Cross-border Crowdfunding within the European
Union: Striking a Balance between Improving Access to
Capital in the Single Market and Investor Protection
Master Thesis
Supervisor: Tawnee Hill LL.M.
Master Law and Finance (LL.M.) / University of Amsterdam
(Word count: 12541)
Desiree Theresa Ongkowidjaja 12830933
Abstract
Following the global financial crisis in 2008, banks have become more conservative in lending capital and start-‐ups and Small Medium Enterprises (SMEs) faced difficulties in raising capital. As a result, start-‐ups and SMEs have resorted to alternative methods of financing, including by means of Crowdfunding – a novel form of technology driven financial service that operates with internet platforms that match potential investors and entrepreneurs in search of capital. In response to the emergence Crowdfunding, and in response to the FinTech Action Plan as well as European Union’s aim in building the Capital Market Union the European Commission has published a proposal for a “Regulation on European Crowdfunding Service Providers (ECSP) for Businesses”. However, legislators of the EU belive that in order for Crowdfunding to work, the regulation must strike a balance between protecting investors and establishing easy market access for SMEs. With this goal in mind, EU legislators have proposed the implementation a European license to facilitate SMEs’ market access and simultaneously proposed a Key Investment Information Sheet that will ensure transparency and sufficient information disclosure, so that investors’ protection will be safeguarded. This paper will explain that the current proposed regulatory requirements on the European license and on the KIIS do not stike this balance yet.
Key words: Crowdfunding, Alternative Financing, Proposed Crowdfunding Regulation (COM/2018/0113), Investor Protection, Key Investment Information Sheet, European Passport
List of Abbreviation
CCD = Consumer Credit Directive CMU = Capital Markets Union
CSP = Crowdfunding Service Provider ECN = European Crowdfunding Network
ECSP License = European Crowdfunding Service Provider License
ECSPR = (Proposed) European Crowdfunding Service Provider Regulation ESMA = European Securities and Markets Authority
EU = European Union
FR-Crowdfunding = Financial Return Crowdfunding KIIS =Key Investment Information Sheet
MAR = Market Abuse Regulation MS = Member State
MTF = Multilateral Trading Facility NCA = National Competent Authority
OECD = Organisation for Economic Co-operation and Development SME = Small and Medium Enterprise
ECSP = European Crowdfunding Service Provider SPV = Special Purpose Vehile
TEU = Treaty of the European Union
Index
Introduction………...5
I. Access to Capital of SMEs and Start-ups within the European
Union………..8
II. Crowdfunding as Alternative Financing
A. Crowdfunding: its Evolution and its Function as Capital
Source?... ……….12 B. Benefits of Crowdfunding and the Problems it Solves?...15 C. Problems and Risks Posed by Crowdfunding?...16
III. Proposed Regulation for European Crowdfunding Service Providers
(ECSP) for Business (COM/2018/0113) A. Aims and
Objectives………17 B. Legal
Basis………19 C. Scope……….20 D. Substantive Regulatory Requirements Introduced
i. Authorization and European
License……….………21 ii. Key Investment Information Sheet………23
IV. Achieving a balance
A. Investor
Protection………26 B. Normative Standard of
Balance……….………28 C. Balance Achieved?
i. Efforts and Flaws of European License in Adequately Support the Access to Capital whilst Protecting
Investors…………..………31 ii. Efforts and Flaws of KIIS in Adequately Safeguarding Investor
Protection whilst Promoting Access to
Capital………33
iii. Does the European License and KIIS together strike the
balance?………36
V. Conclusion………37
Introduction
After the emergence of the financial crisis in 2008, banks have become more conservative in lending capital to start-ups and Small and Medium Enterprises (hereinafter “SME”). However, statistical research has shown that start-ups and SMEs are the main contributors to the development of the economy and are the biggest providers of innovation and employment.1 Due to the crisis, start-ups and SMEs have found it particularly challenging in finding capital.2 Banks had to respond to the financial crisis by adhering to the more stringent regulations imposed to them, leading to the massive credit crunch. Additionally, most start-ups and SMEs that are troubled in finding financial resources have little to almost no data on their (credit) history as well as collateral to provide to their lenders and investors as a means of security in addition to facing great structural asymmetry of information. As a result thereof, start-ups and SMEs have resorted to alternative methods of financing, including crowdfunding. Crowdfunding is a novel form of technology driven financial service that operates with internet platforms matching potential investors with entrepreneurs and/or business projects that are in search for capital. There are four forms of crowdfunding, namely investment-based crowdfunding, lending-based crowdfunding, reward-based crowdfunding and donation-based crowdfunding; the first two are also categorized as financial-return crowdfunding (hereinafter “FR-crowdfunding”) and both of those first two terms together will be referred to as such in this thesis. Due to the varying rules, approaches and interpretations that regulate crowdfunding platforms in each Member State of the European Union as well as through the recognition of the importance of crowdfunding as an alternative method of finance for the economic development in the European Union (EU), the European Commission has published a proposal for a “Regulation on European Crowdfunding Service Providers (ECSP) for Businesses”3 (hereinafter “ECSPR”), which regulates all FR-crowdfunding activities. Reward-based and donation-based crowdfunding, is not covered within the scope of the ECSPR because the inclusion thereof “would be disproportionate as they do not deal with financial products and the
1 Oliver Wyman, 'Towards Better Capital Markets Solutions For SME Financing' (Oliver Wyman 2014), p. 2-‐4; John Armour and Luca Enriques, 'The Promise And Perils Of Crowdfunding: Between Corporate Finance And Consumer Contracts' (2018) 81 The Modern Law Review, p. 51. 2 Ibid (Armour et al).
