Equity crowdfunding: caveat emptor?

Author: | Published: 21 Apr 2016
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

The practice is gaining traction in Hong Kong. A regulatory approach has been proposed, but can it manage investor risks?

A recent paper by the Hong Kong Financial Services Development Council (FSDC Paper No 21) suggests legislative changes are not needed to establish a robust equity crowdfunding (ECF) market in the city-state. Titled Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong, it states that regulatory oversight is sufficient for the practice to 'operate safely and efficiently' while allowing it 'to develop in an environment that provides a level of protection and supervision appropriate to the risk presented to investors'.

The suggested approach, arrived at after comparison with the US, UK, China and Singapore, comprises four key elements. ECF platforms would be brought within an existing category of activity regulated by the Securities and Futures Ordinance (SFO) to provide a basis for regulatory oversight of the platform. Offering securities to the public would be subject to additional exemptions, tailored to ECF, from Hong Kong's prospectus law being granted by the Securities and Futures Commission (SFC) under its existing powers. Issuers would be subjected to disclosure requirements either by being incorporated in Hong Kong, and so subject to the requirements of the new Companies Ordinance (CO), or be required to offer equivalent disclosure. And the extent to which retail investors may participate in ECF offerings would be determined by primarily financial measures.

Within this broad framework, a number of difficult implementation questions fall to the SFC to determine in view of its overarching regulatory objectives.

Economic expectations

The impetus behind ECF is based on a generally accepted understanding that it can present opportunities for furthering economic development. It does so by providing another avenue for capital funding to a wider pool of business ventures, particularly those having difficulty raising funds outside a close group of family and friends or via traditional bank lending.

Essentially a securities issuance by an issuer (capital user) to an investor (capital provider), there are two fundamental considerations.


"Crowdfunding may democratise opportunity but it also democratises risk"


First, the expected economic (or social) benefit is predicated on capital standing a fair chance of finding its way to where it can be put to work effectively. This requires a means of identifying which prospective capital users can make capital work. In traditional markets, this is normally based on full disclosure to enable informed investment decisions to be made.

Second, capital providers need to be protected from abuse and this traditionally involves several matters including adequate access to up to date information, shareholder involvement and equality, and management accountability and means of redress.

While such matters are well provided for in the context of Hong Kong listings (and regulated investment products), according to the FSDC the difficulty in regulating ECF 'arises in regulating an activity that resembles an IPO without imposing the same, in this case prohibitive, regulatory costs of an IPO'. While Hong Kong already possesses exemptions for small-scale capital raising exercises, the alleged problem with that route to a burgeoning industry is the inherent limitations on the permitted scope and size of fundraising activity. Prospectus exemptions also do not address the activities of, inter alia, advertising, dealing and advising, which are central concerns of securities regulation in Hong Kong.

Information

The quality of issuer disclosure at the point in time an investment decision is made presents the first difficulty. Unlike the US model, the FSDC paper does not propose requiring the ECF platform to perform any specific pre-screening requirement for investments it posts to its platform. The regulatory emphasis appears to be restricted to a platform's operations. Reliance is implicitly placed on a platform's desire to maintain its reputation (and licence), and the issuer's desire to avoid liability under applicable law. It is notable that, compared to the process undertaken in an initial public offering (IPO), the sponsor-type role would be absent, a role widely accepted as having a significant impact on the quality of disclosures made by an issuer seeking a listing. However, even with the sponsor role in place, false and misleading disclosures by issuers in Hong Kong IPOs has been a real problem. While ECF issuers are significantly smaller businesses in earlier stages of the business development cycle, it is nevertheless unclear why removing a vetting mechanism would not prejudice investor protection.

Disclosures post capital raising are under the FSDC's regulatory model to be covered by the CO. While the CO does represent a certain standard of disclosure, this is on an annual not ongoing basis, meaning investors' access to information on how their capital is being employed is delayed. According to the FSDC, companies not incorporated under the CO are either to be excluded from participating in ECF in Hong Kong or are required to provide disclosure equivalent to that required under the CO. The former greatly limits the scope of ECF opportunities in a jurisdiction that otherwise operates in a highly internationalised and border-free manner. As regards the latter, the FSDC's proposal that such disclosure obligations could be tied to the ECF prospectus exemption leaves it unclear how meaningful obligations, actionable by ECF investors after the initial capital raising, are to be imposed on non-Hong Kong issuers without legislative changes.

