ISE16/15-16

• Crowdfunding is an emerging channel of fundraising through intermediary online platforms, usually collected in smaller amount of funds from a large number of individuals or organizations. Buoyed by robust advancement in Internet technology, crowdfunding is becoming an important source of funds for small to medium-sized companies across the globe, especially for start-ups. In just four years, global funds raised through crowdfunding has surged by about 22 times to some US$34 billion (HK$267 billion) in 2015.^{1Legend symbol denoting According to an estimate made by Massolution, a research company specializing in the crowdfunding industry, global funds raised through crowdfunding surged from almost US$1.5 billion (HK$11.6 billion) in 2011 to US$34.4 billion (HK$266.7 billion) in 2015. See Crowdfundinglegalhub.com (2016).}
• In Hong Kong, the regulatory authorities consider that crowdfunding for business purposes is a form of financial instruments and should be subject to securities regulations. Yet the Hong Kong Government has stated most recently that it should "keep an open mind" when examining the need to amend existing rules or introduce new rules to support financial innovation.^{2Legend symbol denoting See the Report of the Steering Group on Financial Technologies released in February 2016 by the Financial Services and the Treasury Bureau.} It is further observed that a set of more flexible and accommodative measures have recently been introduced by the regulators in the United States ("US") and the United Kingdom ("UK") to cater for this emerging activity.
• In this connection, this issue of Essentials provides a review on the key issues of crowdfunding, followed by a discussion on the recent regulatory developments in the US and the UK which are amongst the forerunners in crowdfunding regulation.^{3Legend symbol denoting According to the International Organization of Securities Commissions, which comprises more than 115 securities regulators around the world and is recognized as the global standard setter for the securities sector, the United States ("US"), the Mainland of China and the United Kingdom ("UK") were the three largest crowdfunding markets in 2013 in terms of loan origination, with the respective global shares of 51%, 28% and 17%. Both the US and the UK are selected in this study because they have implemented regulatory changes over the past two years and are widely regarded as the forerunners in the regulation of crowdfunding activities around the globe.}

Key issues of crowdfunding and global regulatory trend

• Types: Crowdfunding can be classified into four major types, based on its funding nature. They include (a) donation-based where the collected funds are earmarked for charitable causes; (b) reward/presales-based where goods or services are delivered in return for fund contribution; (c) equity-based where investors acquire shares of a business investment for financial return; and (d) debt-based or peer-to-peer lending where debts are issued to borrowers for interest in return. As the first two categories of crowdfunding are mainly done for community purposes or do not involve financial return, they are not the regulatory focus around the world. On the other hand, the latter two categories involve financial returns, resulting in tighter supervision primarily by the securities regulators. This note will henceforth focus on equity crowdfunding and peer-to-peer lending.
• Economic benefits: As small enterprises generally have greater difficulties in getting bank loans to propel their business, crowdfunding bridges the financing gap. Flexible online financing is especially convenient to start-ups which have limited track records. For investors, crowdfunding opens up a new horizon of opportunities in some high-growth enterprises and helps them diversify their investment portfolios.
• Investor risks: Yet crowdfunding also brings significant risks to investors, including platform risks, as operators of online portals which act as financial intermediaries between investors and fundraising companies or individuals may shut down due to liquidity constraints or poor management. There are default risks, as business sustainability of debt/equity issuers is not ascertained, especially when the failure rate of start-ups could exceed 50%.^{4Legend symbol denoting According to an estimate, start-ups have a 50% chance to go under within the first five years of operation. See International Organization of Securities Commissions (2014), p.10.} Investors may also face asymmetric information risks, as they need to make investment decision based on very limited information provided by equity/debt issuers.
• Global regulatory trend: Regulators are thus striking an appropriate balance between the objectives of fostering start-ups and investor protection. Based on a global survey released at end-2015, regulation of crowdfunding is still "in their infancy", though some regulators like the US and the UK have introduced some facilitative measures in recent years.^{5Legend symbol denoting See the survey report published by the International Organization of Securities Commissions in December 2015 on the regulatory approaches taken by members towards crowdfunding.}
• Local development: In Hong Kong, most of the online crowdfunding platforms are mostly donation or reward related, but their market size is not known.^{6Legend symbol denoting There is no reliable estimate on the size of crowdfunding market in Hong Kong, although there are some active online portals conducting crowdfunding activities mainly based on donation or reward. See the Financial Services Development Council (2016), pp. 17-19.} Equity crowdfunding and peer-to-peer lending are largely inactive due to stringent regulatory requirements, such as the Securities and Futures Ordinance, the Companies (Winding Up and Miscellaneous Provisions) Ordinance and other regulations on offers of investments, intermediary licensing and conduct of business requirements laid down by the Securities and Futures Commission.^{7Legend symbol denoting See Securities and Futures Commission (2014).} For instance, companies raising funds on equity crowdfunding platforms seeking exemption from the prospectus requirement required by the securities regulation are potentially confined to professional investors with a portfolio of at least HK$8 million or else subject to a maximum of 50 investors. As to the operators of such online portals, they may also need to apply for relevant securities licences which require a minimum paid up share capital of HK$5 million.

