Jung Min Lee, Gye-Jeong Kim and Denai (Minji) Koh of Kim & Chang take a look at how crowdfunding is regulated in Korea, and assess if this new flexible form of financing could one day surpass bank lending for SMEs
Crowdfunding generally refers to a method of financing that entails an entrepreneur with a creative idea or business plan who proposes an idea or business plan online to procure financing for the business from a large number of small sum investors through a broker entity (funding entity).
Crowdfunding can be categorised into different types based on the method of procuring funds or compensation, and the most representative types are: (i) equity-based crowdfunding, where investors invest in exchange for shares, and; (ii) lending-based crowdfunding, whereby investors provide loans in certain amounts in exchange for repayment of principal and interest upon expiration of the loan.
In relation to equity-based crowdfunding (crowdfunding in a narrow sense), the Financial Investment Services and Capital Markets Act (FISCMA), as amended in July 2015, included online small-investment brokerage entities as a type of investment brokerage entity and established the relevant legal grounds for crowdfunding. The amended Capital Markets Act has been in force since January 25 2016, and this new legislation has prepared the mechanism for startup enterprises to procure funding from a number of small-sum investors through online funding portals.
Prospects of financing by SMEs through crowdfunding
Under the Capital Markets Act, an online small sum brokerage entity is a company that engages in the business of solicitation and contribution of small-sum equities with respect to investors through online funding portals. As an online small-sum brokerage entity can commence business only after registration and with a modest amount of capital of KRW500 million ($450,000), the regulations for entry into the market have been relaxed in comparison to investment brokerage entities under the original legislation.
However, based on the regulation that limits the issuance of equity in relation to crowdfunding, a single company can only procure funds through crowdfunding of up to KRW700 million per year. Therefore, crowdfunding may be meaningful for SMEs that procure investment for their establishment. However, in order to procure funds that exceed KRW700 million, traditional means of financing, such as the issuance of shares or bonds or obtaining loans, need to be used.
In addition, according to the current Capital Markets Act, the issuance of equity for crowdfunding is only permitted if a non-listed small to mid-sized startup company procures at least 80% of the target amount of funding within seven years of business. Thus, an SME that has operated for at least seven years would not be able to procure investments through crowdfunding. To remedy this limitation, the financial regulatory authority is currently promoting an amendment to the policy to enable innovative-business type SMEs to engage in crowdfunding without a limit on the company's length of operation.
In addition, the company that issues equity for crowdfunding usually limits the investment amount of investors, considering that the targets of investment are startups that have a high investment risks. The limit of investment varies based on the investor's expertise, capability to endure risk and other factors. Although an expert investor does not have a limit for investment, an ordinary investor has a limit of KRW5 million per year (limit of KRW2 million per company), and an investor that satisfies certain income requirements has a limit of KRW20 million (limit of KRW1 million per company).
As such, since there is a limit to the amount of investment that can be procured from a number of individual investors for an SME through crowdfunding, the limit inevitably applies when setting the target amount of contribution.
Current status of financing by SMEs through crowdfunding
According to the Financial Services Commission's (FSC) press release dated January 24 2017, as of January 25 2016, one year after the implementation of crowdfunding, 116 companies (121 cases) successfully procured funding. Startups received funding of KRW18 billion from approximately 7,000 investors. Diverse categories of businesses were crowdfunded including manufacturing (38 cases), IT/mobile (34 cases) and cultural contents (16 cases), and each company secured an average investment of KRW 160 million. From an investor's perspective, the participation rate of individual investors was 93% (44% of the investment amount) and the average investment amount per investor was approximately KRW1.33 million (limit of KRW2 million).
However, notwithstanding the numbers above, since the total amount of financing through crowdfunding for one year only amounted to KRW18 billion and the average amount of financing for each company was only KRW160 million, it would be premature to conclude that crowdfunding is a substitute to traditional methods of financing for SMEs. However, since this policy has only been implemented for one year, the effect of implementation is yet to be realised, and since the financial regulatory authority is actively promoting the vitalisation of crowdfunding, the volume of financing by way of crowdfunding for SMEs is expected to increase.
Korea's P2P loan regulations
Although crowdfunding has new legal grounds based on amendments to the Capital Markets Act, a peer-to-peer (P2P) business is not regulated as a separate and independent category of business under the relevant Korean financial laws, including the Capital Markets Act.
However, since the P2P business involves providing loans, entities that engage in the business must abide by the regulations applicable to lenders. In order to engage in a money lending business or loan brokerage business in Korea, the relevant entity has to register under the Money Lending Business Registration and Consumer Protection Act and a licensed loan brokerage company can provide brokerage services only to registered money-lending companies and not to unregistered businesses. Due to this restriction, Korean P2P businesses (ie platform businesses) almost always form a partnership with a money lending company or financial institution to engage in a money-lending or loan business.
A P2P business entails collecting or brokering funds from multiple investors and providing the funds to multiple borrowers. Investor protection is critical and amending the regulations to address this issue has become necessary, particularly with the recent increase in activity in the P2P market. Taking this into consideration, the FSC formed a P2P loan taskforce in July 2016 to prepare regulations for P2P loans. The financial regulatory authorities considered the following three ways to implement new regulations regarding the P2P loan industry:
(1) implementing guidelines without amending the existing laws or establishing new laws;
(2) incorporating regulations on the P2P loan industry into existing laws, such as the Capital Markets Act; and
(3) implementing new laws on the P2P loan industry.
