filling

in questionnaires.103

In July 2013 CONSOB implemented Regulation No. 18592 providing the legislative

framework for the conduct of all crowd-funding activities through Italian-based equity

platforms. The general rules contained therein require equity platforms to register with

CONSOB104 upon meeting specific competence and reputation requirements.105 The same

regulatory organ has the right to supervise the crowd-funding activities carried out on

platforms and impose penalties when necessary.106 CONSOB moreover manages the

arbitration chamber solving conflicts between investors and broker-dealers. Also, at least 5%

of the amounts raised via crowd-funding shall be invested by a professional investor as

defined in the CONSOB Regulation.107There is, however no investment cap on the amount

that a retail investor is allowed to invest in a single project or within a calendar year.

The Regulation moreover provides for a simplified process for small investments108

not requiring the involvement of a broker-dealer and risk assessment testing of investors.109

One of the most significant rights granted to Italian crowd-funders is to exit the

investment they have entered into. They can do that without any reason within seven days

from investing,110if something new happens or a material mistake affecting their investment

decision is found after the investment but before closing of the offer and within 7 days from

finding out such news,111 or if the founding shareholders sell the business or somehow amend

the control of the company.112 Therefore, companies must include such rights in their

shareholders agreements before being admitted to crowd-funding and keep them there as long

as they benefit from the ‘innovative start-up’ status. Interestingly, retail investors are

103 A. M. Lerro, ‘Protections Offered to Investors under Italy’s Equity Crowd-funding Law’, 2 August 2013, <http://www.crowdsourcing.org/editorial/protections-offered-to-investors-under-italys-equitycrowdfunding-law/27455> accessed on 20 December 2014; Italian Growth Decree bis 2.0, Part II, Title III, Article 15.2(b).104 Italian Growth Decree bis 2.0, Part II, Title I, Articles 4-6.105 Ibid., Part II, Title II, Articles 8,9; Root,’A look into Italy’s Recent Crowdfunding Legislation (Part I)’, 15 July 2013 www.crowdsourcing.org/editorial/a-look-at-italys-recent-crowdfunding-legislation-part-i/27122 accessed on 20 December 2014.106 Ibid., Part III, Articles 24, 25.107 Ibid., Part I, Article 2(j),Part III, Article 24.2.108 Small investments are up to €500 per investment and €1000 per year for individuals and ten times the same amounts for legal persons.109 Italian Growth Decree bis 2.0, Part II, Title III, Article 17.4.110 Ibid., Part II, Title III, Article 13.5.111 Ibid., Part III, Article 25.2.112 Ibid., Part III, Article 24.1(a).

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encouraged to keep their investments up to 2 years by tax incentives – they can deduct up to

25% of their investment, €0.5 million at a maximum.

The regulatory approach in Italy can be regarded as the most developed one in Europe

due to its carefully developed features. It provides for a high degree of investor protection by

delegating it to an experienced regulatory organ, CONSOB, requiring utmost competence by

platforms, ensuring that investors are thoroughly informed, and giving them the right the exit

their investments.

3.3. Conclusive lines

Currently there is no EU equity crowd-funding legislation meaning that this activity is

subjected to the existing EU Directives as implemented in domestic legal orders and to the

national-specific rules across Europe. Fragmentation and legal uncertainty is created by the

varying methods of implementation of the EU Directives affecting crowd-investing. Italy is

the only country in Europe which has developed adequate measures upholding investor

protection in its national crowd-investing laws and therefore represents a genuinely advanced

regulatory regime. The EU is considering the possibility of harmonizing the equity crowd-

funding field and the European Commission has been monitoring crowd-investing’s

development since late 2013, exploring its added value to the internal market and the need for

EU legislation through consultations with involved parties113. Harmonizing equity crowd-

funding legislation across the EU would improve investor protection by removing the legal

uncertainty created by different regimes in each Member state and setting a common playing

field in the internal market.

113 A. Root, ‘A Cloudy Forecast: Equity Crowdfunding In Europe’, 25 October 2012, www.crowdsourcing.org/editorial/acloudy-forecast-equity-crowdfunding-in-europe-part-1/20692, accessed December 17 2014.

