By Vlad Calina , JD 2014, and Parsa Pezeshki, JD/MBA 2014
Equity crowdfunding, the practice of soliciting investment in companies via the Internet, has been described by some as a revolution—a way to greatly expand the available pool of capital to start-ups and entrepreneurs and drive innovation in key knowledge-based industries, especially information technology. Although it is still awaiting implementation, President Obama signed the JOBS (“Jumpstart Our Business Startups”) Act into law in April 2012 and the United Kingdom has had funding portals in operation for two years. In December 2012, the Ontario Securities Commission published a consultation paper asking the public whether equity crowdfunding should also be permitted here. The University of Toronto Faculty of Law’s Centre for Innovation Law and Policy brought together on March 27 some of the foremost experts in securities law in Ontario, government officials, and the crowdfunding industry to discuss the issue.
Broader public sentiment concerning crowdfunding has certainly been positive. But on the day of the panel supportive voices were dampened by vociferous opposition to the idea in what turned out to be a lively and engaging discussion.
Professor Anita Anand, who chaired the panel discussion, laid the groundwork by setting out the Ontario Securities Commission’s (OSC) current regime. She explained that corporations can raise capital from the public in Ontario in two ways: (i) via an initial public offering, which requires an expensive (for small companies, often prohibitively expensive) process of disclosure under a prospectus; and (ii) through the exempt market, where securities may be issued without a prospectus if the investor qualifies under one of several bright-line thresholds, such as the “accredited” (wealthy or financially sophisticated) investor or the minimum size of the investment ($150,000, the assumption being that a person investing such an amount is sufficiently incentivized to do her due diligence). A small Ontario company that can’t afford an IPO cannot solicit even small equity investments from average consumers, unless there is a pre-existing relationship (the founder’s close family and friends, or employees, for example).
Anand then asked the day’s key question: should the bright-line exempt market rules be expanded to include equity crowdfunding? She identified three practical concerns regarding the exempt market: (i) there is a lack of information on the extent of compliance due to (ii) minimal reporting obligations and (iii) insufficient monitoring of exempt issuers. Anand’s main claim was clear: without increased monitoring and greater disclosure obligations, it is difficult to see how any proposed sanction of equity crowdfunding could adequately protect investors or stimulate growth by efficiently allocating capital. In this analysis, “efficiency” includes a securities market in which investors can have confidence that the risk is in the business model, not the market itself.
Professor Jeffrey MacIntosh approached the same question from a conceptual point of view. Securities regulation facilitates efficient markets and protects investors by ensuring that information regarding the risk of investments is disclosed and accurate. In the public markets this is done primarily through the prospectus requirement, but in the private markets we sometimes have exemptions from such requirements. For MacIntosh, all exemptions including any for crowdfunding must be judged by a cost-benefit analysis of available data. Where do we get this data? His suggestion was that Canada’s provincially-based securities regulation is the best laboratory for testing and generating data, successfully sneaking in a jab at the idea of a national securities commission (supported by Anand).
FAIR Canada, an investors' rights organization, has called equity crowdfunding “a stupid idea whose time has come."
MacIntosh suggested we might explain current exemptions as a response to “gaps” in the capital markets and crowdfunding as a potential remedy for an arguable gap in sources of funding for high-tech start-ups. But he doubts that equity crowdfunding is the solution for this gap. Because of extreme information asymmetry, tech investments involve significant risks of misallocation of capital (in other words, extreme divergence between expected and actual returns). In the absence of data to show that equity crowdfunding would effectively plug a capital market gap, MacIntosh concluded that at this point, he saw the addition of a crowdfunding exemption as “more politics than economics.”
Moving from academic to regulatory perspectives, James Turner, vice-chair of the OSC, discussed the OSC’s consultation process and expressed his own personal views on regulating equity crowdfunding in Ontario. Three themes emerged. First, the OSC’s consultation was extensive, surveying investors and dealers and receiving more than 100 written comments. Second, he said it was clear that the high risk of crowdfunding, if permitted, should be addressed by including bans on secondary market trading and a cap on the amounts invested. Third, because the funding portal operates as a “gatekeeper,” adequate regulation of portals (including a right withdrawal and a risk acknowledgement form) should form a core part of any new crowdfunding exemption.
The panel then put forward perspectives from investor advocacy groups and the exempt market dealers. Ermanno Pascutto of FAIR Canada (a national, non-profit organization advocating for investor rights) criticized the ability of the exempt market regime to adequately protect investors and expressed serious concerns that equity crowdfunding would magnify these flaws. Pascutto, whose organization has called equity crowdfunding “a stupid idea whose time has come,” said that the exempt market was too risky to think about expanding; only the public markets have the adequate safeguards necessary to protect investors, he claimed, and have been one of the key reasons for the greatest tremendous wealth generation of the past century and the envy of the world.
Brian Koscak, a partner at the law firm Cassels Brock, the chairman of the Exempt Market Dealers Association of Canada, and a passionate advocate in favour of equity crowdfunding, responded to Pascutto’s concerns. Koscak addressed the claim that the public markets always adequately protected investors by reminding the audience of some of the biggest public market frauds, including Enron and Sino Forest. He pointed out that Canadian businesses are experiencing a funding problem and that the demand for equity crowdfunding is there and will be satisfied, if not in Ontario then elsewhere. Our choices, he says, are either to carefully adopt it or to see the opportunity pass us by. Mr. Koscak emphasized that the need to protect investors has to be balanced against the desire and demand of the public to invest and endorsed the idea of a carefully structured equity crowdfunding trial by the OSC.
Finally, Darren Westlake, the co-founder and CEO of Crowdcube (who participated via Skype, from the UK) provided an insightful and illuminating overview of the UK’s approach to crowdfunding and the measures adopted by Crowdcube to protect investors while greatly increasing start-ups’ access to capital. Crowdcube has helped raise more than £5.7 million for 42 companies from 32,000 investors since its launch in February 2011. Westlake emphasized Crowdcube has a rigorous application process which includes investigating the background of the company, the people involved in running it and the quality of the business plan and venture. (Crowdcube only accepts about 16% of the companies that apply for funding, and not one of its funded companies has failed.) On the investor side, Westlake emphasized that a prerequisite for participating in Crowdcube is investment knowledge, obtained either by having experience in the capital markets or by passing a Crowdcube certification test assessing investor knowledge (of, for example, the risks of crowdfunding).
The audience seemed, in general, to be more pro-equity-crowdfunding than con. Several members of the audience challenged the skeptics on the panel. One notable comment came from Christopher Charlesworth, co-founder of HiveWire, a Toronto-based startup that works with organizations to implement crowdfunding and crowdsourcing solutions. Charlesworth suggested there is a gap in the capital markets that the panel had not discussed: startups led by women and minorities. He said that his company’s data showed 30% of crowd-based funding projects are led by women— a higher proportion than in traditional funding sources. Turner said this is precisely part of the justification for crowdfunding in the US. This was problematic for Professor Anand, who remarked that such a justification would stretch the mandate of a securities regulator from investor protection to issuer promotion.
The OSC received public comments on the concept through March 8. It has not yet indicated when it will make a decision whether to allow equity crowdfunding in Ontario.