The idea of allowing startup companies to raise capital online with minimal regulation is not winning much favour from the traditional securities sector.
Late last year, the Ontario Securities Commission (OSC) published a consultation paper that proposed creating a handful of new prospectus exemptions, including a possible model for equity “crowdfunding” that would allow companies to raise relatively small amounts of capital from a large number of investors online. This is not an approach that fits easily within either the traditional prospectus-based regulated market or the established exempt market.
In fact, crowdfunding is new turf for securities regulators and has become a hot topic, as some in the technology sector have lobbied to permit crowdfunding in Canada and U.S. policy-makers appear to be moving to allow this method of raising capital. (The U.S. Congress passed legislation last year to allow this method of raising capital, but the U.S. Securities and Exchange Commission has yet to finalize the necessary rules.)
In the meantime, the OSC is floating the idea of a possible new prospectus exemption in Ontario that would mimic much of what has been proposed in the U.S.: allowing crowdfunding, subject to certain restrictions designed to reduce investor risk, by limiting how much money companies can raise; restricting the amount investors can risk; and requiring that transactions take place through a registered portal, which would serve as a sort of gatekeeper to keep out obvious fraud.
Nevertheless, investor advocates are adamantly opposed to the concept of crowdfunding. The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada), for example, has called equity crowdfunding “a dumb idea.” FAIR Canada’s comment to the OSC reiterates that stance, warning that the advocate “believes that permitting equity crowdfunding will pose great harm to investors.”
FAIR Canada’s comment argues that the proposed model wouldn’t ensure that investors are given enough information and that the risk of fraud is too high. Thus, the comment recommends that policy-makers abandon the idea “on the basis that it is too risky for investors and will undermine investor confidence in the Canadian capital markets.”
For once, FAIR Canada’s concerns are being echoed by the investment industry as well. The comment from the Investment Industry Association of Canada, for example, says that it’s not clear that crowdfunding will be useful in the long run or that it’s a better way to allow firms to raise capital without exposing investors to increased risk.
The comment from the Investment Funds Institute of Canada also questions the desirability of exposing the average investor to lower standards of disclosure and oversight. This comment suggests that simply limiting the amount investors can risk in a crowdfunding deal is not enough and that “a strong framework that mandates the provision of information about the investment for investors at and subsequent to purchase, and that regulates and supervises the portal intermediary is essential for investor protection.”
This industry opposition shouldn’t be entirely unexpected. After all, firms that are subject to regulatory requirements and oversight don’t want to face competition for investors’ dollars from others that don’t have to play by similar rules.
In light of this widespread skepticism of the merits of crowdfunding, the question regulators face is whether there’s something fundamentally different about crowdfunding that should allow it to operate with much weaker standards of investor protection.
Indeed, crowdfunding is likely to be economically viable only if regulatory restrictions are minimal. It won’t be worth it to companies to try and raise small amounts from thousands of investors if there are too many requirements to follow. And supporters of the crowdfunding concept stress the importance of light-touch regulation.
According to the comment from Toronto-based tech-company incubator MaRS Discovery District, which supports the crowdfunding proposal: “If the portal is not providing advice to investors on the suitability of investments and/or is not active in the exchange of cash between investors and the issuers, then the portal should only be subject to a light regulatory framework to validate the management and board of the issuer against key risks associated with fraud.
“If there is heavy regulation,” the comment continues, “this financing option will be too expensive for [small firms] to consider and portals will be unable to build a viable business model.”
Yet, if regulators set the bar too low, they risk investors being lured into funding hopeless ventures. In that case, the FAIR Canada comment argues, allowing crowdfunding will actually be counterproductive for capital markets, as these transactions won’t represent true capital formation and there will be no resulting boost to employment and economic output.
According to the FAIR Canada comment: “The lowering of investor protections with the resultant likely increase in fraud has the real possibility of hurting legitimate businesses by increasing the cost of capital while making it easy for fraudsters and scammers to make off with investors’ funds.”
Now, regulators must decide whether crowdfunding is really a clever new way for genuine startups to raise much-needed capital or a gimmick that will inevitably expose investors to unacceptable risks.
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