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Chapter 4: Crowd-funder protection in the United States

The second regulatory approach towards investor protection in equity crowd-funding

under discussion is that of the United States. It has been selected to form part of this paper

along with Europe due to the fact that it is the leading crowd-funding market on a global scale

and therefore US legislators have been concerned with the question of its regulation in the

past years. Moreover, comparing the US regulatory approach to the European one in terms of

providing investor protection is challenging because the two systems do not share the same

history or legal order. It is interesting to see if the two world leaders in crowd-funding

approach similarly the same legal issue qua regulation given their significantly differing

features.

This chapter is going to provide an overview of the regulatory landscape for crowd-

investing in the United States and the status of crowd-funder protection there. The discussion

is going to start with a briefing on the US federal laws governing securities offerings and an

explanation of how these laws create hardships for start-ups in obtaining early-stage capital.

Afterwards, the chapter will examine the proposed exemption from US securities regulations

for crowd-investing under Title III of the Jumpstart Our Business Startups Act (JOBS Act).

Last but not least, the chapter is going to look at the proposed crowd-investing law’s approach

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towards upholding investor protection and outline the problems it may cause to crowd-

funders.

4.1. The US securities regulatory past: keeping the crowd away

In 2012 the US President Barack Obama signed the JOBS Act, whose Title III

proposes exempting equity crowd-funding from the registration requirement under the

securities regulations in order to boost the economy and create jobs.

However, before the proposed exemption comes into force equity crowd-funding

offerings are subject to US federal securities rules as they involve the sale of securities to the

general public.114The legislative requirements for offering securities to the public in the

United States are highly demanding and overly costly for businesses aiming to raise small

amounts of money.

The major laws governing the sales and offerings of securities in the United States are

the 1933 Securities Act, regulating the primary securities market, and the 1934 Securities and

Exchange Act, governing the secondary market and establishing the Securities and Exchange

Commission (SEC). Both Acts were adopted by the US Congress after the stock market crash

of 1929 and were aimed at protecting from fraud buyers of securities from the general public

by requiring extensive disclosures by sellers of securities.115 Therefore, the laws require

issuers of securities to register with the SEC116 and disclose enough information to prospective

investors to allow them to make informed decisions regarding securities purchases in light of

the associated risks.117

The following requirements apply to all public securities offerings in the United

States, including equity offerings by start-ups until enactment of the JOBS Act. The 1933

Securities Act prohibits any offering of securities to the public unless the same is registered

with the SEC or qualifies for one of the registration requirement exemptions.118For the

purpose of registering a public security offering with the SEC, a company must prepare a

114 Securities Act 1933 (15 U.S.C., 2012), s 2(a)(1) (“investment contracts” as a form of “securities” under the Act); SEC v. W. J. Howey Co. [1946] 328 U.S. 293, 300-301 (defining “investment contract” under the Securities Act as requiring an investment of money, due to an expectation of profits arising from, a common enterprise, which depends solely on the efforts of a third party); Daniel M. Satorius & Stu Pollard, ‘Crowd Funding: What Independent Producers Should Know About the Legal Pitfalls’, (2010) Ent. & Sports L., 16.115 Deepa Sarkar, ‘Securities Law History’ (2012) Cornell U. L. Sch. Legal Info. Inst., <http://www.law.cornell.edu/wex/securities_law_history> accessed on 17 January 2015.116 James D. Cox et al., Securities Regulation: cases and materials (6th ed., Aspen Publishers, 13 May 2009) 1019.117 Ibid. 118 Securities Act 1933 (15 U.S.C., 2012) §77e(c).