Consequently, the financial regulatory authority has chosen method (1) to regulate the industry through the implementation of the P2P loan guidelines and on February 27 2017 announced the specific content of the guidelines.
The guidelines above have been implemented since May 26 2017 after a grace period of three months.
Overview of P2P guidelines
The main topics of the guidelines include limit of investment, management of investment and regulation of the P2P business.
Limit of investment
One advantage of setting a limit to investments would be that damages borne by investors when a borrower is exposed to credit risk, such as bankruptcy, would be limited. However, setting a limit would also restrict the use of the investors' funds (ie loans), restrain the reinvestment of investors and possibly cause reduced activity in the P2P loan market. Since the P2P loan market is only in its beginning stages in Korea, after a careful review of the pros and cons of the cap policy, the financial regulatory authority did not set a limit of investment for corporate investors or individual expert investors, and only set an investment limit per P2P company for ordinary individual investors to protect individual investors. For individual investors, the investment limits are KRW10 million per P2P company and KRW5 million per borrower. However, individual investors who meet a certain income threshold are subject to higher investment limits of KRW40 million per P2P company and KRW20 million per borrower.
Management of investment
In relation to an internal control system, managing the investors' investment funds separately from the assets of the P2P business is important. For example, for the purposes of maintaining credibility for investors, the P2P business should be prohibited from directly managing or receiving deposits for the investors' investment funds and such funds should be deposited at another financial institution. This would address the risk of the P2P business misappropriating funds and also protect the investors' investment funds from the bankruptcy risk of the P2P business.
Regulation of business
Financial companies are restricted from participating as an investor or borrower for a P2P loan by liaising with a P2P company. A P2P company is prohibited from using P2P loans to earn profits for itself. Furthermore, P2P companies' provision of information in relation to advertisements and announcements related to investments using phrases such as guarantee of principal, confirmed profits and profitability guaranteed that may cause investors to misconceive that investments would be guaranteed is prohibited.
Notwithstanding the rules above, the guidelines would not be sufficient to resolve the fundamental issues of the current laws and regulations discussed above as it is not law and will not have the binding effect of law. The guidelines do not impose any legal obligation onto the market participants, rather, they are like Financial Supervisory Service's administrative orders that are not legally binding. However, in order to enforce these guidelines, the financial regulatory authorities plan to monitor whether the financial companies that are partners of the P2P companies are in compliance and impose corrective measures on these partner financial companies as deemed necessary.
Status of P2P loans in the Korean market
The Korean P2P industry has grown significantly in recent years and the total amount of loans outstanding in the last quarter of 2016 increased more than fourfold compared to that of the first quarter of 2016. The financial regulatory authorities, aware of the drastic increase in market activity, had announced the above guidelines to protect investors as a result. Since these guidelines have imposed limits on the P2P loan market to a certain extent, however, further monitoring would be needed to assess whether the trend of increased market activities would be maintained even after implementation of the guidelines.
Ordinarily, borrowers that use P2P loans are individuals with low credit that have trouble taking out loans from banks. However, through P2P loans, these borrowers can borrow money at a lower interest rate than those offered by money lending companies and investors are able to earn higher profits compared to the average interest rate of banks. The P2P loan business has been active with many borrowers and investors.
However, recently, P2P loans have taken the form of corporate or mortgage loans instead of individual or credit loans, and at least 60% of the loans have focused on real estate, including loans for small-scale construction projects. On the other hand, the rate of increase for individual credit loans is relatively low.
The guidelines do not have any restrictions on who can borrow funds and how much they can borrow through a P2P platform. However, since there is a limit of investment for individual investors pursuant to the P2P guidelines, if a borrower borrows funds through an individual investor, there would be a limit for procuring investment to a certain extent.
Thus, the current regulations and system for P2P loans allows consumers who had difficulty borrowing funds through financial institutions to use P2P loans instead. However, it is difficult to precisely predict how much demand for the loans from financial institutions could be satisfied by P2P loans, or to what extent the P2P companies would be able to substitute the role of financial institutions.
|About the author|
Jung Min Lee
Senior attorney, Kim & Chang
Jung Min Lee is a senior attorney at Kim & Chang, who specialises in finance. He primarily provides legal advice on banking regulations, finance IT, electronic banking and personal/financial information protection. Clients include Korean and global financial companies, Korean and global portal/platform service providers, e-commerce and payment service providers and IT service providers.
Since joining the firm in 2008, he has advised clients on various legal, administrative, and technical regulations related to electronic banking and on the management and protection of financial transaction information. Lee is also licensed to practice as a public accountant and registered as a CPA.
|About the author|
Attorney, Kim & Chang
Gye-Jeong Kim is an attorney at Kim & Chang, who specialises in finance. She primarily provides legal advice on finance IT, electronic financial transaction, personal/financial information protection and credit card regulation. Her clients include Korean and global financial companies, Korean and global IT service providers.
She majored in computer science and worked for a IT company for five years. Since joining the firm in 2013, she has advised clients on various legal and technical regulations related to electronic financial transaction and privacy. She has taken various IT security compliance projects for financial companies.
|About the author|
Denai (Minji) Koh
Foreign attorney, Kim & Chang
Denai Minji Koh is a foreign attorney at Kim & Chang, who is admitted to the New York Bar. Since joining the firm in 2015, her primary practice areas have been finance and real estate.
Koh received her JD from Duke University School of Law and a B.A. from Wellesley College. Prior to joining the firm, she interned at the Financial Industry Regulatory Authority and the Institute of International Finance in the US.
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