Regulation of crowdfunding in the United States

• On the back of its vibrant start-up activities, the crowdfunding market in the US is the largest in the world, taking up about half of the global sum. In the more recent years, the federal government has set up a tailor-made regulatory regime on equity crowdfunding, freeing it from the tight oversight of existing securities regulation.
• In April 2012, the US President Obama signed the Jumpstart Our Business Startups Act ("JOBS Act") into law, exempting equity crowdfunding from the relevant securities regulation. This is followed by the announcement of the final rules on equity crowdfunding in October 2015 under Title III of the JOBS Act, which will come into effect in May 2016.
• In a nutshell, the new regulatory regime on crowdfunding aims to ease the compliance requirement for platform operators and equity issuers, and to protect investors. The following is a summary of key regulatory features:
  
  

  (a)	Registration of online platforms: All crowdfunding portals need to be registered with the Securities and Exchange Commission ("SEC"), although the compliance requirements are less stringent than those for brokers and dealers in the securities market;
  (b)	Upper limit of funds raised by a company: Fundraising companies must be incorporated in the US, and a company can raise no more than US$1 million (HK$7.75 million) through crowdfunding platforms within a 12-month period;
  (c)	Disclosure of information: Fundraising companies need to disclose basic business information to investors, including capital structure, directors and officers, business plan and risks, intended fund usage, and financial statements on a regular basis;
  (d)	Investment ceiling of investors: All US citizens can invest in crowdfunding, subject to an investment ceiling.8Legend symbol denoting The final rule of SEC announced in October 2015 removes the previous restriction requiring investors to have a minimum annual income of US$200,000 (HK$1.55 million) or net worth of US$1 million (HK$7.75 million). All US citizens can invest in crowdfunding after the effective date of 16 May 2016. For those investors having an annual income or a net worth of investable assets below the threshold of US$100,000 (HK$775,000), they can invest at most US$2,000 (HK$15,500) or 5% of the their annual income or net worth of investable assets, whichever is greater. If their annual income and net worth of investable assets are above the threshold, they can invest up to 10% of their annual income or net worth of investable assets, whichever is lesser, but subject to a ceiling of US$100,000 (HK$775,000); and
  (e)	Risk acknowledgment and right of withdrawal: US Investors in crowdfunding need to complete a questionnaire, acknowledging the potential risks in such investment. They also have an unconditional right to withdraw from the investment for any reason until 48 hours prior to the deadline specified in the issuer's offering materials.

• As regards debt-based or peer-to-peer lending, it is subject to the same regulation on equity crowdfunding in the US, as SEC considers that loans issued through peer-to-peer lending platforms are securities.^{9Legend symbol denoting In November 2008, SEC had ruled that the debt notes issued by a peer-to-peer lending platform as securities. As such, debt-based crowdfunding is subject to the relevant securities regulation.} Nevertheless, the announcement of the aforementioned final rules on crowdfunding should relieve some of the compliance burden faced by such platforms and debt issuers.
• However, on top of SEC regulation, peer-to-peer lending to individual borrowers touches upon consumer credit, and hence, is also regulated by other laws and regulations in the US.^{10Legend symbol denoting As an illustration, given that peer-to-peer lenders usually issue consumer credit, they may be subject to the Truth in Lending Act, Equal Credit Opportunity Act, Fair Credit Report Act, Electronic Transfer Act, and Fair Debt Collection Practice Act in the US.} This in particular includes consumer protection, data privacy and anti-money laundering. As such, it is noted that there are calls from peer-to-peer lenders in the US to simplify the relevant regulatory requirements.

