Report: Stringent regulation could make crowdfunding “too safe”

New authorisation and appropriateness regulations set to be implemented later this year could render the European crowdfunding space “too safe”, according to Bruce Davis, director at the UK Crowdfunding Association (UKCFA).

“It’s important to make sure that the direction of travel is towards giving people the opportunity to learn by doing rather than dumbing down retail investment,” says Davis, who is also the co-founder of Abundance Investment – an equity crowdfunding platform for green infrastructure.

The new rules largely mirror UK crowdfunding regulation.

Set out by the European Parliament and approved in October 2020, the rules (Regulation EU 2020/1503) will require providers to submit a key investment information sheet (KIIS) and a pre-contractual reflection period for ‘non-sophisticated’ investors. New investors must also conduct mandatory knowledge tests and loss simulations in order to gauge their understanding of the risk.

“There’s a danger that there’s a lot of political pressure to shut down individuals being able to invest their money, and I think that will be counterproductive for companies,” says Davis. “Trying to use rules to stop things happening is a bad way to approach things.”

But Patrice Fritsch, consulting principle at Ernst & Young, takes a more positive stance on the matter. Investors must feel safe and informed, he argues.

“I am convinced that having investors invest in products they can understand, at a risk level they can understand, will help them continue taking the right decisions during the lifecycle of the product. This will help ensure that if things are going wrong, it doesn’t leave them with a bitter taste.

“This protection is also relevant for the safety of the industry and crowdfunding platforms in the long term. Of course it involves a lot of constraints, but it’s certainly necessary.”

Laying down a harmonised, pan-European crowdfunding framework for the first time, the regulations will also implement new governance for the authorisation of providers. Under these rules, the provider is required to prove that it fulfils a number of criteria, including appropriate investor protection measures, efficient and prudent management and strict due diligence processes for project owners.

“When it comes to reporting obligations and how that ties into general investor protections, it’s about as serious as it gets,” says Kinsey Cronin, SVP business development at financial infrastructure firm Prime Trust. “There were a lot of people who were concerned from the very beginning about people being taken advantage of and being tricked into making bad investments without understanding what they’re doing.”

But Cronin also acknowledges the need for a suitable balance, pointing out that risk is inherent in any investment scenario.

“I do believe in doing the best you can to protect investors, but I also believe in not restricting them. The burden ultimately has to be on those investors.”

The regulations will enter into effect on November 10 and are currently pending further clarification from the European Securities and Markets Authority (Esma).

Mini-bond scandals

Davis goes on to explain that whilst the current system has been “working well”, issues relating to mini-bonds have acted as a “fly in the ointment” and ruptured the UK crowdfunding space.

Despite having no legal definition, the Financial Conduct Authority (FCA) describes mini-bonds as “illiquid debt securities marketed to retail investors”. Usually issued by small or start-up companies, they are non-transferrable and tend to carry high risk.

One such issuer of these securities in recent history is London Capital Finance (LCF). In a now notorious case, it was discovered that the UK investment firm had mislead more than 11,000 retail investors into purchasing unregulated mini-bonds on the proviso that returns would be as high as eight percent.

Following an investigation, it transpired that nearly 60 percent of all of the investors’ cash (around £136m) was channelled to LCF executives. The company tumbled into administration in January 2019 after the FCA froze its bank accounts.

London-based firm Blackmore found itself embroiled in a similar case, almost in tandem with LCF. The company was found to have used a mini-bond scheme to raise £46m from investors, all of which was re-invested in a property development portfolio. The scheme collapsed in 2019, and at the time, administrators estimated that the portfolio was likely to be worth less than £1m.

“It’s a very poor, unwieldy piece of legislation currently,” says Davis. “It was rushed through as a temporary legislation, and they’ve already had to change it twice to try and make it work.

“It has impacted crowdfunding reputation, because the FCA have not been careful enough to draw a distinction between regulated crowdfunding and mini-bonds. They really need to improve their own understanding and education. What we’re hoping is that we get a really clear set of rules about what companies can and can’t do in that space.”

In addition, the UK Treasury announced in April that it would review the regulatory arrangements in place for the issuance of non-transferrable debt securities (NTDS) to retail investors.

Economic recovery

But despite various imperfections, Davis believes that crowdfunding will serve as a crucial avenue for many small businesses in navigating the economic turmoil inflicted by coronavirus.

“I think we’ve all seen that uptick – our pipeline is the strongest it’s ever been. We’re seeing a strong trend here to new business opportunities, and that’s exactly what crowdfunding is designed to do in the first instance.”

Research appears to support Davis’ claims. In its Q1 Small Business Index posting last month, the Federation of Small Businesses (FSB) reported the highest levels of confidence in small businesses since Autumn 2014.

The posting also reported that more than half (51 percent) of those surveyed expect their revenues to increase over the coming three months.

“We didn’t know what to expect as obviously it’s been quiet for a few months whilst the pandemic has been ongoing,” says Davis. “But demand was higher than we expected, and I think that’s probably not a bad bellwether for what’s going on elsewhere.”

Fritsch offers a similar view on the matter, not only agreeing that crowdfunding could rescue some small firms, but also arguing that the pandemic has accelerated the demand for crowdfunding.

“It is a way to recover post-pandemic, but the coronavirus is perhaps more of an accelerator in it. It’s sometimes very difficult to knock on the door of a financial institution and get a loan during a startup phase. What crowdfunding provides is a new way of financing projects.”

London-based SaaS provider Expend is one company that has capitalised on this. In April, the firm launched an equity crowdfunding campaign via UK platform Seedrs. Its £500,000 target was reached in just four days.

“The key difference is the most obvious one – the number of individual investors is much higher and the average investment much smaller, so you’re attracting a mixture of every day and seasoned investors, says Johnny Vowles, CEO and co-founder at Expend.

“Crowdfunding provides access to opportunities like Expend to everyday investors that they would not otherwise have. This has a significant impact on growth as it enables us to do more, and we should see this impact amplified as the economy recovers.”

Vowles also notes that whilst alternative investment avenues can incur new challenges and obligations, the operations of crowdfunding providers are “streamlined and managed pretty well”. For this reason, he says issues around compliance and accounting have been modest in comparison to more traditional routes.

“I believe that it has been an accelerator for finding new sources of revenues, but also an accelerator for developing new projects and more innovation,” Fritsch concludes.

However, Davis notes a final regulatory gripe surrounding the crowdfunding cap in Europe, which he says could be detrimental for some businesses.

Currently, businesses in Europe can crowdfund up to €8m (around £6.8m) without a prospectus. With prospectuses being costly to produce (often running into the hundreds of thousands), few businesses are choosing to take this route.

Davis argues that as a result, there is an inherent funding gap between €8m and around €20m – the general borrowing range that businesses require for scaling up.

“That gap is very real for the UK economy. We hope that over time, it’s going to become easier to do larger scale financing through these structures. Some reform is needed there, and we’ve been pushing for that.”

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