The International Organization of Securities Commissions (“IOSCO”) defines ‘crowdfunding’ as “the use of small amounts of money, obtained from a large number of individuals or organisations [i.e. the “crowd”], to fund a project, a business or personal loan, and other needs through an online web-based platform”.1 According to IOSCO, crowdfunding can be divided into four categories: equity crowdfunding, peer-to-peer lending, reward crowdfunding, and donation funding.
Globally crowdfunding has become an increasingly popular means of fundraising, raising an estimated US$34 billion globally in 2015.2 Asia is the second largest region by fundraising volume (with approximately US$10.5 billion in 2015) after the US, but ahead of Europe. The World Bank has predicted that the market in developing countries will be over US$90 billion by 2025.
However, Hong Kong lags behind other jurisdictions, such as the US and the UK, with equity crowdfunding and peer-to-peer lending largely non-existent in Hong Kong due to restrictions under Hong Kong legislation. At this stage, Hong Kong has not attempted to lighten regulation in order to increase the finance channels available to start-up businesses.
The Financial Services Development Council (“FSDC”) Paper “Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong” of March 2016 recommended regulatory change to facilitate equity crowdfunding, stating that “Hong Kong should try to be near the front rather than the back of this development”.
FinTech and Access to Capital
One of the greatest challenges facing FinTech companies in Hong Kong is their inability to access sufficient capital to develop their business model. Recently, several Hong Kong lawmakers suggested that positive initiatives, such as the introduction of the Sandbox, need additional regulatory support. Hi-tech start-ups are mostly smaller capitalised companies, and as the HKMA’s Sandbox only applies to Authorised Institutions, many start-ups set up their businesses in other countries, such as Singapore. Access to capital in Hong Kong for startups would be enhanced by a relaxation of the current regulatory regime applicable to certain financing channels, for example in relation to crowdfunding and peer-to-peer lending.
Recently, Hong Kong has seen the growth of ICOs, which enable tech start-ups to raise funds to develop blockchain-based technology. Provided that the coins are structured so as not to be securities, they are regarded as ‘virtual commodities’, which are not subject to specific regulation, but remain subject to general laws on fraud and AML/CTF.
Regulatory Position in relation to Crowdfunding in Hong Kong
Reward-based and donation crowdfunding
Under Hong Kong law, reward or pre-sale or donation crowdfunding is permitted. Pre-sale crowdfunding models essentially involve consumers paying for products in advance thus providing the capital to fund entrepreneurs’ manufacture of particular products. Like donation crowdfunding, which raises money for charitable causes, reward or pre-sale crowdfunding does not yield a financial return on investment and is not therefore regulated by Hong Kong’s corporate securities legislation. Reward-based models that have set up in Hong Kong include:
FringeBacker: reward-based crowdfunding for creative projects and direct fundraising for charities;
SparkRaise: hybrid rewards and donation crowdfunding platform; and
Dreamna: supports creative projects and rewards sponsors with a unique product or experience.
Notice on Potential Regulations Applicable to, and Risks of, Crowd-funding Activities
As regards other types of crowdfunding, the SFC issued guidance in May 2014, namely ‘Notice on Potential Regulations Applicable to, and Risks of, Crowd-funding Activities’. The guidance warns that equity crowdfunding and peer-to-peer lending platforms risk breaching the restrictions on public offers of securities under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”) and/or the Securities and Futures Ordinance (“SFO”) as well the SFO’s prohibition on carrying on “regulated activities” under the SFO without being licensed by the SFC. Breaches of the relevant provisions constitute criminal offences which carry penalties of imprisonment and substantial fines.
Equity crowdfunding refers to where investors invest in a project or a business, usually a start-up, in return for an interest in the shares or debt of a company or an interest in participating in the profits or income of a collective investment scheme.
Where investors will receive an interest in the shares or debt of a company, the platform risks breaching provisions of the CWUMPO which prohibits the offer of shares or debentures to the public without compliance with the detailed “prospectus” requirements of that ordinance. The provision of information on the internet in relation to equity crowdfunding (involving investment in shares or debt securities) is likely to constitute the issue of a prospectus in breach of the CWUMPO.
Certain exemptions are available under the CWUMPO, although these are difficult to rely on in the context of online crowdfunding since they require access to the information to be restricted. These include:
Offers to not more than 50 persons
Since the limitation is on the number of offers made (not offers accepted), this exemption would only apply where access to online information is restricted to 50 persons.
Offers only to professional investors (as defined in the SFO)
Professional investors under the SFO fall into two main categories:
institutional investors including authorised banks, licensed investment intermediaries; authorised funds; authorised insurers; authorised pension schemes etc.; and
“high net worth investors” who include:
individuals who have a securities portfolio of HK$8 million or more;
corporations or partnerships with:
a securities portfolio of HK$8 million or more; or
HK$40 million in total assets; or
- investment companies owned by an individual, corporation or partnership who qualify as professional investors where the investment company’s sole business is to hold investments.
For an online platform to take advantage of the professional investors’ exemption, it would need to restrict access to the platform to professional investors, for example by requiring proof of qualification as a professional before providing a potential investor with login details to access the site. This requirement in practice defeats the object of raising money from the “crowd”.