Access to information is also important in another phase of the investment cycle: deciding when it's time to sell and at what price. Exiting investments present significant hurdles for ECF investors since issuers do not list the shares on the platform post transaction. ECF investors therefore face two problems: how to find a buyer for an illiquid stock, and how to obtain a fair price since there is no price formation mechanism other than what is negotiated with a buyer. Establishing an equal bargaining position may be difficult or impossible where one party is informationally disadvantaged, for example, where a seller negotiates with a buying founder of the business who possesses up to date but unpublished information. This opens avenues to investor abuse and is a potential problem whether the investor is retail or classified as a professional investor. In the venture capital world these issues are ameliorated since investors know their way around the marketplace and its players, and have real knowledge and expertise to negotiate terms both on entry and exit. This reflects one of the real difficulties of translating, or downsizing, what really amounts to venture capital into ECF – the investment dynamics are not the same.

Equality

The CO enables companies to create different classes of shares with different rights attached to them. For example, founders of an ECF issuer could create a class of shares that enable them to control the board with a minority holding. In the listed context, Alibaba had proposed just that, something unacceptable to the SFC because it regards shareholder equality as fundamental to shareholder protection. This leaves open the question as to whether, or how, an ECF issuer or offer should be regulated with regard to an equality principle.

The presence or absence of other shareholder arrangements that would often be in place for venture capital and similar investments may also need to be addressed. Matters such as rights of first refusal, restrictions on share transfers, tag-along rights, change of business, and so on may be prepared in ways that put public ECF investors in a disadvantageous position. Consumers are already accustomed to agreeing to contracts of adhesion, so it seems perfectly possible that issuers may also set up shareholder agreements that do not reflect a fair bargaining position. This is territory ripe for investor abuse, unless it is specifically regulated.

Identifying success and misfeasance

ECF is gaining traction insofar as the amount of capital raised through ECF platforms is increasing. However, it would be premature to depict this as an indication of success more broadly as we are generally still in the first stage of an investment cycle. Whether capital has found its way to efficient uses and whether investors have, on the whole, reaped benefits can only be measured at a later phase of the business venture – success is easy to quantify once money has been returned to the investor's pocket.

Positivistic statements in the FSDC that ECF brings 'the proverbial wisdom of crowds to valuing innovation and entrepreneurship in Hong Kong' and 'allows a community to take a stake in the businesses that serve it, adding solidarity and support to a hope for financial return' must be tempered against realities. Business ventures can and do fail for a variety of reasons, ranging from honest but unsuccessful ventures, to sham ventures, to ventures that fall into a wide and muddy landscape in between. The ability to distinguish between these is largely based on access to information, something that tends to be less forthcoming in sham operations and those in the muddy area.

The real ability of individual investors to identify and bring actions for misfeasance must be considered. Regulating the platform can assist in a general way with standards at the point of investment, but once the capital has been raised the proposed regulatory approach relies primarily on annual disclosure obligations imposed by the CO. It is a reasonable regulatory question to ask whether sponsoring platforms, once they are subject to the SFC's licensing lever, should be subject to any continuing obligations, or whether this should be left to each platform to decide what works best for its business model.

As is well known, Hong Kong does not possess class action rights, its culture does not lean toward litigation, and individuals (particularly retail investors) look to regulatory infrastructure to protect their interests. This represents an important difference from the US model which has long been based on a more purely disclosure-based approach to public offerings in which investors can join together and take action as a class. The UK model approaches this problem from a slightly different angle insofar as it requires investors to be 'sophisticated', a somewhat equivocal term in its application.

A significant import of the SFO in protecting the public market is the vesting of specific powers in the SFC that enable it to identify and address corporate wrongdoing. However, the SFO assumes public market concepts that are challenged to the extent that ECF accesses the public outside the context of listed securities and regulated investment products.

For example, the power to conduct investigations under section 182, and to a more limited extent the power to seek injunctions and other orders under section 213, can apply to ECF issuers and platforms though possibly only in relation to the raising of capital, not subsequent activities including breaches of the CO disclosure requirements. Similarly, section 384 which imposes criminal penalties on filing false information with the SFC could apply to disclosures made in a public offer under a prospectus exemption, depending on the documentary filing requirements the SFC attaches to reliance on a prospectus exemption. However, since subsequent annual disclosures are based on the CO, section 384 would not apply, unless the SFC imposed something like a dual filing requirement on these subsequent disclosures.

Important tools used by the SFC in relation to listed issuers would not apply to public companies in the ECF context including the powers under section 179 to obtain records and under section 214 to obtain remedies where fraudulent, unlawful or oppressive behaviour is suspected, or in relation to a failure to provide information that is reasonably expected. However, the power under section 212 to wind-up corporations where it is in the public interest can be applied.

This is a somewhat discordant situation given the obviously public basis of what drives the ECF industry, and one that is hard to rationalise based on the usual principles of regulating the public market. The only material difference is essentially the size of individual offerings.

