In recent years, crowdfunding has become an increasingly important form of alternative finance for start-ups and small and medium sized enterprises (“SMEs”). A crowdfunding service provider (“CSP”) operates a digital platform to act as an intermediary and facilitate the matching of prospective investors with these type of companies seeking capital. Globally the crowdfunding market has grown rapidly with the largest markets being China, the United States (the “US”), and the United Kingdom, (“UK”)[1]. In recent years, the UK has accounted for three quarters of the crowdfunding activity in Europe[2]. The development of a significant crowdfunding market in the UK has been supported by a comprehensive regulatory framework comprising both legislation and detailed rules issued by the local regulator.
At present within the European Union (“EU”) the is no Union-wide legislation of crowdfunding. Instead, several, but by no means all, Member States have established their own regimes. Ireland is one of those Member States which has not implemented any specific regulations regarding crowdfunding, although the adoption of regulations has been proposed in various government plans. As has been noted by the European Commission[3] (“Commission”), this fragmented regulatory environment in Europe creates substantial legal costs for retail investors attempting to decipher the various applicable laws affecting the provision of cross-border crowdfunding services. The effect of these obstacles has been to discourage CSPs from expanding their product offering cross-border to other Member States. It was against this backdrop that Regulation (EU) 2020/1503 (the “Crowdfunding Regulation”) was introduced. By establishing a single market for the provision of an alternative source of financing for start-ups and SMEs, crowdfunding can provide a viable solution to the lack of access for such entities, further contribute to the establishment of the Capital Markets Union (“CMU”) and grow the EU’s market share in this sector.
The Crowdfunding Regulation is accompanied by Directive 2020/1504 (“MiFID II Amending Directive”), which exempts CSPs from the application of Directive 2014/65/EU (“MiFID II”).
In this article, we build on Matheson’s Insight article published in November 2020 (please click here to view same), consider CP141- Crowdfunding Marketing Requirements (recently released by the Central Bank of Ireland) and consider some of the potential wider implications of the Crowdfunding Regulation.
When will the Crowdfunding Regulation apply?
The Crowdfunding Regulation will apply from 10 November 2021. Member States are required to adopt and publish the necessary laws, regulations and provisions to give effect to the MiFID II Amending Directive by 10 May 2021, and to apply those measures from 10 November 2021.
What is the Scope?
The Crowdfunding Regulation does not apply to project owners who are classified as consumers as defined in Article 3 of Directive 2008/48/EC, namely, where the project owner is acting for purposes which are outside its trade, business or profession[4].
The Crowdfunding Regulation will not apply to crowdfunding platforms offering funding in excess of €5 million, calculated over a period of 12 months per project owner. However, the Commission has introduced a temporary derogation provision whereby a Member State may, for a period of 24 months from 10 November 2021, adopt a lower threshold to the limit stated in Article 1(2)(c) of the Crowdfunding Regulation. This is to reduce the risk of regulatory arbitrage which may arise in circumstances where a Member State has set a threshold below €5 million exempting offers of securities to the public from the obligation to publish a prospectus in accordance with Regulation (EU) 2017/1129 (“Prospectus Regulation”). Once Member States have had this opportunity to align the thresholds set out in the Crowdfunding Regulation and the Prospectus Regulation, CSPs which offer securities on their digital platform to investors not exceeding €5 million, and which are exempt from the application of the Prospectus Regulation, will be required to prepare a Key Investment Information Sheet (“KIIS”) instead. Annex 1 of the Crowdfunding Regulation provides the content of what the project owner is to include in its KIIS, which must be produced in respect of each crowdfunding offer.
Summary of Key Provisions
Authorisation
Prospective CSPs must apply for authorisation to the designated competent authority in the Member State in which they are established (where they are currently engaging in these activities) before 10 November 2022. Authorisation will require provision of name, legal form, constitutional documents, programme of operations, description of governance arrangements and details of policies in relation to risk assessment, complaints handling, business continuity and other matters, and details of the natural persons responsible for the management of the CSP. The Central Bank of Ireland (“Central Bank”) will be the designated competent authority in Ireland[5].
The Central Bank must provide a decision within three months of receipt of a complete application, refusing or granting authorisation. The European Securities and Markets Authority (“ESMA”) must be informed of all authorisations and will maintain a public register of all authorised CSPs across the EU. Article 12 of the Crowdfunding Regulation sets out in further detail the authorisation process and timelines for legal persons who intend to provide crowdfunding services.
CSPs will be subject to ongoing supervision by the Central Bank and will need to provide an annual report to the Central Bank. Authorisation can be withdrawn if, among other things, the CSP is not providing services or no longer meets the conditions for authorisation.
The Crowdfunding Regulation also contains provisions relating to passporting, such that an CSP authorised in an EU Member State will be able to passport its services into other Member States. The relevant provisions are consistent with the overall approach to passporting for other financial services within the EU. This is anticipated to be one of the most significant benefits of becoming authorised under the Crowdfunding Regulation.
