Opportunities and risks in securities-based crowdfunding

03 May ,2016

Crowdfunding is not a modern invention.

As scholar Nadine Scholz points out, the construction of the plinth of the Statue of Liberty was possible only after 160,000 New York citizens made donations in response to a call by the renowned publisher Joseph Pulitzer.

Music masterminds like Mozart and Beethoven also received support from the public in the form of donations for their concerts and compositions.

In the modern sense, crowdfunding consists in the application of online platforms to raise small amounts of funds from a large number of individuals or organizations for specific events or projects, the Securities and Futures Commission (SFC) of Hong Kong says.

The process involves fundraisers, investors and the intermediaries that provide the online platforms and could be based on charitable donations, rewards, debt or securities.

This article will focus on the last category.

Securities-based crowdfunding carries certain risks.

Since many fundraisers are startups with uncertain prospects, people could lose their entire investment.

Second, given the information asymmetry, investors might not readily see through bogus projects by fraudsters, and the unexpected shutdown of the crowdfunding platform could also be a concern.

At the same time, however, the positive impact of crowdfunding should not be overlooked.

As the Financial Services Development Council pinpoints, enterprises in Hong Kong raise funds mainly through debt, grants or equity financing.

Grants provided by the government or private donors are very limited, while debt and equity financing often come with a threshold so high as to frustrate most small and medium-sized enterprises and startups.

So, crowdfunding can bridge the funding gap by serving as a valuable, easily accessible financing channel.

The United States is one of the first economies to have regulated crowdfunding by legislation.

In 2012, the US federal government rolled out the Jumpstart Our Business Startups Act, or JOBS Act, where Title III permits securities-based crowdfunding with certain strings attached.

Several points of the act are worth noting.

First, over a 12-month period, companies are allowed to raise no more than US$1 million through crowdfunding, while the maximum amount that individuals can invest in crowdfunding offerings is also capped, based on their annual income or net assets.

Second, the law bans specific parties from engaging in crowdfunding; for example, companies that are non-local or have failed to comply with reporting requirements in the past two years.

The fundraisers are also obliged to disclose their financial statements and provide a description of their business, the intended use of the proceeds, the amount of the target offering, the oversubscription policy and so on.

Third, all transactions must take place on platforms duly registered with the authorities.

A crowdfunding offering can be made only on one platform, which in turn should have reasonable grounds to believe that the fundraising companies will comply with statutory requirements.

Crowdfunding platforms are also prohibited from certain activities, such as possessing an economic stake in the companies that are offering securities on their platforms.

In Hong Kong, the SFC issued a notice in 2014 reminding citizens of the existing statutes that are applicable to crowdfunding.

First of all, a person who knowingly issues any advertisement, invitation or document to solicit public participation in a collective investment scheme without authorization or exemption by the SFC may have breached Section 103(1) of the Securities and Futures Ordinance (SFO).

Besides, according to the Companies (Winding Up and Miscellaneous Provisions) Ordinance, a company may have committed an offence if its prospectus falls short of the statutory disclosure and registration requirements.

Depending on the actual business operations, a crowdfunding platform may also need to apply for licenses for activities such as dealing in and advising on securities and asset management.

However, it is noteworthy that, according to Section 103(3)(k) of the SFO, if the securities, products or interests mentioned in an advertisement, invitation or document are intended to be transferred only to professional investors with portfolios of more than HK$8 million (US$1.03 million), then the restriction in Section 103(1), mentioned above, will not apply.

Indeed, in a reply to the Legislative Council, the administration recently stated that, under the current regulatory framework, there is room for the development of securities-based crowdfunding platforms targeting professional investors.

With this de facto asset requirement, similar to that in Singapore, it is unlikely that the man in the street in Hong Kong will be able to take part in securities-based crowdfunding any time soon.

The Hong Kong government is prudent about this matter, and rightly so.

However, to consolidate its standing as an international financial center, Hong Kong cannot afford to be too conservative.

Fintech like crowdfunding presents both risks and opportunities.

While safeguarding investors, the authorities should also strive to boost the development of the financial industry.

The SFC set up a fintech contact point earlier this year, a promising development that is worth keeping track of.


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