The hot new practice area of equity crowdfunding law  supports innovation—but does it protect investors?

Crowdfunding illustrationBy Randi Chapnik Myers / Illustration by Taylor Callery

From the Fall/Winter 2014 issue of Nexus.

There’s no question about it: There is incredible power in numbers. But how do we harness that “crowd power” to boost our economy? We start with crowdfunding, of course—the online movement to raise money from the public that’s exploding so fast, it’s hard to keep up.

We’ve all heard of Kickstarter and Indiegogo, the popular Internet portals through which enterprising self-starters reach out to fans for cash to get their projects off the ground. Now, new security exemptions are being proposed to allow crowdfunding as a fundraising channel for early stage companies. That means there’s a hot new practice area taking shape in Canada—equity crowdfunding law.

These days, just about everything is being financed through crowdfunding, from a trial bus run in Toronto’s Liberty Village to the salary of freelance journalists (think Jesse Brown of recent CBC fame). The movement is inspiring a new generation of people who are collaborating to raise money to effect change. And with companies getting in on the action, the stakes are about to get a whole lot higher.

While the industry originated with donors funding new ventures with little expectation of return, it grew to include the reward-based model where fundraisers offer perks — such as a T-shirt or film credit — if the project succeeds, says Albert Lin, JD 2013, an associate who works on real estate financing, acquisitions and sales at McCarthy Tétrault in Toronto. More recently, crowdfunding evolved to include the debt model, where it facilitates financing but doesn’t offer a stake in the project.

“The reward model is most popular in the media, as it has really taken off in the cultural sector, where artists turn to fans online to help them reach their financial goals on projects banks might not back, such as indie films, books, poetry and music,” Lin says. The demand for crowdfunding is huge because people are looking to support projects they believe in, he explains. “They want to see a change where they live, and they realize they can help make that happen. With people directly asking each other for what they want and funding it themselves, we all see improvement in the way we live at a pace we like.”

Already, the industry reportedly raised $2.7 billion in 2012, with some industry research groups anticipating an increase of up to $5.1 billion in 2013, says the National Crowdfunding Association of Canada (NCFA). By expanding the practice into the equity sphere, the hope is that it will power business growth, support entrepreneurial innovation, create jobs and give Canada a competitive advantage on an international scale.

With this new moneymaking movement spawning so much opportunity, the time is ripe for expansion into the equity market. If so many people are willing to back cultural and community projects, why not small businesses?

“Out in the community, there’s a real demand for crowdfunding from investors and businesses. It really is an exciting space,” says Ontario Securities Commission (OSC) vice-chair Monica Kowal, LLB 1987.

It all starts with helping to propel startups and small to medium-sized enterprises (SMEs) by allowing them to raise capital online through the issuance of securities in exchange for investment, Kowal explains. Essentially, that means you will be able to buy a share of the equity in early stage companies through an Internet crowdfunding portal—with limits.

“As a small business, especially a startup without proven revenue, it can be hard to get financing. If you have a great idea and need money to develop it, your only option was friends and family, angel investors or venture capitalists,” explains Afzal Hasan, JD 2011, a securities lawyer at Cassels Brock in Toronto.  

Not any more. The JOBS Act, or “Jumpstart Our Business Startups Act,” was tabled with the hopes of stimulating the US economy after the 2007-2009 recession by relaxing the rules that regulate how small businesses raise capital. “The US sees small business as the backbone of their economy,” says Hasan. “Keep in mind that Coca Cola and Apple didn’t launch billion dollar enterprises. Everyone has to start somewhere, and by supporting the small business, we boost the economy.”  

This side of the border, the economic view is no different. SMEs are fundamental to our economy, too, representing approximately half of private sector GDP and accounting for 88.5 per cent of all private sector jobs in Ontario in 2012. Although the regulatory landscape in Canada is different, Hasan says, Canadian security regulators and businesses are also paying more attention to this area.

While the U.S. Securities and Exchange Commission is currently evaluating a proposed crowdfunding prospectus exemption for US issuers, Canada is doing the same.

Saskatchewan was the first province to jump aboard. The Saskatchewan Equity Crowdfunding Exemption was adopted in December 2013. Similar regulations, some with different limits, are currently being considered by securities commissions in British Columbia, Manitoba, Quebec, New Brunswick and Nova Scotia. Through Saskatchewan’s exemption, startups and SMEs can raise up to $300,000 per 12-month calendar year. On crowdfunding portals that distribute offerings for up to 90 days online, investors can invest up to $1,500 for a single deal.

Then there’s Ontario’s proposal: the Crowdfunding Exemption, which allows for even higher caps and limits. Here, startups and SMEs would be able to raise up to $1.5 million per 12-month calendar year with investments capped at up to $2,500 per deal, and maximum $10,000 per year.