Investor Protection
The Commission has placed an emphasis on the distinction between different categories of investor for the purpose of varying levels of investor protection and this has been reflected in the Crowdfunding Regulation. The Crowdfunding Regulation distinguishes between sophisticated and non-sophisticated investors.
A sophisticated investor is defined as “an investor who possesses the awareness of the risks associated with investing in capital markets and adequate resources to undertake those risks without exposing [itself] to excessive financial consequences.” This builds on the distinction between professional clients and retail clients established in MiFID II. Annex II of the Crowdfunding Regulation outlines the criteria for this categorisation of investor.
Each investor will initially have a non-sophisticated categorisation by default, but may formally request categorisation as a sophisticated investor, provided they meet the criteria laid out in Annex II. Categorisation as a sophisticated investor will mean the investor will not be subject to entry knowledge tests (as provided for under Article 21 of the Crowdfunding Regulation) nor be subject to certain disclosure requirements such as investment objectives and basic understanding of risks. A non-sophisticated investor must satisfy these criteria prior to obtaining full access to invest in projects on the platform. However, once categorised as a sophisticated investor, an investor will not be able to avail of the pre-contractual reflection period outlined in Article 22. This four day period will commence from the date in which the investor makes the offer / expression of interest. This provision only applies to non-sophisticated investors.
Individual Portfolio Management of Loans
CSPs may propose crowdfunding projects to individual investors based on parameters and risk factors pre-determined by the investor and communicated to the CSP. However, in the recitals, the Commission has clarified that authorisation as a CSP under the Crowdfunding Regulation does not grant CSPs the right to provide individual or collective asset management services. Article 6 provides that the investor shall grant the mandate to provide such services accompanied by at least two of the following parameters that a crowdfunding project must satisfy:
- the minimum and maximum interest rate payable under any loan facilitated for the investor;
- the minimum and maximum maturity date of any loan facilitated for the investor;
- the range and distribution of any risk categories applicable to the loans; or
- if an annual target rate of return on investment is offered, the likelihood the selected loans will enable the investor to achieve the target rate with reasonable certainty.
The CSP will also be required to keep the investor updated with information concerning the investor’s portfolio, such as a list of the loans the portfolio is composed of, applicable interest rates and fees under the loans, and risk mitigation measures adopted in respect of these loans. As noted under Article 3(5) of the Crowdfunding Regulation, while CSPs may exercise discretion on behalf of their investors upon the grant of this mandate, they must ensure to act strictly within the risk parameters provided by the investors as outlined above.
Key Investment Information Sheet and Bulletin Board
As highlighted above, CSPs will be required to provide the KIIS in respect of each crowdfunding offer, and to be prepared by the project owner (borrower). Annex I of the Crowdfunding Regulations contains the information disclosures the project owner will be required to make, such as the project owner’s principal business activities, the provision of financial statements, conditions for the capital raising and identification of the main risks associated with the project. While the Central Bank may seek prior notification of a KIIS at least 7 (seven) working days before making it available to prospective investors, the KIIS will not be subject to prior approval by the Central Bank.
Provision is also made for a secondary market facility under the Crowdfunding Regulation, whereby a CSP may operate a bulletin board on its platform, upon which investors can advertise their interest in buying or selling loans, transferable securities and other admitted instruments originally offered on the platform. This feature promotes the transferability of admitted instruments, which the Commission has identified as an important safeguard to enable investors to dispose of their interest on crowdfunding projects.
Operational Requirements
The Crowdfunding Regulation also identifies operational requirements which must be complied with. These include such requirements as:
a duty to act honestly, fairly, professionally and in the best interests of investors;
- to exercise effective and prudent management and adopt risk assessment and risk management procedures and policies;
- a minimum level of due diligence in relation to the project owners;
- effective and transparent procedures in relation to complaints handling, whereby clients can file complaints free of charge using a standard template; and
avoiding conflicts of interest.
Crowdfunding Marketing Requirements
On 13 April 2021, the Central Bank published its Consultation Paper on Crowdfunding Marketing Requirements – CP141. The Consultation Paper sets out the advertising rules that the Central Bank is proposing to apply to crowdfunding provided by CSPs to Irish consumers, in line with Member States’ entitlement set out in the Crowdfunding Regulation.
The Consultation Paper highlights that the Crowdfunding Regulation sets out a number of marketing requirements applicable to CSPs, including requirements to ensure that information contained in any marketing communication must be fair, clear and not misleading and consistent with the information contained in the KIIS. CSPs should note that all marketing communications about their services must be clearly identifiable as marketing communications under the Crowdfunding Regulation. The Consultation Paper also notes that CSPs must ensure that marketing communications do not disproportionately encourage investment in any one crowdfunding project.
The Central Bank has utilised Provision 9 (advertising) of the Consumer Protection Code 2012 (the “Code”) as the basis of identifying the requirements which must be complied with. The Consultation Paper states that this decision was taken to ensure that Irish consumers of crowdfunding services “receive the same protections as regards advertising communications as is required for other financial services.”