3 European Commission, Proposal for a “Regulation of the European Parliament and of the Council on European Crowdfunding Service Providers (ECSP) for Business” 2018/0048 (COD), 8.3.2018, COM(2018) 113 final (hereinafter “ECSPR”).
information asymmetries that these products create” 4 and are not considered as financial services by the European Commission.5 Additionally, reward-based crowdfunding is already regulated under the EU consumer protection legislation, to which strict rules are applicable in safeguarding the consumers of this type of crowdfunding.6 As a result, the focus of this thesis will be on the regulation of financial-return crowdfunding. The ECSPR is also part of the FinTech Action Plan7 and one of Commission’s priorities of building a Capital Markets Union (hereinafter “CMU”) that aims to “tackle investment shortages by increasing and diversifying the funding sources for European businesses – especially SMEs – and term projects and to provide more options and better returns for savers and investors”8 as well as to enlarge financial access to entrepreneurs requiring funding, respectively. Objectives that follow from this initiative are not only to widen the financial opportunities of capital seeking businesses, but also to safeguard potential investors from risks so that they are more inclined in getting involved in the two types of crowdfunding activities the ECSPR regulates.
Given the introduction of the ECSPR as a response to the need to develop crowdfunding services within the EU, to create a harmonised crowdfunding regulation on EU-level, to protect Investors and to promote the development and funding access of start-ups and SMEs beyond one national jurisdiction, this thesis seeks to answer the following research question:
“To what extent will the proposed regulation, by means of introducing Key-Investment-Information-Sheet and the European Crowdfunding Service Provider (ECSP) License, achieve the balance between its objectives of investor protection and meeting the funding
needs of start-ups and SMEs in the European Union?”.
Special attention is given to the introduction of the Key-Investment-Information-Sheet (hereinafter “KIIS”) and the European Crowdfunding Service Providers (hereinafter “ECSP”) License, as they respectively contribute to the improvement of information disclosure as a means of protecting investors as well as promote the possibility of start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start- start-
4 ECSPR Explanatory Memorandum, p. 2
5 < https://ec.europa.eu/commission/presscorner/detail/en/MEMO_18_1423 > last accessed: 7 June 2020.
6 Ibid(n4).
7 European Commission, “Communication from the commission to the european parliament, the council, the european central bank, the european economic and social committee and the committee of the regions. FinTech Action Plan: For a more competitive and innovative European financial secotr” (COM(2018) 109/2), pp 5-‐7.
8 Lars Klöhn, ‘The Regulation of Crowdfunding in Europe’ in Douglas Cumming and Lars Hornuf, The
ups and SMEs in developing their opportunities of accessing finance beyond their national jurisdiction, i.e. home Member State (hereinafter “MS”), both being part of the objective of the Commission in implementing the ECSPR. By answering this research question, the end goal of this thesis is to fill in the gap in the current literature on this specific topic as well as contributing in warning start-ups, SMEs, investors, crowdfunding platforms as well as European and national legislators and competent supervisors in the future shortcomings of this ECSPR.
Each chapter and subchapter of this thesis will answer these thoroughly thought sub-questions with the goal of successfully arriving at the appropriate answer to the aforementioned question. Chapter I will answer the question as to what are the funding needs of SMEs and start-ups and what legal and regulatory challenges are SMEs and start-ups facing in accessing finance within the single market of the European Union. Chapter II will delve deeper into questions on what crowdfunding is, how the business model work works, how it has evolved, what its benefits and drawbacks are and to what extent crowdfunding is used by start-ups and SMEs in the European Union as a source of financing and to what extent is crowdfunding used by investors as a medium for placing investments. Chapter III will discuss the proposed regulation COM/2018/0113 in greater detail, answering questions on what it is, what it’s legal basis is, why there is a call for a Union-level regulation, and will discuss in depth the substantive requirements of the proposed regulation. Chapter IV, will analyse as to what extent the proposed regulation, through the implementation of the Key Investment Information Sheet as well as the European License, has achieved the balance between enabling easier capital access for SMEs and start-ups within the single market and protecting the concerned investors.
In order to answer all the above-stated questions and most importantly the main research question, the main research tools consulted throughout this research include legislations, both proposed and enacted, relevant case law, literature from books and journal articles as well as other official publications. This thesis falls under the category of “Classic Legal Research” and the research method, thus, mimics the “judicial method of legal interpretation”.
I. Access to Capital of SMEs and Start-ups within the European Union
SMEs are important contributor to the economic development, innovation and employment of a country, a specific region, such as the EU and even globally. In fact, nine out of ten existing businesses worldwide fall under the category of SMEs, namely firms that employ less than 250 employees.9 Their impact to the economy is large, as SMEs account to 60% of the employment worldwide and circa 80% of the jobs available just in developed countries alone.10 Figure 1 below illustrates the impact of SMEs to the employment and the Gross Value Added, regionally and on a global level. As depicted in Figure 1, in the European Union alone, roughly 65% of jobs are established by SMEs. In addition to that, roughly 55% of the Gross Value Added of the European Union, that is the Gross Domestic Product plus the Subsidies on Product minus the Taxes on products,11 is contributed by the existence and operation of all SMEs in the EU. SMEs are, thus, a paramount component to the Union’s economy and economic development and it is imperative for the Union to support its needs and take all necessary measures required to foster its development.
9 Ibid (n1, Perterhoff et al), p. 2-4.
10 Naoko Nemoto, David Storey, Bihong Huang, “Optimal Regulation of P2P Lending for Small and Medium-Sized Enterprises“Working paper 912, Asian Development Bank Institute (2019), p. 1 ; See also Zorica Golic, “Advantages of Crowdfunding as an alternative source of financing of small and medium-sized enterprises”, Proceedings of the Faculty of Economics in East Sarajevo (8) 2014, p. 40: “In the EU, more than 66% of all employees work in SMEs, and in developing countries this percentage is much higher”.