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registration statement with disclosures on ownership, description of the business, director

background information, balance sheet, a profit and loss statement.119 The document must be

filed with the SEC and made available as the SEC requires.120 Crowd-investing is in practice

prohibited under Section 5 of the Securities Act which bars the use of “means or instruments

of transportation or communication in interstate commerce or of the mails” to sell an

unregistered security. Along with the registration requirement, a company selling securities is

obliged under the Securities and Exchange Act to comply with periodic disclosure reporting

requirements.121 Complying with both the registration and the disclosure and reporting

requirements involves costly preparation which may exceed the amount of capital a company

is aiming at.122 This explains why early-stage companies are reluctant to seek seed capital by

means of a public offering and are looking for alternatives.123

Before the JOBS Act came on the US regulatory stage start-ups may try to raise capital

by making use of the available registration requirement exemptions. Issuers may consider

making Regulation A offerings amounting up to $5 million124 – a satisfactory amount for an

early-stage financing round. However, the exemption requires the filing of a disclosure

document with the SEC, Form 1-A, which amounts to a partial registration process125 that

pushes small entrepreneurs away.126 Another possible alternative to exempt a securities

offering is Regulation D providing for three separate registration exemptions depending on

the targeted funding amounts.127All Regulation D exemptions however prohibit general

solicitation or advertising of the offerings by their issuers which makes them incompatible

with equity crowd-funding.128

119 Securities Act 1933 (15 U.S.C., 2012) §77aa(4)-(6), §77aa(8), §77aa(25), §77aa(26).120 Securities Act 1933 (15 U.S.C., 2012) §77aa.121 Securities Act 1933 (15 U.S.C., 2012) § 78o(d); Michael B. Dorff, ‘The siren call of equity crowd-funding’ (2014) 39 J. Corp. L. 493, 5.122 Supra note 26, at 907.123 Supra note 12, at 107.124 Securities and Exchange Act 1934 (17 C.F.R., 2013) § 230.251(a)(2).125 Ibid., § 230.251(d); Supra note 121.126 Eliminating the Prohibition against General Solicitation and General Advertising in Rule 506 and Rule 144A, Securities Act Release No. 9354, 77 Fed. Reg. 54, 464, 54, 477, n.126 (proposed Aug. 29, 2012).127 Securities and Exchange Act 1934 (17 C.F.R., 2013) § 230.504(b)(2), § 230.505(b)(2), § 230.506: Rule 504 exempts security offerings amounting up to $1 million, Rule 505 exempts offerings up to $5 million, and Rule 506 exempts offerings with no limitation in their amount but allowing only 35 non-accredited investors to take part in the offering; Ryan Sanchez, ‘The new crowd-funding exemption: only time will tell’ (2013) 14 U. C. Davis Bus. L. J. 109.128 Thomas Lee Hazen, ‘Crowd-funding or Fraud-funding? Social Networks and the Securities Laws - Why the Specially Tailored Exemption Must be Conditioned on Meaningful Disclosure’ (2012) 90 N.C. L. Rev. 1735, 1769.

23

The US federal securities laws were enacted at times when legislators were worried

that allowing citizens to invest their money in a process not subjected to securities regulation

could harm both the investors and the economy due to wrong decisions taken in relation to

unregulated investment activities.129 However, decades have passed since the 1930s and the

perceptions have changed which leads to asking if the time for a change in the attitude

towards offering securities to the general public has come.

4.2. The proposed crowd-funding exemption under the JOBS Act

The costly regulatory burden of registering a security transaction with the SEC and the

inappropriateness of existing registration exemptions for crowd-investing have motivated

equity crowd-funding proponents to advocate for easing small businesses in accessing early-

stage capital by exempting crowd-investing from federal securities regulation.130 The

legislative proposals started in 2010 and after a number of introduced amendments131 on April

5th 2012 the JOBS Act was signed into law.132 The Act’s Title III known as the Crowd-funding

Act is aimed at increasing the opportunities for entrepreneurs by exempting start-ups from

compliance with the costly federal registration requirements when raising capital.133 The task

of implementing the JOBS Act is delegated to the gate-keeper of the capital markets in the

United States, the SEC.134 On October 23rd 2013 the SEC proposed rules to implement the

crowd-funding exemption but final rules are still expected and until adopted crowd-investing

over the Internet violates the federal securities registration requirement.

The following constitute the requirements for conducting crowd-investing in the

United States as proposed by Title III of the JOBS Act.

