Crowd funding represents an untapped source of funding for projects and businesses trying to get off the ground, but regulatory traps lurk for those who are not aware.
Crowd funding is the latest confrontation between the borderless, fast-paced world of social media and traditional regulation. It is a burgeoning industry both in Australia and worldwide, and in light of the Australian Securities and Investments Commission's (ASIC) recent guidance note on crowd funding, practitioners need to be aware of the potential issues that could arise when acting for participants.
In particular, it is important to understand the limitations that the current regulatory framework places on crowd funding activities in Australia, as well as strategies that might be available to aid clients. Practitioners should also understand overseas developments in crowd funding regulation, in order to anticipate better the direction of possible law reform at home.
What is crowd funding?
Crowd funding involves harnessing the power of the internet and social media to fund projects and business ideas. Musicians, film-makers, inventors, charities and, increasingly, start-up businesses are turning to their online 'friends' to contribute funding to their various initiatives.
Crowd funding platforms (websites such as Kickstarter and Crowd Cube, and, in Australia, iPledg and Pozible) allow a person (promoter) seeking to raise money to fund a project to post an outline of their proposal on the website, and enable friends, family and the online community at large to contribute money towards the project. In return for their contribution, contributors receive the promise of a reward, the nature of which will vary from project to project, but usually involves the product of the project they have funded (for example, in the case of a promoter seeking to record a CD, contributors might be promised a signed copy of the CD once it has been launched).
Often, the promoter is required to specify a funding target, namely the amount they nominate as necessary to complete the project. If contributions sufficient to reach the target are received, then the project goes live and the funds are made available to the promoter.
Traditionally – and this is still the case in the majority of instances – projects that feature on crowd funding platforms have tended to be artistic initiatives, for example, film-makers seeking resources to make independent films, or community-oriented initiatives, such as groups seeking funding to launch educational campaigns.
Increasingly, however, entrepreneurs are recognising the potential to use crowd funding platforms to sidestep traditional bank lending and venture capital, and use them to raise funds for profit-making initiatives.
In late 2011, Rushmore Group, owner and operator of three bars and clubs in London, used Crowd Cube to raise Ł1m in 32 days from 143 investors worldwide in order to fund the launch of a new club. Rushmore Group in return offered contributors a total of 10 per cent of the company's equity.1
Crowd funding of this kind is sometimes referred to as "equity crowd funding". As the name suggests, in equity crowd funding, contributors are making an investment. They are not looking to receive a CD – they are looking for a financial return on their contribution.
While Australian crowd funding platforms currently prohibit offering financial rewards or incentives to contributors, 2 crowd funding in the US and Europe has taken on a distinctly entrepreneurial character. Some US and European platforms explicitly allow start-up businesses to seek seed capital from contributors in exchange for shares and ownership stakes in the businesses being promoted. 3 As demonstrated by the case of Rushmore Group referred to above, the amount raised by these projects can be significant.
Forbes estimates that, in 2011, crowd funding platforms raised nearly US$1.5 billion worldwide, predicting this figure to rise to US$2.8 billion in 2012.4
Given the sums being raised offshore and the essentially borderless nature of the internet, it is no surprise that ASIC recently issued guidance on crowd funding.5
In its media release, ASIC pointed out that crowd funding, as such, is not specifically regulated under Australian law. However, it cautioned that crowd funding could in some circumstances stray into the heavily regulated territory of financial services, with potentially serious consequences for promoters and the operators of crowd funding platforms.
In particular, depending on the nature of the project and the reward being offered to contributors, crowd funding can give rise to issues in terms of:
- financial services licensing and disclosure;
- advertising financial products;
- fundraising disclosure regimes; and
- managed investment schemes.
In addition, the general law relating to misleading or deceptive conduct, and contract law, are also likely to be relevant.
ASIC warned that those involved in crowd funding activities that stray into these areas could be subject to heavy penalties if they do not comply with Australia's regulatory requirements.
It is worthwhile taking a closer look at how crowd funding could be affected by some of these areas of the law.
Financial services licensing and disclosure
A person carrying on a financial services business in Australia within the meaning of the Corporations Act 2001 (Cth) (the Act) requires an Australian Financial Services Licence (AFSL) 6 and is subject to a rigorous disclosure regime. 7 This will also affect foreign platform operators if they are seen to intend to induce Australians to use their services. 8
But why would operating a crowd funding platform, or promoting a project through one, constitute carrying on a financial services business?
It really depends on the nature of the reward being offered to contributors in return for funds. Clearly, the offer of a signed CD from a musician whose album has been funded does not involve the offering of, or dealing in, a financial product.
However, a crowd funding platform allowing promoters to offer shares in a start-up company could very easily be seen to be "dealing" in a financial product for the purposes of s.766C of the Act. The platform operator in such a case would require an AFSL, and would be subject to the full gamut of licensing obligations in Part 7.6 of the Act.