Small Offers where the total consideration payable does not exceed HK$5 million
Reliance on this exemption may be possible where the amount to be raised is HK$5 million or less.
Offers where the minimum consideration payable (for shares) or the minimum principal amount to be subscribed (for debentures) does not exceed HK$500,000
This exemption requires a minimum investment of HK$500,000.
Requirement to be Licensed by the SFC to Carry on a Regulated Activity under the SFO
Even where an exemption is available for an offer of shares or debt instruments, operators of crowdfunding platforms will still need to obtain a licence from the SFC to carry on any applicable “regulated activity”. The regulated activities which are likely to be involved in crowdfunding are:
- Type 1: Dealing in Securities
- Type 4: Advising on Securities
- Type 7: Providing Automated Trading Services
- Type 9: Asset Management
- Type 10: Providing Credit Rating Services
The SFC may also determine an equity or other type of crowdfunding platform to be offering interests in a collective investment scheme which requires SFC authorisation. The SFC Handbook for Unit Trusts and Mutual Funds establishes guidelines for the authorisation of collective investment scheme. The platform would also need to be licensed by the SFC to conduct asset management.
It is open to the SFC to determine whether any particular fundraising platform is offering a collective investment scheme. The SFC’s guidance indicates that the essential features of a collective investment scheme are:
it must involve an arrangement in respect of property (property is broadly defined);
participants do not have day-to-day control over the management of the property (even if they have the right to be consulted or to give directions about the management of the property);
the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the participants’ contributions and the profits or income are pooled; and
the purpose of the arrangement is to provide participants with profits, income or other returns from the acquisition or management of the property.
Online property investment platforms as well as investment funds will generally be regarded as collective investment schemes.
In relation to platforms providing peer-to-peer lending, this typically requires a licence under the Money Lenders Ordinance. Where the platform provides an evaluation service of borrowers’ loan applications, a Type 10 licence will generally be required as this may be regarded as providing credit rating services. In Hong Kong, there are no true peer-to-peer lending platforms, probably because if an individual lends through a platform, he/she and the platform itself will need to be licensed under the Money Lenders Ordinance. Peer-to-peer lending platforms that manage or pool client money may also be regarded as offering interests in a collective investment scheme which would require SFC authorisation of the scheme and offering documentation and licensing of the platform.
Some indirect peer-to-peer models are available in Hong Kong. For example, in the case of the MoneySQ.com online lending platform, MoneySQ.com has collaborated with Bridgeway which holds a Type 9 licence (asset management) that allows it to operate a collective investment scheme and accept funding from professional investors. MoneySQ.com, which holds a money lending licence, then lends the money to borrowers. This is a modified, indirect peer-to-peer model, where one intermediary raises funds from professional investors and another intermediary lends money to borrowers.
Regulatory Position in the US
In the US, under the Securities Act of 1933 (“Securities Act”), the offer and sale of securities is required to be registered unless an exemption is available.
In April 2012, the Jumpstart Our Business Startups Act (“JOBS Act”) was enacted. Title III of the JOBS Act added Securities Act section 4(a)(6) which provides an exemption from registration for certain crowdfunding transactions. In October 2015, the Securities and Exchange Commission (“SEC”) adopted Regulation Crowdfunding to implement the requirements of Title III. Since 16 May 2016, companies have been allowed to raise capital under Regulation Crowdfunding.
The regulatory regime does not apply to non-U.S. companies, Exchange Act reporting companies, certain investment companies, companies that are subject to disqualification under Regulation Crowdfunding, companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
The key features of the US crowdfunding regime are:
Upper Limit on Funds Raised by Issuers
Issuers can raise a maximum aggregate amount of US$1.07 million in reliance on the crowdfunding exemption in a 12-month period.
Investment Ceiling for Investors
The aggregate amount sold to any investor across all issuers in reliance on the exemption within a 12-month period cannot exceed:
the greater of US$2,200 or 5% of the investor’s annual income or net worth, if either the investor’s annual income or net worth (excluding the investor’s primary residence) is less than US$107,000; or
- 10% of the lesser of the investor’s annual income or net worth (excluding the investor’s primary residence), not to exceed an amount sold of US$107,000, if both the investor’s annual income and net worth are equal to or more than US$107,000.
Registration of Online Platforms
In order to be exempt from registration, crowdfunding transactions must take place through intermediaries which are registered with the SEC as either a broker or funding portal. An intermediary must also be a member of a national securities association, i.e. FINRA.
The JOBS Act introduces a new type of entity, a funding portal, which is any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act, that does not:
offer investment advice or recommendations;
solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;
compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; or
hold, manage, possess, or otherwise handle investor funds or securities.
Brokers and funding portals are subject to various requirements, such as providing educational materials to investors, and before accepting an investor commitment, obtaining a questionnaire demonstrating the investor’s understanding that investing in the securities involves risks, as well as obtaining various representations from the investors, including that the investor understands that the entire investment may be lost and that the investor is in a financial condition to bear the loss.
Intermediaries are required to take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that an issuer complies with Regulation Crowdfunding and that the issuer has established means to keep accurate records of securities holders.
An intermediary may not have a financial interest in the issuer that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services provided to or for the benefit of the issuer in connection with the offer or sale of securities in a crowdfunding offering and the financial interest consists of securities of the same class and having the same terms, conditions and rights as the securities being offered or sold in the crowdfunding offering through the intermediary’s platform.