Issuers are allowed to raise a maximum of $1 million from crowd-funders within a 12-

month period.135 They are however banned from advertising their offering except if aimed at

directing investors to the portals where they can invest.136 There is no limit on the number of

shareholders an issuer can have as the Act exempts all crowd-funders from the shareholder

129 Edmund W. Kitch, ‘Crowd-funding and an innovator’s access to capital’ (2014) 21 Geo. Mason L. Rev. 887, 2.130 Supra note 12, at 28.131 C. Steven Bradford, ‘The New Crowd-funding Exemption: Promise Unfulfilled’ (2012) 40 No. 3 Sec. Reg. Law J., 1.132 Jumpstart Our Business Start-ups Act 2012, Pub. L. No. 112-106, 126 Stat. 306.133 Supra note 8, at 1460-61; Jacques F. Baritot, ‘Increasing Protection for Crowdfunding Investors under the JOBS Act’, (2013) 13 U.C. Davis Bus. L. J. 259, 281.134 Lindsay Sherwood Fouse, ‘The Crowd-funding Act: a new frontier’ (2013) 16 Duq. Bus. L. J. 21.135 Jumpstart Our Business Start-ups Act 2012, Pub. L. No. 112-106, § 302(a)(6), 126 Stat. 315.136 Ibid., § 302(b)(b)(2), 126 Stat. at 318.

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caps contained in other securities regulations.137Strict disclosure requirements apply for

issuers depending on the capital they aim to raise. If the targeted amount falls below

$100.000, the issuer is obliged to provide the most recent income tax returns along with

financial statements prepared by an internal accountant.138 If the amount goes above $100.000

but below $500.000, the issuer is required to provide financial statements prepared by an

independent public accountant.139 If the targeted amount of the crowd-funding offering

increases $500.000 the respective issuer must provide an audited financial statement140 and

give information about the intended purpose and use of the offering’s proceeds.141 An issuer

must also provide general business information to the SEC and to investors: name, legal

status, physical address, website address, names of directors and substantial shareholders,

description of the business and a business plan, financial condition, price of the securities and

the method of determining their price, capital structure and ownership.142 Along with these

disclosures, issuers are obliged to report annually the results from their business operations

and financial statements to the SEC and to investors.143

The Crowd-funding Act imposes limits and requirements on investors as well. The

amount an investor is allowed to pool in a single crowd-funding project in a 12-month period

depends on his net annual income.144 If an investor’s income is less than $100.000, his

investment in an offering cannot go beyond 5% of that income and be no greater than

$2000.145If an investor’s net income is equal to or exceeds $100.000, he can invest a

maximum of 10% of his annual income, no greater than $100.000.146 Crowd-funding

intermediaries are under the obligation to ensure that no investor exceeds the relevant to his

case investment cap.147 In order to be allowed to crowd-fund a project, investors are required

to show that they understand the risks involved in crowd-investing by reviewing investor-

education information and affirming that they agree with the associated responsibilities.148

Finally, after having purchased crowd-funding securities, investors are banned from selling

137 Supra note 8.138Jumpstart Our Business Start-ups Act 2012, Pub. L. No. 112-106, § 302(b)(b)(1)(D)(i), 126 Stat. 317.139 Ibid., § 302(b)(b)(1)(D)(ii), 126 Stat. 317.140 Ibid., 302(b)(b)(1)(D)(iii), 126 Stat. 317.141 Ibid., § 302(b)(b)(1)(E)-(G), 126 Stat. 317.142 Ibid., § 77d-1(b)(1).143 Ibid., § 302(b)(b)(4), 126 Stat. 318.144 Ibid., § 302(a)(6)(B), 126 Stat. 315.145 Ibid., § 302(a)(6)(B)(i), 126 Stat. 315.146 Ibid., § 302(a)(6)(B)(ii), 126 Stat. 315.147 Ibid., § 302(b)(a)(8), 126 Stat. 316.148 Ibid., § 302(b)(a)(4)(A)-(C), 126 Stat. 316.

