Crowdfunding is the collective effort of individuals, usually through the internet, to fund the activities of other people and organizations. When it takes the form of donations or prepayment for goods or services (e.g., a philanthropic endeavour, or a book, or a music recording, or a movie) it does not come under the jurisdiction of securities laws. However, if it constitutes an investment contract (i.e., there is an exchange of money with an expectation of profit from an enterprise that depends solely on the efforts of others), it is considered a security, and as such, it needs to be registered with a local securities regulator unless it qualifies for a local exemption. Crowdfunding investments can take the form of debt or equity and are usually supported by an organization or funding portal that brings together the project initiator and the “crowd.”

The internet’s ability to bring vast numbers of people rapidly into contact with each other is a marvel of our modern age, and its potential applications have yet to be fully exploited. One of the latest forms of social/economic interactions spawned by the internet is a controversial phenomenon called crowdfunding, whereby companies or not-for-profits raise money from large groups of people online. While it is often used for charitable donations, its application to equity investment is more controversial and is not yet permitted in Canada. The question facing regulators and other industry professionals is whether crowdfunding is an innovative start-up financing technique or an unconscionable retreat from a century of progressive investor protection.

CFA Society Toronto recently hosted a luncheon seminar at which expert speakers addressed a range of views on this topic. Speaking at the event were James Turner, vice-chair of the Ontario Securities Commission (OSC); Craig Asano, founder and executive director of the National Crowdfunding Association of Canada; Brian Koscak, partner at Cassels Brock and Blackwell LLP and chairman of the Exempt Market Dealers Association of Canada; Marian Passmore, associate director of the Canadian Foundation for the Advancement of Investor Rights; and Douglas Cumming, professor of finance and entrepreneurship and the Ontario Research Chair at the Schulich School of Business.

Crowdfunding of investments received a boost in April 2012 when U.S. president Barack Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), which gave the U.S. Securities and Exchange Commission (SEC) 270 days to set forth specific rules and guidelines for crowdfunding while also protecting investors. After some delay, the SEC has proposed rules that would require funding portals to register with the SEC as well as with an applicable self-regulatory organization. Investors with an annual income of less than US$100,000 would be subject to an investment limit of US$2,000 or five percent of their annual net income or net worth, whichever is greater. Investors with an annual income greater than US$100,000 would be subject to a limit of 10 percent of their annual income or net worth, whichever is greater. Investors would be prohibited from purchasing more than US$100,000 of securities through a crowdfunding offering in one year. Also, investors would not be able to resell securities purchased through crowdfunding for a one-year period. Under the proposed rules, issuers would be limited to raising US$1 million through crowdfunding in any one-year period.

U.S. companies taking advantage of crowdfunding would be required to file certain information with the SEC and also provide it to potential investors and crowdfunding portals. These disclosures would require information about:

• officers, directors, and owners of 20 percent or more of the company;
• the company’s business, and how the company is going to use the funds raised;
• the price of securities being offered;
• the target offering amount and the deadline to reach that amount, and whether the company will accept investments in excess of that amount;
• the company’s financial condition; and
• the company’s financial statements, which must be audited if the company is seeking to raise more than $500,000.

In its examination of crowdfunding, the OSC has stated that it has a responsibility to consider whether Ontario’s regulatory framework supports efficient capital formation and contributes to its economic growth. At the same time, no doubt, the OSC is mindful of the actions of the SEC and other securities regulators. The commission has announced that in the first quarter of 2014, it intends to publish a proposed crowdfunding exemption together with a registration framework for online funding portals, among other new capital raising prospectus exemptions, for a 90-day public comment period.

The OSC previously published OSC Notice 45-712 Progress Report on Review of Prospectus Exemptions to Facilitate Capital Raising, which set out the next steps in its exempt market review and consideration of these possible new prospectus exemptions. The objective of this work is to facilitate capital raising for start-ups and small- and medium-sized enterprises and to modernize Ontario’s exempt market regulatory regime.

The National Crowdfunding Association believes that the potential for raising equity for start-up enterprises through crowdfunding is potentially both very large and very important in providing capital for small businesses. It believes that equity crowdfunding would democratize access to investment opportunities previously available only to large sophisticated investors. While acknowledging the need to protect investors from fraud and incompetence, the association also emphasizes the benefits of funding a new wave of start-up businesses.

However, FAIR Canada uses the analogy of the Titanic heading into iceberg alley to describe the deregulation of securities laws to allow anyone to make investments via crowdfunding. It states that it abandons fundamental principles that have made Canadian capital markets among the most successful at raising capital, including full disclosure, due diligence, insider regulation, and the role of professional advisors. FAIR Canada believes that by participating in crowdfunding, investors would be gambling with high-risk speculative investments where returns are unlikely and the probability of total loss of capital is extremely high.

Alarmingly, an OSC-commissioned survey has revealed that 45 percent of people interested in crowdfunding thought it was a medium-risk area, and 12 percent of people who described themselves as having low risk tolerance were strongly interested in crowdfunding. Proponents of crowdfunding believe the crowd will be able to detect fraud and weed out bad entrepreneurs, but FAIR Canada points out that experience and research clearly demonstrate that this is not the case and that investors fall victim to fraud at an alarming rate.

All the speakers at the luncheon seminar agreed with the observation of Brian Koscak, chairman of the Exempt Market Dealers Association, that the regulation and the performance of crowdfunding portals will be critical to the results of crowdfunding as a form of start-up financing. Crowdfunding combines the ease of new technology with the promise of lottery-sized winnings but with extremely limited financial disclosure and no protection or assurances as to the integrity of the system of raising and investing funds and reporting to investors, despite the integrity and good motives of those currently involved in the debate. Crowdfunding is an area where securities laws and technology find themselves moving in opposite directions.

Should securities laws be changed to accommodate the freedom desired by many internet users? Or is crowdfunding an example of technological determinism at work, as the social media that facilitate crowdfunding distract us from the historic goals of securities regulation and investor protection? Are we being confused into thinking that because new technologies enable money to be readily raised from the masses, it is somehow less important to protect the smallest and least sophisticated investors whose losses would be the most painful?

Some attendees at the Society’s luncheon seminar cited the poor performance of labour-sponsored investment funds in Ontario (a venture financing vehicle carrying considerably less risk than crowdfunding) and asked why we have not learned from this experience.

Investment professionals might also ask if we would be considering crowdfunding as an exempt form of financing were it not for the communications-enhancing device of the internet. The advent of technologies like telegraph, telephone, radio, and television did not lead to any relaxation of securities laws. So we should ask ourselves if the growing importance of the internet is a valid reason for reducing the protection accorded the most vulnerable class of investors in this extremely high-risk area. Of all the questions about crowdfunding, this is arguably the most important in this debate. For many prudent investment professionals, the answer appears only too clear.