Investors have a right to cancel investment commitments for any reason until 48 hours prior to the new offering deadline.
Disclosure of Information
Issuers are required to file certain information with the SEC and must provide this information to investors and the intermediary facilitating the offering, , including the following:
details about the issuer, including name, legal status, physical address and website;
names of directors, officers and beneficial owners of 20% or more of the issuer’s voting equity securities;
a description of the business and the anticipated business plan of the issuer;
the current number of employees;
a discussion of the material factors that make an investment in the issuer speculative or risky;
the target offering amount, the deadline to reach the target offering amount, and updates regarding the issuer’s progress in meeting the target offering amount;
whether the issuer will accept investments in excess of the target offering amount and, if so, the maximum amount that the issuer will accept and how oversubscriptions will be allocated;
a description of the purpose and intended use of the offering proceeds;
a description of the process to complete the transaction or cancel an investment commitment;
the price to the public of the securities or the method for determining the price, provided that, prior to sale, each investor shall be provided in writing the final price and all required disclosures;
a description of the ownership and capital structure of the issuer;
details of the intermediary through which the offering is conducted;
a description of the intermediary’s financial interests in the issuer’s transaction and in the issuer, including compensation;
a description of the material terms of any indebtedness of the issuer;
a description of exempt offerings conducted within the past three years;
a description of certain related-party transactions;
a discussion of the financial condition of the issuer and financial statements;
whether the issuer or any of its predecessors previously failed to comply with the ongoing reporting requirements; and
any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.
Issuers are subject to ongoing reporting requirements, including filing with the SEC and posting on the issuer’s website an annual report, along with financial statements and a description of its financial condition.
Issuers must not advertise the terms of the offering, except for limited notices which direct investors to the funding portal or broker, and include no more than the following information:
a statement that the issuer is conducting a crowdfunding offering, the name of the intermediary conducting the offering and a link to the intermediary’s platform;
the terms of the offering; and
limited factual information about the legal identity and business location of theissuer..
Title III also provides for liability for material misstatements and omissions, whereby persons who purchased a security in a crowdfunding exempted transaction may bring an action against an issuer either at law or in equity, where the issuer makes an untrue statement of a material fact or omits a material fact required to be stated or necessary in order to make the statements not misleading, provided that the purchaser did not know of such untruth or omission.
Restrictions on Resale
Securities purchased through a crowdfunding platform cannot be resold for one year beginning on the purchase date, unless they are transferred:
to the issuer of the securities;
to an accredited investor;
as part of an offering registered with the SEC; or
to a member of the family of the purchaser or the equivalent, or in connection with the death or divorce of the purchaser or other similar circumstance, in the discretion of the SEC.
The SEC’s Regulation Crowdfunding provides for the disqualification of “bad actors” that is “covered persons” who have experienced a disqualifying event, such as certain criminal convictions, certain court injunctions and restraining orders, certain SEC disciplinary orders, suspension or expulsion from membership in a self-regulatory organization such as FINRA, or being barred from association with a member of a self-regulatory organization. “Covered persons” include, inter alia, the issuer, directors, officers, general partners, managing members, promoters, compensated solicitors of investors, and beneficial owners of at least 20% of the issuer’s outstanding voting equity securities, calculated on the basis of voting power.
There is an exemption from disqualification where the issuer is able to demonstrate that it did not know, and in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.
This registration requirement is also likely to apply to peer-to-peer lending platforms . In November 2008, the SEC found that loan notes issued through Prosper, one of the leading peer-to-peer lending platforms in the US, are securities, and imposed a cease-and-desist order as the offer and sale of the securities were not registered with the SEC. The SEC applied Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”). According to Reves, there is a presumption that every note is a security, except for notes of a type specifically identified as a non-security. The types of non-security notes identified in Reves include notes delivered in a consumer financing; notes secured by a mortgage on a home; short-term notes secured by a lien on a small business or its assets; short-term notes evidenced by accounts receivable; notes evidencing “character” loans to bank customers; notes formalizing open account debts incurred in the ordinary course of business; and notes evidencing loans from commercial banks for ordinary operations. A note which is not included in the list is a security unless it bears a “strong family resemblance” to the above specified non-security notes.
Reves established a “family resemblance” balancing test to determine whether a note is a security:
the motivations of the buyer and seller;
the plan of distribution;
the reasonable expectations of the investing public; and
the existence of an alternate regulatory regime.
The SEC found that the Prosper notes are securities under Reves because:
Prosper lenders are motivated by an expected return on their funds;
the Prosper loans are offered to the general public;
a reasonable investor would likely expect that the Prosper loans are investments; and
there is no alternate regulatory scheme that reduces the risks to investors presented by the platform.
The significance of the Prosper case is that the SEC is likely to consider many peer-to-peer lending platforms as securities.
Peer-to-peer lending platforms must not only comply with corporate securities laws (if applicable), but also a range of other federal and state regulation, especially consumer credit.