Access

The FSDC is right in stating that 'prudent investor choices will remain important, as investors must bear the risk of their own decisions'. Nevertheless, it must be recognised that, unlike the strongly disclosure-based approach taken in the US, aspects of the regulatory approach taken in Hong Kong is merit-based which serves to protect investors from, inter alia, their own decisions. For example, in the context of investment products, the SFC's policy position is that closed ended funds are not suitable for offering to the public. It is unclear why an ECF investment should be treated any differently since both are subject to significant lock-ups on investor capital. Allowing the public to invest in ECF subject to simple financial restrictions represents a glaring inconsistency.

When ECF is viewed as a downsized version of venture capital, connecting access rights to financial restrictions could create another potential problem. Whereas in venture capital an adequate spread of investments is a basic risk management tool, the ability of a public ECF investor to build a portfolio of investments could be limited by financial and behavioural factors. While this is not to say that there should be no limits, it does highlight that the limit for smaller investors may increase the risk profile of the investment portfolio. This would in part depend on how the financial limits operated.

These considerations reflect a basic conundrum in determining how to regulate ECF, namely, who to allow to invest. It has often been said that ECF democratises opportunity in that, per the FSDC, it 'gives ordinary savers an opportunity to benefit from the kind of high-return investment previously reserved for wealthy angel investors and sophisticated institutions'. However, it also democratises risk, and in Hong Kong's culture investors frequently look to the regulators where that risk has materialised. The Lehman Brothers minibond crisis was an example of this.

Regulatory clarification

The FSDC's statement that 'while individual exposure may be small, social benefits are great' must be premised on a context where the interests of investors, the industry and society are properly balanced.

At present, ECF activity can be undertaken via existing exemptions from the prospectus law including offers to professional investors, offers where the total amount raised is less than HK$5 million ($645,000), and offers to not more than 50 persons. However, statistics in the FSDC's paper suggesting the level of financing needs for local start-ups is well under HK$1 million do not offer an argument that such routes constrain ECF activities, at least not at present.


"At present it is difficult to quantify the benefits or risks of ECF to Hong Kong"


The ability of the platform to leverage prospectus exemptions into a wider and more faceless public domain may challenge that equilibrium if a range of issues are not well regulated. Iosco (International Organisation of Securities Commissions) paper SWP3/2014 discusses not only investor protection risks but also points out that while crowdfunding is presently a small market, its growth could potentially give rise to systemic risks.

Platform self-regulation is emerging. While primarily reputation driven, some investor protection issues are being addressed, for example, through pre-selecting viable issuers, filtering investors, and specifying required terms of an offering that go some way to striking a fair bargaining position. However, self-regulation has not always worked to protect investors, or indeed the industry it serves.

Licensing platforms brings clarity to a platform's activities regulated by the SFO and provides a mechanism that permits conduct regulation. It also provides an appropriate lens on important regulatory oversight questions, for example: whether it is acceptable to allow a platform to act, if it so wishes, as a purely passive conduit for information distribution; how to apply suitability requirements (if at all); how to prevent ECF platform arrangements from falling foul of collective investment scheme regulation under the SFO.

Platform licensing could also work to regulate the structure and fairness of offers permitted to be made on platforms. For example, only offers that adhere to the principle of one-share-one-vote and otherwise preserve shareholder equality could be permitted, and questionable subscription terms inconsistent with protecting the investing public (and which could otherwise give rise to contractual estoppel questions) could be forbidden.

A complete regulatory perspective on ECF also requires looking beyond the point at which capital has been invested, in particular as to the degree of continuing regulatory oversight and the availability of meaningful and accessible investor remedies. Given the central role of the platform as an accelerant bringing issuers to minority investors, who may be in a disadvantaged position, it could be asked whether it is acceptable that the platform's obligations completely cease once the capital raising has been completed. ECF is sufficiently dissimilar from an IPO that analogies with investment banking practices in this regard are of questionable relevance.

Platform licensing may seem a relatively straightforward step to take, but it is not a quick fix solution. If ECF is capable of developing meaningfully as an industry that brings desired economic benefits to Hong Kong, then perhaps thinking beyond the regulated activities box will facilitate more comprehensive solutions to the potential risks. Indeed, whether ECF is able to fulfil its expectations will depend on how adequately these risks are managed. It remains to be seen whether regulatory measures alone will be sufficient to enable this to happen.

Specific regulation that promotes the growth of the ECF industry also comes with responsibilities that suggest the SFC is wise to move forward carefully and with a firm hand on principles, in particular investor protection. This will also require consideration being given to the possible evolution of ECF into a larger scale and more complex industry that could have systemic implications.

At this point in time it is difficult to quantify what benefits or risks ECF can bring to Hong Kong's society. More water will need to flow under the bridge before that assessment can be made.

By Syren Johnstone, adjunct associate professor at Hong Kong University