Figure 112
An important aspect to the development of SMEs as well as start-ups, namely firms that employ less than 100 full time employees,13 is their access to funding throughout their stages of development. Unfortunately, for these types of firms, the access to such a necessity does not come without challenges. This is particularly burdensome for start-ups and SMEs that are at the very beginning of their development cycle, when “seed capital” is required to establish their existence, hindering start-ups to rise above the status of SME, withholding their growth entirely. In fact, it has been estimated that a total of USD 3.5 trillion of finance is demanded by SMEs that is currently not met. Moreover, a third of the global funding gap present at the moment, namely amounting to USD 1.5 trillion, comes from developed Organization for Economic Co-operation and Development countries, which includes MS of the EU.14
This challenge became particularly significant in 2008 with the occurrence of the global financial crisis, as a prolonged economic stagnation in countries with developing economies as part of the recovery followed after. This came with the implementation of Basel III, in which banks had to adhere to more stringent requirements. Moreover, the financial crisis has not only left costumers of banks with little trust in the banks, but the historically low interest rates have also lead investors to seek for other investment venues that can offer them with a higher profit.15 In order for the banking sector to maintain its significance in the financial market, not responding to these more stringent requirements and not responding to the crisis to refrain from further and future systemic risks. This all together has caused banks more conservative and also unable in providing loans to consumers. This credit crunch by banks was especially made to start-ups and SMEs as they carry high default rates, lack historical (credit) data, limited operating history and have limited to no collateral to provide to banks. 16 Additionally, banks have become more reluctant in facilitating these companies funding as lending smaller amounts to start-ups and SMEs is overall much less profitable as compared to investing in larger enterprises.
12 Ibid (n1, Peterhoff et al), p. 2-‐4. 13 Ibid, p. 7.
14 Ibid, p. 2-‐4
15 Tanja Jorgensen, ‘Peer-to-Peer Lending – A New Digital Intermediary, New Legal Challenges’,
Nordic Journal of Commercial Law 2018, Issue 1, p. 233.
16 Dr. Md. Bokhtiar Hasan, ‘SMEs Access to Capital Market: An Alternative Financing Tool’,
Traditionally European SMEs have relied on banks for financing their companies during the early stages of growth, before going public on the primary capital market. 17 Unfortunately, and corresponding to the reasoning provided earlier, this is not the case. In fact, only 3% of SMEs in Europe on average rely on equity as a means of funding.18 The reason to this low number of SME participation in the capital market is relatively manifest; SMEs generally face proportionally greater costs than larger corporations when offering shares on the primary market.19 The initial cost and on-going listing requirements that most equity platforms demand, with all the legal costs that come along, are the main contributors to the high cost of listing.20 As a result, the opportunity for start-ups and SMEs to conduct go public only becomes available once they have become well established. Another factor that adds to the difficulty of SMEs in accessing capital is because institutional investors are reluctant to buy and trade the small amounts of issuances that SMEs do, curtailing the liquidity of their issuances on exchanges.21
With respect to the failures and difficulties of SMEs and start-ups in obtaining loans from banks and in raising finance in the equity market, the development of crowdfunding, for instance, where lending occurs between peers without the involvement of formal financial institutions, is a seen significant opportunity that helps SMEs and start-ups overcome these challenges and fill the discussed financial void.22 Given the great importance and great role start-ups and SMEs have in contributing to the economic development of a country and of the EU, regulators and experts are called to solve these problems in terms of improving the development of alternative sources of financing in order to foster the development of the economy. Governments are called to decrease the widening funding gap between lending to SMEs and to larger, established companies by improving the instruments that facilitate the of flow of capital to SMEs and by guaranteeing that the institutional and financial environment is conducive for SMEs to raise capital. Changes can be made with respect to the regulatory requirements applicable, the costs of issuance, the improvement of trading and liquidity and other
17 EuropeanCommission, Commission Staff Working Document, Impact Assessment, at 12, SWD (2015) 255 final.
18 Ibid (Impact Assessment).
19 Elif Härkönen, 'Crowdfunding And The Small Offering Exemption In European And US
Prospectus Regulation: Striking A Balance Between Investor Protection And Access To Capital?' (2017) 14 European Company and Financial Law Review, p. 124.
20 Ibid (n1, Peterhoff et al), p. 6. 21 Ibid.
incentives such as grants or tax incentives.23 This all is so that prudential needs of investors, such as protection from defaults, are met, so that SMEs are no longer financially burdened, yet assisted in accessing these alternative financial markets and so that investors feel secured by the possibility of exiting the market when it wishes and as a result, making the alternative possibilities of raising finance more attractive to investors and to start-ups and SMEs that are seeking capital. This does not mean that regulators and experts will not face any obstacles in solving this problem; a challenge will definitely be encountered in the improvement of regulatory requirements where, for instance, lowering disclosure requirements allows capital seekers to access capital easier, yet does the opposite of improving the protection of (potential) investors from risks of default.24 Crowdfunding as an alternative method of financing will be elaborately discussed in Chapter III and a greater discussion on the regulatory changes and challenges will be discussed in the rest of this thesis.
II. Crowdfunding as Alternative Financing
Alternative finance is described by Wierzbicka as “an innovative segment of the financial market whose goal is to provide consumer loans, finance start-ups, and provide capital to the SME sector”, which bypasses the long preparatory processes common in traditional funding sources, such as banks, charitable institutions and the state, and relies on internet platforms and social networks as a distribution channel.25 Crowdfunding is an alternative to traditional financing, such as traditional bank financing or entering into the capital market,26 in order to raise small amounts of capital from the crowd by means of technological intermediaries, i.e. platforms. In the previous chapter we have discussed the need of start-ups and SMEs in the EU to access capital as well the problems start-ups and face due to the funding-gap available to them on the financial market. In this chapter, we will discuss the relevance of crowdfunding as an alternative method of financing available to start-ups and SMEs. In subsection A, we will discuss what crowdfunding is, its function as a source of capital, the different types of crowdfunding models available
23 Ibid (n16), p. 4. 24 Ibid.
25 Katarzyna Wierzbicka, ‘Crowdfunding as an Alternative Method of Raising Capital’ 14(4)
e-Finanse 2018, p.56-66.
26 Guido Ferrarini and Eugenia Macchiavello, ‘FinTech and Alternative Finance in the CMU: The Regulation of Marketplace Investing’ in Danny Busch, Emilios Avgouleas, and Guido Ferrarini, Capital
and the evolution of crowdfunding. In subsection B and C, we will discuss in great detail, the benefits and the potential risks crowdfunding poses to its users, i.e. Project Owners as defined in Art. 3(1)(f) ECSPR – namely start-ups and SMEs seeking capital, and Investors as defined in Art. 3(1)(g) ECSPR- namely the crowdinvestors and crowdlenders, and to the European single market, respectively.
