Crowdfunding is a quickly growing alternative financing method which in 2013 had reached $5.1bn.
There is no legal definition of "crowdfunding" and whilst a number of different models have arisen, crowdfunding can essentially be described as the provision by a large number of members of the public of finance for projects or ventures through an internet platform. Crowdfunding is used for varying types of projects but amongst the most popular are social causes, film, performing arts, music and recording arts. Whilst the largest market share is in the US, the market share of Europe is on the up.
In a crowdfunding transaction there are typically 3 actors:
- project owner;
- investors / contributors; and
- internet platform, which brings the other two together.
Usually the crowdfunding transaction will fix the target investment required and the funding period. If the target is not met by the cut-off date, the funding will not proceed and any funds collected will need to be returned.
Types of Crowdfunding
Essentially three models have developed:
- donations and rewards;
(a) Donations and rewards
In a donation model the investors/contributors give their funds without the expectation of any return, whilst in the reward model, the reward or return is of a non-financial nature.
In the lending model (also known as peer-to-peer lending), the borrowers (owners of the project) borrow money from the contributors (lenders) with a promise to return the funds plus interest.
This model involves either a profit sharing based transaction or an equity based transaction involving the acquisition of shares or bonds or other forms of securities.
For the purposes of this article we will confine ourselves to an analysis of lending and investment crowdfunding based models since the donations/rewards models do not display any risks to the contributors/investor as they do not expect to recover their money.
Risks and Benefits
Crowdfunding has inherent risks and benefits. In an era of increasing financial services regulation aimed at protecting retail investors (i.e. the consumers), crowdfunding presently stands at the antithesis of such an environment.
In a financial climate where it is very difficult for SMEs to source finance, particularly for start-up projects, crowdfunding presents a viable alternative to seeking funding from venture capital funds or angel investors.
The principle risks associated with crowdfunding are fraud (money not used for intended project), loss due to project failure, lack of liquidity, dilution of investment, mis-selling, no protection of investor or shareholder rights, operational risk and money-laundering.
It is argued by supporters of crowdfunding that contributors/investors know they are purchasing risky or unsafe investments in an unregulated environment and, thus, assume that risk. All risks identified with crowdfunding arise largely because crowdfunding currently operates outside any unitary or other regulatory regime.
Current Legal Regulation
As mentioned above there is no unitary or other regulation of crowdfunding. The European Banking Authority (EBA) has recently issued an opinion (EBA/Op/2015/03) to the effect that in order to level the playing field and avoid "regulatory arbitrage", EU regulations should be introduced based on existing EU laws. It is of the view that these risks can be addressed by application and extension of these existing laws. The lending model and the investment model raise difficult legal issues. In the case of the investment model which involves issuing of shares or other securities to contributors/investors, the provisions of the prospectus directive (2003/71/EC) (as amended) ("PD") and the Cyprus Prospectus Law, Law 114(I)/2005 may apply as the offering ever the internet platform of shares or securities can amount to a public offering. However the PD will not apply to offerings within the EU of less than €5m, the provisions of national legislation will apply instead. Under the Prospectus Law (which has transposed the PD), there are a member of exemptions from a requirement to publish a prospectus that will likely apply in the context of an investment based crowdfunding transaction:
- The offer is addressed to investors who acquire shares for a total consideration of at least €100,000 per investor;
- The offer is addressed to less than 150 persons.
Other legislation that will impact on investment type crowdfunding include:
- Companies Law, cap.113 (as amended) which prohibits private companies from offering shares to the public;
- Investment Services and Activities and Regulated Markets Law, Law 144(I)/2007 (transposing MiFID) which requires the licensing of any person that provides investment services or engages in investment activities, including the operation of a multilateral trading facility (MTF). The operation of the internet crowdfunding platform can be considered as an MTF, thus requiring licensing by CySEC.
In the case of the lending model or P2P/P2B platform other legal issues arise, particularly as to whether the provisions of the Banking Laws, the Payment Services Laws and the Consumer Credit Laws apply.
It is widely agreed that the lending model, as it does not involve the taking of deposits, does not constitute banking business for the purpose of the Credit Institutions Law, Law 66(I)/1997 (as amended) and accordingly no banking licence is required.
Payment Services Laws
The EBA in its opinion considered the Payment Services Directive (2007/64/EC) (transposed in Cyprus by the Payment Services Law, Law 128(I)/2009 (as amended)) to be the Directive that is most feasibly applicable to lending-based crowdfunding. The relevance and applicability of the PSD derives from the fact that crowdfunding involves through the internet platform money handling. The following services, as provided in the PSD, are part of lending-based crowdfunding:
- services enabling cash to be placed in or withdrawn from, a payment account as well as operations required for operating a payment amount;
- execution of payment transactions including transfers of funds on a payment account with user payment service provider or with another payment service provider;
- issuing and/or acquiring payment instruments; or
- money remittance.
In the context of the crowdfunding structure, it will be the internet platform that will be providing or facilitating these services, which will necessitate the platform to be licensed under the PSD legislation – in the case of Cyprus by the Central Bank of Cyprus.
Where the platform is a payment institution it will have to satisfy a number of conditions under the PSD legislation:
- capital requirements covering initial capital, own funds and safeguarding requirements;
- proportionate, appropriate, sound and adequate governance arrangements and internal control mechanisms;
- transparency of conditions and information requirements;
The PSD legislation does provide for a number of transactions that are not subject to the laws, however in the authors view none of these fit with crowdfunding transactions. It is our view that crowdfunding particularly lending based crowdfunding, falls within the PSD legislation which will require the licencing of the internet platform.
The scope of application of the PSD legislation is that it applies to the provision of payment services in Cyprus or cross-border between member states. In a crowdfunding transaction, what triggers the application of the PSD is that payment transactions are done in cash from the payer to the payee through the internet platform. This in our view brings crowdfunding within the PSD legislation.
In addition to the PSD legislation, there are other EU and domestic laws that have an application to lending based or investment based crowdfunding:
- Capital Requirements Directive 2013/36/EU (as transposed by Business Credit Institutions (Amendment) (No.2) Law, 2015);
- Capital Requirements Regulation (EU) 575/2013;
- Mortgage Credit Directive 2014/17/EU (which has not yet been transposed into Cypriot law but must be by 21 March 2016)
- Electronic money directive 2009/110/EU (which has been transposed in to Cyprus law by Electronic Money Law, Law 81(I)/2012;
- Anti-money laundering directive 2005/60/EC (transposed into Cyprus law by the Prevention and Suppression of Money Laundering Activities Law, Law 188(I)/2007 (as amended)).
The EBA in its opinion concludes that the PSD legislation is the "most feasibly applicable to lending-based crowdfunding", however only on the payment side of the activities and does not address issues of borrowers and lenders, thus duties, rights and obligations inter se. Furthermore, it would not appear to regulate other forms of crowdfunding, in particular investment based crowdfunding. It is the authors' view that to adapt existing EU or domestic legislation to cover crowdfunding is a less than satisfactory piecemeal approach. It is a preferred option to prepare a discreet piece of legislation which will apply to all types of crowdfunding and address all legal and regulatory risks. This is further emphasized by the divergence within the EU on how individual members regulate or do not regulate crowdfunding. A unitary legal and regulatory approach needs to be adopted.
We firmly believe that crowdfunding presents a very sustainable financing and inventing alternatives to participants and at the same time presents risks. For crowdfunding to develop even more, it requires clear and complete regulation but not in a piecemeal way.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.