The Ontario proposal was developed as part of the OSC’s broadened exempt market review, which included stakeholder meetings and town halls to gauge interest in this new field, and to advise on possibilities for regulatory approaches to the exempt market.

In fact, the OSC received more than 800 comment letters on the equity crowdfunding issue, which is “just huge” in the securities world, says Kowal, where only 30 letters would be more typical. “Now that we’ve tapped into something people really care about, our challenge is to get the balance right. We want to promote innovation and capital-raising but that side has to be weighed against having a fair capital market and protecting investors,” Kowal says.

Investor protection doesn’t mean that regulators remove all the risk from an investment, says Faculty of Law scholar Anita Anand, LLM 1996, who has researched equity crowdfunding.

“Rather, it involves the provision of protections, such as adequate disclosure and, in the case of equity crowdfunding, registered portals, so that investors can make informed decisions.  The proposed exemption would be a middle ground between full-blown prospectus offerings on the one hand, and exemptions that require no disclosure and carry little regulatory oversight with them on the other,” says Anand.  She argues the potential for fraud does warrant careful consideration in the crafting of the exemption, “but should not stand as the reason that investors are denied the investment opportunities otherwise available under the proposed exemption."

This new fundraising channel will affect and benefit more than just new companies. Stakeholders will be involved, from entrepreneurs to investors to portal operators—to lawyers. Inevitably, once the door is opened to higher investment with fewer restrictions, there will be many legal issues to consider. What if the new business goes belly up or there is misrepresentation, or worse yet, fraud? Who protects your investment?  

That’s where regulators like the OSC come in. “We created limits because of the risks with crowdfunding, such as the absence of investment advice by a registered dealer and the inability to resell the securities,” Kowal explains. As a result, the registered online portal that arranges and facilitates the equity crowdfunding also plays a role in protecting advisers.

After registering with the OSC as a restricted dealer, the online portal engaged in equity crowdfunding must conduct background checks on companies’ principals, and do a high-level review of the information presented to it, Kowal says.

Basically they need to be on the lookout for bogus business plans. The portals are also required to provide an investor with a crowdfunding offering document that includes information about the company and the offering, as well as financial statements. All this in order to make the investor aware of the risks associated with investing under the crowdfunding prospectus exemption—such as the real risk of losing money in a company with no track record, and the challenge that reselling your securities poses. Investors would need to sign a risk acknowledgment indicating their understanding of the risks, and issuers must provide initial and continuous disclosure.

“Under the new proposal, issuers would have to sign off on a certificate so that there’s no misrepresentation, or there will be liability,” Lin adds. “And with a market that’s growing exponentially, that increased risk to the investors could be significant.”

So far, the stats on potential problems look promising. In other jurisdictions around the world, such as Australia, where equity crowdfunding has been possible for high-level investors for more than five years, the Australian Small Scale Offerings Board, a leading portal, has raised more than $140 million in seed and growthcapital for 130-plus companies. As of 2012, 83 per cent of them were still operational—and there has not been a single incident of fraud reported.

“This is very useful, but there are concerns other than fraud,” says Prof. Jeffrey MacIntosh, LLB 1981, who holds the Toronto Stock Exchange Chair in Capital Markets Law: “The fact that companies are being funded is not enough to conclude that crowdfunding results in an efficient allocation of capital. To make that leap, we need returns data. Moreover, with many, and largely unknowledgeable, investors holding small stakes, receiving little information, and lacking an incentive to sue because of free rider and collective action problems, crowdfunding creates an ownership structure that is likely to result in little effective oversight of management.  This makes it particularly ill-suited to high-tech ventures in which effective monitoring can only come from skilled and knowledgeable investors.”

Not so, argues Lin.

“In an industry that is self-regulated, you’d expect it would be a ‘Wild West’ out there but it’s not,” Lin says. “Over the past five years, crowdfunding has done a good job of self-regulating. Thus far, we haven’t heard of any systemiccriminal wrongdoing.” That’s because all the stakeholders in this microenvironment have an interest, he says, so they are all motivated to do their due diligence. Simply put: “Everyone in the crowd wants the business to succeed.”

There are also educational initiatives that bridge the gap as the industry moves toward regulation. “There are a lot of people rolling up their sleeves to help,” says Lin, who sits on the advisory board of NCFA Canada, a national crowdfunding hub that provides education, advocacy and networking opportunities in this rapidly growing field. It is currently in consultations to create an industry best practices guide to educate about risks and to inform regulators down the road. It also holds workshops for anyone considering crowdfunding or working in the area.

“It’s very exciting to watch the fusion of technology and startup financing through crowdfunding,” Lin says. “Like eBay or Amazon changed the retail world, this movement has the potential to revolutionize how venture financing works, and lawyers will definitely be a big part of that.”

Additional reporting by Lucianna Ciccocioppo