A. Crowdfunding: its Evolution and its Function as Capital Source
Crowdfunding is an innovative funding method that enables Project Owners (entrepreneurs seeking capital, typically start-ups and SMEs), to make an “open call” to a greater public for the purpose of funding specific projects, ideas or new ventures, raising small amounts of money from a large number of investors using internet-based platforms as the intermediary.27 Crowdfunding is viewed as a way of reducing the funding gap that is present in the early stages of newly established companies, also referred to as “the early-stage gap”, as raising capital through venture capitalists and banks may only be widely available in the later, more developed phase of these new-ventures, once the start-up companies can provide (tangible) collateral and prove credit history.28 Crowdfunding only prominently emerged and evidently grew after the global financial crisis in 2008 when the consumer credit market was impaired and start-ups and SMEs were inclined to search for alternative ways of raising capital.29 The rise of crowdfunding as an alternative method of traditional financing is also attributed by the emerging technological advances associated with the development of the internet at the same time as the era of the global financial crisis.30 The progression of the internet has positively contributed the emergence
27 Antonella Francesca Cicchiello, 'Harmonizing The Crowdfunding Regulation In Europe: Need, Challenges, And Risks' [2019] Journal of Small Business & Entrepreneurship, p. 1
28 Dennis Brüntje and Oliver Gajda, Crowdfunding in Europe: State of the Art in Theory and
Practice (Springer Berlin Heidelberg 2015), p. 25; European Commission, “Frequently Asked
Questions: Proposal for a Regulation on European Crowdfunding for Business”
<https://ec.europa.eu/commission/presscorner/detail/en/MEMO_18_1423 > last accessed: 7 June 2020.
29 Michael M. Gierczak et al., ‘Crowdfunding: Outlining the New Era of Fundraising’, in Dennis Brüntje and Oliver Gajda, Crowdfunding in Europe: State of the Art in Theory and Practice (Springer Berlin Heidelberg 2015), pp. 7; Inês Tomaz da Costa Pacheco, ‘Regulating the Online Peer-to-Peer Lending Industry: A Proposal for a Regulatory Approach in the US’ (2018) Tilburg University, p. 4.
30 See: Sameer Kochhar, Growth and Governance: Essays in honour of Nandan Nilekani (Skoch Media Pvt Ltd 2016): “The growth of the Internet in India has led to concepts like ‘Crowdfunding’ slowly gaining popularity to fund project by raising small amounts of money from a large number of people online. This itself has led to start-‐ups that have created crowdfunding platofrms like Wishberry and Ignite Intent that offer consulting services to link start-‐ups with potential invsetors and donors”
of crowdfunding due to the internet’s ability in lowering the costs of raising funds, by enabling the distribution of information about small projects as well as small entrepreneurs to become easier.31
The capital raised through crowdfunding may take place in four different forms, such as through loans (“lending-based crowdfunding”), by means of investments in equity of other financial instruments (“investment-based crowdfunding”), in the form of a donation (“donation-based crowdfunding”) or in exchange of a reward, such as a product sample or the future product (“reward-based crowdfunding”). The first two types of crowdfunding, are classified as “FR-crowdfunding” and permits the internet-based crowdfunding platforms to intermediate lending and investments with the expectation of profits or financial return.32 In lending-based crowdfunding, “the crowd lends money to a company with the understanding that the money will be repaid with interest. It is very similar to traditional borrowing from a bank, except that you borrow from lost of investors.”33 In equity-based crowdfunding, the “sale of a stake in a business to a number of investors” is made “in return for investment. The idea is similar to how common stock is bought or sold on a stock exchange, or to a venture capital”.34 This thesis will only focus on crowdfunding business models that are covered within the scope of the Proposed Regulation and is considered as a “Crowdfunding service” under the definition of the Proposed Regulation.35
For one to understand the dynamics of crowdfunding and see the benefits, risks and essence of the regulation of crowdfunding and particularly of crowdfunding platforms, it is necessary to understand the functioning of crowdfunding and its constituent elements.36 Figure 2 illustrates how crowdfunding operates. There are two essential aspects of crowdfunding; The first is that the crowdfunding is a two-sided market, “where two groups of agents”, namely the Investor and the Project Owner as depicted in Figure 2, “are interacting on a crowdfunding platform”.37 Secondly, this
31 Ibid (n1, Armour et al), p 52; Ajay Agrawal, Christian Catalini and Avi Goldfarb, 'Some Simple Economics Of Crowdfunding' (2014) 14 Innovation Policy and the Economy, p. 6.
32 Eugenia Macchiavello, 'Financial-Return Crowdfunding And Regulatory Approaches In The Shadow Banking, Fintech And Collaborative Finance Era' (2018) 14 European Company and Financial Law Review, p. 665.
33< https://ec.europa.eu/growth/tools-‐databases/crowdfunding-‐guide/what-‐is/explained_en > last accessed: 7 June 2020.
34 Ibid.
35 Art. 3(1)(a)(i) jo. Art. 3(1)(a)(ii) CSPR.
36 Philipp Haas, Jan Marco Leimeister and Ivo Blohm, 'An Empirical Taxonomy Of Crowdfunding Intermediaries' [2014] International Conference on Information Systems (ICIS), p. 2.
crowdfunding platform, which the ECSPR aims to regulate, acts as a financial intermediate between an Investor and a Project Owner. In contrast to traditional financial intermediaries, such as investment banks, crowdfunding platforms (hereinafter “Crowdfunding Service Providers” or “CSP”) “are not involved in the actual funding process” and “do not borrow, pool, and lend money on their own account”.38 The intermediary provides certain functionalities and performs as electroning matching market in order to overcome information asymmetries and to minimize transaction costs”.39
Figure 2.40
Although this diagram illustrated in Figure 2 is generally representative to all types of crowdfunding in the way that in each crowdfunding form a two-sided market is applicable and a crowdfunding intermediary is present, one has to consider, however, that the specificity of this model differs for each type of crowdfunding, specficially with regards to the return types. With regards to lending-based crowdfunding, the expected return would be in the form of interest, which amount is appropriate to the amount of loan offered. In equity-based crowdfunding, profit shares would be the appropriate return from the project funded. Reward-based crowdfunding would return the investors with non-monetary returns such as goods or services. While these three forms of crowdfunding may expect a return, donation-based crowdfunding receive no compensation.41
