Crowdfunding: a democratic online marketplace?
The current sources of finance for start-ups in Hong Kong are limited, so should Hong Kong be promoting crowdfunding as a alternative funding model?
Hong Kong has been slow on the uptake when it comes to harnessing the huge potential of the new technologies that are rapidly changing the business environment globally. One example of this is the HKSAR’s lack of a clear strategy for internet-based crowdfunding.
Like many technology-based innovations, crowdfunding – the raising of many small contributions of capital from individual funders via the internet – had become a de facto part of the emerging financial environment before regulators and governments had time to install a regulatory structure to control it. Nevertheless, governments around the world have, to varying degrees, attempted to catch up with crowdfunding. Some have amended existing regulations to cover crowdfunding, while others have introduced specific, bespoke regulations, such as the Jumpstart Our Business Start-ups (JOBS) Act in the US.
Which of these options would suit Hong Kong best? How can the HKSAR strike a balance between nurturing innovation and protecting the interests of consumers and investors? Before we tackle these interesting questions, perhaps we should take a quick armchair tour of the crowdfunding phenomenon.
What is crowdfunding?
‘Crowdfunding has several dimensions. It could be donation crowdfunding, reward crowdfunding, peer-to-peer lending, and equity-based crowdfunding,’ says Jyoti Vazirani, Principal, Advisory, KPMG. As long as money is pooled together from a group of people for a specific purpose, say to fund a startup, sponsor a charity, or lend money to someone, that constitutes crowdfunding. The growing availability of internet access and secure electronic payment systems has contributed to its growth, making it easier to create a large pool of money in a much shorter time, usually through a so-called crowdfunding platform.
As Vazirani points out, there are four main types of crowdfunding.
- Donation crowdfunding – contributors donate to a cause without any expectation of receiving a return.
- Reward crowdfunding – contributors receive a reward – whether a tangible product or service – for their funds.
- Peer-to-peer lending – contributors lend money to projects/individuals
in need of capital and are repaid over time.
- Equity crowdfunding – contributors pay for equity shares in a project.
Crowdfunding, particularly equity crowdfunding, is of interest to regulators and governments around the world since the risks for investors can be significant. The genie, however, is very definitely already out of the bottle. According to a recent survey conducted by KPMG on the Asia Pacific online alternative finance market, China is by far the world’s largest online alternative financial market by transaction volume, it was worth US$101.7 billion (RMB 638.79 billion) in 2015. This constitutes almost 99% of the total volume in the Asia Pacific region. By comparison, Hong Kong is ranked ninth out of the 17 jurisdictions surveyed in terms of market volume, behind Taiwan and slightly ahead of Malaysia.
In Hong Kong, crowdfunding activity is dominated by reward-based crowdfunding and marketplace/peer-to-peer (P2P) consumer lending. The bulk of market activity took place within reward-based crowdfunding, with almost 57% of the total Hong Kong market, and over US$7.5 million raised in the period 2013-2015. Marketplace/P2P consumer lending emerged in 2014 with US$0.25 million raised and then accelerated markedly in 2015 to US$5.5 million, according to the report.
Successful reward- and donation-based crowdfunding campaigns witnessed include the launch of two independent news organisations, Hong Kong Free Press (HKFP) and Factwire, which raised seed funding through Hong Kong-based crowdfunding platform FringeBacker. P2P consumer lending sites like WeLend and Queen Captial allow individuals to lend money to other individuals, or ‘peers’, without going through a traditional financial intermediary such as a bank. These lending platforms offer their own credit checking and scoring tools.
Across the Asia Pacific region, equity crowdfunding is the largest market segment within crowdfunding, with US$948.26 million raised just in 2015. And it is evident that Hong Kong is far behind the Mainland and other Asian nations in equity crowdfunding, not to mention western Europe and the US.
Is Hong Kong missing out?
The current sources of finance for start-ups in Hong Kong are limited. Globally, crowdfunding has proved itself as a highly popular alternative funding model – both for projects in need of capital and retail investors. As an alternative source of financing, equity crowdfunding opens up a new source of seed funding for start-ups that may be too small or risky for angel investors, venture capitalists or banks to invest in or lend money to. Risks aside, it also provides opportunities for the public to invest in a potentially profitable venture or an organisation which they share a vision with. Indeed, crowdfunding has been hailed as a democratic online marketplace – enabling ordinary retail investors to benefit from start-ups in ways usually reserved for wealthy and sophisticated venture capital investors.