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them for one year from the date of the purchase, unless transferring to a family member or an

accredited investor.149

Crowd-funding offerings must be conducted via an intermediary, a broker-dealer or a

funding portal registered with the SEC150 and a member of the Financial Industry Regulatory

Authority.151 Intermediaries have the responsibility of providing investors with disclosures

and extensive information regarding the risks they may face through investor-education

materials and ensure that they affirm to accept these risks.152 Investors shall be allowed by

intermediaries to withdraw their investment at any time prior to the deadline set by the issuer

to collect his targeted amount.153 Intermediaries shall moreover, take appropriate measures to

prevent investor fraud154 and protect the privacy of the information provided by

investors.155Not in the last place, the proposed law establishes rules for liability for misleading

statements against issuers156 and the SEC is encouraged to adopt disqualification rules for

brokers, funding portals and issuers.157

4.3. Potential impact on investor protection

The proposed crowd-investing exemption is challenging and its constituent rules were

a difficult compromise among legislators because they attempt to balance between supporting

small businesses in raising early-stage capital while protecting members of the general public

willing to become investors.158All disclosure requirements provided for in the proposed

Crowd-funding Act are aimed at protecting investors coming from the general public. The

legislative proposal addresses the risks of fraud and inaccurate information and caps the

amounts crowd-funders are allowed to pool in crowd-funding campaigns to off-set potential

losses. Moreover, it envisages civil action right for investors in case of misrepresentations or

inaccurate statements. Are the proposed protections however likely to succeed in their

purpose to prevent fraud towards crowd-funders?

149 Ibid., § 302(b)(e)(1), 126 Stat. 319.150 Ibid., § 302(b)(a)(1)(A)-(B), 126 Stat. 316.151 Supra note 127.152 Ibid., § 302(b)(a)(3), 126 Stat. 316.153 Ibid., § 302(b)(a)(7), 126 Stat. 316.154 Ibid., § 302(b)(a)(5), 126 Stat. 316 (requiring the portal to obtain a background and securities enforcement regulatory check on each officer, director, and person holding twenty percent of the outstanding equity of every issuer).155 Ibid., § 302(b)(a)(9), 126 Stat. 316.156 Ibid., § 302(b)(c)(2)(A), 126 Stat. 319.157 Ibid., § 302(d), 126 Stat. 320-321.158 Supra note 128.

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One of the main shortcomings of the proposed crowd-funding exemption is the failure

of the drafters to realize that investor protection arises not only from providing one with

adequate information but also from the ability to understand that information.159

Unsophisticated investors who are able to become crowd-funders in accordance with the

proposed Crowd-funding Act lack sufficient financial knowledge by definition160 which

makes availing them of thorough information inefficient as a protective legislative measure,

because they will not understand it and make informed decisions on its basis. Moreover, it

remains unclear how funding portals are going to ensure that crowd-funders have understood

the risks of the investment they make161 and merely informing them that a risk exists is

insufficient to protect them.

Furthermore, crowd-funders in the USA will be faced with a liquidity problem as the

proposed Crowd-funding Act bans the transfer of purchased crowd-funding securities within

one year since their purchase. There is therefore no envisaged market for the secondary

distribution of such securities making them quite illiquid.162 Reselling crowd-funding

securities after the one-year restriction will require compliance with federal securities laws.163

Another aspect of the crowd-funding exemption endangering investor protection is the

right to private action against issuers in cases of fraud. It may turn out to be an unworkable

option in the case of small crowd-funders, who are limited to investing only a small amount of

money, because the Crowd-funding Act allows recovering only the amount that has been

invested and eventually lost due to issuer fraud.164 Faced with substantial costs for bringing an

individual action,165 small crowd-funders may consider an alternative remedy - bringing a

class action against fraudulent issuers.166 Doing so, however, would be impeded by the

pleading restrictions imposed by the Private Securities Litigation Reform Act of 1995

(PSLRA) governing private class actions alleging securities fraud.167 Showing the defendant

159 Thomas G. James, ‘Far from the maddening crowd: does the JOBS Act provide meaningful redress to small investors for securities fraud in connection with crowd-funding offerings?’ (2013) 54 Boston College L. Rev. 1767, 1783.160 Thomas Lee Hazen, The Law of Securities Regulation (5th ed., West Group, April 1 2005). 161 Supra note 12, at 139.162 Supra note 12, at 108-109.163 Supra note 12.164 Jumpstart Our Business Start-ups Act 2012, § 77d-l.165 Supra note 128, at 1736–37.166 Supra note 129, at 18. 167 John W. Avery, ‘Securities Litigation Reform: The Long and Winding Road to the Private Securities Litigation Reform Act of 1995’ (1996) 51 Bus. Law, 335.