Similarly, promoters need to be careful to avoid falling within the fundraising disclosure requirements in Chapter 6D of the Act. Those requirements are very likely to apply in any situation in which a promoter uses crowd funding to raise funds by offering contributors stakes in the promoter's project.
In the example cited above, the promoter would need to lodge a prospectus and otherwise comply with the requirements of Chapter 6D, and would be exposed to the liability provisions in the Act and the Australian Securities and Investments Commission Act 2001 (Cth) relating to the offering of securities.
Managed investment schemes
Offering shares in a company is perhaps an obvious way in which crowd funding activities can stray onto the wrong side of the financial services regulatory regime.
Some less formal crowd funding activities could also fall foul of the Act, and in particular Chapter 5C relating to managed investment schemes.
If we extend the innocuous example of the musician funding the recording of a CD to a situation where, instead of promising contributors a copy of the CD for their personal enjoyment, the musician offers contributors a share of sale proceeds from the CD, then we find ourselves squarely within scheme territory. The monetary contributions are being pooled to produce financial benefits in return for the contributors acquiring an interest in those benefits, satisfying the Act's definition of "managed investment scheme". 9
In that case, assuming there were more than 20 contributors, 10 the scheme would need to be registered under Part 5C of the Act, and there would need to be a responsible entity, a scheme constitution, a compliance plan and a whole range of other things distinctly not-conducive to artistic expression.
Misleading or deceptive conduct
Promoters will need to take care not to run afoul of the statutory prohibitions on misleading or deceptive conduct when outlining their proposals and the rewards they are offering. Liability under s.18 of the Australian Consumer Law (ACL) will of course depend on whether the relevant conduct is seen as being "in trade or commerce". However, in the context of a commercial project seeking crowd funding, it seems reasonably likely that this would fall within the ACL's reach.
Aside from issues relating to statute law, crowd funding gives rise to a host of contract law issues such as: is the contributor contracting directly with a promoter; with both the promoter and the platform operator; or with the platform operator as agent for the promoter?; what is the governing law of the contract?; and how would a contributor enforce it?
The starting point for determining the contractual relationship between crowd funding participants will always be the terms and conditions of the crowd funding platform itself. Potential contributors and promoters can therefore minimise the above uncertainties by carefully reading the terms and conditions (as well as general guidelines and frequently asked questions) of the relevant platform to understand their rights and obligations.
Crowd funding platform terms and conditions often provide for a "hands off" approach on the part of the platform operator, leaving it up to contributors and promoters to deal with issues among themselves should anything go wrong. This makes it all the more important that potential contributors exercise care when assessing a promoter's proposal, and research diligently before making any material contributions. Contributors would be well advised to conduct independent investigation, using publicly accessible information, about the platform and promoter. Platforms usually provide a facility for potential contributors to contact promoters directly, providing a means for potential contributors to ask questions before committing any funds.
Similarly, promoters should be very clear in their pitch about what it is they are seeking from contributors, and what contributors will receive in return. Promoters can also mitigate risk associated with the platform operator by using well established and high-volume platforms with good track records.
The platform operators will need to ensure their platforms are structured in order to minimise the risk of unwanted liabilities. As ASIC pointed out in its recent guidance, it is in the interests of operators to implement strict vetting policies and credential checks to bar unscrupulous promoters from using their platforms. Operators should also consider their money management policies: for example, ensure that crowd funding money is held securely and separately from the operator's own assets.
A need for reform?
The pitfalls outlined above are of only marginal (if any) relevance for traditional crowd funding, in which relatively small-scale artistic projects are funded with small contributions out of a desire to support the arts rather than generate a return.
However, as the overseas experience has shown, crowd funding is a fertile ground for entrepreneurial activity and innovation in which very large sums of money are changing hands. Quite simply, many projects that would struggle to raise bank debt or venture capital suddenly become viable through crowd funding.
By virtue of the regulatory burden it would impose on equity crowd funding, Australian law currently prevents this sort of entrepreneurial activity.
ASIC received criticism for its media release from some quarters, with the allegation that by pointing out the law and the penalties it attracts, the regulator was being heavy-handed and stifling innovation. It seems to us that this is a case of shooting the messenger.
If equity crowd funding is to be permitted or encouraged in Australia, then law reform is required.
In April this year, the US government introduced the Jumpstart Our Business Startups (JOBS) Act, which is in part designed to facilitate restricted forms of commercially oriented crowd funding arrangements that issue shares in return for contributions. 11
The JOBS Act exempts persons seeking crowd funding from the US requirement to provide prospectuslevel disclosure, provided that the total value of shares issued to contributors is not more than $1 million. It also places restrictions on the amounts that individual contributors can contribute towards crowd funded projects, depending on their verifiable income or net worth.