‘Not only does equity crowdfunding benefit tech start-ups or innovative products, it also can support social enterprises or NGOs that aim to deliver a more meaningful social impact,’ says Ming Wong, co-founder and CEO of Asia Community Ventures, who advocates the combination of crowdfunding and impact investing. ‘Personally I think the social impact of an invention or an idea that can significantly reduce the use of plastic bottles or food waste far outweighs that of yet another dating app. Crowdfunding can help convert such brilliant ideas into a reality. Social entrepreneurs are worth supporting and equity crowdfunding could be a way out for them,’ he says.
On the other hand, crowdfunders risk losing their shirts or a fortune if the amount committed is big. It has taken hundreds of years to build up the regulatory and institutional mechanisms that protect investors in official securities markets – where is the proper due diligence on information disclosure and investor protection in the crowdfunding scenario?
‘Fairly speaking, given the small size and infant stage of the ventures, there is a big risk that they will fail after seeking the seed funding. There must be someone held responsible for doing proper due diligence and valuation KPMG’s Vazirani says. In a regular IPO, the sponsor is held responsible for conducting due diligence on the company filing for an IPO – in the crowdfunding model, this role can be assumed by equity crowdfunding platforms.
Moreover, because of the large number of investors and the small amount of initial equity, a crowdfunding investor’s share can be easily diluted by the company issuing more shares through private placements at a later stage, Vazirani adds. Crowdfunded equity investments are also generally illiquid because there is no organised secondary market for crowdfunded shares.
The regulatory options
The KPMG report points out that the regulatory environment for alternative finance across Asia Pacific is diverse and rapidly changing. While some countries, such as Singapore and Thailand, have opted to regulate alternative finance within pre-existing regulatory frameworks, others, such as Malaysia, New Zealand and recently South Korea, have created bespoke regulation to govern equity and debt-based alternative finance activities.
Hong Kong has yet to introduce specific regulations on crowdfunding. The present challenge is striking the best balance between nurturing the alternative finance industry and protecting the interests of consumers and investors.
‘If you look at the regulations all over the world, Hong Kong’s regulatory environment has yet to catch up with the development of fintech and equity crowdfunding,’ KPMG’s Vazirani says. In addition to streamlining local regulations to pick up the pace of development, she suggests that training, guidelines and resources be offered to fintech companies, entrepreneurs and investors interested in taking part in equity crowdfunding activities.
Although equity crowdfunding is not yet fully legalised in China, the China Securities Association (SAC) issued tentative draft regulations on equity crowdfunding for discussion in December 2014. The proposal lays out a regulatory framework to guide crowdfunding in China and encourage the development of private finance for innovative small and micro enterprises.
Last year, the Securities and Exchanges Commission (SEC) in the US adopted rules on crowdfunding under Title III of the Jumpstart Our Business Start-ups (JOBS) Act. These rules relate to a new exemption under the Securities Act of 1933 (the Securities Act) that will permit securities-based crowdfunding by private companies without registering the offering with the SEC. Larger crowdfunded businesses with more than 500 investors and more than US$25 million in assets still have to file reports like a public company.
The Hong Kong government certainly knows that the city must embrace fintech – without compromising investor interests and protection – in order to stay competitive globally. In doing so, however, it should bear in mind the lessons learned from the misselling of minibond and structured products before the global financial crisis.
In his 2015-2016 budget speech, Financial Secretary John Tsang Chun-wah set out the government’s intention to set up a steering group to study how to develop Hong Kong into a financial technology hub and to look into issues relating to crowdfunding in Hong Kong. The Innovation and Technology Bureau (ITB) and Financial Services Development Council (FSDC) were established to galvanise efforts towards these goals.
In March this year, the FSDC issued a research paper – Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong (FSDC Paper No 21) proposing a number of different options the Hong Kong government could consider, including making amendments to existing regulations, to facilitate equity crowdfunding activities while ensuring sufficient investor protection. The SFC has also set up a fintech contact point and is setting up a fintech advisory group to discuss the interaction between regulation and fintech, an SFC spokesman told CSj.