27

crowd-funding issuer’s intent to defraud168 and proving that the same caused the investor

losses prior to discovery169 would be quite difficult for crowd-funders classes given the scarce

information available about the issuer, despite the disclosures made.170 Therefore, neither the

right to private action in the proposed Crowd-funding Act nor the right to a securities fraud

class action under the PSLRA can provide small investors with an efficient remedy against

issuer fraud.

Chapter 5: Comparative review

Chapters 3 and 4 of this paper looked into the approaches taken by three European

countries and the United States towards regulating crowd-investing activities and solving the

issue of investor protection. In order to investigate their similarities and differences, the

present chapter will conduct a comparative review between the discussed jurisdictions

pertaining to crowd-funder protection based upon five key areas developed through studying

them. Each area of comparison will be discussed in a separate section to follow in the present

chapter and in its end the identified similarities and differences will be presented.

5.1. Imposition of investment caps on crowd-funders

The imposition of investment caps on crowd-funders represents an important

regulatory measure aimed at risk-diversification. It serves to protect investors from losing all

their money in early-stage investing and therefore restricts them to investing only a

percentage of their wealth depending on their net income.

Only the UK among the three examined European regimes has introduced a rule

restricting retail investors to investing up to 10% of their net financial wealth in order to off-

set potential losses. France has introduced an investment cap for participants in the loan-based 168 Private Securities Litigation Reform Act (PSLRA) 1995, § 78u-4(b)(2)(A).; Ernst & Ernst v. Hochfelder [1976] 425 U.S. 185, 193; Tellabs, Inc. v. Makor Issues & Rights Ltd. [2007] 551 U.S. 308, 324. 169 PSLRA § 78u-4(b)(4); Dura Pharm., Inc. v. Broudo [2005] 544 U.S. 336, 345.170 Taku Yoichiro, ‘Crowd-funding: Its Practical Effects May Be Unclear until SEC Rulemaking Is Complete’ (2012) Bus. L. Today, 3.

28

model of crowd-funding, while Italy has decided to disregard including such a measure in its

legislation at all. The proposed crowd-investing legislation in the United States contains a

notable provision imposing investment caps on crowd-funders depending on their net annual

income - if less than $100.000, the investment in an offering cannot go beyond 5% of that

income and be no greater than $2000; if equal to or exceeding $100.000, an investment can be

up to 10% of the annual income and no more than $100.000.

5.2. Requirements for equity crowd-funding intermediaries

The next key area of comparison is the requirements imposed by the discussed

jurisdictions on equity crowd-funding platforms in order to allow them to operate. This issue

is of particular significance for investors, since ensuring that crowd-funding is facilitated by

intermediaries possessing recognized competence, skills and reputation can build investor

trust and can reduce the risks. Knowledgeable platforms are capable of implementing

effective measures to prevent fraud and to protect investors.

Both the European national rules and the US rules envisage some requirements for the

intermediaries facilitating crowd-funding campaigns. In Europe, the United Kingdom has not

imposed specific competence and background requirements for platforms but merely

delegates the task of their monitoring to the FCA. France has introduced a separate legal

status for crowd-investing platforms, requiring them to register with ORIAS, to have

managers with background in banking or finance, who are not bad actors, to adhere to a code

of conduct and set up adequate management procedures. Platforms in Italy are required to

register with CONSOB as long as they meet specific competence and reputation criteria. The

proposed rules in the United States require crowd-funding deals to be facilitated via

intermediary, a broker-dealer or a funding portal. To be either of the two, an equity platform

is required to register with the SEC and become a member of the Financial Industry

Regulatory Authority.

5.3. Information for investors

The information required to be provided to crowd-funders by each legal system will be

compared next. The aspect of access to proper information is of huge importance for investors

due to the problem of information asymmetry existing in crowd-funding. It is therefore crucial

to assess how the European jurisdictions and the USA aim to tackle the informational

asymmetry in crowd-investing.

