MFSA Issues Discussion Paper on Investment-based Crowdfunding
With access to finance becoming more difficult for start-ups and small businesses, the evolution of crowdfunding is becoming an emerging alternative funding source for project owners seeking starting capital.
Crowdfunding is a means of raising finance from ‘the crowd’, often by means of a platform through which project owners ‘pitch’ their project or idea to potential investors who, in turn, contribute funds for a financial return or otherwise. The crowdfunding platform intermediates in the crowdfunding transaction by providing a mechanism for projects to find investors and investors to find projects.
There are different models of crowdfunding, depending on the instrument used to contribute to the funds. Typically, investors in a crowdfunding transaction provide capital in return for a financial return or a right to participate in a share of the profits of the project. However, another emerging alternative is ‘investment-based crowdfunding’: a mechanism that provides investors with equity or debt instrument in return for their contribution in startup companies and small businesses.
An ‘investment-based crowdfunding’ transaction typically involves at least three parties: the project owner who sets up a crowdfunding campaign to access finance; the platform which acts as an intermediary between the project owners and the investor; and the investors who fund the project and who, in return, receive ownership of a small piece of that project or business. Once the target investment amount is reached, the funds are transferred to the project owner in return for the ownership of the security.
Investment-based crowdfunding can potentially be beneficial to the Maltese economy as it provides an alternative form of financing for unlisted companies, start-ups and SMEs. However, given the high risks that are inherent in crowdfunding platforms and investments – such as loss of capital, lack of liquidity, fraud, platform closure or failure, limited information, and potential conflicts of interest – the need for a regulatory framework has grown.
EU financial services rules were not designed with crowdfunding in mind and despite the European Securities Markets Authority expressing concern that crowdfunding platforms are incentivised to operate in a way that they fall outside existing regulatory frameworks, a recent Working Document on crowdfunding issued by the European Commission on the 3rd of May 2016  ruled out any action at EU level in the near future and said there is no case for EU wide policy intervention.
In view of this, on the 3rd of November 2016, the Malta Financial Services Authority (MFSA) issued a working document with the aim of enacting a framework for the regulation of investment-based crowdfunding in Malta. The approach chosen by the MFSA is to apply the current general securities regulatory framework applicable to investment services providers, with the addition of some ad hoc investment protection measures.
In terms of the proposed regulatory framework, both the corporate issuers and platform operators would be required to be limited liability companies formed and registered in Malta. Since investment-based crowdfunding contributors purchase financial instruments, the intermediary role played by the platform could be deemed to be falling within the scope of the investment services activity of reception and transmission of orders. As a result, since this constitutes a licensable activity under the Investment Services Act (‘the Act’), the platform operator would require a Category 1A licence.
In terms of the applicable laws and regulations, a category 1A licence holder is required to have the initial capital requirement of €50,000 and is authorized to receive and transmit orders in relation to one or more instruments, provide investment advice, and also place instruments without a firm commitment.
Notwithstanding the above, however, the MFSA is proposing to restrict the category 1A licence when provided to an investment-based crowdfunding platform in order to restrict the platforms’ provision of investment advice. The MFSA provides that since platforms do not usually market themselves as providing personalized recommendations on investments, the platforms should restrict their involvement to only customer due diligence checks. Investors should be encouraged to make their own well informed investment choices.
A licensed Maltese investment-based crowdfunding platform would need to have its registered office and head office in Malta, and it would fall within the ambit of the Markets in Financial Instruments Directive (MiFID). This would grant the platform passporting rights to market its activities within the EU. It would also be subject to the licence conditions applicable investment services licence holders qualifying as MiFID Firms, and be subject to several conduct of business requirements. The platform operator would be required to provide appropriate information in a comprehensible form to its clients or potential clients such that they are reasonably able to understand the nature and risks of the investment service to be provided and the type of instrument being offered, and consequently to take investment decisions on an informed basis.
The platform must also assess the appropriateness of the instrument for the client, unless a number of conditions are satisfied. Moreover, since a web-based crowdfunding platform offers its services to individuals from different member states, it may therefore need to abide to the legislation related to consumer protection in the context of consumer contracts.
In an effort to further mitigate the risks posed by investment-based crowdfunding, the MFSA is also proposing the introduction of several other investment protection measures over and above the authorization and conduct of business requirements applicable to investment service providers. These include:
- A cap on the maximum funds that an individual investor or potential investor may contribute to the project or idea of the project owners;
- A cap of maximum project size;
- Requirements for platforms to conduct minimum due diligence tests on the projects/project owners and to take measures to reduce the risk of fraud;
- Specific disclosure requirements tailored to crowdfunding even where the offer would the application of an exemption to the general prospectus requirements. Such key information document would include prominent risk warnings.
The MFSA is seeking initial feedback from the industry before deciding whether to go forward with its proposals for a legal framework on investment-based crowdfunding. Any comments and feedback should reach the MFSA by 31st January 2017.
Dr. Kurt Hyzler
 Commission Staff Working Document on “Crowdfunding in the EU Capital Markets Union,” issued on the 3rd of May 2016
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