38 Ibid, p. 5. 39 Ibid.
40 Ibid (n30), p. 11. 41 Ibid (n38), p. 7.
B. Benefits of Crowdfunding and the Problems it Solves
Crowdfunding comes with a lot of benefits for both, the Investors and for the Project Owners. The former, such as the crowd-lenders and crowd-investors, might be granted higher returns with FR-Crowdfunding as compared to the classical forms of investments, due to the higher risk that follows with such investments. Moreover, crowdfunding allows investors to diversify their investment and lending opportunities to sectors and industries that might be novel or uncommon42. However, the first, main and most important, benefit of crowdfunding is that, by reason of the lower transaction costs, i.e. the costs and expenses usually spent on brokers or agents as a commission for their service, as explained in the subsection above, Project Owners now have the potential of expanding the access to financing opportunities for innovation and Investors have a greater chance of accessing financial markets and better means of diversifying their investment and lending. Crowdfunding also allows funding possibilities to niche projects that are otherwise perceived as non-profitable and may, therefore, find difficulties in raising funding from traditional sources.43
Secondly, De Buysere is of the opinion that start-ups and SMEs use crowdfunding for market research and marketing purposes.44 Due to the decreased transaction costs and the large network, crowdfunding allows the simplification of sharing information on certain projects or innovations across geographical borders and thus can create viral marketing effects.45 These marketing and market research benefits provide these Project Owners a further advantage of competition, as interests in new projects can be provoked in the early stages of their development.46 This is particularly the case when the Investors are also the potential customers or assist the project through their own network.47 Thirdly, with the help of the “crowd” that does not necessarily need to have special knowledge about the particular industry, solving problems in the company is more effective for the
42 Authors such as Macchiavello also classifies these markets as ‘alternative’ ones. See: Ibid (n34), p. 668.
43 Ibid (n29), p.15.
44 Kristof De Buysere, Oliver Gajda, Ronald Kleverlaan and Dan Marom, ‘A Framework for European Crowdfunding’ (2012) Resource Document, European Corwdfunding Network, p. 9. 45 Ibid (n29), p. 15; Armin Schwienbacher and Benjamin Larralde, ‘Crowdfunding of Small Entrepreneurial Ventures’ (2010) SSRN Electronic Journal, pp. 7.
46 Ethan Mollick, ‘The Dynamics of Crowdfunding: An Exploratory Study’ (2014) 29 Journal of
Business Venturing 1, p. 3.
47 Golić, Zorica. ‘ADVANTAGES OF CROWDFUNDING AS AN ALTERNATIVE SOURCE OF
FINANCING OF SMALL AND MEDIUM-SIZED ENTERPRISES' (2014) 1 ЗБОРНИК РАДОВА
entrepreneurs than with several individual investors.48 Fourthly, through crowdfunding, Project Owners enjoy the benefit of retaining management control over their project or company, unlike other funding modalities such as business angels and venture capital funds that permit investors to acquire significant control over the company’s decisions.49 Furthermore, crowdfunding fosters competition in the financing market and can be a form of innovation simulator among start-ups and SMEs.50
C. Problems and Risks Posed by Crowdfunding
Besides its numerous advantages, crowdfunding is not immune to risks; this is particularly the case for Investors. Investors might face multitude risks including, inter alia, credit risk, fraud, issues of identity theft, money laundering, consumer privacy and data protection violations.51 The most evident risk of crowdfunding is that Investors in FR-crowdfunding might face the potential risks of asymmetric information due to the inadequate disclosure of corporate information from the Project Owner and crowdfunding platform. As a result, borrower fraud, that is the risk that information provided by the Project Owners may be incorrect, insufficient or misleading due to the lack of its verification, is a great risk faced by Investors. Furthermore, the Investors are exposed to credit risks, namely the risk that the Project Owner defaults on its due payments as a result of a simple business failure.52 This goes similarly with respect to the crowdfunding platforms; insolvent or defaulting platforms might result in Investors facing the risk of their rights to loan payments being exposed to their claims of other platform creditors. Another significant risk is the potential CSP’s malpractice as a result of heavily relying on misleading advertisements and/or unchecked information.53 Additionally, it should not be disregarded that Investors may also face the potential risks in terms of agency costs with respect to lending-based crowdfunding as well as governance problems with respect to equity-based crowdfunding.54 All these risks that come along with crowdfunding are promoted by the anonymity and pervasiveness of the internet.
48 Ibid. 49 Ibid. 50 Ibid (n34), p. 671. 51 Ibid (n30, Pacheco), p. 14. 52 Ibid (n30), p. 16 53Ibid (n34), p. 669. 54 Ibid (n30), p. 16.
III. Proposed Regulation for European Crowdfunding Service Providers (ECSP) for Businesses (COM/2018/0113)
As part of the FinTech Action Plan and in order to complete the Capital Markets Union, the European Commission presented a proposal (COM/2018/0113) (hereafter, “ECSPR”) on the 8th of March 2018 for a EU Regulation that concerns FR-crowdfunding service providers, also referred to as, which also will be relevant and potentially bring benefits for capital seeking businesses and potentially interested Investors in the EU. This chapter will delve deeper into the details of the ECSPR; sub-section A discusses the aims and objectives as well as the driver of this proposal, sub-section B addresses the legal bases of the ECSPR, sub-section C addresses the scope of the ECSPR and sub-section D discusses the substantive regulatory requirements adopted in the CSPR.
A. Aims and Objective
The ECSPR was drafted not only as a response to the crowdfunding issues and challenges faced by start-ups and SMEs in the EU but it was also drafted as a response to the calls by both the European Parliament and the European Council, who had set an aim of establishing more “future-oriented regulatory frameworks” on the digitalization of the single market and in establishing “an environment where innovative FinTech products and solutions can be rapidly rolled out across the EU to benefit from the economies of scale of the single market, without compromising financial stability or consumer or investor protection”. 55 Additionally, the ECSPR is motivated by the Action Plan, which has the purpose of making the financial sector equipped for rapid developments and advances in new technologies. The Action Plan itself is part of the motivation of creating a well established CMU and “a true single market for consumer financial services”.56 The CMU became one of the Commission’s priority as the European Parliament has declared in its Resolution of 9 July 2015 that the CMU “should create an appropriate regulatory environment that enhances cross-border access to information on the companies looking for credit, quasi-equity, equity structures, in order to promote growth of non-bank
55 < https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52018DC0109 > last accessed: 7 June 2020.