29

The three European jurisdictions have all to a certain extent imposed on platforms the

responsibility to ensure that investors are aware of the risks associated with early-stage

investments. The UK legislation requires platforms to check the knowledge of investors via

the means of an appropriateness test, while the French obliges platforms to inform investors

regarding the projects listed on their website and the risks they face by investing and to get

confirmation by investors that they realize these risks. In Italy, the task of checking and

ensuring investor readiness to participate in crowd-funding is delegated to broker-dealers who

do so by requiring investors to fill in questionnaires. In the United States crowd-funding

intermediaries are under the obligation to provide investors with disclosures and extensive

information regarding the projects they list, their owners and the risks through investor-

education materials. The proposed law moreover requires intermediaries to ensure that

investors agree to take these risks but does not specify how they have to do that.

5.4. Availability of exit rights

The availability of exit rights has significance for retail investors because it allows

them to exit an investment at any time. Lacking an exit right condemns investors to being

stuck with shares which may harm them once the particular business starts going down – a

situation which does not occur on a sporadic basis with start-ups, being the main ventures

listed on crowd-funding websites.

In Europe only Italy gives investors an exit right in three different situations, but

encourages them to keep their investments through tax incentives. In the United States, the

law does not allow investors to sell their investment once the funding target set by an

entrepreneur has been met unless selling to sophisticated investors or family members. This

limitation on exiting an investment lasts for one year after which an investor is allowed to sell

the purchased equity.

5.5. Dispute resolution rules

Finally, the comparison will turn to the presence of dispute resolution rules

specifically established for crowd-investing, because investors’ interests are closely knit to the

remedies made available to them by law in case their rights are infringed. Being a new

method of financing, crowd-funding may call for tailor-made dispute settlement mechanisms

corresponding to its needs.

The European countries and the USA differ concerning the last criterion of dispute

resolution rules. In Europe, the framework in France is ‘silent’ on that aspect and the UK has

30

only introduced specific dispute resolution rules for loan-based crowd-funding. Italy,

however, has decided to rely on arbitration for solving disputes between investors and broker-

dealers administered by CONSOB. The proposed rules on crowd-investing in the United

States give investors the right to a civil action in case of fraud or misrepresentation by issuers

or portals.

5.6. Differences and similarities identified

It appears that the US and some of the European national legislations share certain

protections accorded to crowd-funders and differ concerning others. The USA was the first to

propose a limitation on the amount an investor should be allowed to pool in a crowd-funding

project depending on his net annual income while in Europe only the UK has so far followed

this example via the so called ‘10% rule’. The legal systems differ in their approaches towards

the requirements for crowd-funding platforms. In Europe, France and Italy oblige platforms to

register with the relevant monitoring regulatory body and meet qualification criteria. In the

USA crowd-funding intermediaries must instead comply with expensive and complex

registration and membership requirements. They moreover differ with regards investors’ right

to exit since in Europe Italy gives crowd-funders an immediate right to exit their investment,

while the US legislation strictly forbids the immediate transfer of the investment. Another

aspect of difference is the approach towards crowd-investing dispute resolution. In Europe,

Italy is the only regime which has so far addressed this issue requiring conflicts between

investors and broker-dealers to be resolved via arbitration, while the proposed Title III of the

JOBS Act allows investors to individually bring civil action against issuers or portals. There is

unanimity among the discussed legislations, though, that intermediaries shall be responsible

for ensuring investors’ awareness of and an agreement to investment risks.

31

Chapter 6: Conclusion and Recommendations

The lack of specific regulations in the field of equity crowd-funding faces all of its

stakeholders with legal uncertainty. Governments have started encouraging crowd-investing

because of its benefits for national economies but the adopted legal frameworks differ from

each other due to the varying countries’ perceptions and preferences. The way in which one

country addresses a particular issue in its legislation may completely contradict the approach

of another country. One of the major legal problems in equity crowd-funding, protection of

crowd-funders has been selected as the focus of this paper and it aimed at investigating the

multiplicity of regulatory approaches towards solving that problem in order to assess their

similarities, differences, and the areas where improvement is required.

