Securities Crowdfunding And Investor Protection
Joan MacLeod Heminway
University of Tennessee College of Law
May 2, 2016
CESifo DICE Report 2/2016
Crowdfunding remains a bit of an unknown in business finance. Securities crowdfunding, as a subset of that financing market, is no more familiar. Diverse investors and risks make for a complex regulatory puzzle.
Investor protection regulation has begun to develop in a path-dependent manner. Although there are some core similarities in rule types (e.g., as to offering and investment limits), there is a lot of variation beyond those fundamental similarities. Whether the crowdfunding regulations adopted in various jurisdictions adequately protect investors while, at the same time, promote capital formation through crowdfunding remains to be seen. Experience should give regulators enough information about crowdfunding investors and their risk profiles to enable a more accurate calibration of investor protection mechanisms. If crowdfunding business practices and regulations become more consistent across jurisdictions, investor protection rules may then begin to converge.
Securities Crowdfunding And Investor Protection – Introduction
As most who have been or worked with entrepreneurs know well, there are many practical and legal constraints on financing small business entities and projects. One significant practical impediment to capital access for small ventures is the lack of a pre-existing set of established contacts from and through which funding may be sought. In other words, it can be hard for entrepreneurs and others involved in small business undertakings to find people who want to contribute their financial wherewithal to unknown (and often untested) venturers and ventures.
Yet business finance is a creative enterprise. Participants in business capital formation, large and small, are constant innovators. They are forever fashioning new financing instruments and means of offering them to address barriers to access.
In this innovative business finance environment, the internet was destined to play a more leading role. Given the success of e-commerce and social media, it was only logical that businesses and projects needing funding and those keen to fund them would find each other online. Crowdfunding, as we have come to call this web-enabled, crowdsourced financing proposition, has been hailed as the panacea for the ills of small business capital-raising. A form of business finance almost unknown ten years ago, crowdfunding has become a popular topic in entrepreneurial circles and an established term in the lexicon.
Panacea, passing fad, or otherwise categorized, crowdfunding most often enables fundraisers and funders to meet through electronic intermediation.2 Participants not only do not know each other, but also cannot see each other in person or easily verify facts about the business or project seeking funding using methods customary in other, more traditional financing transactions. Crowdfunding’s use of the faceless internet to generate and consummate financing transactions between and among fundraisers and funders who may not have pre-existing relationships gives rise to concern that crowdfunding will be the source of rampant fraudulent activity – or at least frequent misunderstandings – giving rise to inherent agency costs and information asymmetries (Hazen 2012; Ibrahim 2015). Heminway and Hoffman (2011, 933) observed generally that:
Comprised of a rapidly changing set of internet business models, crowdfunding may be less transparent and more intangible to investors and regulators. Promoters of crowdfunding interests are often anonymous individuals and unknown entities. Moreover, in its prevalent current form as a small business startup financing method, crowdfunding shares many of the overall negative attributes of small business and start-up capital formation.
Media reports have begun to catalogue public instances of fraud and suspected fraud in crowdfunding (Fredman 2015).
The application of protective regulation in this environment is to be expected. And the transaction participant most likely to need protection is the individual or entity providing the funding. The key fears are those common to funding in any context: that the fundraiser will misappropriate received funds for personal benefit or employ them unwisely.
This article addresses the responses to these concerns in the context of crowdfunding involving investment interests recognized as securities under applicable law. It begins by defining and explaining securities crowdfunding (also known as investment crowdfunding, crowdfund investing, or equity crowdfunding) conceptually and legally – firstly by further describing crowdfunding and subsequently by outlining the specific attributes and regulatory consequences of crowdfunding involving securities. The article then elucidates investor protection in the securities crowdfunding setting, focusing on the diverse attributes of securities crowdfunding investors and the emerging elements of investor protection regimes tailored to securities crowdfunding. The descriptions, analysis, and observations in the article are founded in and rely primarily on US legal doctrine. International or multinational references are included, however, where possible.
The nature of securities crowdfunding
In order to intelligibly define securities crowdfunding, one must first define crowdfunding. Despite the omnipresence of crowdfunding in academic and industry conversations about small business finance, a universal definition of crowdfunding has proven rather elusive. In some circles, the definition of crowdfunding is contended. In general, however, it is fair to note that there are a number of helpful contextual definitions and taxonomies of crowdfunding. “As in any emergent field, the popular and academic conceptions of crowdfunding are in a state of evolutionary flux that makes complete definitions arbitrarily limiting” (Mollick 2014, 2).
This article takes an expansive view and defines crowdfunding as a method for financing businesses or projects that involves soliciting and securing funding from a broad, disaggregated mass of potential funders, typically through the internet.3 Belleflamme, Lambert and Schwienbacher (2013, 586) summarize the nature of crowdfunding in a manner consistent with the definition proffered here.
[T]he objective is to collect money for investment, generally by using online social networks. In other words, instead of raising money from a small group of sophisticated investors, crowdfunding helps firms to obtain money from large audiences (the “crowd”), in which each individual provides a very small amount. Such investment can take the form of equity purchase, loan, donation, or pre-ordering of the product … Bradford (2012b, 5) takes a similar view when he defines crowdfunding as “funding from the crowd – raising small amounts of money from a large number of investors.”
Definitions of crowdfunding are often accompanied or enriched by categorizations. For instance, crowdfunding may be used to solicit donations – funding for which nothing is promised in return. This form of crowdfunding is typically referred to as donative crowdfunding. However, crowdfunded offerings may also involve promises to funders of some specific benefit as a reward for their largess. These promises may be of a commercial or financial nature. For example, a business or project seeking funding may offer a discount on, presale of, or other preference relating to the product or service being developed or may offer another type of incentive reward (usually a promotional item related to the fundraiser’s business). Offerings in which these types of commercial promises are made are variously identified. Among the more popular descriptive labels: presale crowdfunding and reward crowdfunding. When promises of a financial nature (e.g., profit-sharing, revenue-sharing, or the provision of any other pecuniary benefit) are made to funders in a crowdfunding campaign, the resulting financial interest is commonly known as a security, and the campaign is most commonly characterized as securities crowdfunding or investment crowdfunding. With these categories in mind, Belleflamme, Lambert and Schwienbacher (2014, 588) synthesize the following salient definition of crowdfunding: “Crowdfunding involves an open call, mostly through the Internet, for the provision of financial