Nonetheless, at least for now, requirements for fintech companies in Hong Kong are more challenging than those imposed in other jurisdictions in the Asia Pacific region. In May 2014, the SFC issued a notice regarding crowdfunding, its risks and issues relating to legal compliance. The financial market watchdog warned that parties seeking to engage in crowdfunding activities should be aware of the potential breach of the relevant laws, which could lead to serious consequences, including criminal liability.
While donation and reward crowdfunding activities are not regulated in Hong Kong, P2P lending and equity crowdfunding are potentially subject to certain regulatory provisions, including:
- restrictions on offers of shares or debentures to the public under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (C(WUMP)O)
- prohibition of the issue of unauthorised invitations’ to the public under Section 103(1) of the Securities and Futures Ordinance (SFO)
- prohibition of carrying on a ‘regulated activity’ under the SFO without being licensed/registered to do so by the SFC, and
- prohibition of carrying on a money lending business without a money lender’s licence under Section 7 of the Money Lenders Ordinance.
The FSDC proposal
The FSDC research paper – Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong – calls on the Hong Kong government to study the legal frameworks in other countries to regularise crowdfunding. Suggestions range from making amendments to Hong Kong’s regulations, such as capping the number of investors and the monetary value of funds, to leaving the current regime unchanged.
‘Right now we don’t have any regulation and that’s why we are proposing a change,’ says David Donald, Professor, Faculty of Law, The Chinese University of Hong Kong, a key contributor to the FSDC research report. ‘Equity crowdfunding helps fill the financing void where angel investors, venture capitalists and banks are not reaching, and where IPO doesn’t work because these companies are too small and have no track record. From my point of view, equity crowdfunding does not shake up the traditional financial service sector as it’s not competing with it. Companies receiving crowdfunding are small businesses that need a relatively small capital they could not obtain otherwise. So they resort to equity crowdfunding,’ he adds.
One of the proposed changes to the legal framework is making amendments to the C(WUMP)O and the SFO in order to exempt crowdfunding fundraisers from the prospectus requirement for offerings made in a crowdfunding activity as defined by the SFO, which could be a regulated crowdfunding activity carried out by licensed crowdfunding platforms.
The other proposed legal amendment involves making changes to C(WUMP)O and SFO in order to extend the exemption currently available to ‘professional investors’ to retail investors privately investing in the equity of a startup aiming to raise an amount not exceeding HK$5 million. For offerings made this way, a disclaimer must be in place, stating that the offering has not been reviewed by any regulatory authority in Hong Kong and that the potential buyer should ‘exercise caution in relation to the offer’.
Another option for crowdfunding presents itself by stacking up two existing exemptions. Currently, small offerings to no more than 50 ‘professional investors’ enjoy exemption provided in Section 103 of the SFO. As suggested, this exemption could be extended to entities licensed to perform regulated activity types: 1 (dealing in securities), 4 (advising on securities) or 6 (advising on corporate finance).
Under this exemption, the licensed entities are permitted to issue depositary receipts to evidence other securities without a prospectus. This way, like an intermediate agent, they can privately purchase the shares of a crowdfunded startup, and then issue depository receipts, certificating rights in these shares to the general public under an exemption from the prospectus requirement.
The FSDC proposal also explores other options confined to the existing regulatory framework. One suggestion is for the SFC to interpret crowdfunding activity as a regulated activity and issue a conditioned exemption from the prospectus requirement, provided that the disclosure requirements for all Hong Kong public companies under the company law are observed, and each crowdfunding investor declares that he or she will not invest more than a certain amount.
The SFC could issue a single public consultation proposing the class exemption and its interpretation of crowdfunding as a regulated activity. No legislative activity would be necessary, according to the FSDC report.
‘Mainland China is allowing many crowdfunding platforms to run and fail and it is waiting to see what happens. They experiment with it and then they regulate it – this is China’s trial-and-error approach, but Hong Kong would never do that,’ says Professor Donald. ‘Hong Kong doesn’t want to experiment with risks. It would be very bad for Hong Kong’s reputation, especially if unregulated financing activity causes damages. The government is trying to provide a safe environment.’
The FSDC research paper – ‘Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong’ – is available online at: www.fsdc.org.hk/sites/default/files/Final_Report.pdf.
Professor David Donald has co-authored – ‘A People’s Market of Hong Kong: Facilitating Crowdfunding of SMEs’ – to be published in ‘Finance, Rule of Law and Development in Asia: Perspectives from Singapore, Hong Kong and Mainland China’ (Brill Academic Publishers, forthcoming).