Regarding the strong and the weak aspects of each regulatory approach, the following

can be stated. It is positive that some European jurisdictions have enacted crowd-investing

laws and moreover that these laws offer some efficient measures for investor protection. The

biggest disadvantage of the European system is the lack of harmonization and legal certainty

in the field of equity crowd-funding, which creates a fragmented regulatory landscape

endangering investor protection and hindering the market’s development within Europe.

32

The US regulatory approach has some crucial drawbacks in its attempt to provide

adequate investor protection. The imposed investment caps measure on crowd-funders may

result in that wealthier investors will be able to push away the rest as they will be allowed by

law to pool larger amounts or even fund whole projects. This means that the investment cap

measure indirectly discriminates against less wealthier investors. Moreover, the proposed

legislation does not impose competence or reputation requirements on platforms before being

allowed to operate which compromises investor protection and the expertise involved in the

crowd-investing market of the USA. A huge disadvantage of the proposed US legislation is

the one-year ban on crowd-funding securities transfer, meaning that crowd-funders are faced

with a lack of liquidity in the newly emerging market, at least for a year. Finally, the

investor’s right to civil action is a strong side of the legislative proposal but unfortunately

inefficient in practice because it allows crowd-funders to claim back only the amount they

have invested – therefore small investors would prefer to let the lost amount go rather than to

bring an individual claim that would cost them more than their investment.

On the basis of the comparative review between the European and the US regulatory

approaches presented in Chapter 5, the following recommendations can be made towards each

of the two systems.

Investors can be protected in the most effective way in Europe if the EU harmonizes

the rules in the equity crowd-funding market. Adopting supranational legislation in the field

would help the development of crowd-investing and would bring legal certainty for all

stakeholders who will no longer need to familiarize themselves with all existing different

regimes. EU crowd-funding regulation will make the functioning of the market more

transparent as crowd-funding platforms will need to abide to the same set of rules rather than

having a different status in each member state. The EU has headed towards harmonizing the

crowd-investing market as it currently monitors its developments and added value. The Italian

legal framework can serve as a good example for the EU being the most innovative regime so

far and offering the most adequate investor protection balanced with not overly burdensome

obligations for issuers and platforms. Standardization will eliminate the barriers for investors,

entrepreneurs and platforms and allow the market to develop.

The US equity crowd-funding legislative proposal should reconsider some of its

measures. The investment cap requirement should not depend on the investor’s net income

but instead on his experience and knowledge in the investment field. Moreover, the US

33

legislation should impose competence and reputation requirements on platforms to ensure

their fair, transparent and professional operation. The one-year transfer restriction on crowd-

funding securities should be removed in order to encourage investors to participate in the

market and have trust in it. Finally, the provision giving investors the right to civil action

should be amended to allow them to recover only the invested amount in case where it

outweighs the costs of bringing an individual claim. For all other cases the provision should

refer to the right to initiate a securities fraud class action under the PSLRA, which on its side

should introduce an exemption from its strict pleading restrictions for equity crowd-funding.

As a final recommendation, both the European and the US systems should

acknowledge that educated investors are the key to achieving the highest gains for both

entrepreneurs and investors. The aim of crowd-investing laws should be to crate sustainable

value and for that purpose legislators should encourage traditional funders to guide crowd-

funders and educate them. One way to do so could be an educative program for crowd-

funders and professional investors combined with guidance by angels, venture funds and

banks sharing their investment knowledge with crowd-investors via the platforms’ websites.

Regulating a fast-growing risky market at an early stage is crucial for its survival.

Crowd-investing is not a traditional financing method and as such should not just be placed

within the existing frameworks. It needs specific legislation, addressing the needs of all

stakeholders in order to achieve its purpose. All parties involved in equity crowd-funding

would benefit from specific regulations in the field, but the biggest stake is for the general

public member, who now gets the chance to pool his money in promising business ideas and

become an investor. He needs protections at an early stage in order to become educated, learn

the industry and trust the market. Therefore, governments drafting equity crowd-funding laws

should aim at striking balance between the overall idea of unpacking new capital for early-

stage businesses and protecting investors from the crowd.

34

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