In early 2015, when the first crowdfunding platforms in Latvia, Mintos and Twino, started operating, the Latvian financial environment also became more familiar with the fast-growing worldwide FinTech industry – crowdfunding – that brings together the interests of investors and projects needing financing through crowdfunding platforms.
The aim of providing collective financing or crowdfunding services is to facilitate the financing of a project by raising capital from a large number of people, each of whom invests relatively small amounts through a publicly available Internet-based information system. Crowdfunding services are thus available to an unlimited number of investors, including those who do not have a large amount of assets to invest in or experience in investing.
To date, crowdfunding platforms have adapted their operation to different legal frameworks in different countries. The lack of uniform crowdfunding rules across the European Union created legal uncertainty and prevented crowdfunding platforms from offering cross-border services. Differences in EU legislation and its interpretation have hampered the cross-border development of platforms, which is particularly important in the case of FinTech services. Platforms intending to expand internationally throughout the European Union have so far had to invest significant resources in launching them in each Member State individually. In addition, more often than not, after reviewing the legal framework of one country, the platforms decided not to operate in such a country at all. Therefore, until now, crowdfunding services have been limited to certain countries and have not been able to develop in the European Union’s single market.
With a view to facilitating cross-border financing for businesses, on 5 October 2020, the European Parliament approved a new Regulation on European crowdfunding service providers for business. In future, platforms operating in more than one Member State will be able to organize their activities according to uniform rules – they will no longer have to comply with national rules. The new framework aims to eliminate the fragmentation of the legal framework for crowdfunding and to foster cross-border funding of businesses, while improving investor protection and the efficiency of the single market. It is important to note that not all issues are made uniform with the new Regulation and that platforms still have to take into account the specificities of each country, for example in such areas as taxation.
As a result of the new Regulation, the crowdfunding will hopefully become more accessible to small and medium-sized enterprises, which still find it relatively difficult to obtain funding from traditional sources. In addition, attracting funding through platforms will also be a valuable opportunity to test your business idea – whether it will gain the support of investors and thus be successful. In addition, by using the opportunities offered by the platform, business operators will be able to access a wide range of people (crowd), which will be useful in the development of later marketing activities.
Comparing the new Regulation with the draft Law on Crowdfunding developed in Latvia, the progress of which was suspended due to the drafting of the Regulation, it can be concluded that the single European Union Regulation for platforms is much friendlier and provides milder requirements than the original Latvian intention. This leads to the conclusion that with regard to the crowdfunding sector as a new FinTech trend, the Regulation envisaged by Latvia was too strict, which, if adopted, would not allow this sector to successfully develop and form its unicorns.
Issues to be covered by the NEW REGULATION
One of the most important criteria of the new Regulation, which allows platforms to carry out their activities in accordance with the Regulation, is the amount of funding. In order for the platforms to be able to operate under the new Regulation, such platforms can raise a maximum of EUR 5 million per project per year. This is the threshold used by most European Union Member States to exempt offers of securities to the public from the obligation to publish a prospectus.
The Regulation aims to foster cross-border funding of businesses in particular, so it does not apply to consumers who need financing, such as the purchase of a new home, repairs or major purchase. At the same time, the Regulation applies to individuals and legal entities wishing to attract crowdfunding for business projects. Taking into account the above, it will still not be possible to create a crowdfunding platform in Latvia, through which consumers who want to borrow can be brought together with investors who want to lend, because consumer lending requires a special permit (licence) issued by the CRPC, which had to be obtained by each investor in such a case.
The new Regulation applies to both loans and investments. Accordingly, the platform will allow investors to either lend their money in the form of a loan or invest in transferable securities. In view of the definition of a loan in the Regulation, it must be concluded that the new rules do not apply to interest-free loans, including loans which, for tax or other reasons, are not subject to interest for the use of funds but provide for other charges (e.g. loan servicing fees), because the Regulation stipulates that a loan is a transaction under which the loan is repayable together with the accrued interest. However, the author of this article doubts whether the aim of the legislator was to exclude from the scope of the Regulation loans for the use of which no interest is provided, while other payments are due, therefore this issue needs further clarification.
The loan-based crowdfunding provided for in the new Regulation does not include the so-called assignment or notary model, on the basis of which all the largest platforms in Latvia have been operating so far. The Regulation makes it clear that the platform only facilitates the conclusion of loan agreements between investors and project owners and does not at any time act as a creditor to the project owner. Accordingly, if a platform wishes to initially issue a loan to the project owner and, after issuing it, to offer the claims arising from such a loan to investors, then the question is whether such a platform does not meet the characteristics of a credit institution or investment firm, in which case a special licence would be required for the provision of such services. The same would apply if, through the platform, third parties offered investors to purchase the loans they had originally granted by their assignment.
When assessing the possibilities offered by the new framework for raising funds directly in the form of investments, it is still necessary to take into account the national regulations applicable to transferable securities (including shares and stocks), as they are not affected by the new Regulation. Consequently, the design of platforms through which companies seek to raise funding in return for their shares, stocks or other transferable securities must take into account various practical and legal constraints that may complicate the transfer of those securities, as the personal presence of investors or the involvement of a notary is too cumbersome in crowdfunding.