Regulation of crowdfunding in the United Kingdom

• The crowdfunding market in the UK is the third largest in the world, with a global share of around 17%. Both equity crowdfunding and peer-to-peer lending are regulated under the Financial Services and Market Act 2000 ("FSM Act"). The Financial Conduct Authority ("FCA") is the regulator, implementing new regulatory measures on crowdfunding with effect from 1 April 2014, after a public consultation exercise conducted six months earlier.^{11Legend symbol denoting In March 2014, FCA issued the policy statement and final rules on its regulatory approach to crowdfunding over the Internet. It provided its response to the feedback gathered from the public consultation exercise started in October 2013, and published its final rules that came into effect on 1 April 2014.}
• Unlike the US, FCA does not set up a new regulatory regime over equity crowdfunding, but fine-tune the existing securities regime to cater for this new activity. The following are the key provisions of the final rules:
  
  

  (a)	New financial instrument: "Non-readily realisable securities" is introduced into the FSM Act, referring to shares or debt securities not listed on the stock markets but carrying significant risks;
  (b)	Platform authorization: Equity crowdfunding platforms conducting business of such securities need to be authorized by FCA beforehand;
  (c)	Information disclosure: While firms issuing such securities need to provide clear and fair information to investors, business promotion is confined to high net-worth or sophisticated investors, or those retail investors with investment advice12Legend symbol denoting In short, high net worth investors refer to those investors with an annual income of at least £100,000 (HK$1.19 million) or net assets of at least £250,000 (HK$2.96 million). Sophisticated investors refer to those who have a written certificate confirming that they have sufficient knowledge to understand the risks associated with investment activity in non-mainstream pooled investments. Retail investors are the rest of investors.; and
  (d)	Investment limit: Retail investors need to certify that they will not invest more than 10% of their investible assets on such securities.

• As to peer-to-peer lending in the UK, it used to be regulated as consumer credit by the Office of Fair Trading, but it has been transferred to FCA for regulation as from 1 April 2014. FCA has thus introduced a newly regulated activity named as "operating an electronic platform in relation to lending" into the FSM Act in 2014. The following are the key regulatory features:
  
  

  (a)	Regulated lending activity: The newly regulated activity applies to loans where the lender or borrower on such platforms is an individual; and the amount of loan is £25,000 (HK$296,250) or less;
  (b)	Minimum capital of platform operators: Operators of peer-to-peer lending platforms must have authorization from FCA for continuation of activity. They need to meet the minimum capital requirement of a fixed minimum of £20,000 (HK$237,000) before 1 April 2017 and £50,000 (HK$592,500) thereafter, or 0.05%-0.2% of the value of loaned fund13Legend symbol denoting The loan-based minimum capital requirement is calculated as the sum of (a) 0.2% of the first £50 million (HK$592 million) of total value of loaned funds outstanding; (b) 0.15% of the next £200 million (HK$2.37 billion) of total value of loaned funds outstanding; (c) 0.1% of the next £250 million (HK$2.96 billion) of total value of loaned funds outstanding; and (d) 0.05% of any remaining balance of total value of loaned funds outstanding above £500 million (HK$5.93 billion)., whichever is the higher;
  (c)	Risk management of the platforms: Operators of such platforms must communicate with their customers in an easily understandable manner and display the risks or warnings. In addition, the platforms must have a resolution plan so that loan repayments to lenders will continue in the event that the platforms collapse; and
  (d)	Disclosure of business information: Platform operators need to submit regular reports to FCA through its online reporting system. Business promotion of peer-to-peer lending (including comparison of interest rates) must be fair, clear and not misleading, ensuring that investors make informed decisions.

• By and large, the regulatory approach in the UK is more disclosure-based. In February 2015, FCA completed an interim review over the regulation of crowdfunding after implementation of such measures in less than one year. It noted that the number of authorized loan-based crowdfunding firms or seeking authorization in the UK had increased from 50 to 56 during April-December 2014, and the equity-based crowdfunding firms from 14 to 35. FCA thus concluded that there was "no need to change" its regulatory approach to crowdfunding, pending a full review scheduled within 2016.

Observations

• Both US and UK regulators support crowdfunding activity by easing their compliance requirements. Yet their regulatory approaches appear to vary in terms of scope and complexity. Taking equity crowdfunding as an example, the US regulator has set up a new regulatory regime, while the UK regulator fine-tuned its securities framework to cater for this emerging activity.
• There are some common regulatory features in investor protection. They include (a) management of platform risks; (b) requiring equity/debt issuers to disclose essential business information; and (c) putting extra safeguard to the investment made by small investors.

Prepared by Kari CHU
Research Office
Information Services Division
Legislative Council Secretariat
20 April 2016