56< https://www.moodysanalytics.com/regulatory-‐news/Mar-‐08-‐18-‐EC-‐Action-‐Plan-‐for-‐Fintech-‐
financing models, including crowdfunding and peer-to-peer lending”. 57 As the Commission recognizes that the main reason why start-ups and SMEs revert to alternative financing methods, such as crowdfunding, is because of the challenges they face on the financial market, the ECSPR especially focuses on innovative companies, start-ups and other unlisted firms as well as on the challenges they face, as explicitly written down in Preamble 2 ECSPR.58
The European Commission said to have monitored the development of crowdfunding market prior to the drafting of the ECSPR. During its examination, the Commission came with the conclusion that there has been no single EU-level intervention in the development of crowdfunding on the Union’s financial market and that the development of crowdfunding as an alternative finance was very much as a result of the different approaches, interpretations and treatments of crowdfunding in each of its MS, making expansion beyond one national jurisdiction difficult. Therefore, the main objective of the ECSPR is the harmonization of crowdfunding regulation within and throughout the EU.59 The other objective that follows is the increased access to finance for start-ups and SMEs in the EU. With respect to this objective, the Commission aims that the ECSPR can deem the possibility to apply for a EU-license (passport) that enables the cross-border operation of crowdfunding platform.
Furthermore, the Commission has noticed the risks that potential investors might face when investing through crowdfunding60 and acknowledges the importance of the confidence of investors in crowdfunding platforms and in the investments they make, as a large contributor to the growth of crowdfunding activites.61 As a result, the Commission also seeks to protect investors and offer them safeguards to minimize the risks they are facing by allow investors to obtain all the necessary information on crowdfuning as well as information on the investment and of its underlying risks.62
It is also explicitly mentioned in the ECSPR that the ECSPR itself does not deem to “interfere with national bespoke regimes or existing licenses, including those under the Markets in Financial Instruments Directive (hereinafter “MiFID II”), the Payment Service
57 European Parliament, “European Parliament Resolution of 9 July 2015 on Building Capital Markets Union” (2015/2634(RSP)), par. 47.
58 ECSPR Explanatory memorandum, p. 1; see: Recital 2 ECSPR. 59 See: ECSPR Explanatory memorandum, p. 2
60 Recital 12 ECSPR: “Given the risks associated with crowdfunding investments…”; Recital 15 ECSPR: “In order to maintain a high standard of investor protection, to reduce the risks associated with crowdfunding….”
61 Recital 23 ECSPR.
Directive (hereinafter “PSD”) or the Alternative Investment Fund Managers Directive (hereinafter “AIFM”)”. Instead, the ECSPR intends to implement the EU-license as an additional regime and does not intend to force any currently existing licenses. This is because the Commission has recognized that prior to the drafting of ECSPR, several MS have relied on other existing national or EU policy provisions, such as those previously mentioned, for the licensing of CSPs.63 Additionally, the Commission has also clarified that with the implementation of the ECSPR, the aim of maintaining “consistency with other Union policies”, i.e. the FinTech Action Plan, and the aim of taking a more “innovation-oriented approach to FinTech” will be met.64
Since the harmonization of diverging crowdfunding rules is one of the main objectives of the Proposed Regulation, European legislators have opted for a Regulation, in lieu of a Directive, as the choice of instrument, simply because of the direct applicability of Regulation, i.e. does not require implementation by the MS into their national law, thus maintaining also a harmonized interpretation of law.65
B. Legal Basis
Since the main objective of this ECSPR is the harmonization of differing national rules on crowdfunding in its MS,66 Article 114 of the Treaty of the Functioning of the European Union (hereinafter “TFEU”)67 is the chosen legal basis for the enactment of this ECSPR. The diverse rules, interpretation, classification as well as take on crowdfunding in the EU became an obstacle for crowdfunding to expand its activity within the EU, entering into markets outside the national jurisdiction of the member state where they are registered, and as a result thereof, the establishment of a “smooth functioning” internal market was hindered.68 Not only does this issue arise to crowdfunding platforms with respect to their expansion, but also poses barriers for investors in diversifying their
63 ECSPR Explanatory memorandum, p. 2.
64 The last aim will be achieved by “facilitating a regulatory environment where innovative financial services, products and solutions can be rolled out across the EU in a safe, financially stable
environment for investors and firms alike”, see: Ibid, p. 3. 65 Ibid, p. 6.
66 Ibid, p. 8; during stakeholder consultations, “almost half of the respondents who expressed an opinion on the matter believed that national regulatory regimes hindered cross-‐border
crowdfunding activity and that harmonization at the EU level was required”, see: Ibid, p. 6. 67 Consolidated Version of the Treaty of the Functioning of the European Union [2012] OJ C326/49 (hereinafter “TFEU”).
investments in diverging markets as well as hinders SMEs and start-ups from seeking capital beyond their national jurisdiction.
The Regulation is also said to be in compliance with Article 5(3) of the Treaty of the European Union (hereinafter “TEU”) on the Principle of Subsidiarity.69 The European Commission argues in the ECSPR that the “varying approaches taken by MS and their different interpretations of crowdfunding activity have been increasingly amplifying the outlined issues.”70 At the time the ECSPR was drafted, the European legislative body saw that “there is no coordination effort undertaken so far among MS on rules for lending services by non-deposit taking institutions and the application of MiFID rules to investment-based crowdfunding platforms remains insufficiently uniform to enable cross-border activity”.71 As a result, the introduction and implementation of the EU-license, a measure taken as part of harmonizing crowdfunding rules, would deem to be in line with the Principle of Subsidiarity. Moreover it is said to comply with Article 5 TEU on the Principle of Proportionality. 72 While there is an urgent need for the harmonization of crowdfunding, especially on certain aspects such as its licensing, the implementation of a “stand-alone voluntary European crowdfunding regime under the label of a ECSP, which platforms would choose when wishing to conduct cross-border business would leave the tailored national crowdfunding frameworks unchanged, whilst providing an opportunity for platforms that want to scale their operations at Union level and wishing to conduct cross-border business”.73
C. Scope
The ECSPR exempts several crowdfunding services. Firstly, it excludes those provided to project owners that are consumers within the meaning of the Consumer Credit Directive (hereinafter “CCD”),74 so that consumer lending for the purpose of consumption, i.e. peer-to-peer lending, and not business lending (“funding”) does not fall within the scope of the ECSPR.75 Secondly, it exempts crowdfunding services provided
69 Consolidated Version of the Treaty on European Union [2008] OJ C115/13 (hereinafter “TEU”). 70 ECSPR Explanatory memorandum, p. 4.