In addition to the above, it is also proposed that a requirement for a specific warning in CSP advertisements be included. This is proposed as a new Provision 9.53 of the Code, which would be introduced through an addendum to the Code. Under existing Code provisions, a warning is required in advertisements for investment products that “The value of your investment may go down as well as up”. The Central Bank is of the view that this is not consistent with the investor warning to be contained in the KIIS and so has proposed specific wording for CSP advertisements. The two alternative risk warnings proposed are detailed below and the Central Bank has request feedback in respect of same:
Option A:
WARNING "Investment in crowdfunding projects entails risks, including the risk of partial or entire loss of the money invested.”
Option B:
WARNING "Investment in crowdfunding projects entails risks, including the risk of partial or entire loss of the money invested. Your investment is not covered by a deposit guarantee scheme or by an investor compensation scheme.”
In addition to seeking input on the proposed wording of the Addendum, the Central Bank has also posed a number of specific questions. These include:
(1) Do you support the proposal to apply national marketing requirements to CSPs, as foreseen by the Crowdfunding Regulation?
(2) Do you consider all of the proposed advertising requirements for CSPs are appropriate to the business model of CSPs? If not, please specify:
(a) which provision is not appropriate and why; and
(b) whether the entire provision should not apply, or whether it could be amended to fit with the CSP business model.
(3) Do you consider that there should be additional advertising requirements for CSPs, appropriate to their business model, in addition to those proposed here? If so, please provide details.
The Central Bank is to be commended for posing these considered questions, particularly given that this will for many impacted firms, be their first time to engage with a regulator. Impacted firms should take the opportunity to make their views known to the Central Bank in respect of the questions raised before the closing date of 13 July 2021.
Commentary
The Crowdfunding Regulation is a welcome regulatory development to facilitate the integration of crowdfunding services provided across member states of the EU and one which is expected to contribute to further growth in the crowdfunding market in the EU. As highlighted above, CSPs have previously been reluctant to provide their services on a cross-border basis, owing to the significant divergence in national laws governing the activities of these entities, and the legal and administrative costs that reflect this reality. Additionally, the fact that investors/project owners do not require to be licensed as credit institutions is also expected to make crowdfunding more cost-efficient and more attractive to investors/project owners.
What does this mean for the CMU?
The Crowdfunding Regulation must also be considered in the context of the EU’s ambition of achieving a CMU amongst its member states. By mobilising capital and enabling the cross-border flow of investment, the EU envisages a fully functioning and integrated market for capital, which will ultimately make the EU economy more competitive.
Furthermore, given the current Covid-19 pandemic, government imposed restrictions have had a detrimental impact on SMEs. The CMU promotes the availability of financing alternatives for struggling SMEs, reducing their reliance on a single source of finance. Without such alternatives, excessive demand would pose a strain on traditional lenders’ capital, and slow down the recovery from the pandemic. As part of its CMU Action Plan, the Commission notes that the banks can play an important role in facilitating the move towards the CMU by advising SMEs seeking a loan of alternative services to meet their financing needs. From November of this year, CSPs will be another key actor in achieving the CMU and fulfilling such a need by permitting CSPs to access new funding sources on a pan European basis.
What should CSPs be doing now?
For some CSPs, authorisation pursuant to the Crowdfunding Regulation, will be their first move into the regulatory environment. The Central Bank has high standards in terms of governance arrangements, policies, procedures and processes which must be in place for all entities seeking an authorisation from it. While existing CSPs will no doubt be comfortable with their operating processes we expect that it is the extra expectations of the regulator which will inevitably take longer and cost more than anticipated to address. CSPs would be well advised to begin their preparations for this move without delay.
We are already seeing several UK authorised CSPs weighing up the benefits of an EU authorisation to access the 27 Member States. Ireland is extremely well placed to provide this legal and regulatory base, as it has done for multiple other financial service entities in the context of the UK’s departure from the EU. Many of our clients which made that move tell us that they made their location decisions based on the strength of the talent pool, the reputation of the regulator, the proximity to and cultural similarities to the UK. We expect that CSPs which want to establish in the EU will also reach this conclusion.
Should you require further information in relation to the material contained in this article, please get in touch with a member of the team or your usual Matheson contact. Full details of Matheson's Financial Institutions group together with further updates, articles and briefing notes written by members of these teams, can be accessed at www.matheson.com
[1] The Global Alternative Finance Market Benchmarking Report, Cambridge Centre for Alternative Finance, January 22, 2021.
[2] 4th European alternative finance benchmarking industry report Shifting Paradigms, Cambridge Centre for Alternative Finance, November 2019.
[3] In the recitals to Regulation (EU) 2020/1503 on Crowdfunding
[4] In scope are (1) P2P crowdfunding platforms facilitating ‘business funding’ and (2) investment-based crowdfunding platforms in relation to transferable securities only.