Peer-to-peer lending to individual borrowers involves consumer credit, and thus is subject to laws and regulations, such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, the Electronic Fund Transfer Act, the Gramm-Leach-Bliley Act, the Bank Secrecy Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act. These laws are designed to protect consumers and make guidelines available to the credit industry. For example, the Truth in Lending Act promotes the informed use of consumer credit by requiring disclosures about its terms and cost.
Given the complexity of regulation facing peer-to-peer lenders in the US, there have been calls to simplify the relevant regulatory requirements.
Regulatory Position in the UK
In the UK, investment-based crowdfunding and peer-to-peer lending are regulated by the Financial Conduct Authority (“FCA”) under the Financial Services and Markets Act 2000 (“FSMA”).
The FCA differentiates3 between investment-based crowdfunding and loan-based crowdfunding. Investment-based crowdfunding occurs when people invest directly or indirectly in new or established businesses by buying shares or debt securities, or units in an unregulated collective investment scheme. Loan-based crowdfunding occurs when people lend money to individuals or businesses in return for a financial return in the form of interest payments and a repayment of capital over time (this excludes some business-to-business loans).
According to the FCA, crowdfunding is already subject to regulation if it involves a person carrying on a regulated activity in the UK, such as arranging deals in investments, or the communication of a financial promotion. If a crowdfunding platform enables a business to raise money by arranging the sale of unlisted equity or debt securities, or units in an unregulated collective investment scheme, then this is ‘investment-based crowdfunding’ subject to regulation by the FCA. In such a case, the operator of the crowdfunding platform is required to be authorised, unless an exemption is available.
The FCA introduced a new regulatory approach to dealing with crowdfunding in 2014.
This new regulatory approach introduces the concept of “non-readily realisable securities”, which is defined under the FCA Handbook as a security which is not:
a readily realisable security (includes listed securities);
a packaged product;
a non-mainstream pooled investment;
a mutual society share;
a deferred share issued by a credit union; or
credit union subordinated debt.
Firms (defined as including authorised persons and authorised professional firms) are not permitted to communicate or approve a direct-offer financial promotion in relation to a non-readily realisable security to a retail client. A direct-offer financial promotion is a financial promotion which contains an offer or invitation, and specifies the manner of response or provides a form by which a response can be made. This restriction does not appear to apply to a communication which merely supplies marketing information about the promoter of an offer.
There are several exceptions to this direct-offer financial promotion restriction:
the firm complies with the suitability rules in relation to the investment promoted;
the retail client has confirmed before the promotion that they are a retail client of another firm that will comply with the suitability rules in relation to the investment promoted;
the retail client is a corporate finance contact or a venture capital contact;
the retail client is a certified high net worth investor – income of at least £100,000 and net assets of at least £250,000;
the retail client is a certified sophisticated investor – sufficiently knowledgeable to understand the risks associated with engaging in investment activity;
the retail client is a self-certified sophisticated investor – clients can self-certify where they fall into at least one of the specified categories, for example where they are working, or have worked in the previous two years, in a professional capacity in the private equity sector;
the retail client is a certified restricted investor – individual investors who have made a statement that they will not invest more than 10% of their net assets in non-readily realisable securities during a twelve month period.
The firm itself, or the person who will arrange or deal in relation to the non-readily realisable security, must comply with the rules on appropriateness. This includes an assessment of whether the service or product envisaged is appropriate for the client, whereby a firm must determine whether the client has the necessary experience and knowledge in order to understand the risks involved in relation to the product or service offered or demanded. The firm must warn the client where it considers that the product or service is not appropriate to the client.
Apart from certified restricted investors, there are no limits on the amount investors can invest through crowdfunding platforms.
Under the Companies Act 2006, there is a prohibition on private companies issuing shares to the public. An offer of securities is not regarded as an offer to the public if it can properly be regarded as not being calculated to result, directly or indirectly, in securities of the company becoming available to persons other than those receiving the offer.
There is a requirement under the FSMA that an approved prospectus must be made available to the public before offering transferable securities to the public. There are various exceptions, including that the total consideration for the transferable securities being offered in the EEA States is less than 5 million euros. Thus, there is often a ceiling of 5 million euros being offered so as to avoid the prospectus requirements and approval.
The regulation of peer-to-peer lending, along with the wider consumer credit regulation, was transferred from the Office of Fair Trading to the FCA on 1 April 2014. In order to enhance protection for consumers, a new regulated activity of “operating an electronic system in relation to lending” was added to the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”).
Under the RAO, operating an electronic system which enables the operator to facilitate persons becoming the lender and borrower under an article 36H agreement is a regulated activity.
An ‘article 36H agreement’ is an agreement between the borrower and the lender by which the lender provides the borrower with credit and one of the following conditions is satisfied:
the lender is an individual or relevant person; or
- the borrower is an individual or relevant person and:
the lender provides the borrower with credit less than or equal to £25,000, or
the agreement is not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower.
These criteria mean that business-to-business loans are not FCA-regulated. Only principal firms (and not their appointed representatives) can perform the new regulated activity.
To address the risk of non-repayment and lenders’ potential ineligibility for the statutory compensation scheme, P2P agreements are categorised as “designated investment business” in the FCA Handbook so that key parts of the Handbook apply.
