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Crowdfunding – the legal lowdown

What is Crowdfunding?

Crowdfunding is the practice of raising capital through numerous small investors. This is predominantly done online and the investment platform will rarely have a lower limit with many accepting as little as £10. In return the investor will receive either share equity and/or an “exclusive gift” which could be a ticket to a concert or a backstage pass where the investment vehicle is a band. The hosting platform generally takes around 5% commission.

There are 2 types of crowd fund:

  • All or nothing – A target is set for the required level of investment within a time limit and the funds are only released to the business or individual once the target has been reached. If the target is not reached then the investments are returned.
  • Keep it all – A target is set as above, but whether funds are returned or not is at the discretion of the individual or business.

FSA Position

At present the majority of websites offering crowd-funding service are not FSA authorised and as such provide little or no protection for the investor with no recourse to the Financial Ombudsman or the Compensation scheme. Recent guidance published by the FSA stated that crowd-funding should only be targeted at “sophisticated investors who know how to value a startup business, understand the risks involved and that investors could lose all of their money.” Consumer protection legislation states that only PLCs can promote or offer their shares for sale to the general public, all of which is heavily regulated by the FSA. In addition to this there are restrictions placed on carrying out a “regulated activity” such as arranging or advising on investments or offering the public securities without producing an approved prospectus. The UK regulation of collective investment schemes restricts the ability of crowd-funding platforms to use models based on a fund (as opposed to a corporate) structure.

The dangers of crowdfunding

The dangers to a naive investor or an unlucky hosting site remain high. Crowdfunding firms may be mixing client and investor money without FSA authorisation removing any protection for the investor as seen in the collapse of MF Global where the investors were left with a shortfall of $1.6billion. The FSA has yet to prosecute any site offering crowd-funding yet that does not mean it will not chose to do so in the future.

Seedrs

As of July 2012, Seedrs is the only crowdhosting platform authorised and regulated by the FSA, affording protection for investments of up to £85,000 should a regulated institution collapse.

Loopholes

Many other crowdfunding platforms are operating through legal loopholes, one such example is Crowdcube. When an investor signs up to Crowdcube’s website it becomes a “shareholder” without the standard rights. Crowdcube also takes shares in the companies looking to raise capital. Therefore when the investment “opportunities” are advertised they are targeted at the same group of existing shareholders. This is a legal promotion under FSA regulations.

Another loophole allows potential investors to buy a share in the hosting site and in doing so not only acknowledge the investment is not FSA regulated but also take responsibility for due diligence.

The practice of crowd-funding has grown over the past few years both in number of platforms and investment vehicles yet it has never been challenged by the FSA. However, any money laundering, fraud or a high profile collapsed venture could change the current relaxed attitude to these practices.

One of the key foundations of the FSA is the protection of the investor, yet the existence and use of unregulated crowdfunding sites seems to undermine this.

The Future

The current economic pressures and reluctance of banks to invest in potentially risky ventures have made crowd-funding a popular option amongst many who see it as a good way to stimulate growth and kick-start the economy. It remains to be seen whether legislation in the UK will legitimise crowd-funding, forcing Companies to take the Seedrs line or follow the US JOBs Act and deregulate passing responsibility to individual investors.

For more information, please contact Simon Halberstam.