71 Ibid.
72 Article 5(4) TEU.
73 ECSPR Explanatory memorandum, p. 5. 74 Art. 2(2)(a) ECSPR.
75 See: Recital 8 ECSPR, “this Regulation aims to foster cross-‐border business funding” and not consumer lending such as peer-‐to-‐peer lending.
by investment firms that have received authorization under MiFID II.76 As a result, the European Commission has also proposed to amended Article 2(1) of Directive 2014/65/EU (MiFID) to include CSPs, within the meaning of Article 3(1)(c) ECSPR, into the scope of activity of MiFID II.77 Thirdly, it exempts each crowdfunding offer, which amount exceeds EUR 1,000,000 over a period of 12 months with regards to one particular crowdfunding project, and is therefore subject to the ECSPR.78 Lastly, it exempts crowdfunding services that are provided by natural or legal persons in accordance with national law.79
D. Substantive Regulatory Requirements Introduced
The ECSPR regulates CSPs based in the EU on five main aspects - the authorization and supervision of CSPs (Chapter III ECSPR), on investor protection and transparency requirements (Chapter IV ECSPR), on marketing communications (Chapter V ECSPR), on the European Securities and Markets Authority’s (hereinafter “ESMA”) competence in tasks and competences in supervising CSPs (Chapter VI ECSPR), and on safeguards to minimize the risks of money laundering and terrorism financing. The substantive requirements of this thesis’ interest are those concerning the authorization and licensing of CSPs on an EU-basis as well as the provisions concerning investor protection and transparency requirements, particularly on the KIIS publication. In Subsection (i) and (ii), those substantive requirements will be explored in greater depth.
i. Authorization and European License
European financial law mandates licensing to foster “fairness, honesty and professionalism by those who provide financial services, on the one hand, while ensuring
76 Art. 2(2)(b) ECSPR.
77 Recital 4 jo. Article 1 European Commission, Proposal for a Directive of the European Parliament and of the Council amending Directive 2014/65/EU on markets in financial instruments
2018/0047(COD) (hereinafter “Amending MiFID”).
78 See Art. 2(2)(d) ESCPR; Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC.
that intermediaries remain financially solvent on the other.”80 Chapter III ECSPR regulates the authorization of CSPs as well as the requirements on the continuous supervision thereof. The introduction of the EU-License corresponds with the aim of the Commission in fostering cross-border business funding. 81 All crowdfunding authorizations issued by the ECSPR will allow the CSPs to conduct its services in all MS by means of the EU-license, which grants the CSPs a European passport.82 Article 10 ECSPR lays down the requirement of authorizations and the preconditions to be met by crowdfunding platforms in order to achieve a successful authorization. Articles that follow, i.e. Article 11, Article 12, Article 13, concern the role of the ESMA in administering, granting and withdrawing such authorisations as well as in supervising the services offered by the crowdfunding platforms.
CSPs are subjected to a number of licensing requirements; these, amongst others, include requirements on the “fit and purpose” of the CSP’s management,83 adequate governance arrangements of the CSP, 84 “adequate and appropriate business organization”,85 “reliable significant shareholder”86. The European Passport that comes along with the authorization of the crowdfunding platform as a CSP by ESMA, once all the licensing requirements are met. As soon as the CSP has been authorized by ESMA, this authorization will be “effective and valid for the entire territory of the Union”.87 Moreover, CSPs will no longer be required to have “physical presence in the territory of a Member State other than the Member State in which those CSPs are established in order to provide crowdfunding services on a cross-border basis”.88 This creates “uniform conditions of operation for CSPs within the EU” and “ensures a level playing field among all the service providers using the same EU label”.89 These two key provisions, furthermore, allow CSP and investors to “move cross-border”, which then allows Project Ownersof various sectors to access finance.90 In other words, it would not only “result in more competition between CSPs and would allow MS with small internal markets to
80 Sebastiaan Niels Hooghiemstra, ‘Will the Proposed European Crowdfunding Regulation lead to a ‘true’ European Market for Crowdfunding?’ (2019) Available at SSRN:
https://ssrn.com/abstract=3492981, p. 8. 81 Recital 8 ECSPR.
82 ECSPR Explanatory memorandum, p. 9.
83 Ibid (n86, Hooghiemstra), p. 8; Art. 10(2)(h) jo. (i),(3) ECSPR. 84 Art. 10(2)(e) jo. Art. 5 ECSPR.
85 Art. 10(2)(d),(e),(f),(h),(k) ECSPR; Ibid (n86, Hooghiemstra), p. 8. 86 Art. 10(2)(j) Proposed Regulation; Ibid (n86, Hooghiemstra), p. 8. 87 Art. 10(8) ECSPR.