In regards to an operator of an electronic system in relation to lending, there is a general solvency requirement (a firm must at all times be able to meet its liabilities as they fall due), as well as a general financial resource requirement (a firm must ensure that at all times its financial resources are not less than its financial resources requirement). The financial resources requirement for a firm is the higher of: (1) £50,000; and (2) the sum of: (a) 0.2% of the first £50 million of the total value of loaned funds outstanding; (b) 0.15% of the next £200 million of the total value of loaned funds outstanding; (c) 0.1% of the next £250 million of the total value of loaned funds outstanding; and (d) 0.05% of the total value of loaned funds outstanding. Firms are required to notify the FCA if the total value of loans outstanding increases by 25%.
A firm must provide a client with a general description of the nature and risks of designated investments (which includes P2P agreements), taking into account, in particular, the client’s categorisation as a retail client or a professional client. That description must contain specified information, including information in sufficient detail to enable the client to take investment decisions on an informed basis.
The FCA Handbook includes examples of information a firm should provide concerning the specific nature and risks of a P2P agreement, such as expected and actual default rates, a description of how loan risk is assessed, and a fair description of the likely actual return.
Under the FSMA, persons must not, in the course of business, communicate an invitation or inducement to engage in investment activity (which includes operating an electronic system in relation to lending), unless the person is an authorised person or the content of the communication is approved by an authorised person.
An operator of an electronic system in relation to lending must take reasonable steps to ensure that arrangements are in place to ensure that P2P agreements facilitated by it will continue to be managed and administered, in accordance with the contract terms, if at any time it ceases to carry on the activity of operating an electronic system in relation to lending.
The FCA Handbook includes rules and guidance on holding client assets and client money, including requirements as to segregation, statutory trusts in respect of client money, and retrieving information in the event of insolvency. Firms are required to ensure adequate protection of client money when the firm is responsible for it (for example by holding it in different accounts from the firm’s own bank accounts, and by reconciling it at regular intervals). Firms must maintain a CASS resolution pack at all times. The purpose of the CASS resolution pack is to ensure that a firm maintains and is able to retrieve information that would, in the event of its insolvency, assist an insolvency practitioner in achieving a timely return of client money and safe custody assets to the firm’s clients.
P2P agreements which involve individual or relevant persons borrowers are subject to more stringent regulation under the new Consumer Credit sourcebook (“CONC”) which provides enhanced protections to borrowers. If the platform is captured by CONC, it must:
provide an adequate explanation of the key features of the credit agreement to enable borrowers to make an informed choice;
undertake an assessment of the creditworthiness of borrowers;
comply with the financial promotions rules – these rules include that a firm must ensure that a communication or a financial promotion is fair, clear and not misleading. A firm must also ensure that information does not disguise, diminish or obscure important items, statements or warnings;
allow the borrower 14 days to withdraw from the agreement; and
provide post-contract information where the borrower is in arrears or default.
Regulatory Position in Singapore
In June 2016, the Monetary Authority of Singapore (“MAS”) issued its Response to Feedback Received (“Response”) in relation to its consultation paper ‘Facilitating Securities-Based Crowdfunding’ (“Consultation Paper”) issued in February 2015.
In Singapore, any offer of securities is required to be made in or accompanied by a prospectus unless it qualifies for an exemption under Part XIII of the Securities and Futures Act (Cap. 289) (“SFA”). Further, intermediaries which deal in securities, such as a securities-based crowdfunding platform which facilitates securities offerings, are required to hold a Capital Markets Services (“CMS”) licence under the SFA, unless exempted. Intermediaries may also be deemed to be carrying on other regulated activities, such as advising on corporate finance under the SFA if they provide advice to the person making an offer of securities, or providing financial advisory services under the Financial Advisers Act (“FAA”) if the intermediary provides financial advice to investors on the securities.
Under the SFA, offerors can rely on various exemptions to the prospectus requirement, including:
Institutional Investors (“IIs”);
Accredited Investors (“AIs”) (an individual whose net personal assets exceed S$2 million; or whose income in the preceding 12 months is at least S$300,000);
Small Offers (personal offers of securities up to S$5 million within any 12 month period); and
Private Placements (offers of securities to no more than 50 persons within a 12 month period).
Thus, securities-based crowdfunding from non-AI/II investors, such as retail investors, may be carried out, albeit in a limited way, without the need to register a prospectus where they are able to rely on a prospectus exemption, such as the Small Offers or Private Placement exemptions.
MAS has taken the view that retail investors may have insufficient investment experience or expertise to fully appreciate the high risks in securities-based crowdfunding. For this reason, MAS has stated that that it does not have the intention to remove the current regulatory safeguards that apply where securities are offered to retail investors, whether with a prospectus or in reliance on existing prospectus exemptions.
Easing of financial requirements for dealing licensees
MAS proposed a relaxation of the current financial requirements for intermediaries that deal in securities (“Dealing Licensees”), including securities-based crowdfunding intermediaries, by lowering the base capital requirement from S$250,000 to S$50,000 and lowering the minimum operational risk requirement from S$100,000 to S$50,000, as well as removing the requirement to maintain a security deposit of $100,000 with MAS. These lower requirements apply if the Dealing Licensees only serve AIs and IIs, do not handle or hold customer moneys, assets or positions, and do not act as principal against customers. Dealing Licensees that deal with retail investors continue to be required to maintain a base capital of $500,000.