The Regulation does not apply to initial coin offerings (ICOs) as their characteristics are significantly different from crowdfunding services. On the other hand, with regard to the existence of filtering tools, the Regulation clarifies that such filtering tools should not be regarded as investment advice as long as those tools provide information to clients in a neutral manner (namely, they display results based on criteria relating to purely objective project characteristics, e.g. , economic sector, the instrument used, interest rate, or the risk category, key financial figures, etc.). Therefore, the use of such filtering tools on the platform does not require a licence for provision of investment services.
Key provisions of the new framework
During the discussion on the draft Regulation, a number of supervisory models were proposed, including the proposal to determine that ESMA (European Securities and Markets Authority) is the central authority that will authorize all crowdfunding platforms in the Member States of the European Union. However, the adopted Regulation has decided to entrust the authorisation and supervision of the platforms to the competent authority of each Member State, while maintaining close cooperation with ESMA. In addition, ESMA is tasked with setting up a dedicated register where anyone will have access to a wide range of information on all crowdfunding platforms in the European Union that have been authorised under the new Regulation.
The new framework clarifies one of the key issues that has so far been regulated and interpreted differently in different Member States, namely whether the acceptance of funds from investors and the creation of virtual accounts are subject to the regulation of payment services. The Regulation clearly states that the authorisation to provide crowdfunding services does not equate to an authorisation also to provide payment services. Where a platform provides such payment services (for example, offers to set up a virtual account), such platform must either obtain a payment institution licence or cooperate with a third party that has obtained such a licence. It should be noted that if the platform decides to cooperate with a third party payment institution, then the platform is likely to be registered as an agent of the payment institution.
As in the case of investment funds and alternative investment funds, the Regulation distinguishes between sophisticated and non-sophisticated investors and introduces different levels of investor protection measures that are appropriate for each of these categories. For example, in the case of non-sophisticated investors, the platform must run an entry knowledge test of prospective non-sophisticated investors, which requires different types of information from the investor and requires prospective non-sophisticated investors to simulate their ability to bear loss, calculated as 10 % of their net worth. The solution of the new Regulation in case the investor does not provide such information or the platform considers that the investor’s knowledge, skills and experience are insufficient is more lenient than the solution provided in the draft law developed in Latvia, as the Regulation stipulates that in this case the platform informs the prospective non-sophisticated investor that the services offered on the crowdfunding platform may be inappropriate for him and issues him a risk warning, while the prospective non-sophisticated investor has to expressly acknowledge that he has received and understood the warning. The Latvian draft law banned the platform from providing services to such an investor at all.
In addition to the foregoing, each time before a non-sophisticated investor makes a new investment in excess of EUR 1000 or 5% of the net worth of such investor calculated in the above simulation, the platform must ensure that such investor receives a risk warning, provides explicit consent to the platform and proves to the platform that the investor understands the investment and its risks.
Another notable innovation for the protection of non-sophisticated investors, which bears similarities to the consumer’s right of withdrawal in the case of a distance contract, is the reflection period. During this period, the investor may withdraw his investment without giving a reason and without penalty. The reflection period is 4 days from the day the investor makes an offer to invest or expresses interest.
As we can learn from the negative experiences of investors in such platforms as Keutzel, Evnestio, Monethera, WiseFund and Grupeer, the information about the projects offered on the platforms must be reliable, sufficient and clear. The Regulation stipulates that in future platforms have to undertake due diligence of project owners and provide investors with a key investment information sheet, which, unlike a prospectus, does not have to be approved by the competent authority.
Platforms wishing to provide cross-border services under the Regulation will need to develop business continuity plans to ensure that critical functions related to existing investments are not interrupted and contracts between the platform and its customers are properly managed in the event of termination of operation of the platform. One example is the creation and maintenance of the contingency fund. In addition, platforms will need to put in place measures to prevent conflicts of interest, including ensuring that the platforms do not participate in any project on their own platform, nor do they accept projects from related parties. At the same time, related parties are not prevented from investing through platforms, provided that it is ensured that they are subject to the same rules as any other investor. In addition, in such a case, the platform must disclose information about the acceptance of investments from related parties. In turn, platforms that provide the facilitation of granting of loans should make available to all clients default rates of loans over at least the preceding 36 months, as well as publish the expected and actual default rate of all loans on a quarterly basis.
As with other regulated market participants, crowdfunding platforms will need to provide prudential safeguards in the form of own funds, insurance policies or a combination of both. Platforms must, at all times, have in place at least EUR 25,000 or 1/4 of the platform’s expenditure in the previous year. If the platform carry out payment transactions related to transferable securities, then the platform must use the services of a custodian bank.
The Regulation facilitates the provision of cross-border services, which is of particular importance in the case of crowdfunding platforms. To do this, the platform will have to provide the competent authority with a list of Member States where it intends to provide crowdfunding services. In turn, the competent authority will inform the competent authorities of such other Member States accordingly and this will be included in the register kept by ESMA. The Regulation prohibits Member States from requiring the physical presence (office) of platforms in the territory of a Member State other than the Member State in which the platform is authorised.
Crowdfunding investments are not covered by the deposit guarantee scheme and the investor compensation scheme.
The new rules will apply to European crowdfunding service providers from 10 November 2021. Until then, ESMA and EBA (European Banking Authority) will develop regulatory technical standards with regard to individual portfolio management of loans, complaints handling, conflicts of interest, authorisation as crowdfunding service provider, information to clients, default rate disclosure, the entry knowledge test and simulation of the ability to bear loss, the key investment information sheet and cooperation between competent authorities that will facilitate the consistent application of the Regulation in all Member States.