The legislation further provides for crowd funding platforms to register as "funding portals" with the US Securities and Exchange Commission (SEC). Such funding portals, as well as prospective promoters, will be subject to a separate, lighter-touch disclosure regime to that which applies to other issues of securities. The precise details of the disclosure regime are yet to be finalised by the SEC.
For and against
Proponents of crowd funding law reform in Australia might look to the developments in the US as a model, which seems intended to find a middle ground: regulation that offers contributors a reasonable degree of protection while not subjecting platform operators and those seeking funding to the same degree of disclosure and licensing requirements as fully-fledged financial services providers.
But why should Australian law be adapted to facilitate crowd funding in the first place?
The principal argument against reform is that crowd funding in its entrepreneurial guise can in some cases involve raising significant amounts of money and represent a risky investment for contributors who may be unaware of the risk they are taking. The argument goes that the mere fact that crowd funding is facilitated by internet platforms and social media does not justify exempting this activity from regulation: money invested online is no different from money invested in normal investment markets.
One could argue that the need to protect vulnerable and relatively unsophisticated investors, which forms part of the rationale for the Act's strict regulation of financial services, is just as strong in the case of equity crowd funding as in any other investment scenario. Indeed, it could be argued that the need is even stronger, given the openness and accessibility of crowd funding platforms.
Perhaps the most persuasive rejoinder to this argument is to insist that Australian law should not stifle innovation but should encourage it in a way that does not expose the public to undue risk. Requiring a crowd funding project to register as a managed investment scheme, for example, is tantamount to prohibiting the activity altogether given the Act's exacting requirements. As the Australian government itself noted as far back as 1997: "It is important to ensure that regulatory interventions support and do not hinder the operation of the competitive process. The benefits that electronic commerce offers, and its increasing use across a wide range of markets, make it important that regulation does not impede the evolution of new electronic technologies and products. The regulation of electronic commerce, while providing for the protection of investors against unnecessary risk, should not be so heavy-handed as to impede market efficiency and competition." 12
Another interesting argument in support of accommodating crowd funding in Australian law is that it comes with inherent and in-built safety mechanisms to ward off fraud and protect participants. In the rapidly-moving world of instant social media communication, one might say, the "crowd" is its own regulator. 13 Untoward behaviour on the part of platform operators or those seeking funding will be quickly weeded out through internet and social media channels, ensuring contributors are not taken advantage of.
For example, it was reported that earlier this year, Kickstarter cancelled a purported video game production company's solicitation after finding that the promotional material for the project had been taken from another gaming website. The company's conduct was outed by the online community forum of popular social news website Reddit, as well as other vigilant social media users. 14
Whether developments in Australian law will occur in the future with respect to crowd funding, and if so, what form they will take, is at this stage uncertain. What is certain, however, is that Australian law currently limits crowd funding to relatively modest individual and community projects where contributors receive nonfinancial rewards.
Without law reform, platform operators and other crowd funding participants who seek to emulate the development of entrepreneurial crowd funding elsewhere are likely to stray all too easily into the thicket of financial services regulation.
1. See tinyurl.com/ bpx72jp.
2. Both iPledg and Pozible, two main Australian crowd funding platforms, prohibit offering financial incentives or rewards, for example, shares or other forms of ownership, to contributors: ipledg. com/help/guidelines and www.pozible.com/ index.php/help/i/ project_guide.
3. UK platform Crowd Cube is a prominent example. See www. crowdcube.com/pg/ how-investing-works-70 for an overview of how investors on the Crowd Cube platform contribute funds towards companies in return for shares.
4. J. Wasik, "What you need to know to profit from crowdfunding", Forbes (6 June 2012), see tinyurl.com/7ce53t8.
5. ASIC, 12-196MR ASIC guidance on crowd funding (14 August 2012), see tinyurl.com/ckzlcx6.
6. Corporations Act, s.911A.
7. Corporations Act, Part 7.7.
8. Corporations Act, s.911D.
9. See the definition of "managed investment scheme" in s.9 Corporations Act.
10. Corporations Act, s.601ED.
11. Available online from the website of the US Government Printing Office at tinyurl.com/762c7pf. See also US Securities and Exchange Commission, Jumpstart Our Business Startups Act – Frequently Asked Questions About Crowdfunding Intermediaries (7 May 2012), at tinyurl. com/7f45ocj.
12. Corporate Law Economic Reform Program Proposals for Reform: Paper No. 5, "Electronic commerce: cutting cybertape – building business" (1997), quoted in ASIC Regulatory Guide 141 at RG 141.8.
13. See for example J. Best and S. Neiss, "Crowdfunding delayed again, blasted as 'top danger", VentureBeat (22 August 2012), which points to the "strong disinfectant power of social media" and social media's ability to create "crowddiligence". See tinyurl. com/96xjbgc.
14. Above n.4.
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