The Securities and Futures (Financial And Margin Requirements For Holders Of Capital Markets Services Licences) Regulation has been amended so that the base capital requirement applicable to a corporation to be granted a CMS licence in respect of dealing in securities is S$500,000 where the applicant (i) does not carry any customer’s positions in securities, margins or accounts in the applicant’s own books; (ii) deals in securities only with AIs or IIs; (iii) does not accept money or assets from any customer as settlement of, or as a margin for, or to guarantee or secure, any contract for the purchase or sale of securities by that customer; and (iv) does not enter into any transaction with any customer to deal in securities as principal.
The ‘Notice on Risk Based Capital Adequacy Requirements for Holders of Capital Markets Services Licences’ has been amended so that the minimum operation risk requirement for a CMS licence that deals in securities only with AIs or IIs and that does not enter into any transaction with any customer to deal in securities as principal is S$50,000.
The Securities and Futures (Licensing and Conduct of Business) Regulations has been amended so that the security deposit requirement is not required for an applicant that is a person which: (i) does not carry any customer’s positions in securities, margins or accounts in that person’s own books; (ii) deals in securities only with AIs or IIs; (iii) does not accept money or assets from any customer as settlement of, or as a margin for, or to guarantee or secure, any contract for the purchase or sale of securities by that customer; and (iv) does not enter into any transaction with any customer to deal in securities as principal.
Clarification on the Advertising Restriction
MAS clarified in its Consultation Paper and in the subsequent ‘Guidelines on the Advertising Restrictions in Sections 272A, 272B and 275’ the scope of the advertising restriction for exempted offers, namely the AI exemption, the Small Offers exemption and the Private Placement exemption.
An exempted offer is subject to the condition that it is not accompanied by an advertisement making an offer or calling attention to the offer (“Advertising Restriction”). Communication may only be made to qualified persons, and the content of such communication must only include factual information.
Publication of information on an offeror on an unrestricted access platform (platform on which information relating to offers is also accessible by persons who are not qualified persons) is considered a breach of the Advertising Restriction.
However, publication of information on an offer on a restricted access platform (platform on which information relating to offers is accessible only by qualified persons upon logging in with their unique identifier and passwords) that contains only factual information about offers and is provided only to the qualified persons, complies with the Advertising Restriction. Here, the platform operator must conduct due diligence to confirm that investors who have access to the platform are within the scope of the prospectus exemption, for example that the investor is an AI.
Nevertheless, the publishing of generic information on any unrestricted section of a restricted access platform so that the information is also accessible to non-qualified persons would not comply with the Advertising Restriction if such generic information draws attention to an offer.
MAS also clarified that the Advertising Restriction does not prohibit a securities-based crowdfunding platform operator from advertising the existence of its platform to the general public. Such advertisement may include general information about the platform and its services, so long as the advertisement does not include any information on specific offers that may be available on the platform.
Securities-based Crowdfunding from any investor – Small Offers exemption
To recap, companies may engage in securities-based crowdfunding without a prospectus by relying on the Small Offers exemption. This exemption was created in 2005 to reduce the compliance costs for companies that wish to raise a small amount of capital.
In 2016, in consequence of the consultation process regarding securities-based crowdfunding, MAS amended its ‘Guidelines on Personal Offers made pursuant to the Exemption for Small Offers’.
Firstly, MAS amended the investor pre-qualification procedures. A licensed securities-based crowdfunding platform operator and an offeror should have proper pre-qualification procedures in place to ensure that (a) investors who are offered the securities possess sufficient knowledge or experience to understand the risks of investing in the securities offered in reliance on the small offers exemption (“Knowledge or Experience Test”); or (b) the investment is suitable for the investor in light of the investor’s investment objectives and risk tolerance (“Suitability Assessment Test”).
This relaxes the previous guidelines where there was an assessment of the knowledge and experience of potential investors, and the suitability of securities-based crowdfunding investments for the investors by examining their investment objectives, risk tolerance and financial means.
MAS has also strengthened the existing risk disclosure requirements and introduced a prescribed risk disclosure statement, as part of the pre-qualification procedure. For every offer of securities made through an online crowdfunding platform, the platform must provide the prescribed general risk disclosure statement to investors, and require potential investors to acknowledge that they have read and understood the risk disclosure statement and are fully aware of and accepts the risks. The crowdfunding platform should, at least annually, provide the general risk disclosure statement and obtain an acknowledgement from the qualified investor of the risks.
In appointing a licensed securities-based crowdfunding platform operator to intermediate the offeror’s Small Offers, the offeror should ensure that the securities-based crowdfunding platform operator has in place proper procedures to adhere to the revised pre-qualification procedures and risk disclosure requirements.
A new investor class?
MAS, in its Response, stated that its approach is to regulate securities-based crowdfunding within its existing regulatory framework, and apply lower regulatory requirements based on the risks and characteristics of the business model (e.g. serving only AIs and IIs, and not handling clients’ monies). MAS considers it unnecessary to create a new investor class specifically for securities-based crowdfunding, as its current regulatory framework is already calibrated to accord differential treatment between retail and non-retail investors (i.e. AIs and IIs).