88 Art. 11 ECSPR.
89 ECSPR Explanatory memorandum, p. 4. 90 Ibid.
develop alternative funding sources”, but “it would also provide start-ups and SMEs with more capital and allow investors access to an alternative asset-class”.91 However, shall a CSP no longer meet one of the licensing requirements of the ECSPR, ESMA will be competent in withdrawing the concerned CSP’s authorization as a penalty.92
However, the ECSPR prohibits CSPs from seeking treatment and authorization on both national and European regimes simultaneously, to avoid diverging authorizations of the same activity.93 Therefore, the CSPs in the EU are not obliged to authorize their services on EU-level at ESMA. Instead, EU-level authorization is optional. Given that Article 2(2)(c ) CSPR exempts CSPs from authorizing their services at ESMA, CSPs, that offer any crowdfunding service other than lending-based crowdfunding provided to consumers, as defined under the CCD, or investment-based crowdfunding on securities that are not ‘transferable securities’, are allowed to either opt for “EU regulatory treatment” under the Proposed Regulation or a “national regulatory treatment”.94 The choice of regimes is, however, still granted to CSPs, so that the Proposed Regulation does not oblige CSPs to seek for EU authorization under the Proposed Regulation and does not automatically grant current authorized CSPs an EU-license.
ii. Key Investment Information Sheet
Chapter IV ECSPR safeguards investor protection by means of improving the transparency and disclosure requirements. In this chapter of the ECSPR, the KIIS is introduced and the disclosure requirements and access to information that come with it are laid down in Article 16, 17 and 19. The purpose of the KIIS is to “warn prospective investors that the investing environment they have entered into entails risks and is covered neither by the deposit compensation scheme, nor by the investor compensation guarantees”.95 The introduction of the KIIS adheres to the goal of the Commission in protecting all Investors and in empowering all Investors with relevant “information on crowdfunding, including the information on the underlying risks”, in order to “support investors’ trust in these innovative services”.96 The KIIS is, therefore, a means of 91 Ibid, p. 5. 92 Art. 13 ECSPR. 93 Ibid (n86, Hooghiemstra), p. 8. 94(n86, Hooghiemstra), p. 86. 95 Recital 31 ECSPR.
providing the “necessary safeguards” that can “minimize the likelihood of risks materializing”.97
The KIIS, which is adopted as a means to guarantee transparency and of offering investors protection from crowdfunding risks, is mandatory to all crowdfunding offerings98, which fall within the scope of the ECSPR,99 including offers that amount to not more than EUR 1,000,000.100 The KIIS, which is a ‘short-form investor disclosure’ mimicking the Key Investor Document under the PRIIPs Regulation101 in terms of its length, is a document of not longer than 6 pages that should provide the prospective Investor with a thorough understanding of the “nature, risks, costs and charges of crowdfunding services”102 offered and should also “warn the prospective Investor that the investing environment that they have entered into entails risks and is covered neither by a deposit compensation scheme, nor by investor compensation guarantees”.103 The type of information that is required to be disclosed under the KIIS includes “specific features and risks associated with early stage companies, material information about the project owners, the investors’ rights and fees, and the type of securities offered and loan agreements”.104
Moreover, the KIIS shall contain general information, in accordance to the requirements laid down in the Annex to the Proposed Regulation (hereafter “KIIS Annex”)105, firstly, relating to the Project Owner(s) and the crowdfunding project; secondly, relating to the target capital raised or borrowed and the corresponding crowdfunding process; thirdly, regarding all the risks associated - including risks associated with the crowdfunding project, the sector, the Project Owner, the investment instrument as well as geographic risks; and fourthly, information on fees, on where to
97 Ibid.
98 Art. 1(d) ECSPR defines a “Crowdfunding Offer” as “any communication by crowdfunding service providers that contains information which enables prospective investors to decide on the merits of entering into a crowdfunding transaction”.
99 Art. 2 ECSPR regulates the scope of the proposed regulation. 100 Recital 12 jo. Art. 2(2)(d) ECSPR.
101 Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 3024 on key information documents for packaged retail and insurance-‐based investment products (PRIIPs)
102 Ibid (n86, Hooghiemstra), p. 13.
103 Ibid, p. 14; Recital 30, 32 jo. Art. 2(b) and (c) ECSPR. 104 Recital 32 ECSPR.
105 European Commission Brussels, 8.3.2018 COM (2018) 113 final Annex – Annex to the Proposal for a Regulation of the European Parliament and of the Council on European Crowdfunding Service Providers (ECSP) for Business {SWD(2018)56 final} – {SWD(2018) 57 final} (hereinafter “KIIS Annex”).
gather additional information about the project as well as on legal redress.106 Depending on whether the crowdfunding project offered concerns loan- or investment-based crowdfunding, additional, specific information that shall be included in the KIIS varies. The additional, specific information that shall be included in the KIIS for crowdfunding offers of lending-based crowdfunding concerns the nature and duration of the credit agreement, the interest rates or compensation, the risk mitigation measures (i.e. whether the credit is secured or not), and on the amortization and interest repayment schedule.107 Where the crowdfunding offer involves investment, instead of credit intermediation, the KIIS shall include information relating to the offering of the securities, information on the issuer provided that the issuer is not the Project Owner and is therefore a Special Purpose Vehicle (hereinafter “SPV”), as well as information on what rights the investor has.108 The standard of accuracy of the KIIS shall be guaranteed by its “clear, comprehensible, complete and correct” format, and it is prohibited for KIIS to contain footnotes that are not referring to its applicable law to ensure that nothing in the KIIS could mislead potential investors.109 Although the KIIS has to be drafted in one of the official languages of the MS concerned,110 investors have the right to request for a translation into their language of choice and may refrain from making an investment if such request is not fulfilled.111 The KIIS does neither require the approval from nor an ex-ante notification to a National Competent Authority (hereinafter “NCA”).112 It is, however, the CSP’s responsibility in ensuring that the KIIS is clear, comprehensible, complete, correct and up-to-date.113 In sum, it is the CSP that carries a ‘duty of care’ to make certain that the KIIS will not misguide the investors.114
106 See: Part A, Part B, Part C and Part H KIIS Annex. 107 See: Part G KIIS Annex.
108 See: Part D, Part E, Part F KIIS Annex.
109 See Art. 16(3) ECSPR; the Parliament version has proposed a different wording, namely “fair, clear and not misleading”; see European Crowdfunding Network, “Proposed Regulation on European Crowdfunding Service Providers (ESCP) for Business, Position Paper of the European Crowdfunding Network -‐ Trialogue Stage” European Crowdfunding Network (2019), p. 19.
110 Art. 16(1) ECSPR. 111 Art. 16(7) ECSPR.
112 Recital 33 jo. Art. 16(8) ECSPR. 113 See: Art. 16(3),(4),(5) and (6) ECSPR. 114 Ibid (n86, Hooghiemstra), p. 15.