Corporate Track Record
In assessing corporate licence applications, where an applicant does not possess the prescribed minimum five years corporate track record requirement, MAS stated that it will consider alternative factors, such as the experience and track record of the shareholders and key officers of the applicant.
Handling, Holding or Acceptance of Customer Monies, Assets or Positions
Securities-based crowdfunding intermediaries that handle, hold or accept customer monies, assets or positions are required to comply with the existing financial requirements under the Securities and Futures (Financial and Margin Requirements for Holders of Capital Markets Services Licences) Regulations and relevant requirements on customer’s monies and assets under the Securities and Futures (Licensing and Conduct of Business) Regulations.
Fundraising from the public through lending-based crowdfunding, or P2P lending, is regulated by MAS under the SFA and the FAA. Under the SFA, any invitation to lend money to an entity is deemed an offer of debentures, which is a type of security. Therefore, the entity offering debentures is required to prepare and register a prospectus with MAS unless it falls within one of several prospectus exemptions previously discussed. In addition, the operator of a lending based platform may be required to hold a CMS licence and/or a FAA licence, as I have already discussed.
FSDC Possible Approaches to Equity Crowdfunding Regulation
While the UK and US have introduced specific legislation governing crowdfunding activities, Hong Kong has not yet followed suit. In March 2016, the Hong Kong government advisory body, the FSDC, in its paper “Introducing a Regulatory Framework for Equity Crowdfunding in Hong Kong” recommended regulatory changes to facilitate the development of a Hong Kong equity crowdfunding market, which it considered would be highly beneficial to Hong Kong’s small enterprises and start-ups. The FSDC’s paper proposes two possible approaches. Firstly, to enact substantial legislative amendments to specifically regulate crowdfunding; secondly, issuing an interpretation to bring crowdfunding within the scope of the existing regulation coupled with an exemption notice to take it outside the offering and marketing restrictions.
Legislative Changes to Facilitate Equity Crowdfunding
To recap, the core activity involved in equity crowdfunding is facilitating investors’ acceptance of offers to the public to purchase shares issued by a start-up company. This activity is managed through the crowdfunding platform or entity. Offers of securities to the public are subject to prospectus and registration requirements under Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”), while dealing in securities, advising on such deals and facilitating the contracting behind such dealing are all regulated activities requiring licensing under the SFO. Legislative amendment would therefore focus on CWUMPO and the SFO.
A specific exemption from the prospectus and registration requirements could be created expressly to address crowdfunding. This could be done by amending section 38B of the CWUMPO to insert an exception from the prospectus requirement for offerings made in a crowdfunding, as defined in the SFO. There would be a new section in the SFO dealing with crowdfunding, which would contain a detailed definition of the regulated activity and provide for the licensing of the crowdfunding platform. This new section would also set out the type of information that would need to be disclosed to investors, and impose restrictions on investment (such as a percentage of income limit). The aim would be to balance the lower disclosure requirements with the higher risks of investing in start-ups. This legislative provision could resemble Title III of the US JOBS Act, by regulating the platform, the disclosure of the offering and the exposure of an investor.
The advantage of amending legislation would be to create high legal certainty and allow a custom-designed regulatory framework governing crowdfunding. However, given the time it takes to enact legislative initiatives in Hong Kong, it is likely that this approach would further delay the introduction of crowdfunding in Hong Kong. Another issue which was noted in the FSDC paper, is whether the American model of regulatory intervention at the legislative level is appropriate for the regulatory style of the Hong Kong market.
Allowing Crowdfunding within the scope of Current Regulated Activities
This approach would require the SFC to firstly interpret crowdfunding as falling within one of the existing regulated activities under the SFO. It would also require the SFC to issue a conditioned exemption from the prospectus requirement of the CWUMPO. This condition could require the issuer to provide investors with disclosure equivalent to that required under Hong Kong company law for annual general meetings of listed companies. Another condition could be for the platform to receive undertakings from each investor that he or she will not invest above a certain threshold. This approach would allow the SFC to issue the class exemption and the interpretation of crowdfunding as a regulated activity in a single consultation with draft texts. No legislative change would be needed.
The Basic Framework
The FSDC paper considers three possible regulated activities within which crowdfunding could be included: (i) providing automated trading services (Type 7), (ii) dealing in securities (Type 1), or (iii) advising on corporate finance (Type 6). Currently, it is unclear which activity type crowdfunding falls within since platforms facilitate the forming of contracts for the transfer securities, investing in those same securities and often have revenue models that are comparable to underwriters (earning a percentage of the capital amount placed).
Generally, the requirements for licensing are derived from sections 114 to 116 of the SFO, and the applicable SFC rules and guidelines. If the ATS form is selected, the rules on electronic trading systems set out in Paragraph 18 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Code of Conduct”) and the rules on alternative liquidity pools (“ALPs”) set out in Paragraph 19 of the Code of Conduct will apply. Platforms would also be required to have adequate operational facilities ensuring secure provision of the regulated service, and would need to comply with the “fit and proper” requirements which apply to the entity and to its management.
The licensing of each of these activities additionally requires paid-up share capital of HK$5 million and liquid capital of HK$3 million, adequacy of staff and organization, and ongoing reporting. Licensed entities would be required to maintain full records and audit trails, provide users with adequate transparency, and in the case of ATS operations, participate in ongoing surveillance of operations in accordance with Hong Kong and international market practices.
The FSDC proposes that irrespective of the regulated activity or activities type(s) that crowdfunding would fall under, two requirements should be added to the SFC guidelines:
the platform should be required to receive an undertaking from each investor confirming that he/she understands the risks of the offering, has read the materials published by the issuer, and will not invest more than a certain amount; and
the platform should be required to provide materials, and if possible, seminars on investor and financial education.
A General Prospectus Exemption for Crowdfunding Offerings
If crowdfunding was subject to disclosure requirements of a full public offering, the regulatory costs would stultify the development of the market. The FSDC therefore believes that the SFC should exercise its power under section 38A(2) of the CWUMPO to create and publish general exemptions “for any class of prospectuses issued by companies”. To safeguard investors while reducing onerous regulatory requirements, the exemption should be made subject to conditions. For instance, it could apply to: (i) offerings of companies formed under the Hong Kong Companies Ordinance that provide potential investors with all reports and statements which would be required at an annual general meeting; or (ii) equivalent information for non-Hong Kong companies; and (iii) it would only be available to offers conducted through a licensed crowdfunding platform. If the conditions for the exemption are met, the offering could be covered by the exemption provided in section 103(3) of the SFO.
This proposal would not require substantive changes as Hong Kong company law already provides for a core set of disclosure documents that are sufficient without being too onerous. Transparency would be sufficient since shareholders would be provided with the following documents at every annual general meeting (irrespective of whether the company is listed or unlisted):
audited financial statements that have complied with Hong Kong accounting standards;
a directors’ report explaining:
the company’s principal activities during the financial year;
principal risks and uncertainties facing the company;
important events that have affected the company in the past year;
an indication of the company’s future development;
an analysis of the key performance indicators;
key relationships with employees, customers and suppliers;
information on arrangements enabling a director to acquire shares;
directors’ direct and indirect interests under significant transactions entered into by the company;
shares issued and equity-linked agreements entered into by the company;
reasons for any resignation of a director; and
a permitted provision indemnifying a director; and
an auditor’s report, which is expressly subject to criminal sanction for knowing or reckless omission of required content.
Given the above disclosures, the FSDC believes an exemption from issuing a prospectus in connection with a crowdfunding offering would not compromise the amount of disclosure available to investors, while it would allow crowdfunding to be provided at low cost with low risk.
An advantage of this suggestion is that it would encourage start-ups to incorporate in Hong Kong and thus base their operations, employ staff, pay registration fees, and employ legal and accounting expertise in Hong Kong, all of which would contribute to the Hong Kong economy.
To allow crowdfunding to operate efficiently and safely, Hong Kong should specify some form of investor eligibility approach. The FSDC believes that crowdfunding could subject ordinary retail investors to financial risk in a way that other forms of investment do not. As a result, rather than adopting the UK’s risk assessment approach, the FSDC proposes an investment limitation threshold(s) for investors, similar to the one prescribed in the US.
Prescribing an investment limitation threshold could adopt one of two approaches:
prescribe a single quantum percentage limit of, e.g., 10% of an investor’s annual income, or a standard measure including both annual income and net worth could be used for all new investments during the same period; or
numerical caps could be prescribed on the amount that an investor could invest into any one company and any number of companies during a specific period.
The enforcement of these limits could be either a condition of licensing for platforms, or be left to the investor to ensure compliance with its undertaking coupled with an ongoing licensing obligation on the platform to collect and document investors’ undertakings.
The FSDC has suggested that the limitation threshold and compliance with the threshold should be determined after public consultation or quantitative analysis.
The FSDC’s Conclusion
The options discussed in the FSDC paper were not intended to be an exhaustive list of regulatory strategies, but rather possible regulatory frameworks for encouraging the development of a Hong Kong equity crowdfunding market. The economic evidence suggests that such crowdfunding finance would be of significant benefit to small enterprises in Hong Kong.
Any regulatory changes would need to balance the need for investor protection against the importance of entrepreneurship and new forms of financial innovation. It is for this reason that the goal of Hong Kong should be to become a leading player in FinTech, and create an appropriate regulatory regime applying to crowdfunding.
It appears that policymakers and regulators in jurisdictions such as the UK and Singapore are mainly concerned with investor protection rather than facilitating the development of FinTech crowdfunding. Even under the US reforms, regulation is still onerous. In order for Hong Kong to become a FinTech hub, it should implement the FSDC’s regulatory proposals.
Note: The above information is for informational purposes only. Charltons is only qualified to advise on Hong Kong law. Charltons is not qualified to advise on the laws of the US, the UK and Singapore, and the above information is based on Charltons’ understanding of the position in this jurisdiction only. Specific advice should be sought from lawyers practising in these jurisdictions in relation to any specific situation.
1 International Organization of Securities Commissions (IOSCO), “Crowd-funding: An Infant Industry Growing Fast,” Staff Working Paper SWP3/2014 < https://www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf>.
2South China Morning Post, “Kickstarter crowdfunding platform launches in Hong Kong”, 31.8.2016 < http://www.scmp.com/lifestyle/article/2011156/kickstarter-crowdfunding-platform-launches-hong-kong>.
3FCA Policy Statement (PS14/14).